**Exhibit 13**

 

**FINANCIAL REVIEW**

**Avaya Inc. and Subsidiaries**

 

**Table of Contents**

 
| **Selected Financial Data**                                                                             |   |
|---------------------------------------------------------------------------------------------------------|--------|
| **Management’s Discussion and Analysis  of Financial Condition and Results of Operations**         |   |
| **Management’s  Report on Internal Control Over Financial Reporting**                              |   |
| **Report of  Independent Registered Public Accounting Firm**                                            |   |
| **Consolidated  Statements of Operations**                                                              |   |
| **Consolidated  Balance Sheets**                                                                        |   |
| **Consolidated  Statements of Changes in Stockholders’ Equity and of Comprehensive Income (Loss)** |   |
| **Consolidated  Statements of Cash Flows**                                                              |   |
| **Notes to  Consolidated Financial Statements**                                                         |   |

 

**SELECTED FINANCIAL DATA**

 

The following table sets forth selected financial information derivedfrom our audited consolidated financial statements as of and for the fiscalyears ended September 30, 2005, 2004, 2003, 2002 and 2001.  The selected financial information for allperiods should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” and theConsolidated Financial Statements and the notes included elsewhere in thisAnnual Report.

 

The following items affect the comparability of the selected financialinformation for the years presented:

 

•                  During the fourth quarter offiscal 2005, we recorded a $590 million net tax benefit related to the reversalof a portion of our deferred tax valuation allowance.

 

•                  During fiscal 2005, we repaid asubstantial portion of our debt, including all of the outstanding LYONs, all ofthe secured floating rate notes associated with our Tenovis acquisition, andmost of our senior notes.  Our debtbalance decreased from $593 million as of September 30, 2004 to $30million as of September 30, 2005.

 

•                  Duringfiscal 2005, we repurchased and retired 11,525,000 shares of our common stockin accordance with the share repurchase plan authorized by the Board ofDirectors on April 19, 2005.

 

•                  On September 16, 2005, weacquired all of the issued share capital of Nimcat Networks Incorporated, a leading developerof embedded peer-to-peer IP call processing software headquartered in Canada.  We paid $38 million in cash, net of cashreceived.  Nimcat results have beenconsolidated as of September 16, 2005.

 

•                  On November 18, 2004, we acquiredall of the issued share capital of Tenovis Germany GmbH, a major Europeanprovider of enterprise communications systems and services.  We paid $265 million in cash, includingtransaction fees and net of cash received, and assumed $287 million in debt.  Tenovis results have been consolidated as of November 18,2004.  The acquisition of Tenovisresulted in a significant increase to our consolidated revenues andexpenses.  The pro forma impact on fiscal2005 and 2004 of the Tenovis acquisition is included in the accompanying notesto the Consolidated Financial Statements.

 

•                  On October 4, 2004, weacquired all of the issued share capital of Spectel plc, a leading provider ofaudio conferencing solutions incorporated in Ireland.  We paid $110 million in cash, includingtransaction fees and net of cash received. Results of Spectel are included in our Consolidated Financial Statementsbeginning on October 4, 2004.

 

•                  On August 4, 2004, we paid$24 million in cash to increase our ownership in Tata Telecom Ltd., a leadingvoice communications solution provider in India, from 25.5% to 59.1%.  This was accomplished through the acquisitionof 25.1% of the issued share capital of Tata Telecom from the Tata Group, andan additional 8.5% through a public tender offer conducted pursuant tostatutory requirements in India.  As aresult of acquiring a majority interest, the Tata Telecom results have beenconsolidated as of August 4, 2004. Tata Telecom has been renamed Avaya GlobalConnect Limited.

 

•                  InJanuary 2004, we sold certain assets and liabilities of our ConnectivitySolutions segment to CommScope, Inc. Accordingly, the statement of operations and balance sheet informationreflects the results of the disposal group as 

 

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discontinued operations for all periodspresented.

 

•                  OnNovember 25, 2003, we acquired substantially all of the assets and assumedcertain liabilities of Expanets for a purchase price of $117 million.  Upon the closing, we decided to sell a portionof the Expanets business that previously distributed other vendors’ productsand accounted for this portion of the business as a component of discontinuedoperations.   This portion was sold in aseries of transactions during December 2003 and January 2004.

 

•                  Commencingin fiscal 2002, we discontinued amortization of goodwill upon adoption of SFAS142 “Goodwill and Other Intangible Assets.”

 

•                  In October 2000,we sold to Warburg Pincus Equity Partners, L.P. and certain affiliatedinvestment funds four million shares of our Series B convertibleparticipating preferred stock and warrants to purchase our common stock for$400 million. In March 2002, all shares of the Series Bpreferred stock were converted into approximately 38 million shares of ourcommon stock, warrants for 286,682 shares of our common stock were exercised,and we sold an additional 14,383,953 shares of our common stock. The conversionof the Series B preferred stock and the exercise of warrants resulted in acharge to accumulated deficit of $125 million, which was included in thecalculation of net loss for fiscal 2002.

 

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**Statement of Operations Information**

 
| ** **                                                            | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions, except per share amounts**                     | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                                  |       |                              |       |   |   |   |   |   |   |   |   |
| Revenue                                                               |       | $                                 | 4,902      |   | $ | 4,069 |   | $ | 3,796 |   | $ | 4,387 |   | $ | 5,473 |   |
| Gross margin                                                          |       | 2,297                             |       | 1,945 |   | 1,639 |   | 1,864 |   | 2,359 |   |
| Gross margin  as a percent of revenue                                 |       | 46.9                              | %          | 47.8 | % | 43.2 | % | 42.5 | % | 43.1 | % |
| Selling,  general and administrative expenses                         |       | 1,583                             |       | 1,274 |   | 1,240 |   | 1,502 |   | 1,921 |   |
| Selling,  general and administrative expenses as a percent of revenue |       | 32.3                              | %          | 31.3 | % | 32.7 | % | 34.2 | % | 35.1 | % |
| Research and  development expenses                                    |       | 394                               |       | 348 |   | 336 |   | 436 |   | 536 |   |
| Research and  development expenses as a percent of revenue            |       | 8.0                               | %          | 8.6 | % | 8.9 | % | 9.9 | % | 9.8 | % |
| Restructuring  charges                                                |       | 22                                |       | — |   | — |   | 209 |   | 837 |   |
| Operating  income (loss)                                              |       | 298                               |       | 323 |   | 63 |   | (354 | ) | (967 | ) |
| (Benefit  from) provision for income taxes                            |       | (676                              | )          | (49 | ) | 84 |   | 273 |   | (373 | ) |
| Income  (loss) from continuing operations                             |       | 923                               |       | 291 |   | (128 | ) | (677 | ) | (600 | ) |
| (Loss)  income from discontinued operations                           |       | (2                                | )          | 5 |   | 40 |   | 11 |   | 248 |   |
| Net income  (loss)                                                    |       | $                                 | 921        |   | $ | 296 |   | $ | (88 | ) | $ | (666 | ) | $ | (352 | ) |
|                                                                  |       |                              |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per common share - basic:                            |       |                              |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share from continuing operations                 |       | $                                 | 1.95       |   | $ | 0.66 |   | $ | (0.34 | ) | $ | (2.47 | ) | $ | (2.20 | ) |
| Earnings per  share from discontinued operations                      |       | —                            |       | 0.01 |   | 0.11 |   | 0.03 |   | 0.87 |   |
| Earnings  (loss) per share                                            |       | $                                 | 1.95       |   | $ | 0.67 |   | $ | (0.23 | ) | $ | (2.44 | ) | $ | (1.33 | ) |
|                                                                  |       |                              |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per common share - diluted:                          |       |                              |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share from continuing operations                 |       | $                                 | 1.89       |   | $ | 0.63 |   | $ | (0.34 | ) | $ | (2.47 | ) | $ | (2.20 | ) |
| Earnings per  share from discontinued operations                      |       | —                            |       | 0.01 |   | 0.11 |   | 0.03 |   | 0.87 |   |
| Earnings  (loss) per share                                            |       | $                                 | 1.89       |   | $ | 0.64 |   | $ | (0.23 | ) | $ | (2.44 | ) | $ | (1.33 | ) |

 

**Balance Sheet Information**

 
| ** **                                               | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|
| **Dollars in millions**                                  | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Total assets                                             |       | $                      | 5,219      |   | $ | 4,159 |   | $ | 4,057 |   | $ | 3,897 |   | $ | 4,648 |   |
| Cash and  cash equivalents                               |       | 750                    |       | 1,617 |   | 1,192 |   | 597 |   | 250 |   |
| Goodwill                                                 |       | 914                    |       | 257 |   | 146 |   | 144 |   | 175 |   |
| Total debt                                               |       | 30                     |       | 593 |   | 953 |   | 933 |   | 645 |   |
| Series B  convertible participating preferred stock |       | —                 |       | — |   | — |   | — |   | 395 |   |
| Total  stockholders’ equity                         |       | 1,961                  |       | 794 |   | 200 |   | — |   | 481 |   |
|                                                          |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Other Information**

 
| ** **                                                    | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|
| **Dollars in millions**                                       | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net cash  (debt) (1)                                          |       | $                      | 720        |   | $ | 1,024 |   | $ | 239 |   | $ | (336 | ) | $ | (395 | ) |
| Cash flow  from operating activities of continuing operations |       | 334                    |       | 479 |   | 169 |   | 86 |   | (655 | ) |
| Capital  expenditures                                         |       | (147                   | )          | (81 | ) | (57 | ) | (104 | ) | (315 | ) |
| Number of  employees (2)                                      |       | 19,100                 |       | 14,900 |   | 16,900 |   | 18,800 |   | 23,000 |   |
|                                                               |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Weuse net cash (debt) as an indicator of our balance sheet position relative toour future cash needs.  In addition, webelieve that the presentation of net cash provides useful information toinvestors about our liquidity.  Thefollowing table provides the reconciliation of this measure to the mostdirectly comparable GAAP measure:

 
| ** **                | ** ** | **September 30,** | ** ** |
|---------------------------|------------|------------------------|------------|
| **Dollars in millions**   | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash and cash equivalents |       | $                      | 750        |   | $ | 1,617 |   | $ | 1,192 |   | $ | 597 |   | $ | 250 |   |
| Total debt                |       | 30                     |       | 593 |   | 953 |   | 933 |   | 645 |   |
| Net cash (debt)           |       | $                      | 720        |   | $ | 1,024 |   | $ | 239 |   | $ | (336 | ) | $ | (395 | ) |

 

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(2) Numberof employees as of September 30, 2005 includes 4,800 employees acquiredwith Tenovis.  Amounts exclude 550 AGCemployeees. For fiscal years 2003 and prior, employee numbers include employeesof Connectivity Solutions.

 

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**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 
| Overview                                                             | 4  |
|----------------------------------------------------------------------|----|
| Key Trends and Uncertainties Affecting Our  Results                  | 6  |
| Operating Segments                                                   | 8  |
| Acquisitions and Divestitures                                        | 8  |
| Restructuring Programs                                               | 9  |
| Outsourcing of Certain Manufacturing  Operations                     | 9  |
| Results from Continuing Operations                                   | 10 |
| Segment Results                                                      | 13 |
| Results of Discontinued Operations                                   | 19 |
| Liquidity and Capital Resources                                      | 20 |
| Guarantees of Indebtedness and Other  Off-Balance Sheet Arrangements | 26 |
| Legal Proceedings and Environmental, Health  and Safety Matters      | 26 |
| Financial Instruments                                                | 26 |
| Recent Accounting Pronouncements                                     | 26 |
| Recent Tax Legislation                                               | 28 |
| The Application of Critical Accounting  Policies                     | 28 |

 

“Management’s Discussion and Analysis of Financial Condition andResults of Operations” should be read in conjunction with the ConsolidatedFinancial Statements and the notes included elsewhere in this Annual Report.The matters discussed in “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” contain certain forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of1995.  Please see “Forward LookingStatements” included elsewhere in this Annual Report for a discussion of theuse of forward-looking statements.

 

**Overview**

 

***Products, Applications andServices***

 

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

 

Ourproduct offerings include:

 

•       IP telephonysolutions;

 

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

 

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

 

•       appliances,such as telephone sets; and

 

•       traditionalvoice communication systems.

 

Wesupport our broad customer base with comprehensive global services offeringsthat enable our customers to plan, design, implement, maintain and manage theircommunications networks. We believe our global services organization is animportant consideration for customers purchasing our products and applicationsand is a source of significant revenue for us, primarily from maintenancecontracts. The skilled professionals of our services organization, togetherwith our network of business partners and our ability to diagnose customernetwork faults remotely, can provide 24-hour-a-day, seven-day-a-week service toour customers around the world. Our end-to-end portfolio of services offeringsprovides a single point of accountability and includes:

 

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•       value-addedmaintenance services;

 

•       professionalservices, consulting, design and network integration;

 

•       productimplementation; and

 

•       managedservices.

 

***Customers andCompetitive Advantages***

 

Ourcustomer base is diverse, ranging in size from small businesses employing a fewemployees to large government agencies and multinational companies with over100,000 employees. Our customers include enterprises operating in a broad rangeof industries around the world, including financial services, manufacturing,media and communications, professional services, health care, education andgovernment.

 

Weoperate in approximately 50 countries and sell products and services through anetwork of business partners, distributors and dealers who have customers innearly 100 other countries.  As a resultof our acquisition of Tenovis in November 2004, we have significantlyincreased our presence in Europe, particularly in Germany. For fical 2005,approximately 41% of our revenues were generated outside the U.S.

 

Weare focused on the migration of our customers’ traditional voice communicationsto a converged network that provides for the integration of voice, data, videoand other applications traffic on a single network. We offer customers theflexibility to implement new IP telephony solutions or “IP-enable” theirexisting voice communications systems, thereby preserving some of theirexisting communications technology investments and allowing them to implementIP telephony at their own pace. Converged networks offer increasedfunctionality and provide our enterprise customers with the ability to reachthe right person at the enterprise, at the right time, in the right place andin the right way, thereby optimizing business interactions and enhancing ourcustomers’ ability to grow revenue and reduce costs. Our products, applicationsand services are driving the integration of communications and businessprocesses, making communications an important component of our customers’business strategies.

 

Weenjoy several strengths that we believe provide us with a competitive advantagein the enterprise communications market:

 

•       clear focuson the enterprise;

 

•       extensivevoice experience and expertise, and a reputation for superior products andtechnology for voice processing and applications;

 

•       acomprehensive suite of industry-leading communications applications, includingremote/mobile offerings such as speech access, remote agents and softphones,which allow our customers to improve worker productivity and reduce network andreal estate costs by providing secure business communications to a dispersedworkforce;

 

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

 

•       a largeinstalled global customer base, further enhanced in Europe with the acquisitionof Tenovis;

 

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

 

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

 

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

 

***Fiscal 2005 Financial and Operating Results***

 

*Revenue growth* – Revenue was $4,902 millionand $4,069 million for fiscal 2005 and 2004, respectively.  The 20% revenue growth was across all of ouroperating segments and in our regions outside the U.S., which benefited fromour acquisition of Tenovis as well as the increase in our ownership interest inAvaya GlobalConnect.  Revenue growthoutside the U.S. was also due to the growing adoption of our IP telephonysolutions. Revenues in the U.S. decreased compared to fiscal 2004 due todisruption caused by the 

 

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implementation of our go-to-market strategy earlier in theyear, lower inventory balances held by our indirect channel partners, anddisruption caused by the Tenovis integration.

 

*Continuedprofitability* – We earned income fromcontinuing operations during fiscal 2005 of $923 million, compared to $291million during fiscal 2004.  As a resultof our continued profitability and our projections of future profitability, wereversed the valuation allowance that was recorded against our U.S. deferredtax assets, resulting in a net tax benefit of $590 million being recognized infiscal 2005. We have achieved net income for each of the last ten consecutivequarters and each of our operating segments has been profitable for the pasttwo fiscal years.  Our operating incomewas $298 million, or 6.1% of revenue for fiscal 2005, compared to $323 million,or 7.9% of revenue for fiscal 2004.

 

*Enhancedliquidity **–*** We significantly reduced our debt to $30 millionas of September 30, 2005, from $593 million as of September 30,2004.  During fiscal 2005, we repurchaseda significant portion of our senior notes, retired our outstanding convertibledebt (“LYONs”), and repaid all of the secured floating rates notes assumed withthe Tenovis acquisition.  Our debtbalance as of September 30, 2005 is comprised primarily of capital leaseobligations and the remaining senior notes. Although we used significant amountsof cash for strategic acquisitions, repayment of debt and repurchases of stock,we ended fiscal 2005 with strong cash and net cash balances of $750 million and$720 million, respectively.

 

#### **Key Trends and Uncertainties Affecting Our Results**

 

***Trendsand Uncertainties Affecting Our Revenue***

 

Thefollowing are the key factors currently affecting our revenue:

 

•       *Acquisition of Tenovis—*Our acquisition of Tenovis resulted in asignificant increase in our revenues. The large installed base of Europeancustomers that we acquired has enabled us to increase our presence in Europe.The integration of the Tenovis business into ours was a substantial effortrequiring significant managerial resources and attention during fiscal 2005.

 

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

 

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

 

•       *Pressures on services business*— We expectto continue to face challenges in our Avaya Global Services segment. A highcorrelation exists with respect to customers who purchase products alsoelecting to purchase maintenance contracts at the time equipment ispurchased.  The maintenance business hasbeen negatively affected by cancellations, subsequent contract renegotiationsand changes in scope (*i.e*. number ofports, number of sites, or hours and levels of coverage) at the time ofrenewal, and pricing pressures. Our managed services business generallyinvolves larger contracts with customers who outsource responsibility for theirvoice applications domain to us. We expect to face challenges in this arearelating to timing and closure of the new business opportunities, as well aspricing pressures and scope changes similar to the maintenance business thatare discussed above.

 

•       *Economic conditions—*An important factor affecting our abilityto generate revenue is the effect of general economic conditions on ourcustomers’ willingness to spend on information technology and, particularly,enterprise communications technology. As economic conditions have graduallyimproved in most of our markets over the past few years, we have seen 

 

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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 worldwide economic growthcould also impact our business as growth rates of developed and more stableeconomies tend to be lower than that of emerging economies, where there couldbe more variables affecting the economic growth. Weakness and uncertainty inEuropean economies, coupled with the high concentration of our business inGermany, have the potential to affect our results in Europe as highunemployment levels and low economic growth forecasts, particularly in Germany,remain a concern.

 

•       *Foreign currency—*With the acquisition of Tenovis, ourrevenues outside the U.S. were 41% of our consolidated revenues for fiscal2005 compared to 24% for fiscal 2004. Any weakening of the U.S. dollar againstother currencies, particularly the euro, will have a positive impact on ourreported revenues and profitability. Conversely, any strengthening of the U.S.dollar will have a negative impact.

 

•       *Indirect distribution channel–*Duringfiscal 2005, some of our indirect channel partners began to reduce their levelsof inventory.  Although we noted nodecreases in sales out to end customers, the timing of purchases by indirectchannel distributors affected our revenues. In addition, we have begun to implement programs with our largestdistributors to move toward an inventory replenishment model, which may furtheraffect the timing of purchases of our products made by our channel partners.

 

***Continued Focuson Cost Structure***

 

Asa result of the growth of our revenue and our continued focus on controllingcosts, we returned to profitability in the third quarter of fiscal 2003 andhave been profitable in each of the nine subsequent quarters. During fiscal2005, we continued to focus on controlling our costs, particularly in relationto our revenue. As part of our focus on controlling costs, we have reducedprimarily the management and back office headcount in our U.S. sales organization,and have also reduced the headcount in our services business. We have reachedagreements with the works councils in Europe to reduce our workforce byapproximately 530.  Most of thesepositions have already been eliminated, and we expect the full year benefits ofthese actions to be realized beginning in fiscal 2006.

 

Asdiscussed in more detail below, our gross margin decreased from 47.8% forfiscal 2004 to 46.9% for fiscal 2005. The decrease is primarily due to thelower margins achieved by the Tenovis services business, which historically hasachieved lower margins than the rest of the Company.

 

Asa percentage of revenue, selling, general and administrative, or SG&A,expenses increased from 31.3% for fiscal 2004 to 32.3% for fiscal 2005.  The increase in dollar terms for both periodswas due to the inclusion of Tenovis SG&A expenses following theacquisition, as well as our other recent acquisitions.

 

***StrategicUses of Cash and Cash Equivalents***

*** ***

Asfurther discussed in “Liquidity and Capital Resources,” we have been focused onusing cash for strategic acquisitions, debt reduction and sharerepurchases.  We used net cash of $265million and $110 million to acquire Tenovis and Spectel, respectively, in thefirst quarter of fiscal 2005.  Duringfiscal 2005, we used $318 million, including $4 million of interest and fees,to reduce substantially the amount of our senior notes outstanding and $277 million, including $15 million ofinterest and fees, to repurchase Tenovis’s outstanding secured floating ratenotes.  In addition, we used $107million to repurchase 11,525,000 shares of our common stock in accordance witha share repurchase plan authorized by the Board of Directors.

 

Ourcash position, net of debt,  was $1,024million and $720 million as of September 30, 2004 and 2005, respectively.

 

***DeferredTax Assets***

*** ***

Ourdeferred tax assets are primarily a result of deductible temporary differencesrelated to pension and other accruals, as well as tax credit carryforwards andnet operating loss carryforwards which are available to reduce taxable incomein future periods.  As of September 30,2005, we had $958 million in net deferred tax assets consisting of recognizeddeferred tax assets of $1,098 million offset by deferred tax liabilities of$140 million.  The recognized deferredtax assets consist of gross deferred tax assets of $1,263 million less avaluation allowance of $165 million. These amounts differed significantly from the amounts as of September 30,2004 due to the reversal of a portion of the valuation allowance, based upon adetailed analysis of historical and expected book and taxable income.

 

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**Operating Segments**

 

Beginningin the first quarter of fiscal 2005, we are managing our business based on twooperating segments: Global Communications Solutions, or GCS, which includes ourprior reportable segments of Enterprise Communications Group and Small andMedium Business Solutions, and Avaya Global Services, or AGS. This realignmentof operating segments enables management to assess results of operations in amanner consistent with our operating structure and go-to-market strategies. Ourcomparative results have been reclassified to reflect this segment structure.

 

In January 2004, we sold substantially all of our ConnectivitySolutions segment to CommScope Inc. (Commscope), except for the sale of certainremaining international operations that was substantially completed during theremainder of fiscal 2004.  ConnectivitySolutions provided structured cabling systems and electronic cabinets to ourcustomers.  This business was previouslydisclosed as a separate operating segment and subsequent to its disposal, isreflected in discontinued operations. Income from discontinued operations for fiscal 2004 includes $168million of revenue and $71 million of loss before income taxes related toConnectivity Solutions’ operations. We received $256 million ofcash, and 1,761,538 shares of CommScope common stock valued at $33 million onthe closing date.  We paid $9 million intransaction costs relating to the sale. During the second quarter of fiscal 2004, we sold all the shares ofCommScope common stock and recognized a pre-tax loss of $5 million, which isincluded in other expense, net.  Ourremaining operating segments include Connectivity Solutions’ portion ofcorporate related expenses.  See thediscussion in Note 4 “Business Combinations and Other Transactions” to ourConsolidated Financial Statements for details related to this sale.

 

The following table sets forth the allocation of our revenue among ouroperating segments, expressed as a percentage of total revenue:

 
| ** **                            | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|
| ** **                            | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**               | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Global Communications Solutions       |       | $                                 | 2,572      |   | $ | 2,044 |   | 52.5 | % | 50.2 | % | $ | 528 |   | 25.8 | % |
| Avaya Global Services                 |       | 2,330                             |       | 2,021 |   | 47.5 | % | 49.7 | % | 309 |   | 15.3 | % |
| Total  operating segments             |       | 4,902                             |       | 4,065 |   | 100.0 | % | 99.9 | % | $ | 837 |   | 20.6 | % |
| Corporate / Other Unallocated Amounts |       | —                            |       | 4 |   | 0.0 | % | 0.1 | % | (4 | ) | -100.0 | % |
| Total                                 |       | $                                 | 4,902      |   | $ | 4,069 |   | 100.0 | % | 100.0 | % | $ | 833 |   | 20.5 | % |

 

**Acquisitionsand Divestitures**

 

We havecompleted the following acquisition transactions during fiscal 2005:

 

***Acquisitionof Tenovis***

 

OnNovember 18, 2004, we acquired all of the issued share capital of Tenovis.Tenovis is a major European provider of enterprise communications systems andservices. Under the terms of the share purchase agreement we paid $381 millionin cash (which includes $10 million of transaction fees that were not paid tothe sellers) and assumed $287 million in debt, including $17 million of capitallease obligations. Additionally, we acquired cash and cash equivalents of $116million, resulting in a net cash outlay related to the acquisition of $265million. We also recorded $313 million of pension liabilities in connectionwith this acquisition. Tenovis results are included in our ConsolidatedFinancial Statements as of November 18, 2004.

 

Theintegration of Tenovis has resulted in significant cross-deployment ofresources and the integration of various legal entities and operations.  As previously disclosed, we will thereforenot be providing Tenovis financial information on a stand-alonebasis herein or in the future.

 

Thefollowing estimated unaudited pro forma financial information presents theCompany’s results as if the Tenovis acquisition had occurred at the beginningof the respective periods:

 
| ** **                                        | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions, except per share amounts** | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| 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 |   |

 

8

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***OtherAcquisitions***

*** ***

OnOctober 4, 2004, we acquired all of the issued share capital of Spectelfor $110 million in cash (which includes $6 million of transaction fees thatwere not paid to the sellers), net of cash acquired of $3 million. Spectel wasa company incorporated in Ireland and a leading provider of audio conferencingsolutions. Results from Spectel are included in our Consolidated FinancialStatements beginning on October 4, 2004.

 

OnOctober 15, 2004, we acquired a 23% share of Agile Software, a softwaresubsidiary of Agile (NZ) Limited, which primarily produces contact centersoftware, as well as other software products. We account for this investmentusing the equity method.

 

OnDecember 15, 2004, we acquired substantially all of the assets ofRouteScience, a software company based in California which focuses on productsthat monitor, assess and optimize network applications.

 

On September 16,2005, we acquired Nimcat for $38 million in cash, net of cash acquired of $1million.  Nimcat was a privately heldCompany headquartered in Canada and a leading developer of embeddedpeer-to-peer IP call processing software. Peer-to-peernetworking is a network that relies on the computing powerand bandwidth of the participants in the network rather than concentratingit in a relatively few servers.  These networks are useful for manypurposes, including file sharing containing audio, video, data andreal-time data, such as telephony traffic. Results from Nimcat areincluded in our Consolidated Financial Statements beginning on September 16,2005.

 

See thediscussions in Note 4 “Business Combinations and Other Transactions” to ourConsolidated Financial Statements for more information relating to theseacquisition transactions.

 

**RestructuringPrograms**

 

During thefourth quarter of fiscal 2005, we recorded a restructuring charge of $22million in connection with the reorganization of our North American sales andservices organizations.  This chargeconsists of severance and one-time employee termination benefits of $12 millionrelated to the termination of employees in the North America region across manybusiness functions and job classes, as well as costs of $10 million related tothe consolidation of excess facilities.  During the fourth quarter of fiscal 2005, the majority of the employeesidentified for termination had been exited and $5 million of theaccrued employee termination costs had been paid.  We expect to make payments for these items of$10 million during fiscal 2006 and $7 million during fiscal 2007 and beyond.

 

The September 30, 2005 other liabilities balanceincludes $24 million associated with the excess of facilities related to thebusiness restructuring charges recorded in fiscal 2000 and 2002.

 

See the discussion in Note 7 “Restructuring Programs” to ourConsolidated Financial Statements for more information on these items.

 

**Outsourcing of Certain ManufacturingOperations**

 

Wehave outsourced substantially all of our product manufacturing operations. Mostof these operations have been outsourced to Celestica Inc. and arecurrently manufactured in North America, France and Malaysia. Our outsourcingagreement with Celestica expires in May 2006. The agreement willautomatically renew for successive one-year terms unless either party elects toterminate the agreement by giving notice to the other party six months prior tothe expiration.  Pursuant to therequirements of the agreement, we gave notice to Celestica on November 2,2005 of our intention not to renew our outsourcing agreement.  We are in discussions to negotiate a newoutsourcing agreement.  The remainingsources of our manufacturing capacity are outsourced to a number of othercontract manufacturers located in the United Kingdom, France and China.  All manufacturing of the Company’s productsis performed in accordance with detailed specifications and product designfurnished by the Company and is subject to quality control standards.

 

Thesuccess of our manufacturing initiative depends on the willingness and abilityof contract manufacturers to produce our products. We may experiencesignificant disruption to our operations by outsourcing so much of ourmanufacturing. If our contract manufacturers terminate their relationships withus or are unable to fill our orders on a timely basis, or if we do notaccurately forecast our requirements, we may be unable to deliver our productsto meet our customers’ orders, which could delay or decrease our revenue.

 

Webelieve we have adequate sources for the supply of the components of ourproducts and for the finished products that we purchase from third parties.

 

9

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**Results From Continuing Operations**

 

***Fiscal Year Ended September 30,2005 Compared with Fiscal Year Ended September 30, 2004***

 

### ***Revenue***

### ** **

The primary driverof the increase in our revenues for fiscal 2005 compared to fiscal 2004 was ouracquisition of Tenovis. Revenues in fiscal 2005 were also positively impactedby the acquisition of the majority interest in AGC in the fourth quarter offiscal 2004, as well as foreign currency fluctuations. This impact waspartially offset by declines in U.S. sales of both products and services. Thedecline in U.S. revenues was primarily attributable to the following:

 

•       We previously announced changes in ourgo-to-market strategy to realign our sales and marketing efforts. Although wehave begun to see the benefits as we focus our direct sales efforts on ourlarger enterprise customers, the benefits have taken longer than expected tomaterialize, resulting in a disruption to our sales efforts during fiscal2005. This disruption primarily affected our U.S. business. We worked tominimize the effects of this disruption and continued to implement therealignment through fiscal 2005.

 

•       We continue to see declines in revenuesfrom our 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.

 

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

 

A detailedanalysis of the impact of these factors is included in the discussion below.

 

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

 
| ** **                  | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**     | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Sales of products           |       | $                                 | 2,294      |   | $ | 2,048 |   | 47 | % | 51 | % | $ | 246 |   | 12 | % |
| Services                    |       | 1,971                             |       | 1,761 |   | 40 | % | 43 | % | 210 |   | 12 | % |
| Rental and managed services |       | 637                               |       | 260 |   | 13 | % | 6 | % | 377 |   | 145 | % |
| Total revenue               |       | $                                 | 4,902      |   | $ | 4,069 |   | 100 | % | 100 | % | $ | 833 |   | 20 | % |

 

Higher revenues in all categories were primarily due to the acquisitionof Tenovis.  Revenues from sales ofproducts also benefited from the acquisition of a majority interest in AGC inthe fourth quarter of fiscal 2004.  Theincreases in revenues from sales of product were partially offset by lowervolumes in the U.S. due to the disruption from the realignment of our salesefforts in the first half of the fiscal year.  The increase in revenues from services andrental and managed services, primarily attributable to Tenovis, was partiallyoffset by lower volumes in the U.S. due mainly to renegotiations affecting thescope of existing managed services contracts, as well as pricing pressures andcancellations.

 

The following table sets forth a geographic comparison of revenue:

 
| ** **                                            | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**                               | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| 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 | % |
| 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 period due to thedisruption from the realignment of our sales and marketing efforts as well asdecreases in the scope of existing maintenance contracts and pricing pressuresin our services business as described above.

 

Higher revenues in Germany were almost entirely attributable to theacquisition of Tenovis.  The majority ofthe increase in revenues in EMEA (excluding Germany) was due to the acquisitionof Tenovis, and was also a result of increased acceptance of IP telephony, andincreased willingness of customers to spend on converged communications technology.  This increased acceptance resulted in highersales of large communications systems. In addition, currency translation had a positive impact as the eurostrengthened against 

 

10

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the U.S. dollar for most of the period. Revenues in APAC benefited from the acquisition of a majority ownershipinterest in AGC as well as higher volumes in China and Japan, particularly inconnection with sales to our customers in the financial services industry.  Revenues in the 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.

 

The following table sets forth a comparison of revenue from sales ofproducts by channel:

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Direct                  |       | $                                 | 1,127      |   | $ | 923 |   | 49 | % | 45 | % | $ | 204 |   | 22 | % |
| Indirect                |       | 1,167                             |       | 1,125 |   | 51 | % | 55 | % | 42 |   | 4 | % |
| Total sales of products |       | $                                 | 2,294      |   | $ | 2,048 |   | 100 | % | 100 | % | $ | 246 |   | 12 | % |

 

Revenuefrom the sales of products through the direct channel increased due to theacquisition of Tenovis, which sells primarily through the direct channel.

 

***Gross Margin***

 

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

 
| ** **                     | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**        | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| 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 increased primarily due toadditional sales volumes gained from the acquisition of Tenovis, the increasedproportion of software to hardware in our product mix and the benefitsassociated with our ongoing cost reduction initiatives. However, while theacquisition of Tenovis added additional gross margin in dollars, as a percentof revenue, our overall gross margin gains were more than offset by the lowermargin rates achieved by Tenovis.

 

Gross margin on services decreased mainly due to the impact of lowerrevenues in the U.S., as well as the impact of the significantly lower marginTenovis services business.  In addition,gross margins were negatively impacted by changes in revenue mix, including ahigher proportion of government contracts and wire installations, as well as ahigher proportion of implementation services revenues, which generate lowermargins than those achieved by annuity contracts.  These declines in gross margin were partiallyoffset by cost savings as a result of headcount reductions taken during thisfiscal year.

 

Gross margin on rental and managed services increased due primarily tothe acquisition of Tenovis, which was partially offset by lower revenuesassociated with U.S. managed services. The improvement in gross margin percentage is due to the higher marginsachieved by the Tenovis rental business.

 

***Operating Expenses***

 

The following table sets forth a comparison of operating expenses:

 
| ** **                          | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**             | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| 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 |   | n/a |   |
| Total operating expenses            |       | $                                 | 1,999      |   | $ | 1,622 |   | 40.8 | % | 39.9 | % | $ | 377 |   | 23 | % |

 

Our selling, general and administrative, or SG&A, expenses consistprimarily of salaries, commissions, benefits and other items.  The increase in SG&A expenses isprimarily due to the acquisition of Tenovis, and to a lesser extent our otheracquisitions, which resulted 

 

11

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in higher SG&A expenses in dollar terms and as a percent ofrevenue.  Included with SG&A expensesis approximately $52 million of amortization of intangible assets as a resultof our acquisitions of Tenovis and Spectel. These negative impacts associated with our acquisitions were partiallyoffset by improved operational efficiencies.

