AGERE SYSTEMS INC - 10-Q Quarterly Report

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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 4, 2004

________________________________________________________________________________

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2003
OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 001-16397

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AGERE SYSTEMS INC.

A DELAWARE I.R.S. EMPLOYER
CORPORATION NO. 22-3746606

1110 AMERICAN PARKWAY NE, ALLENTOWN, PA 18109

Telephone: 610-712-1000

-------------------

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

At January 31, 2004, 801,285,831 shares of Class A common stock and
907,994,888 shares of Class B common stock were outstanding.

________________________________________________________________________________

AGERE SYSTEMS INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2003
TABLE OF CONTENTS

1

PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

2

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

3

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

4

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

1. BACKGROUND AND BASIS OF PRESENTATION

BACKGROUND

Agere Systems Inc. (the 'Company' or 'Agere') is a provider of advanced
integrated circuit solutions for applications such as high-density storage,
multi-service networking, wireless data and personal computer connectivity.
These solutions form the building blocks for a broad range of communications and
computing applications. Integrated circuits are made using semiconductor wafers
imprinted with a network of electronic components. They are designed to perform
various functions such as processing electronic signals, controlling electronic
system functions and processing and storing data. Business operations are
divided into two market-focused groups, Client Systems and Infrastructure
Systems.

On December 31, 2003, the Company acquired TeraBlaze, Inc., a developer of
Gigabit Ethernet switching solutions. See Note 5 'Acquisition of TeraBlaze,
Inc.' for more information.

In fiscal 2003, the Company exited its optoelectronic components business.
The condensed consolidated financial statements reflect this business as
discontinued operations. See Note 6 'Discontinued Operations.'

INTERIM FINANCIAL INFORMATION

These condensed financial statements have been prepared in accordance with
the rules of the Securities and Exchange Commission for interim financial
statements and do not include all annual disclosures required by accounting
principles generally accepted in the United States ('U.S.'). These financial
statements should be read in conjunction with the audited consolidated and
combined financial statements and notes thereto included in the Company's
Form 10-K for the fiscal year ended September 30, 2003. The condensed financial
information as of December 31, 2003 and for the three months ended December 31,
2003 and 2002 is unaudited, but includes all adjustments that management
considers necessary for a fair presentation of the Company's consolidated
results of operations, financial position and cash flows. Results for the three
months ended December 31, 2003 are not necessarily indicative of results to be
expected for the full fiscal year 2004 or any other future periods.

2. STOCK COMPENSATION PLANS

The Company applies Accounting Principles Board Opinion No. 25, 'Accounting
for Stock Issued to Employees' ('APB No. 25') and related interpretations in
accounting for its plans, as permitted under Statement of Financial Accounting
Standards ('SFAS') No. 123, 'Accounting for Stock-Based Compensation'
('SFAS 123'), as amended by SFAS No. 148 'Accounting for Stock-Based
Compensation -- Transition and Disclosure.' Compensation expense net of related
tax recorded under APB No. 25, which uses the intrinsic value method, was $0 and
$1 for the three months ended December 31, 2003 and 2002, respectively.

5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

The following table illustrates the effect on net loss and loss per share if
Agere had applied the fair value recognition provisions of SFAS 123 to its stock
option plans and employee stock purchase plan (the 'ESPP'):

As of December 31, 2003, 249,497,362 stock options were outstanding. The
Company granted 61,630,128 stock options from its stock option plans during the
first quarter of fiscal 2004, primarily related to broad based grants as part of
its annual grant program.

As of December 31, 2003, 72,776,565 shares remained available for purchase
under the ESPP. During the three months ended December 31, 2003, 3,364,278
shares were purchased under the ESPP.

3. RECENT PRONOUNCEMENTS

On December 8, 2003, President Bush signed into law the Medicare
Prescription Drug, Improvement and Modernization Act of 2003 (the 'Act'). The
Act expanded Medicare to include, for the first time, coverage of prescription
drugs. Agere sponsors retiree medical programs for certain of its locations and
this legislation may eventually reduce the Company's costs for some of these
programs. The Company is waiting for guidance from various governmental and
regulatory agencies concerning the requirements that must be met to obtain these
cost reductions as well as the manner in which such savings should be measured.

Because of various uncertainties related to this legislation, Agere has
elected to defer financial recognition of this legislation until the Financial
Accounting Standards Board ('FASB') issues final accounting guidance. When
issued, the final guidance could require the Company to change previously
reported information. The deferral election is permitted under FASB Staff
Position No. FAS 106-1, 'Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003.'

4. RESTRUCTURING AND OTHER CHARGES -- NET

For the three months ended December 31, 2003, restructuring and other
charges -- net was $47 and includes asset retirement obligation charges of $31
and restructuring and related expenses of $16. Restructuring and other
charges -- net was $25 for the three months ended December 31, 2002, comprised
entirely of restructuring and related expenses.

ASSET RETIREMENT OBLIGATION

In the first quarter of fiscal 2004, the Company recorded a $31 charge
within restructuring and other charges -- net for an asset retirement
obligation. This liability relates to the decommissioning of the Company's
Allentown and Reading, Pennsylvania former manufacturing facilities that is
expected to be substantially complete by the middle of fiscal 2005. The Company
made $5 of cash payments toward

6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

this obligation during the first quarter of fiscal 2004 and the remaining
balance of $26 as of December 31, 2003 is recorded in other current liabilities.
There was no asset retirement obligation expense associated with the Company's
restructuring activities for the three months ended December 31, 2002.

RESTRUCTURING AND RELATED EXPENSES

The Company has implemented restructuring and consolidation actions to
improve gross profit, reduce expenses and streamline operations. These actions
include workforce reductions, rationalization and consolidation of manufacturing
capacity, and the exit of the optoelectronic components business. Charges and
credits related to continuing operations are included in restructuring and other
charges -- net, while charges and credits related to discontinued operations are
included in income from discontinued operations (net of taxes). The
restructuring actions associated with discontinued operations remain an
obligation of the Company and are reflected in the restructuring reserve.

THREE MONTHS ENDED DECEMBER 31, 2003

The following table sets forth the Company's restructuring reserve as of
December 31, 2003 and the activity affecting the reserve for the three months
ended December 31, 2003:

Workforce Reductions

During the first quarter of fiscal 2004, the Company recorded restructuring
charges of $7 related to additional domestic and international workforce
reductions of approximately 35 employees and revisions of prior cost estimates.

Rationalization of Manufacturing Capacity and Other Charges

The Company recorded restructuring and related charges of $9 in the first
quarter of fiscal 2004 relating to the rationalization of under-utilized
manufacturing facilities and other restructuring related activities. These
charges consist of $4 for asset decommissioning costs and $5 for other related
costs.

Restructuring Reserve Balances as of December 31, 2003

The Company anticipates that the majority of the $8 restructuring reserve
relating to workforce reductions as of December 31, 2003 will be paid by the end
of fiscal 2004. The Company also anticipates that the restructuring reserve of
$35 relating to the rationalization of manufacturing capacity and other charges
as of December 31, 2003 will be paid as follows: contract terminations of $5
will be paid $1 per quarter through the second quarter of fiscal 2005; and
facility lease termination, facility restoration and

7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

other costs of $30 will be paid over the respective lease terms through 2010.
The Company expects to fund these cash payments with cash on hand.

THREE MONTHS ENDED DECEMBER 31, 2002

The following table sets forth the Company's restructuring reserve as of
December 31, 2002 and reflects the activity affecting the reserve for the three
months ended December 31, 2002:

Workforce Reductions

During the first quarter of fiscal 2003, the Company recorded restructuring
cash charges of $7 and credits of $12 related to workforce reductions. The
credits are principally due to the reversal of severance and benefit costs
associated with approximately 340 employees who joined TriQuint Semiconductor,
Inc. ('TriQuint'). Of this credit, $7 is a non-cash credit primarily due to the
decrease in severance and benefits to be paid from the Company's pension assets.

