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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File Number 001-15951

AVAYA INC.

        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 ý    No o

        At June 30, 2003, 382,184,702 common shares were outstanding.

TABLE OF CONTENTS

        This Quarterly Report on Form 10-Q contains trademarks, service marks and registered marks of Avaya and its subsidiaries and other companies, as indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q, trademarks identified by ® and ™ are registered trademarks or trademarks, respectively, of Avaya Inc. or its subsidiaries. All other trademarks are the properties of their respective owners. Liquid Yield Option™ Notes is a trademark of Merrill Lynch & Co., Inc.

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PART I

Item 1.    Financial Statements.

AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in millions, except per share amounts)
(unaudited)

See Notes to Consolidated Financial Statements.

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AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in millions, except per share amounts)
(unaudited)

See Notes to Consolidated Financial Statements.

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AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in millions)
(unaudited)

See Notes to Consolidated Financial Statements.

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AVAYA INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1.    Background and Basis of Presentation

Background

        Avaya Inc. (the "Company" or "Avaya") provides communication systems, applications and services for enterprises, including businesses, government agencies and other organizations. The Company's product offerings include converged voice and data networks, traditional voice communication systems, customer relationship management applications, unified communications applications and structured cabling products. The Company supports its broad customer base with comprehensive global service offerings that enable customers to plan, design, implement and manage their communications networks.

Basis of Presentation

        The accompanying unaudited consolidated financial statements as of June 30, 2003 and for the three and nine months ended June 30, 2003 and 2002, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and Exchange Commission for interim financial statements, and should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2002. In the Company's opinion, the unaudited interim consolidated financial statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated. Certain prior year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year.

2.    Recent Accounting Pronouncements

FASB Interpretation No. 45

        In November 2002, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 expands on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also requires that at the time a company issues a guarantee, the company must recognize an initial liability for the fair market value of the obligation it assumes under that guarantee and must disclose that information in its interim and annual financial statements. The initial recognition and measurement provisions of FIN 45 apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company adopted the recognition and measurement provisions of FIN 45 beginning in the second quarter of fiscal 2003. The applicable disclosures are reflected in Note 12-Commitments and Contingencies.

EITF Issue No. 00-21

        In November 2002, the Emerging Issues Task Force ("EITF") reached a consensus on Issue No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements that involve the delivery or performance of multiple revenue generating activities, including the sale of products combined with initial installation, initiation, or activation services, that may occur at different points in time or over different periods of time. This consensus addresses when and, if so, how an arrangement

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with multiple deliverables should be divided into separate units of accounting. EITF 00-21 will apply to revenue arrangements entered into by the Company beginning in the fourth quarter of fiscal 2003. The adoption of EITF 00-21 is not expected to have a material impact on the Company's consolidated results of operations, financial position or cash flows.

SFAS 148

        In December 2002, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS 148"), which amends SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation, and requires disclosure about those effects in both annual and interim financial statements.

        The Company has elected to continue to account for its stock compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost related to stock options is reflected in the Company's Statements of Operations, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company records compensation expense for the amortization of restricted stock units issued to employees. The following table illustrates the effect on net income (loss) and earnings (loss) per share as if the Company had applied the fair value recognition provisions of SFAS 123.

        The fair value of stock options used to compute pro forma net loss resulted in additional income in the nine months ended June 30, 2003 and 2002 because a substantial number of previously granted options had been forfeited/expired and the cumulative reversal of pro forma expense related to these options exceeds the pro forma expense related to the remaining outstanding options.

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FASB Interpretation No. 46

        In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51" ("FIN 46"). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The disclosure requirements of FIN 46 and the consolidation requirements for variable interest entities created or acquired subsequent to January 31, 2003 became effective for financial statements issued by the Company beginning in the second quarter of fiscal 2003. For variable interest entities created or acquired prior to February 1, 2003, the consolidation requirements of FIN 46 become effective for the Company in the fourth quarter of fiscal 2003. The Company currently has no significant contractual relationship or other business relationship with a variable interest entity and therefore the adoption of FIN 46 did not have a material effect on the Company's consolidated results of operations, financial position or cash flows.

SFAS 149

        In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The changes are intended to improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. Additionally, those changes are expected to result in more consistent reporting of contracts as either derivatives or hybrid instruments. The requirements of SFAS 149 become effective for the Company for contracts entered into or modified after June 30, 2003, with the exception of Implementation Issues that have been cleared by the FASB and have been effective for fiscal quarters that began prior to June 15, 2003, and for hedging relationships designated after June 30, 2003. The provisions of this statement are applied on a prospective basis. The adoption of SFAS 149 is not expected to have a material effect on the Company's consolidated results of operations, financial position or cash flows.

SFAS 150

        In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The changes are intended to result in a more complete representation of an entity's liabilities and equity and will, thereby, assist investors and creditors in assessing the amount, timing, and likelihood of potential future cash outflows and equity share issuances. This Statement also requires that certain obligations that could be settled by the issuance of equity, but lack other characteristics of equity, be reported as liabilities even though the obligation does not meet the definition of a liability. The requirements of SFAS 150 became effective for the Company for financial instruments entered into or modified after May 31, 2003, or at the beginning of the fourth quarter of fiscal 2003 for financial instruments entered into on or prior to May 31, 2003. The adoption of

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SFAS 150 is not expected to have a material effect on the Company's consolidated results of operations, financial position or cash flows.

3.    Goodwill and Intangible Assets

        The carrying value of goodwill as of June 30, 2003, by operating segment, was comprised of $118 million attributed to the Enterprise Communications Group, formerly named Converged Systems and Applications, and $28 million attributed to Small and Medium Business Solutions.

        Amortization expense for the Company's existing technology and other definite life intangible assets was $3 million and $9 million for the three months ended June 30, 2003 and 2002, and $9 million and $26 million for the nine months ended June 30, 2003 and 2002, respectively. Estimated amortization expense for the succeeding fiscal years as of June 30, 2003 is (i) $4 million for the remaining three months in fiscal 2003; (ii) $4 million in 2004; and (iii) $1 million in 2005. The net carrying value of intangible assets having definite lives was $9 million as of June 30, 2003 and is included in other assets.

4.    Comprehensive Income (Loss)

        Other comprehensive income is recorded as a component of accumulated other comprehensive loss within the Stockholders' Equity section of the Consolidated Balance Sheets and includes unrealized gains and losses excluded from the Consolidated Statements of Operations. These unrealized gains and losses for the three and nine months ended June 30, 2003 and 2002 consisted of foreign currency translation adjustments, which were not adjusted for income taxes as they primarily relate to indefinite investments in non-U.S. subsidiaries.

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5.    Supplementary Financial Information

Statements of Operations Information

Other Income (Expense), Net

Balance Sheet Information

Inventory

Capitalized Software Costs

        The Company's capitalized software costs, net of accumulated amortization, are included in other assets on the Consolidated Balance Sheet and amounted to $45 million and $47 million as of June 30, 2003 and September 30, 2002, respectively. Amortization expense for the Company's capitalized software costs was $6 million and $5 million for the three months ended June 30, 2003 and 2002, and $19 million and $15 million for the nine months ended June 30, 2003 and 2002, respectively.

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Cash Flow Information

Non-Cash Transactions:

6.    Business Restructuring Reserve

        The business restructuring reserve reflects the remaining balance associated with the Company's business restructuring charges recorded in fiscal 2000 through 2002. The following table summarizes the status of the Company's business restructuring reserve as of and for the nine months ended June 30, 2003:

        In the second quarter of fiscal 2003, the Company recorded a reversal of $17 million primarily attributable to higher employee attrition than originally anticipated and more favorable than expected real estate lease termination costs.

        The charges for employee separation costs in fiscal 2002 were recorded in connection with the elimination of approximately 4,240 management and union-represented employee positions worldwide. This workforce reduction has been substantially completed and the remaining employees are largely expected to depart the Company by the end of fiscal 2003. The workforce reductions associated with the business restructuring activities in fiscal 2001 and 2000 have been completed. Payments on lease termination obligations are related to vacated real estate facilities and will be substantially completed by 2011.

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7.    Long-Term Debt and Derivative Financial Instruments

        Long-term debt outstanding consisted of the following:

(1)

As of June 30, 2003, the Senior Secured Notes include $17 million representing the unamortized deferred gain related to the termination in December 2002 of the Company's interest rate swap agreements. Upon termination of the agreements, the Company received cash proceeds of $19 million representing a deferred gain, which is being amortized as a reduction to interest expense over the remaining term of the Senior Secured Notes.

(2)

As of September 30, 2002, the Senior Secured Notes include $22 million representing the corresponding increase of the hedged portion of the debt attributable to the interest rate swap agreements.