 

Our research and development, or R&D, expenses consist primarily ofsalaries and benefits.  R&D expensesincreased due to our fiscal 2005 acquisitions. In addition, in connection with our acquisitions of Tenovis, Spectel andNimcat during fiscal 2005, we allocated $7 million to in-process research anddevelopment which was charged to R&D expense during the period.

 

Ourrestructuring charges for fiscal 2005 were recorded in connection with thereorganization of our North American sales and services organizations.  This charge consists of severance andone-time employee termination benefits of $12 million related to the terminationof employees in the North America region across many business functions and jobclasses, as well as costs of $10 million related to the consolidation of excessfacilities.

 

***Other Expense, Net***

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

 

Otherexpense, net for fiscal 2005 consists primarily of a $41 million loss on therepurchase of $271 million principal amount of senior notes, a $3 million losson the repayment of $262 million principal amount of secured floating ratenotes and other costs related to the repayment of our debt, partially offset by$24 million of interest income.

 

For fiscal2004, other expense, net primarily consisted of a $42 million loss associatedwith the redemption of $224 million principal amount of our senior notes in thesecond quarter of fiscal 2004 and the repurchase of $132 million principalamount of our senior notes in the third quarter of fiscal 2004.  These amounts were partially offset by $19million of interest income generated primarily from invested cash and $7million of foreign currency transaction gains.

 

***Interest Expense***

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

 

Thedecrease in interest expense is due to lower year-over-year debt levels.  Overall debt decreased primarily due to therepurchases of our senior notes in fiscal 2004 and the first quarter of fiscal2005, as well as the conversion into common stock of our LYONs and theredemption for cash of the remaining LYONs in the first quarter of fiscal2005.  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.  Interest expense for fiscal2004 primarily includes $53 million of interest on our senior notes and $15million of interest for the amortization of debt discount, premium and deferredfinancing costs related primarily to our LYONs, which were issued in October 2001.

 

***Benefit from IncomeTaxes***

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

 

In fiscal 2005, we recorded a benefit for income taxes of $676 millionas compared with a $49 million benefit in fiscal 2004.   The benefit for fiscal 2005 included a $590million net tax benefit due to the realization of certain deferred tax assetsupon the reversal of a portion of the valuation allowance that had beenrecorded in prior periods. The $590 million benefit is net of a tax provisionrecorded for the year.  In addition, the$676 million benefit included a $124 million income tax benefit which iscomprised 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 and expected book andtaxable income, we have determined that the realization of certain deferred taxassets for which there is a valuation allowance is considered to be more likelythan not for purposes of reversing the valuation allowance.  Therefore, a portion of the valuationallowance was reversed resulting in a net tax benefit of $590 million.  We 

 

12

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have recorded pre-tax income from continuing operations in 2005 and2004, with income levels rising each year. In addition, we are no longer in a 3-year cumulative loss position forbook purposes. We consider this positive evidence regarding the futurerealization of deferred tax assets, which is primarily based on actualhistorical book results, to outweigh any negative evidence that may exist.

 

The remaining valuation allowance of $165 million iscomprised of $142 million relating to foreign deferred tax assets for which wehave determined, based on historical results and projected future book andtaxable income levels, that a valuation allowance should remain.  The foreign valuation allowance includesapproximately $120 million relating to our German operations.

 

The benefit for fiscal 2004 of $49 million included an $89 millionincome tax benefit which was comprised of $102 million tax benefit resulting fromthe resolution of U.S. federal income tax audit matters for the pre-distributionyears 1990 through 1998 offset by $13 million due to certain state tax mattersand other adjustments that arose prior to our separation from Lucent.

 

**Segment Results**

 

***Global Communications Solutions***

 

The GCS segment sells communications systems and converged voiceapplications designed for both large and small enterprises.  Our offerings in this segment include IPtelephony solutions, multi-media contact center infrastructure and applicationsin support of customer relationship management, unified communicationsapplications and appliances, and traditional voice communications systems.

 

Large Communications Systems are IP andtraditional telephony systems marketed to large enterprises. These systemsinclude:

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

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

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

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

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

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

 

Small Communications Systems are IP andtraditional telephony systems marketed to smaller enterprises.  These systems include:

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

•                  TraditionalKey Systems, Partner®, Merlin Magix®, Merlin LegendTM and I5 brands;

•                  associatedappliances, such as telephone handsets; and

•                  mediaservers for voice applications used by smaller businesses.

 

Converged Voice Applications consist ofapplications for multi-media contact centers and unified communications. Theseinclude:

•                  applicationsin support of customer relationship management; and

•                  messagingfor IP and traditional systems.

 

The following table sets forth revenue by similar class of productswithin the GCS segment:

 
| ** **                   | ** ** | **Year ended September 30,** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**      | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| 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 |   | 10 | % |
| Other                        |       | 46                                |       | 54 |   | 2 | % | 3 | % | (8 | ) | -15 | % |
| Total revenue                |       | $                                 | 2,572      |   | $ | 2,044 |   | 100 | % | 100 | % | $ | 528 |   | 26 | % |

 

The increase in total revenue for all GCSproduct classes was primarily attributable to the acquisition of Tenovis. LargeCommunications Systems also benefited from increased sales of IP products.  The increase in Small Communications Systemsrevenues attributable to Tenovis was partially offset by lower U.S. salesvolumes, mainly in the indirect channel due to lower purchases by our U.S.indirect channel partners.  Inaddition to the increased revenue from Tenovis, Converged VoiceApplications also benefited from higher volumes in sales of OEM softwareproducts.

 

13

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The following table sets forth operating income of the GCS segment:

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

 

The decrease in operating income was primarily due to the effects of adecrease in operating margin resulting from an unfavorable product mix,including increased sales of third-party, or OEM, software products whichgenerate lower margins than the sales of products we have developed.  The decrease is also a result of higherSG&A costs and increased R&D spending over the prior year due to theacquisition of Tenovis, Spectel and RouteScience.

 

***Avaya GlobalServices***

 

The AGS segment is focused on supporting our broad customer base withcomprehensive end-to-end global service offerings that enable our customers toplan, design, implement, monitor and manage their converged communicationsnetworks worldwide.  AGS provides itsservices through the following offerings:

 

*Maintenance*– AGSmonitors and optimizes customers’ network performance and keeps communicationnetworks current with the latest software releases. In the event of an outage,our customers receive the on-site support they need to recover quickly.

 

*Implementation and integration services*–Through operation, implementation and integration specialists worldwide, AGShelps customers leverage and optimize their multi-technology, multi-vendorenvironments through the use of contact centers, unified communication networksand IP telephony.

 

*Managed services* –AGS supplements our customers’ in-house staff and manages complex multi-vendor,multi-technology networks, optimizes network performance and configurations,backs up systems, detects and resolves faults, performs moves, adds, and changesand manages our customers’ trouble tickets and inventory. This categoryincludes customers who have chosen a bundled solution with enhanced servicesnot provided in a basic maintenance contract. With the acquisition of Tenovis, Avaya acquired a business that includesboth bundled services and products that are sold to customers on a monthlypayment or rental payment basis.  Thisbusiness model is predominantly located in Germany.

 

The following table sets forth revenue by similar class of services withinthe AGS segment:

 
| ** **                              | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**                 | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Maintenance                             |       | $                                 | 1,491      |   | $ | 1,422 |   | 64 | % | 70 | % | $ | 69 |   | 5 | % |
| Implementation and integration services |       | 467                               |       | 338 |   | 20 | % | 17 | % | 129 |   | 38 | % |
| Managed services                        |       | 350                               |       | 260 |   | 15 | % | 13 | % | 90 |   | 35 | % |
| Other                                   |       | 22                                |       | 1 |   | 1 | % | 0 | % | 21 |   | 2100 | % |
| Total revenue                           |       | $                                 | 2,330      |   | $ | 2,021 |   | 100 | % | 100 | % | $ | 309 |   | 15 | % |

 

The increase in revenue for AGS was primarily attributable to theacquisition of Tenovis and sales of new services, partially offset by a declinein maintenance and managed services revenues in the U.S.

 

Tenovis generated revenue for each of the service lines.  Lower revenues in existing contract-relatedmaintenance were primarily due to cancellations, changes in contract scope andpricing pressures for U.S. customers. This was partially offset by increases insales of new services and off-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.  Managed services revenues in the U.S. wereunfavorably affected by customer changes in scope, pricing pressures andcancellations, as well as lower sales of telephony equipment to the U.S.managed services customers.

 

14

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The following table sets forth operating income of the AGS segment:

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

 

The decrease in operating income for fiscal 2005 is due to lower grossmargin and additional expenses attributable to Tenovis.  Additionally, the U.S. business experienced alower proportion of higher-margin annuity services such as maintenance and ahigher proportion of implementation and integration services, whichtraditionally have lower margins.  Thedecrease in gross margin was partially offset by the cost savings resultingfrom headcount reductions taken during fiscal 2005.

 

**Corporate / Other Unallocated Amounts**

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

 

Revenue of $4 million in fiscal 2004represents sales associated with the acquisition of Expanets, Inc., asubsidiary of Northwestern Corporation (Expanets).  These sales were not allocated to one of ouroperating segments because the sales were of non-Avaya products that were inthe Expanets pipeline prior to the acquisition, and were consummated subsequentto the closing of our acquisition of Expanets.

 

Operating income forboth fiscal years is mainly due to the actual corporate overhead and certainother expenses being lower than that estimated in the annual plan. At thebeginning of each fiscal year, the amount of corporate overhead and certainother expenses, including targeted annual incentive awards, to be charged tooperating segments is determined and fixed for the entire year in the annualplan. The annual incentive award accrual is adjusted quarterly based on actualyear-to-date results and those estimated for the remainder of the year. Infiscal 2005, the Company incurred discretionary employee annual incentive awardsof $25 million, which is $80 million less than would have been recorded if wehad met our fiscal 2005 targets regarding operating income, operating cashflows and revenues.  The significantlylower employee incentive awards, as well as any other over/under absorption ofcorporate overheads against plan, is recorded and reported within theCorporate/Other Unallocated Amounts caption.

 

**Fourth Quarter Items**

 

Revenues increased by $220 million in the fourth quarter of fiscal 2005compared to the fourth quarter of fiscal 2004 primarily due to the acquisitionof Tenovis as well as a $31 million and $7 million increase in quarterlyrevenue achieved in the APAC and Americas (non - U.S.)  regions, respectively.  Operatingincome decreased by $37 million to $82 million, primarily due to additionalexpenses associated with Tenovis, restructuring charges and in-process researchand development costs.  Net income forthe quarter increased by $560 million to $660 million, primarily as a result ofthe reversal of a portion of our deferred tax valuation allowance, as describedin Note 12 “Income Taxes” to our Consolidated Financial Statements.

 

***Fiscal Year Ended September 30,2004 Compared with Fiscal Year Ended September 30, 2003***

 

The followingtable sets forth a comparison of revenue by type:

 
| ** **                  | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**     | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Sales of products           |       | $                                 | 2,048      |   | $ | 1,880 |   | 50 | % | 50 | % | $ | 168 |   | 9 | % |
| Services                    |       | 1,761                             |       | 1,645 |   | 43 | % | 43 | % | 116 |   | 7 | % |
| Rental and managed services |       | 260                               |       | 271 |   | 7 | % | 7 | % | (11 | ) | -4 | % |
| Total revenue               |       | $                                 | 4,069      |   | $ | 3,796 |   | 100 | % | 100 | % | $ | 273 |   | 7 | % |

 

### **Revenue increases were primarily attributableto stronger product sales volumes related to IP telephony solutions, softwareand applications, as well as higher maintenance contract revenue associatedwith the acquisition of Expanets.  Theseincreases were**

 

15

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### **partially offset by expected declines inproduct sales of traditional telephony systems and declines in maintenanceservices billed on a time and materials basis.**

 
| ** **                                            | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**                               | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| U.S.                                                  |       | $                                 | 3,089      |   | $ | 2,905 |   | 76 | % | 77 | % | $ | 184 |   | 6 | % |
| Outside the  U.S.:                                    |       |                              |       |   |   |   |   |   |   |   |   |   |   |
| Germany                                               |       | 45                                |       | 41 |   | 1 | % | 1 | % | 4 |   | 10 | % |
| EMEA  (excluding Germany) - Europe/Middle East/Africa |       | 493                               |       | 447 |   | 12 | % | 12 | % | 46 |   | 10 | % |
| APAC - Asia  Pacific                                  |       | 226                               |       | 195 |   | 6 | % | 5 | % | 31 |   | 16 | % |
| Americas,  non-U.S.                                   |       | 216                               |       | 208 |   | 5 | % | 5 | % | 8 |   | 4 | % |
| Total  outside the U.S.                               |       | 980                               |       | 891 |   | 24 | % | 23 | % | 89 |   | 10 | % |
| Total  revenue                                        |       | $                                 | 4,069      |   | $ | 3,796 |   | 100 | % | 100 | % | $ | 273 |   | 7 | % |

 

Our revenue for fiscal 2004 increased both in the U.S. and outside theU.S. as well as across all of our operating segments as compared with fiscal2003.  In general, revenues wereprimarily driven by higher IP telephony sales, which offset declines in thetraditional markets.  Revenues were alsohelped by our acquisition of Expanets during fiscal 2004.

 

The following table sets forth a comparison of revenue from sales ofproducts by channel:

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Direct                  |       | $                                 | 923        |   | $ | 819 |   | 45 | % | 44 | % | $ | 104 |   | 13 | % |
| Indirect                |       | 1,125                             |       | 1,061 |   | 55 | % | 56 | % | 64 |   | 6 | % |
| Total sales of products |       | $                                 | 2,048      |   | $ | 1,880 |   | 100 | % | 100 | % | $ | 168 |   | 9 | % |

 

Revenue from the sales of products through both channels increasedduring fiscal 2004, and our proportion shifted slightly toward direct sales.

 

***Gross Margin***

 
| ** **                     | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**        | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| On sales of products           |       | $                                 | 1,120      |   | $ | 936 |   | 54.7 | % | 49.8 | % | $ | 184 |   | 20 | % |
| On services                    |       | 697                               |       | 575 |   | 39.6 | % | 35.0 | % | 122 |   | 21 | % |
| On rental and managed services |       | 128                               |       | 128 |   | 49.2 | % | 47.2 | % | — |   | 0 | % |
| Total gross margin             |       | $                                 | 1,945      |   | $ | 1,639 |   | 47.8 | % | 43.2 | % | $ | 306 |   | 19 | % |

 

Grossmargins for sales of products and services improved both in dollar terms andpercentage terms in fiscal year 2004 as a result of a combination of increasedsales volumes and lower costs.

 

Our cost on sales of products consists primarily of the costs paid tocontract manufacturers for components, and overhead costs.  As compared to 2003, costs of products solddecreased by $16 million while corresponding revenues increased by $168million, resulting in product gross margin improvement to 54.7% in 2004 from49.8% in 2003.  The year-over-yearimprovement was driven primarily by three factors:  (i) higher overall product volumewithout a corresponding increase in overhead costs, (ii) the increasedproportion of software to hardware in our product mix resulting inproportionately lower variable costs and (iii) improved pricing oncomponents purchased from our various contract manufacturers.

 

Our cost of services consists primarily of labor, parts and serviceoverhead.  Services gross marginincreased to 39.6% in 2004 from 35.0% in 2003, primarily because of improvedutilization of the technician workforce and continuing cost reductions. Ouracquisition of Expanets enabled us to achieve cost synergies that resulted in increasedservice revenue without a proportionate increase in cost.

 

Our cost of rental and managed services consists primarily of labor,parts and service overhead.  Rental andmanaged services gross margin increased to 49.2% although gross margin dollarswere flat.  The improvement was primarilydue to continuing cost reductions.

 

16

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***Operating Expenses***

 
| ** **                          | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**             | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Selling, general and administrative |       | $                                 | 1,274      |   | $ | 1,240 |   | 31.3 | % | 32.7 | % | $ | 34 |   | 3 | % |
| Research and development            |       | 348                               |       | 336 |   | 8.6 | % | 8.8 | % | 12 |   | 4 | % |
| Total operating expenses            |       | $                                 | 1,622      |   | $ | 1,576 |   | 39.9 | % | 41.5 | % | $ | 46 |   | 3 | % |

 

Total SG&A expenses increased in fiscal 2004, but decreased as apercentage of revenue.  The increase intotal expense was primarily attributable to higher sales expense associatedwith the acquisition of Expanets in the first quarter of 2004, increases inexpense for incentive compensation programs and employee benefits costs, andincreased costs associated with corporate development activities.  In addition, fiscal 2004 includes $1 millionof reversals of business restructuring liabilities established in prior periodsrelated to involuntary employee separations. Fiscal 2003 included $21 million of similar reversals, due primarily tofewer involuntary employee separations than originally anticipated, but waspartially offset by $16 million of expenses related to information technology costsincurred to relocate the development of certain IT applications to India.

 

The increases in SG&A expenses in fiscal 2004 were partially offsetby lower compensation expense resulting from fewer employees, and lower IT andnetworking expenses, including telecommunication and computer related servicecosts, which reflect a favorable renegotiated agreement for the outsourcing ofcertain IT functions.

 

R&D expenses increased slightly due mainly to increased headcountand higher compensation associated with research and developmentactivities.  Investments in R&Dfocused on the high growth areas of our business while spending on our moremature product lines decreased.

 

***Other Expense, Net***

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **Change** | ** ** |
| Other expense, net      |       | $                                 | (15        | ) | $ | (29 | ) | $ | 14 |   | -48 | % |
|                         |            |                                   |            |  |  |  |  |  |  |  |  |  |

 

For fiscal2004, other expense, net was primarily attributable to a $42 million lossassociated with the redemption of $224 million principal amount of our seniornotes in the second quarter of fiscal 2004 and the repurchase of $132 millionprincipal amount of our senior notes in the third quarter of fiscal 2004.  These amounts were partially offset by $19million of interest income related primarily to invested cash and $7 million offoreign currency transaction gains.

 

For fiscal2003, other expense, net was primarily attributable to a net loss of $34million on the extinguishment of a portion of our LYONs and a $25 millioncharge associated with our share of the Lucent securities litigationsettlement.  These losses in fiscal 2003were partially offset by a gain of $14 million on the sale of assets and $15million of interest income.

 

***Interest Expense***

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **Change** | ** ** |
| Interest expense        |       | $                                 | (66        | ) | $ | (78 | ) | $ | 12 |   | -15 | % |
|                         |            |                                   |            |  |  |  |  |  |  |  |  |  |

 

Interest expense decreased in fiscal 2004 primarily due to theredemption of $224 million principal amount, and the repurchase in a series ofopen market transactions of $132 million principal amount, of our senior notesduring the year.  Interest expense forfiscal 2004 primarily includes $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 in October 2001.

 

Interest expense for fiscal 2003 primarily includes$58 million of interest on $640 million principal amount of oursenior notes, $440 million of which were issued in March 2002 and$200 million of which were issued in May 2003.  In addition, we recorded interest expense of$20 million for the amortization of debt discount, premium and deferredfinancing costs related primarily to our LYONs.

 

17

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

 
| ** **                                | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                   | ** ** | **2004**                          | ** ** | **2003** | ** ** | **Change** | ** ** |
| (Benefit from) provision for income taxes |       | $                                 | (49        | ) | $ | 84 |   | $ | (133 | ) | -158 | % |
|                                           |            |                                   |            |  |  |  |  |  |  |  |  |  |

 

The benefit for fiscal 2004 of $49 million included an $89 millionincome tax benefit which was comprised of $102 million tax benefit resultingfrom the resolution of U.S. federal income tax audit matters for the years 1990through 1998 offset by $13 million in payments made to resolve certain statetax matters and other adjustments that arose prior to our separation from Lucent.  The $89 million benefit consisted of a $37million net cash refund from Lucent in accordance with the terms of a TaxSharing Agreement that we and Lucent entered into in connection with thedistribution.  This was partially offsetby a $40 million provision related to state and foreign income taxes.

 

The provision for fiscal 2003 of $84 million included an$83 million provision to increase the deferred tax asset valuationallowance, a $13 million provision for state and foreign income taxes, a$4 million provision for other adjustments, a $10 million benefitrelated to the early extinguishment in January 2003 of a portion of ourLYONs and a $6 million benefit related to a favorable auditsettlement.  The $83 millionprovision for the increase in the deferred tax asset valuation allowancereflects the difference between the actual and expected tax gain associatedwith the LYONs exchange offer consummated in fiscal 2002.

 

**Segment Results**

 

***Global Communications Solutions***

 
| ** **                   | ** ** | **Year ended September 30,** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**      | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Large Communications Systems |       | $                                 | 1,210      |   | $ | 1,129 |   | 59 | % | 60 | % | $ | 81 |   | 7 | % |
| Small Communications Systems |       | 228                               |       | 206 |   | 11 | % | 11 | % | 22 |   | 11 | % |
| Converged Voice Applications |       | 552                               |       | 486 |   | 27 | % | 26 | % | 66 |   | 14 | % |
| Other                        |       | 54                                |       | 59 |   | 3 | % | 3 | % | (5 | ) | -8 | % |
| Total revenue                |       | $                                 | 2,044      |   | $ | 1,880 |   | 100 | % | 100 | % | $ | 164 |   | 9 | % |

 

### **The increase in revenue in fiscal 2004 wasattributable to continued growth from IP telephony solutions, software, andapplications more than offsetting the declines in sales of traditionaltelephony systems.  This change inproduct mix reflects the transition our customers are making to IP telephonysolutions.  Revenue also increased due toour acquisition of Expanets in fiscal 2004 offset by a negative impact from theacquisition of a majority interest in AGC. This negative impact in fiscal 2005was primarily a result of the elimination of intercompany revenue from sales toAGC, formerly Tata Telecom. The increase in Small Communications Systems is dueprimarily to growth in sales of IP Office, our IP telephony offering.**

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Operating income (loss) |       | $                                 | 71         |   | $ | (120 | ) | 3.5 | % | -6.4 | % | $ | 191 |   | -159 | % |
|                         |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

### **The increase in operating income in fiscal2004 was primarily attributable to an increase in gross margin resulting fromincreased volumes over which our fixed costs are spread, a more favorableproduct mix with respect to software and applications, cost reductions from ourcontract manufacturers and continued improvements in overhead costreductions.  Operating expenses have beenreduced primarily due to savings associated with our business restructuringinitiatives related to headcount, which decreased by 3% from September 30,2003, and a continued focus on core initiatives.**

 

***Avaya Global Services***

 
| ** **                              | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**                 | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Maintenance                             |       | $                                 | 1,422      |   | $ | 1,309 |   | 70 | % | 68 | % | $ | 113 |   | 9 | % |
| Implementation and integration services |       | 338                               |       | 340 |   | 17 | % | 18 | % | (2 | ) | -1 | % |
| Managed services                        |       | 260                               |       | 271 |   | 13 | % | 14 | % | (11 | ) | -4 | % |
| Other                                   |       | 1                                 |       | (4 | ) | 0 | % | 0 | % | 5 |   | 125 | % |
| Total revenue                           |       | $                                 | 2,021      |   | $ | 1,916 |   | 100 | % | 100 | % | $ | 105 |   | 5 | % |

 

18

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The increase in contract-related maintenancerevenues in fiscal 2004 was primarily due to the Expanets acquisition and alsodue to an increase in sales of new services, partially offset by pricingpressures on renewal of maintenance contracts. Implementation and integration services revenue declined due todecreases in per occurrence activities that are not covered by a long-termcontract. Managed services revenues were unfavorably affected by customers’cost reduction initiatives which included changes in scope and cancellations.

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | ** **                        | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
| Operating income        |       | $                                 | 249        |   | $ | 163 |   | 12.3 | % | 8.5 | % | $ | 86 |   | 53 | % |
|                         |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operating income in fiscal2004 was primarily due to an improvement in gross margin.  This increase reflects continued costreduction initiatives in the first half of fiscal 2004, improved revenue andbetter utilization of our technician workforce as a result of the integration ofExpanets, partially offset by a write-down of inventory.  The acquisition of Expanets helped contributeto a stronger presence in the U.S. direct channel.  Sales of services through our direct channelincreased, representing 88.1% in fiscal 2004 as compared with 84.6% in fiscal2003, favorably impacting gross margin. Operating expenses increased primarily due to additional selling expenseassociated with the integration of Expanets.

 

**Corporate / Other Unallocated Amounts**

 
| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| **Dollars in millions** | ** ** | **2004**                          | ** ** | **2003** | ** ** | **Change** | ** ** |
| Revenue                 |       | $                                 | 4          |   | $ | — |   | $ | 4 |   |
| Operating income        |       | $                                 | 3          |   | $ | 20 |   | $ | (17 | ) |

 

Revenue of $4 million in fiscal 2004represents sales associated with the acquisition of Expanets.  These sales were not allocated to one of ouroperating segments because the sales were of non-Avaya products that were inthe Expanets pipeline prior to the acquisition, and were consummated subsequentto the closing of our acquisition of Expanets.

 

Operating income for both fiscal years is dueto a combination of certain corporate overhead expenses not charged to theoperating segments (such as cost of vacant real estate space, businessrestructuring charges, etc.) and over/under absorbed corporate overheadexpenses.

 

#### **Results of Discontinued Operations**

 
| ** **                                                            | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                                               | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue from discontinued operations:                                 |       |                              |       |   |   |   |   |
| Connectivity  Solutions                                               |       | $                                 | —     |   | $ | 168 |   | $ | 542 |   |
| Expanets                                                              |       | —                            |       | 8 |   | — |   |
| Total  revenue from discontinued operations                           |       | $                                 | —     |   | $ | 176 |   | $ | 542 |   |
|                                                                  |       |                              |       |   |   |   |   |
| (Loss) income before income taxes from  discontinued operations:      |       |                              |       |   |   |   |   |
| Connectivity  Solutions                                               |       |                              |       |   |   |   |   |
| Results of  operations                                                |       | $                                 | (2         | ) | $ | (71 | ) | $ | 49 |   |
| Gain on sale                                                          |       | —                            |       | 84 |   | — |   |
| Total (loss)  income before income taxes for Connectivity Solutions   |       | (2                                | )          | 13 |   | 49 |   |
| Expanets:                                                             |       |                              |       |   |   |   |   |
| Results of  operations                                                |       | —                            |       | (7 | ) | — |   |
| Total (loss)  income before income taxes from discontinued operations |       | $                                 | (2         | ) | $ | 6 |   | $ | 49 |   |

 

As a result of their divestitures, weclassified our Connectivity Solutions business and the portions of the Expanetsbusiness that previously distributed non-Avaya products as discontinuedoperations.  The table above summarizesthe operating results of the businesses included in (loss) income fromdiscontinued operations, as well as the gain recognized on the sale ofConnectivity Solutions.  The results ofoperations for Connectivity Solutions for the fiscal 2004 include a charge of$48 million comprised of a $24 million pension and postretirement curtailmentloss and a $24 million settlement loss recognized upon the transfer of pensionand postretirement benefit assets and liabilities to CommScope.  Upon the transfer of these pension andpostretirement benefit assets and liabilities to CommScope, an offsetting gainof $48 million was recognized and included in the $84 million gain on sale of 

 

19

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discontinued operations for the assumption of these liabilities byCommScope.

 

The amounts presented for Expanets for fiscal2004 represent the results generated by the portion of the Expanets businessthat previously distributed non-Avaya products from the date of acquisition on November 25,2003, through June 30, 2004.  Wedivested the entire portion of the Expanets business as of June 30, 2004.

 

**Liquidity and Capital Resources**

 

During fiscal 2005, we focusedon reducing the amount of our debt, while balancing our cash needs forstrategic acquisitions and our stock repurchase program.  As a result, our cash and cash equivalentsdecreased to $750 million as of September 30, 2005 from$1,617 million as of September 30, 2004.

 

As part of our strategy to reduce our debt, we redeemed allof our remaining outstanding LYONs (after substantially all the holders ofLYONs converted their LYONs into Avaya common stock shortly before therepurchase date) and repurchased substantially all of our outstanding seniornotes during the first quarter of fiscal 2005. These reductions in debt were partially offset by the closing of theTenovis acquisition and the assumption of certain related debt, all of which wehave repaid except for certain amounts relating to capital leaseobligations.  The impact of thesetransactions is described in the “Investing Activities” and “FinancingActivities” discussions below.  Primarilyas a result of these actions, we reduced our debt balance from $593 million asof September 30, 2004 to $30 million as of September 30, 2005.

 

20

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### ***Sources and Uses of Cash for****the Fiscal YearEnded September 30, 2005*

 

A condensed statement of cash flows for fiscal 2005and 2004 follows:

 
| *** ***                                                                     | ** ** | **Year ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                                                          | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net cash provided by (used for):                                                 |       |                              |       |   |   |
| Operating  activities from continuing operations                                 |       | $                                 | 334        |   | $ | 479 |   |
| Investing  activities from continuing operations                                 |       | (558                              | )          | 21 |   |
| Financing  activities from continuing operations                                 |       | (638                              | )          | (64 | ) |
| Effect of exchange rate changes on cash and  cash equivalents                    |       | (5                                | )          | 10 |   |
| Net (decrease) increase in cash and cash  equivalents from continuing operations |       | (867                              | )          | 446 |   |
|                                                                             |       |                              |       |   |   |
| Net decrease in cash and cash equivalents  from discontinued operations          |       | —                            |       | (21 | ) |
|                                                                             |       |                              |       |   |   |
| Cash and cash equivalents at beginning of  year                                  |       | 1,617                             |       | 1,192 |   |
| Cash and cash equivalents at end of year                                         |       | $                                 | 750        |   | $ | 1,617 |   |

 

***Operating Activities***

 

Our net cash provided by operating activitiesfrom continuing operations was $334 million for fiscal 2005, compared to $479million for fiscal 2004.  The decrease incash provided by operating activities was primarily driven by higher incentivepayments, as explained below, partially offset by an increase in net income infiscal 2005.

 

*Higher incentives*–Fiscal 2005 included payments of employee incentives based on the full fiscalyear 2004 performance. The payments made during fiscal 2004 were based on onlythe second half of fiscal 2003 as incentive payments were made in fiscal 2003related to the first half of fiscal 2003. The higher payments are also attributable to our significantly increasedprofitability in fiscal 2004 compared to fiscal 2003.

 

*Increase in net income*– Net income of $921 million for fiscal 2005 represents a $625 million increasefrom fiscal 2004.  This increase wasprimarily due to changes in deferred tax balances resulting in a non-cash taxbenefit of $590 million and a non-cash tax benefit of $124 million on auditsettlements, which are described fully in Note 12  “Income Taxes” and Note 17 “ “Commitments andContingencies” to our Consolidated Financial Statements, respectively.  Fiscal 2005 net income includes $125 millionof additional depreciation and amortization charges compared to fiscal 2004.

 

The changes in our working capital accountsreflect cash outflows resulting from an increase of business volume in fiscal2005 compared to fiscal 2004.  Listed beloware additional comments with respect to certain individual working capitalaccounts:

 

*Accounts Receivable,Net* – The following summarizes our accounts receivableand related metrics:

 
| ** **                                                                  | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|
| **Dollars in millions**                                                     | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
| Accounts receivable, gross                                                  |       | $                      | 920        |   | $ | 744 |   | $ | 176 |   |
| Allowance for doubtful accounts                                             |       | (58                    | )          | (48 | ) | (10 | ) |
| Accounts receivable, net                                                    |       | $                      | 862        |   | $ | 696 |   | $ | 166 |   |
|                                                                        |       |                   |       |   |   |   |   |
| Allowance for doubtful accounts as a  percent of accounts receivable, gross |       | 6.3                    | %          | 6.5 | % | -0.2 pts |   |
|                                                                        |       |                   |       |   |   |   |   |
| Days sales outstanding (DSO)                                                |       | 60 days                |       | 58 days |   | + 2 days |   |
|                                                                        |       |                   |       |   |   |   |   |
| Past due receivables as a percent of  accounts receivable, gross            |       | 21.7                   | %          | 13.3 | % | +8.4 pts |   |

 

The increase in the accounts receivablebalance since September 30, 2004 is primarily due to the acquisition ofTenovis.

 

As of September 30, 2005, the allowancefor doubtful accounts includes Tenovis’ post-acquisition allowance for doubtfulaccounts, while the allowance at the acquisition date was netted againstTenovis’ gross accounts receivable.

 

The past due receivables percentage hasincreased by 8.4 percentage points in fiscal 2005, driven by Tenovisreceivables for which the majority of rental customers have net payment termsof 10 days.  Historically, Tenovis’customers do not meet these terms, thus creating a significant percentagefalling overdue on the eleventh day. Typically, Avaya’s payment terms are approximately 30 days.

 

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

 
| ** **              | ** ** | **September 30,** | ** ** |
|-------------------------|------------|------------------------|------------|
| **Dollars in millions** | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
| Finished goods          |       | $                      | 274        |   | $ | 221 |   | $ | 53 |   |
| Raw materials           |       | 14                     |       | 18 |   | (4 | ) |
| Total  inventory        |       | $                      | 288        |   | $ | 239 |   | $ | 49 |   |
|                    |       |                   |       |   |   |   |   |
| Inventory turnover      |       | 9.4 times              |       | 9.0 times |   | + 0.4 times |   |

 

Our acquisition of Tenovis accounts for the majority of the $49 millionincrease in inventory levels since September 30, 2004.  In addition,due to the lower levels of purchases made by our indirect channel partners andincreased lead times for inventories purchased from our contract manufacturersin the second quarter of fiscal 2005, there was an increase in our inventoryholdings.  During the remainder of fiscal2005, we reduced our inventory levels to adjust for the new level of purchasesby our indirect channel partners, and the balance as of September 30, 2005represents our lowest inventory balance since the acquisition of Tenovis in November 2004.

 

Additionally, the acquisition of Tenovis had a negative impact on ourinventory turnover, however, this impact was more than offset by our inventorymanagement efforts.

 

*Accounts Payable*– The following summarizes our accounts payable:

 
| ** **               | ** ** | **September 30,** | ** ** |
|--------------------------|------------|------------------------|------------|
| **Dollars in millions**  | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
| Accounts payable         |       | $                      | 402        |   | $ | 345 |   | $ | 57 |   |
|                     |       |                   |       |   |   |   |   |
| Days payable outstanding |       | 53                     |       | 58 |   | - 5 days |   |
|                          |            |                        |            |  |  |  |  |  |  |  |

 

Our accounts payable increased primarily as aresult of trade payables recorded related to our acquisitions.

 

***Investing Activities***

 

Net cash used by investing activities forcontinuing operations was $558 million for fiscal 2005, compared with net cashprovided by investing activities from continuing operations of $21 million forfiscal 2004.  Fiscal 2005 activitiesprimarily include $421 million, net, used for acquisitions, including $265 millionfor Tenovis, $110 million for Spectel and $38 million for Nimcat.  We used $147 million for capital expendituresand received proceeds of $52 million from the sale of our corporate aircraft.  The Company incurred R&D costs of $453million in fiscal 2005 of which $59 million were capitalized as softwaredevelopment costs.