Rationalization of Manufacturing Capacity and Other Charges

The Company recorded restructuring and related charges of $57 in the first
quarter of fiscal 2003 relating to the rationalization of under-utilized
manufacturing facilities, the exit of the optoelectronic components business and
other restructuring related activities. Of the charges recorded for the first
quarter of fiscal 2003, $23 was for asset impairments, $8 for facility closings,
$5 for contract terminations, $9 for additional depreciation and $12 for other
related costs. The asset impairment charges of $23, include $11 related to the
resizing of Orlando's research and development and manufacturing operations and
$12 for all other impairments related to the rationalization of under-utilized
manufacturing facilities. The facility closing charges of $8 are due to facility
lease terminations, including non-cancelable leases, and facility restoration
costs associated with exiting the portion of the optoelectronic components
business located in Irwindale, California. The additional depreciation charges
of $9 were recognized due to shortening the estimated useful lives of certain
assets in connection with the planned closing of certain administrative
facilities. The $12 of other related costs was incurred to implement the
restructuring initiatives and includes costs for the relocation and training of
employees and for the relocation of equipment.

The Company recorded restructuring credits of $27 in the first quarter of
fiscal 2003. These credits consisted of $10 for asset impairment adjustments due
to realizing more proceeds than expected from asset dispositions and $17 for a
reversal of reserves associated with the resizing of the research and
development and manufacturing operations in Orlando, including $13 for operating
lease terminations and $4 for related asset decommissioning costs.

8

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

5. ACQUISITION OF TERABLAZE, INC.

On December 31, 2003, the Company acquired TeraBlaze, Inc. ('TeraBlaze'), a
developer of Gigabit Ethernet switching solutions, for approximately $21. The
Company issued 6,921,188 shares of Class A common stock in exchange for all the
outstanding shares of TeraBlaze, of which 692,119 shares are being held in
escrow to satisfy potential liabilities, if any, resulting from claims for
breaches of representations and warranties under the merger agreement. If such
shares are not needed to satisfy any claims made, a portion of these shares will
be released on each of the first and second anniversary of the acquisition date.

The acquisition of TeraBlaze was accounted for under the purchase method of
accounting. The purchase price, including acquisition costs, was allocated to
the net assets acquired based on the relative fair market values. The condensed
consolidated financial statements include the results of operations for
TeraBlaze from the date of acquisition. The allocation of the purchase price by
major balance sheet line item is provided below. The final allocation of the
purchase price is contingent on the revision of estimates. The Company does not
expect the final allocations to differ materially from the preliminary
allocation.

Goodwill.................................................... $10
In-process research and development......................... 13
Current liabilities......................................... (2)
---
Total................................................... $21
---
---

The only acquired intangible asset apart from goodwill was in-process
research and development. The goodwill has been assigned to the Infrastructure
segment and is not deductible for tax purposes.

Approximately $13 of the purchase price represents the fair value of
acquired in-process research and development which has not yet reached
technological feasibility and has no alternative future use. Accordingly, this
amount was expensed in the statement of operations on the date of acquisition.
The in-process research and development consists of one project, the development
of Gigabit Ethernet switching technology. The fair value of this project was
determined using the excess earnings method of the income approach. This method
employs a discounted cash flow analysis using the present value of the estimated
after-tax cash flows expected to be generated by the purchased in-process
research and development. A discount rate of 40% was used, which reflects the
development stage of the technology and risks associated with attaining full
technological and commercial feasibility.

6. DISCONTINUED OPERATIONS

On August 14, 2002, the Company announced plans to exit its optoelectronic
components business. The Company had historically reported this business as part
of its Infrastructure Systems segment. The Company reflected this business as
discontinued operations beginning in fiscal 2003 when the Company entered into
an agreement to sell a substantial portion of the business and determined it
could sell the remainder of the business. The revenues, costs and expenses
directly associated with this business have been classified as discontinued
operations in the condensed consolidated statements of operations. Corporate
expenses such as general corporate overhead and interest were not allocated to
discontinued operations. Revenue recorded within income from discontinued
operations was $54 for the three months ended December 31, 2002. Income from
discontinued operations before income taxes was $7 for the three months ended
December 31, 2002. There is no revenue or expenses for discontinued operations
in the three months ended December 31, 2003.

During the second quarter of fiscal 2003, the Company sold a portion of its
optoelectronic components business to TriQuint for $40 in cash and the remainder
of that business to EMCORE Corporation for $25 in cash. The Company has
completed its exit from the optoelectronic components business as a result of
these two sales.

9

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

7. ACCOUNTS RECEIVABLE SECURITIZATION

Agere Systems Inc. and certain of its subsidiaries amended the accounts
receivable securitization agreement on October 3, 2003. Agere Systems Inc. and
certain of its subsidiaries irrevocably transfer accounts receivable on a daily
basis to a wholly-owned, fully consolidated, bankruptcy-remote subsidiary, Agere
Systems Receivables Funding LLC ('ASRF'). ASRF has entered into a loan agreement
with certain financial institutions, pursuant to which the financial
institutions agreed to make loans to ASRF secured by the accounts receivable.
The financial institutions have commitments under the loan agreement of up to
$200; however the amount the Company can actually borrow at any time depends on
the amount and nature of the accounts receivable that the Company has
transferred to ASRF. The loan agreement expires on October 1, 2004.

ASRF had borrowings of $135 and $154 outstanding under this agreement as of
December 31, 2003 and September 30, 2003, respectively. The majority of the
Company's accounts receivable are required to be pledged as security for the
outstanding loans even though some of those receivables may not qualify for
borrowings. As of December 31, 2003 and September 30, 2003, $198 and $228,
respectively of gross receivables were pledged as security for the outstanding
loans. The Company pays interest on amounts borrowed under the agreement based
on one-month LIBOR. The weighted average annual interest rate on amounts
borrowed was 1.16% as of December 31, 2003. In addition, the Company pays an
annual commitment fee, which varies depending on its credit rating, on the total
$200 loan commitment. As of December 31, 2003, the commitment fee was 1.5% per
annum. If the Company's credit rating were to decline one or two levels, the
commitment fee would increase to 2% or 3% per annum, respectively.

ASRF is a separate legal entity with its own separate creditors. Upon
liquidation of ASRF, its assets will be applied to satisfy the claims of its
creditors prior to any value in ASRF becoming available to the Company. The
business of ASRF is limited to the acquisition of receivables from Agere Systems
Inc. and certain of its subsidiaries and related activities.

8. CUMULATIVE EFFECT OF ACCOUNTING CHANGE

Effective October 1, 2002, the Company adopted SFAS No. 143, 'Accounting for
Asset Retirement Obligations' ('SFAS 143'). This standard provides the financial
accounting and reporting requirements for the cost of legal obligations
associated with the retirement of tangible long-lived assets. SFAS 143 requires
the Company to record asset retirement obligations at fair value. The obligation
is recorded as a liability and the associated cost is capitalized as part of the
related long-lived asset and then depreciated over its remaining useful life.
Changes in the liability resulting from the passage of time are recognized as
operating expense. The adoption of SFAS 143 as of October 1, 2002 resulted in
capitalizing a net long-lived asset of $2, related to the restoration of leased
facilities, recording an associated liability of $7 and a cumulative loss of $5.
The cumulative loss represents the depreciation and other operating expenses
that would have been recorded previously if SFAS 143 had been in effect in prior
years. There were no income taxes provided due to the recording of a full
valuation allowance against U.S. net deferred tax assets.