LYONs Convertible Debt

        In December 2002, the Company, together with the Warburg Pincus Equity Partners L.P. and affiliated investment funds (the "Warburg Entities"), commenced an exchange offer to purchase up to approximately $661 million aggregate principal amount at maturity, or 70%, of the Company's outstanding Liquid Yield Option™ Notes due 2021 ("LYONs") (the "Exchange Offer"). Under the terms of the Exchange Offer, holders of LYONs could elect to receive, for each $1,000 aggregate principal amount at maturity of LYONs exchanged, either (i) $389.61 in cash (the "Cash Consideration") or (ii) a combination of $208.40 in cash plus 77 shares of the Company's common stock (the "Mixed Consideration").

        Avaya and the Warburg Entities entered into a Backstop Agreement, as amended (the "Backstop Agreement"), which contains the terms relating to the Warburg Entities' participation in the Exchange Offer. Under the terms of the Backstop Agreement, the Company granted the Warburg Entities series C warrants described in Note 8-Stock Compensation and Other Equity Transactions, and reduced the exercise price of 5,581,101 of the 6,724,665 series A warrants held by the Warburg Entities to $0.01 per share. The Warburg Entities exercised the 5,581,101 series A warrants and converted the LYONs they acquired in the Exchange Offer into shares of the Company's common stock, each as described below.

        In January 2003, the Exchange Offer expired and an aggregate principal amount at maturity of LYONs of $84,426,000, representing approximately 8.9% of the outstanding LYONs, or approximately $43 million in accreted value, was tendered. Of these LYONs, $84,416,000 aggregate principal amount at maturity were tendered for the Mixed Consideration and $10,000 aggregate principal amount at maturity were tendered for the Cash Consideration. In exchange for the LYONs accepted in the Exchange Offer, the Warburg Entities paid an aggregate amount of approximately $18 million in cash

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and the Company delivered 6,500,032 shares of its common stock. The Company delivered an additional 1,588,548 shares of its common stock to the Warburg Entities upon conversion of LYONs acquired by them in the Exchange Offer.

        In the second quarter of fiscal 2003, the Company recognized in the Consolidated Statement of Operations a pre-tax charge of $36 million in loss on long-term debt extinguishment, net related to the Exchange Offer. This charge reflects a $26 million loss related to the retirement of LYONs and $10 million of expenses related to (a) series C warrants issued to the Warburg Entities; (b) common stock issued to the Warburg Entities; (c) estimated transaction costs; and (d) the unamortized deferred financing costs from the original issuance of LYONs that were retired.

        In the first quarter of fiscal 2003, the Company recorded a deferred income tax valuation allowance through a non-cash income tax charge of $83 million in the Consolidated Statement of Operations. This amount increased the deferred tax asset valuation allowance to reflect the difference between the actual and expected tax gain associated with the LYONs Exchange Offer.

        During the second and third quarters of fiscal 2003, the Company repurchased $232 million aggregate principal amount at maturity of LYONs, or $119 million in accreted value, in a series of open market transactions. The Company used a total of approximately $115 million in cash to repurchase these LYONs of which $7 million has been recorded as a component of accounts payable as of June 30, 2003 since the cash settlement occurred in July 2003. The Company recognized a pre-tax gain of approximately $1 million and $2 million, net of the write-off of deferred financing costs related to the LYONs repurchased, for the three and nine months ended June 30, 2003, respectively.

        Interest expense related to the amortization of the discount on the LYONs of $4 million and $12 million was recorded for the three and nine months ended June 30, 2003, respectively. In addition, interest expense related to the amortization of deferred financing costs on the LYONs of $1 million and $3 million was recorded for the three and nine months ended June 30, 2003, respectively.

Add-On Public Offering of Senior Secured Notes

        In May 2003, the Company sold $200 million aggregate principal amount of 11¹/8% Senior Secured Notes due April 2009 ("Senior Secured Notes"), at a price of 108% of par, resulting in net proceeds of approximately $212 million, which includes approximately $2 million in accrued interest and a $16 million premium, partially offset by $6 million of issuance costs. The issuance costs, which were recorded as deferred financing costs, and premium are being amortized to interest expense over the term of the Notes. These Notes constitute a further issuance of, and form a single series with, the 11¹/8% Senior Secured Notes due April 2009 that the Company issued in the second quarter of fiscal 2002.

        Interest on the Senior Secured Notes is payable on April 1 and October 1 of each year. The Company recorded interest expense related to the Senior Secured Notes of $15 million and $40 million for the three and nine months ended June 30, 2003, respectively. In addition, the Company recorded interest expense related to the amortization of discount, premium and deferred financing costs on the Senior Secured Notes of $1 million and $2 million for the three and nine months ended June 30, 2003, respectively.

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Interest Rate Swap Agreements

        In December 2002, the Company cancelled two interest rate swap agreements under which the difference between fixed and floating rate interest amounts, calculated on a $200 million notional principal amount which correlated to a like amount of fixed rate Senior Secured Notes, was exchanged at specified intervals. The cancellation resulted in a reduction to other assets for the removal of the fair market value of the interest rate swaps and cash proceeds of $19 million representing a deferred gain, which is being recognized as a reduction to interest expense over the remaining term to maturity of the Senior Secured Notes. For the three and nine months ended June 30, 2003, the Company recognized $1 million and $2 million, respectively, as a reduction to interest expense related to this deferred gain. The unamortized balance of the deferred gain is included in long-term debt on the Consolidated Balance Sheet and amounted to $17 million as of June 30, 2003.

Credit Facility

        In April 2003, the Company and the lenders under the Company's five-year revolving credit agreement (the "Credit Facility") amended the Credit Facility to reduce the size of the facility to $250 million and amend certain covenants included in the Credit Facility. As of June 30, 2003, there were no amounts outstanding under the Credit Facility, which expires in September 2005.

        The Credit Facility contains covenants, including a requirement that the Company maintains certain financial covenants relating to a minimum amount of earnings before interest, taxes, depreciation and amortization ("EBITDA"), adjusted for certain exclusions as summarized below ("Adjusted EBITDA") and a minimum ratio of Adjusted EBITDA to interest expense. The covenants permit the Company to exclude up to a certain amount of business restructuring charges and related expenses, including asset impairment charges, from the calculation of Adjusted EBITDA. The definition of Adjusted EBITDA in the Credit Facility also excludes certain other non-cash charges. The Company is permitted to exclude from the calculation of Adjusted EBITDA in the fourth quarter of fiscal 2003, an additional $63 million in business restructuring charges and related expenses in connection with the amendments described below.

        For the four quarter period ending June 30, 2003, the Company was required to maintain a minimum Adjusted EBITDA of $190 million and a ratio of Adjusted EBITDA to interest expense of 2.50 to 1. The Company was in compliance with all required covenants as of June 30, 2003.

        The amended Credit Facility requires the Company to maintain a ratio of consolidated Adjusted EBITDA to interest expense of:

•

2.70 to 1 for the four quarter period ending September 30, 2003;



•

2.90 to 1 for the four quarter period ending December 31, 2003;



•

3.20 to 1 for the four quarter period ending March 31, 2004;



•

3.50 to 1 for the four quarter period ending June 30, 2004; and



•

4.00 to 1 for each four quarter period thereafter.

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        If the Company's Connectivity Solutions segment is sold, for purposes of these calculations, the ratios above will be reduced (i) by 0.20 for the fiscal quarter in which the Company's Connectivity Solutions segment is sold, (ii) by 0.40 for the fiscal quarter following the fiscal quarter referred to in (i) above, (iii) by 0.60 for the fiscal quarter following the fiscal quarter referred to in (ii) above and (iv) by 0.80 for each fiscal quarter thereafter.

        The Company is required to maintain consolidated Adjusted EBITDA of:

•

$220 million for the four quarter period ending September 30, 2003;



•

$230 million for the four quarter period ending December 31, 2003;



•

$270 million for the four quarter period ending March 31, 2004;



•

$300 million for the four quarter period ending June 30, 2004;



•

$330 million for the four quarter period ending September 30, 2004; and



•

$350 million for each four quarter period thereafter.

        If the Company's Connectivity Solutions segment is sold, for purposes of these calculations, the minimum Adjusted EBITDA amounts will be reduced (i) by $15 million for the fiscal quarter in which the Company's Connectivity Solutions segment is sold, (ii) by $30 million for the fiscal quarter following the fiscal quarter referred to in (i) above, (iii) by $45 million for the fiscal quarter following the fiscal quarter referred to in (ii) above and (iv) by $60 million for each fiscal quarter thereafter.

        Prior to the amendment, the Company's Credit Facility prohibited the Company from using more than $100 million in cash to redeem or repurchase the LYONs. However, under the amended Credit Facility, this limitation may be increased, up to a maximum of $400 million, by an amount equal to 100% of the net cash proceeds of equity and debt issuances in the capital markets, including the May 2003 issuance of the Senior Secured Notes, and 50% of the net cash proceeds from the sale of the Company's Connectivity Solutions segment and its corporate aircraft. As of August 8, 2003, the Company has used approximately $156 million in cash to repurchase LYONs and, as a result of the amendments to the Credit Facility and the May 2003 public offering of Senior Secured Notes, has the ability under the amended Credit Facility to use an additional $154 million in cash to repurchase LYONs.