 

Fiscal 2004 activities primarily include netcash proceeds of $256 million from the sale of our Connectivity Solutionsbusiness and $28 million from the sale of CommScope stock.  These increases in cash were partially offsetby $128 million used for acquisitions, of which $115 million was used toacquire substantially all of the assets and certain liabilities of Expanets, aswell as $81 million used for capital expenditures and $38 million forcapitalized software development costs.

 

***Financing Activities***

 

**Netcash used by financing activities for continuing operations was $638 millionfor fiscal 2005, compared with $64 million for fiscal 2004.  Cash used in the current period consisted primarilyof $314 million to repurchase substantially all of our senior notes in a publictender offer, $262 million to repay the outstanding principal of Tenovis’secured floating rate notes and $107 million to repurchase and retire ourcommon stock pursuant to our stock repurchase plan.  These uses of cash were partially offset by$49 million of cash received in connection with the issuance of common stockunder our employee stock purchase plan and the exercise of options under ourstock option plans.**

** **

**Cashused during fiscal 2004 consisted primarily of $249 million to redeem $224million of principal amount of our senior notes and $155 million to repurchase$132 million of principal amount of our senior notes in a series of open markettransactions.  These uses of cash werepartially offset by $249 million in net proceeds received in connection withthe sale of 14,039,481 shares of our common stock in February 2004 and $91million of cash received in connection with the issuance of common stock underour employee stock purchase plan and stock option plans.  We used the net proceeds from the February 2004sale of our common stock to fund the redemption of a portion of our seniornotes, as described above.**

 

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***Cash Flows of DiscontinuedOperations***

 

**Net cash used for discontinued operations of $21million for fiscal 2004 was attributed to operating activities and consisted of$15 million related to Connectivity Solutions and $6 million related to theportion of the Expanets business divested subsequent to the acquisition.**

** **

The following table represents changes in our cash and cash equivalentsbalance attributable to discontinued operations.

 
| ** **                                                                       | ** ** | **Year ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                                                          | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Net cash (used for) provided by operating  activities of discontinued operations |       | $                                 | (21        | ) | $ | 57 |   |
| Net cash used for investing activities of  discontinued operations               |       | —                            |       | (3 | ) |
| Net cash (used for) provided by  discontinued operations                         |       | $                                 | (21        | ) | $ | 54 |   |

 

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

** **

***Future CashRequirements***

*** ***

The following table summarizes our contractual obligations as of September 30,2005:

 
| ** **                                                          | ** ** | **Payments due by period** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                          | ** ** | ** **                 | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| **In millions**                                                     | ** ** | **Total**                  | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **5 years** | ** ** |
| Long-term debt obligations (1)                                      |       | $                          | 30         |   | $ | 5 |   | $ | 9 |   | $ | 16 |   | $ | — |   |
| Operating lease obligations (2)                                     |       | 639                        |       | 121 |   | 184 |   | 116 |   | 218 |   |
| Purchase  obligations with contract manufacturers and suppliers (3) |       | 210                        |       | 210 |   | — |   | — |   | — |   |
| Other purchase obligations (4)                                      |       | 91                         |       | 91 |   | — |   | — |   | — |   |
| Total                                                               |       | $                          | 970        |   | $ | 427 |   | $ | 193 |   | $ | 132 |   | $ | 218 |   |

 

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(1)          Long-term debt paymentsdue in less than 1 year and due in one to three years primarily representcapital lease obligations. Long-term debt payments due in 3-5 years representthe $13 million outstanding principal amount of senior notes plus the netunamortized premium and unamortized deferred gain on the interest rate swapshedged against the senior notes, as well as capital lease obligations.  These amounts do not include future paymentsfor interest.

 

(2)          Contractual obligationsfor operating leases include $34 million of future minimum lease payments thathave been accrued for in accordance with generally accepted accountingprinciples pertaining to restructuring and exit activities.

 

(3)          We purchase componentsfrom a variety of suppliers and use several contract manufacturers to providemanufacturing services for our products. During the normal course of business,in order to manage manufacturing lead times and to help assure adequatecomponent supply, we enter into agreements with contract manufacturers andsuppliers that allow them to produce and procure inventory based uponforecasted requirements provided by us. If we do not meet these specified purchase commitments, we could berequired to purchase the inventory.

 

(4)          Other purchaseobligations represent an estimate of contractual obligations in the ordinarycourse of business, other than commitments with contract manufacturers andsuppliers, for which we have not received the goods or services as of September 30,2005.  Although contractual obligationsare considered enforceable and legally binding, the terms generally allow usthe option to cancel, reschedule, and adjust our requirements based on ourbusiness needs prior to the delivery of goods or performance of services.

 

Our primary future cash requirements will be to fund working capital,capital expenditures, employee benefit obligations, strategic acquisitions,share repurchases and our restructuring payments.

 

Specifically, we expect our primary cash requirements forfiscal 2006 to be as follows:

 

•                  *Share Repurchase Plan*– In accordance with the share repurchaseplan authorized by the Board of Directors on April 19, 2005, we may use upto $500 million of cash to repurchase shares of our outstanding common stockthrough April 30, 2007. Our credit facility, described below, provided uswith the ability to make dividend payments or distributions or to repurchase, 

 

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redeemor otherwise acquire shares of our common stock in fiscal 2005 up to an amountnot to exceed $250 million.  For fiscal2006, the credit facility limits our ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares of ourcommon stock to $461 million (which represents 50% of net income for theCompany for fiscal 2005).  We paid $107million during fiscal 2005 to repurchase and retire****our shares, leaving approximately $393million available for further share repurchases according to the limitations ofthe plan.  Between September 30,2005 and November 30, 2005, we repurchased and retired 6.6 million sharesat an average purchase price of $11.40 per share. These repurchases are made atmanagement’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms ofAvaya’s credit facility and other factors. See Note 8 “Long-Term Debt,” to our Consolidated Financial Statementsfor further information.

 

•                  *Capital expenditures* – We expect to spendapproximately $135 million for capital expenditures and approximately $65million for capitalized software development costs during fiscal 2006.

 

•                  *Restructuring payments*– We expect to makeTenovis employee termination payments aggregating approximately $70 millionduring fiscal 2006.  We also plan to payapproximately $10 million for employee separation and lease termination costsrelated to our fourth quarter fiscal 2005 restructuring.

 

•                  *Debt repayments -* We expect to call for redemption theoutstanding senior notes in April 2006 for approximately $14 million.

 

•                  *Employee incentive payments –*  We did not meet the corporate targets(operating income, revenue growth and cash flow target)  established for bonuses under the Avaya ShortTerm Incentive Plan (“STIP”) for fiscal 2005 and were thus not required to makea cash payment in 2006 pursuant to the Plan. However, in the first quarter of fiscal 2006, the Company paid out $25million of discretionary employee incentive awards..  Cash payments for employee incentive awardswould have been approximately $80 million higher had the corporate targets beenachieved. Cash payments made with respect to the 2006 STIP are expected to bepaid out in fiscal 2007.

 

•                  *Pension plan funding*– We estimate we will make payments totaling $7 million for certainU.S. pension benefits that are not pre-funded, and contributions totaling $11million for non-U.S. plans. Under current law, we will not be required to makea contribution to our U.S. pension plans in fiscal 2006 to satisfy minimumstatutory funding requirements.

 

***FutureSources of Liquidity***

 

We expect our primary source of cash during fiscal 2006 to be positivenet cash provided by operating activities. We expect that growth in ourrevenues outside the U.S. and continued focus on accounts receivable, inventorymanagement and cost containment will enable us to continue to generate positivenet cash from operating activities.

 

Based on past performance and current expectations, we believe that ourexisting cash and cash equivalents of $750 million and our net cash provided byoperating activities will be sufficient to meet our future cash requirementsdescribed above.  We also believe we havesufficient cash and cash equivalents for future acquisitions.  Our ability to meet these requirements willdepend on our ability to generate cash in the future, which is subject togeneral economic, financial, competitive, legislative, regulatory and otherfactors that are beyond our control.

 

We and a syndicate of lenders are currently party to a $400 millionrevolving credit facility (see Note 8 “Long-Term Debt” to our ConsolidatedFinancial Statements), which expires in February 2010.  Our existing cash and cash equivalents andnet cash 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 weacquire a business in the future that has existing debt, our debt servicerequirements may increase, thereby increasing our cash needs.

 

If we do not generate sufficient cash from operations, faceunanticipated 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 cash needs we may, fromtime to time, borrow under our credit facility or issue other long- orshort-term debt or equity, if the market and the terms of our existing debtinstruments permit us to do so.

 

***Uncertainties Regarding Our Liquidity***

 

We believe the following uncertainties exist regarding our liquidity:

 

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•                  *Ability to Increase Revenue* – Our ability to generate netcash from operating activities has been a primary source of our liquidity.  If our revenues were to stagnate or decline,our ability to generate net cash from operating activities in a sufficientamount to meet our cash needs could be adversely affected.

 

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

 

•                  *Future Acquisitions*– We may from time to time in the futuremake additional acquisitions.  Suchacquisitions may require significant amounts of cash or may result in increaseddebt service requirements to the extent we assume or incur debt in connectionwith such acquisitions.

 

•                  *Pension Reform*- The Company has reviewed the variouspension legislation reform proposals.  The reform proposalsmay cause a significant increase in the Company’s required pensioncontributions beginning in fiscal year 2007.

 

***Debt Ratings***

 

Our ability to obtain external financing and the related cost ofborrowing is affected by our debt ratings, which are periodically reviewed bythe major credit rating agencies.  As of September 30,2005, we had a senior implied rating of Ba3 with a positive outlook from Moody’sand a corporate credit rating of BB with a stable outlook from Standard &Poor’s.

 

These ratings are not recommendations to buy,sell or hold securities.  The ratings aresubject to change or withdrawal at any time by the respective credit ratingagencies.  Each credit rating should beevaluated independently of any other ratings.

 

***Contribution of Common Stock to Pension Plan***

 

During June 2004, we made a voluntary contribution of $111 millionof our common stock to fund our U.S. management pension plan.  The contribution was funded with acombination of 2,448,602 shares of treasury stock and 4,510,646 shares of newlyissued common stock.  The per share valueof common stock contributed to the pension plan was $15.95, which representedthe average of the opening and closing share price on June 9, 2004, thedate of the contribution.  As of the dateof the contribution, the treasury stock had a carrying value of $27million.  The difference between the $27million carrying value and the $39 million fair value of the treasury stockcontributed was recorded as an increase to additional paid-in capital.  As a result of this contribution, based oncurrent law, we expect we will not be required to make a contribution tosatisfy minimum statutory funding requirements for our U.S. pension plans untilfiscal 2007.

 

***Credit Facility***

 

Our credit facility contains affirmative and restrictive covenants thatwe must comply with, including: (a) periodic financial reportingrequirements, (b) maintaining a maximum ratio of consolidated debt toearnings before interest, taxes, depreciation and amortization, adjusted forcertain business restructuring charges and related expenses and non-cashcharges, referred to as adjusted EBITDA, of 2.00 to 1.00, (c) maintaininga minimum ratio of adjusted EBITDA to interest expense of 4.00 to 1.00, (d) limitationson the incurrence of subsidiary indebtedness, (e) limitations on liens, (f) limitationson investments and (g) limitations on the creation or existence ofagreements that prohibit liens on our properties.  The credit facility also limits theCompany’s ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock to an amount notto exceed 50% of consolidated net income of the Company for the fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made.  The credit facility was amended in May 2005to provide us with the ability to make dividend payments or distributions or torepurchase, redeem or otherwise acquire shares of our common stock infiscal 2005 up to an amount not to exceed $250 million.  As of September 30, 2005, we were incompliance with all of the covenants included in the credit facility.

 

The credit facility provides that wemay use up to $1 billion in cash (excluding transaction fees) and assumed debtfor acquisitions completed after February 23, 2005, provided that we arein compliance with the terms of the agreement. The acquisition amount will be permanently increased to $1.5 billionafter consolidated EBITDA of us and our subsidiaries for any period of twelveconsecutive months equals or exceeds $750 million.

 

As of September 30, 2005, there are $55million of letters of credit issued under the credit facility.  Thereare no other outstanding borrowings under the facility and the remainingavailability is $345 million.  We believethe credit facility provides us with an important source of backupliquidity.  See Note 8 “Long-Term Debt,”to our Consolidated Financial Statements, for a more detailed discussion of ourcredit facility.

 

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

 

We are party to several types of agreements, including surety bonds,purchase commitments, product financing arrangements and performanceguarantees, which are fully discussed in Note 17 “Commitments and Contingencies”to our Consolidated Financial Statements.

 

**LegalProceedings and Environmental, Health and Safety Matters**

 

We are subject to certain legal proceedings as fully discussed in Note17 “Commitments and Contingencies” to our Consolidated Financial Statements.

 

**Financial Instruments**

 

***Foreign CurrencyTransactions***

 

***RecordedTransactions***—We utilize foreign currency forwardcontracts primarily to manage short-term exchange rate exposures on certainreceivables, payables and loans residing on foreign subsidiaries’ books, whichare denominated in currencies other than the subsidiary’s functionalcurrency.  For fiscal 2005 and 2004, thechanges in the fair value of the foreign currency forward contracts weresubstantially offset by changes resulting from the revaluation of the hedgeditems.

 

The fair value of foreign currency forward contracts is sensitive tochanges in foreign currency exchange rates. As of September 30, 2005 and 2004, a 10% appreciation intraded-against foreign currency value from the prevailing market rates wouldhave decreased our related net unrealized gain from continuing operations forfiscal 2005 and 2004 by $37 million and $40 million, respectively.Conversely, a 10% depreciation would have increased our related net gain fromcontinuing operations for fiscal 2005 and 2004 by $27 million and$56 million, respectively. Consistent with the nature of the economic hedge of such foreigncurrency forward contracts, such unrealized gains or losses would be offset bycorresponding decreases or increases, respectively, of the underlying asset,liability or transaction being hedged.

 

***ForecastedTransactions***—From time to time, we use foreigncurrency forward contracts to offset certain forecasted foreign currencytransactions primarily related to the purchase or sale of product expected tooccur during the ensuing twelve months. The change in the fair value of foreign currency forward contracts isrecognized as other income or expense in the period in which the exchange rateschange.  For fiscal 2005 and 2004, thesegains and losses were not material to our results of operations.

 

***Interest Rate SwapAgreements***

 

During the first and second quarters of 2004, we entered into a totalof five interest rate swap agreements each having a notional amount of $50million and a maturity date of April 2009, which matched the notionalamount of the senior notes outstanding. The interest rate swaps effectively converted $250 million of the seniornotes from fixed rate debt into floating rate debt.  During the third and fourth quarters offiscal 2004, 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 final maturity dateof November 2007. These interest rate swap agreements were executed inorder to convert the secured notes floating rate debt into fixed ratedebt.  During the second and thirdquarters of fiscal 2005, we repaid the outstanding principal amount of thesecured floating rate notes and concurrently terminated the two interest rateswaps.

 

See Note 9 “Derivatives and Other Financial Instruments” to ourConsolidated Financial Statements for further details related to these interestrate swap agreements.

 

**Recent Accounting Pronouncements**

 

***SFAS 123(R)***

 

In December 2004, the FASB issued SFAS 123(R), which requires theCompany to recognize compensation expense for stock options and discounts underemployee stock purchase plans granted to employees based on the estimated fairvalue of the equity instrument at the time of grant.  Currently, the Company discloses the proforma net income and earnings per share as if the Company applied the fairvalue recognition provisions of SFAS 123 as amended by SFAS 148.  The requirements of SFAS 123(R) are effectivefor the Company beginning in the first quarter of fiscal 2006.  We will recognize compensation expense forstock-based awards issued after October 1, 2005 on a straight-line basisover the requisite service period for the entire award.  We also expect to record expense ofapproximately $6 million in fiscal 2006 and $2 million in fiscal 2007 relatedto previously-issued, unvested stock options for which 

 

26

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vesting has not been accelerated. Beginning October 1, 2005, upon the adoption of SFAS 123(R), theCompany began using a binomial model in calculating the estimated fair value ofstock options.  The binomial model usesmore inputs than the Black-Scholes model, and management believes use of thebinomial model will result in a better estimate of fair value than was previouslyused for purposes of determining the pro-forma impact of SFAS 123.  The change to the binomial model did not havea material impact on the fair value of the 4.6 million stock options issued in October 2005.  Estimated aggregate fair value of $21 millionrelated to the stock options issued in October 2005 will be expensedratably over the three-year vesting period.

 

***FSP SFAS 123(R)-1***

 

In August 2005, the FASB issued FSP 123(R)-1, which defers therequirement of SFAS 123(R) that a freestanding financial instrument originallysubject to SFAS 123(R) becomes subject to the recognition and measurementrequirements of other applicable GAAP when the rights conveyed by theinstrument to the holder are no longer dependent on the holder being anemployee of the Company.  A freestandingfinancial instrument issued to an employee in exchange for past or futureemployee services that is subject to SFAS 123(R) will continue to be subject tothe recognition and measurement provisions of SFAS 123(R) throughout the lifeof the instrument, unless the terms are modified when the holder is no longeran employee.  The requirements of FSPSFAS 123(R)-1 are effective upon the initial adoption of SFAS 123(R), which isbeginning in the first quarter of fiscal 2006. The adoption of SFAS 123(R)-1 is not expected to have a material impacton the Company’s Consolidated Financial Statements.

 

***SFAS 154***

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes andError Corrections – a Replacement of APB Opinion No. 20 and FASB StatementNo. 3” (“SFAS 154”).  SFAS 154changes the requirements for the accounting for, and reporting of, a change inaccounting principle.  SFAS 154 requiresthat a voluntary change in accounting principle be applied retrospectively withall prior period financial statements presented using the new accountingprinciple.  SFAS 154 is effective foraccounting changes and corrections of errors in fiscal years beginning after December 15,2005.  The Company will apply therequirements of SFAS 154 on any changes in principle made on or after October1, 2006.

 

***FIN 47***

 

In March 2005, the FASB issued Interpretation No. 47, “Accountingfor Conditional Asset Retirement Obligations, an Interpretation of FASBStatement No. 143” (“FIN 47”).  FIN47 clarifies the term “conditional asset retirement obligation” used in FASBStatement No. 143, “Accounting for Asset Retirement Obligations,” andrefers to a legal obligation to perform an asset retirement activity in whichthe timing and (or) method of settlement are conditional on a future event thatmay or may not be within the control of the Company.  The obligation to perform the assetretirement activity is unconditional even though uncertainty exists about thetiming and (or) method of settlement. Accordingly, FIN 47 requires the Company to recognize a liability forthe fair value of a conditional asset retirement obligation if the fair valueof the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirementobligation is to be recognized when incurred. FIN 47 will be effective for the Company no later than the end of its2006 fiscal year.  The implementation ofthis interpretation is not expected to have a material effect on the Company’sConsolidated Financial Statements.

 

***FIN 46-R-5***

 

In March 2005, FASB issued Interpretation No. 46(R)-5, “ImplicitVariable Interests under FASB Interpretation No. 46” (“FIN 46(R)-5”).  This interpretation further expands andclarifies current accounting guidance for variable interest entities addressingwhether a reporting enterprise should consider whether it holds an implicitvariable interest in a variable interest entity or potential variable interestentity when certain specific conditions exist. The Company adopted the guidance in this interpretation as of March 2005.  The adoption of FIN 46(R)-5 did not have amaterial effect on the Company’s Consolidated Financial Statements.

 

***FSP SFAS 143-1***

 

On June 8, 2005, FASB issued FASB Staff Position (“FSP”) SFAS No. 143-1,“Accounting for Electronic Equipment Waste Obligations,” to address theaccounting for obligations associated with the Directive on Waste Electricaland Electronic Equipment (“the Directive”) issued by the European Union (“EU”).  The Directive was enacted on February 13,2003 and directs EU-member countries to adopt legislation to regulate thecollection, treatment, recovery and environmentally sound disposal ofelectrical and electronic waste equipment. The Directive concludes that commercial users are obligated to retire,in an environmentally sound manner, specific assets that qualify as historicalwaste.  FSP SFAS 143-1 is effective forreporting periods ending after June 8, 2005.  The adoption of FSP SFAS 143-1 has notmaterially affected the Consolidated Financial Statements with respect tolegislation enacted to date.  The Companywill continue to evaluate the impact as other EU-member countries enact thelegislation.

 

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**Recent Tax Legislation**

 

On October 22, 2004, the American Jobs Creation Act of 2004, or theAct, was signed into law.  The Actincludes a deduction of 85% of certain foreign earnings that are repatriated,as defined in the Act.  With respect tothe repatriation provision, we continue to evaluate the potential benefits ascompared to the costs with a decision expected to be made by the end of fiscal2006.

 

**The Application of Critical AccountingPolicies**

 

Our Consolidated Financial Statements are based on the selection andapplication of accounting principles generally accepted in the United States ofAmerica, which require us to make estimates and assumptions about future eventsthat affect the amounts reported in our financial statements and the accompanyingnotes. Future events and their effects cannot be determined with absolutecertainty. Therefore, the determination of estimates requires the exercise ofjudgment. Actual results could differ from those estimates, and any suchdifferences may be material to the financial statements. We believe that thefollowing policies may involve a higher degree of judgment and complexity intheir application and represent the critical accounting policies used in thepreparation of our financial statements. If different assumptions or conditionswere to prevail, the results could be materially different from our reportedresults.

 

***Revenue Recognition***

 

We derive revenue primarily from the sale and service of communicationsystems and applications. In accordance with SEC Staff Accounting BulletinNo. 104, “Revenue Recognition,” revenue is recognized when persuasiveevidence of an arrangement exists, delivery has occurred, the fee is fixed anddeterminable, collectibility is reasonably assured, contractual obligationshave been satisfied, and title and risk of loss have been transferred to thecustomer.  When we provide a combinationof products and services to customers, the arrangement is evaluated underEmerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables,” or EITF 00-21, which addresses certain aspects of accounting bya vendor for arrangements under which the vendor will perform multiple revenuegenerating activities.  The applicationof the appropriate accounting guidance to our revenue requires judgment and isdependent upon the specific transaction and whether the sale includes systems,applications, services or a combination of these items.  As our business evolves, the mix of productsand services sold may impact the timing of when revenue and related costs arerecognized.

 

Our products are sold directly through our worldwide sales force andindirectly through our global network of distributors, dealers, value-addedresellers and system integrators.  Thepurchase price of our systems and applications typically includes installationand a warranty for up to one year. Revenue from the direct sales of products that include installationservices is recognized at the time the products are installed, aftersatisfaction of all the terms and conditions of the underlying customercontract.

 

Our indirect sales to distribution partners are generally recognized atthe time of shipment if all contractual obligations have been satisfied. Weaccrue a provision for estimated sales returns and other allowances anddeferrals as a reduction of revenue at the time of revenue recognition, asrequired.  We calculate the provision forsales returns and allowances based on a quarterly analysis of actual historicalreturns and allowances in relation to current quarter sales, and determine therequired allowance.  This analysisrequires a significant amount of judgment. If the accrued provision is higher or lower than required based on ourquarterly analysis, the provision is adjusted against revenue.

 

Revenue and the related costs from services performed under managedservices arrangements, professional services and services performed undermaintenance contracts are 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.

 

Most of our sales require judgments principally in the areas ofcustomer acceptance, returns assessments and collectibility. The assessment ofcollectibility is particularly critical in determining whether or not revenueshould be recognized. We assess collectibility based primarily on thecreditworthiness of the customer as determined by credit checks and analysis,as well as the customer’s payment history. In addition, a significant amount ofour revenue is generated from sales of product to distributors. As such, ourprovision for estimated sales returns and other allowances and deferralsrequires significant judgment. We provide for estimated sales returns and otherallowances and deferrals as a reduction of revenue at the time of revenuerecognition, as required. If these estimates, which are based on historicalexperience, are significantly below the actual amounts, our revenue could beadversely affected.

 

***Collectibility of Accounts Receivable***

 

Our accounts receivable are recorded net of an allowance for doubtfulaccounts.  As discussed above, we accruefor the allowance based on an analysis of historical trends.  In order to record our accounts receivable attheir net realizable value, we must also assess their collectibility. Aconsiderable amount of judgment is required in order to make this assessmentincluding a detailed analysis of the 

 

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aging of our receivables and the current creditworthiness of ourcustomers and an analysis of historical bad debts and other adjustments. Wehave recorded allowances for receivables which we believe are uncollectible,including amounts for the resolution of potential credit and other collectionissues such as disputed invoices, customer satisfaction claims and pricingdiscrepancies. However, depending on how such potential issues are resolved, orif the financial condition of any of our customers were to deteriorate andtheir ability to make required payments became impaired, increases in theseallowances may be required. We actively manage our accounts receivable tominimize credit risk, and as of September 30, 2005, we have no individualcustomer that constitutes more than 10% of our accounts receivable.

 

***Inventories***

 

In order to record our inventory at its lower of cost or market value,we regularly assess the ultimate realizability of our inventory. We adjust ourinventory balance based on historical usage, inventory turnover and productlife cycles through the recording of a provision which we include in cost ofsales. In certain circumstances such as the introduction of a new product, wemay make judgments as to future demand and compare that with the current orcommitted inventory levels. Where we have determined that the future demand islower than our current inventory levels, we adjust our inventory balanceaccordingly. In addition, we have outsourced the manufacturing of substantiallyall of our GCS products. We may be obligated to purchase certain excessinventory levels from our outsourced manufacturer that could result from ouractual sales of product varying from forecast, in which case we may need to recordadditional inventory provisions in the future.

 

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

 

Our deferred tax assetsare primarily a result of deductible temporary differences related to pensionand other accruals, as well as tax credit carryforwards and net operating losscarryforwards which are available to reduce taxable income in futureperiods.  A considerable amount ofjudgment is required in estimating the amount of deferred tax assets torecognize in the financial statements. In determining whether or not a valuation allowance is required, we mustconsider, among other things, historical results for both book and tax purposesand expectations of future book and taxable income.

 

The Company is directly responsible for allU.S. federal, state, local or foreign tax audit issues for periods subsequentto the distribution.  Significantjudgment is required in determining the worldwide provision for incometaxes.  While it is often difficult topredict the final outcome or the timing of resolution of tax issues, theCompany establishes tax reserves based on estimates of additional taxes andinterest due with respect to certain positions that may not be sustained onreview by tax authorities.  The Companyadjusts these reserves in light of changing facts and circumstances, includingthe results of tax audits and changes in tax law.  The Company believes that its tax reservesreflect the probable outcome of known contingencies.

 

***Long-Lived Assets***

 

We have recorded property, plant and equipment, intangible assets, andcapitalized software costs at cost less accumulated depreciation oramortization. The determination of useful lives and whether or not these assetsare impaired involves significant judgment.

 

A considerable amount of judgment is also required in calculating animpairment charge for assets that are held and used, principally in determiningdiscount rates, market premiums, financial forecasts, and allocationmethodology. In calculating an impairment charge for assets held for sale,significant judgment is required in estimating fair value and costs to sell.Our estimates are based on valuations obtained from third parties and onestimates of incremental costs such as commissions and fees that are customaryfor sales of similar assets.

 

Goodwill impairment is determined using a two-step approach.  The first step of the goodwill test is usedto identify potential impairment by comparing the fair value of a reportingunit, which is one level below our operating segments, with its carryingamount, including goodwill.  The secondstep of the goodwill impairment test compares the implied fair value of thereporting unit’s goodwill with the carrying amount of that goodwill.  If the carrying amount of the reporting unit’sgoodwill exceeds the implied fair value of that goodwill, an impairment loss isrecognized in an amount equal to that excess. We conducted the required annual goodwill impairment review during thefourth quarter of fiscal 2005.  Wecompleted updated valuations for all reporting units with goodwill as ofSeptember 30, 2005 using a discounted cash flow approach based on forward-lookinginformation regarding market share, revenues and costs for each reporting unitas well as appropriate discount rates. As a result, we determined that goodwillwas not impaired as of September 30, 2005.

 

***RestructuringPrograms***

 

Werecorded a restructuring charge during the fourth quarter of fiscal 2005 inaccordance with SFAS 146.  Therestructuring charge includes employee termination benefits as well as accrualsfor vacating leased premises and terminating operating leases.  In connection with our acquisition ofTenovis, we recorded restructuring charges in accordance with EITF 95-3 fortermination benefits 

 

29

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to bepaid to former Tenovis employees.  Inprior years, we recorded restructuring charges in accordance with EITF94-3.  The balance remaining from thesepast restructurings relate to leased premises that have been vacated.

 

Asignificant amount of judgment is required in estimating the amount ofrestructuring charges to record. Estimates used to determine employee termination benefit payments maydiffer from actual amounts to be paid.  Estimatesused to establish reserves related to real estate lease obligations have beenreduced for sublease income that we believe is probable.  Because certain of our real estate leaseobligations extend through fiscal year 2021, assumptions were made as to thetiming, availability and amount of sublease income that we expect to receive.In making these assumptions, we considered many variables such as the vacancyrates of commercial real estate in the local markets and the market rate forsublease rentals.  Because we arerequired 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 subleaseincome estimates were too high, we would incur additional real estate leaseobligation 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 pension plans covering themajority of our U.S. employees and retirees, and postretirement benefit plansfor U.S. retirees that include healthcare benefits and life insurance coverage.Certain non-U.S. operations have various retirement benefit programs coveringsubstantially all of their employees. Some of these programs are considered tobe defined benefit pension plans for accounting purposes.

 

Our pension and postretirement benefit costs are developed fromactuarial valuations. Inherent in these valuations are key assumptions,including the discount rate and expected long-term rate of return on planassets. Material changes in our pension and postretirement benefit costs mayoccur in the future due to changes in these assumptions, changes in the numberof plan participants, changes in the level of benefits provided, changes inasset levels and changes in legislation.

 

The discount rate is subject to change each year, consistent withchanges in applicable high-quality, long-term corporate bond indices. Based onthe expected duration of the benefit payments for our U.S. pension plans, werefer to applicable indices, such as Moody’s AA Corporate Bond Index and theCitigroup Pension Discount Curve, to select a rate at which we believe the U.S.pension benefits could be effectively settled. Based on the published rates asof September 30, 2005, we used a discount rate of 5.50%, a decline of 25basis points from the 5.75% rate used as of September 30, 2004. For the fiscalyear ended September 30, 2005, this had the effect of increasing ourprojected pension benefit obligation by approximately $90 million, and ouraccumulated postretirement benefit obligation by approximately $22 million. Forfiscal 2006, this has the effect of increasing pension service cost byapproximately $1 million. The estimated impact on postretirement servicecost is less than $1 million.

 

The expected long-term rate ofreturn on U.S. pension and postretirement plan assets is selected by takinginto account the expected duration of the projected benefit obligation for theplans, the targeted asset mix of the plans, and whether the plan assets areactively managed. The forward-looking assumptions underlying our expectedlong-term rate of return are developed by our investment adviser and reviewedby us for reasonableness. The return and risk assumptions consider such factorsas anticipated long-term performance of individual asset classes, risk premiumfor active management based on qualitative and quantitative analysis andcorrelations of the asset classes that comprise the asset portfolio. Based on the study completedthis year, the expected rate of return on the pension plan assets will remainunchanged at 9.0% for fiscal 2006, and the expected rate of return onpostretirement plan assets will be changed from 7.25% to 7.0% for fiscal 2006. A 25basis point 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-related value of our plan assets is developed using a 5-yearsmoothing technique. The market-related value as of the measurement date iscalculated as follows: (1) A preliminary market-related value iscalculated by adjusting the market-related value at the beginning of the yearfor payments to and from plan assets and the expected return on assets duringthe year. The expected return on assets represents the expected long-term rateof return on plan assets adjusted up to plus or minus 2% based on the actual10-year average rate of return on plan assets. (2) The final market-relatedvalue is determined by adding to the preliminary market-related value from(1) above 20% of the difference between the actual return and expectedreturn for each of the past five years.

 

***Commitmentsand Contingencies***

 

We are subject to legal proceedings related to environmental, product,employment, intellectual property, 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 

 

30

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developments in each matter or changes in approach such as a change 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” to ourConsolidated Financial Statements.

 

***Accounting for Stock Options***

 

During fiscal 2005 and prior years, we accounted for stock options inaccordance with Accounting Principles Board Opinion 25 and disclosed the proforma effect of expensing stock options in accordance with FAS 123.  Effective October 2005, we have adopted FAS123(R), which requires us to recognize compensation expense in our financialstatements for the fair value of stock options we issue.  Both FAS 123 and FAS 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 underlyingassumptions may have significant impact on the underlying value of the stockoptions, which could have a material impact on our financial statements.

 

31

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**Management’sReport on Internal Control Over Financial Reporting**

 

Management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange ActRule 13a-15(f).  Management (withthe participation of our principal executive officer and principal financialofficer) conducted an evaluation of the effectiveness of internal control overfinancial reporting based on the framework in *InternalControl — Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on this evaluation,management concluded that internal control over financial reporting waseffective as of September 30, 2005 based on criteria in Internal Control —Integrated Framework issued by COSO. Management’s assessment of the effectiveness of internal control overfinancial reporting as of September 30, 2005 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,and PricewaterhouseCoopers LLP has issued an attestation report on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting, which is included herein. 

 

 
| /s/ Donald K. Peterson               |   | /s/ Garry K. McGuire                                                           |
|--------------------------------------|--------|--------------------------------------------------------------------------------|
|                                 |   |                                                                           |
| Chairman and Chief Executive Officer |   | Chief Financial Officer and Senior Vice  President, Corporate Development |
|                                 |   |                                                                           |
| December 13, 2005                    |   | December 13, 2005                                                              |

 

32

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### **Report of IndependentRegistered Public Accounting Firm**

 

To****the Board of Directors and Stockholdersof Avaya Inc.:

 

We have completed an integrated audit of Avaya Inc.’s (the “Company”)2005 consolidated financial statements and of its internal control overfinancial reporting as of September 30, 2005 and audits of its 2004 and 2003consolidated financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States).  Our opinions, based on our audits, arepresented below.