9. SUPPLEMENTARY FINANCIAL INFORMATION

STATEMENT OF OPERATIONS INFORMATION

The Company recorded increased depreciation of $5 for the three months ended
December 31, 2003, all of which is recorded in costs. The Company recorded
increased depreciation of $26 for the three months ended December 31, 2002, $17
of which is recorded in costs and $9 is recorded in restructuring and other
charges-net. The increased depreciation was due to a change in accounting
estimate as a result of shortening the estimated useful lives of certain assets
in connection with the

10

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

Company's restructuring activities. This additional depreciation is reflected in
net loss and resulted in no change in the per share loss for the three months
ended December 31, 2003 and an increase of $0.02 in the per share loss for the
three months ended December 31, 2002.

For the three months ended December 31, 2003, the Company recorded a
provision for income taxes of $3 on a pre-tax loss of $36 yielding an effective
tax rate of (8.3)%. This rate differs from the statutory rate primarily due to
recording a full valuation allowance against U.S. net deferred tax assets, the
impact of the non-tax deductible in-process research and development charge
related to the acquisition of TeraBlaze, and the provision for taxes in non U.S.
jurisdictions. For the three months ended December 31, 2002, the Company
recorded a provision for income taxes of $24 on pre-tax loss from continuing
operations of $124, yielding an effective tax rate of (19.4)%, due to the
recording of a full valuation allowance against U.S. net deferred tax assets and
the provision for taxes in foreign jurisdictions.

BALANCE SHEET INFORMATION

10. INVESTMENT IN SILICON MANUFACTURING PARTNERS

In December 1997, the Company entered into a joint venture, called Silicon
Manufacturing Partners Pte Ltd. ('SMP'), with Chartered Semiconductor
Manufacturing Ltd. ('Chartered Semiconductor'), a leading manufacturing foundry
for integrated circuits, to operate a 54,000 square foot integrated circuit
manufacturing facility in Singapore. The Company owns a 51% equity interest in
this joint venture, and Chartered Semiconductor owns the remaining 49% equity
interest. The Company's 51% interest in SMP is accounted for under the equity
method due to Chartered Semiconductor's participatory rights under the joint
venture agreement. Under the joint venture agreement, each partner is entitled
to the margins from sales to customers directed to SMP by that partner, after
deducting their respective share of the overhead costs of SMP. Accordingly,
SMP's net income (loss) is not expected to be shared in the same ratio as equity
ownership. As of December 31, 2003, the Company's investment in SMP was $178, of
which $20 is a dividend receivable recorded in other current assets and $158 is
recorded in other assets. The Company's investment in SMP was $197 as of
September 30, 2003, and was recorded in other assets.

For the three months ended December 31, 2003 and 2002, the Company
recognized an equity loss of $3 and equity earnings of $2 from SMP,
respectively, recorded in other income -- net. The Company received a dividend
of $20 from SMP for the three months ended December 31, 2003. No dividends were
received in the prior year quarter. SMP reported net income of $12 and net loss
of $9 for the three months ended December 31, 2003 and 2002, respectively. As of
December 31, 2003, SMP reported total assets of $478 and total liabilities of
$275 compared to total assets of $489 and total liabilities of $247 as of
September 30, 2003.

11

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

11. COMPREHENSIVE INCOME (LOSS)

Total comprehensive loss represents net loss plus the results of certain
equity changes not reflected in the condensed consolidated statements of
operations. The components of comprehensive income (loss) are shown below.

The unrealized gain on cash flow hedges is related to hedging activities by
SMP and there are no income taxes provided as they relate to an equity method
investee.

12. LOSS PER COMMON SHARE

Basic and diluted loss per common share is calculated by dividing net loss
by the weighted average number of common shares outstanding during the period.
As a result of the net loss reported for the three months ended December 31,
2003, 249,497,362 outstanding stock options, 123,960,695 potential common shares
related to convertible notes and 26,293 potential common shares related to other
stock units have been excluded from the December 31, 2003 calculation of diluted
loss per share because their effect would be anti-dilutive. As a result of the
net loss reported for the three months ended December 31, 2002, 230,287,098
outstanding stock options and 123,960,695 potential common shares related to
convertible notes have been excluded from the December 31, 2002 calculation of
diluted loss per share because their effect would be anti-dilutive.

13. INTANGIBLE ASSETS

The Company accounts for goodwill and acquired intangible assets under SFAS
No. 142, 'Goodwill and Other Intangible Assets.' The following table reflects
intangible assets by major class and the related accumulated amortization:

Intangible asset amortization expense for the three months ended
December 31, 2003 and 2002 was $2. Intangible asset amortization expense for the
remainder of fiscal 2004 is estimated to be $5. The amortization for future
fiscal years is estimated to be:

12

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

14. OPERATING SEGMENTS

The Company's business operations are divided into two market-focused
groups, Client Systems and Infrastructure Systems. The Client Systems segment
targets the computer and consumer communications market and the Infrastructure
Systems segment targets the network equipment market. These two groups comprise
the Company's reportable operating segments. The segments each include revenue
from the licensing of intellectual property. There were no intersegment sales.

The Client Systems segment provides integrated circuit solutions for a
variety of end-user applications such as hard disk drives and modems for
computers, data-enabled mobile phones and wireless local area networking.

The Infrastructure Systems segment provides integrated circuit solutions to
makers of high-speed communications systems. Prior to the reflection of the
Company's optoelectronic components business as discontinued operations, the
Infrastructure Systems segment also included the results of operations from this
business.

Each segment is managed separately. Disclosure of segment information is on
the same basis used internally for evaluating segment performance and allocating
resources. Performance measurement and resource allocation for the segments are
based on many factors. The primary financial measure used is operating income
(loss), exclusive of amortization of acquired intangible assets, purchased
in-process research and development, net restructuring and other charges, and
net gain on the sale of operating assets.

The Company does not identify or allocate assets by operating segment. In
addition, the Company does not allocate interest income or expense, other income
or expense, or income taxes to the segments. Management does not evaluate
segments based on these criteria. The Company has centralized corporate
functions and uses shared service arrangements to realize economies of scale and
efficient use of resources. The costs of shared services, and other corporate
center operations managed on a common basis, are allocated to the segments based
on usage or other factors based on the nature of the activity.

The Company generates revenues from the sale of one product, integrated
circuits. Integrated circuits are made using semiconductor wafers imprinted with
a network of electronic components. They are designed to perform various
functions such as processing electronic signals, controlling electronic system
functions and processing and storing data.

REPORTABLE SEGMENTS

13

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

RECONCILING ITEMS

A reconciliation of the totals reported for the operating segments to the
significant line items in the condensed consolidated statements of operations is
shown below.

15. FINANCIAL GUARANTEES

A subsidiary of Agere Systems Inc. has guaranteed $9 of debt and interest
incurred by SMP. As of December 31, 2003, the Company believes it is unlikely
that the subsidiary would be required to make any payments associated with this
guarantee. No liability is recorded since recognition of guarantee liabilities
is required only for guarantees issued or modified after December 31, 2002 and
the Company entered into this guarantee prior to that date.

Two real estate leases were assigned in connection with the sale of the
Company's wireless local area networking equipment business. The Company remains
secondarily liable for the remaining lease payments in the event of a default.
The maximum potential amount of future payments that the Company could be liable
for is $6 as of December 31, 2003. As of December 31, 2003, no liability is
recorded since the Company entered into the guarantee prior to December 31, 2002
and believes it is unlikely that it would be required to make any payments
related to these obligations.

Agere Systems Inc. includes indemnification clauses in its standard terms
and conditions for product sales agreements, which indemnify its customers from
third party intellectual property infringement litigation. Also, the Company's
installment note contains an indemnification clause in which Agere provides
indemnification against any claims, liabilities, losses and costs associated
with the collateral named in the agreement. There are no liabilities recorded as
of December 31, 2003 for indemnification clauses since the fair value of
potential obligations cannot be estimated.