        The amended Credit Facility also requires the Company to maintain, as of each day in the period commencing September 30, 2004 until the later of (a) the date that the put obligation under the LYONs is satisfied and (b) the date upon which the Company delivers to the lenders under the amended Credit Facility a certificate certifying the Company's compliance with the covenants included in the amended Credit Facility for the fiscal quarter ended September 30, 2004, liquidity of not less than $300 million on a pro forma basis as if the put obligation under the LYONs had been satisfied as of such day. Holders of LYONs may require the Company to purchase all or a portion of their LYONs on October 31, 2004, 2006 and 2011 at a price per LYON of $542.95, $583.40 and $698.20, respectively. For purposes of this calculation, liquidity is defined as the sum of the unused commitments under the Company's amended Credit Facility plus domestic cash, to the extent free and clear of any liens other than liens under the collateral arrangements securing the Company's obligations to the lenders under

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the amended Credit Facility, less its obligations under its Senior Secured Notes and the put obligation related to the LYONs had it been satisfied as of such day.

        The Credit Facility was also amended to permit the Company to issue up to $200 million in debt provided such debt is junior to the amended Credit Facility and matures not less than 90 days after the amended Credit Facility matures in September 2005. Pursuant to this provision of the amended Credit Facility, in May 2003, the Company issued $200 million aggregate principal amount of Senior Secured Notes as described above. In addition, the Credit Facility was amended to reduce the Company's ability to incur other secured and unsecured debt, make investments, and to prohibit the Company from prepaying long-term debt other than the LYONs.

8.    Stock Compensation and Other Equity Transactions

Stock Options and Restricted Stock Units Grants

        During the nine months ended June 30, 2003, the Company granted to eligible employees approximately 13.7 million stock options at a weighted average exercise price of $3.09 per option and 5.8 million restricted stock units at a weighted average market price of $3.01 per unit.

Warrants to Purchase Common Stock

        In consideration of their agreement to participate in the LYONs Exchange Offer, in December 2002, the Company granted the Warburg Entities series C warrants that have a four-year term and are exercisable for an aggregate of 7,355,824 shares of Avaya common stock at an exercise price of $3.50 per share. The fair value of these warrants was estimated to be $5 million using a Black-Scholes securities-pricing model and has been included in additional paid-in capital. During the second quarter of fiscal 2003, upon completion of the Exchange Offer, the Company recognized the cost of these warrants as a commitment fee and recorded the amount in loss on long-term debt extinguishment, net.

        Following completion of the Exchange Offer, in January 2003 the Warburg Entities exercised 5,581,101 of the series A warrants for an aggregate cash consideration of $55,811.

        As of June 30, 2003, the Warburg Entities hold warrants to purchase the following additional shares of the Company's common stock:

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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

9.    Earnings (Loss) Per Share of Common Stock

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

(1)

The increase in diluted shares for the period ending June 30, 2003 primarily represents the average number of shares the Company would expect to issue if it were required to purchase LYONs currently outstanding on the initial October 31, 2004 put date.

(2)

These securities have been excluded from the diluted earnings (loss) per common share calculation either because the respective exercise prices are greater than the average market value of the underlying stock, or their inclusion would have been antidilutive.

(3)

These securities have been excluded from the diluted earnings (loss) per common share calculation due to the assumption that this portion of the debt would have been settled in cash.

10.    Operating Segments

        During the third quarter of fiscal 2003, the Company changed the name of the Converged Systems and Applications segment to the Enterprise Communications Group. The Company reports its operations in four segments: (1) Enterprise Communications Group ("ECG"), (2) Small and Medium Business Solutions ("SMBS"), (3) Services and (4) Connectivity Solutions. The ECG segment is focused on large enterprises and includes converged systems products, unified communications applications and customer relationship management offerings. The SMBS segment develops, markets and sells converged

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and traditional voice communications products for small and mid-sized enterprises and includes all key and Internet Protocol telephony systems and applications, as well as messaging products. The Services segment offers a comprehensive portfolio of services that enable customers to plan, design, build and manage their communications networks. The Connectivity Solutions segment provides structured cabling systems and electronic cabinets to its customers.

        The segments are managed as four functional businesses and, as a result, include certain allocated costs and expenses of shared services, such as information technology, human resources, legal and finance. Costs remaining in the other unallocated category represent expenses that are not identified with the operating segments and include costs incurred to maintain vacant real estate facilities. Intersegment sales approximate fair market value and are not significant.

Reportable Segments

        Summarized financial information relating to the Company's reportable segments is shown in the following table:

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Geographic Information

        Financial information relating to the Company's revenue by geographic area was as follows:

(1)

Revenue is attributed to geographic areas based on the location of customers.

Concentrations

        Following the Company's sale in March 2000 of its primary distribution function for voice communications systems for small and mid-sized enterprises to Expanets, Inc. ("Expanets"), the Company agreed in May 2001 to provide a $125 million short-term secured line of credit to Expanets. The line of credit applied to certain unpaid amounts and outstanding receivables due to Avaya by Expanets and was secured by a first priority lien on Expanets' receivables and inventory. In March 2002, the Company entered into an amended Dealer Credit Agreement with Expanets and its parent company, NorthWestern Corporation ("NorthWestern") to provide for installment payments under the line of credit with the final balance due to Avaya on December 31, 2002.

        The Company had been engaged in discussions with Expanets regarding certain operating issues and customer data and billing management services related to the March 2000 sale to Expanets. Although these issues were unrelated to Expanets' and NorthWestern's obligations under the Dealer Credit Agreement, the Company, because of the importance of its relationship with Expanets and the customer base served by Expanets, agreed in December 2002 to extend the term of the final installment payment of $27 million to February 2003.

        In March 2003, the Company entered into a restructured agreement with Expanets and NorthWestern to resolve matters related to the March 2000 sale to Expanets and to set payment terms for the remaining amounts due to Avaya under the line of credit. In exchange for the companies providing mutual general releases of liability concerning the outstanding operational issues, the parties agreed to, among other things, the following:

•

The Company canceled the notes receivable and surrendered the preferred equity interests delivered to Avaya by Expanets in March 2000 in partial payment of the purchase price for the sale of the distribution function to Expanets. The Company did not record a charge in its Consolidated Statement of Operations during the second quarter of fiscal 2003 related to this transaction because no value was ascribed to these securities in the Company's financial statements. The Company had written off the value of these securities at the time of the sale primarily because the notes were by their terms subordinated to Expanets' senior debt and collection of the notes was unlikely, and the preferred equity was junior to Expanets' senior debt and the notes receivable, as well as Expanets' other series of preferred equity.

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•

The Company converted $27 million owed to Avaya by Expanets under the line of credit, initially due in December 2002, to a term loan, which will be repaid in three equal installments of $9 million on January 1, April 1, and July 1, 2004. As of June 30, 2003, this note receivable is recorded as $18 million in other current assets and $9 million in other assets in the Consolidated Balance Sheet. Expanets will continue to pay interest on this amount on a monthly basis at the agreed upon annual rate of 15%.



•

If Expanets defaults on the installments under the extended payment terms, the Company retains the right to require NorthWestern to purchase an interest in the term loan from Avaya in an amount equal to the outstanding balance on the term loan at the time of default. A default by NorthWestern of its obligations could, at Avaya's election, be declared a default under the Expanets Dealer Credit Agreement, resulting in a termination of certain non-competition provisions contained in such agreement and permitting Avaya to sell products and services to certain of Expanets' customers.

        Additionally, as of June 30, 2003 the Company recorded $22 million in receivables representing trade receivables due from Expanets on recurring sales of products and maintenance services.

        In April 2003, NorthWestern announced that it expected to record charges in its December 31, 2002 financial statements related to, among other things, asset impairments and deferred tax valuation allowances related to Expanets. In addition, NorthWestern announced that it filed for an extension to file its Annual Report on Form 10-K in order to take certain actions related to identified deficiencies in internal controls. In its Annual Report on Form 10-K, NorthWestern disclosed that its independent auditors had advised its Audit Committee that these internal control deficiencies constituted reportable conditions and, collectively, a material weakness as defined in Statement of Auditing Standards No. 60. In its Quarterly Report on Form 10-Q for the quarter ended March 31, 2003, NorthWestern disclosed that the SEC is conducting an informal inquiry relating to the restatements of its financial statements and other accounting and reporting matters.