 

**Consolidated financial statements**

 

In our opinion, the accompanying consolidated balance sheets and therelated consolidated statements of operations, of changes in stockholders’equity and of comprehensive income (loss), and of cash flows present fairly, inall material respects, the financial position of the Company at September 30,2005 and 2004, and the results of its operations and its cash flows for each ofthe three years in the period ended September 30, 2005****inconformity with accounting principles generally accepted in the United Statesof America.  These financial statementsare the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

**Internal control over financial reporting**

 

Also, in our opinion, management’sassessment, included in the accompanying Management’s Report on InternalControl Over Financial Reporting, that the Company maintained effectiveinternal control over financial reporting as of September 30, 2005 based oncriteria established in *Internal Control -Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all materialrespects, effective internal control over financial reporting as of September30, 2005, based on criteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness of theCompany’s internal control over financial reporting based on our audit.  We conducted our audit of internal controlover financial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  An audit of internal control over financialreporting includes obtaining an understanding of internal control overfinancial reporting, evaluating management’s assessment, testing and evaluatingthe design and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinions.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles.  A company’s internal 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) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

PricewaterhouseCoopers LLP

Florham Park, New Jersey

December 13, 2005

 

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**AVAYAINC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                       | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions, except per  share amounts**               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUE                                                          |       |                         |       |   |   |   |   |
| Sales of products                                                |       | $                            | 2,294      |   | $ | 2,048 |   | $ | 1,880 |   |
| Services                                                         |       | 1,971                        |       | 1,761 |   | 1,645 |   |
| Rental and managed services                                      |       | 637                          |       | 260 |   | 271 |   |
|                                                             |       | 4,902                        |       | 4,069 |   | 3,796 |   |
| COSTS                                                            |       |                         |       |   |   |   |   |
| Sales of products                                                |       | 1,049                        |       | 928 |   | 944 |   |
| Services                                                         |       | 1,297                        |       | 1,064 |   | 1,070 |   |
| Rental and managed services                                      |       | 259                          |       | 132 |   | 143 |   |
|                                                             |       | 2,605                        |       | 2,124 |   | 2,157 |   |
| GROSS MARGIN                                                     |       | 2,297                        |       | 1,945 |   | 1,639 |   |
|                                                             |       |                         |       |   |   |   |   |
| OPERATING  EXPENSES                                              |       |                         |       |   |   |   |   |
| Selling, general and administrative                              |       | 1,583                        |       | 1,274 |   | 1,240 |   |
| Research and development                                         |       | 394                          |       | 348 |   | 336 |   |
| Restructuring charges                                            |       | 22                           |       | — |   | — |   |
| TOTAL OPERATING EXPENSES                                         |       | 1,999                        |       | 1,622 |   | 1,576 |   |
|                                                             |       |                         |       |   |   |   |   |
| OPERATING  INCOME                                                |       | 298                          |       | 323 |   | 63 |   |
| Other expense, net                                               |       | (32                          | )          | (15 | ) | (29 | ) |
| Interest expense                                                 |       | (19                          | )          | (66 | ) | (78 | ) |
|                                                             |       |                         |       |   |   |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS  BEFORE INCOME TAXES    |       | 247                          |       | 242 |   | (44 | ) |
| (Benefit from) provision for income taxes                        |       | (676                         | )          | (49 | ) | 84 |   |
|                                                             |       |                         |       |   |   |   |   |
| INCOME  (LOSS) FROM CONTINUING OPERATIONS                        |       | 923                          |       | 291 |   | (128 | ) |
|                                                             |       |                         |       |   |   |   |   |
| (LOSS) INCOME FROM DISCONTINUED OPERATIONS,  NET OF INCOME TAXES |       | (2                           | )          | 5 |   | 40 |   |
|                                                             |       |                         |       |   |   |   |   |
| **NET  INCOME (LOSS)**                                           | ** ** | **$**                        | **921**    | ** ** | **$** | **296** | ** ** | **$** | **(88** | **)** |
|                                                             |       |                         |       |   |   |   |   |
| **Earnings  (Loss) Per Common Share - Basic:**                   |       |                         |       |   |   |   |   |
| Earnings (loss) per share from continuing  operations            |       | $                            | 1.95       |   | $ | 0.66 |   | $ | (0.34 | ) |
| Earnings per share from discontinued  operations                 |       | —                       |       | 0.01 |   | 0.11 |   |
| Earnings (loss) per share                                        |       | $                            | 1.95       |   | $ | 0.67 |   | $ | (0.23 | ) |
|                                                             |       |                         |       |   |   |   |   |
| **Earnings  (Loss) Per Common Share - Diluted:**                 |       |                         |       |   |   |   |   |
| Earnings (loss) per share from continuing  operations            |       | $                            | 1.89       |   | $ | 0.63 |   | $ | (0.34 | ) |
| Earnings per share from discontinued  operations                 |       | —                       |       | 0.01 |   | 0.11 |   |
| Earnings (loss) per share                                        |       | $                            | 1.89       |   | $ | 0.64 |   | $ | (0.23 | ) |

 

See Notes to Consolidated FinancialStatements.

 

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**AVAYAINC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                              | ** ** | **As of September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **Dollars in millions, except per  share amounts**                                                                                                                                                      | ** ** | **2005**                | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                                              |       |                    |       |   |   |
| Current assets:                                                                                                                                                                                         |       |                    |       |   |   |
| Cash and cash equivalents                                                                                                                                                                               |       | $                       | 750        |   | $ | 1,617 |   |
| Accounts receivable, less allowances of $58  million and $48 million as of September 30, 2005 and 2004, respectively                                                                                    |       | 862                     |       | 696 |   |
| Inventory                                                                                                                                                                                               |       | 288                     |       | 239 |   |
| Deferred income taxes, net                                                                                                                                                                              |       | 143                     |       | 27 |   |
| Other current assets                                                                                                                                                                                    |       | 128                     |       | 145 |   |
| TOTAL  CURRENT ASSETS                                                                                                                                                                                   |       | 2,171                   |       | 2,724 |   |
| Property, plant and equipment, net                                                                                                                                                                      |       | 738                     |       | 509 |   |
| Deferred income taxes, net                                                                                                                                                                              |       | 911                     |       | 400 |   |
| Intangible assets                                                                                                                                                                                       |       | 337                     |       | 75 |   |
| Goodwill                                                                                                                                                                                                |       | 914                     |       | 257 |   |
| Other assets                                                                                                                                                                                            |       | 148                     |       | 194 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                       | ** ** | **$**                   | **5,219**  | ** ** | **$** | **4,159** | ** ** |
|                                                                                                                                                                                                    |       |                    |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                          |       |                    |       |   |   |
| Current  liabilities:                                                                                                                                                                                   |       |                    |       |   |   |
| Accounts payable                                                                                                                                                                                        |       | 402                     |       | 345 |   |
| Debt maturing within one year                                                                                                                                                                           |       | 5                       |       | 299 |   |
| Payroll and benefit obligations                                                                                                                                                                         |       | 300                     |       | 328 |   |
| Deferred revenue                                                                                                                                                                                        |       | 244                     |       | 178 |   |
| Other current liabilities                                                                                                                                                                               |       | 368                     |       | 273 |   |
| TOTAL  CURRENT LIABILITIES                                                                                                                                                                              |       | 1,319                   |       | 1,423 |   |
| Long-term debt                                                                                                                                                                                          |       | 25                      |       | 294 |   |
| Benefit obligations                                                                                                                                                                                     |       | 1,561                   |       | 1,263 |   |
| Deferred income taxes, net                                                                                                                                                                              |       | 96                      |       | — |   |
| Other liabilities                                                                                                                                                                                       |       | 257                     |       | 385 |   |
| TOTAL  NON-CURRENT LIABILITIES                                                                                                                                                                          |       | 1,939                   |       | 1,942 |   |
|                                                                                                                                                                                                    |       |                    |       |   |   |
| Commitments  and contingencies                                                                                                                                                                          |       |                    |       |   |   |
|                                                                                                                                                                                                    |       |                    |       |   |   |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                                                          |       |                    |       |   |   |
| Series A junior participating preferred  stock, par value $1.00 per share, 7.5 million shares authorized; none issued  and outstanding                                                                  |       | —                  |       | — |   |
| Common stock, par value $0.01 per share,  1.5 billion shares authorized, 471,328,963 and 455,827,524 issued (including  207,053 and 0 treasury shares) as of September 30, 2005 and 2004,  respectively |       | 5                       |       | 5 |   |
| Additional paid-in-capital                                                                                                                                                                              |       | 2,895                   |       | 2,592 |   |
| Accumulated deficit                                                                                                                                                                                     |       | (53                     | )          | (974 | ) |
| Accumulated other comprehensive loss                                                                                                                                                                    |       | (883                    | )          | (829 | ) |
| Less: treasury stock at cost                                                                                                                                                                            |       | (3                      | )          | — |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                        |       | 1,961                   |       | 794 |   |
|                                                                                                                                                                                                    |       |                    |       |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                    | ** ** | **$**                   | **5,219**  | ** ** | **$** | **4,159** | ** ** |

 

See Notes toConsolidated Financial Statements.

 

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**AVAYA INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYAND OF COMPREHENSIVE INCOME (LOSS)**

 
| ** **                                                                            | ** ** | ** **    | ** ** | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | ** **   | ** ** | ** **             |       |              |       |
|---------------------------------------------------------------------------------------|------------|---------------|------------|------------|------------|----------------|------------|-----------------|------------|-------------------|------------|--------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                            | ** ** | ** **    | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | **Other**         | ** ** | ** **   | ** ** | **Total**              |       | **Comprehensive** |       |
| ** **                                                                            | ** ** | **Number**    | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Treasury** | ** ** | **Stockholders’** |       | **Income**        |       |
| **Dollars in millions, shares in thousands**                                          | ** ** | **of Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Loss**          | ** ** | **Stock**    | ** ** | **Equity**             |       | **(Loss)**        |       |
| **Balance  as of September 30, 2002**                                                 | ** ** | **364,195**   | ** ** | **$**      | **4**      | ** **     | **$**      | **1,693**       | ** ** | **$**             | **(1,182** | **)**        | **$**      | **(512**               | **)**      | **$**             | **(3**     | **)** | **$** | **—** |   |   |   |
| Issuance of  common stock through public offering                                     |       | 34,500        |       |       |       | 349            |       |            |       |              |       |         |       | 349                    |       |              |       |
| Issuance of  common stock in connection with the LYONs Exchange offer, net of tax     |       | 13,670        |       |       |       | 57             |       |            |       |              |       |         |       | 57                     |       |              |       |
| Issuance of  common stock to employees under the stock purchase plan                  |       | 3,942         |       |       |       | 16             |       |            |       |              |       |         |       | 16                     |       |              |       |
| Issuance of  common stock - other awards                                              |       | 2,570         |       |       |       | 31             |       |            |       |              |       |         |       | 31                     |       |              |       |
| Issuance of  warrants                                                                 |       | —        |       |       |       | 5              |       |            |       |              |       |         |       | 5                      |       |              |       |
| Purchase of  treasury stock                                                           |       | (321          | )          |       |       |           |       |            |       |              |       | (3           | )          | (3                     | )          |              |       |
| Net loss                                                                              |       |          |       |       |       |           |       | (88             | )          |              |       |         |       | (88                    | )          | $                 | (88        | ) |
| Minimum pension  liability, net of tax effect of $93 and valuation allowance of ($93) |       |          |       |       |       |           |       |            |       | (237              | )          |         |       | (237                   | )          | (237              | )          |
| Foreign currency  translation                                                         |       |          |       |       |       |           |       |            |       | 70                |       |         |       | 70                     |       | 70                |       |
| Total  comprehensive loss                                                             |       |          |       |       |       |           |       |            |       |              |       |         |       |                   | ** ** | **$**             | **(255**   | **)** |
| **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 / treasury 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 / treasury 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 for 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** |   |   |   |

 

See Notes to Consolidated Financial Statements.

 

36

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**AVAYA INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**                                                                   | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **OPERATING  ACTIVITIES:**                                                                |       |                         |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                            | 921        |   | $ | 296 |   | $ | (88 | ) |
| Less: (loss) income from discontinued  operations, net                                    |       | (2                           | )          | 5 |   | 40 |   |
| Income (loss) from continuing operations                                                  |       | 923                          |       | 291 |   | (128 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                         |       |   |   |   |   |
| Business restructuring charges (reversals),  net                                          |       | 17                           |       | (1 | ) | (21 | ) |
| Depreciation and amortization                                                             |       | 272                          |       | 147 |   | 171 |   |
| Provision for uncollectible receivables                                                   |       | 18                           |       | 9 |   | 12 |   |
| Deferred taxes, including reversal of  valuation allowance                                |       | (601                         | )          | 8 |   | 68 |   |
| Reversal of tax liabilities related to  audit settlement                                  |       | (124                         | )          | (47 | ) | — |   |
| Loss on extinguishment of debt, net                                                       |       | 44                           |       | 42 |   | 34 |   |
| Litigation settlements                                                                    |       | —                       |       | (23 | ) | 25 |   |
| Amortization of restricted stock units                                                    |       | 10                           |       | 15 |   | 31 |   |
| Gain on curtailment of pension and  postretirement plans                                  |       | —                       |       | — |   | (46 | ) |
| Adjustments for other non-cash items, net                                                 |       | 3                            |       | 37 |   | 8 |   |
| Changes in operating assets and  liabilities, net of effects of acquired businesses:      |       |                         |       |   |   |   |   |
| Receivables                                                                               |       | (68                          | )          | 2 |   | 184 |   |
| Inventory                                                                                 |       | 56                           |       | 34 |   | 77 |   |
| Restricted cash                                                                           |       | 9                            |       | 28 |   | (27 | ) |
| Accounts payable                                                                          |       | (15                          | )          | — |   | (80 | ) |
| Payroll and benefits                                                                      |       | (89                          | )          | 77 |   | (139 | ) |
| Accrued interest payable on long-term debt                                                |       | (17                          | )          | (70 | ) | (49 | ) |
| Restructuring reserve                                                                     |       | (17                          | )          | (24 | ) | (83 | ) |
| Deferred revenue                                                                          |       | 2                            |       | 16 |   | 22 |   |
| Other assets and liabilities                                                              |       | (89                          | )          | (62 | ) | 110 |   |
| NET CASH PROVIDED BY OPERATING ACTIVITIES  FROM CONTINUING OPERATIONS                     |       | 334                          |       | 479 |   | 169 |   |
| **INVESTING  ACTIVITIES:**                                                                |       |                         |       |   |   |   |   |
| Capital expenditures                                                                      |       | (147                         | )          | (81 | ) | (57 | ) |
| Capitalized software development costs                                                    |       | (59                          | )          | (38 | ) | (29 | ) |
| Acquisitions of businesses, net of cash  acquired                                         |       | (421                         | )          | (128 | ) | — |   |
| (Payments) Proceeds from sales of  discontinued operations                                |       | (3                           | )          | 260 |   | — |   |
| Proceeds from sale of Commscope common  stock                                             |       | —                       |       | 28 |   | — |   |
| Proceeds from sale of property, plant and  equipment                                      |       | 52                           |       | — |   | 21 |   |
| Investments in marketable securities                                                      |       | —                       |       | (9 | ) | — |   |
| Other investing activities, net                                                           |       | 20                           |       | (11 | ) | 5 |   |
| NET CASH (USED FOR) PROVIDED BY INVESTING  ACTIVITIES FROM CONTINUING OPERATIONS          |       | (558                         | )          | 21 |   | (60 | ) |
| **FINANCING  ACTIVITIES:**                                                                |       |                         |       |   |   |   |   |
| Issuance of common stock                                                                  |       | 49                           |       | 342 |   | 368 |   |
| Repurchase of common stock                                                                |       | (107                         | )          | — |   | — |   |
| Issuance of long-term debt                                                                |       | —                       |       | — |   | 216 |   |
| Repayment of long-term borrowings                                                         |       | (580                         | )          | (404 | ) | (156 | ) |
| Other financing activities, net                                                           |       | —                       |       | (2 | ) | (7 | ) |
| NET CASH (USED FOR) PROVIDED BY FINANCING  ACTIVITIES FROM CONTINUING OPERATIONS          |       | (638                         | )          | (64 | ) | 421 |   |
| Effect of  exchange rate changes on cash and cash equivalents                             |       | (5                           | )          | 10 |   | 11 |   |
| Net  (decrease) increase in cash and cash equivalents from continuing operations          |       | (867                         | )          | 446 |   | 541 |   |
| Net  (decrease) increase in cash and cash equivalents from discontinued operations        |       | —                       |       | (21 | ) | 54 |   |
| Cash and  cash equivalents at beginning of fiscal year                                    |       | 1,617                        |       | 1,192 |   | 597 |   |
| Cash and  cash equivalents at end of fiscal year                                          |       | $                            | 750        |   | $ | 1,617 |   | $ | 1,192 |   |

 

SeeNotes to Consolidated Financial Statements.

 

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**AVAYA INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

Avaya Inc. (the “Company”or “Avaya”) provides communication systems, applications and services forenterprises, including businesses, government agencies and other organizations.The Company’s 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 Company supports its broad customer base with comprehensiveglobal service offerings that enable customers to plan, design, implement,monitor and manage their communications networks.  Beginning in the first quarter of fiscal2005, the Company is managing its business based on two operating segments:Global Communications Solutions (“GCS”), which includes the prior reportablesegments of Enterprise Communications Group and Small and Medium BusinessSolutions, and Avaya Global Services (“AGS”).

 

We were incorporated under the laws of theState of Delaware under the name “Lucent EN Corp.” on February 16, 2000,as a wholly owned subsidiary of Lucent Technologies Inc. (“Lucent”). As ofJune 27, 2000, our name was changed to “Avaya Inc.” On September 30,2000, Lucent contributed its enterprise networking business to us anddistributed all of the outstanding shares of our capital stock to itsshareowners.  We refer to thesetransactions in this Annual Report as the “distribution.”  Prior to the distribution, we had no materialassets or activities as a separate corporate entity.  Following the distribution, we became anindependent public company, and Lucent has no continuing stock ownershipinterest in us.

 

**2. Summary of Significant Accounting Policies**

 

***Principles of Consolidation***

 

The Consolidated Financial Statements include the accounts of Avaya andits subsidiaries.  All intercompanytransactions and balances have been eliminated in consolidation.

 

***Use of Estimates***

 

The Consolidated Financial Statements and related disclosures areprepared in conformity with accounting principles generally accepted in theUnited 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 the periodreported.  These estimates includeassessing the collectibility of accounts receivable, sales returns andallowances, the use and recoverability of inventory, the realization ofdeferred tax assets, business restructuring reserves, pension andpostretirement benefit costs, the fair value of assets and liabilities acquiredin business combinations and useful lives and impairment of tangible andintangible assets, among others.  Themarkets for the Company’s products are characterized by intense competition,rapid technological development and frequent new product introductions, all ofwhich could affect the future recoverability of the Company’s assets.  Estimates and assumptions are reviewedperiodically and the effects of revisions are reflected in the ConsolidatedFinancial Statements in the period they are determined to be necessary.  Actual results could differ from theseestimates.

 

***Foreign Currency Translation***

 

Balance sheet accounts of the Company’s foreign operations aretranslated from foreign currencies into U.S. dollars at period-end exchangerates while income and expenses are translated at average exchange rates duringthe period.  Translation gains or lossesrelated to net assets located outside the U.S. are shown as a component ofaccumulated other comprehensive loss in stockholders’ equity.  Gains and losses resulting from foreigncurrency transactions, which are denominated in currencies other than theentity’s functional currency, are included in the Consolidated Statements ofOperations.

 

***Revenue Recognition***

 

The Company derives revenue primarily from the sale and service ofcommunication systems and applications. In accordance with SEC Staff AccountingBulletin No. 104, “Revenue Recognition” (“SAB 104”), revenue is recognizedwhen persuasive evidence of an arrangement exists, delivery has occurred, thefee is fixed and determinable, collectibility is reasonably assured, contractualobligations have been satisfied, and title and risk of loss have beentransferred to the customer.

 

The Company’s products are sold directly through its worldwide salesforce and indirectly through its global network of distributors, dealers, value-addedresellers and system integrators.  Thepurchase price of the Company’s systems and applications typically includes 

 

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installation and 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.  When the Companyprovides a combination of products and services to customers, the arrangementis evaluated under Emerging Issues Task Force Issue (“EITF”) No. 00-21, “RevenueArrangements with Multiple Deliverables” (“EITF 00-21”), which is effective forthe Company for transactions entered into after July 1, 2003.  EITF 00-21 addresses certain aspects ofaccounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. The application of EITF 00-21 did nothave a material effect on the Company’s consolidated results of operations,financial position or cash flows.

 

The Company’s indirect sales to****distributionpartners are generally recognized at the time of shipment if all contractualobligations have been satisfied.  TheCompany accrues a provision for estimated sales returns and other allowancesand deferrals relating to inventory levels held by distributors, promotionalmarketing programs, etc. as a reduction of revenue at the time of revenuerecognition, as required by EITF 01-9 “Accounting for Consideration Given by aVendor 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 andmaterials basis; (ii) professional services for implementation andintegration of converged voice and data networks, network security and unifiedcommunications; and (iii) managed services provided to customers who havechosen bundled solutions and enhanced services not included in basicmaintenance contracts for messaging and other parts of communicationssystems.  Maintenance contracts typicallyhave terms that range from one to five years. Contracts for professional services typically have terms that range fromtwo to four weeks for standard solutions and from six months to one year forcustomized solutions.  Contracts formanaged services typically have terms that range from one to seven years.  Revenue from services performed under managedservices arrangements, professional services and services performed undermaintenance contracts is accounted for in accordance with FASB TechnicalBulletin No. 90-1 “Accounting for Separately Priced Extended Warranty andProduct Maintenance Contracts”, and is deferred and recognized ratably over theterm of the underlying customer contract or at the end of the contract, whenobligations have been satisfied.  Forservices performed on a time and materials basis, revenue is recognized uponperformance.

 

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

 

Research and development costs are charged to expense as incurred. Thecosts incurred for the development of communications software that will besold, leased or otherwise marketed, however, are capitalized when technologicalfeasibility has been established. These capitalized costs are subject to anongoing assessment of recoverability based on anticipated future revenues andchanges in hardware and software technologies. Costs that are capitalized include direct labor and related overhead.

 

Amortization of capitalized software development costs begins when theproduct is available for general release to customers. Amortization isrecognized on a product-by-product basis on the greater of either the ratio ofcurrent gross revenues to the total of current and anticipated future grossrevenues, or the straight-line method over a period of up to two years.  Unamortized capitalized software developmentcosts determined to be in excess of net realizable value of the product are expensedimmediately.  As of September 30,2005 and 2004, the Company had unamortized software development costs of$73 million and $53 million, respectively.   Amortization expense of $36 million, $28million and $25 million was recorded for the fiscal years 2005, 2004 and 2003,respectively, and was included as a component of gross margin for each year.

 

***Cash and Cash Equivalents***

 

All highly liquid investments with original maturities of three monthsor fewer when purchased are considered to be cash equivalents. These short-terminvestments are stated at cost, which approximates market value. The Company’scash and cash equivalents are invested in various investment gradeinstitutional money market accounts.

 

***Restricted Cash***

 

As of September 30, 2005 and 2004, the Company had $1 million and $10million, respectively, of restricted cash included in other current assets andother assets in the Consolidated Balance Sheets.  This cash is restricted in use and has beenpledged to secure letters of credit, surety bonds and other purchase guaranteesthat ensure the Company’s performance or payment to third parties in accordancewith specified terms and conditions.

 

***Accounts Receivable***

 

Accounts receivable are recorded net of reserves for sales returns andallowances, and provisions for doubtful accounts.  The allowances are based on an analysis ofhistorical trends, aging of accounts receivable balances and on thecreditworthiness of the customer as determined by credit checks and analysis, 

 

39

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as well as the customer’s payment history.

 

***Inventory***

 

Inventory includes goods awaiting sale (finished goods) and goods to beconsumed directly or indirectly in production (raw materials and supplies).Included with finished goods inventory is equipment that is being installed atcustomer locations for various installations that are not yet complete.  Inventory is stated at the lower of cost,determined on a first-in, first-out basis, or market. Reserves to reduce theinventory to market value are based on current inventory levels, historicalusage and product life cycles for the various inventory types.

 

***Property, Plant and Equipment***

 

Property, plant and equipment are stated at cost less accumulateddepreciation. Depreciation is determined using a straight-line method over theestimated useful lives of the various asset classes. Estimated lives range fromthree to 10 years for machinery and equipment, five years for rentalequipment and up to 40 years for buildings.

 

Major improvements are capitalized and minor replacements, maintenanceand repairs are charged to expense as incurred. Upon retirement or disposal ofassets, the cost and related accumulated depreciation are removed from theConsolidated Balance Sheets and any gain or loss is reflected in theConsolidated Statements of Operations.

 

Certain costs of computer software developed or obtained for internaluse are capitalized and amortized on a straight-line basis over three to sevenyears. General and administrative costs, overhead, maintenance and training, aswell as the cost of software that does not add functionality to the existingsystem, are expensed as incurred. As of September 30, 2005 and 2004, theCompany had unamortized internal use software costs of $131 million and $103million, respectively.

 

***Goodwill, Other Intangible and Long-livedAssets***

 

Goodwill is the excess of the purchase price over the fair valuesassigned to the net assets acquired in business combinations.  Goodwill is not amortized, but instead is subjectto periodic testing for impairment. Goodwill of a reporting unit, which is one level below the Company’soperating segments, is tested for impairment on an annual basis or betweenannual tests if events occur or circumstances change indicating that the fairvalue of a reporting unit may be below its carrying amount.  Goodwill impairment is determined using atwo-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 other long-lived assets are reviewed for impairmentwhenever events such as product discontinuance, product dispositions or otherchanges in circumstances indicate that the carrying amount may not berecoverable.  In reviewing forimpairment, the Company compares the carrying value of the relevant assets tothe estimated undiscounted future cash flows expected from the use of theassets and their eventual disposition. When the estimated undiscounted future cash flows are less than theircarrying amount, an impairment loss is recognized equal to the differencebetween the assets’ fair value and its carrying value. Intangible assetsinclude existing technology, customer relationships, trademarks and otherintangibles.

 

***Investments***

 

The Company’s investment portfolio as of September 30, 2005consists 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 2005 and 2004, the Company had investmentsaccounted for under the cost and equity methods in addition to investmentscarried at fair value. The Company’s share of earnings or losses from equitymethod investments is recorded in other expense, net. Investments areperiodically reviewed for impairment and a write down is recorded wheneverdeclines in fair value below carrying value are considered to be other thantemporary. In making this determination, the Company considers, among otherfactors, sustained decreases in quoted market prices and a series of historicand projected operating losses by the investee. During fiscal 2004 the Companyacquired a controlling interest in AGC. AGC had been previously accounted for as an equity method investment. Asof September 30, 2005 and 2004, the Company had investments of$11 million and $9 million, respectively, which are included in othercurrent assets disclosed on the Consolidated Balance Sheets.

 

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***Financial Instruments***

 

The Company uses various financial instruments, including interest rateswap agreements and foreign currency forward contracts, to manage and reducerisk to the Company by generating cash flows that offset the cash flows ofcertain transactions in foreign currencies or underlying financial instrumentsin relation to their amount and timing. The Company’s derivative financial instruments are used as riskmanagement tools and not for speculative 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 changes in the fair values of the Company’sderivative instruments are included in other expense, net.

 

As permitted under SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS 133”), the Company has electednot to designate its forward contracts as hedges thereby precluding the use ofhedge accounting for these instruments. Such treatment could result in a gain or loss from fluctuations inexchange rates related to a derivative contract which is different from theloss or gain recognized from the underlying forecasted transaction.  However, the Company has procedures to managerisks associated with its derivative instruments, which include limiting theduration of the contracts, typically six months or fewer, and the amount of theunderlying exposures that can be economically hedged.  Historically, the gains and losses on thesetransactions have not been significant.

 

The Company also utilizes non-derivative financial instrumentsincluding letters of credit and commitments to extend credit.

 

***Restructuring Programs***

 

The Company accounts for exit or disposal activities initiated afterDecember 31, 2002, in accordance with SFAS No. 146, “Accounting ForCosts Associated with Exit or Disposal Activities” (“SFAS 146”).

 

In accordance with SFAS 146, a business restructuring is definedas an exit activity that includes but is not limited to a program that isplanned and controlled by management, and materially changes either the scopeof a business or the manner in which that business is conducted.  Business restructuring charges include(i) one-time termination benefits related to employee separations,(ii) contract termination costs and (iii) other associated costs suchas consolidating or closing facilities and relocating employees.

 

A liability is recognized and measured at its fair value for one-timetermination benefits once the plan of termination is communicated to affectedemployees and it meets all of the following criteria: (i) managementcommits to a plan of termination, (ii) the plan identifies the number ofemployees to be terminated and their job classifications or functions,locations and the expected completion date, (iii) the plan establishes theterms of the benefit arrangement and (iv) it is unlikely that significantchanges to the plan will be made or the plan will be withdrawn.  Contract termination costs include costs toterminate a contract or costs that will continue to be incurred under thecontract without benefit to the 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 recognizedand measured at its fair value for other associated costs in the period inwhich the liability is incurred.

 

Prior to December 31, 2002, the Company accounted for itsrestructuring activities in accordance with EITF No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”).

 

***Pension andPostretirement Benefit Obligations***

 

The Company maintains defined benefit pension plans covering themajority of its employees, which provide benefit payments to vestedparticipants upon retirement.  TheCompany also provides certain postretirement healthcare and life insurancebenefits to eligible employees.  Thesepension and other postretirement benefit plans are accounted for in accordancewith SFAS 87, “Employers’ Accounting for Pensions” and SFAS 106, “Employers’Accounting for Postretirement Benefits Other Than Pensions,” which requirecosts and the related obligations and assets arising from the pension and otherpostretirement benefit plans to be accounted for based on actuariallydetermined estimates.  The plans usedifferent factors, including age, years of service and eligible compensation,to determine****the benefit amountfor eligible participants.  The Companyfunds its pension plans in compliance with applicable laws. See Note 13 “BenefitObligations” for a discussion of amendments made to the Company’s pension andpostretirement plans which froze benefits accruals and additional participationin the plans for its U.S. management employees effective December 31,2003.

 

***Stock Compensation***

 

Certain of the Company’semployees participate in stock option plans and stock purchase plans. TheCompany applies the recognition and measurement principles of AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”) 

 

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and relatedinterpretations in accounting for such stock compensation. Accordingly, nostock-based employee compensation cost related to stock options is reflected inthe Company’s Consolidated Statements of Operations, as all options grantedunder the plan had an exercise price equal to or greater than the market valueof the underlying common stock on the date of grant. The Company recordscompensation expense for the amortization of restricted stock units issued toemployees based on the fair market value of the restricted stock units at thedate of grant over the vesting period, which is typically three years.

 

The following tableillustrates the effect on net income and earnings per share as if the Companyhad applied the fair value recognition provisions of Statement of FinancialAccounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”) as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure” (“SFAS 148”).

 
| ** **                                                                                                                         | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions, except per  share amounts**                                                                                 | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income  (loss) available to common stockholders, as reported                                                                   |       | $                            | 921        |   | $ | 296 |   | $ | (88 | ) |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects                 |       | 6                            |       | 9 |   | 19 |   |
| (Deduct) add: Total stock compensation  (expense) income determined under the fair value based method, net of related  tax effects |       | (69                          | )          | (31 | ) | 20 |   |
| Net income  (loss) available to common stockholders, pro forma                                                                     |       | $                            | 858        |   | $ | 274 |   | $ | (49 | ) |
|                                                                                                                               |       |                         |       |   |   |   |   |
| Earnings  (Loss) per Common Share - Basic:                                                                                         |       |                         |       |   |   |   |   |
| As reported                                                                                                                        |       | $                            | 1.95       |   | $ | 0.67 |   | $ | (0.23 | ) |
| Pro forma                                                                                                                          |       | 1.81                         |       | 0.63 |   | (0.13 | ) |
|                                                                                                                               |       |                         |       |   |   |   |   |
| Earnings  (Loss) per Common Share - Diluted:                                                                                       |       |                         |       |   |   |   |   |
| As reported                                                                                                                        |       | $                            | 1.89       |   | $ | 0.64 |   | $ | (0.23 | ) |
| Pro forma                                                                                                                          |       | 1.76                         |       | 0.60 |   | (0.13 | ) |

 

In July 2005, theCompany’s Board of Directors approved a plan to accelerate the vesting ofcertain outstanding stock options exercisable for Avaya common stock.  Based on this action, all stock optionsoutstanding as of July 26, 2005 having an exercise price greater than orequal to $13 per share vested and became fully exercisable as of that date.Aside from the acceleration of the vesting date, the terms and the conditionsof the stock option award agreements governing the underlying stock options grantsremained unchanged. As a result of this plan, options to purchase approximately10.2 million shares became exercisable. This action will result in stock optionexpense to be recorded in the Consolidated Statements of Operations over thenext three fiscal years in accordance with SFAS 123 (revised 2004) “Share-BasedPayment” (“SFAS 123(R)”) to be approximately $62 million lower on a pre-taxbasis than the expense would have been if the vesting had not been accelerated.As a result of the accelerated vesting, the pro forma stock-based employeecompensation expense for the fourth quarter of fiscal 2005 increased by $62million.

 

The fair value of stock options used to compute pro forma net lossresulted in additional income in fiscal 2003 because a substantial number ofpreviously granted options were either forfeited or expired and the cumulativereversal of pro forma expense related to these options exceeded the pro formaexpense related to the remaining outstanding options.

 

The fair value of stock options used to compute pro forma net lossdisclosures is the estimated fair value of an option at grant date using theBlack-Scholes option-pricing model with the following assumptions:

 
| ** **                         | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| WEIGHTED  AVERAGE ASSUMPTIONS:     |       |                         |       |   |   |   |   |
| Dividend yield                     |       | 0.0                          | %          | 0.0 | % | 0.0 | % |
| Expected volatility                |       | 64.8                         | %          | 73.6 | % | 75.0 | % |
| Risk-free interest rate            |       | 3.2                          | %          | 2.6 | % | 2.7 | % |
| Expected holding period (in years) |       | 3.0                          |       | 3.0 |   | 3.8 |   |

 

***Income Taxes***

 

Income taxes are accounted for under the asset and liabilitymethod.  Under this method, deferred taxassets and 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 

 

42

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liabilities are measured using enacted tax rates in effect for the yearin which those temporary differences are expected to be recovered orsettled.  The effect on deferred taxassets and liabilities of a change in tax rates is recognized in theConsolidated Statements of Operations in the period that includes the enactmentdate.  A valuation allowance is recordedto reduce the carrying amounts of deferred tax assets if it is more likely thannot that such assets will not be realized.

 

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

 

Other comprehensive income (loss) is recorded directly to a separatesection of stockholders’ equity in accumulated other comprehensive loss andincludes unrealized gains and losses excluded from the Consolidated Statementsof Operations.  These unrealized gainsand losses consist of adjustments to the minimum pension liability, foreigncurrency translation, and unrealized losses on securities classified asavailable-for-sale.  The minimum pensionliability adjustment represents the excess of the additional pension liabilityover the unrecognized prior service cost.

 

***Reclassifications***

 

Certain prior year amounts have been reclassified to conform to thecurrent year presentation.