The Company's policy is to record a liability, which is reflected within
other current liabilities, for known or potential warranty claims based on
historical experience. The table below presents a reconciliation of the changes
in the Company's aggregate product warranty liability for continuing operations
for the three months ended December 31, 2003 and 2002:

16. COMMITMENTS AND CONTINGENCIES

In the normal course of business, the Company is involved in proceedings,
lawsuits and other claims, including proceedings under laws and government
regulations related to environmental, tax and

14

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

other matters. The semiconductor industry is characterized by substantial
litigation concerning patents and other intellectual property rights. From time
to time, the Company may be party to inquiries or claims in connection with
these rights. In addition, from time to time the Company is involved in legal
proceedings arising in the ordinary course of business, including unfair labor
charges filed by its unions with the National Labor Relations Board, claims
before the U.S. Equal Employment Opportunity Commission and other employee
grievances. These matters are subject to many uncertainties, and outcomes are
not predictable with assurance. Consequently, the ultimate aggregate amount of
monetary liability or financial impact with respect to these matters at
December 31, 2003 cannot be ascertained. While these matters could affect the
operating results of any one quarter when resolved in future periods and while
there can be no assurance with respect thereto, management believes that after
final disposition, any monetary liability or financial impact to the Company
beyond that provided for at December 31, 2003, would not be material to the
annual consolidated financial statements.

The Company has an agreement with SMP under which it has agreed to purchase
51% of the managed wafer capacity from SMP's integrated circuit manufacturing
facility and Chartered Semiconductor agreed to purchase the remaining 49% of the
managed wafer capacity. SMP determines its managed wafer capacity each year
based on forecasts provided by Agere and Chartered Semiconductor. If the Company
fails to purchase its required commitments, it will be required to pay SMP for
the fixed costs associated with the unpurchased wafers. Chartered Semiconductor
is similarly obligated with respect to the wafers allotted to it. The agreement
may be terminated by either party upon two years written notice, but may not be
terminated prior to February 2008. The agreement may also be terminated for
material breach, bankruptcy or insolvency. Based on forecasted demand, the
Company believes it is unlikely that it would have to pay any significant
amounts for underutilization in the near future. However, if the Company's
purchases under this agreement are less than anticipated, the Company's cash
obligation to SMP may be significant.

LEGAL PROCEEDINGS

On October 17, 2002, the Company filed a patent infringement lawsuit against
Intersil Corporation ('Intersil') in the United States District Court in
Delaware. The Company alleged that Intersil had infringed six of the Company's
patents related to integrated circuits for wireless networking using the
IEEE 802.11 standard and is seeking monetary damages for Intersil's infringement
of these patents and an injunction prohibiting Intersil from using the patents
in the future. On November 6, 2002, Intersil filed a counterclaim in this
matter, alleging that ten patents of Intersil are infringed by unspecified Agere
products. Two of the patents relate to system-level circuits, and eight patents
relate to semiconductor processing. The complaint seeks an injunction and
damages. On July 22, 2003, the Company filed a second patent infringement
lawsuit against Intersil in the United States District Court in Delaware,
alleging that Intersil had infringed four additional Company patents -- three
covering semiconductor processing and one covering integrated circuits for
wireless networking. The Company is seeking an injunction and damages. Intersil
counterclaimed with four additional patents relating to semiconductor
processing. The Company believes that Intersil's claims are without merit.

On October 30, 2002, Choice-Intersil Microsystems, Inc. ('Choice-Intersil'),
filed a lawsuit against the Company in the United States District Court for the
Eastern District of Pennsylvania. The amended complaint alleges misappropriation
of trade secrets and copyrights that were jointly developed and jointly owned by
Digital Ocean, Inc. (which, following several acquisitions and corporate
reorganizations, is now Choice-Intersil) and Lucent. The trade secrets and
copyrights relate to media access controller technology for wireless local area
networks. The complaint seeks an injunction and damages. The Company
counterclaimed for misappropriation of trade secrets and breach of contract. On
September 2, 2003, the court issued a decision denying Choice-Intersil's motion
for a preliminary injunction and holding that the Company had lawfully obtained
the trade secrets and copyrights alleged to have been infringed. Choice-Intersil
has appealed. The Company believes that Choice-Intersil's claims are without
merit.

15

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

On November 19, 2002, the Company filed a lawsuit against Choice-Intersil,
Intersil and Intersil Americas Inc. in state court in Delaware. The Company
alleged, among other things, misappropriation of trade secrets and breach of
contract relating to the trade secrets that were jointly developed and
jointly-owned by Digital Ocean, Inc. and Lucent. The Company is seeking an
injunction against further use and disclosure of the trade secrets and damages
for past disclosure and misuse. This matter has been consolidated with the
Pennsylvania Choice-Intersil proceeding described above.

The Company intends to vigorously defend itself against the claims of the
Intersil parties.

On August 28, 2003, GlobespanVirata, Inc. acquired Intersil's wireless
networking product group, and the Company has added Globespan Virata, Inc. as a
defendant in both the Delaware and Pennsylvania proceedings.

ENVIRONMENTAL, HEALTH AND SAFETY

The Company is subject to a wide range of U.S. and non-U.S. governmental
requirements relating to employee safety and health and to the handling and
emission into the environment of various substances used in its operations. The
Company also is subject to environmental laws, including the Comprehensive
Environmental Response, Compensation and Liability Act, also known as Superfund,
that require the cleanup of soil and groundwater contamination at sites
currently or formerly owned or operated by the Company, or at sites where the
Company may have sent waste for disposal. These laws often require parties to
fund remedial action at sites regardless of fault. Agere is a potentially
responsible party at a number of Superfund sites and sites otherwise requiring
cleanup action. Specifically, Agere has liabilities for costs associated with
five Superfund sites and two facilities formerly owned by Lucent.

It is often difficult to estimate the future impact of environmental
matters, including potential liabilities. The Company has established financial
reserves to cover environmental liabilities where they are probable and
reasonably estimable. This practice is followed whether the claims are asserted
or unasserted. Management expects that the amounts reserved will be paid out
over the period of remediation for the applicable site, which typically ranges
from five to thirty years. Reserves for estimated losses from environmental
remediation are, depending upon the site, based primarily upon internal or third
party environmental studies, estimates as to the number, participation level and
financial viability of all potentially responsible parties, the extent of the
contamination and the nature of required remedial actions. Accruals are adjusted
as further information develops or circumstances change. The amounts provided
for in the consolidated and combined financial statements for environmental
reserves are the gross undiscounted amount of such reserves, without deductions
for insurance or third party indemnity claims. Although the Company believes
that its reserves are adequate, including those covering the Company's potential
liabilities at Superfund sites, there can be no assurance that expenditures
which will be required relating to remedial actions and compliance with
applicable environmental laws will not exceed the amounts reflected in these
reserves or will not have a material adverse impact on the Company's financial
condition, results of operations or cash flows. Any possible loss or range of
loss that may be incurred in excess of that provided for as of December 31,
2003, cannot be estimated.

17. SUBSEQUENT EVENTS

SINGAPORE TAX HOLIDAY

As of January 1, 2004, Agere's Pioneer tax holiday in Singapore expired. The
Company is in the process of applying for a renewal of the tax holiday with the
Economic Development Board ('EDB') of Singapore. The type and length of any tax
holiday to be granted is at the discretion of the EDB. The Company will record a
deferred tax asset of $81 which the Company estimates will reverse at post
Pioneer holiday tax rates. A full valuation allowance will be recorded as
realization of these assets is uncertain.