        In June 2003, Expanets entered into a $25 million credit facility with a third party financial institution. As required by the terms of the March 2003 agreements with Expanets, the Company agreed to subordinate its rights in the collateral securing the $27 million term loan from Expanets to the third party financial institution. Under the subordination agreement, the Company may not take action with regard to the collateral until Expanets' obligations under the senior credit facility are paid in full. In addition, if a payment default has occurred under the senior credit facility at the time a payment is due to the Company under the term loan, Expanets is prohibited under the subordination agreement from making such payment on the term loan until the payment default under the senior credit facility has been cured or waived in writing by the third party financial institution. If a covenant default has occurred under the senior credit facility at the time a payment is due to the Company under the term loan, Expanets is prohibited under the subordination agreement from making such payment on the term loan until the earlier of the date the covenant default under the senior credit facility has been cured or waived in writing by the third party financial institution and 180 days from the date the notice of default is delivered to the Company. The subordination agreement does not affect the Company's rights with regard to NorthWestern, including the Company's rights in the event of a default by NorthWestern under the credit agreement governing the term loan.

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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

        There can be no assurance that Expanets or NorthWestern will be able to comply with the terms of the restructured agreement. In the event Expanets or NorthWestern are unable to comply with the terms of the restructured agreement and a default occurs, the remedies available to Avaya under such agreement may be insufficient to satisfy in full all of Expanets' obligations to the Company.

11.    Related Party Transactions

        The Warburg Entities are substantial stockholders of Avaya and are considered affiliates. As of June 30, 2003, the Warburg Entities hold approximately 60 million shares of Avaya common stock, which represents approximately 15.8% of the Company's outstanding common stock, and warrants to purchase approximately 14 million additional shares of Avaya common stock.

        In connection with their agreement to participate in the LYONs Exchange Offer, the Company granted the Warburg Entities the right to designate one individual for election to Avaya's board of directors for so long as they hold a specified number of shares of the Company's common stock. In accordance with these provisions, in January 2003, Joseph P. Landy, Co-President of Warburg Pincus LLC, was appointed to Avaya's board of directors.

12.    Commitments and Contingencies

Legal Proceedings

        From time to time, the Company is involved in legal proceedings arising in the ordinary course of business. Other than as described below, the Company believes there is no litigation pending against it that could have, individually or in the aggregate, a material adverse effect on its financial position, results of operations or cash flows.

Year 2000 Actions

        Three separate purported class action lawsuits are pending against Lucent Technologies, Inc. ("Lucent"), the Company's former parent, one in state court in West Virginia, one in federal court in the Southern District of New York and another in federal court in the Southern District of California. The case in New York was filed in January 1999 and, after being dismissed, was refiled in September 2000. The case in West Virginia was filed in April 1999 and the case in California was filed in June 1999, and amended in 2000 to include Avaya as a defendant. The Company may also be named a party to the other actions and, in any event, has assumed the obligations of Lucent for all of these cases under the Contribution and Distribution Agreement, as described in "Transactions with Lucent," between the Company and Lucent. All three actions are based upon claims that Lucent sold products that were not Year 2000 compliant, meaning that the products were designed and developed without considering the possible impact of the change in the calendar from December 31, 1999 to January 1, 2000. The complaints allege that the sale of these products violated statutory consumer protection laws and constituted breaches of implied warranties.

        A class has been certified in the West Virginia state court matter. The certified class in the West Virginia matter includes those persons or entities that purchased, leased or financed the products in question. In addition, the court also certified as a subclass all class members who had service protection plans or other service or extended warranty contracts with Lucent in effect as of April 1, 1998, as to which Lucent failed to offer a free Year 2000-compliant solution. The Fourth Circuit Court of Appeals

21

recently denied the defendant's attempt to have the Federal District Court in West Virginia retain jurisdiction in this matter. This matter is now in West Virginia state court. The federal court in the New York action has issued a decision and order denying class certification, dismissing all but certain fraud claims by one representative plaintiff. No class claims remain in this case at this time. The federal court in the California action has issued an opinion and order granting class certification. The class includes any entities that purchased or leased certain products on or after January 1, 1990, excluding those entities who did not have a New Jersey choice of law provision in their contracts and those who did not purchase equipment directly from defendants. The federal court in the California action has issued an order staying the action pending the outcome of the West Virginia matter. The complaints seek, among other remedies, compensatory damages, punitive damages and counsel fees in amounts that have not yet been specified. At this time, the Company cannot determine whether the outcome of these actions will have a material adverse effect on its financial position, results of operations or cash flows. These cases have required in the past, and may require in the future, expenditure of significant legal costs related to their defense.

Lucent Securities Litigation

        In November 2000, three purported class actions were filed against Lucent in the Federal District Court for the District of New Jersey alleging violations of the federal securities laws as a result of the facts disclosed in Lucent's announcement on November 21, 2000 that it had identified a revenue recognition issue affecting its financial results for the fourth quarter of fiscal 2000. The actions purport to be filed on behalf of purchasers of Lucent common stock during the period from October 10, 2000 (the date Lucent originally reported these financial results) through November 21, 2000.

        The above actions have been consolidated with other purported class actions filed against Lucent on behalf of its stockholders in January 2000 and are pending in the Federal District Court for the District of New Jersey. The consolidated cases were initially filed on behalf of stockholders of Lucent who bought Lucent common stock between October 26, 1999 and January 6, 2000, but the consolidated complaint was amended to include purported class members who purchased Lucent common stock up to December 20, 2000. A class has not yet been certified in the consolidated actions. The plaintiffs in all these stockholder class actions seek compensatory damages plus interest and attorneys' fees.

        In March 2003, Lucent announced that it had entered into a $420 million settlement of all pending shareholder and related litigation. Certain cases which are the subject of the settlement are shared contingent liabilities under the Contribution and Distribution Agreement and accordingly, the Company is responsible for 10% of the liabilities attributable to those cases, including 10% of the legal costs associated with the portion of the litigation for which the Company shares liability. The amount of the Company's portion of this liability has not yet been finally determined. However, in the second quarter of fiscal 2003, the Company recorded a charge of $25 million representing the Company's estimate of its liability in this matter. Upon settlement, the amount of this liability will be adjusted to reflect the Company's actual obligation in this matter. The liability may be settled, at the Company's option, in any combination of cash and the Company's equity securities. See "Guarantees of Indebtedness-Transactions with Lucent" for a discussion of the maximum amount of the Company's liability in this matter.

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Licensing Arbitration

        In March 2001, Voxem, Inc. made formal demand for alleged royalty payments which it claims the Company owes as a result of a contract between it and the Company's predecessors, initially entered into in 1995, and renewed in 1997. Voxem claims that the Company owes royalty payments for software integrated into certain of the Company's products. Voxem also alleges that the Company has breached the governing contract by not honoring a right of first refusal related to development of fax software for next generation products. In May 2003, the arbitrator awarded Voxem approximately $650,000 in total damages, including interest and certain legal costs.

Commissions Arbitration Demand

        In July 2002, Communications Development Corporation, a British Virgin Islands corporation, made formal demand for arbitration for alleged unpaid commissions in an amount in excess of $10 million, stemming from the sale of products from the Company's businesses that were formerly owned by Lucent involving the Ministry of Russian Railways. The plaintiff alleges that as a result of agreements entered into between the plaintiff and the Company, it is owed commissions on sales by the Company to the Ministry of Russian Railways on a continuing basis. The Company believes that the agreements relating to their claim have expired or do not apply to the products in question. As the sales of products continue, Communications Development Corporation may likely increase its commission demand. The claimant recently filed its arbitration demand with the American Arbitration Association.

Lucent Consumer Products Class Actions

        In several class action cases (the first of which was filed on June 24, 1996), plaintiffs claim that AT&T and Lucent engaged in fraud and deceit in continuing to lease residential telephones to consumers without adequate notice that the consumers would pay well in excess of the purchase price of a telephone by continuing to lease. The cases were removed and consolidated in federal court in Alabama, and were subsequently remanded to their respective state courts (Illinois, Alabama, New Jersey, New York and California). In July 2001, the Illinois state court certified a nationwide class of plaintiffs. The case in Illinois was scheduled for trial on August 5, 2002. Prior to commencement of trial, however, the Company was advised that the parties agreed to a settlement of the claims on a class-wide basis. The settlement was approved by the court on November 4, 2002. Claims from Class members were required to be filed on or about January 15, 2003. The amount of Avaya's portion of the liability has not yet been determined.

        Any liability incurred by Lucent in connection with these class action cases will be considered an exclusive Lucent liability under the Contribution and Distribution Agreement between Lucent and Avaya and, as a result, Avaya would be responsible for 10% of any such liability in excess of $50 million.

Environmental Matters

        The Company is subject to a wide range of 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 is subject to certain provisions of environmental laws, particularly in the

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United States, governing the cleanup of soil and groundwater contamination. Such provisions impose liability for the costs of investigating and remediating releases of hazardous materials at currently or formerly owned or operated sites. In certain circumstances, this liability may also include the cost of cleaning up historical contamination, whether or not caused by the Company. The Company is currently conducting investigation and/or cleanup of known contamination at approximately seven of its facilities either voluntarily or pursuant to government directives. None of the sites is reasonably likely to generate environmental costs that will be individually material. There are no known third parties who may be responsible for investigation and/or cleanup at these sites and therefore, for purposes of assessing the adequacy of financial reserves for these liabilities, the Company has not assumed that it will recover amounts from any third party, including under any insurance coverage or indemnification arrangement. The Company does not separately track recurring costs of managing hazardous substances and pollutants in ongoing operations, but does not believe them to be material.