 

**3. Recent Accounting Pronouncements**

 

***SFAS 123(R)***

 

In December 2004, the FASB issued SFAS 123(R), which requires theCompany to recognize compensation expense for stock options and discounts underemployee stock purchase plans granted to employees based on the estimated fairvalue of the equity instrument at the time of grant.  Currently, the Company discloses the proforma net income and earnings per share as if the Company applied the fairvalue recognition provisions of SFAS 123 as amended by SFAS 148.  The requirements of SFAS 123(R) are effectivefor the Company beginning in the first quarter of fiscal 2006.  We will recognize compensation expense forstock-based awards issued after October 1, 2005 on a straight-line basis overthe requisite service period for the entire award.  We also expect to record expense ofapproximately $6 million in fiscal 2006 and $2 million in fiscal 2007 relatedto previously-issued, unvested stock options for which vesting has not beenaccelerated.  Beginning October 1, 2005,upon the adoption of SFAS 123(R), the Company plans to begin using a binomialmodel in calculating estimated fair value of stock options.  The binomial model uses more inputs than theBlack-Scholes model, and management believes use of the binomial model willresult in a better estimate of fair value than was previously used for purposesof determining the pro-forma impact of SFAS 123.  The Company issued 4.6 million options inOctober 2005, which were valued using the binomial method, resulting in estimatedaggregate fair value of $21 million which will be expensed ratably over thethree-year vesting period.

 

***FSP SFAS 123(R)-1***

 

In August 2005, the FASB issued FSP 123(R)-1, which defers therequirement of SFAS 123(R) that a freestanding financial instrument originallysubject to SFAS 123(R) becomes subject to the recognition and measurementrequirements of other applicable GAAP when the rights conveyed by theinstrument to the holder are no longer dependent on the holder being anemployee of the Company.  A freestandingfinancial instrument issued to an employee in exchange for past or futureemployee services that is subject to SFAS 123(R) will continue to be subject tothe recognition and measurement provisions of SFAS 123(R) throughout the lifeof the instrument, unless the terms are modified when the holder is no longeran employee.  The requirements of FSPSFAS 123(R)-1 are effective upon the initial adoption of SFAS 123(R), which isbeginning in the first quarter of fiscal 2006. The adoption of SFAS 123(R)-1 isnot expected to have a material impact on the Company’s Consolidated FinancialStatements.

 

***SFAS 154***

 

In May, 2005, the FASB issued SFAS No. 154, “Accounting Changes andError Corrections – a Replacement of APB Opinion No. 20 and FASB Statement No.3” (“SFAS 154”).  SFAS 154 changes therequirements for the accounting for, and reporting of, a change in accountingprinciple.  SFAS 154 requires that avoluntary change in accounting principle be applied retrospectively with allprior period financial statements presented using the new accountingprinciple.  SFAS 154 is effective foraccounting changes and corrections of errors in fiscal years beginning afterDecember 15, 2005.  The Company willapply the requirements of SFAS 154 on any changes in principle made on or afterOctober 1, 2006.

 

***FIN 47***

 

In March 2005, the FASB issued Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations, an Interpretation of 

 

43

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FASB Statement No. 143” (“FIN 47”). FIN 47 clarifies the term “conditional asset retirement obligation” usedin FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” andrefers to a legal obligation to perform an asset retirement activity in whichthe timing and (or) method of settlement are conditional on a future event thatmay or may not be within the control of the Company.  The obligation to perform the assetretirement activity is unconditional even though uncertainty exists about thetiming and (or) method of settlement. Accordingly, FIN 47 requires the Companyto recognize a liability for the fair value of a conditional asset retirementobligation if the fair value of the liability can be reasonably estimated.  The fair value of a liability for theconditional asset retirement obligation is to be recognized when incurred.  FIN 47 will be effective for the Company nolater than the end of its 2006 fiscal year. The implementation of this interpretation is not expected to have amaterial effect on the Company’s Consolidated Financial Statements.

 

***FIN 46-R-5***

 

In March 2005, FASB issued Interpretation No. 46(R)-5, “ImplicitVariable Interests under FASB Interpretation No. 46” (“FIN 46(R)-5”).  This interpretation further expands andclarifies current accounting guidance for variable interest entities addressingwhether a reporting enterprise should consider whether it holds an implicitvariable interest in a variable interest entity or potential variable interestentity when certain specific conditions exist. The Company adopted the guidance in this interpretation as of March2005.  The adoption of FIN 46(R)-5 didnot have a material effect on the Company’s Consolidated Financial Statements.

 

***FSP SFAS 143-1***

 

On June 8, 2005, FASB issued FASB Staff Position (“FSP”) SFAS No.143-1, “Accounting for Electronic Equipment Waste Obligations,” to address theaccounting for obligations associated with Directive on Waste Electrical and ElectronicEquipment (“the Directive”) issued by the European Union (“EU”).  The Directive was enacted on February 13,2003 and directs EU-member countries to adopt legislation to regulate thecollection, treatment, recovery and environmentally sound disposal ofelectrical and electronic waste equipment. The Directive concludes that commercial users are obligated to retire,in an environmentally sound manner, specific assets that qualify as historicalwaste.  FSP SFAS 143-1 is effective forreporting periods ending after June 8, 2005. The adoption of FSP SFAS 143-1 has not materially affected theConsolidated Financial Statements with respect to legislation enacted to date.The Company will continue to evaluate the impact as other EU-member countriesenact the legislation.

 

**4. Business Combinations and OtherTransactions**

 

***Acquisitionof Tenovis***

*** ***

On November 18,2004, the Company completed its acquisition of Tenovis Germany GmbH (“Tenovis”).Tenovis is the parent company of Avaya-Tenovis GmbH & Co. KG (formerlyTenovis GmbH & Co. KG), a major European provider of enterprisecommunications systems and services. The acquisition of Tenovis significantlyexpands the Company’s European operations and increases the Company’s access toEuropean customers, particularly in Germany. In connection with the sharepurchase agreement, the Company paid $381 million in cash (which includes $10million of transaction fees that were not paid to the sellers) and assumed $287million in debt, including $17 million of capital lease obligations.Additionally, the Company acquired cash and cash equivalents of $116 million,resulting in a net cash outlay related to the acquisition of $265 million.Results of operations for Tenovis are included in the Company’s consolidatedresults as of November 18, 2004.

 

At the date ofacquisition, the Company recorded Tenovis’s accounts receivable, inventory,fixed assets, liabilities and identified intangibles at estimated fair value.The remainder of the purchase price in excess of the net assets acquired wasrecorded as goodwill, which was allocated $400 million to the GCS segment and$206 million to the AGS segment.  None ofthe goodwill, intangibles or in-process research and development amounts isexpected to be deductible for tax purposes. The Company allocated $298 million to intangible assets (includingcontractual customer relationships, existing technology and trademarks) basedon valuation studies performed with the assistance of third party valuationconsultants. These intangible assets are being amortized over their estimateduseful lives. The weighted average useful lives of the existing technology,customer relationships and trademarks are 5 years, 6 years and 1.5 years,respectively.  In addition, the Companyallocated $1 million to in-process research and development, which was chargedto research and development expense in the Consolidated Statements ofOperations during the first quarter of fiscal 2005.

 

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

 

44

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

 

The Company recorded arestructuring liability of $106 million in connection with the acquisition toreflect the estimate of restructuring-related costs in accordance with EITF95-3, “Recognition of Liabilities in Connection with a Purchase BusinessCombination.”  This liability is forcosts to be incurred to terminate Tenovis employees as part of the integrationof Tenovis operations.  The plan, whichwas completed during fiscal 2005, provides for the termination of certainemployees across various Tenovis functional groups and subsidiaries, includingsales, operations, finance, human resources, etc.  Most of these positions have already beeneliminated. Terminations are planned to be completed by the end of the thirdquarter of fiscal 2006.  During fiscal2005, the Company paid cash of $30 million for termination benefits.  The $70 million accrual as ofSeptember 30, 2005 reflects  theremaining termination payments, adjusted for foreign currency fluctuationssince the acquisition date.  The final termination payment amount peremployee is subject to applicable legislation and/or approval by the relevantcompetent Works Councils or other employee representative organizations.

 

Management is responsible for estimating the fair value ofthe assets and liabilities acquired, and has conducted due diligence indetermining the fair value. Management has made estimates and assumptions thataffect the reported amounts of assets, liabilities and expenses resulting fromthe acquisition.  Actual results coulddiffer from these amounts.

 

The following unauditedpro forma financial information presents the Company’s results as if theTenovis acquisition had occurred at the beginning of the respective periods:

 
| ** **                                         | ** ** | **Year ended September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions, except per  share amounts** | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| 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 |   |

 

These pro forma resultshave been prepared for comparative purposes only and include certainadjustments such as additional estimated depreciation and amortization expenseas a result of identifiable intangible assets arising from the acquisition. Thepro forma results are not necessarily indicative of the results of operationsthat actually would have resulted had the acquisition been in effect at thebeginning of the respective periods or of future results.

 

In connection with theacquisition, the Company identified three variable interest entities (“VIEs”)and further determined that the Company, through its ownership of Tenovis, wasthe primary beneficiary of all three VIEs. However, in accordance with FIN46(R), “Consolidation of Variable Interest Entities, an Interpretation of ARBNo. 51” (“FIN 46(R)”), the Company is not required to apply the provisionsof FIN 46(R) to two of the VIEs because it is unable to obtain theinformation necessary to perform the accounting required to consolidate theseVIEs. Although the Company has made an effort to gather the requiredinformation, management of these two VIEs has declined in writing to transferany of the necessary financial data to the Company. For information concerningthe Company’s one consolidated VIE, see Note 8 “Long-Term Debt” to theConsolidated Financial Statements. Information concerning the Company’s two non-consolidated VIEs followsbelow.

 

45

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The firstnon-consolidated VIE is a non-U.S. telecommunications hardware manufacturer andservice provider. Prior to its acquisition by the Company, Tenovis agreed topurchase from the VIE certain amounts of products and services, and the VIEcontracted with Tenovis to provide certain IT services and purchasing serviceswith respect to raw materials. Subsequent to the acquisition of Tenovis, theCompany purchased products and services aggregating $36 million. Thesecontracts expire in August 2007. Additionally, the Company is required topay monthly rental subsidies on the VIE’s premises, and in the event the VIE isunable to pay its portion of the rental payments, the Company is liable for theVIE’s portion as well. During fiscal 2005, the Company paid $1 million inconnection with rental subsidies. The maximum exposure to loss as ofSeptember 30, 2005 for the remainder of the agreement is the minimumpurchase order commitments and the minimum service levels for service contractsof $13 million and the guarantee for rents to be paid by the VIE of $1 million.

 

The secondnon-consolidated VIE provides development, testing and quality control servicesto companies in the telecommunications industry. Prior to the acquisition,Tenovis guaranteed the VIE minimum revenue over a period of three years throughguaranteed annual purchase orders. Subsequent to the acquisition of Tenovis andthrough March 31, 2005, the Company purchased services aggregating $4 millionfrom this VIE. This service contract expired on March 31, 2005 andconsequently the entity is no longer considered to be a VIE of the Company.

*** ***

***OtherFiscal 2005 Acquisitions***

*** ***

***The respective purchase prices for the following acquisitions were notmaterial, either individually or in the aggregate, to the ConsolidatedFinancial Statements of the Company. Therefore, disclosures of pro forma financial information have not beenpresented.***

 

**Acquisitionof Spectel**

 

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 Company allocated$3 million to in-process research and development, which was charged toresearch and development expense in the Consolidated Statements of Operationsduring the first quarter of fiscal 2005.

 

**Acquisitionof Minority Interest in Agile Software**

 

On October 15,2004, the Company acquired a 23% share of Agile Software NZ Limited (“AgileSoftware”), a software subsidiary of Agile (NZ) Limited, which primarilyproduces contact center software, as well as other software products. Underterms of the subscription and shareholding agreement, the Company has theoption to acquire the remaining equity in Agile Software. This option vests inOctober 2005 and has no expiration date. The fair value of this purchaseoption is not material to the Company’s consolidated results of operations,financial position or cash flows. The Company accounts for its investment inAgile Software using the equity method.

 

**Acquisitionof RouteScience**

 

On December 15,2004, the Company acquired substantially all of the assets of RouteScienceTechnologies, Inc. (“RouteScience”), a software company based inCalifornia which focuses on products that monitor, assess and optimize networkapplications.

 

**Acquisitionof Nimcat Networks**

 

OnSeptember 16, 2005, the Company acquired Nimcat Networks Incorporated. (“Nimcat”)for $38 million in cash, net of cash acquired. Nimcat was privately held and headquartered in Ottawa, Canada and is adeveloper of embedded peer-to-peer IP call processing software.  Results from Nimcat are included in the Company’sConsolidated Financial Statements beginning on September 16, 2005.  In connection with the acquisition, theCompany allocated $3 million to in-process research and development, which wascharged to research and development expense in the Consolidated Statements ofOperations at the date of the acquisition.

 

***Aircraft Transactions***

 

Inthe fourth quarter of fiscal 2004, the Company reduced the carrying value ofits two corporate airplanes and classified them as held for sale. The resulting$10 million impairment charge is included in the calculation of operatingincome in the Company’s fiscal 2004 results. During fiscal 2005, the Companyreceived proceeds of $52 million on the sales of the two aircraft, which arereflected in net 

 

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cashused for investing activities.  InNovember 2004, the Company entered into operating leases for two new aircraftwhich were delivered during the second half of fiscal 2005.

 

***Fiscal 2004 Acquisitions and Divestitures***

 

**Acquisition of a Majority Interest in Tata Telecom**

 

On April 2, 2004, theCompany announced an agreement with the Tata Group to acquire its shares ofTata Telecom Ltd. (“Tata Telecom”), a leading voice communications solutionsprovider in India, representing 25.1% ownership of Tata Telecom.  As of the date of the agreement, the Companyowned a 25.5% interest in Tata Telecom. Under the terms of the agreement, the Company was required to pay 220Rupees per share.  Statutory requirementsin India mandated that the Company also conduct a public tender offer for aminimum of 20% of the outstanding shares of Tata Telecom at a price of 220Rupees per share. The public tender offer closed in July 2004 with 8.5% of thepublic shares tendering into the offer. The sale of the shares by the Tata Group and the tendering shareholdersclosed on August 4, 2004.  Avaya paid atotal of $24 million in August 2004 related to this acquisition, of which $17million was paid to the Tata Group, $6 million was paid in relation to the publictender offer and Avaya realized a $1 million loss associated with forwardexchange contracts, which were used to hedge foreign currency risk associatedwith the acquisition.  Following theacquisition of these additional equity interests, the Company now owns 59.1% ofTata Telecom.  The Company changed thename of Tata Telecom to Avaya GlobalConnect Limited (“AGC”) and beganconsolidating its results on August 4, 2004.

 

**Acquisition of Expanets**

 

On November25, 2003, the Company acquired substantially all of the assets and assumedcertain liabilities of Expanets. Expanets, a subsidiary of Northwestern Corp., was a nationwide providerof networked communications and data products and services to small andmid-sized businesses and prior to the acquisition was one of the Company’slargest dealers.  The acquisition allowsthe Company to continue providing quality sales and service support forExpanets’ customers and grow its small and mid-sized business.  Under the terms of the asset purchaseagreement, the Company paid a purchase price of $117 million, consisting of (i)$55 million in cash paid to Expanets, (ii) $27 million paid to acreditor of Expanets to satisfy a debt obligation of Expanets, (iii) $18million to Northwestern to finalize working capital adjustments, (iv) $15million deposited into an escrow account to satisfy certain liabilities ofExpanets and (v) $2 million in business combination costs.  The results of the Expanets businesses the Companyacquired have been included in the Company’s Consolidated Financial Statementsfrom the date of acquisition on November 25, 2003.

 

Atthe date of acquisition, the Company recorded Expanets’ accounts receivable,inventory, fixed assets, liabilities and identified intangibles at estimatedfair value.  The remainder of thepurchase price in excess of the net assets acquired was recorded as goodwill.

Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed as of the acquisition date:

 

| ** **                               | ** ** | **Purchase**   | ** ** |
|------------------------------------------|------------|----------------|------------|
| ** **                               | ** ** | **Price**      | ** ** |
| **Dollars in millions**                  | ** ** | **Allocation** | ** ** |
| Cash                                     |       | $              | 3          |   |
| Accounts  receivable                     |       | 50             |       |
| Inventory                                |       | 21             |       |
| Other assets                             |       | 6              |       |
| Fixed assets                             |       | 3              |       |
| Intangibles                              |       | 32             |       |
| Accounts  payable                        |       | (42            | )          |
| Termination  obligations                 |       | (19            | )          |
| Other  liabilities                       |       | (37            | )          |
| Net assets  from discontinued operations |       | 10             |       |
| **Net assets acquired**                  |       | 27             |       |
| Goodwill                                 |       | 90             |       |
| **Purchase price**                       | ** ** | **$**          | **117**    | ** ** |

 

Management is responsible for estimating the fair value ofthe assets and liabilities acquired, and has conducted due diligence indetermining the fair value. Management has made estimates and assumptions thataffect the reported amounts of assets, liabilities and expenses resulting fromsuch acquisitions. Actual results could differ from these amounts.

 

Identifiable intangibles consist of $21million of customer relationships, which are being amortized over 15 years, and$11 million of 

 

47

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agency relationships, which are beingamortized over 10 years.  Customerrelationships represent a database of information that acts as a source ofrepeat business for the Company.  Theinformation contained in the database includes the preferences of the customer,along with the history of services provided to the customer.  Agency relationships represent therelationship Expanets had with multiple phone carriers across the U.S. that theCompany assumed.  The Company receives acommission for selling phone services to its customers on behalf of the phonecarriers.

 

Goodwill of $90 million was assigned$66 million to the AGS segment and $24 million to the GCS segment.  Of the total, $77 million is expected to bedeductible for tax purposes over a 15-year period.

 

In connection with the acquisition, inaccordance with EITF No. 95-3, the Company recorded liabilities of $21 millionfor termination obligations.  The Companyhas recognized these obligations as a liability assumed as of the acquisitiondate.  These termination obligationsconsisted of $10 million of employee separation costs for approximately 1,750employees and $11 million related to the closure of redundant real estatefacilities.  The Company completed theseverance payments during fiscal 2004 and expects to substantially complete thelease termination obligations by fiscal 2007. During fiscal 2004 and 2005, the Company made cash payments of $11million and $1 million, respectively. The balance of $3 million as of September 30, 2005 relates to leaseobligations.

 

***Sale of aPortion of Expanets’ Business***

 

Upon the closing of the Expanetsacquisition, the Company decided to sell the Expanets businesses thatpreviously distributed other vendors’ products and, accordingly, accounted forthis portion of Expanets’ business as a component of discontinuedoperations.  In the first half of fiscal2004, the Company sold, in a series of transactions, certain assets andliabilities attributed to these businesses for an aggregate consideration of$13 million, $4 million of which was cash consideration and $9 million of whichwas in the form of notes receivable. During fiscal 2004, the Company divested this portion of the Expanetsbusiness, collected $8 million of these notes receivable and wrote off theremainder of the receivables.

 

Results from discontinued operations for these businesses includerevenue of $8 million and loss before income taxes of $7 million for fiscal2004.

 

The following unaudited pro forma financial information presents theCompany’s results as if the Expanets acquisition and the discontinuedoperations presentation of a portion of the Expanets businesses referred to abovehad occurred at the beginning of the respective periods:

 
| ** **                           | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**              | ** ** | **2004**                     | ** ** | **2003** | ** ** |
| Revenue                              |       | $                            | 4,117      |   | $ | 4,112 |   |
| Net income  (loss)                   |       | $                            | 279        |   | $ | (140 | ) |
| Earnings  (loss) per share - basic   |       | $                            | 0.64       |   | $ | (0.37 | ) |
| Earnings (loss)  per share - diluted |       | $                            | 0.61       |   | $ | (0.37 | ) |

 

These pro forma results havebeen prepared for comparative purposes only and include certain adjustmentssuch as the elimination of intercompany revenue and costs, additionalamortization expense as a result of identifiable intangible assets arising fromthe acquisition and the removal of items included in Expanets’ historicalresults that did not relate to assets or liabilities acquired by theCompany.  The pro forma results are notnecessarily indicative of the results of operations that actually would haveresulted had the acquisition been in effect at the beginning of the respectiveperiods or of future results.

 

**Sale of Connectivity Solutions**

 

In January 2004,the Company sold certain assets and liabilities of its Connectivity Solutionsbusiness to CommScope, Inc. (“CommScope”). Accordingly, the Company has accounted for this business as adiscontinued operation.  On January 31,2004, the sale of substantially all of Connectivity Solutions was completed, exceptfor the sale of certain international operations, substantially all of whichoccurred during the remainder of fiscal 2004. The Company received $256 million of cash, and 1,761,538 shares ofCommScope common stock valued at $33 million on the closing date.  The Company paid $9 million in transactioncosts relating to the sale.  During thesecond quarter of fiscal 2004, the Company sold all the shares of CommScopecommon stock and recognized a pre-tax loss of $5 million, which is included inother expense, net.

 

The Companyrecorded an $84 million pre-tax gain from the sale of Connectivity Solutionsduring fiscal 2004, which is included in income from discontinuedoperations.  In accordance with the assetpurchase agreement between CommScope and the Company, certain liabilitiesrecorded by the Company relating to Connectivity Solutions employeestransferred to CommScope were not assumed 

 

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by CommScope, butare no longer obligations of the Company. Therefore, included in the gain is a reversal of $27 million of suchliabilities that primarily represent employee-related costs for which theCompany no longer has an obligation.

 

The $84 milliongain also includes the recognition of $32 million of foreign currencytranslation adjustments related to the divestiture of Connectivity Solutions’international operations.  Acorresponding decrease has been recorded in the accompanying ConsolidatedBalance Sheet during fiscal 2004 through accumulated other comprehensive lossto reflect the realization of foreign currency translation adjustments upon theliquidation of these foreign operations. These foreign currency translation adjustments represent the netunrealized gains and losses arising from changes in exchange rates and therelated effect on the translation of assets and liabilities of thoseinternational operations.

 

Listed below are the major classes of assets and liabilitiesof Connectivity Solutions that were sold and transferred to CommScope duringfiscal 2004.

 

| **Dollars in millions**          | ** ** | **September 30, 2003** | ** ** |
|----------------------------------|------------|------------------------|------------|
| **Assets**                       |       |                   |       |
| Receivables                      |       | $                      | 68         |   |
| Inventory                        |       | 142                    |       |
| Property,  plant and equipment   |       | 179                    |       |
| Other assets                     |       | 13                     |       |
| Total assets                     |       | $                      | 402        |   |
|                             |       |                   |       |
| **Liabilities**                  |       |                   |       |
| Accounts  payable                |       | $                      | 54         |   |
| Payroll and  benefit obligations |       | 31                     |       |
| Other  liabilities               |       | 24                     |       |
| Total  liabilities               |       | $                      | 109        |   |
| **Net  assets sold**             |       | $                      | 293        |   |

 

***Discontinued Operations***

 

The following table displays revenue and (loss) income before incometaxes from discontinued operations for fiscal 2005, 2004 and 2003:

 
| ** **                                                            | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**                                               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue from  discontinued operations:                                |       |                         |       |   |   |   |   |
| Connectivity Solutions                                                |       | $                            | —     |   | $ | 168 |   | $ | 542 |   |
| Expanets                                                              |       | —                       |       | 8 |   | — |   |
| Total revenue from discontinued operations                            |       | $                            | —     |   | $ | 176 |   | $ | 542 |   |
|                                                                  |       |                         |       |   |   |   |   |
| (Loss)  income before income taxes from discontinued operations:      |       |                         |       |   |   |   |   |
| Connectivity Solutions                                                |       |                         |       |   |   |   |   |
| Results of operations                                                 |       | $                            | (2         | ) | $ | (71 | ) | $ | 49 |   |
| Gain on sale                                                          |       | —                       |       | 84 |   | — |   |
| Total (loss) income before income taxes for  Connectivity Solutions   |       | (2                           | )          | 13 |   | 49 |   |
| Expanets:                                                             |       |                         |       |   |   |   |   |
| Results of operations                                                 |       | —                       |       | (7 | ) | — |   |
| Total (loss) income before income taxes  from discontinued operations |       | $                            | (2         | ) | $ | 6 |   | $ | 49 |   |

 

Inconnection with the closing of the transaction, the Company recognized apension and postretirement curtailment loss of $24 million and a settlementloss of $24 million upon the transfer of pension and postretirement benefitassets and liabilities to CommScope, and recorded a corresponding increase of$48 million to the benefit obligation. These losses were included in income from discontinued operations in thesecond quarter of fiscal 2004.  Upon thetransfer of these pension and postretirement benefit assets and liabilities toCommScope, an offsetting gain of $48 million was recognized and included in the$84 million gain on sale of discontinued operations for the assumption of theseliabilities by CommScope.  These twotransactions resulted in a net zero impact to income from discontinued operationsfor fiscal 2004.

 

49

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As a resultof the transfer of Connectivity Solutions employees to CommScope in the secondquarter of fiscal 2004, the Company remeasured its minimum pension liabilityrelated to the pension plan for represented employees.  In accordance with SFAS No. 87, “Employers’Accounting for Pensions,” the Company recorded an adjustment in the secondquarter of fiscal 2004 of $50 million to decrease the additional minimumpension liability.  This resulted in a$36 million decrease to accumulated other comprehensive loss and a $14 milliondecrease to intangible assets.

 

On October 30, 2003, in exchange for the agreement of the InternationalBrotherhood of Electrical Workers to withdraw numerous pending and threatenedgrievances and arbitration demands against the Company in connection with theConnectivity Solutions business, the Company agreed to provide a one-timepayment of five thousand dollars per person to certain employees and offer anenhanced retirement incentive for those employees who were pension eligible asof December 2, 2003.  In fiscal 2004, a$5 million charge was recorded in the Consolidated Statements of Operations.

 

**5. Goodwill and Intangible Assets**

 

The Company conducted the required annual impairment reviewduring the fourth quarters of fiscal 2005 and 2004 and determined that nogoodwill was impaired.

 

The changes in the carrying value of goodwill for fiscal 2005 and 2004by operating segment are as follows: 

 
| ** **                                             | ** ** | **Global**         | ** ** | **Avaya**    | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|--------------|------------|------------|------------|
| ** **                                             | ** ** | **Communications** | ** ** | **Global**   | ** ** | ** ** | ** ** |
| **Dollars in millions**                                | ** ** | **Group**          | ** ** | **Services** | ** ** | **Total**  | ** ** |
| **Balance  as of September 30, 2003**                  | ** ** | **$**              | **146**    | ** **   | **$**      | **—** | ** ** | **$** | **146** | ** ** |
| Goodwill acquired                                      |       | 38                 |       | 70           |       | 108        |       |
| Impact of foreign currency exchange rate  fluctuations |       | 3                  |       | —       |       | 3          |       |
| **Balance  as of September 30, 2004**                  | ** ** | **$**              | **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** | ** ** |

 

The following table presents the components of the Company’s intangibleassets as shown in the Consolidated Balance Sheets.

 
| ** **                                    | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                    | ** ** | **Gross**              | ** ** | ** **             | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**           | ** ** | **Accumulated**        | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| **Dollars in millions**                       | ** ** | **Amount**             | ** ** | **Amortization**       | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| Existing  technology                          |       | $                      | 101        |                   | $          | 41 |   | $ | 60 |   | $ | 28 |   | $ | 26 |   | $ | 2 |   |
| Customer relationships and other  intangibles |       | 288                    |       | 45                     |       | 243 |   | 32 |   | 2 |   | 30 |   |
| **Total amortizable intangible assets**       | ** ** | **$**                  | **389**    | ** **             | **$**      | **86** | ** ** | **$** | **303** | ** ** | **$** | **60** | ** ** | **$** | **28** | ** ** | **$** | **32** | ** ** |
| Minimum  pension adjustment                   |       | 34                     |       | —                 |       | 34 |   | 43 |   | — |   | 43 |   |
| **Total  intangible assets**                  | ** ** | **$**                  | **423**    | ** **             | **$**      | **86** | ** ** | **$** | **337** | ** ** | **$** | **103** | ** ** | **$** | **28** | ** ** | **$** | **75** | ** ** |

 

During the first quarterof fiscal 2005, the Company acquired $298 million of intangible assets inconnection with the acquisition of Tenovis consisting of existing technology of$36 million, customer relationships of $254 million and trademarks of $8million. Other acquisitions during fiscal 2005 resulted in additional existingtechnology and customer relationships of $38 million and $7 million,respectively. These acquisitions, as well as the impact of foreign currencytranslation, resulted in an increase of $330 million in the gross balance ofamortizable intangible assets compared to September 30, 2004. The weightedaverage useful lives of the existing technology, customer relationships andother intangibles are 5 years, 6 years and 5 years, respectively.

 

During the first quarter offiscal 2004, the Company acquired $32 million of intangible assets representingcustomer and agency relationships, in connection with the acquisition ofExpanets.

 

50

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The minimum pensionliability represents unrecognized prior service costs.  This intangible asset is not amortized, butmay be eliminated or adjusted as necessary when the amount of minimum pensionliability is reassessed, which is conducted at least annually.

 

Amortization expense forthe Company’s acquired intangible assets was $59 million, $6 million and $12million for fiscal 2005, 2004 and 2003, respectively.  The majority of future estimated amortizationexpense is associated with intangible assets acquired in the Tenovisacquisition.  Estimated futureamortization expense is shown in the following table.

 
| ** **                       | ** ** | **Expected future**      | ** ** |
|----------------------------------|------------|--------------------------|------------|
| **Dollars in millions**          | ** ** | **amortization expense** | ** ** |
| 2006                             |       | $                        | 62         |   |
| 2007                             |       | 59                       |       |
| 2008                             |       | 58                       |       |
| 2009                             |       | 57                       |       |
| 2010                             |       | 44                       |       |
| 2011 and thereafter              |       | 23                       |       |
| **Future  amortization expense** | ** ** | **$**                    | **303**    | ** ** |

 

**6. Supplementary Financial Information**

 

***Statements of Operations Information***

*** ***
| ** **                                                                                | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**                                                                   | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **DEPRECIATION  AND AMORTIZATION:**                                                       |       |                         |       |   |   |   |   |
| INCLUDED IN COSTS:                                                                        |       |                         |       |   |   |   |   |
| Amortization of software development costs                                                |       | $                            | 36         |   | $ | 28 |   | $ | 25 |   |
| INCLUDED IN SELLING, GENERAL AND  ADMINISTRATIVE EXPENSES:                                |       |                         |       |   |   |   |   |
| Amortization of intangible assets                                                         |       | 59                           |       | 6 |   | 12 |   |
| INCLUDED IN COSTS AND OPERATING EXPENSES:                                                 |       |                         |       |   |   |   |   |
| Depreciation and amortization of property,  plant and equipment and internal use software |       | 177                          |       | 113 |   | 134 |   |
| **Total  depreciation and amortization**                                                  | ** ** | **$**                        | **272**    | ** ** | **$** | **147** | ** ** | **$** | **171** | ** ** |
|                                                                                      |       |                         |       |   |   |   |   |
| **OTHER  INCOME (EXPENSE), NET**                                                          |       |                         |       |   |   |   |   |
| Loss on long-term debt extinguishment, net                                                |       | $                            | (44        | ) | $ | (42 | ) | $ | (34 | ) |
| Other financing expenses                                                                  |       | (5                           | )          | (2 | ) | — |   |
| Interest income                                                                           |       | 24                           |       | 19 |   | 15 |   |
| Gain on assets sold                                                                       |       | 1                            |       | — |   | 14 |   |
| Gain (loss) on foreign currency  transactions                                             |       | —                       |       | 7 |   | (1 | ) |
| Lucent securities litigation charge                                                       |       | —                       |       | — |   | (25 | ) |
| Miscellaneous, net                                                                        |       | (8                           | )          | 3 |   | 2 |   |
| **Total  other income (expense), net**                                                    | ** ** | **$**                        | **(32**    | **)** | **$** | **(15** | **)** | **$** | **(29** | **)** |

 

51

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***Balance SheetInformation***

 
| ** **                                   | ** ** | **Year ended September 30,** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**                      | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **VALUATION  AND QUALIFYING ACCOUNTS**       |       |                         |       |   |   |   |   |
| ** **                                   |       |                         |       |   |   |   |   |
| **Allowance  for Accounts Receivable:**      |       |                         |       |   |   |   |   |
| Balance at beginning of period               |       | $                            | 48         |   | $ | 86 |   | $ | 118 |   |
| Charged to costs, expenses and other         |       | 83                           |       | 73 |   | 207 |   |
| Deductions                                   |       | (73                          | )          | (111 | ) | (239 | ) |
| **Balance at end of period**                 | ** ** | **$**                        | **58**     | ** ** | **$** | **48** | ** ** | **$** | **86** | ** ** |
|                                         |       |                         |       |   |   |   |   |
| **Deferred  Tax Asset Valuation Allowance:** |       |                         |       |   |   |   |   |
| Balance at beginning of period               |       | $                            | 781        |   | $ | 769 |   | $ | 576 |   |
| Charged to costs and expenses                |       | 174                          |       | 17 |   | 118 |   |
| Charged to other accounts                    |       | (16                          | )          | 97 |   | 93 |   |
| Deductions/ reversals                        |       | (774                         | )          | (102 | ) | (18 | ) |
| **Balance at end of period**                 | ** ** | **$**                        | **165**    | ** ** | **$** | **781** | ** ** | **$** | **769** | ** ** |

 
| ** **                                                              | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------|------------|
| **Dollars in millions**                                                 | ** ** | **2005**          | ** ** | **2004** | ** ** |
| **INVENTORY:**                                                          |       |              |       |   |   |
| Finished goods                                                          |       | $                 | 274        |   | $ | 221 |   |
| Raw materials                                                           |       | 14                |       | 18 |   |
| **Total  inventory**                                                    | ** ** | **$**             | **288**    | ** ** | **$** | **239** | ** ** |
|                                                                    |       |              |       |   |   |
| **PROPERTY,  PLANT AND EQUIPMENT, NET:**                                |       |              |       |   |   |
| Land and improvements                                                   |       | $                 | 41         |   | $ | 27 |   |
| Buildings and improvements                                              |       | 430               |       | 394 |   |
| Machinery and equipment                                                 |       | 640               |       | 581 |   |
| Rental equipment                                                        |       | 210               |       | — |   |
| Assets under construction                                               |       | 7                 |       | 1 |   |
| Internal use software                                                   |       | 237               |       | 175 |   |
| Total  property, plant and equipment                                    |       | 1,565             |       | 1,178 |   |
| Less:  Accumulated depreciation and amortization                        |       | (827              | )          | (669 | ) |
| **Property,  plant and equipment, net**                                 | ** ** | **$**             | **738**    | ** ** | **$** | **509** | ** ** |
|                                                                    |       |              |       |   |   |
| **ACCUMULATED  OTHER COMPREHENSIVE LOSS:**                              |       |              |       |   |   |
| Cumulative translation adjustment                                       |       | $                 | 48         |   | $ | 89 |   |
| Minimum pension liability, net of tax                                   |       | (928              | )          | (915 | ) |
| Unrealized holding loss on securities  classified as available for sale |       | (3                | )          | (3 | ) |
| **Accumulated  other comprehensive loss**                               | ** ** | **$**             | **(883**   | **)** | **$** | **(829** | **)** |

 

52

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***Supplemental CashFlow Information***

 
| ** **                                                                      | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------|------------|
| **Dollars in millions**                                                         | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **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 $1, $5 and $23, respectively  |       | $                            | 19         |   | $ | 61 |   | $ | 52 |   |
| Income tax  payments                                                            |       | $                            | 23         |   | $ | 23 |   | $ | 17 |   |
|                                                                            |       |                         |       |   |   |   |   |
| **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 |   | — |   |
| Issuance of common stock in connection with  LYONs exchange offer               |       | —                       |       | — |   | 67 |   |
| Warrants to purchase common stock issued in  LYONs exchange offer               |       | —                       |       | — |   | 5 |   |
| **Total  non-cash transactions**                                                | ** ** | **$**                        | **300**    | ** ** | **$** | **184** | ** ** | **$** | **72** | ** ** |
|                                                                            |       |                         |       |   |   |   |   |
| **CASH  FLOWS FROM DISCONTINUED OPERATIONS:**                                   |       |                         |       |   |   |   |   |
| Net cash (used for) provided by Operating  Activities                           |       | $                            | —     |   | $ | (21 | ) | $ | 57 |   |
| Net cash used for Investing Activities                                          |       | —                       |       | — |   | (3 | ) |
| **Net cash  (used for) provided by discontinued operations**                    | ** ** | **$**                        | **—** | ** ** | **$** | **(21** | **)** | **$** | **54** | ** ** |

 

**7. Restructuring Programs**

 

***Fourth Quarter 2005 Restructuring Plan***

 

During the fourth quarter of fiscal 2005, the Company recordeda $22 million restructuring charge to reorganize our North American sales andservice organizations, consolidate facilities and reduce the workforce in orderto optimize the cost structure.  Thecharges described below are presented as restructuring charges in theConsolidated Statements of Operations and are included with Corporate / OtherUnallocated Amounts in Note 15 “Operating Segments.”  The following table summarizes the activityrelated to the fourth quarter fiscal 2005 restructuring liability recorded inaccordance with SFAS 146.

