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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

Quarterly Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

(Mark One)

For the quarterly period ended June 30, 2004

OR

For the transition period from              to             

Commission file number 000-30865

AVICI SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

101 Billerica Avenue

North Billerica, Massachusetts 01862

(Address of Principal Executive Offices) (Zip Code)

Registrant’s Telephone Number, Including Area Code (978) 964-2000

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

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

At August 4, 2004 12,679,441 shares of the registrant’s Common Stock, par value $0.0001 per share, were outstanding.

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AVICI SYSTEMS INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

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AVICI SYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

See accompanying notes.

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AVICI SYSTEMS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

See accompanying notes.

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AVICI SYSTEMS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(unaudited)

See accompanying notes.

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AVICI SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(all tabular amounts are in thousands except per share data)

NOTE 1. BASIS OF PRESENTATION

The financial information included herein has been prepared by Avici Systems Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and includes the accounts of Avici Systems Inc. and subsidiaries (“Avici” or the “Company”). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted in accordance with such rules and regulations. In the opinion of Avici, the accompanying consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial position at June 30, 2004 and December 31, 2003 and the operating results and cash flows for the periods ended June 30, 2004 and 2003. These consolidated financial statements and notes should be read in conjunction with Avici’s consolidated audited financial statements and notes thereto for the year ended December 31, 2003, which appear in Avici’s Annual Report on Form 10-K. The consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements as of that date.

The results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2004.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Revenue Recognition

Avici recognizes revenue from product sales upon shipment to customers, including resellers, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. Revenue from support and maintenance contracts is recognized ratably over the period of the related agreements. Revenue from installation and other services is recognized as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue.

(b) Cost of Revenue – Service

Cost of Revenue – Service includes internal costs associated with providing customer support and maintenance services. As personnel responsible for providing such services are also engaged in other activities such as sales and marketing and product development, Avici aggregates certain costs, including payroll, fringe, overhead and depreciation, and allocates a portion of those costs to Cost of Revenue – Service. Such allocation is based on an estimation of time devoted towards supporting the service programs, which Avici believes to be reasonable.

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(c) Guarantees and Product Warranties

In the normal course of business, Avici may agree to indemnify other parties, including customers, lessors and parties to other transactions with Avici, with respect to certain matters. Avici has agreed to hold these other parties harmless against losses arising from a breach of representations or covenants, or other claims made against these parties. Historically, payments made by Avici, if any, under these agreements have not had a material impact on Avici’s operating results or financial position.

Avici establishes warranty reserves for costs expected to be incurred after the sale and delivery of product for deficiencies as required under specific product warranty provisions. The warranty reserves are determined based on the actual trend of historical charges incurred over the prior twelve-month period excluding any significant or infrequent issues, which are specifically identified and reserved for. The warranty liability is established when it is probable that customers will make claims and when a reasonable estimate of costs can be made. Warranty reserves are included in “accrued other” in the accompanying consolidated balance sheets.

(d) Cash and Cash Equivalents and Marketable Securities

Avici has classified its cash equivalents and marketable securities as held-to-maturity and recorded them at amortized cost, which approximates market value. Avici considers all highly liquid investments with original maturities of three months or less at the date of acquisition to be cash equivalents. Cash and cash equivalents and marketable securities include money markets, certificates of deposit and commercial paper. Long-term marketable securities include commercial paper, corporate bonds and U.S. government obligations with remaining maturities greater than one year.

Cash, cash equivalents and marketable securities consist of the following:

(e) Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions, including certain allocations of costs, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

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(f) Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

Avici regularly reviews inventory quantities on hand and inventory commitments with suppliers and records a provision for excess and obsolete inventory based primarily on the estimated forecast of product demand for the next twelve months.

Basic and diluted net loss per common share was determined by dividing net loss available for common stockholders by the weighted average common shares outstanding during the period, less shares subject to repurchase. Basic and diluted net loss per share are the same because all outstanding common stock options have been excluded, as they are considered antidilutive.

(h) Comprehensive Income

Comprehensive income (loss) is the total of net income and all other nonowner changes in equity, including items such as unrealized gains (losses) on securities classified as available for sale, foreign currency translation adjustments and minimum pension liability adjustments. Comprehensive loss equaled net loss for all periods presented.

(i) Disclosures about Segments of an Enterprise

SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information regarding operating segments and establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions regarding resource allocation and assessing performance. Avici has determined that it conducts its operations in one segment.