16

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

TAX SETTLEMENT

Agere is party to a tax sharing agreement with Lucent Technologies Inc.
('Lucent') and is liable for tax adjustments that are attributable to its
business as well as a portion of certain shared tax adjustments during the years
prior to the separation from Lucent, which includes the period during which
Lucent was part of AT&T Corp. The Company has been advised by Lucent that
certain of the Internal Revenue Service audits relating to these pre-separation
years have been completed and tax adjustments have been proposed or assessed
subject to this tax sharing agreement. The Company expects to have discussions
with Lucent related to these tax adjustments during the next few months and
based on the limited information received to date, the final settlement is not
expected to have a material adverse effect on our results of operations, or
financial position.

17

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion of our financial condition and results of
operations should be read in conjunction with our unaudited financial statements
for the three months ended December 31, 2003 and 2002 and the notes thereto.
This discussion contains forward-looking statements. Please see 'Forward-
Looking Statements' and 'Factors Affecting Our Future Performance' for a
discussion of the uncertainties, risks and assumptions associated with these
statements.

OVERVIEW

We provide advanced integrated circuit solutions that are made using
semiconductor wafers imprinted with a network of electronic components. They are
designed to perform various functions such as processing electronic signals,
controlling electronic system functions and processing and storing data.

Our business operations are divided into two market-focused groups, Client
Systems and Infrastructure Systems. The Client segment targets the computer and
consumer communications market and the Infrastructure segment targets the
network equipment market. Each of these two groups is a reportable operating
segment. The segments each include revenue from the licensing of intellectual
property. The Client segment provides integrated circuit solutions for a variety
of end-user applications such as hard disk drives and modems for computers,
data-enabled mobile phones and wireless local area networking. The
Infrastructure segment provides integrated circuit solutions to makers of
high-speed communications systems. In addition, the Infrastructure segment
formerly provided optoelectronic components; however, we have sold those
operations and have reflected them as discontinued operations for all periods
presented. See Note 6 in Item 1 for additional details.

OPERATING ENVIRONMENT

Our business depends in large part on demand for personal computers and
associated equipment, wireless communications equipment such as mobile phones
and wireless local area networking equipment and telecommunications
infrastructure equipment. Our revenues can be affected by changes in demand for
any of these types of products. The Client segment depends on demand for
personal computers and associated equipment and tends to experience increases in
demand in the September and December quarters as personal computer manufacturers
build supplies for the holiday season. Our markets are competitive and rapidly
changing and significant technological changes, new customer requirements,
changes in customer buying behavior or the emergence of competitive products
with new capabilities or technologies could adversely affect our revenues and
operating results.

Our revenue has increased in each of the last four quarters after reaching a
low-point in the first quarter of fiscal 2003. This improvement was driven by
increased Client segment revenues due to higher demand for integrated circuits
supporting the mobile phone and hard disk drive markets. During the same period,
the Infrastructure business continued to decline, however we believe that this
business has stabilized and reached the bottom of the decline as we are
beginning to see improving demand from wireline and wireless infrastructure
applications.

During fiscal 2003, we substantially completed a major restructuring of our
business. We undertook this restructuring in response to significant declines in
our revenue, particularly from our telecommunications network equipment
customers. We believe that these customers were themselves experiencing
significant declines in demand from their customers. As part of this
restructuring, we:

Sold our optoelectronic components business, including the
manufacturing facilities associated with that business;

Reduced our headcount;

Consolidated our operations into fewer facilities; and

Closed two integrated circuit wafer manufacturing
facilities.

These restructuring actions have resulted in increased capacity utilization
at our remaining manufacturing facilities, reduced fixed costs and eliminated
unprofitable businesses and, together with

18

an increase in revenues in our Client segment, have resulted in a significant
improvement in our gross margin and net loss. Our target is to end fiscal 2004
with gross margin at the high end of the 45 to 50 percent range. We believe we
can achieve this target by continued focus on improving efficiencies in our
supply chain, increasing the capacity utilization at our assembly and test
facilities as demand increases, and improving yields.

The integrated circuit manufacturing industry has a history of developing
new manufacturing processes. We believe that the costs associated with
implementing new processes, including acquiring the necessary equipment and
building appropriate facilities, are increasing with each generation of
manufacturing processes. Because we do not want to make the financial
investments necessary for future processes, we plan to rely on third-party
contract manufacturers to make integrated circuits for us using any
manufacturing processes that we do not currently use internally. We also intend
to rely on third-party contract manufacturers for additional capacity when our
internal facilities are insufficient. We refer to this strategy as our
'fab-lite' strategy. We believe this strategy will lead to lower capital
expenditures and fixed costs than if we continued to invest in new manufacturing
facilities.

RESTRUCTURING AND DECOMMISSIONING ACTIVITIES

As a result of our restructuring activities, we recorded $31 million for the
decommissioning of the Reading and Allentown manufacturing facilities and $16
million for net restructuring and related charges for continuing operations
during the three months ended December 31, 2003, which are classified within
restructuring and other charges -- net. We recorded $25 million for net
restructuring and related charges for continuing operations during the three
months ended December 31, 2002. In addition, within gross margin we recorded
approximately $6 million and $25 million of restructuring related charges during
the three months ended December 31, 2003 and 2002, respectively, of which $5
million and $17 million respectively, resulted from increased depreciation. This
additional depreciation is due to the shortening of estimated useful lives of
certain assets in connection with our restructuring actions. For additional
details regarding our restructuring activities, see Note 4 to our financial
statements in Item 1.

To complete our remaining restructuring and decommissioning actions, we
estimate that we will incur approximately $35 million in additional cash
charges, the majority of which is for the remaining consolidation of employees
to our Lehigh Valley facility and the trailing costs associated with completing
the decommissioning of our manufacturing sites in Allentown and Reading.

APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements and revenues and expenses
during the period reported. The following accounting policy involves a 'critical
accounting estimate' because it is particularly dependent on estimates and
assumptions made by management about matters that are highly uncertain at the
time the accounting estimates are made. See Item 7 -- 'Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Application of
Critical Accounting Policies and Estimates' in our Annual Report on Form 10-K
for the fiscal year ended September 30, 2003, for other critical accounting
policies and estimates.

In-process research and development

We review our acquisitions to determine if there are any intangible assets
relating to purchased in-process research and development. Projects that have
not achieved technological feasibility and have no alternative future use are
valued at fair market value using a discounted cash flow analysis and are
expensed in the statement of operations on the date of acquisition. The discount
rate used reflects the development stage of the technology and risks associated
with attaining full technological and commercial feasibility. When we value
in-process research and development, we must make a number of estimates,
including the timing and amounts of future cash flows to be generated as a
result of these

19

projects, how close the projects are to technological feasibility and how much
risk and cost is involved in finalizing the projects. It is reasonably likely
that our estimates for these amounts will differ from actual results, in which
case our in-process research and development charge may be over- or under-
valued, which would also result in an under- or over-valuation of our goodwill.

RESULTS OF OPERATIONS

THREE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THE THREE MONTHS ENDED
DECEMBER 31, 2002

The following table shows the change in revenue, both in dollars and in
percentage terms by segment:

Revenue. Revenue increased 18% or $80 million, for the three months ended
December 31, 2003, as compared to the same period in 2002. The increase of $98
million within the Client segment was driven primarily by volume increases in
the sales of integrated circuits used in mobile phones and system-on-a-chip
solutions used in hard disk drives, partially offset by volume and price
decreases from wireless local area networking solutions as we transition from
providing higher priced cards and modules to providing lower priced
chipset-based solutions. Intellectual property licensing revenues in the Client
segment were $18 million for the three months ended December 31, 2003, an
increase of $6 million from the prior year quarter. The decrease of $18 million
within the Infrastructure segment was primarily caused by decreased volume in
the mature telephony markets, as demand for older telecommunications focused
products continued to decline. Intellectual property licensing revenues in the
Infrastructure segment increased $3 million from the prior year quarter to $12
million for the three months ended December 31, 2003.