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

 

The fourth quarter fiscal 2005 restructuring charge of $22million consists of severance and other one-time employee termination benefitsof $12 million related to the termination of employees in the North Americansales and service organization, as well as costs of $10 million related to theconsolidation of excess facilities. During the fourth quarter of fiscal 2005, the majority of the employeesidentified for termination had been exited and $5 million of the accruedemployee termination costs was paid.

 

Lease termination obligations of $10 million related to 74properties include both costs to terminate leases and the present value offuture cash flows relating to real estate space vacated as of September 30,2005. In cases where lease contracts were terminated, the committed terminationnotices were issued by September 30, 2005 and accruals were recorded for anylease termination fees to be 

 

53

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paid. In cases where space was vacated and future economicbenefit was foregone, use of the properties ceased by September 30, 2005 andthe present value of remaining lease payments (net of sublease assumptions) wasaccrued.

 

The Company expects to make payments for these items of $10million in fiscal 2006 and $7 million in fiscal 2007 and beyond.

 

***EITF 94-3 Reserve***

 

The restructuring reserve reflects the remaining balanceassociated with the business restructuring charges recorded in fiscal 2000through 2002 in accordance with EITF 94-3, and is included in other liabilitiesin the Company’s Consolidated Balance Sheets Reversals of $1 million and $5million recorded during fiscal 2004 and 2003, respectively, were previouslyreported as Restructuring Charges.  Theseamounts have been reclassified to Selling, General and Administrative expensesto conform with the current year Consolidated Statements of Operationspresentation.  The following tablesummarizes the components of the Company’s restructuring reserve during fiscal2005 and 2004:

 
| ** **                            | ** ** | **Employee**   | ** ** | **Lease**       | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** **                            | ** ** | **Separation** | ** ** | **Termination** | ** ** | ** ** | ** ** |
| **Dollars in millions**               | ** ** | **Costs**      | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| Balance as  of September 30, 2003     |       | $              | 4          |            | $          | 62         |       | $ | 66 |   |
| Changes in estimates and reversals    |       | (1             | )          | —          |       | (1         | )          |
| Cash payments                         |       | (3             | )          | (21             | )          | (24        | )          |
| Balance as  of September 30, 2004     |       | $              | —     |            | $          | 41         |       | $ | 41 |   |
| Changes in estimates and reversals    |       | —         |       | (5              | )          | (5         | )          |
| Cash payments                         |       | —         |       | (12             | )          | (12        | )          |
| **Balance  as of September 30, 2005** | ** ** | **$**          | **—** | ** **      | **$**      | **24**     | ** ** | **$** | **24** | ** ** |

 

**8. Long-Term Debt**

 

Debt outstanding consists of the following:

 
|                                                                                        |       | **September 30,** |       |
|---------------------------------------------------------------------------------------------|------------|-------------------|------------|
| **Dollars in millions**                                                                     |       | **2005**          | ** ** | **2004** |   |
| Debt  maturing within one year:                                                             |       |              |       |   |   |
| LYONs convertible debt, net of discount                                                     |       | $                 | —     |   | $ | 297 | (3) |
| Capital lease obligations                                                                   |       | 5                 | (1)   | — |   |
| Other current debt                                                                          |       | —            |       | 2 |   |
| Total current portion of long-term debt                                                     |       | 5                 |       | 299 |   |
| Long-term  debt:                                                                            |       |              |       |   |   |
| 11 1/8% Senior Notes, net of discount,  premium and net deferred gain on interest rate swap |       | 14                | (2)   | 294 | (2) |
| Capital lease obligations                                                                   |       | 11                | (1)   | — |   |
| Total long-term debt                                                                        |       | $                 | 25         |   | $ | 294 |   |
| **Total  debt**                                                                             | ** ** | **$**             | **30**     | ** ** | **$** | **593** |   |

 

----

| (1) |   | Primarily  represents the current and long-term portions of capital lease obligations  associated with Tenovis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | The  carrying value of the 111/8%  Senior Notes  due April 2009 (“senior notes”) as of September 30, 2004 of $294  million is comprised of the principal amount outstanding of $284 million  increased for $5 million of unamortized premium, net of discount and the net  unamortized deferred gain of $5 million related to the termination of  interest rate swap agreements. All of these notes except for approximately  $13 million principal amount were repurchased for cash through a public  tender offer during the first quarter of fiscal 2005. These notes are no  longer secured and can be called at the Company’s option in April 2006. |
| (3) |   | The  carrying value of the LYONs represented the value of 549,022 notes  outstanding. These notes were redeemed for cash or converted into shares of  Avaya common stock during the first quarter of fiscal 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |

** **

**See below for a detailed discussionof actions the Company has taken during fiscal 2005 related to its long-termdebt.**

*** ***

***SecuredFloating Rate Notes***

*** ***

In November 2001,Tenovis entered into an asset securitization transaction whereby TenovisFinance Limited, a variable interest entity for which Tenovis is the primarybeneficiary, issued Secured Floating Rate Notes due 2013 (“secured floatingrate notes”) that were 

 

54

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secured by a pool ofTenovis’s current and future receivables associated with rental contracts. Inaccordance with FIN 46(R), the Company consolidated Tenovis Finance Limitedupon the acquisition of Tenovis. Tenovis Finance Limited is a special purposecompany established to issue the secured floating rate notes and enter into allrelated financial arrangements and is the consolidated VIE as discussed in Note4 “Business Combinations and Other Transactions”.

 

The secured floatingrate notes were denominated in euros and were originally issued in an principalamount of Euro 300 million, representing 3,000 notes each having a principalamount of Euro 100,000. As of the date of the Company’s acquisition of Tenovis,each note translated to principal of $130,300 or $268 million in total for the2,060 notes outstanding.  In connectionwith these notes, Tenovis Finance Limited also entered into two interest rateswap agreements, which are discussed further in Note 9 “Derivatives and OtherFinancial Instruments.”

 

During the second and thirdquarters of fiscal 2005, the Company repaid the outstanding principal amount of$262 million and terminated the related interest rate swaps described above.Additionally, the Company paid $15 million in interest and related costs. As aresult of the repayment, the Company recognized a pre-tax loss of $3 million,which is included in other expense, net for fiscal 2005. This loss primarilyconsists of a $5 million reduction in the net unamortized discount recorded atthe time of the original debt issuance, partially offset by a $2 million gainon the change in the fair market value of the interest rate swaps.

 

***SeniorNotes***

 

During fiscal 2002 and2003, the Company issued $640 million principal amount of senior notes.  In connection with these issuances, theCompany recorded a net premium and deferred financing costs.  The Company also subsequently entered intointerest rate swaps to effectively convert the fixed-rate debt into floatingrate debt.  See Note 9 “Derivatives andOther Financial Instruments” for further discussion of these interest rate swapagreements.

 

On November 1,2004, the Company commenced a cash tender offer for any and all of its seniornotes and a consent solicitation to amend the related indenture as describedbelow. The offer included an early consent date of November 15, 2004, and expiredon December 1, 2004. The consideration for each $1,000 principal amount ofsenior notes validly tendered by the early consent date and not validlywithdrawn and accepted for payment was $1,158.95, which included a consentpayment of $30 per $1,000 principal amount.

 

As of the early consentdate, holders tendered $271 million principal amount of senior notes, and werepaid $314 million in cash. An additional $100,000 principal amount was tenderedprior to December 1, 2004, and cash of $113,000 was paid. Upon repurchaseof the notes, the Company paid interest of $4 million, which had accrued fromOctober 1, 2004 through November 15, 2004.

 

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

 

Contemporaneously withthe tender offer, the Company received the requisite consents with respect tothe consent solicitation for the adoption of certain proposed amendments to theindenture relating to the senior notes. On November 16, 2004, the Companyand the trustee for the senior notes executed a supplemental indenture, whicheliminated substantially all of the restrictive covenants, the reportingrequirements and certain events of default from the indenture. Additionally,the supplemental indenture eliminated the requirement under the indenture toprovide security for the senior notes and accordingly, the Company’sobligations under the senior notes that remain outstanding are unsecured.

 

As of September 30,2005, $13 million principal amount was outstanding.  The senior notes are redeemable inApril 2006.

 

***LYONs ConvertibleDebt***

 

Througha series of transactions during fiscal years 2004 and 2005, the Company repaidwith cash or converted into common shares all of the outstanding LYONs.  These LYONs were issued during the firstquarter of fiscal 2002 through an underwritten public offering 

 

55

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undera shelf registration statement.

 

Interest expense related to the amortization of the discount on theLYONs amounted to $2 million, $10 million and $14 million for fiscal 2005,2004 and 2003, respectively.  Inaddition, interest expense related to the amortization of deferred financingcosts on the LYONs amounted to $2 million and $4 million for fiscal 2004 and2003, respectively, and was insignificant for fiscal 2005.

 

As of September 30, 2004, theoutstanding LYONs were convertible into an aggregate of 20,557,415 shares, allof which were reflected in the diluted share calculations for fiscal 2004, asmore fully described in Note 11 “Earnings (Loss) Per Share of Common Stock,”.Upon conversion, the holders were not entitled to receive any cash paymentrepresenting accrued original issue discount. Accrued original issue discount was considered to be paid by the sharesof common stock received by the holder of the LYONs upon conversion.

 

Pursuant to the terms of the indenture, the Company had the ability toredeem all or a portion of the LYONs for cash at any time on or afterOctober 31, 2004 at a price equal to the sum of the issue price andaccrued original issue discount on the LYONs as of the applicable redemption date.  Conversely, holders had the ability torequire the Company to purchase all or a portion of their LYONs onOctober 31, 2004, 2006 and 2011 at a price per LYON of $542.95, $583.40and $698.20, respectively.  The indentureallowed the Company at its option, to elect to pay the purchase price in cashor shares of common stock, or any combination thereof.

 

On October 31, 2004, 238 LYONs were put to the Company for an aggregateredemption price of $129,000, which the Company elected to pay in cash.  On November 18, 2004, the Company announcedthat it would redeem for cash all of the remaining outstanding LYONs onDecember 20, 2004.  As provided pursuantto the indenture governing the LYONs, the redemption price was $545.67 per$1,000 principal amount at maturity of LYONs. Each LYON remained convertible at any time prior to the redemption dateat the option of the holder into 37.4437 shares of Avaya common stock.

 

Prior to the redemption date, holders of $549 million principal amountat maturity of LYONs converted their outstanding LYONs into 20,546,199 sharesof Avaya common stock pursuant to terms of the indenture.  On the stated redemption date, December 20,2004, $61,000 principal amount at maturity of LYONs, which represented allremaining outstanding LYONs, were redeemed for cash at an aggregate redemptionprice of $33,000.

 

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

 

The following table summarizes the components of the Company’slong-term debt, their aggregate carrying values and related fair market valuesas of September 30, 2005 and 2004:

 
| ** **              | ** ** | **September 30,** | ** ** |
|-------------------------|------------|-------------------|------------|
| ** **              | ** ** | **2005**          | ** ** | **2004** | ** ** |
| ** **              | ** ** | **Number**        | ** ** | ** ** | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **of Notes**      | ** ** | **Carrying** | ** ** | **Fair** | ** ** | **of Notes** | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| **Dollars in millions** | ** ** | **Outstanding**   | ** ** | **Value** | ** ** | **Value** | ** ** | **Outstanding** | ** ** | **Value** | ** ** | **Value** | ** ** |
| LYONs                   |       | —            |       | $ | — |   | $ | — |   | 549,022 |   | $ | 297 |   | $ | 307 |   |
| Senior Notes            |       | 13,205            |       | $ | 14 |   | $ | 15 |   | 284,395 |   | $ | 289 |   | $ | 330 |   |

 

In addition to the itemsin the table above, debt as of September 30, 2005 includes $16 million ofcapital lease obligations primarily associated with Tenovis, $5 million ofwhich represents the current portion of long-term debt.

 

Total debt as ofSeptember 30, 2004 includes $5 million of net unamortized deferred gainincluded in the long-term debt balance, related to the termination of theinterest rate swap agreements related to the senior notes and $2 million in thecurrent debt balance, primarily related to commercial paper of AGC.

 

The carrying value ofthe debt instruments listed above reflects the principal amount outstandingadjusted for the unamortized discount and premium related to each debtinstrument, as well as the related interest rate swap values.

 

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

 

56

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***CreditFacility***

 

OnFebruary 23, 2005, the Company entered into a Credit Agreement (the “creditfacility”), among the Company, Avaya International Sales Limited, an indirectsubsidiary of the company, a syndicate of lenders and Citicorp USA, Inc.,as agent for the lenders. The commitments pursuant to the Company’s previousAmended and Restated Five Year Revolving Credit Facility Agreement, dated as ofApril 30, 2003 (as amended), among the Company, the lenders party theretoand Citibank, N.A., as agent for the lenders, were terminated and the securityinterests securing obligations under that facility were fully released.

 

Underthe credit facility, borrowings are available in U.S. dollars or euros, and themaximum amount of borrowings that can be outstanding is $400 million, of which$150 million may be in the form of letters of credit. The credit facility is afive-year revolving facility (with an expiration date of February 23,2010) and is not secured by any assets. The credit facility contains affirmativeand restrictive covenants, including: (a) periodic financial reportingrequirements, (b) maintaining a maximum ratio of consolidated debt toearnings before interest, taxes, depreciation and amortization, adjusted forcertain business restructuring charges and related expenses and non-cashcharges, referred to as adjusted EBITDA, of 2.00 to 1.00, (c) maintaininga minimum ratio of adjusted EBITDA to interest expense of 4.00 to 1.00, (d) limitationson the incurrence of subsidiary indebtedness, (e) limitations on liens, (f) limitationson investments and (g) limitations on the creation or existence ofagreements that prohibit liens on our properties. The credit facility also limits theCompany’s ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock to an amount notto exceed 50% of consolidated net income of the Company for the fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. The credit facility wasamended in May 2005 to provide the Company with the ability to make dividend payments or distributions or torepurchase,redeem or otherwise acquire shares of its common stock in fiscal 2005 up to anamount not to exceed $250 million. As of September 30, 2005, the Companywas in compliance with all of the covenants included in the credit facility.

 

Thecredit facility provides that the Company may use up to $1 billion in cash(excluding transaction fees) and assumed debt for acquisitions completed after February 23,2005, provided that it is in compliance with the terms of the agreement. Theacquisition amount will be permanently increased to $1.5 billion afterconsolidated EBITDA of the Company and its subsidiaries for any period oftwelve consecutive months equals or exceeds $750 million.

 

Thereare currently $55 million of letters of credit issued under the creditfacility. There are no other outstanding borrowings under the facility, and theremaining availability is $345 million. The Company believes the creditfacility provides it with an important source of backup liquidity.

 

Fromtime to time, certain of the lenders provide customary commercial andinvestment banking services to the Company.

 

**9. Derivatives and Other FinancialInstruments**

 

The Company conducts its business on a multi-national basisin a wide variety of foreign currencies and, as such, uses derivative financialinstruments to reduce earnings and cash flow volatility associated with foreignexchange rate changes.  Specifically, theCompany uses foreign currency forward contracts to mitigate the effects offluctuations of exchange rates associated with certain existing assets andliabilities that are denominated in non-functional currencies and, from time totime, to reduce anticipated net foreign currency cash flows resulting fromnormal business operations.  In addition,the Company has used interest rate swap agreements to manage its proportion offixed and floating rate debt and to reduce interest expense.

 

The Company engages in foreign currency hedging activities to reducethe risk that changes in exchange rates will adversely affect the eventual netcash flows resulting from the sale of products to foreign customers andpurchases from foreign suppliers.  TheCompany believes that it has achieved risk reduction and hedge effectivenessbecause the gains and losses on its derivative instruments substantially offsetthe losses and gains on the assets, liabilities and transactions being hedged.  Hedge effectiveness is periodically measuredby comparing the change in fair value of each hedged foreign currency exposureat the applicable market rate with the change in market value of thecorresponding derivative instrument.

 

***Recorded Transactions***

 

The Company utilizes foreign currency forward contractsprimarily to manage short-term exchange rate exposures on certain receivables,payables and loans residing on foreign subsidiaries’ books, which aredenominated in currencies other than the subsidiary’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 Operations as other expense, net. Changes in the fair value of the Company’s foreign currency forwardcontracts used to offset these exposed items are also recognized in theConsolidated Statements of Operations as other expense, net in the period inwhich the exchange rates change.  For fiscal2005, 2004 

 

57

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and 2003, 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 currency forwardcontracts to offset certain forecasted foreign currency transactions primarilyrelated to the purchase or sale of products expected to occur during theensuing twelve months.  The change in thefair value of foreign currency forward contracts is recognized as otherexpense, net in the period in which the exchange rates change.  For fiscal 2005, 2004 and 2003, these gainsand losses were not material to the Company’s results of operations.  As permitted under SFAS No. 133 “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS 133”),,the Companyhas elected not to designate its foreign currency forward contracts as hedgesthereby precluding the use of hedge accounting for these instruments.

 

The notional amount of the Company’s financial instruments representsthe face amount of the contractual arrangements and the basis on which U.S.dollars are to be exchanged. They are not a measure of market or creditexposure. The notional amounts as of September 30, 2005 and 2004 of theCompany’s foreign currency forward contracts were $323 million and$558 million, respectively.  Infiscal 2005, these notional amounts principally represent the equivalent inU.S. dollars for contracts in British pounds sterling of $174 million, euros of$162 million, Canadian dollars of $57 million, Mexican pesos of $27 million,Australian dollars of $16 million, Japanese yen of $14 million, Hungarianforints of $13 million and other foreign currencies.  In fiscal 2004, these notional amountsprincipally represent the equivalent in U.S. dollars for contracts in euros of$282 million, British pounds sterling of $171 million, Canadian dollars of $27million, Singapore dollars of $22 million, Japanese yen of $13 million, Mexicanpesos of $12 million, Hungarian forints of $10 million and other foreigncurrencies of $21 million.

 

***Fair Value***

 

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

 

The estimated fair values of the Company’s foreign currency forwardcontracts are included in the Consolidated Balance Sheets, reflected as another current liability of $6 million as of September 30, 2005 and another current asset of $8 million as of September 30, 2004.  The estimated fair values of these forwardcontracts were based on market quotes obtained through independent pricing sources.

 

***Interest Rate Swap Agreements***

 

Included in the September 30, 2004 Consolidated Balance Sheet isthe net unamortized balance of $5 million of a deferred gain which is beingrecognized as a reduction to interest expense over the remaining term to maturityof the senior notes.  The remainingbalance as of September 30, 2005 is insignificant.  This deferred gain resulted from thetermination of two interest rates swaps in December 2002. In April 2002,the Company entered into these interest rate swap agreements with a totalnotional amount of $200 million that qualified and were designated as fairvalue hedges in accordance with SFAS 133. These arrangements generally involve the exchange of fixed and floatingrate interest payments without the exchange of the underlying principal.  Net amounts paid or received are reflected asadjustments to interest expense.  TheCompany recorded the fair market value of the swaps as other assets along witha corresponding increase to the hedged debt, both of which were recordedthrough other expense, net.

 

During the first and second quarters of 2004, the Company entered intoa total of five interest rate swap agreements each having a notional amount of$50 million and a maturity date of April 2009.  These interest rate swap agreements wereexecuted in order to: (i) convert a portion of the senior notes fixed-ratedebt into floating-rate debt; (ii) maintain a capital structure containingappropriate amounts of fixed- and floating-rate debt; and (iii) reduceinterest payments and expense in the near term. These agreements qualified and were designated as fair value hedges inaccordance with SFAS 133.  Under theseagreements, the Company received a fixed interest rate of 111/8% andpaid a floating interest rate based on the six-month LIBOR (in arrears) plus anagreed-upon spread of 6.55%, 6.8575%, 6.94%, 6.8% and 6.98%, respectively.  The interest rate swaps effectively converted$250 million of the senior notes from fixed rate debt into floating ratedebt.  Since the relevant terms of theinterest rate swap agreements matched the corresponding terms of the seniornotes, there was no hedge ineffectiveness. Accordingly, gains and losses on the interest rate swap agreements fullyoffset the losses and gains on the hedged portion of the senior notes, whichwere marked to market at each reporting date, both of which were recorded inother expense, net.

 

During the third and fourth quarters of fiscal 2004, the Companyterminated all five of its interest rate swap agreements.  The terminations resulted in a reduction toother liabilities for the removal of the fair market value of the interest rateswap and cash payments of $2 million representing the loss on termination,which is being recognized as an increase to interest expense over the 

 

58

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remaining term to maturity of the senior notes.  The unamortized balance of the loss inincluded as a reduction to long-term debt. The Company terminated these interest rate swap agreements as itanticipated 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 final maturity dateof November 2007. These interest rate swap agreements were executed in orderto convert the floating rate debt into fixed rate debt. Under these agreements,Tenovis received a floating interest rate based on the three-month EURIBOR andpaid a fixed interest rate of 4.72%. Because there was a 1.50% spread on theunderlying floating rate notes, the total fixed rate interest payment on thenotes was 6.22% per annum. The swaps were marked to market at each reportingdate.

 

Duringthe second and third quarters of fiscal 2005, the Company repaid the securedfloating rate notes and terminated the related interest rate swap agreements,which resulted in a $2 million gain on the change in the fair market value ofthe interest rate swaps.

 

***Non-Derivative andOff-Balance-Sheet Instruments***

 

Requests for providing commitments to extend credit and financialguarantees are reviewed and approved by senior management. Management regularlyreviews all outstanding commitments, letters of credit and financialguarantees, and the results of these reviews are considered in assessing theadequacy of the Company’s reserve for possible credit and guarantee losses. SeeNote 17 “Commitments and Contingencies” for the disclosure of these items.

 

**10. Convertible Participating Preferred Stockand Other Equity Transactions**

 

***Warburg Transactions***

 

**Convertible Participating Preferred Stock**

 

In October 2000, the Company sold to Warburg PincusEquity Partners, L.P. and certain affiliated investment funds (the “WarburgEntities”) four million shares of the Company’s Series B convertibleparticipating preferred stock and Series A and Series B warrants topurchase the Company’s common stock for an aggregate purchase price of$400 million.  In March 2002,the Company completed a series of transactions to convert all the Series Bconvertible participating preferred stock and Series A warrants into theCompany’s common stock.

 

**Warrants to Purchase Common Stock**

 

In December 2002, the Company, together with theWarburg Entities, commenced an exchange offer to purchase up to $661 millionprincipal amount at maturity, or 70% at the time, of the Company’s outstandingLYONs (the “Exchange Offer”). In consideration of their agreement toparticipate in the Exchange Offer, in December 2002, the Company grantedthe Warburg Entities Series C warrants that have a four-year term and areexercisable for an aggregate of 7,355,824 shares of Avaya common stock at anexercise price of $3.50 per share.  Thefair value of these warrants was estimated to be $5 million and wasincluded in additional paid-in capital. During the second quarter of fiscal 2003, upon completion of theExchange 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 expense, net.

 

As of September 30, 2005, the Warburg Entities held warrants topurchase the following additional shares of the Company’s common stock:

 
| **Warrants**  | ** ** | **Number of Shares** | ** ** | **Exercise Price** | ** ** | **Expiration Date** | ** **               |
|---------------|------------|----------------------|------------|--------------------|------------|---------------------|--------------------------|
| Series B |       | 5,379,732            |       | $                  | 34.73      |                | October 2, 2005 (1) |   |
| Series C |       | 7,355,824            |       | $                  | 3.50       |                | December 23, 2006   |   |
|          |       | 12,735,556           |       |               |       |                |                     |

 

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(1)          Expiredunexercised on October 2, 2005.

 

In October 2005,the Warburg Entities (i) exercised the 7,355,824 Series C Warrantsheld by them, resulting in their acquisition of an aggregate of 5,236,861shares of our common stock and (ii) distributed to their partners anaggregate of 15,299,993 shares of our common stock.  As a result of the foregoing, as of November 1,2005, the total number of shares of our common stock beneficially owned by theWarburg Entities was 156,529 shares, which represented approximately 0.056% ofAvaya’s common stock outstanding on that date.

 

59

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***Other EquityTransactions***

 

During the second half of fiscal 2005, the Companyrepurchased and retired 11,525,000 shares of its common stock at an averageprice of $9.27 per share, under the provisions of the share repurchase planauthorized by the Board of Directors in April 2005 (see Note 11 “Earnings(Loss) per Share of Common Stock”).

 

During the first quarter of fiscal 2005, the Company issued20,546,199 shares of its common stock to holders of the LYONs who chose toconvert their LYONs into Company shares (see Note 8 “Long-Term Debt”).

 

In September 2004, the Company paid $24 million of itscommon stock to fund its portion of the Lucent securities litigation settlement(see Note 17 “Commitments and Contingencies”). The payment was funded with a combination of 221,882 shares of treasurystock and 1,600,303 shares of newly issued common stock.

 

During the third quarter of fiscal 2004, the Company made avoluntary contribution of $111 million of its common stock to fund its U.S.pension plan (see Note 13 “Benefit Obligations”).  The contribution was funded with acombination of 2,448,602 shares of treasury stock and 4,510,646 shares of newlyissued common stock. As of the date of the contribution, the treasury stock hada 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.

 

In February 2004, the Company sold 14,039,481 shares of its commonstock for $17.85 per share in a public offering.  The Company received proceeds of $249million, net of $2 million of underwriting discounts and commissions, whichhave been recorded as a reduction to additional paid-in capital.  The Company used the entire net proceeds toredeem a portion of its outstanding senior notes (see Note 8 “Long-Term Debt”).

 

In September 2003, the Company sold 34,500,000 shares ofcommon stock for $10.20 per share in a public offering. The Company receivedproceeds of $349 million, which was net of $3 million of underwritingdiscounts and commissions reflected as a reduction to additional paid-incapital.

 

**11. Earnings (Loss) Per Share of Common Stock**

 

Basic earnings (loss) per common share is calculated by dividing netincome (loss) available to common stockholders by the weighted average numberof common shares outstanding during the period. Diluted earnings (loss) per common share is calculated by adjusting netincome (loss) available to common stockholders and weighted average outstandingshares, assuming conversion of all potentially dilutive securities includingstock options, restricted stock units, warrants and convertible debt.

 

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| ** **                                                                                 | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions, except per share amounts**                                          | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                       |       |                              |       |   |   |   |   |
| **Earnings  (Loss) Per Common Share - Basic:**                                             |       |                              |       |   |   |   |   |
| Income  (loss) from continuing operations available to common stockholders                 |       | $                                 | 923        |   | $ | 291 |   | $ | (128 | ) |
| (Loss)  income from discontinued operations                                                |       | (2                                | )          | 5 |   | 40 |   |
| Net income  (loss)                                                                         |       | $                                 | 921        |   | $ | 296 |   | $ | (88 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| Earnings  (loss) per share from continuing operations                                      |       | $                                 | 1.95       |   | $ | 0.66 |   | $ | (0.34 | ) |
| Earnings per  share from discontinued operations                                           |       | —                            |       | 0.01 |   | 0.11 |   |
| Earnings  (loss) per share - basic                                                         |       | $                                 | 1.95       |   | $ | 0.67 |   | $ | (0.23 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| Weighted  average shares outstanding - basic                                               |       | 473                               |       | 439 |   | 378 |   |
|                                                                                       |       |                              |       |   |   |   |   |
| **Earnings  (Loss) Per Common Share - Diluted:**                                           |       |                              |       |   |   |   |   |
| Income  (loss) from continuing operations available to common stockholders                 |       | $                                 | 923        |   | $ | 291 |   | $ | (128 | ) |
| Interest  charges associated with LYONs convertible debt, net of tax effects               |       | 2                                 |       | 10 |   | — |   |
| Income  (loss) from continuing operations after assumed conversion of LYONs debt           |       | 925                               |       | 301 |   | (128 | ) |
| (Loss)  income from discontinued operations                                                |       | (2                                | )          | 5 |   | 40 |   |
| Net income  (loss) after assumed conversion of LYONs debt                                  |       | $                                 | 923        |   | $ | 306 |   | $ | (88 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| Earnings  (loss) per share from continuing operations                                      |       | $                                 | 1.89       |   | $ | 0.63 |   | $ | (0.34 | ) |
| Earnings per  share from discontinued operations                                           |       | —                            |       | 0.01 |   | 0.11 |   |
| Earnings  (loss) per share- diluted                                                        |       | $                                 | 1.89       |   | $ | 0.64 |   | $ | (0.23 | ) |
|                                                                                       |       |                              |       |   |   |   |   |
| **Diluted  Weighted Average Shares Outstanding:**                                          |       |                              |       |   |   |   |   |
| Weighted average  shares outstanding - basic                                               |       | 473                               |       | 439 |   | 378 |   |
| Dilutive  Potential Common Shares:                                                         |       |                              |       |   |   |   |   |
| Stock  Options                                                                             |       | 6                                 |       | 8 |   | — |   |
| Restricted  Stock Units                                                                    |       | 1                                 |       | 2 |   | — |   |
| Warrants                                                                                   |       | 5                                 |       | 6 |   | — |   |
| LYONs  Convertible Debt                                                                    |       | 4                                 |       | 21 |   | — |   |
| Weighted  average shares outstanding - diluted                                             |       | 489                               |       | 476 |   | 378 |   |
|                                                                                       |       |                              |       |   |   |   |   |
| **Securities  excluded from the computation of diluted earnings (loss) per common share:** |       |                              |       |   |   |   |   |
| Stock  options (1)                                                                         |       | 36                                |       | 25 |   | 43 |   |
| Restricted  stock units (1)                                                                |       | —                            |       | — |   | 4 |   |
| Warrants (1)                                                                               |       | 6                                 |       | 6 |   | 10 |   |
| Common shares  issuable upon conversion of LYONs                                           |       |                              |       |   |   |   |   |
| Settled in  common shares (2)                                                              |       | —                            |       | — |   | 136 |   |
| Settled in  cash (3)                                                                       |       | —                            |       | — |   | 20 |   |
|                                                                                       |       | 42                                |       | 31 |   | 213 |   |

 

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(1)          These securities havebeen excluded from the diluted earnings (loss) per common share calculation eitherbecause the respective exercise prices are greater than the average marketvalue of the underlying stock or their inclusion would have been antidilutive.

 

(2)          For the year ended September 30,2003, the securities listed represent the average number of shares issuable bythe Company if it were required to purchase LYONs outstanding as of September 30,2003 on the initial October 31, 2004 put date and if the Company electedto satisfy the put obligation in shares of common stock.  Such securities were excluded from thediluted loss per common share calculation as their inclusion would have beenantidilutive.

 

(3)          These securities havebeen excluded from the diluted earnings (loss) per common share calculation dueto the assumption that this portion of the debt would have been settled incash.

 

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OnApril 19, 2005, the Board of Directors authorized a share repurchase plan(the “plan”).  Under the provisions ofthis plan, Avaya may use up to $500 million of cash to repurchase shares of itsoutstanding common stock through April 2007. The Company’s credit facilityprovided it with the ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock in fiscal 2005 up to anamount not to exceed $250 million. During fiscal 2005, the Company repurchased 11,525,000 shares of itscommon stock at an average price of $9.27 per share, for a total of $107million.  For fiscal 2006, the creditfacility limits our ability to make dividend payments or distributions or torepurchase, redeem or otherwise acquire shares of our common stock to $461million (which represents 50% of net income for the Company for fiscal2005).  Since September 30, 2005, wehave repurchased 6,603,000 shares at an average purchase price of $11.40 pershare, for an additional $75 million. Approximately $318 million is available through April, 2007 for furthershare repurchases under the plan. These repurchases are made at management’sdiscretion in the open market or in privately negotiated transactions incompliance with applicable securities laws and other legal requirements and aresubject to market conditions, share price, the terms of Avaya’s credit facilityand other factors.  See Note 8 “Long-TermDebt,” for further information concerning the limitations under the creditfacility.