        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. Reserves for estimated losses from environmental matters are undiscounted and consist primarily of estimated remediation and monitoring costs and are, depending on the site, based primarily upon internal or third-party environmental studies and the extent of contamination and the type of required cleanup. The Company is not aware of, and has not included in reserves any provision for, any unasserted environmental claims.

        The reliability and precision of estimates of the Company's environmental costs may be affected by a variety of factors, including whether the remediation treatment will be effective, contamination sources have been accurately identified and assumptions regarding the movement of contaminants are accurate. In addition, estimates of environmental costs may be affected by changes in law and regulation, including the willingness of regulatory authorities to conclude that remediation and/or monitoring performed by the Company is adequate.

        The Company assesses the adequacy of environmental reserves on a quarterly basis. For the three and nine months ended June 30, 2003 and 2002, respectively, no amounts were charged to the Statements of Operations for environmental costs as reserves were deemed to be adequate. Expenditures for environmental for the three and nine months ended June 30, 2003 were not material to the Company's financial position, results of operations or cash flows. Payment for the environmental costs covered by the reserves may be made over a 30-year period. Although the Company believes that its current reserves are adequate to cover known environmental liabilities, due to the uncertainties described above, there can be no assurance that the actual amount of environmental liabilities will not exceed the amount of reserves for such matters or will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.

Product Warranties

        The Company recognizes a liability for the estimated costs that may be incurred to remedy certain deficiencies of quality or performance of Avaya products. These product warranties extend over a specified period of time generally ranging up to one year from the date of sale depending upon the product subject to the warranty. The Company accrues a provision for estimated future warranty costs based upon the historical relationship of warranty claims to sales. The Company periodically reviews the adequacy of its product warranties and adjusts, if necessary, the warranty percentage and accrued

24

warranty reserve, which is included in other current liabilities in the Consolidated Balance Sheets, for actual experience.

        The following table reconciles the changes in the Company's product warranty reserve as of and for the nine months ended June 30, 2003:

Guarantees of Indebtedness

Irrevocable Letters of Credit and Other Arrangements

        The Company has entered into several uncommitted credit facilities totaling $44 million and other arrangements similar to irrevocable letters of credit that vary in term, of which an aggregate of $32 million in irrevocable letters of credit and other arrangements were outstanding as of June 30, 2003. Letters of credit are purchased guarantees that ensure the Company's performance or payment to third parties in accordance with specified terms and conditions.

Purchase Commitments and Termination Fees

        The Company has commitment contracts with certain suppliers in which Avaya is obligated to purchase a specified amount of inventory based on its forecasts, or pay a charge in the event the Company does not meet its designated purchase commitments. Additionally, certain agreements call for an early termination fee, obligating the Company to make a payment to the supplier. As of June 30, 2003, the maximum potential payment under these commitments was approximately $82 million, of which the Company recorded $3 million in other current liabilities and $5 million in other liabilities.

Product Financing Arrangements

        Avaya sells products to various resellers that may obtain financing from certain unaffiliated third party lending institutions.

        For the Company's U.S. product financing arrangement with resellers, in the event the lending institution repossesses the reseller's inventory of Avaya products, Avaya is obligated under certain circumstances to repurchase such inventory from the lending institution. The Company's obligation to repurchase inventory from the lending institution terminates 180 days from the date of invoicing by Avaya to the reseller. The repurchase amount is equal to the price originally paid to Avaya by the lending institution for the inventory. During the third quarter of fiscal 2003, one of the resellers that previously participated in this type of arrangement established a direct line of credit with the Company. The remaining reseller has financed inventory purchases under this agreement of approximately $35 million as of June 30, 2003. There have not been any repurchases made by Avaya since the Company entered into this agreement in March 2001. The Company has estimated the fair value of this guarantee as of June 30, 2003 and has adequately provided for this guarantee in its financial statements

25

at June 30, 2003. The fair value of the guarantee is not significant. There can be no assurance that the Company will not be obligated to repurchase inventory under this arrangement in the future.

        For the Company's product financing arrangement with resellers outside the U.S., in the event participating resellers default on their payment obligation to the lending institution, the Company is obligated under certain circumstances to guarantee repayment to the lending institution. The repayment amount fluctuates with the level of product financing activity. The guarantee repayment amount reported to the Company from the lending institution was approximately $17 million as of June 30, 2003. Avaya reviews and sets the maximum credit limit for each reseller participating in this financing arrangement. There have not been any guarantee repayments by Avaya since the Company entered in this arrangement in October 2000. The Company has estimated the fair value of this guarantee as of June 30, 2003 and has adequately provided for this guarantee in its financial statements at June 30, 2003. The fair value of the guarantee is not significant. There can be no assurance that the Company will not be obligated to repurchase inventory under this arrangement in the future.

Credit Facility Indemnification

        In connection with its obligations under the amended Credit Facility described in Note 7-Long-Tem Debt and Derivative Financial Instruments, the Company has agreed to indemnify the third party lending institutions for costs incurred by the institutions related to changes in tax law or other legal requirements. While there have been 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 indemnify the lenders under this arrangement in the future.

Transactions with Lucent

        In connection with the Company's spin-off from Lucent in September 2000, the Company and Lucent executed and delivered the Contribution and Distribution Agreement and certain related agreements.

        Pursuant to the Contribution and Distribution Agreement, Lucent contributed to the Company substantially all of the assets, liabilities and operations associated with its enterprise networking businesses (the "Company's Businesses"). The Contribution and Distribution Agreement, among other things, provides that, in general, the Company will indemnify Lucent for all liabilities including certain pre-Distribution tax obligations of Lucent relating to the Company's Businesses and all contingent liabilities primarily relating to the Company's Businesses or otherwise assigned to the Company. In addition, the Contribution and Distribution Agreement provides that certain contingent liabilities not allocated to one of the parties will be shared by Lucent and the Company in prescribed percentages. The Contribution and Distribution Agreement also provides that each party will share specified portions of contingent liabilities based upon agreed percentages related to the business of the other party that exceed $50 million. In the second quarter of fiscal 2003, the Company recorded a charge of $25 million representing its estimate of the amount of its liability associated with the settlement by Lucent of the securities litigation described previously. The Company cannot at this time determine the maximum amount of its liability for this matter, however, because it is not responsible for all of the cases which are the subject of Lucent's $420 million settlement. The maximum amount of the Company's liability will be less than $42 million, or 10% of the total Lucent settlement. The Company

26

is unable to determine the maximum potential amount of other future payments, if any, that it could be required to make under this agreement.

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

13.    Subsequent Events

Repurchases of LYONs

        In July and August 2003, the Company repurchased $78 million aggregate principal amount at maturity of LYONs, or $41 million in accreted value, in a series of open market transactions. The Company used a total of approximately $41 million in cash to repurchase these LYONs.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

        The following section should be read in conjunction with the consolidated financial statements and the notes included elsewhere in this Quarterly Report on Form 10-Q.

        Our accompanying unaudited consolidated financial statements as of June 30, 2003 and for the three and nine months ended June 30, 2003 and 2002, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and Exchange Commission for interim financial statements, and should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2002. In our opinion, the unaudited interim consolidated financial statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated. Certain prior year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year.

Forward Looking Statements

        (Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)

        Our disclosure and analysis in this report contain some forward-looking statements. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts. They use words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public.

        Any or all of our forward-looking statements in this report, and in any other public statements we make may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in the discussion below will be important in determining future results. Consequently, no forward-looking statement can be guaranteed. Actual future results may vary materially.

        Except as may be required under the federal securities laws, we undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Form 10-K and 8-K reports to the SEC. Also note that we provide the following cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our businesses. These are factors that we think could cause our actual results to differ materially from expected and historical results. Other factors besides those listed here could also adversely affect us. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.

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

•

price and product competition;



•

rapid technological development;



•

dependence on new product development;



•

the mix of our products and services;



•

customer demand for our products and services;



•

risks related to inventory, including warranty costs, obsolescence charges, excess capacity and material and labor costs;

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•

the ability to successfully integrate acquired companies;



•

the ability to attract and retain qualified employees;



•

control of costs and expenses;



•

the ability to form and implement alliances;



•

the ability to implement in a timely manner our restructuring plan;



•

the economic, political and other risks associated with international sales and operations;



•

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



•

general industry and market conditions; and



•

growth rates and general domestic and international economic conditions including interest rate and currency exchange rate fluctuations.

        The categorization of risks set forth below is meant to help you better understand the risks facing our business and are not intended to limit your consideration of the possible effects of these risks to the listed categories. Any adverse effects related to the risks discussed above may, and likely will, adversely affect many aspects of our business.

Risks Related To Our Revenue and Business Strategy

        Our revenue has declined significantly during the past several years and if business capital spending, particularly for enterprise communications products, applications and services, does not improve or deteriorates, our revenue may continue to decline and our operating results may be adversely affected.