(j) Stock-Based Compensation

Avici accounts for stock-based compensation for employees under APB Opinion No. 25, “Accounting for Stock Issued to Employees” and elected the disclosure-only alternative under SFAS No. 123, “Accounting for Stock Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to FASB No. 123,” which requires disclosure of the pro forma effects on earnings as if the fair-value-based method of accounting under SFAS No. 123 had been adopted, as well as certain other information.

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If compensation cost had been determined for stock option grants to employees based on the provisions of SFAS No. 123 the effect on net loss and net loss per share would have been as follows:

In January 2004, Avici granted 30,000 shares of restricted stock to certain key employees of the Company. The shares vest on a quarterly basis over four quarters ending in January 2005. The value of the shares at the date of grant was $0.4 million and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the vesting period.

In June 2004, Avici granted 120,000 shares of restricted stock to certain key employees of the Company. The shares vest five years from the grant date. Vesting may be accelerated upon the achievement of certain pre-defined performance milestones. The value of the shares at the date of grant was $1.3 million and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the five year vesting period. If the performance milestones are achieved and vesting is accelerated, the remaining unamortized value of the shares will be charged to expenses in the period in which performance is achieved.

(k) Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 (FIN No. 46), “Consolidation of Variable Interest Entities,” which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities, commonly referred to as special-purpose entities, in the first reporting period ending after December 15, 2003. It applies in the first fiscal year or interim period ending after March 15, 2004, to all other variable interest entities in which an enterprise holds a variable interest. Avici has not created, nor has an interest in a variable interest entity. As a result, the provisions of FIN No. 46 did not have a material impact on Avici’s consolidated financial position or results of operations.

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NOTE 3. STOCKHOLDERS’ EQUITY

Common Stock Warrant Discount - Product

In January 2004, in connection with three-year strategic OEM agreement with Nortel Networks, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel Networks with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel Networks achieves certain performance milestones. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and is recorded as a reduction of revenue on a systematic basis, currently straight-line, over the economic life of the agreement, which is expected to be three years. The unamortized balance of $5.3 million at June 30, 2004 is recorded as a Contract Distribution Right in the accompanying balance sheet.

In December 2000, in connection with the execution of a nonexclusive systems and services agreement with AT&T, Avici issued a warrant to purchase 212,500 shares of Avici’s common stock at a per-share exercise price of $110.92. The agreement provides AT&T with the ability, but not the obligation, to purchase equipment and services from Avici. The warrant is nonforfeitable, fully exercisable and has a term of five years from the date of issuance. The fair value of the warrant was calculated to be $9.8 million using the Black-Scholes valuation model, and was deferred as a reduction to equity and was amortized as an offset to gross revenue on a straight-line basis over the three-year term of the agreement. The fair value of the warrant was fully amortized at December 31, 2003.

NOTE 4. RESTRUCTURING AND OTHER CHARGES

Avici implemented restructuring programs during the third and fourth quarters of 2001 and during the third quarter of 2002 and recorded cumulative net charges of $2.0 million. During the six months ended June 30, 2004, Avici paid $0.4 million in lease payments associated with those charges. As of June 30, 2004, the remaining liability for future lease payments is approximately $0.1 million, which will be fully liquidated in July of 2004.

Additionally, in the third quarter of 2001, Avici recorded a charge of $17.2 million as an element of product cost of revenue to reflect a write down of inventories and inventory commitments for long lead-time items that were considered to be in excess of the then foreseeable demand. The charge included commitments to suppliers including ASICs, module components, and TSR bay components totaling approximately $9.6 million and inventory components and finished goods on hand relating to the TSR product, totaling approximately $7.6 million which were identified as in excess of the then forecasted demand for the next 12 months. Since the end of the third quarter of fiscal 2001, Avici has paid approximately $9.4 million to settle inventory commitments with suppliers, and has discarded approximately $6.3 million of the excess inventory on hand. Since 2001, Avici has utilized approximately $5.2 million of this inventory including approximately $0.8 million during the first six months of 2004. Such utilization has been recorded and disclosed primarily as a reduction of cost of revenue in the period utilized. Avici does not expect significant utilization of such inventory in the future.

NOTE 5. LITIGATION

In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated

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amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.

On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.

In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.

The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement.

The parties to the proposed settlement have drafted formal settlement documents and requested preliminary approval by the Court of the proposed settlement, including the form of the notice of the proposed settlement that will be sent to members of the proposed classes in each settling case. Certain underwriters who were named as defendants in the settling cases, and who are not parties to the proposed settlement, have filed an opposition to preliminary approval of the proposed settlement of those cases. If preliminary Court approval is obtained, notice of the proposed settlement will be sent to the class members, and a motion will then be made for final Court approval of the proposed settlement. Consummation of the proposed settlement remains conditioned on, among other things, receipt

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of both preliminary and final Court approval. If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.