 

**12. Income Taxes**

 

A reconciliation of the Company’s income tax provision (benefit) oncontinuing operations at the federal statutory rate to the (benefit) provisionfor income taxes at the effective tax rate is as follows:

 
| ** **                                                                    | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                                                       | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income tax  provision (benefit) computed at the federal statutory rate of 35% |       | $                                 | 86         |   | $ | 85 |   | $ | (15 | ) |
| State and  local income taxes, net of federal income tax effect               |       | 5                                 |       | 9 |   | 2 |   |
| Tax  differentials on foreign earnings                                        |       | 36                                |       | (1 | ) | 23 |   |
| Non-deductible  restructuring costs                                           |       | —                            |       | 22 |   | 17 |   |
| U.S. federal  audit settlements                                               |       | (109                              | )          | (102 | ) | (45 | ) |
| Other  differences - net                                                      |       | (1                                | )          | 3 |   | 4 |   |
| Valuation  allowance                                                          |       | (693                              | )          | (65 | ) | 98 |   |
| **(Benefit)  provision for income taxes**                                     | ** ** | **$**                             | **(676**   | **)** | **$** | **(49** | **)** | **$** | **84** | ** ** |

 

During fiscal 2005, the Company recognized $36 million of tax expenserelating to the differentials on foreign earnings that is primarily resultingfrom the unfavorable geographic mix of earnings and the non-deductibility ofcertain foreign losses and expenses.  The$109 million tax benefit resulted from the resolution of U.S. federal incometax audit matters for the pre-distribution years 1999 and 2000 (see Note 17 “Commitmentsand Contingencies”).  The $693 milliontax benefit relating to the reversal of a portion of the valuation allowance ispartially offset by a tax provision recorded for the year resulting in a nettax benefit of $590 million.  In fiscal2004, the Company recognized a $102 million tax benefit resulting from theresolution of U.S. federal income tax audit matters for the pre-distributionyears 1990 to 1998.

 

The following table presents the U.S. and foreign components of income(loss) from continuing operations before income taxes and the provision(benefit) for income taxes on continuing operations for fiscal 2005, 2004 and2003:

 

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| ** **                                    | ** ** | **Year ended September 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| **Dollars in millions**                       | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| INCOME (LOSS) BEFORE INCOME TAXES:            |       |                              |       |   |   |   |   |
| U.S.                                          |       | $                                 | 254        |   | $ | 170 |   | $ | (7 | ) |
| Foreign                                       |       | (7                                | )          | 72 |   | (37 | ) |
| Income (loss) before income taxes             |       | $                                 | 247        |   | $ | 242 |   | $ | (44 | ) |
|                                          |       |                              |       |   |   |   |   |
| (BENEFIT FROM) PROVISION FOR INCOME TAXES:    |       |                              |       |   |   |   |   |
| CURRENT                                       |       |                              |       |   |   |   |   |
| Federal                                       |       | $                                 | (109       | ) | $ | (95 | ) | $ | — |   |
| State and  local                              |       | (12                               | )          | 8 |   | 3 |   |
| Foreign                                       |       | 40                                |       | 25 |   | 13 |   |
| Subtotal                                      |       | $                                 | (81        | ) | $ | (62 | ) | $ | 16 |   |
|                                          |       |                              |       |   |   |   |   |
| DEFERRED                                      |       |                              |       |   |   |   |   |
| Federal                                       |       | $                                 | (468       | ) | $ | 12 |   | $ | 49 |   |
| State and  local                              |       | (117                              | )          | 1 |   | 22 |   |
| Foreign                                       |       | (10                               | )          | — |   | (3 | ) |
| Subtotal                                      |       | $                                 | (595       | ) | $ | 13 |   | $ | 68 |   |
| **(Benefit from) provision for income taxes** | ** ** | **$**                             | **(676**   | **)** | **$** | **(49** | **)** | **$** | **84** | ** ** |

 

The components of deferred tax assets and liabilities oncontinuing operations as of September 30, 2005 and 2004 are as follows:

 
| ** **                                 | ** ** | **September 30,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| **Dollars in millions**                    | ** ** | **2005**               | ** ** | **2004** | ** ** |
| DEFERRED INCOME TAX ASSETS:                |       |                   |       |   |   |
| Benefit  obligations                       |       | $                      | 562        |   | $ | 601 |   |
| Accrued  liabilities                       |       | 163                    |       | 223 |   |
| Net  operating loss / credit carryforwards |       | 492                    |       | 399 |   |
| Other                                      |       | 46                     |       | 30 |   |
| Gross deferred tax assets                  |       | $                      | 1,263      |   | $ | 1,253 |   |
|                                       |       |                   |       |   |   |
| DEFERRED INCOME TAX LIABILITIES:           |       |                   |       |   |   |
| Goodwill &  Intangible Assets     |       | $                      | (136       | ) | $ | (23 | ) |
| Property,  plant and equipment             |       | —                 |       | (7 | ) |
| Other                                      |       | (4                     | )          | (15 | ) |
| Gross deferred tax liabilities             |       | $                      | (140       | ) | $ | (45 | ) |
| Valuation allowance                        |       | $                      | (165       | ) | $ | (781 | ) |
| **NET DEFERRED TAX ASSET**                 | ** ** | **$**                  | **958**    | ** ** | **$** | **427** | ** ** |

 

As of September 30, 2005, the Company had net operating losscarryforwards (after-tax) totaling $447 million, comprised of $363 for U.S.federal, state and local and $84 million for foreign, primarily inGermany.  U.S. federal and state netoperating loss carryforwards expire through the year 2025, 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 carryforwards totaling $45 million. Of this total, $21 million expire between five and ten years and $24million expire in excess of ten years.

 

During fiscal 2005, the Company reduced its deferred taxasset valuation allowance by $616 million. In assessing the realizability of deferred tax assets, the Companyconsiders whether it is more likely than not that some portion or all of thedeferred tax assets will not be realized. The Company considered historical book income, the scheduled reversal ofdeferred tax liabilities, and projected future book and taxable income inmaking this assessment.  Based upon adetailed analysis of historical and expected book and taxable income, theCompany determined that the realization of certain deferred tax assets forwhich a valuation allowance had been recorded is considered to be more likelythan not for purposes of reversing the valuation allowance.  The reduction in valuation allowance waspartially offset by other adjustments, primarily relating to an increase inforeign deferred tax assets and their attending valuation allowance relating tothe acquisition of Tenovis.  Theremaining valuation allowance of $165 million is comprised of $142 millionrelating to foreign deferred tax assets for which we have determined, based onhistorical results and projected future book and taxable income levels, that a 

 

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valuation allowance should remain.  The foreign valuation allowance includesapproximately $120 million relating to our German operations.

 

During fiscal 2004, the Company recorded an increase of $12 millionto its net deferred tax asset valuation allowance. The increase in thevaluation allowance was comprised of a reduction in accumulated othercomprehensive loss associated with the minimum pension liability recorded inaccordance with SFAS No. 87, “Employers’ Accounting for Pensions” (“SFAS87”), a reduction in goodwill related to the acquisition of Expanets whichrepresents future deductible expenses and an adjustment related to the exerciseof stock options which served to decrease taxable income for the year.  The increase in the valuation allowance waspartially offset as a result of having positive book taxable income for theyear including certain other tax adjustments.

 

The Company has not provided for U.S. deferred income taxes or foreignwithholding taxes on $847 million and $748 million of undistributedearnings of its non-U.S. subsidiaries as of September 30, 2005 and 2004,respectively, since the Company intends to reinvest these earningsindefinitely.

 

On October 22, 2004, the American Jobs Creation Act of 2004, orthe Act, was signed into law.  The Actincludes a deduction of 85% of certain foreign earnings that are repatriated,as defined in the Act.  With respect tothe repatriation provision, we continue to evaluate the potential benefits ascompared to the costs with a decision expected to be made by the end of fiscal2006.

 

**13. Benefit Obligations**

 

***Pension andPostretirement Benefits***

 

Historically, the Companysponsors non-contributory defined benefit pension plans covering the majorityof our U.S. employees and retirees, and postretirement benefit plans for U.S.retirees that include healthcare benefits and life insurance coverage. EffectiveJanuary 1, 2004, the pension plan for U.S. salaried employees was amendedto eliminate benefit accruals for compensation paid after December 31,2003.

 

Certain non-U.S. operations have variousretirement benefit programs covering substantially all of their employees. Someof these programs are considered to be defined benefit pension plans foraccounting purposes. Prior to the acquisition of Tenovis on November 18,2004, the non-U.S. retirement plans were not material to total operations.

 

Our general funding policy with respect toour qualified pension plans is to contribute amounts at least sufficient tosatisfy the minimum amount required by applicable law and regulations, or todirectly pay benefits where appropriate. In fiscal 2005 and 2004, contributionsto our U.S. pension plans totaled $7 million and $118 million,respectively, and contributions to our non-U.S. pension plans totaled$9 million and $4 million, respectively. The contributions to theU.S. pension plans in fiscal 2005 consisted of payments for certain pensionbenefits that are not pre-funded. The contributions to the U.S. pension plansin fiscal 2004 consisted of payments totaling $7 million for certainpension benefits that are not pre-funded, and a voluntary contribution of$111 million, in the form of shares of common stock of the Company, tofund the pension obligation for salaried employees. In fiscal 2005 and 2004, wewere not required to make a contribution to satisfy the minimum statutoryfunding requirements in the U.S. In fiscal 2006, we estimate we will makepayments totaling $7 million for certain U.S. pension benefits that arenot pre-funded, and contributions totaling $11 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 these retiree medicalbenefits increased from $20 million in fiscal 2004 to $27 million infiscal 2005, and they are expected to increase to $47 million in fiscal2006.

 

On September 30, 2005, our annualmeasurement date, the accumulated benefit obligation related to our U.S. andnon-U.S. pension plans exceeded the fair value of the pension plan assets (suchexcess is referred to as an unfunded accumulated benefit obligation). Changesin the amount of the unfunded accumulated benefit obligation result from factorssuch as a change in the interest rate used to discount the accumulated benefitobligation to its present settlement amount, contributions to the pension planand the investment return generated by pension plan assets.  For U.S. plans, the unfunded accumulatedbenefit obligation exceeded the Company’s accrued pension liability by$911 million, a decrease of $47 million from September 30,2004.  For non-U.S. plans, the unfundedaccumulated benefit obligation exceeded the Company’s accrued pension liabilityby $36 million, an increase of $36 million from September 30, 2004. As aresult, in accordance with SFAS 87, the Company recorded an adjustment todecrease the additional minimum pension liability from $958 million at September 30,2004 to $947 million at September 30, 2005.  This resulted in a $2 million netdecrease to 

 

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accumulated other comprehensive loss to$913 million as of September 30, 2005, and a $9 million decreaseto intangible assets, to $34 million as of September 30, 2005. Thecharge to stockholders’ equity represents a net loss not yet recognized aspension expense.

 

In connection with the recognition of theadditional minimum pension liability, the Company also recorded in fiscal 2005a reduction to the deferred tax asset of $15 million. This reduced thedeferred tax asset related to the minimum pension liability from$360 million as of September 30, 2004, to $345 million as of September 30,2005.

 

A reconciliation of the changes in the benefitobligations and fair value of assets of the defined benefit pension andpostretirement plans, the funded status of the plans, and the amountsrecognized in the Consolidated Balance Sheets is provided in the table below:

 
| ** **                                                         | ** ** | **Pension Benefits**   | ** ** | **Pension Benefits**   | ** ** | **Postretirement**     | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **US**                 | ** ** | **Non-US**             | ** ** | **Benefits**           | ** ** |
| ** **                                                         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| **Dollars in millions**                                            | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005**               | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| CHANGE IN BENEFIT OBLIGATION                                       |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| Benefit obligation as of October 1                            |       | $                      | 3,023      |                   | $          | 2,926                  |       | $ | 30 |   | $ | 31 |   | $ | 723 |   | $ | 686 |   |
| Acquisition  of Tenovis                                            |       | —                 |       | —                 |       | 314                    |       | — |   | — |   | — |   |
| Sale of  Connectivity Solutions                                    |       | —                 |       | 31                     |       | —                 |       | — |   | — |   | 14 |   |
| Service cost                                                       |       | 17                     |       | 16                     |       | 10                     |       | 4 |   | 5 |   | 4 |   |
| Interest  cost                                                     |       | 169                    |       | 170                    |       | 14                     |       | 1 |   | 39 |   | 41 |   |
| Amendments                                                         |       | —                 |       | —                 |       | —                 |       | — |   | — |   | — |   |
| Actuarial  loss (gain)                                             |       | 68                     |       | 125                    |       | 39                     |       | 1 |   | (157 | ) | 23 |   |
| Benefits  paid                                                     |       | (195                   | )          | (245                   | )          | (7                     | )          | — |   | (49 | ) | (45 | ) |
| Exchange  rate movements                                           |       | —                 |       | —                 |       | (26                    | )          | 2 |   | — |   | — |   |
| Curtailments,  settlements and other                               |       | —                 |       | —                 |       | (5                     | )          | (9 | ) | — |   | — |   |
| Benefit obligation as of September 30                         |       | $                      | 3,082      |                   | $          | 3,023                  |       | $ | 369 |   | $ | 30 |   | $ | 561 |   | $ | 723 |   |
|                                                               |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| CHANGE IN PLAN ASSETS                                              |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| Fair value of plan assets as of October 1                     |       | $                      | 2,169      |                   | $          | 2,126                  |       | $ | 18 |   | $ | 20 |   | $ | 143 |   | $ | 145 |   |
| Sale of  Connectivity Solutions                                    |       | (2                     | )          | 25                     |       | —                 |       | — |   | — |   | 3 |   |
| Transfer to  Lucent                                                |       | —                 |       | —                 |       | —                 |       | — |   | (12 | ) | — |   |
| Actual  return on plan assets                                      |       | 292                    |       | 145                    |       | —                 |       | — |   | 16 |   | 20 |   |
| Employer  contributions                                            |       | 7                      |       | 118                    |       | 9                      |       | 4 |   | 27 |   | 20 |   |
| Benefits  paid                                                     |       | (195                   | )          | (245                   | )          | (7                     | )          | — |   | (49 | ) | (45 | ) |
| Exchange rate  movements                                           |       | —                 |       | —                 |       | (1                     | )          | 1 |   | — |   | — |   |
| Settlements  and other                                             |       | —                 |       | —                 |       | (1                     | )          | (7 | ) | — |   | — |   |
| Fair value of plan assets as of September 30                  |       | $                      | 2,271      |                   | $          | 2,169                  |       | $ | 18 |   | $ | 18 |   | $ | 125 |   | $ | 143 |   |
|                                                               |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| UNFUNDED STATUS OF THE PLAN                                        |       | $                      | (811       | )                      | $          | (854                   | )          | $ | (351 | ) | $ | (12 | ) | $ | (436 | ) | $ | (580 | ) |
| Unrecognized  prior service cost                                   |       | 16                     |       | 22                     |       | —                 |       | — |   | 59 |   | 68 |   |
| Unrecognized  net loss                                             |       | 900                    |       | 940                    |       | 42                     |       | 5 |   | 10 |   | 165 |   |
| Net amount recognized                                              |       | $                      | 105        |                   | $          | 108                    |       | $ | (309 | ) | $ | (7 | ) | $ | (367 | ) | $ | (347 | ) |
|                                                               |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| AMOUNT RECOGNIZED  IN THE CONSOLIDATED BALANCE SHEETS CONSISTS OF: |       |                   |       |                   |       |                   |       |   |   |   |   |   |   |
| Accrued benefit liability                                          |       | $                      | (806       | )                      | $          | (850                   | )          | $ | (345 | ) | $ | (7 | ) | $ | (367 | ) | $ | (347 | ) |
| Intangible asset                                                   |       | 34                     |       | 43                     |       | —                 |       | — |   | — |   | — |   |
| Accumulated other comprehensive loss                               |       | 877                    |       | 915                    |       | 36                     |       | — |   | — |   | — |   |
| **Net  amount recognized**                                         | ** ** | **$**                  | **105**    | ** **             | **$**      | **108**                | ** ** | **$** | **(309** | **)** | **$** | **(7** | **)** | **$** | **(367** | **)** | **$** | **(347** | **)** |

 

In fiscal 2005, as part of the Tenovis acquisition, Avaya assumed a$314 million benefit obligation in connection with the defined benefit pensionplans of Tenovis.

 

In fiscal 2005, we experienced a $157 million net actuarial gain withrespect to measurement of our postretirement benefit obligation. The net gainwas primarily due to expected cost savings associated with the Medicare Part Dprescription drug subsidy, based on the 

 

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final regulations issued by the Centers for Medicare and MedicaidServices on January 21, 2005, and due to changes in assumptions concerningenrollment in retiree medical coverage based on current experience.

 

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

 

In fiscal 2004, in connection with the sale of Connectivity reflectedin the above table are the result of a retirement window program offered toretirement eligible represented employees of Connectivity Solutions prior toconsummating the transfer of these employees to CommScope. This had the effectof reducing the number of employees who transferred to CommScope, andincreasing the number of retirees of Avaya. The impact was a reduction in the September 30,2003 estimate of the benefit obligations and plan assets to be transferred toCommScope. In fiscal 2005 the Company made a final adjustment to the amount ofpension and postretirement plan assets originally transferred to CommScope. Theadjustment resulted in an additional transfer of $2 million of pension planassets to CommScope.

 

The following table provides the accumulated benefit obligation for alldefined benefit pension plans and information for pension plans with anaccumulated benefit obligation in excess of plan assets:

 
| ** **                                                              | ** ** | **U.S. Plans**         | ** ** | **Non - U.S. Plans**   | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| **Dollars in millions**                                                 | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Accumulated Benefit Obligation for all  plans                           |       | $                      | 3,077      |                   | $          | 3,019 |   | $ | 359 |   | $ | 23 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| **Plans  with Accumulated Benefit Obligation in excess of plan assets** |       |                   |       |                   |       |   |   |   |   |
| Projected  Benefit Obligation                                           |       | $                      | 3,082      |                   | $          | 3,023 |   | $ | 369 |   | $ | 28 |   |
| Accumulated  Benefit Obligation                                         |       | 3,077                  |       | 3,019                  |       | 359 |   | 21 |   |
| Fair Value  of Plan Assets                                              |       | 2,271                  |       | 2,169                  |       | 18 |   | 16 |   |

 

Estimated future benefits expected to be paidin each of the next five fiscal years, and in aggregate for the five fiscalyears thereafter, is presented below: 

 
| ** **              | ** ** | ** **           | ** ** | ** ** | ** ** | ** **   | ** ** | **Federal**      | ** ** |
|-------------------------|------------|----------------------|------------|------------|------------|--------------|------------|------------------|------------|
| ** **              | ** ** | ** **           | ** ** | ** ** | ** ** | ** **   | ** ** | **Prescription** | ** ** |
| ** **              | ** ** | ** **           | ** ** | ** ** | ** ** | ** **   | ** ** | **Drug**         | ** ** |
| ** **              | ** ** | **Pension Benefits** | ** ** | **Other**  | ** ** | **Subsidy**  | ** ** |
| **Dollars in millions** | ** ** | **US**               | ** ** | **Non-US** | ** ** | **Benefits** | ** ** | **Receipts**     | ** ** |
| 2006                    |       |                 | $          | 180        |       | $            | 8          |             | $          | 49 |   | $ | — |   |
| 2007                    |       |                 | 184        |       | 10         |         | 42         |             | —     |   |
| 2008                    |       |                 | 188        |       | 12         |         | 42         |             | 1          |   |
| 2009                    |       |                 | 192        |       | 14         |         | 42         |             | 1          |   |
| 2010                    |       |                 | 196        |       | 15         |         | 42         |             | 1          |   |
| 2011 - 2015             |       |                 | 1,016      |       | 94         |         | 192        |             | 15         |   |
|                         |            |                      |            |            |            |              |            |                  |            |  |  |  |  |  |

 

The components of the pension net periodic benefit cost (credit) forthe fiscal 2005, 2004 and 2003 are provided in the table below:

 

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| ** **                                            | ** ** | **Pension Benefits - US**         | ** ** | **Pension Benefits - Non- US**    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **Year ended September 30,** | ** ** | **Year ended September 30,** | ** ** |
| **Dollars in millions**                               | ** ** | **2005**                          | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **COMPONENTS  OF NET PERIODIC BENEFIT COST (CREDIT)** |       |                              |       |                              |       |   |   |   |   |   |   |   |   |
| Service cost                                          |       | $                                 | 17         |                              | $          | 16 |   | $ | 48 |   | $ | 10 |   | $ | 4 |   | $ | 4 |   |
| Interest  cost                                        |       | 169                               |       | 170                               |       | 165 |   | 14 |   | 1 |   | 1 |   |
| Expected  return on plan assets                       |       | (217                              | )          | (217                              | )          | (201 | ) | (1 | ) | (1 | ) | (1 | ) |
| Amortization  of unrecognized prior service cost      |       | 6                                 |       | 7                                 |       | 3 |   | — |   | — |   | — |   |
| Recognized  net actuarial loss                        |       | 35                                |       | 15                                |       | — |   | — |   | — |   | — |   |
| Amortization  of transition asset                     |       | —                            |       | —                            |       | (1 | ) | — |   | — |   | — |   |
| Curtailment  gain                                     |       | —                            |       | —                            |       | (31 | ) | — |   | (1 | ) | — |   |
| Special  termination benefits                         |       | —                            |       | —                            |       | 5 |   | — |   | — |   | — |   |
| **Net  periodic benefit cost (credit)**               | ** ** | **$**                             | **10**     | ** **                        | **$**      | **(9** | **)** | **$** | **(12** | **)** | **$** | **23** | ** ** | **$** | **3** | ** ** | **$** | **4** | ** ** |

 

The components of the postretirement net periodic benefit cost for thefiscal 2005, 2004 and 2003 are provided in the table below:

 
| ** **                                       | ** ** | **Postretirement Benefits**       | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                       | ** ** | **Year ended September 30,** | ** ** |
| **Dollars in millions**                          | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **COMPONENTS OF NET PERIODIC BENEFIT COST**      |       |                              |       |   |   |   |   |
| Service cost                                     |       | $                                 | 5          |   | $ | 4 |   | $ | 5 |   |
| Interest  cost                                   |       | 39                                |       | 41 |   | 36 |   |
| Expected  return on plan assets                  |       | (11                               | )          | (15 | ) | (16 | ) |
| Amortization  of unrecognized prior service cost |       | 9                                 |       | 10 |   | 2 |   |
| Recognized  net actuarial loss (gain)            |       | 5                                 |       | 5 |   | 2 |   |
| Amortization  of transition asset                |       | —                            |       | — |   | — |   |
| Curtailment  (gain) loss                         |       | —                            |       | — |   | (15 | ) |
| Special  termination benefits                    |       | —                            |       | — |   | — |   |
| **Net periodic benefit cost**                    | ** ** | **$**                             | **47**     | ** ** | **$** | **45** | ** ** | **$** | **14** | ** ** |

 

In fiscal 2003, the net pension credit for U.S. plans of$12 million included a $31 million curtailment gain from freezing managementpension benefit accruals, and a $5 million charge for special terminationbenefits offered to represented employees as a result of the new collectivebargaining agreements. Also, the net postretirement benefit expense of$14 million included a $15 million curtailment gain from freezingmanagement retiree health care benefit accruals.

 

The weighted average assumptions used to determine the projectedbenefit obligation and net periodic benefit cost for the pension plans areprovided in the table below:

 
| ** **                                                                                                      | ** ** | **Pension Benefits -** | ** ** | **Pension Benefits -** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                      | ** ** | **US**                 | ** ** | **Non-US**             | ** ** |
| **Dollars in millions**                                                                                         | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Weighted-average  assumptions used to determine Benefit obligations at September 30**                    |       |                   |       |                   |       |   |   |   |   |   |   |   |   |
| Discount  rate                                                                                                  |       | 5.50                   | %          | 5.75                   | %          | 6.00 | % | 4.24 | % | 5.22 | % | 5.31 | % |
| Rate of  compensation increase                                                                                  |       | 4.00                   | %          | 4.00                   | %          | 4.00 | % | 3.04 | % | 3.40 | % | 3.29 | % |
|                                                                                                            |       |                   |       |                   |       |   |   |   |   |   |   |   |   |
| **Weighted-average  assumptions used to determine net periodic benefit cost for years ended September 30** |       |                   |       |                   |       |   |   |   |   |   |   |   |   |
| Discount  rate                                                                                                  |       | 5.75                   | %          | 6.00                   | %          | 6.50 | % | 4.79 | % | 5.31 | % | 5.44 | % |
| Expected  return on plan assets                                                                                 |       | 9.00                   | %          | 9.00                   | %          | 9.00 | % | 5.41 | % | 5.58 | % | 5.88 | % |
| Rate of  compensation increase                                                                                  |       | 4.00                   | %          | 4.00                   | %          | 4.00 | % | 3.03 | % | 3.29 | % | 3.43 | % |

 

67

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The weighted average assumptions used to determine theaccumulated postretirement benefit obligation and net periodic benefit cost forthe postretirement plans are provided in the table below:

 
| ** **                                                                                                      | ** ** | **Postretirement** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                      | ** ** | **Benefits**       | ** ** |
| ** **                                                                                                      | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Weighted-average  assumptions used to determine Benefit obligations at September 30**                    |       |               |       |   |   |   |   |
| Discount  rate                                                                                                  |       | 5.50               | %          | 5.75 | % | 6.00 | % |
| 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                                                                                                  |       | 5.75               | %          | 6.00 | % | 6.50 | % |
| Expected  return on plan assets                                                                                 |       | 7.25               | %          | 9.00 | % | 9.00 | % |
| Rate of  compensation increase                                                                                  |       | 4.00               | %          | 4.00 | % | 4.00 | % |

 

The assumptions in the above table were reassessed as of September 30,2005. The weighted average discount rate used to determine the benefitobligation was reduced from 5.75% to 5.50% for U.S. plans, and from 5.22% to4.24% for non-U.S. plans. The discount rate is selected based on current yieldson high quality corporate fixed-income investments that are available andexpected to be available with maturities corresponding to the expected durationof the benefit obligations. We also conducted a study of the expected long-termrate of return on the pension and postretirement 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 will remain unchangedfor fiscal 2006, and the expected rate of return on postretirement plan assetswill be changed from 7.25% to 7.0% for fiscal 2006.

 

The assumed health care cost trend rates for postretirementbenefit plans were as follows:

 
| ** **                                                                     | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                     | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Health care cost trend rate assumed for  next year                             |       | 9.7                    | %          | 10.3 | % |
| 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 aminimal effect on the amounts reported for the postretirement health care plan.A one-percentage-point increase in the Company’s healthcare cost trend rateswould have increased the postretirement benefit obligation and the service andinterest 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.

 

The weighted-average asset allocation of thepension and postretirement plans by asset category and target allocation is asfollows:

 
| ** **            | ** ** | **Pension Plan**       | ** ** | **Pension Plan**    | ** ** | **Postretirement**     | ** ** |
|-----------------------|------------|------------------------|------------|---------------------|------------|------------------------|------------|
| ** **            | ** ** | **Assets - US**        | ** ** | **Assets - Non-US** | ** ** | **Plan Assets**        | ** ** |
| ** **            | ** ** | **September 30,** | ** ** | **Long-term**       | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **Long-term** | ** ** |
| **Asset Category**    | ** ** | **2005**               | ** ** | **2004**            | ** ** | **Target**             | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Target** | ** ** |
| Equity Securities (1) |       | 61                     | %          | 63                  | %          | 55                     | %          | 0 | % | 9 | % | 71 | % | 68 | % | 70 | % |
| Debt Securities       |       | 28                     | %          | 29                  | %          | 30                     | %          | 75 | % | 68 | % | 29 | % | 32 | % | 30 | % |
| Other (2)             |       | 11                     | %          | 8                   | %          | 15                     | %          | 25 | % | 23 | % | 0 | % | 0 | % | 0 | % |
| Total                 |       | 100                    | %          | 100                 | %          | 100                    | %          | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % |

 

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(1)          Equity securities in thepension plan included $23 million and $77 million of Avaya common stock as of September 30,2005 and 2004, respectively.

 

68

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(2)          Other includes cash/cashequivalents, hedge funds and limited partnerships of various types.

 

Our asset investment strategy focuses on maintaining a diversifiedportfolio designed to optimize returns subject to a prudent level of risk. Weperform an asset-liability study every two to three years (or more frequently,if necessary) for the pension plans, and on an as necessary basis for thepostretirement plans, to determine the optimal asset mix to meet future benefitobligations. The most recent pension asset-liability study was completed infiscal 2004.

 

We use derivative financial instruments including futures, options andswaps in support of our investment strategy, principally to limit or minimizeexposure to certain risks, and to increase investment returns. The use ofderivative financial instruments for speculative purposes is prohibited by ourinvestment policy.

 

***Savings Plans***

 

Substantially all of the Company’s U.S. employees are eligible toparticipate in savings plans sponsored by the Company. The plans allowemployees 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 $53 million, $40 million and$31 million in fiscal 2005, 2004 and 2003, respectively.

 

Effective January 1, 2004, the Company enhanced its savings plansfor management employees that increased the value of the Company’s contributiontowards the plans in order to offset in part the freezing of pension benefitaccruals as described above.

 

**14. Stock Compensation Plans**

 

The Company has a stock compensation plan that provides forthe issuance to eligible employees of nonqualified stock options and restrictedstock units representing Avaya common stock. In addition, the Company has astock purchase plan under which eligible employees have the ability to purchaseshares of Avaya common stock at 85% of market value.

 

***Stock Options***

 

Stock options are generally granted with an exercise price equal to orabove the market value of a share of common stock on the date of grant, have aterm of 10 years or less and vest within four years from the date ofgrant. All stock options granted in fiscal 2004 or after have a term of sevenyears and vest in three years.  As of September 30,2005, there were 21 million stock options authorized for grant to purchaseAvaya common stock under the Company’s stock compensation plan.   At the 2004 Annual Meeting of Shareholders,the Avaya Inc. 2004 Long Term Incentive Plan (the “Plan”) was approved.  The Plan became the successor plan and nofurther grants will be made from, the Company’s four previous existing plans:the 2000 Long Term Incentive Plan, the 2000 Stock Compensation Plan forNon-employee Directors, the Broad Based Stock Option Plan, and the Long TermIncentive Plan for Management Employees (the “Existing Plans”).  The consolidation of the Existing Plans intothe Plan resulted in an aggregate reduction in the number of shares eligiblefor awards under the existing plans.

 

In connection with certain of the Company’s acquisitions, outstandingstock options held by employees of acquired companies became exercisable forAvaya’s common stock, according to their terms, effective at the acquisitiondate. The fair value of these options was included as part of the purchaseprice.

 

The following table summarizes information concerning optionsoutstanding including the related transactions for fiscal 2005, 2004 and 2003: 

 

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| ** **                                         | ** ** | **Shares**          | ** ** | **Weighted Average** | ** ** |
|----------------------------------------------------|------------|---------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **(000’s)(1)** | ** ** | **Exercise Price**   | ** ** |
| OPTIONS OUTSTANDING AS OF SEPTEMBER 30,  2002 |       | 44,828              |       | $                    | 15.46      |   |
| Granted                                            |       | 14,076              |       | 3.26                 |       |
| Exercised                                          |       | (1,087              | )          | 5.24                 |       |
| Forfeited  and Expired (2)                         |       | (6,115              | )          | 14.67                |       |
| OPTIONS OUTSTANDING AS OF SEPTEMBER 30,  2003 |       | 51,702              |       | 12.44                |       |
| Granted                                            |       | 10,230              |       | 13.72                |       |
| Exercised                                          |       | (9,206              | )          | 8.43                 |       |
| Forfeited  and Expired (2)                         |       | (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)                         |       | (2,783              | )          | 15.72                |       |
| OPTIONS OUTSTANDING AS OF SEPTEMBER 30,  2005 |       | 48,525              |       | $                    | 13.95      |   |

 

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(1)                                  Amountsinclude 2 million stock options outstanding related to Connectivity Solutionsemployees as of September 30, 2003 and 2002.

(2)                                  Primarilyrepresents normal option expiration and forfeitures attributed to employeeterminations resulting from the Company’s restructuring programs.

 

The weighted average fair value of the Company’s stockoptions granted during fiscal 2005, 2004 and 2003, calculated using the Black-Scholesoption-pricing model, was $6.72, $6.80 and $1.80 per share, respectively.

 

The following table summarizes the status of the Company’s stockoptions as of September 30, 2005:

 
| ** **                   | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | ** **                    | ** ** | **Average**                   | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                   | ** ** | ** **                    | ** ** | **Remaining**                 | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                   | ** ** | **Shares**                    | ** ** | **Contractual**               | ** ** | **Exercise** | ** ** | **Shares** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | **(000’s)**              | ** ** | **Life (Years)**              | ** ** | **Price** | ** ** | **(000’s)** | ** ** | **Price** | ** ** |
| $0.01 to $9.70               |       | 11,112                        |       | 4.03                          |       | $ | 4.42 |   | 8,712 |   | $ | 4.58 |   |
| $9.71 to $14.79              |       | 11,041                        |       | 5.11                          |       | 12.94 |   | 10,064 |   | 13.17 |   |
| $14.80 to $15.19             |       | 12,360                        |       | 5.01                          |       | 14.84 |   | 12,360 |   | 14.84 |   |
| $15.20 to $19.36             |       | 7,043                         |       | 5.81                          |       | 16.17 |   | 7,005 |   | 16.17 |   |
| $19.36 to $51.21             |       | 6,969                         |       | 3.42                          |       | 26.88 |   | 6,969 |   | 26.88 |   |
| Total                        |       | 48,525                        |       |                          |       | $ | 13.95 |   | 45,110 |   | $ | 14.55 |   |

 

As of September 30, 2004, there were 31.3 million exercisableoutstanding stock options with a weighted average exercise price of $15.37.

 

The Company also has awarded stock optiongrants to non-employee Directors. Stock options were granted to non-employeeDirectors in order to attract and retain qualified individuals to serve asmembers of the Board of Directors. The options granted were priced at the fairmarket value on the date of grant. These options generally became exercisablesix months from the date of grant and expire after ten years. No options havebeen granted to non-employee Directors since December 2002.  As of September 30, 2005, there were774,000 stock options outstanding, with a weighted average exercise price of$10.48, issued to non-employee Directors.

 

***RestrictedStock Units***

*** ***

The Company’s stock compensation plan permits the grantingof restricted stock units to eligible employees and non-employee Directors atfair market value at the date of grant and typically become fully vested over afour-year period. Restricted stock units are payable in shares of the Company’scommon stock upon vesting. The Company records compensation expense for theamortization of restricted stock units issued to employees, utilizing theintrinsic-value method, which would result in the same amount of compensationexpense that would be recognized as if the Company had applied the fair valuerecognition provisions of SFAS 123. Compensation expense recorded underAPB 25 related to restricted stock units was $10 million, $15 million and$31 million for fiscal 2005, 2004 and 2003, respectively.