        Our revenue for the quarter ended June 30, 2003 was $1,072 million, a decrease of 12.1%, or $147 million, from $1,219 million for the quarter ended June 30, 2002, and a sequential decrease of 0.8%, or $9 million, from $1,081 million for the quarter ended March 31, 2003, and an increase of 0.5%, or $5 million, from $1,067 million for the quarter ended December 31, 2002.

        Our operating results are significantly affected by the impact of economic conditions on the willingness of enterprises to make capital investments, particularly in enterprise communications technology and related services. Although general economic conditions have shown some signs of improvement recently, we have seen a continued decline in spending on enterprise communications technology and services by our customers. We believe that enterprises continue to be concerned about their ability to increase revenue and thereby increase their profitability. Accordingly, they have tried to maintain or improve profitability through cost reduction and reduced capital spending. Because we do not believe that enterprise communications spending will improve significantly in the near term, we expect continued pressure on our ability to generate revenue.

        To the extent that enterprise communications spending does not improve or deteriorates, our revenue and operating results will continue to be adversely affected and we may not be able to comply with the financial covenants included in our credit agreement.

        Revenue generated by our traditional business, enterprise voice communications systems, has been declining for the last several years and if we do not successfully implement our strategy to expand our sales in market segments with higher growth rates, our revenue and operating results may continue to be adversely affected.

        We have been experiencing declines in revenue from our traditional business, enterprise voice communications systems. We expect, based on various industry reports, a low growth rate or no growth in the future in the market segments for these traditional systems. We are implementing a strategy to capitalize on the higher growth opportunities in our market, including converged voice and data network products, customer relationship management applications and unified communication

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applications. This strategy requires us to make a significant change in the direction and strategy of our company to focus on the development and sales of these products and applications.

        Our traditional enterprise voice communications systems and the advanced communications products and applications described above are a part of our Enterprise Communications Group and Small and Medium Business Solutions segments. If we are unsuccessful in implementing our strategy, the contribution to our results from these segments may decline, reducing our overall operating results and thereby requiring a greater need for external capital resources. In addition, our Services segment may be adversely affected to the extent that Services revenue are related to sales of these products and applications.

        We are significantly changing our focus in order to concentrate on the development and marketing of advanced communications products and applications, including converged voice and data network products, and this change in focus may not be successful or may adversely affect our business.

        We are making a significant change in the direction and strategy of our company to focus on the development and sales of converged voice and data networks and other advanced communications products and applications. In order to implement this change, we must:

•

retrain our sales staff to sell new types of products, applications and services and improve our marketing of such products, applications and services;



•

retrain our Services employees to service the new products and applications;



•

develop relationships with new types of distribution partners;



•

research and develop more converged voice and data products and products and applications using communications media other than voice traffic, which has historically been our core area of expertise;



•

build credibility among customers that we are capable of delivering advanced communications products and applications beyond our historic product lines; and



•

expand our current customer base by selling our advanced communications products and applications to enterprises who have not previously purchased our products and applications.

        If we do not successfully implement this change in focus, our operating results may be adversely affected. However, even if we successfully address these challenges, our operating results may still be adversely affected if the market opportunity for advanced communications products and applications, including converged voice and data network products, does not develop in the ways that we anticipate. Because this market opportunity is in its early stages, we cannot predict whether:

•

the demand for advanced communications products and applications, including converged voice and data products, will grow as fast as we anticipate;



•

new technologies will cause the market to evolve in a manner different than we expect; or



•

we will be able to obtain a leadership or profitable position as this opportunity develops.

Risks Related To Our Liquidity And Capital Resources

We may not have adequate or cost-effective liquidity or capital resources.

        Our cash needs include making payments on and refinancing our indebtedness and funding working capital, capital expenditures, strategic acquisitions, business restructuring charges and related expenses, employee benefit obligations and for general corporate purposes. Our ability to satisfy our cash needs depends on our ability to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control, including the risks described in this Form 10-Q.

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        Our ability to generate cash from operations is affected by the terms of our credit agreement, the indenture governing our Liquid Yield Option™ Notes due 2021, or LYONs, and the indenture governing our 11¹/8% Senior Secured Notes due April 2009, or senior secured notes. These instruments impose, and any future indebtedness may impose, various restrictions and covenants, including financial covenants, that may limit our ability to respond to market conditions, provide for unanticipated capital investments, make strategic acquisitions or take advantage of business opportunities.

        If we do not generate sufficient cash from operations, we will need to access the financial markets. External financing may not be available to us on acceptable terms or at all. Under the terms of any external financing, we may incur higher than expected financing expenses, and become subject to additional restrictions and covenants. In addition, our ability to obtain external financing is affected by the terms of our debt agreements. Our existing debt agreements include covenants that limit our ability to incur additional indebtedness. In addition, our credit agreement requires us to comply with certain financial covenants. In February 2002, September 2002 and April 2003, we amended our credit agreement in order to ensure our compliance with the financial covenants. If we are unable to comply with our financial covenants and cannot amend or waive those covenants, an event of default under our credit agreement would occur. If a default occurs, the lenders under our credit agreement could accelerate the maturity of our debt obligations and terminate their commitments to lend to us. If such a default occurs when our debt obligations under the credit agreement exceed $100 million, our debt obligations in respect of the LYONs and the senior secured notes could be accelerated. Currently there are no funds drawn under our credit agreement.

        Our ability to obtain external financing and, in particular, debt financing, is also affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. Our corporate credit is currently rated B+ and our long-term senior unsecured debt is currently rated B by Standard & Poor's, each with a stable outlook, and our long-term senior unsecured debt is currently rated B3 by Moody's with a negative outlook. Any increase in our level of indebtedness or deterioration of our operating results may cause a further reduction in our current debt ratings. Any downgrade of our credit rating, among other factors, could impair our ability to secure additional financing on acceptable terms, and we cannot assure you that we will be successful in raising any new financing on acceptable terms.

        Our substantial amount of debt could limit our ability to obtain additional financing, limit our ability to react to changes in business conditions and require us to divert financial resources from investments in our business to servicing our debt.

        We have a substantial amount of debt. At June 30, 2003, we had approximately $993 million of debt outstanding on a consolidated basis and $250 million available under our credit agreement.

        Our substantial amount of debt and other obligations could have important consequences to you. For example, it could:

•

increase our vulnerability to general adverse economic and industry conditions;



•

limit our ability to obtain additional financing for future working capital, capital expenditures, acquisitions and other general corporate requirements;



•

increase our vulnerability to interest rate fluctuations because our credit agreement provides for interest at variable rates;



•

require us to dedicate a substantial portion of our cash flow from operations to payments on our debt and other obligations thereby reducing the availability of our cash flow from operations for other purposes;



•

limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and

31

•

place us at a competitive disadvantage compared to our competitors that have less debt.

        The agreements governing our debt limit, but do not prohibit, us from incurring additional debt, and we may incur a significant amount of additional debt in the future. If new debt is added to our current debt levels, these related risks could increase.

        Our ability to make scheduled payments on or to refinance our debt and other obligations will depend on our financial and operating performance, which, in turn, is subject to prevailing economic conditions and to certain financial, business and other factors beyond our control. If our cash flow and capital resources are insufficient to fund our debt service and other obligations, we may be forced to reduce or delay scheduled expansion plans and capital expenditures, sell material assets or operations, obtain additional capital or restructure our debt. We cannot assure you that our operating performance, cash flow and capital resources will be sufficient to pay our debt obligations when they become due. In the event that we are required to dispose of material assets or operations or restructure our debt or other obligations, we cannot assure you as to the terms of any such transactions or how soon any such transaction could be completed.

        The value of the assets in our pension plans has decreased significantly and, as a result, we will likely incur additional expense and funding obligations that may have an adverse effect on our financial position, results of operations and cash flows.

        The decline in the global equity markets and interest rates over the past few years has resulted in a decrease in the value of the assets and an increase in the value of the obligation in our pension plans. As a result, the value of the assets in our pension plans is currently less than the obligations they are intended to fund. This decline may adversely affect our related accounting results in future periods through higher pension expense, additional minimum liabilities with corresponding reductions in stockholders' equity, and increased cash funding requirements.

        The indices we use to select a discount rate for measuring the value of our pension obligations at year-end have declined during the year. Therefore, we may be required to record an additional minimum liability with a corresponding reduction to stockholders' equity as of September 30, 2003. Currently, a 25 basis point decline in the discount rate will generate an increase in our accumulated benefit obligation of approximately $80 million.

        In compliance with ERISA/IRS requirements, we have made cash contributions of $7 million to fund our pension obligations during the first nine months of fiscal 2003. We are required to fund an additional $35 million to the plans in the fourth quarter of fiscal 2003. We estimate that for fiscal 2004, we will be required to fund approximately $44 million to our pension plans.