The Securities and Exchange Commission (the “SEC”) is conducting several investigations relating to Qwest Communications (“Qwest”) and its business relationships. In the SEC investigation entitled “Issuers Related to Qwest,” Avici understands that it is one of eleven companies whose business dealings with Qwest are being investigated. Avici has cooperated with these investigations and there has been no wrong doing by Avici alleged in any of these investigations. How long these investigations may continue and their ultimate outcome cannot be determined.

Except for the historical information contained herein, certain matters discussed in this Report on Form 10-Q constitute forward-looking statements that involve risks and uncertainties. Avici’s actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including without limitation those discussed under the caption “Factors That May Affect Future Results” included in Avici’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 12, 2004 and elsewhere herein. Forward-looking statements include statements regarding the future or Avici’s expectations, beliefs, intentions or strategies regarding the future and may be identified by the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” and similar expressions. There may be events in the future that could affect these matters.

Overview

Avici Systems provides high-speed data networking equipment that enables telecommunications companies and Internet service providers to transmit high volumes of information across their networks.

Since our inception, we have incurred significant losses. As of June 30, 2004, we had an accumulated deficit of $381 million. Our operating activities from inception through 1999 were primarily devoted to research and development, including the design and development of our proprietary application specific integrated circuits, or ASICs, and software, and system testing our Terabit Switch Router (TSR®). Revenue was first recognized during the first quarter of 2000. Since then we have also built our administrative, marketing, sales, customer support and manufacturing organizations and developed strategic relationships with systems integrators, distributors, customers and complementary vendors. We have not achieved profitability on a quarterly or an annual basis and anticipate that we will continue to incur operating losses in the foreseeable future. We have a lengthy sales cycle for our products and, accordingly, we expect to incur significant selling and other expenses before we realize the related revenue. During 2001 and 2002 we took actions to realign our cost structure in reaction to industry conditions resulting in a significant decrease in capital spending by telecommunications service providers. We expect that sales and marketing, research and development, and general and administrative expenses will increase from current levels as our business expands. As a result, we will need to generate significant revenues to achieve and maintain profitability.

During the fourth quarter of 1999, we introduced the TSR which is purpose-built for the stresses of carrier core routing in large IP networks. The first TSR sale occurred during the first quarter of 2000. During 2001, we introduced the Avici Stackable Switch Router (SSR^™), a rack-mountable scalable router for carriers and service providers with smaller core networks. The first SSR sale occurred during the fourth quarter of 2001. During the fourth quarter of 2002, we introduced the Avici Quarter-rack Scalable Router (QSR^™), which provides customers with one of the smallest footprint, highest density routers commercially available. The first QSR sale occurred during the fourth quarter of 2003. We currently market our products to major carriers in North America through our

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direct sales force and third party distribution partners. We also market our products internationally through sales agents, systems integrators and distributors, and through a direct sales force in Europe and Asia. We currently provide product installation and customer field support through our internal customer service organization and third-party support organizations. During 2003, we entered into a strategic relationship with Huawei Technologies (Huawei) for sale of our products in Greater China and distribution arrangements with several resellers. In January 2004, we entered into a worldwide strategic relationship with Nortel Networks (Nortel) to market, sell and support our products.

Our target end-user customers include incumbent local exchange carriers, inter-exchange carriers, postal telephone and telegraph operators (PTTs or international incumbent operators), international competitive carriers, Internet service providers, and agencies of the United States government. Our products have been deployed at AT&T Corp. (AT&T), Qwest Communications (Qwest), several agencies of the United States government, and in laboratory environments including the France Telecom R&D VTHD research network and Chung Hwa Telecom, among others and in Greater China through our distribution partner, Huawei. Our products are currently in trials and tests with additional prospective customers, both internationally and domestically. There can be no assurance as to the timing of the completion of these trials and tests or that their outcome will be favorable.

Revenue

We expect that in the foreseeable future, substantially all of our revenue will continue to depend on sales of our TSR, SSR, and QSR products to current customers and a limited number of potential new customers. We also expect to generate revenue through our distribution and OEM partnering arrangements. Generally, these customers and partners are not contractually committed to purchase any minimum quantities of products from us.

The initial term of our procurement agreement with AT&T continued through December 2003. The agreement remains in effect unless terminated by either party. We have no current intention to terminate the agreement and we are not aware of any intention of AT&T to terminate the agreement. The agreement describes the conditions under which AT&T may acquire equipment from us. The agreement has no minimum purchase commitment associated with it.