 

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The following table presents the total number of shares ofcommon stock represented by restricted stock units granted to Companyemployees:

 
| ** **                                                         | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                         | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Restricted stock units granted (in thousands)                      |       | 2,422                             |       | 582 |   | 6,247 |   |
| Weighted average market value of shares  granted during the period |       | $                                 | 14.82      |   | $ | 13.91 |   | $ | 3.29 |   |
|                                                                    |            |                                   |            |  |  |  |  |  |  |  |

 

As of September 30, 2005, there were approximately4.9 million restricted stock units outstanding. This included 3.7 millionthat have not vested.

 

On December 16, 2004, the Compensation Committee of the Board ofDirectors approved awards of 0.4 million performance vesting restricted stockunits to executive officers of the Company pursuant to the terms of the AvayaInc. 2004 Long Term Incentive Plan.  Theperformance vesting restricted stock units vest upon the achievement of certaintargets.

 

***Employee Stock Purchase Plan***

 

Under the terms of the Company’s employee stock purchase plan, eligibleemployees may have up to 10% of eligible compensation deducted from their payto purchase Avaya common stock. The Avaya Inc. Employee Stock PurchasePlan (“2000 ESPP”) was terminated on March 1, 2003 and replaced with theAvaya Inc. 2003 Employee Stock Purchase Plan (“2003 ESPP”) which has termsvirtually identical to the 2000 ESPP. The 2003 ESPP was approved by the Company’sstockholders in February 2003, became effective January 1, 2003, andexpires on March 1, 2006, subject to extension by the Company’s Board ofDirectors if all of the shares reserved under the ESPP have not been issued.All purchases of the Company’s common stock made after December 31, 2002were made under the 2003 ESPP.

 

Under the 2003 and 2000 ESPPs, the per share purchase price is 85% ofthe average high and low per share trading price of Avaya’s common stock on theNew York Stock Exchange on the last trading day of each month. During fiscal2005, 2004 and 2003, 1.4 million, 1.1 million and 3.9 million shares werepurchased under the 2003 and 2000 ESPPs at weighted average prices of $10.11,$12.03 and $2.48, respectively.

 

**15. Operating Segments**

 

TheCompany reports its operations in two segments—Global Communications Solutions (“GCS”)and Avaya Global Services (“AGS”). This structure represents a change from theCompany’s three-segment structure utilized in fiscal 2004, and reflects how thebusinesses are being managed consistent with the Company’s operating structureand go-to-market strategies. Accordingly, prior period amounts have beenrestated to reflect this change. The GCS segment, which includes our priorreportable segments of Enterprise Communications Group (“ECG”) and Small andMedium Business Solutions (“SMBS”), develops, markets and sells communicationssystems including IP telephony solutions, multi-media contact centerinfrastructure and converged applications in support of customer relationshipmanagement, unified communications applications, appliances such as IPtelephone sets, and traditional voice communications systems. The AGS segmentdevelops, markets and sells comprehensive end-to-end global service offeringsthat enable customers to plan, design, implement, monitor and manage theirconverged communications networks worldwide.

 

TheGCS segment includes the portion of the Tenovis rental services revenue attributableto the equipment used in connection with the customer contracts. The portion ofthe customer contracts attributable to maintenance and other services isincluded in the AGS segment.

 

Thesegments are managed as two individual businesses and, as a result, includecertain allocated costs and expenses of shared services, such as informationtechnology, human resources, legal and finance (collectively, “corporateoverhead expenses”). At the beginningof each fiscal year, the amount of certain corporate overhead expenses,including targeted annual incentive awards, to be charged to operating segmentsis determined and fixed for the entire year in the annual plan. The annualincentive award accrual is adjusted quarterly based on actual year to date resultsand those estimated for the remainder of the year. This adjustment of theannual incentive award accrual, as well as any other over/under absorption ofcorporate overhead expenses against plan is recorded and reported within theCorporate/Other Unallocated Amounts caption. Restructuring charges are alsorecorded and reported within the Corporate/Other Unallocated Amounts caption.

 

***Reportable Segments***

 

Summarized financial information relating to the Company’s reportablesegments is shown in the following table:

 

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| ** **                        | ** ** | **Reportable Segments** | ** ** | ** **   | ** ** | ** **          | ** ** |
|-----------------------------------|------------|-------------------------|------------|--------------|------------|---------------------|------------|
| ** **                        | ** ** | **Global**              | ** ** | **Avaya**    | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Communications**      | ** ** | **Global**   | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| **Dollars in millions**           | ** ** | **Solutions**           | ** ** | **Services** | ** ** | **Amounts**         | ** ** | **Total** | ** ** |
|                              |       |                    |       |         |       |                |       |   |   |
| **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 |   |
|                              |       |                    |       |         |       |                |       |   |   |
| **2003**                          |       |                    |       |         |       |                |       |   |   |
| Revenue                           |       | $                       | 1,880      |         | $          | 1,916               |       | $ | — |   | $ | 3,796 |   |
| Operating income (loss)           |       | (120                    | )          | 163          |       | 20                  |       | 63 |   |
| Capital expenditures (1)          |       | 5                       |       | 4            |       | 48                  |       | 57 |   |
| Depreciation and amortization (1) |       | 102                     |       | 64           |       | 5                   |       | 171 |   |
| Interest expense (2)              |       | —                  |       | —       |       | 78                  |       | 78 |   |
| Provision for income taxes (2)    |       | —                  |       | —       |       | 84                  |       | 84 |   |
| Assets:                           |       |                    |       |         |       |                |       |   |   |
| Inventory                         |       | 146                     |       | 118          |       | —              |       | 264 |   |
| Goodwill                          |       | 146                     |       | —       |       | —              |       | 146 |   |
| Corporate  assets (2)             |       | —                  |       | —       |       | 3,245               |       | 3,245 |   |
| Total assets (3)                  |       | $                       | 292        |         | $          | 118                 |       | $ | 3,245 |   | $ | 3,655 |   |

 

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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 the other unallocated category. However, theassociated depreciation and amortization expense has been allocated to eachsegment since these amounts are included in each segment’s results for purposesof evaluating performance. The increase in unallocated capital expendituresrelates primarily to acquisitions.

 

(2)                                  Interestexpense, Provision for (Benefit from) income taxes and Restructuring chargesare managed at a corporate level by senior management of the company and not ata segment level. These are therefore disclosed in the Corporate / OtherUnallocated Amounts column. Corporate assets consist primarily of cash and cashequivalents, deferred income taxes, and property, plant and equipment.Corporate assets are included in the Corporate / Other Unallocated Amountscategory since they are managed at a corporate level and are not identifiedwith the segments.

 

(3)                                  Totalassets exclude $402 million as of fiscal 2003 for other current assets ofdiscontinued operations and other assets of discontinued operations.

 

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***GeographicInformation***

 

Financial information relating to the Company’s revenue by geographicarea is as follows:

 
| ** **                                                 | ** ** | **External Revenue (1)**          | ** ** | **Long-Lived Assets (2)** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Year ended September 30,** | ** ** | **September 30,**    | ** ** |
| **Dollars in millions**                                    | ** ** | **2005**                          | ** ** | **2004**                  | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| U.S.                                                       |       | $                                 | 2,908      |                      | $          | 3,089 |   | $ | 2,905 |   | $ | 453 |   | $ | 460 |   |
| Outside the U.S.:                                          |       |                              |       |                      |       |   |   |   |   |   |   |
| Germany                                                    |       | 724                               |       | 45                        |       | 41 |   | 214 |   | 1 |   |
| EMEA  (excluding Germany) - Europe /  Middle East / Africa |       | 696                               |       | 493                       |       | 447 |   | 52 |   | 30 |   |
| APAC - Asia  Pacific                                       |       | 336                               |       | 226                       |       | 195 |   | 14 |   | 13 |   |
| Americas,  non-US                                          |       | 238                               |       | 216                       |       | 208 |   | 5 |   | 5 |   |
| Total outside  the U.S.                                    |       | 1,994                             |       | 980                       |       | 891 |   | 285 |   | 49 |   |
| **Total**                                                  | ** ** | **$**                             | **4,902**  | ** **                | **$**      | **4,069** | ** ** | **$** | **3,796** | ** ** | **$** | **738** | ** ** | **$** | **509** | ** ** |

 

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(1)                                  Revenueis attributed to geographic areas based on the location of customers.

(2)                                  Representsproperty, plant and equipment, net.

 

**16. Related Party Transactions**

 

In August and September 2005, the Warburg Entitiesdistributed to their partners an aggregate of 24,999,988 shares of the Company’scommon stock, according to Schedules 13D/A filed with the SEC on August 4,2005 and September 2, 2005, respectively (see Note 10 “ConvertibleParticipating Preferred Stock and Other Equity Transactions” ).

 

In October 2005, the Warburg Entities (i) exercised the7,355,824 Series C Warrants held by them, resulting in their acquisitionof an aggregate of 5,236,861 shares of our common stock and (ii) advisedthe Company that they had distributed to their partners an aggregate of15,299,993 shares of our common stock. As a result of the foregoing, as of November 1, 2005, the totalnumber of shares of our common stock beneficially owned by the Warburg Entitieswas 156,529 shares, which represented approximately 0.056% of our common stockoutstanding on that date.

 

As previously reported, in 2004, Gyro Graphic Communications, Inc. (“Gyro”)was selected to provide certain services regarding marketing events and demandgeneration activities related to the launch of various Avaya products. GarryMcGuire, Jr., the President of Gyro USA, a division of Gyro, is the son ofGarry K. McGuire, Avaya’s Chief Financial Officer. The Company continued toobtain services from Gyro for similar events and activities during 2005. InJune 2005, Daniel Peterson, the son of Avaya’s Chairman and Chief ExecutiveOfficer, Donald K. Peterson, became employed by Gyro. During fiscal 2005 andfiscal 2004, the Company paid Gyro $4.6 million and $1.3 million, respectively,for its services. The terms, including pricing, on which the Company didbusiness with Gyro during fiscal years 2004 and 2005 were comparable overallwith those on which the Company obtained similar services from other vendors.

 

During a portion of fiscal 2005, Mr. Peterson served on the boardof directors of Reynolds and Reynolds. During fiscal 2005, Reynolds and Reynolds paid approximately $0.5million to the Company for maintenance on certain equipment and software underservice agreements and for the continuation of other communications-relatedservices for that company’s facilities.  Mr. Odeen,who is Chairman of Avaya’s Compensation Committee and Chairman of Reynolds andReynolds, also served as the Interim Chief Executive Officer of Reynolds andReynolds from July 2004 through January 2005.  Mr. Odeen no longer holds that interimposition, and Mr. Peterson no longer serves as a director of Reynolds andReynolds.

 

**17. Commitments and Contingencies**

 

**LegalProceedings**

** **

Inthe ordinary course of business the Company is involved in lawsuits, claims,government inquiries, investigations, charges and proceedings, including, butnot limited to, those identified below, relating to intellectual property,commercial, securities, employment, employee benefits, environmental andregulatory matters. Often these issues are subject to substantial uncertaintiesand, therefore, the probability of loss and an estimation of damages aredifficult to ascertain. Consequently, it is difficult to reasonably estimatethe maximum potential exposure or the range of possible loss. These assessmentscan involve a series of complex judgments about future events and can relyheavily on estimates and assumptions. Our assessments are based on estimatesand assumptions that have been deemed reasonable by management. In accordancewith SFAS No. 5, “Accounting for Contingencies,” theCompany makes a provision 

 

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fora liability when it is both probable that a liability has been incurred and theamount of the loss can be reasonably estimated. Other than as described below,the Company believes there is no litigation pending against the Company thatcould have, individually or in the aggregate, a material adverse effect on theCompany’s financial position, results of operations or cash flows.

 

***Year2000 Actions***

*** ***

On September 30,2000, Lucent contributed its enterprise networking business to us anddistributed all of the outstanding shares of our capital stock to itsshareowners. We refer to these transactions in this Quarterly Report on Form 10-Qas the “distribution.” Three purported class actions were pending against Lucent at the time ofthe spin-off of the Company from Lucent. Two were filed in federal courts in California and New York,respectively, in 1999, and one was filed in state court in West Virginia, alsoin 1999.  All three matters allegedsubstantially similar allegations that Lucent and its predecessor, AT&TCorp., sold equipment that was not Year 2000 or “Y2K” compliant, meaning thatthe products were designed and developed without considering the possibleimpact of the change in the calendar from December 31, 1999 to January 1,2000. The complaints allege that the sale of these products violated statutoryconsumer protection laws and constituted breaches of implied warranties.

 

Thefederal court in California and the state court in Virginia certified classesessentially consisting of those entities who purchased the products identifiedin the suits between January 1, 1990 and December 31, 1999, with theWest Virginia state court also certifying a sub-class of those who hadmaintenance and/or extended warranty agreements in effect as of April 1,1998.  The federal court in New Yorkdenied class certification to plaintiffs in New York matter and remanded thecase to state court.

 

InMay 2004, after extensive litigation and negotiations, the Company andplaintiffs in all three actions entered into a settlement agreement to resolveof the above-described actions. Under the general terms of the agreement,eligible class members who acquired certain products between 1990 and 1999 mayreceive credits up to $110 million or a cash alternative. The credits are validfor a three-year period and can be applied toward a 45 percent discount onpurchases of new Avaya products and/or a 30 percent discount on Avayamaintenance services. Alternatively, eligible class members may receive aone-time cash payment equal to 25 percent of the credits to which they may beentitled. The state court in West Virginia approved the settlement in July 2004and issued an order of final approval of the settlement. The period of time foreligible customers to file claims has concluded, and Avaya has begun todistribute payments to class members who elected to receive cashdistributions.  Those eligible customerswho have elected to apply credits to applicable accounts may do so for a threeyear period, concluding in August 2008.

 

Pursuantto the terms of the Contribution and Distribution Agreement, Lucent isresponsible for 50% of the costs related to these matters in excess of $50million, including attorneys’ fees. The Company has notified Lucent that costsincurred in these matters, including costs expended since these matterscommenced in 1999, have exceeded the $50 million threshold. Accordingly, Lucentwill be responsible for a portion of the cost of the settlement. Based on existingreserves for these matters, the Company does not believe the settlement willhave a material adverse effect on its financial position, results of operationsor cash flows.

 

***CommissionsArbitration Demand***

*** ***

InJuly 2002, Communications Development Corporation (“CDC”), a BritishVirgin Islands corporation, made formal demand for arbitration for allegedunpaid commissions in an amount in excess of $10 million, stemming fromthe sale of products from Avaya’s businesses that were formerly owned by Lucentinvolving the Ministry of Russian Railways. In April 2003, CDC initiatedthe arbitration before the American Arbitration Association. The plaintiffalleges that as a result of agreements entered into between the plaintiff andthe Company, it is owed commissions on sales by the Company to the Ministry ofRussian 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 is scheduled to begin inDecember 2005.  As the hearing inthe matter is commencing in mid December 2005, an outcome cannot bepredicted and, as a result, we cannot be assured that these cases will not havea material adverse effect on our financial position, results of operations orcash flows.

 

***SecuritiesLitigation***

*** ***

InApril and May of 2005, purported class action lawsuits were filed inthe Federal District Court for the District of New Jersey against us andcertain of our officers, alleging violations of the federal securities laws.The actions purport to be filed on behalf of purchasers of our common stockduring the period from October 5, 2004 (the date of our signing of theagreement to acquire Tenovis) through April 19, 2005.

 

Thecomplaints, which are substantially similar to one another, allege, among otherthings, that the plaintiffs were injured by reason of certain allegedly falseand misleading statements made by us relating to the cost of the Tenovisintegration, the disruption caused by 

 

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changesin the delivery of our products to the market and reductions in the demand forour products in the U.S., and that based on the foregoing we had no basis toproject our stated revenue goals for fiscal 2005. The Company has been servedwith a number of these complaints. No class has been certified in the actions.The complaints seek compensatory damages plus interest and attorneys’fees.  In August 2005, the courtentered an order identifying a lead plaintiff and lead plaintiffs’ counsel. Aconsolidated amended complaint was filed in October 2005.  Pursuant to a scheduling order issue by theDistrict Court, defendants will file a motion to dismiss this complaint nolater than December 16, 2005.

 

Thisconsolidated matter is still in the early stages of litigation and an outcomecannot be predicted and, as a result, we cannot be assured that these caseswill not have a material adverse effect on our financial position, results ofoperations or cash flows.

 

***DerivativeLitigation***

*** ***

InMay and July of 2005,  threederivative complaints were filed against certain officers and the Board ofDirectors (“Board”) of the Company. Two complaints were filed in the UnitedStates District Court, District of New Jersey, and one was filed in theSuperior Court of New Jersey, Somerset County. The allegations in each of thecomplaints are substantially similar and include the Company as a nominaldefendant. The complaints allege, among other things, that defendants violatedtheir fiduciary duties by failing to disclose material information and/or bymisleading the investing public about the Company’s business, asserting claimssubstantially similar to those asserted in the actions described above under “SecuritiesLitigation.”  The complaints seekcontribution from the defendants to the Company for alleged violations of thesecurities laws, restitution to the Company and disgorgement of profits earnedby defendants, and fees and costs.  These actions are in the early stages oflitigation and an outcome cannot be predicted and, as a result, we cannotdetermine if they will have an effect on our business or operations or, if theydo, whether their outcomes will have a material adverse effect on our businessor operations.

 

***ERISAClass Action***

*** ***

InJuly 2005, a purported class action lawsuit was filed in the United StatesDistrict Court for the District of New Jersey against us and certain of ourofficers, employees and members of the Board of Directors (the “Board”) of theCompany, alleging violations of certain laws under the Employee RetirementIncome Security Act of 1974 (“ERISA”). On October 17, 2005, an amendedpurported class action was filed against us and certain of our officers,employees and members of the Board.  Likethe initial complaint, the amended complain purports to be filed on behalf ofall participants and beneficiaries of the Avaya Inc. Savings Plan, the AvayaInc. Savings Plan for Salaried Employees and the Avaya Inc. Savings Plan forthe Variable Workforce (collectively, the “Plans”), during the period from October 5,2004 through July 20, 2005. It contains factual allegations substantiallysimilar to those asserted in the matters under the heading of “SecuritiesLitigation.”

 

Thecomplaint alleges, among other things, that the named defendants breached theirfiduciary duties owed to participants and beneficiaries of the Plans and failedto act in the interests of the Plans’ participants and beneficiaries inoffering Avaya common stock as an investment option, purchasing Avaya commonstock for the Plans and communicating information to the Plans’ participantsand beneficiaries.  No class has beencertified in the action. The complaint seeks a monetary payment to the plans tomake them whole for the alleged breaches, costs and attorneys’ fees. Pursuantto a scheduling order entered by the District Court, defendants will file amotion to dismiss the amended complaint no later than December 16, 2005.

 

Thismatter is still in the early stages of litigation and an outcome cannot bepredicted and, as a result, we cannot be assured that this case will not have amaterial adverse effect on our financial position, results of operations orcash flows.

 

***GovernmentSubpoenas***

*** ***

OnApril 29, 2005, the Company received a subpoena to produce documentsbefore a grand jury of the United States District Court, District of SouthCarolina, relating to the United States’ investigation of potential antitrustand other violations in connection with the federal E-Rate Program. Thesubpoena requests records from the period January 1, 1997 to the present.At this time, we cannot determine if this matter will have an effect on ourbusiness or, if it does, whether its outcome will have a material adverseeffect on our financial position, results of operations or cash flows.

 

OnMay 3, 2005, the Company received a subpoena from the Office of InspectorGeneral, U.S. General Services Administration, relating to a federalinvestigation of billing by the Company for telecommunications equipment andmaintenance services. The subpoena requests records from the period January 1,1990 to the present. At this time, we cannot determine if this matter will havean effect on our business or, if it does, whether its outcome will have amaterial adverse effect on our financial position, results of operations orcash flows.

 

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TheCompany is cooperating with the relevant government entities with respect to thesesubpoenas.

 

***AntitrustLawsuit***

*** ***

In August 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 complaintsought a temporary restraining order against the Company to enjoin immediatelyits practice of limiting the use of its proprietary information in a mannerwhich the Company believes is in violation of its contracts and licensingagreements.  The court denied UAC’smotion for temporary restraints.  Apreliminary injunction hearing began on October 25, 2005, and afterseveral adjournments of the hearing based on the District Court’s schedule,concluded on November 22, 2005.  Theparties are scheduled to submit post-hearing briefs in support of theirrespective positions in mid December 2005, and a decision is expected sometime thereafter. As the District Court has not issued its decision on plaintiff’smotion for a preliminary injunction, and because even if Avaya prevails on thatmotion an outcome cannot be predicted, we cannot be assured that this case willnot have a material adverse effect on our financial position, results ofoperations or cash flows.

 

#### **Environmental, Health and Safety Matters**

#### ** **

The Company is subject to a wide range of governmental requirementsrelating to employee safety and health and to the handling and emission intothe environment of various substances used in its operations.  The Company is subject to certain provisionsof environmental laws, particularly in the United States, governing the cleanupof soil and groundwater contamination. Such provisions impose liability for the costs of investigating andremediating releases of hazardous materials at currently or formerly owned oroperated sites.  In certaincircumstances, this liability may also include the cost of cleaning uphistorical contamination, whether or not caused by the Company.  The Company is currently conductinginvestigation and/or cleanup of known contamination at ten of its current orformer facilities either voluntarily or pursuant to government directives.  Based on currently available information,none of the sites is reasonably likely to generate environmental costs thatwill be individually material nor will environmental costs for all sites in theaggregate be material.  There are noknown third parties who may be responsible for investigation and/or cleanup atthese sites and therefore, for purposes of assessing the adequacy of accrualsfor these liabilities, the Company has not assumed that it will recover amountsfrom any third party, including under any insurance coverage or indemnificationarrangement.  Although the Company doesnot separately track recurring costs of managing hazardous substances andpollutants in ongoing operations, it does not believe them to be material.

 

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

 

The reliability and precision of estimates of the Company’senvironmental costs may be affected by a variety of factors, including whetherthe remediation treatment will be effective, contamination sources have beenaccurately identified and assumptions regarding the movement of contaminantsare accurate.  In addition, estimates 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 the adequacy of environmental reserves on aquarterly basis.  The Company does notexpect the outcome of these matters to have a material impact on its financialposition.  Expenditures for environmentalmatters for each of fiscal 2005 and 2004 were not material to the Company’sfinancial position, results of operations or cash flows.  Payment for the environmental costs coveredby the reserves may be made over a 30-year period.

 

**Product Warranties**

 

The Company recognizes a liability for the estimated coststhat may be incurred to remedy certain deficiencies of quality or performanceof the Company’s products.  These productwarranties extend over a specified period of time generally ranging up to oneyear from the date of sale depending upon the product subject to the warranty.Products sales from Tenovis have a two year warranty from date of sales.  Included in the purchase price allocation ofTenovis was an assumed liability of approximately $8 million related to productwarranty costs.  The Company accrues aprovision for estimated future warranty costs based upon the historicalrelationship of warranty claims to sales. The Company periodically reviews the adequacy of its product warrantiesand adjusts, if necessary, the warranty percentage and accrued warrantyreserve, which is included in other current liabilities in the ConsolidatedBalance Sheets, for actual experience.

 

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| **Dollars in millions**                                       | ** ** | ** ** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|
| Balance as of September 30, 2004                         |       | $          | 23         |   |
| Warranty liabilities assumed in connection  with acquisitions |       | 8          |       |
| Reductions for payments and costs to  satisfy claims          |       | (43        | )          |
| Accruals for warranties issued during the  period             |       | 42         |       |
| Balance as of September 30, 2005                         |       | $          | 30         |   |

 

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

 

***Letters of Credit***

 

The Company has entered into uncommitted credit facilities thatvary in term totaling $157 million as of September 30, 2005, for thepurpose of securing third party financial guarantees such as letters of creditwhich ensure the Company’s performance or payment to third parties.  Additionally, the Company has $400 million ofcommitted credit facilities, which is discussed in Note 8 “Long-Term Debt.”  As of September 30, 2005, the Companyhad outstanding an aggregate of $139 million in irrevocable letters of creditunder the committed and uncommitted credit facilities (including $55 millionunder its $400 million committed credit facility) and $1 million of restrictedcash.

 

***Surety Bonds***

 

The Company arranges for the issuance of various types of surety bonds,such as license, permit, bid and performance bonds, which are agreements underwhich the surety company guarantees that the Company will perform in accordancewith contractual or legal obligations. These bonds vary in duration although most are issued and outstandingfrom six months to three years.  If theCompany fails to perform under its obligations, the maximum potential paymentunder these surety bonds is $34 million as of September 30,2005.  Historically, no surety bonds havebeen drawn upon and there is no expectation to do so in the future.

 

***Purchase Commitments and Termination Fees***

 

The Company purchases components from a variety of suppliers and usesseveral contract manufacturers to provide manufacturing services for itsproducts. During the normal course of business, in order to managemanufacturing lead times and to help assure adequate component supply, theCompany enters into agreements with contract manufacturers and suppliers thatallows them to produce and procure inventory based upon forecasted requirementsprovided by the Company.  If the Companydoes not meet these specified purchase commitments, it could be required topurchase the inventory, or in the case of certain agreements, pay an earlytermination fee.  As of September 30,2005, the maximum potential payment under these commitments was approximately$210 million.  Historically, the Companyhas not been required to pay a charge for not meeting its designated purchasecommitments with these suppliers.

 

Ouroutsourcing agreement with our most significant contract manufacturer, expiresin May 2006. The agreement will automatically renew for successive one-yearterms unless either party elects to terminate the agreement by giving notice tothe other party six months prior to the expiration of the renewal term.Pursuant to the requirements of the agreement, the Company gave notice in November 2005of our intention not to renew our outsourcing agreement.  The Company is in discussions to negotiate anew outsourcing agreement. However, there can be no assurance that we will beable to negotiate an a new agreement with this contract manufacturer or,alternatively, negotiate a replacement agreement with a new contractmanufacturer on favorable terms.  TheCompany relies on outside sources for the supply of the components of ourproducts and for the finished products delays or shortages associated withthese components as well as a change in contract manufacturer could adversely affectour operating results.

 

***Product Financing Arrangements***

 

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

 

The Company had a product financing arrangement with one U.S. resellerwhich expired in fiscal 2005. Accordingly, Avaya is no longer obligated to repurchase inventorypreviously sold to this reseller in the event the lending institution, whichfinanced the transaction, repossesses the reseller’s inventory of the Company’sproducts.

 

For the Company’s product financing arrangement with resellers outsidethe U.S., in the event participating resellers default on their paymentobligations to the lending institution, the Company is obligated under certaincircumstances to guarantee repayment to the lending institution. The repaymentamount fluctuates with the level of product financing activity. The guaranteerepayment amount reported to the Company from the lending institution wasapproximately $6 million as of September 30, 2005. The Companyreviews and sets the 

 

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maximum credit limit for each reseller participating in this financingarrangement. There have not been any guarantee repayments by Avaya since theCompany entered in this arrangement in October 2000.  The Company has estimated the fair value ofthis guarantee as of September 30, 2005, and has determined that it is notsignificant.  There can be no assurancethat the Company will not be obligated to repurchase inventory under thisarrangement in the future.

 

***Performance Guarantee***

 

In connection with the sale ofConnectivity Solutions and the sale of a portion of the Expanets business, theCompany has assigned its rights and obligations under several real estateleases to the acquiring companies (the “assignees”).  The remaining terms of these leases vary fromone year to eight years.  While theCompany is no longer the primary obligor under these leases, the lessor has notcompletely released the Company from its obligation, and holds it secondarilyliable in the event that the assignees default on these leases.  The maximum potential future payments theCompany could be required to make, if all of the assignees were to default asof September 30, 2005, would be approximately $20 million.  The Company has assessed the probability ofdefault by the assignees and has determined it to be remote.

 

***Credit Facility Indemnification***

 

In connection with its obligations under the amended Credit Facilitydescribed in Note 8 “Long-Term Debt,” the Company has agreed to indemnifythe third party lending institutions for costs incurred by the institutionsrelated to changes in tax law or other legal requirements. While there havebeen no amounts paid to the lenders pursuant to this indemnity in the past,there can be no assurance that the Company will not be obligated to indemnifythe lenders under this arrangement in the future.

 

***Transactions with Lucent***

 

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

 

Pursuant to the Contribution and Distribution Agreement,Lucent contributed to the Company substantially all of the assets, liabilitiesand operations associated with its enterprise networking businesses (“Company’sBusinesses”).  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.  Inaddition, the Contribution and Distribution Agreement provides that certaincontingent liabilities not allocated to one of the parties will be shared byLucent and the Company in prescribed percentages.  The Contribution and Distribution Agreementalso provides that each party will share specified portions of contingentliabilities based upon agreed percentages related to the business of the otherparty that exceed $50 million.  See “LegalProceedings” above for a discussion of the Company’s obligations under thesettlement of certain litigation constituting shared contingent liabilitiesunder the Contribution and Distribution Agreement.  The Company is unable to determine themaximum potential amount of other future payments, if any, that it could berequired to make under this agreement.

 

In addition, if the separation from Lucent fails to qualify as atax-free distribution under Section 355 of the Internal Revenue Codebecause of an acquisition of the Company’s stock or assets, or some otheractions of the Company, then the Company will be solely liable for anyresulting corporate taxes.

 

During fiscal 2005, the Company recognized a $124 million tax benefitcomprised of a $109 million tax benefit resulting from the resolution of U.S.federal income tax audit matters for the years 1999 and 2000 and a $15 millionbenefit due to certain state matters that arose prior to the Company’sseparation from Lucent.  The $124 millionbenefit consisted of:  $155 millionreversal of certain tax liabilities that were established at the time of thedistribution; $8 million tax refund due from Lucent offset by a $39 millionpayment due to Lucent.  The Company madea net payment of $31 million in accordance with the terms of a Tax SharingAgreement that the Company and Lucent entered into in connection with thedistribution.  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.  The Company may be subject to additionaltaxes or benefits pursuant to the Tax Sharing Agreement related to future settlementsof audits by state and local and foreign taxing authorities for the periodsprior to the Company’s separation from Lucent.

 

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***Leases***

 

The Company leases land, buildings and equipment under agreements thatexpire in various years through 2021. Rental expense under operating leases,excluding any lease termination costs incurred related to the Company’srestructuring programs, was $136 million, $130 million and $167 millionfor fiscal 2005, 2004 and 2003, respectively.

 

The table below sets forth future minimum lease payments, net ofsublease income, due under non-cancelable operating leases, of which $34million of such payments have been accrued for in accordance with generallyaccepted accounting principles pertaining to restructuring and exit activities.

 
| ** **                        | ** ** | **Future minimum** | ** ** |
|-----------------------------------|------------|--------------------|------------|
| **Dollars in millions**           | ** ** | **lease payments** | ** ** |
| 2006                              |       | $                  | 121        |   |
| 2007                              |       | 102                |       |
| 2008                              |       | 82                 |       |
| 2009                              |       | 66                 |       |
| 2010                              |       | 50                 |       |
| 2011 and  thereafter              |       | 218                |       |
| **Future minimum lease payments** | ** ** | **$**              | **639**    | ** ** |

 

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**18. Quarterly Information**

 
| ** **                                                        | ** ** | **Fiscal Year Quarters** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|------------|
| **Dollars in millions, except per share and stock price amounts** | ** ** | **First**                | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| **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                                               |       | $                        | 0.07       |   | $ | 0.08 |   | $ | 0.41 |   | $ | 1.39 |   | $ | 1.95 |   |
| Earnings per  share - Diluted:                                    |       |                     |       |   |   |   |   |   |   |   |   |
| Earnings per  share                                               |       | $                        | 0.07       |   | $ | 0.07 |   | $ | 0.40 |   | $ | 1.36 |   | $ | 1.89 |   |
| Stock price  (1):                                                 |       |                     |       |   |   |   |   |   |   |   |   |
| High                                                              |       | $                        | 17.76      |   | $ | 17.74 |   | $ | 12.15 |   | $ | 10.94 |   | $ | 17.76 |   |
| Low                                                               |       | $                        | 12.93      |   | $ | 11.25 |   | $ | 7.76 |   | $ | 7.85 |   | $ | 7.76 |   |
|                                                              |       |                     |       |   |   |   |   |   |   |   |   |
| **Year  Ended September 30, 2004**                           |       |                     |       |   |   |   |   |   |   |   |   |
| Revenue                                                           |       | $                        | 971        |   | $ | 1,006 |   | $ | 1,016 |   | $ | 1,076 |   | $ | 4,069 |   |
| Gross margin                                                      |       | 448                      |       | 471 |   | 488 |   | 538 |   | 1,945 |   |
| Operating  income                                                 |       | 52                       |       | 60 |   | 92 |   | 119 |   | 323 |   |
| Provision  for (benefit from) income taxes                        |       | 7                        |       | (81 | ) | 9 |   | 16 |   | (49 | ) |
| Income from  continuing operations                                |       | 30                       |       | 103 |   | 58 |   | 100 |   | 291 |   |
| (Loss)  income from discontinued operations                       |       | (20                      | )          | 22 |   | 3 |   | — |   | 5 |   |
| Net income                                                        |       | $                        | 10         |   | $ | 125 |   | $ | 61 |   | $ | 100 |   | $ | 296 |   |
| Earnings per  share - Basic:                                      |       |                     |       |   |   |   |   |   |   |   |   |
| Earnings per  share from continuing operations                    |       | $                        | 0.07       |   | $ | 0.24 |   | $ | 0.13 |   | $ | 0.22 |   | $ | 0.66 |   |
| (Loss)  earnings per share from discontinued operations           |       | (0.05                    | )          | 0.05 |   | 0.01 |   | — |   | 0.01 |   |
| Earnings per  share                                               |       | $                        | 0.02       |   | $ | 0.29 |   | $ | 0.14 |   | $ | 0.22 |   | $ | 0.67 |   |
| Earnings per  share - Diluted:                                    |       |                     |       |   |   |   |   |   |   |   |   |
| Earnings per  share from continuing operations                    |       | $                        | 0.07       |   | $ | 0.22 |   | $ | 0.12 |   | $ | 0.21 |   | $ | 0.63 |   |
| (Loss)  earnings per share from discontinued operations           |       | (0.05                    | )          | 0.05 |   | 0.01 |   | — |   | 0.01 |   |
| Earnings per  share                                               |       | $                        | 0.02       |   | $ | 0.27 |   | $ | 0.13 |   | $ | 0.21 |   | $ | 0.64 |   |
| Stock price  (1)                                                  |       |                     |       |   |   |   |   |   |   |   |   |
| High                                                              |       | $                        | 14.35      |   | $ | 19.00 |   | $ | 17.60 |   | $ | 15.67 |   | $ | 19.00 |   |
| Low                                                               |       | $                        | 10.52      |   | $ | 12.15 |   | $ | 13.40 |   | $ | 11.95 |   | $ | 10.52 |   |

 

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(1)                                  Showsthe intraday high and low sales price per share of the Company’s common stockas reported on the New York Stock Exchange for the periods indicated.

 

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