        One of our largest dealers may not be able to satisfy in full its obligations to us under a short-term line of credit.

        As of December 31, 2002, $27 million was due to us under a short-term line of credit we provided to Expanets Inc., currently one of our largest dealers. At that time, we were engaged in discussions with Expanets regarding operational issues related to the March 2000 sale of our primary distribution function for voice communications systems for small and mid-sized enterprises to Expanets. Although these issues were unrelated to the obligations of Expanets and its parent company, NorthWestern Corporation, under the credit agreement, because of the importance to us of our relationship with Expanets and the customer base served by Expanets, in December 2002, we agreed to extend the term of the final installment payment of $27 million to February 2003.

        In March 2003, we entered into a restructured agreement with Expanets and NorthWestern regarding the operational issues. In exchange for a general release of liability from Expanets related to the operational issues, we agreed, among other things, to extend the payment term of the remaining balance under the credit agreement. The amended credit facility provides that the $27 million will be repaid in three equal $9 million installments on January 1, 2004, April 1, 2004 and July 1, 2004.

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        Outstanding amounts under the line of credit are secured by Expanets' accounts receivable and inventory. In addition, NorthWestern has effectively guaranteed Expanets' obligations under the credit agreement. A default by NorthWestern of its guarantee obligations under the credit agreement would constitute a default under Expanets' dealer agreement with Avaya, resulting in a termination of certain non-competition provisions contained in the dealer agreement and permitting us to sell products to certain of Expanets' customers.

        In April 2003, NorthWestern announced that it expected to record charges in its December 31, 2002 financial statements related to, among other things, asset impairments and deferred tax valuation allowances related to Expanets. In addition, NorthWestern announced that it filed for an extension to file its Annual Report on Form 10-K in order to take certain actions related to identified deficiencies in internal controls. In its Annual Report on Form 10-K, NorthWestern disclosed that its independent auditors had advised its Audit Committee that these internal control deficiencies constituted reportable conditions and, collectively, a material weakness as defined in Statement on Auditing Standards No. 60. In its Quarterly Report on Form 10-Q for the quarter ended March 31, 2003, NorthWestern disclosed that the SEC is conducting an informal inquiry relating to the restatements of its financial statements and other accounting and reporting matters.

        In June 2003, Expanets entered into a $25 million credit facility with a third party financial institution. As required by the terms of the March 2003 agreements with Expanets, we agreed to subordinate our rights in the collateral securing the $27 million term loan from Expanets to the third party financial institution. Under the subordination agreement, we may not take action with regard to the collateral until Expanets' obligations under the senior credit facility are paid in full. In addition, if a payment default has occurred under the senior credit facility at the time a payment is due to us under the term loan, Expanets is prohibited under the subordination agreement from making such payment on the term loan until the payment default under the senior credit facility has been cured or waived in writing by the third party financial institution. If a covenant default has occurred under the senior credit facility at the time a payment is due to us under the term loan, Expanets is prohibited under the subordination agreement from making such payment on the term loan until the earlier of the date the covenant default under the senior credit facility has been cured or waived in writing by the third party financial institution and 180 days from the date the notice of default is delivered to us. The subordination agreement does not affect our rights with regard to NorthWestern, including our rights in the event of a default by NorthWestern under the credit agreement governing the term loan.

        There can be no assurance that Expanets or NorthWestern will be able to comply with the terms of the credit facility. In the event Expanets or NorthWestern are unable to comply with the terms of the credit facility and a default occurs, the remedies available to Avaya under such agreement may be insufficient to satisfy in full all of Expanets' obligations to Avaya.

Risks Related To Our Operating Results

        Disruption of, or changes in the mix of, our product distribution model or customer base could affect our revenue and gross margin.

        If we fail to manage distribution of our products and services properly, or if our distributors' financial condition or operations weaken, our revenue and gross margin could be adversely affected. Furthermore, a change in the mix of direct sales and indirect sales could adversely affect our revenue and gross margin.

        We use a variety of channels to bring our products to customers, including direct sales, distributors, dealers, value-added resellers and system integrators. Since each distribution channel has a distinct profile, the failure to achieve the most advantageous balance in the delivery model for our products and services could adversely affect our gross margins and operating results.

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        We must manage inventory effectively, particularly with respect to sales to distributors. Distributors may increase orders during periods of product shortages, cancel orders if their inventory is too high, or delay orders in anticipation of new products. Distributors also may adjust their orders in response to the supply of our products and the products of our competitors that are available to the distributor and to seasonal fluctuations in end-user demand. If we have excess inventory, we may have to reduce our prices and write down inventory, which in turn could result in lower gross margins. In addition, if sales through indirect channels increase, this may lead to greater difficulty in forecasting the mix of our products, and to a certain degree, the timing of orders from our customers.

        Changes in effective tax rates or the recording of increased deferred tax asset valuation allowances in the future could affect our operating results.

        Our effective tax rates in the future could be adversely affected by earnings being lower or losses being higher than anticipated in countries where we have tax rates that are lower than the U.S. statutory rate and earnings being higher or losses lower than anticipated in countries where we have tax rates that are higher than the U.S. statutory tax rate, changes in our net deferred tax assets valuation allowance, or by changes in tax laws or interpretations thereof.

        For example, during fiscal 2002 our effective tax rate was adversely affected by an unfavorable geographic distribution of earnings and losses and we recorded an increase in our net deferred tax assets valuation allowance of $364 million. If the geographic distribution of our earnings and losses continues to be unfavorable in the future, our effective tax rate could be adversely affected. In addition, in the first quarter of fiscal 2003, we recorded a deferred income tax valuation allowance through a non-cash income tax charge of $83 million to reflect the difference between the actual and expected tax gain associated with our December 2002 exchange offer for a portion of the LYONs. Based on our assessment of our deferred tax assets, we determined, based on certain available tax planning strategies, that $443 million of our deferred tax assets as of June 30, 2003 will more likely than not be realized in the future and no valuation allowance is currently required for this portion of our deferred tax assets. Should we determine in the future that it is no longer more likely than not that these assets will be realized, we will be required to record an additional valuation allowance in connection with these deferred tax assets and our operating results would be adversely affected in the period such determination is made.

Risks Related To Our Operations

        We have restructured our business to respond to industry and market conditions, however, the assumptions underlying our restructuring efforts may prove to be inaccurate and we may have to restructure our business again in the future.

        In response to changes in industry and market conditions, we have restructured our business in the past and may again restructure our business in the future to achieve certain cost savings and to strategically realign our resources. We have based our restructuring plans on certain assumptions regarding the cost structure of our business and the nature, severity and duration of the current slowdown in enterprise communications technology spending which may not prove to be accurate. We will continue to assess our cost structure and restructuring efforts based on an ongoing assessment of industry conditions.

        Our restructuring initiatives may not be sufficient to meet the changes in industry and market conditions, and such conditions may continue to deteriorate or last longer than we expect. In addition, we may not be able to successfully implement our restructuring initiatives and may be required to refine, expand or extend our restructuring initiatives, which may result in additional charges. Furthermore, our workforce reductions may impair our ability to realize our current or future business objectives. Lastly, costs incurred in connection with restructuring actions may be higher than the estimated costs of such actions and/or may not lead to the anticipated cost savings. As a result, our

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restructuring efforts may not result in our return to profitability within the currently expected timeframe.

        We depend on contract manufacturers to produce most of our products and if these manufacturer are unable to fill our orders on a timely and reliable basis, we will likely be unable to deliver our products to meet customer orders or satisfy their requirements.

        We have outsourced all of the manufacturing operations related to our Enterprise Communications Group and Small and Medium Business Solutions segments. Substantially all of these operations have been outsourced to Celestica Inc. Our ability to realize the intended benefits of our manufacturing outsourcing initiative will depend on the willingness and ability of Celestica and other contract manufacturers to produce our products. We may experience significant disruption to our operations by outsourcing so much of our manufacturing. If Celestica or the other contract manufacturers terminate their relationships with us or are unable to fill our orders on a timely basis, we may be unable to deliver our products to meet our customers' orders, which could delay or decrease our revenue or otherwise have an adverse effect on our operations.

        The termination of strategic alliances or the failure to form additional strategic alliances could limit our access to customers and harm our reputation with customers.

        Our strategic alliances are important to our success because they provide us the ability to offer comprehensive advanced communications products and applications, reach a broader customer base and strengthen brand awareness. We may not be successful in creating new strategic alliances on acceptable terms or at all. In addition, most of our current strategic alliances can be terminated under various circumstances, some of which may be beyond our control. Further, our alliances are generally non-exclusive, which means our partners may develop alliances with some of our competitors. We may rely more on strategic alliances in the future, which would increase the risk to our business of losing these alliances.

        If we are unable to protect our proprietary rights, our business and future prospects may be harmed.