In April 2003, we entered into a strategic relationship with Huawei. The agreement describes the terms and conditions under which Huawei may acquire equipment from us for sales and distribution in Greater China. The agreement has no minimum purchase commitment associated with it.

In January 2004, we entered into a worldwide three-year strategic agreement with Nortel. Under this agreement, Nortel will market, sell and support Avici’s carrier-class core routers as part of its converged network solutions based on Internet Protocol (IP) technology. The agreement has no minimum purchase commitment associated with it.

Common Stock Warrant Discount - Product

In January 2004, in connection with three-year strategic OEM agreement with Nortel Networks, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel Networks with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel Networks achieves certain performance milestones. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and is recorded as a reduction of revenue on a systematic basis, currently straight-line, over the economic life of the agreement, which is expected to be three years. The unamortized balance of $5.3 million at June 30, 2004 is recorded as a Contract Distribution Right in the accompanying balance sheet.

In December 2000, in connection with the execution of a nonexclusive systems and services agreement with AT&T, Avici issued a warrant to purchase 212,500 shares of Avici’s common stock at a per-share exercise price of $110.92. The agreement provides AT&T with the ability, but not the obligation, to purchase equipment and services from

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Avici. The warrant is nonforfeitable, fully exercisable and has a term of five years from the date of issuance. The fair value of the warrant was calculated to be $9.8 million using the Black-Scholes valuation model, and was deferred as a reduction to equity and was amortized as an offset to gross revenue on a straight-line basis over the three-year term of the agreement. The fair value of the warrant was fully amortized at December 31, 2003.

Cost of Revenue

Cost of Revenue - Product includes material cost, provision for warranty, rework, depreciation and provision for excess and obsolete inventory. Cost of Revenue – Service includes costs associated with providing customer support and maintenance services.

Restructuring Charges

Avici implemented restructuring programs during the third and fourth quarters of 2001 and during the third quarter of 2002 and recorded cumulative net charges of $2.0 million. During the six months ended June 30, 2004, we paid $0.4 million in lease payments associated with those charges. As of June 30, 2004, the remaining liability for future lease payments is approximately $0.1 million, which will be fully liquidated in July of 2004.

Additionally, in the third quarter of 2001, we recorded a charge of $17.2 million as an element of product cost of revenue to reflect a write down of inventories and inventory commitments for long lead-time items that were considered to be in excess of the then foreseeable demand. The charge included commitments to suppliers including ASICs, module components, and TSR bay components totaling approximately $9.6 million and inventory components and finished goods on hand relating to the TSR product, totaling approximately $7.6 million which were identified as in excess of the then forecasted demand for the next 12 months. Since the end of the third quarter of fiscal 2001, we had paid approximately $9.4 million to settle inventory commitments with suppliers, and have discarded approximately $6.3 million of the excess inventory on hand. Since 2001, we have utilized approximately $5.2 million of this inventory including approximately $0.8 million during the first six months of 2004. Such utilization has been recorded and disclosed primarily as a reduction of cost of revenue in the period utilized. We do not expect significant utilization of such inventory in the future.

We expect telecommunications service providers to continue to maintain conservative levels of capital spending in the near term. However, any decline in spending for certain telecommunications equipment, or any change in our business strategy could necessitate further restructuring and such restructuring could have an adverse impact on the results of operations and financial condition of Avici.

We outsource our manufacturing operations to contract manufacturers that assemble and test our products in accordance with our specifications. Accordingly, a significant portion of our product cost of revenue involves payment to these entities. Avici’s cost of revenue also includes overhead costs, primarily for material procurement associated with our manufacturing. Warranty costs and inventory provisions are expensed as cost of revenue-product.

Research and Development

Research and development expenses consist primarily of salaries and related employee costs, depreciation expense on laboratory equipment and project costs, namely, prototype equipment, materials costs and third-party costs and fees related to the development and prototyping of our proprietary technology. Depreciation expenses have also decreased as current capital expenditures are lower than prior years’ additions which have become fully depreciated. In the future, research and development expenses may increase as additional resources become necessary to further support our channel partners and to remain competitive as demand for new products, product features and functionality increases.

Sales and Marketing

Sales and marketing expenses consist primarily of salaries and related employee costs, sales commissions, travel, public relations, training and other costs associated with marketing material and tradeshows. In the future, we expect

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sales and marketing expenses may increase as demand for our products increases and we broaden our sales infrastructure, establish sales offices in new locations domestically and internationally, initiate new marketing programs and invest to further support our channel partners.

General and Administrative

General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel and professional fees. In the future, we expect that general and administrative expenses may increase as we add personnel and incur additional costs related to the growth of our business.

Stock-based Compensation

Through December 31, 2001, Avici had recorded cumulative non-cash deferred compensation, relating to pre-IPO stock option grants, as an element of stockholders’ equity, representing the aggregate difference between the deemed fair value of Avici’s common stock and the exercise price of stock options and restricted stock granted and the selling price of stock sold. The deferred compensation is being recognized as an expense over the vesting period of the stock options and restricted stock. Avici expects to recognize compensation expense of approximately $0.1 million during the remainder of 2004 related to these grants.

In January 2004, Avici granted 30,000 shares of restricted stock to certain key employees of the Company. The shares vest on a quarterly basis over four quarters ending in January 2005. The value of the shares at the date of grant was $0.4 million and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the vesting period. Avici expects to recognize compensation expense of approximately $0.2 million during the remainder of 2004 related to these grants.

In June 2004, Avici granted 120,000 shares of restricted stock to certain key employees of the Company. The shares vest five years from the grant date. Vesting may be accelerated upon the achievement of certain pre-defined performance milestones. The value of the shares at the date of grant was $1.3 million and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the five year vesting period. If the performance milestones are achieved and vesting is accelerated, the remaining unamortized value of the shares will be charged to expenses in the period in which performance is achieved.

Critical Accounting Policies

Avici considers the following accounting policies related to revenue recognition, cost of revenue – service, inventory valuation, warranty liabilities, and long-lived assets to be critical accounting policies due to the estimation processes and judgments involved in each. Avici bases its estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

Avici recognizes revenue from product sales upon shipment to customers, including resellers, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. We also generate revenue from support and maintenance as well as installation and service. We defer revenue from support and maintenance contracts and recognize it ratably over the period of the related agreements. We recognize revenue from installation and other services as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue. In the event the Company is unable to meet one or all of the above criteria on a timely basis, revenue recognized for any reporting period could be adversely affected.

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Cost of Revenue – Service

Cost of Revenue – Service includes internal costs associated with providing customer support and maintenance services. As personnel responsible for providing such services are also engaged in other activities such as sales and marketing and product development, Avici aggregates certain costs, including payroll, fringe, overhead and depreciation, and allocates a portion of those costs to Cost of Revenue – Service. Such allocation is based on an estimation of time devoted towards supporting the service programs, which Avici believes to be reasonable.

Inventory Valuation

We value our inventory at the lower of the actual cost to purchase or the current estimated market value. We regularly review inventory quantities on hand and inventory commitments with suppliers and record a provision for potentially excess and obsolete inventory based primarily on our estimated forecast of product demand for up to the next twelve months. As demonstrated during 2001, demand for our products can fluctuate suddenly and significantly due to changes in economic and business conditions. A significant increase in demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory on hand and at suppliers. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory on hand and at suppliers. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.

Warranty Liabilities

Our warranties require us to repair or replace defective products returned to us during the warranty period at no cost to the customer. We record an estimate for warranty related costs at the time of sale based on our actual historical return rates and repair costs. While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee we will continue to experience the same warranty return rates or repair costs that we have in the past. A significant increase in product return rates, or a significant increase in the costs to repair our products, could have a material adverse impact on future operating results for the period or periods in which such returns or additional costs materialize and thereafter.

Long-lived Assets

We review property, plant, and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate over the remaining economic life. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. Although we have recognized no material impairment adjustments related to our property, plant, and equipment, except those made in conjunction with restructuring actions, deterioration in our business in the future could lead to such impairment adjustments in future periods. Evaluation of impairment of long-lived assets requires estimates of future operating results that are used in the preparation of the expected future undiscounted cash flows. Actual future operating results and the remaining economic lives of our long-lived assets could differ from the estimates used in assessing the recoverability of these assets. These differences could result in impairment charges, which could have a material adverse impact on our results of operations.

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Results of Operations

Revenue

Total gross revenue increased $2.3 million to $12.1 million in the second quarter of 2004 from $9.8 million in the second quarter of 2003. Total gross revenue increased $1.7million to $19.1 million in the first six months in 2004 from $17.4 million for the same period in 2003. Gross product revenue increased $1.6 million to $10.4 million in the second quarter of 2004 from $8.8 million in the second quarter of 2003. Gross product revenue increased $0.7 million to $16.2 million for the first six months in 2004 from $15.5 million for the same period in 2003. The increase in gross product revenue is primarily due to an increase in our product volume through our channel relationships.

Net product revenue, after warrant amortization of $0.5 million and $0.8 million in the second quarter of 2004 and 2003 respectively, increased $1.9 million to $9.9 million for the second quarter of 2004 from $8.0 million for the second quarter of 2003. Net product revenue, after warrant amortization of $1.1 million and $1.6 million in the first six months of 2004 and 2003 respectively, increased $1.3 million to $15.2 million for the first six months in 2004 from $13.9 million for the same period in 2003.

Service revenue increased $0.7 million to $1.7 million in the second quarter of 2004 from $1.0 million in the second quarter of 2003. Service revenue increased $0.9 million to $2.8 million for the first six months in 2004 from $1.9 million for the same period in 2003. The increase in service revenue relates to a period over period increase in our installed base of products.

Huawei and AT&T each contributed in excess of 10% of gross revenue in the second quarter of 2004 and Huawei, AT&T and Nortel each contributed in excess of 10% of gross revenue in the first six months in 2004. AT&T contributed in excess of 10% of gross revenue in the second quarter of 2003 and AT&T and Qwest each contributed in excess of 10% of gross revenue in the first six months in 2003.

Cost of Revenue

Total cost of revenue increased $2.0 million to $5.6 million in the second quarter of 2004 from $3.6 million in the second quarter of 2003. Total cost of revenue increased $0.6 million to $8.3 million for the first six months in 2004 from $7.7 million for the same period in 2003. Product cost of revenue was 51% and 36% of product net revenue in the second quarter of 2004 and 2003, respectively. Product cost of revenue was 47% and 45% of product net revenue for the first six months in 2004 and 2003, respectively. Product cost of revenue is net of credits for the utilization of inventory previously reserved related to a charge recorded in 2001 resulting from a downturn in industry demand. Such credits were $0.5 million and $0.8 million in the second quarter of 2004 and 2003, respectively and $0.7 million and $0.8 for the first six months in 2004 and 2003, respectively. The higher product cost of revenue as a percentage of product net revenue in the second quarter of 2004 as compared to the second quarter of 2003 was primarily due to customer mix. Revenue in the second quarter of 2004 included a significantly higher percentage of sales through our channel partners, whose average selling price is less than that of direct sales. The slightly higher product cost of revenue as a percentage of product net revenue for the first six months in 2004 as compared to the same period in 2003, was also due to changes in customer mix in the second quarter of 2004 partially offset by cost reductions achieved with key suppliers and reductions of fixed costs in the 2004 period.

Product cost of revenue as a percentage of product net revenue is affected by changes in the mix of products sold, discounts and related pricing, channels of distribution, changes in material costs, excess inventory and obsolescence charges, changes in volume and pricing competition. We anticipate product cost of revenue as a percentage of product net revenue will increase in the near term due to an expected increase in sales through distribution channels, which will typically result in lower margin.

Service cost of revenue was 34% and 72% of service revenue in the second quarter of 2004 and 2003, respectively. Service cost of revenue was 41% and 77% of service revenue for the first six months in 2004 and 2003, respectively. The lower percentage in the 2004 periods is primarily the result of an increase in service revenues due to a larger installed base coupled with lower depreciation costs on service related capital equipment.

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Research and Development

Research and development expenses decreased $4.9 million to $7.8 million for the second quarter of 2004 from $12.7 million for the second quarter of 2003. Research and development expenses decreased $7.2 million to $16.9 million for the first six months in 2004 from $24.1 million for the same period in 2003. The decrease in the 2004 periods from the comparable periods in 2003 was primarily due to a reduction in depreciation expenses of $2.7 million and $4.5 million for the three and six months ended June 30, 2004, respectively, as current capital expenditures are lower than prior years’ additions which have become fully depreciated. Also contributing to the decline in the three & six month periods is a reduction in payroll related expenses of $1.2 million and $1.6 million, respectively, primarily due a reduction in employee incentive accruals as performance targets for the six months ended June 30, 2004 were not achieved, and a reduction of project related costs of $0.8 million and $1.3 million, respectively.

Sales and Marketing

Sales and marketing expenses increased $0.6 million to $3.3 million for the second quarter of 2004 from $2.7 million for the second quarter of 2003. Sales and marketing costs increased $0.5 million to $6.0 million for the first six months in 2004 from $5.5 million for the same period in 2003. The increase in the 2004 periods was primarily due to an increase in personnel and related costs such as recruiting, travel and trade shows and support of our distribution channel relationships.

General and Administrative

General and administrative expenses decreased $0.2 million to $1.4 million for the second quarter of 2004 from $1.6 million for the second quarter of 2003. General and administrative costs decreased $0.3 million to $2.8 million for the first six months in 2004 from $3.1 million for the same period in 2003. The decrease in the second quarter of 2004 was primarily due to a reduction in depreciation expenses, lower personnel related costs and other spending decreases.

Stock-Based Compensation

Stock-based compensation, associated with pre-IPO stock option grants, decreased $0.2 million to $0.1 million for the second quarter of 2004 from $0.3 million for the second quarter of 2003. Stock-based compensation, associated with pre-IPO stock option grants, decreased $0.5 million to $0.2 million for the first six months of 2004 from $0.7 million for the same period in 2003. The decrease in the 2004 periods is primarily the result of certain option grants becoming fully vested and the related compensation becoming fully amortized, as well as the forfeiture of stock options associated with employee terminations.

Interest Income, Net

Interest income decreased $0.3 million to $0.3 million for the second quarter of 2004 from $0.6 million for the second quarter of 2003. Interest income decreased $0.5 million to $0.7 million for the first six months in 2004 from $1.2 million for the same period in 2003. The decrease in the 2004 periods is primarily due to the decrease in invested cash balances resulting from the use of cash to fund operations and lower investment yields available in the market.

Liquidity and Capital Resources

Since our inception, we have financed our operations through private sales of equity securities, an initial public offering in July 2000, and, to a lesser extent, equipment lease financing. From inception through June 30, 2004, we raised approximately $410.3 million from these equity offerings. During the first six months of 2004, we used $10.7 million in cash for operating activities, compared to $17.4 million used during the first six months of 2003. The decrease in cash usage in the 2004 period as compared to the 2003 period is a result of reduced operating losses and a decrease in working capital. We expect working capital requirements will increase further in the future if product

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sales increase, creating larger customer receivable balances and the need to build inventory in advance of shipment. In addition, we expect to selectively invest in infrastructure costs needed to support the scale of operations. As of June 30, 2004, the remaining liability for future lease payments related to excess facility is approximately $0.1 million, which will be fully liquidated in July of 2004.

Purchases of property and equipment were $3.5 million during the first six months of 2004, compared to $2.9 million for the first six months of 2003. The timing and amount of future capital expenditures will depend primarily on our future growth. We expect that capital expenditures will be between $4 million and $6 million during the remaining six months of 2004. Proceeds from employee stock plans provided $3.1 million during the first six months of 2004.

We expect that working capital and capital expenditure requirements may increase if product sales increase, creating larger customer receivable balances, the need to build inventory in advance of shipment and the need for increased levels of test and management information systems equipment. At June 30, 2004, we had cash and cash equivalents of $32.8 million, short-term marketable securities of $27.5 million, and long-term marketable securities of $24.6 million, totaling $84.9 million. In addition, $0.4 million of restricted cash is included in the current and long-term portions of other assets as deposits for facility related obligations. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our normal operating and capital requirements for the next 24 months. However, we could be required, or could elect, to raise additional funds during that period and we may need to raise additional capital in the future. We may not be able to obtain additional capital on terms favorable to us or at all. The issuance of additional equity or equity-related securities would be dilutive to our stockholders. If we cannot raise funds on acceptable terms, or at all, we may not be able to develop or enhance our products or respond appropriately to competitive pressures, which would seriously limit our ability to increase our revenue and grow our business.

Contractual Obligations

At June 30, 2004 our contractual obligations, which consist entirely of contractual commitments for operating leases and inventory purchase commitments, were as follows (in thousands):

Payments made under operating leases will be treated as rent expense for the facilities currently being utilized, or as a reduction of the restructuring liability for payments associated with the excess facility. We outsource the manufacture and assembly of our products. During the normal course of business, in order to maintain competitive lead times for customers and adequate supply of components, we enter into agreements with certain suppliers to procure inventory based upon criteria defined by us.

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Off-Balance Sheet Arrangements

As of June 30, 2004, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Factors That May Affect Future Results

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include management’s plans and objectives for future operations, as well as statements regarding the strategy and plans of Avici. Our actual experience may differ materially from that discussed in the forward-looking statements. Factors that might cause such a difference or otherwise affect our future results of operations include the limited number of customers; continuing acceptance of our products and product enhancements; customer purchasing patterns and commitments; the size, timing and recognition of revenue from customers; the success of our channel relationships; our ability to develop new products and product enhancements; market acceptance of new product offerings and enhancements to our products and our ability to predict and respond to market developments; the failure to keep pace with the rapidly changing requirements of our customers; our ability to attract and retain key personnel; the development and expansion of our direct sales force and/or other distributor channels; risks associated with management of growth; risks associated with international expansion; our ability to obtain component parts; our being held liable for defects or errors in our products; our ability to identify, acquire and integrate acquisition targets; our ability to obtain additional financing; our failure to comply with the listing requirements of the Nasdaq National Market System; the expense of defending and the outcome of pending and future litigation and investigations (including whether or not the Court approves the proposed settlement with the plaintiffs in the New York securities litigation); the adequacy of our insurance to cover our obligations with respect to the ultimate resolution of any pending or future litigation matters; as well as risks of a further downturn in economic conditions generally, and in the telecommunications industry specifically; and risks associated with competition and competitive pricing pressures. For a more detailed description of the risk factors associated with Avici, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 12, 2004.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 (FIN No. 46), “Consolidation of Variable Interest Entities,” which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities, commonly referred to as special-purpose entities, in the first reporting period ending after December 15, 2003. It applies in the first fiscal year or interim period ending after March 15, 2004, to all other variable interest entities in which an enterprise holds a variable interest. Avici has not created, nor has an interest in a variable interest entity. As a result, the provisions of FIN No. 46 did not have a material impact on Avici’s consolidated financial position or results of operations.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

Interest Rate Sensitivity

We maintain an investment portfolio consisting mainly of investment grade money market funds, corporate obligations, federal agency obligations, state and municipal bonds with a weighted-average maturity of less than one year. These held-to-maturity securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at June 30, 2004, the fair market value of these investments would decline by an immaterial amount. We have the ability to hold our fixed income investments until maturity. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates on our securities portfolio.

Exchange Rate Sensitivity

We operate primarily in the United States, and international sales historically have been in U.S. dollars and are expected to continue in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations. If we expand our presence in foreign markets and consummate sales denominated in foreign currencies, our exposure to foreign currency rate fluctuations could be material in the future.

Avici has no off balance sheet concentrations such as foreign exchange contracts, option contracts or other foreign hedging arrangements.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

Avici, under the supervision and with the participation of Avici’s management, including the principal executive officer and principal financial officer, have evaluated the effectiveness of Avici’s disclosure controls and procedures as of the end of the period covered by this quarterly report (the “Evaluation Date”) pursuant to Rule 13a-15(b) and 15d-15(b) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, Avici’s principal executive officer and principal financial officer have concluded, that, as of the Evaluation Date, Avici’s disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in internal control over financial reporting

There were no changes in Avici’s internal control over financial reporting during Avici’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect Avici’s internal control over financial reporting.

ITEM 1. LEGAL PROCEEDINGS

In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici Systems Inc., et al., C.A.

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No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.

On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.

In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.

The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement.

The parties to the proposed settlement have drafted formal settlement documents and requested preliminary approval by the Court of the proposed settlement, including the form of the notice of the proposed settlement that will be sent to members of the proposed classes in each settling case. Certain underwriters who were named as defendants in the

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settling cases, and who are not parties to the proposed settlement, have filed an opposition to preliminary approval of the proposed settlement of those cases. If preliminary Court approval is obtained, notice of the proposed settlement will be sent to the class members, and a motion will then be made for final Court approval of the proposed settlement. Consummation of the proposed settlement remains conditioned on, among other things, receipt of both preliminary and final Court approval. If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.

The Securities and Exchange Commission (the “SEC”) is conducting several investigations relating to Qwest Communications (“Qwest”) and its business relationships. In the SEC investigation entitled “Issuers Related to Qwest,” Avici understands that it is one of eleven companies whose business dealings with Qwest are being investigated. Avici has cooperated with these investigations and there has been no wrong doing by Avici alleged in any of these investigations. How long these investigations may continue and their ultimate outcome cannot be determined.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At Avici’s annual meeting of stockholders held on May 26, 2004, the Stockholders elected the following nominees, each to serve for a three-year term as a Class I Director and until their successors are elected and appointed:

At the same annual meeting, the stockholders approved by the following vote an amendment to the Company’s Amended 2000 Stock Option and Incentive Plan increasing the aggregate number of shares of common stock authorized for issuance by 1,250,000 shares:

At the same annual meeting, the stockholders ratified the appointment of Ernst & Young LLP as Avici’s independent auditors for the fiscal year ending December 31, 2004 by the following vote:

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

Avici filed a Report on Form 8-K dated April 22, 2004 to furnish a press release whereby Avici provided its first quarter financial results and announced that it planned to hold a conference call regarding its financial results for the quarter ended March 31, 2004 on April 22, 2004.

Avici filed a Report on Form 8-K dated May 27, 2004 to file a press release announcing the appointment of William Leighton as a director to fill the seat vacated by Jim Swartz.

Avici filed a Report on Form 8-K dated July 22, 2004 to furnish a press release whereby Avici provided its second quarter financial results and announced that it planned to hold a conference call regarding its financial results for the quarter ended June 30, 2004 on July 22, 2004.

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SIGNATURE

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

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EXHIBIT INDEX

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