Gross margin. Gross margin increased from 25.9% in the prior year quarter to
44.8% in the current quarter, an increase of 18.9 percentage points. Gross
margin for the Client segment increased to 38.9% in the current quarter from
12.3% in the prior year quarter. The Client segment margins were positively
impacted by a $15 million decrease in restructuring related charges from the
prior year quarter, lower manufacturing costs due to a change in product mix to
more products that have lower third party manufacturing costs, and higher
capacity utilization. Gross margin for the Infrastructure segment increased to
64.4% in the current quarter from 55.9% in the prior year quarter. The
Infrastructure segment margin improvement was due to the combination of a $4
million decrease in restructuring related charges from the prior year quarter
and higher capacity utilization.

Selling, general and administrative. Selling, general and administrative
expenses increased 4% or $3 million, from $73 million in the three months ended
December 31, 2002 to $76 million in the three months ended December 31, 2003.
The increase is due to increased bonus accruals for the short-term incentive
plan as management currently plans to fund bonuses at a higher level in fiscal
2004 than in fiscal 2003 and increased litigation expenses.

Research and development. Research and development expenses decreased 6% or
$8 million, from $127 million in the prior year quarter to $119 million in the
current quarter. The decrease was due to a lower investment in silicon
fabrication research due to our conversion to a fab-lite business model and
lower outside contractor expenses as we moved work to Agere employees.

Purchased in-process research and development. Purchased in-process research
and development for the three months ended December 31, 2003 was $13 million due
to our acquisition of TeraBlaze, Inc.

20

There was no purchased in-process research and development for the three months
ended December 31, 2002. See 'Purchased In-Process Research and Development' for
additional details.

Restructuring and other charges -- net. Net restructuring and other charges
increased 88% or $22 million to $47 million for the three months ended December
31, 2003 from $25 million for the three months ended December 31, 2002. See
'Restructuring Activities' for additional details.

Operating loss. We reported an operating loss of $25 million for the three
months ended December 31, 2003, an improvement of $89 million from an operating
loss of $114 million reported for the three months ended December 31, 2002. This
improvement primarily reflects an increase in gross profit and expense
reductions. Although performance measurement and resource allocation for the
reportable segments are based on many factors, the primary financial measure
used is operating income (loss) by segment, exclusive of amortization of
acquired intangible assets, purchased in-process research and development, net
restructuring and other charges and net gain on sale of operating assets, which
is shown in the following table.

Provision for income taxes. For the first quarter of fiscal 2004, we
recorded a provision for income taxes of $3 million on a pre-tax loss from
continuing operations of $36 million, yielding an effective tax rate of (8.3)%.
This rate differs from the U.S. statutory rate primarily due to recording a full
valuation allowance against U.S. net deferred tax assets, the impact of non-tax
deductible in-process research and development expenses related to the
acquisition of TeraBlaze, and the provision for taxes in non U.S. jurisdictions.
For the first quarter of fiscal 2003, we recorded a provision for income taxes
of $24 million on a pre-tax loss from continuing operations of $124 million,
yielding an effective tax rate of (19.4)%. This rate differs from the U.S.
statutory rate primarily due to the recording of a full valuation allowance
against U.S. net deferred tax assets and the provision for taxes in foreign
jurisdictions.

Income from discontinued operations. Income from discontinued operations was
$7 million with income per share of $0.00 for the three months ended December
31, 2002. There was no income from discontinued operations in the current fiscal
quarter. See Note 6 to our financial statements in Item 1.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2003, our cash in excess of short-term debt was $577
million, which reflects $756 million of cash and cash equivalents less $135
million of borrowings under our accounts receivable securitization facility, $38
million from the current portion of our capitalized lease obligations, and $6
million from the current portion of our installment loan. In addition, we have
$16 million of cash held in trust that primarily supports obligations of our
captive insurance company and is not immediately available to fund on-going
operations. As of December 31, 2003, our long-term debt was $440 million, which
consists of $410 million of convertible subordinated notes due in 2009, $21
million from the non-current portion of our capitalized lease obligations, and
$9 million from the non-current portion of our installment loan.

Net cash provided by operating activities from continuing operations was $40
million for the three months ended December 31, 2003 compared with net cash used
in operating activities from continuing operations of $74 million for the three
months ended December 31, 2002. This improvement in cash provided/used by
operating activities is primarily driven by higher sales volumes and improved
cash collections on accounts receivable as our number of days sales outstanding
improved. In addition, we had a $28 million decrease in cash payments for
restructuring and related activities, $20 million in dividends received from our
joint venture with Silicon Manufacturing Partners Pte Ltd, offset in part by a
$25 million decrease in cash due to higher bonus payments.

21

Net cash used by investing activities was $14 million for the three months
ended December 31, 2003 compared with $24 million for the three months ended
December 31, 2002. The decrease in cash used by investing activities in the
current year quarter is due to a decrease of $10 million in capital
expenditures, primarily related to increased spending in the prior year quarter
to establish testing equipment for system-on-a-chip solutions. In addition,
there was a $9 million decrease due to the change from a $4 million increase in
cash held in trust in the prior year quarter to a $5 million decrease in cash
held in trust in the current year quarter, offset by a $9 million decrease in
proceeds from the sale or disposal of property, plant and equipment.

Net cash used by financing activities was $14 million for the three months
ended December 31, 2003, compared with $38 million for the three months ended
December 31, 2002. The decrease in cash used by financing activities in the
current year quarter is mainly due to the following factors: a $9 million
decrease due to repayments of amounts outstanding under our accounts receivable
securitization facility of $19 million in the current year quarter compared to
repayments of $28 million in the prior year quarter, an increase of $8 million
in net proceeds from the issuance of common stock under our employee stock plans
in the current year quarter, and $7 million in lower payments on our capital
lease obligations.

We have entered into a securitization agreement with certain financial
institutions, pursuant to which the financial institutions agreed to make loans
secured by certain of our accounts receivable. The financial institutions have
commitments under the related loan agreement of up to $200 million; however, the
amount that can be borrowed at any time depends on the amount and nature of our
accounts receivable. The loan agreement, as amended on October 3, 2003, expires
on October 1, 2004. As of December 31, 2003, $135 million was outstanding under
this agreement. See Note 7 to our financial statements in Item 1 of Part I for a
description of the structure of the transaction and additional details.

The majority of our accounts receivable are required to be pledged as
security for the outstanding loans even though some of those receivables may not
qualify for borrowings. As of December 31, 2003, $198 million of gross
receivables was pledged as security for the outstanding loans. We pay interest
on amounts borrowed under the agreement based on one-month LIBOR. In addition,
we pay an annual commitment fee, which varies depending on our credit rating, on
the $200 million total loan commitment. As of December 31, 2003, our credit
ratings were BB- with a stable outlook from Standard & Poor's and B2 with a
stable outlook from Moody's. If our credit rating were to decline one or two
levels, the commitment fee would increase to 2% or 3% per annum, respectively.

The loan agreement has a financial covenant which requires us to achieve a
minimum level of earnings before interest, taxes, and depreciation and
amortization each quarter. A covenant violation will end our ability to obtain
further loans under the agreement, but will not accelerate payment or require an
immediate cash outlay to cover amounts previously loaned under the accounts
receivable securitization.

Our primary source of liquidity is our cash and cash equivalents. We believe
our cash and cash equivalents on hand will be sufficient to meet our projected
cash requirements for the next 12 months and for the foreseeable future
thereafter because we believe our cash flow from operations will exceed our cash
requirements.

PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

On December 31, 2003, we acquired TeraBlaze, a developer of Gigabit Ethernet
switching solutions, for approximately $21 million in Agere Class A common
stock. On the date of acquisition, we expensed $13 million of the purchase price
as in-process research and development. This represents the fair value of the
technology we acquired which has not yet reached technological feasibility and
has no alternative future use.

At the date of acquisition, TeraBlaze did not have any developed technology.
It had one project underway to develop Gigabit Ethernet switching solutions. We
expect to use this technology to deliver high-density switching solutions to
serve the Gigabit Ethernet market. We expect to use this switch-on-a-chip
technology to provide single-chip Gigabit Ethernet solutions to equipment
providers addressing small office, home office and enterprise applications.
Based on the complexity and specific nature of this

22

technology, there would be no specific alternative future use for this
technology if we are unsuccessful in our development efforts.

We determined the fair value of the in-process research and development
using the excess earnings method of the income approach. This method employs a
discounted cash flow analysis using the present value of the estimated after-tax
cash flows expected to be generated by the purchased in-process research and
development. We used a discount rate of 40%, which reflects the development
stage of the technology and risks associated with attaining full technological
and commercial feasibility. As of the acquisition date, this project was
estimated to be 70% complete, based on time, man-months completed and
functionality. Costs to complete this project are estimated to be about $5
million. The remaining development effort includes preparing a mask set and
testing the product. We expect to complete these steps by September 2004 and
will release samples to our customers at that time. We anticipate that we will
begin generating revenues and net cash inflows from this product in the third
quarter of fiscal 2005.

RECENT PRONOUNCEMENTS

On December 8, 2003, President Bush signed into law the Medicare
Prescription Drug, Improvement and Modernization Act of 2003. That law expanded
Medicare to include, for the first time, coverage for prescription drugs. We
sponsor retiree medical programs for certain of our locations and this
legislation may eventually reduce our costs for some of these programs.

At this point, our investigation into our response to the legislation is
preliminary, as we await guidance from various governmental and regulatory
agencies concerning the requirements that must be met to obtain these cost
reductions as well as the manner in which such savings should be measured.

Because of various uncertainties related to this legislation, we have
elected to defer financial recognition of this legislation until the Financial
Accounting Standards Board issues final accounting guidance. When issued, that
final guidance could require us to change previously reported information. This
deferral election is permitted under FSP FAS 106-1.

ENVIRONMENTAL, HEALTH AND SAFETY MATTERS

We are subject to a wide range of U.S. and non-U.S. governmental
requirements relating to employee safety and health and to the handling and
emission into the environment of various substances used in our operations. We
are also subject to environmental laws, including the Comprehensive
Environmental Response, Compensation and Liability Act, also known as Superfund,
that require the cleanup of soil and groundwater contamination at sites
currently or formerly owned or operated by us, or at sites where we may have
sent waste for disposal. These laws often require parties to fund remedial
action at sites regardless of fault. We are a potentially responsible party at a
number of Superfund sites and sites otherwise requiring cleanup action.
Specifically, we have liabilities for costs associated with five Superfund sites
and two facilities formerly owned by Lucent.

It is often difficult to estimate the future impact of environmental
matters, including potential liabilities. We have established financial reserves
to cover environmental liabilities where they are probable and reasonably
estimable. This practice is followed whether the claims are asserted or
unasserted. Management expects that the amounts reserved will be paid out over
the period of remediation for the applicable site, which typically ranges from
five to thirty years. Reserves for estimated losses from environmental
remediation are, depending upon the site, based primarily upon internal or third
party environmental studies, estimates as to the number, participation level and
financial viability of all potentially responsible parties, the extent of the
contamination and the nature of required remedial actions. Accruals are adjusted
as further information develops or circumstances change. The amounts provided
for in our financial statements for environmental reserves are the gross
undiscounted amount of such reserves, without deductions for insurance or third
party indemnity claims. Although we believe that our reserves are adequate,
including those covering our potential liabilities at Superfund sites, there can
be no assurance that expenditures which will be required relating to remedial
actions and compliance with applicable environmental laws will not exceed the
amounts reflected in these reserves or will not have a material adverse impact
on our financial condition, results of operations or cash flows. Any possible
loss or range of loss that may be incurred in excess of that provided for as of
December 31, 2003, cannot be estimated.

23

LEGAL PROCEEDINGS

On October 17, 2002, we filed a patent infringement lawsuit against Intersil
Corporation in the United States District Court in Delaware. We alleged that
Intersil had infringed six of our patents related to integrated circuits for
wireless networking using the IEEE 802.11 standard and are seeking monetary
damages for Intersil's infringement of these patents and an injunction
prohibiting Intersil from using the patents in the future. On November 6, 2002,
Intersil filed a counterclaim in this matter, alleging that ten patents of
Intersil are infringed by unspecified Agere products. Two of the patents relate
to system-level circuits, and eight patents relate to semiconductor processing.
The complaint seeks an injunction and damages. On July 22, 2003, we filed a
second patent infringement lawsuit against Intersil in the United States
District Court in Delaware, alleging that Intersil had infringed four additional
patents -- three covering semiconductor processing and one covering integrated
circuits for wireless networking. We are seeking an injunction and damages.
Intersil counterclaimed with four additional patents relating to semiconductor
processing. We believe that Intersil's claims are without merit.

On October 30, 2002, Choice-Intersil Microsystems, Inc., filed a lawsuit
against us in the United States District Court for the Eastern District of
Pennsylvania. The amended complaint alleges misappropriation of trade secrets
and copyrights that were jointly developed and jointly owned by Digital Ocean,
Inc. (which, following several acquisitions and corporate reorganizations, is
now Choice-Intersil) and Lucent Technologies Inc. The trade secrets and
copyrights relate to media access controller technology for wireless local area
networks. The complaint seeks an injunction and damages. We counterclaimed for
misappropriation of trade secrets and breach of contract. On September 2, 2003,
the court issued a decision denying Choice-Intersil's motion for a preliminary
injunction and holding that we had lawfully obtained the trade secrets and
copyrights alleged to have been infringed. Choice-Intersil has appealed. We
believe that Choice-Intersil's claims are without merit.

On November 19, 2002, we filed a lawsuit against Choice-Intersil, Intersil
and Intersil Americas Inc. in state court in Delaware. We alleged, among other
things, misappropriation of trade secrets and breach of contract relating to the
trade secrets that were jointly developed and jointly-owned by Digital Ocean,
Inc. and Lucent. We are seeking an injunction against further use and disclosure
of the trade secrets and damages for past disclosure and misuse. This matter has
been consolidated with the Pennsylvania Choice-Intersil proceeding described
above.

We intend to vigorously defend ourself against the claims of the Intersil
parties.

On August 28, 2003, GlobespanVirata, Inc. acquired Intersil's wireless
networking product group and we have added Globespan Virata as a defendant in
both the Delaware and Pennsylvania proceedings.

RISK MANAGEMENT

We are exposed to market risk from changes in foreign currency exchange
rates and interest rates that could impact our results of operations and
financial position. We manage our exposure to these market risks through our
regular operating and financing activities and, when deemed appropriate, through
the use of derivative financial instruments. We use derivative financial
instruments as risk management tools and not for speculative purposes. We use
foreign currency forward contracts, and may from time to time use foreign
currency options, to manage the volatility of non-functional currency cash flows
resulting from changes in exchange rates. The change in fair market value of
derivative instruments was recorded in other income-net and was not material for
all periods presented.

While we hedge certain foreign currency transactions, any decline in value
of non-U.S. dollar currencies may, if not reversed, adversely affect our ability
to contract for product sales in U.S. dollars because our products may become
more expensive to purchase in U.S. dollars for local customers doing business in
the countries of the affected currencies.

FORWARD-LOOKING STATEMENTS

This Management's Discussion and Analysis of Financial Condition and Results
of Operations and other sections of this report contain forward-looking
statements that are based on current expectations, estimates, forecasts and
projections about the industry in which we operate, management's beliefs and
assumptions made by management. Words such as 'expects,' 'anticipates,'
'intends,' 'plans,'

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'believes,' 'seeks,' 'estimates,' variations of such words and similar
expressions are intended to identify such forward looking statements. These
statements are not guarantees of future performance and involve risks,
uncertainties and assumptions which are difficult to predict. Therefore, actual
outcomes and results may differ materially from what is expressed or forecasted
in such forward-looking statements. Except as required under the federal
securities laws and the rules and regulations of the Securities and Exchange
Commission, we do not have any intention or obligation to update publicly any
forward-looking statements whether as a result of new information, future events
or otherwise.

FACTORS AFFECTING OUR FUTURE PERFORMANCE

The following factors, many of which are discussed in greater detail in our
Annual Report on Form 10-K for the fiscal year ended September 30, 2003, could
affect our future performance and the price of our stock.

RISKS RELATED TO OUR BUSINESS

If we fail to keep pace with technological advances in our
industry or if we pursue technologies that do not become
commercially accepted, customers may not buy our products
and our revenue may decline.

The integrated circuit industry is intensely competitive,
and our failure to compete effectively could hurt our
revenue.

Joint ventures and other third parties manufacture some of
our products for us. If these manufacturers are unable to
fill our orders on a timely and reliable basis, our revenue
may be adversely affected.

A widespread outbreak of an illness such as severe acute
respiratory syndrome, or SARS, could negatively affect our
manufacturing, assembly and test, design or other
operations, making it more difficult and expensive to meet
our obligations to our customers, and could result in
reduced demand from our customers.

Our revenue and operating results may fluctuate because we
expect to derive most of our revenue from semiconductor
devices and the integrated circuits industry is highly
cyclical, and because of other characteristics of our
business, and these fluctuations may cause our stock price
to fall.

Because many of our current and planned products are highly
complex, they may contain defects or errors that are
detected only after deployment in commercial applications,
and if this occurs, it could harm our reputation and result
in reduced revenues or increased expenses.

Because our sales are concentrated on a limited number of
key customers, our revenue may materially decline if one or
more of our key customers do not continue to purchase our
existing and new products in significant quantities.

The demand for components in the communications equipment
industry has declined in recent years, and we cannot predict
the duration or extent of this decline. Our revenue will
depend in part on demand for these types of components.

We are expanding, and may seek in the future to expand, into
new areas, and if we are not successful, our results of
operations may be adversely affected.

If we fail to attract, hire and retain qualified personnel,
we may not be able to develop, market or sell our products
or successfully manage our business.

Because we are subject to order and shipment uncertainties,
any significant cancellations or deferrals could cause our
revenue to decline or fluctuate.

If we do not achieve adequate manufacturing utilization,
yields, volumes or sufficient product reliability, our gross
margins will be reduced.

We have relatively high gross margin on the revenue we
derive from the licensing of our intellectual property, and
a decline in this revenue would have a greater impact on our
net income than a decline in revenue from our integrated
circuits products.

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If our customers do not qualify our products or
manufacturing lines or the manufacturing lines of our
third-party suppliers for volume shipments, our results of
operations may be adversely affected.

We conduct a significant amount of our sales activity and
manufacturing efforts outside the United States, which
subjects us to additional business risks and may adversely
affect our results of operations due to increased costs.

We are subject to environmental, health and safety laws,
which could increase our costs and restrict our operations
in the future.

We may be subject to intellectual property litigation and
infringement claims, which could cause us to incur
significant expenses or prevent us from selling our
products. If we are unable to protect our intellectual
property rights, our business and prospects may be harmed.

We believe that financing has at times been difficult to
obtain for companies in our industry and if we need
additional cash to fund our operations or to finance future
strategic initiatives, we may not be able to obtain it on
acceptable terms or at all.

Because of differences in voting power and liquidity between
our Class A common stock and Class B common stock, the
market price of the Class A common stock may be different
from the market price of the Class B common stock.

The development and evolution of markets for our integrated
circuits are dependent on factors over which we have no
control. For example, if our customers adopt new or
competing industry standards with which our products are not
compatible or fail to adopt standards with which our
products are compatible, our existing products would become
less desirable to our customers and our sales would suffer.

Class action litigation due to stock price volatility or
other factors could cause us to incur substantial costs and
divert our management's attention and resources.

RISKS RELATED TO OUR SEPARATION FROM LUCENT TECHNOLOGIES

We are limited in the amount of stock that we can issue to
raise capital because of potential adverse tax consequences.

We could incur significant tax liabilities and payment
obligations if Lucent fails to pay the tax liabilities
attributable to Lucent under our tax sharing agreement.

Because the Division of Enforcement of the Securities and
Exchange Commission is investigating matters brought to its
attention by Lucent, our business may be affected in a
manner we cannot foresee at this time.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have exposure to foreign exchange and interest rate risk. There have been
no material changes in market risk exposures from those disclosed in our Annual
Report on Form 10-K for the fiscal year ended September 30, 2003. See Item
2 -- 'Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Risk Management' for additional details.

ITEM 4. CONTROLS AND PROCEDURES

With the participation of our Chief Executive Officer and Chief Financial
Officer, management has carried out an evaluation of the effectiveness of our
disclosure controls and procedures (as defined in Rule 13a-15(e) under the
Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls and
procedures were effective as of December 31, 2003.

There were no changes in our internal control over financial reporting (as
defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during the
first quarter of fiscal 2004 that materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting.

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PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

See Part I -- 'Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Legal Proceedings.'

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

(c) Unregistered Sales of Common Stock

On December 31, 2003, we acquired TeraBlaze, Inc., a developer of Gigabit
Ethernet switching solutions. As part of the acquisition, we issued 6,921,188
shares of Class A common stock to the TeraBlaze shareholders in exchange for all
the outstanding shares of TeraBlaze. The shares were issued in a private,
directly negotiated transaction not involving a public offering in reliance on
the exemption from registration provided by Section 4(2) of the Securities Act
of 1933. Our reliance on this exemption was based in principal part on certain
factual representations received from the former TeraBlaze stockholders who
received the shares.

ITEM 5. OTHER INFORMATION

This report on Form 10-Q reflects an adjustment to information contained in
our January 27, 2004 news release, which was filed with the Securities and
Exchange Commission as an exhibit to a report on Form 8-K on that date. The
Condensed Consolidated Balance Sheet as of December 31, 2003 has been revised to
reflect accounts payable of $203 million, a decrease of $7 million and
short-term debt of $179 million, an increase of $7 million. Correspondingly, the
Condensed Consolidated Statement of Cash Flows for the three months ended
December 31, 2003 has been revised to reflect cash provided by operating
activities of $40 million, a decrease of $7 million and cash used by financing
activities of $14 million, a decrease of $7 million.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

See Exhibit Index.

(b) Reports on Form 8-K

Current Report on Form 8-K furnished October 28, 2003 pursuant to
Item 7 (Financial Statements, Pro Forma Financial Information and Other)
and Item 12 (Results of Operations and Financial Condition).

Current Report on Form 8-K furnished November 12, 2003 pursuant to
Item 7 (Financial Statements, Pro Forma Financial Information and
Other), Item 9 (Regulation FD Disclosure) and Item 12 (Results of
Operations and Financial Condition).

Current Report on Form 8-K/A furnished November 13, 2003 pursuant to
Item 7 (Financial Statements, Pro Forma Financial Information and
Other), Item 9 (Regulation FD Disclosure) and Item 12 (Results of
Operations and Financial Condition).

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SIGNATURES

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

AGERE SYSTEMS INC.

Date February 4, 2004 /s/ JOHN W. GAMBLE, JR.
..............................
JOHN W. GAMBLE, JR.
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER

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EXHIBIT INDEX