        Although we attempt to protect our intellectual property through patents, trademarks, trade secrets, copyrights, confidentiality and nondisclosure agreements and other measures, intellectual property is difficult to protect and these measures may not provide adequate protection for our proprietary rights. Patent filings by third parties, whether made before or after the date of our filings, could render our intellectual property less valuable. Competitors may misappropriate our intellectual property, disputes as to ownership of intellectual property may arise and our intellectual property may otherwise become known or independently developed by competitors. The failure to protect our intellectual property could seriously harm our business and future prospects because we believe that developing new products and technology that are unique to us is critical to our success. If we do not obtain sufficient international protection for our intellectual property, our competitiveness in international markets could be significantly impaired, which would limit our growth and future revenue.

        In addition, we rely on the security of our information systems, among other things, to protect our proprietary information and information of our customers. If we do not maintain adequate security procedures over our information systems, we may be susceptible to computer hacking, cyberterrorism or other unauthorized attempts by third parties to access our proprietary information or that of our customers. The failure to protect our proprietary information could seriously harm our business and future prospects or expose us to claims by our customers that we did not adequately protect their proprietary information.

Risks Related To Contingent Liabilities

        We may incur liabilities as a result of our obligations to indemnify, and to share certain liabilities with, Lucent Technologies Inc. in connection with our spin-off from Lucent in September 2000.

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        Pursuant to the contribution and distribution agreement we entered into with Lucent in connection with our spin-off from Lucent on September 30, 2000, Lucent contributed to us substantially all of the assets, liabilities and operations associated with its enterprise networking businesses and distributed all of the outstanding shares of our common stock to its stockholders. The contribution and distribution agreement, among other things, provides that, in general, we will indemnify Lucent for all liabilities including certain pre-distribution tax obligations of Lucent relating to our businesses and all contingent liabilities primarily relating to our businesses or otherwise assigned to us. In addition, the contribution and distribution agreement provides that certain contingent liabilities not directly identifiable with one of the parties will be shared in the proportion of 90% by Lucent and 10% by us. The contribution and distribution agreement also provides that contingent liabilities in excess of $50 million that are primarily related to Lucent's businesses shall be borne 90% by Lucent and 10% by us and contingent liabilities in excess of $50 million that are primarily related to our businesses shall be borne equally by the parties.

        See "Legal Proceedings" in this quarterly report on Form 10-Q for a description of certain matters involving Lucent for which we have assumed responsibility under the contribution and distribution agreement and a description of other matters for which we may be obligated to indemnify, or share the cost with, Lucent. In March 2003, Lucent announced that it had entered into a $420 million settlement of all pending shareholder and related litigation described under "Lucent Securities Litigation" in the "Legal Proceedings" section of this quarterly report on Form 10-Q. Certain cases which are the subject of the settlement are shared contingent liabilities under the contribution and distribution agreement and accordingly, we are responsible for 10% of the liabilities attributable to those cases, including 10% of the legal costs associated with the portion of the litigation for which we share liability. The amount of our portion of this liability has not yet been finally determined, however, in the second quarter of fiscal of 2003, we recorded a charge of $25 million, representing our estimate of our liability in this matter. Upon settlement, the amount of the liability will be adjusted to reflect our actual obligation in this matter.

        We cannot assure you we will not have to make other indemnification or other cost sharing payments to Lucent in connection with these matters or that Lucent will not submit a claim for indemnification or cost sharing to us in connection with any future matter. In addition, our ability to assess the impact of matters for which we may have to indemnify, or share the cost with, Lucent is made more difficult by the fact that we do not control the defense of these matters.

        We may be subject to litigation and infringement claims, which could cause us to incur significant expenses or prevent us from selling our products or services.

        We cannot assure you that others will not claim that our proprietary or licensed products, systems and software are infringing their intellectual property rights or that we do not in fact infringe those intellectual property rights. We may be unaware of intellectual property rights of others that may cover some of our technology. If someone claimed that our proprietary or licensed systems and software infringed their intellectual property rights, any resulting litigation could be costly and time consuming and would divert the attention of management and key personnel from other business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement also might require us to enter into costly royalty or license agreements. However, we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to significant damages or an injunction against use of our proprietary or licensed systems. A successful claim of patent or other intellectual property infringement against us could materially adversely affect our operating results.

        In addition, third parties may claim that a customer's use of our product's, systems or software infringes the third party's intellectual property rights. Under certain circumstances, we may be required to indemnify our customers for some of the costs and damages related to such an infringement claim.

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Any indemnification requirement could have a material adverse effect on our business and our operating results.

        If our separation from Lucent does not qualify for tax-free treatment, we could be required to pay Lucent or the Internal Revenue Service a substantial amount of money.

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

        Although any U.S. federal income taxes imposed in connection with our separation from Lucent generally would be imposed on Lucent, we could be liable for all or a portion of any taxes owed for the reasons described below. First, as part of our separation from Lucent, we and Lucent entered into a tax sharing agreement. This agreement generally allocates between Lucent and us the taxes and liabilities relating to the failure of our separation from Lucent to be tax-free. Under the tax sharing agreement, if our separation from Lucent fails to qualify as a tax-free distribution to Lucent under Section 355 of the Internal Revenue Code because of an issuance or an acquisition of our stock or an acquisition of our assets, or some other actions of ours, then we will be solely liable for any resulting taxes to Lucent.

        Second, aside from the tax sharing agreement, under U.S. federal income tax laws, we and Lucent are jointly and severally liable for Lucent's U.S. federal income taxes resulting from our separation from Lucent being taxable. This means that even if we do not have to indemnify Lucent under the tax sharing agreement, we may still be liable to the Internal Revenue Service for all or part of these taxes if Lucent fails to pay them. These liabilities of Lucent could arise from actions taken by Lucent over which we have no control, including an issuance or acquisition of stock (or acquisition of assets) of Lucent.

Overview

        We are a leading provider of communications systems, applications and services for enterprises, including businesses, government agencies and other organizations. Our product offerings include converged voice and data networks, traditional voice communication systems, customer relationship management applications, unified communications applications and structured cabling products. We support our broad customer base with comprehensive global service offerings that enable our customers to plan, design, implement and manage their communications networks. We believe our global service organization is an important consideration for customers purchasing our products and is a source of significant revenue for us, primarily from maintenance contracts.

        We offer a broad array of communications systems, applications and services that enable enterprises to communicate with their customers, suppliers, partners and employees through voice, Web, electronic mail, facsimile, Web chat sessions and other forms of communication, across an array of devices. These devices include telephones, computers, cell phones and personal digital assistants. Our broad portfolio of products includes:

•

products we have developed internally,



•

products we have obtained through acquisitions,



•

products manufactured by third parties which we resell,



•

products and software provided to us by third parties as components of our offerings, and



•

products we have developed through strategic alliances with other technology leaders.

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        Our products range from systems designed for multinational enterprises with multiple locations worldwide, thousands of employees and advanced communications requirements to systems designed for businesses with less than ten employees.

        Although our revenue has remained relatively stable over the past two fiscal quarters, it has declined significantly during the past several years. Revenue for the fiscal years ended September 30, 2000, 2001 and 2002 was $7,732 million, $6,793 million and $4,956 million, respectively, and revenue for the nine months ended June 30, 2003 was $3,220 million. The decline in revenue is attributable to, among other things, declines in the market for our traditional business, enterprise voice communications products, and the effect of general economic conditions on our customers' willingness to spend on enterprise communications technology during the last several years. The decline in revenue has contributed to our net losses for the fiscal years ended September 30, 2000, 2001 and 2002 of $375 million, $352 million and $666 million, respectively, and our net loss for the nine months ended June 30, 2003 of $154 million. The decline in revenue has also contributed to our large accumulated deficit, which was $1,336 million as of June 30, 2003. We continue to remain focused on our strategy to become increasingly more profitable by strengthening our financial position and focusing on sustainable cost and expense reduction through business restructuring and other initiatives in order to right-size our business to adapt to current market conditions.

Collective Bargaining Agreements

        We recently reached agreement on new collective bargaining agreements with the Communications Workers of America and the International Brotherhood of Electrical Workers, which have been ratified by the union membership and will be retroactive to June 1, 2003.

Business Restructuring Reserve

        The business restructuring reserve reflects the remaining balance associated with our business restructuring charges recorded in fiscal 2000 through 2002. The following table summarizes the status of our business restructuring reserve as of and for the nine months ended June 30, 2003:

        In the second quarter of fiscal 2003, we recorded a reversal of $17 million primarily attributable to higher employee attrition than originally anticipated and more favorable than expected real estate lease termination costs.

        The charges for employee separation costs in fiscal 2002 were recorded in connection with the elimination of approximately 4,240 management and union-represented employee positions worldwide. This workforce reduction has been substantially completed and the remaining employees are largely expected to depart by the end of fiscal 2003. The workforce reductions associated with the business restructuring activities in fiscal 2001 and 2000 have been completed. Payments on lease termination obligations are related to vacated real estate facilities and will be substantially completed by 2011.

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Results of Operations

        The following table sets forth certain line items from our Consolidated Statements of Operations as a percentage of revenue for the periods indicated: