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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-Q
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 001-15951
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AVAYA INC.
A DELAWARE I.R.S. EMPLOYER
CORPORATION NO. 22-3713430
211 MOUNT AIRY ROAD, BASKING RIDGE, NEW JERSEY 07920
TELEPHONE NUMBER 908-953-6000
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
At March 31, 2001, 283,831,630 common shares were outstanding.
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TABLE OF CONTENTS
ITEM DESCRIPTION PAGE
- ---- ----------- --------
PART I
1. Financial Statements........................................ 3
2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 21
3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 35
PART II
1. Legal Proceedings........................................... 37
2. Changes in Securities and Use of Proceeds................... 37
3. Defaults Upon Senior Securities............................. 37
4. Submission of Matters to a Vote of Security Holders......... 37
5. Other Information........................................... 37
6. Exhibits and Reports on Form 8-K............................ 37
2
PART I
ITEM 1. FINANCIAL STATEMENTS.
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
---------------------- ----------------------
2001 2000 2001 2000
-------- -------- -------- --------
REVENUE
Products.............................................. $1,323 $1,459 $2,609 $2,839
Services.............................................. 529 486 1,028 956
------ ------ ------ ------
1,852 1,945 3,637 3,795
------ ------ ------ ------
COSTS
Products.............................................. 792 895 1,593 1,667
Services.............................................. 241 252 468 497
------ ------ ------ ------
1,033 1,147 2,061 2,164
------ ------ ------ ------
GROSS MARGIN............................................ 819 798 1,576 1,631
------ ------ ------ ------
OPERATING EXPENSES
Selling, general and administrative................... 556 600 1,124 1,196
Business restructuring and related charges............ 182 -- 205 --
Research and development.............................. 153 119 293 224
Purchased in-process research and development......... 31 -- 31 --
------ ------ ------ ------
TOTAL OPERATING EXPENSES................................ 922 719 1,653 1,420
------ ------ ------ ------
OPERATING INCOME (LOSS)................................. (103) 79 (77) 211
Other income, net..................................... 18 50 27 54
Interest expense...................................... (10) (21) (20) (42)
------ ------ ------ ------
INCOME (LOSS) BEFORE INCOME TAXES....................... (95) 108 (70) 223
Provision (benefit) for income taxes.................. (31) 42 (22) 88
------ ------ ------ ------
NET INCOME (LOSS)....................................... $ (64) $ 66 $ (48) $ 135
====== ====== ====== ======
EARNINGS (LOSS) PER COMMON SHARE:
Basic................................................. $(0.25) $ 0.25 $(0.21) $ 0.51
====== ====== ====== ======
Diluted............................................... $(0.25) $ 0.24 $(0.21) $ 0.48
====== ====== ====== ======
See Notes to Consolidated Financial Statements.
3
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
MARCH 31, 2001 SEPTEMBER 30, 2000
-------------- ------------------
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 312 $ 271
Receivables, less allowances of $75 at March 31, 2001 and
$62 at September 30, 2000............................... 1,444 1,758
Inventory................................................. 747 639
Deferred income taxes, net................................ 354 450
Other current assets...................................... 324 244
------ ------
TOTAL CURRENT ASSETS........................................ 3,181 3,362
------ ------
Property, plant and equipment, net........................ 1,035 966
Prepaid benefit costs..................................... 269 387
Deferred income taxes, net................................ 103 44
Goodwill and other intangible assets, net................. 282 204
Other assets.............................................. 84 74
------ ------
TOTAL ASSETS................................................ $4,954 $5,037
====== ======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................... $ 569 $ 763
Current portion of long term debt......................... 23 80
Business restructuring reserve............................ 251 499
Payroll and benefit obligations........................... 557 491
Advance billings and deposits............................. 180 253
Other current liabilities................................. 512 503
------ ------
TOTAL CURRENT LIABILITIES................................... 2,092 2,589
------ ------
Long term debt............................................ 700 713
Benefit obligations....................................... 458 421
Deferred revenue.......................................... 71 83
Other liabilities......................................... 485 467
------ ------
TOTAL NONCURRENT LIABILITIES................................ 1,714 1,684
------ ------
Commitments and contingencies
Series B convertible participating preferred stock, par
value $1.00 per share, 4 million shares authorized,
issued and outstanding.................................. 381 --
------ ------
STOCKHOLDERS' EQUITY
Series A junior participating preferred stock, par value
$1.00 per share, 7.5 million shares authorized; none
issued and outstanding.................................. -- --
Common stock, par value $0.01 per share, 1.5 billion
shares authorized, 283,831,630 and 282,027,675 issued
and outstanding as of March 31, 2001 and September 30,
2000, respectively...................................... 3 3
Additional paid-in capital................................ 878 825
Retained earnings (deficit)............................... (61) --
Accumulated other comprehensive loss...................... (53) (64)
Less treasury stock at cost (5,063 shares as of March 31,
2001)................................................... -- --
------ ------
TOTAL STOCKHOLDERS' EQUITY.................................. 767 764
------ ------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $4,954 $5,037
====== ======
See Notes to Consolidated Financial Statements.
4
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
SIX MONTHS ENDED
MARCH 31,
----------------------
2001 2000
-------- --------
OPERATING ACTIVITIES:
Net income (loss)......................................... $(48) $135
Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities:
Business restructuring and related charges.............. 134 --
Depreciation and amortization........................... 131 112
Provision for uncollectible receivables................. 32 17
Deferred income taxes................................... 37 (4)
Purchased in-process research and development........... 31 --
Other adjustments for non-cash items, net............... 1 (45)
Changes in operating assets and liabilities:
Receivables........................................... 282 268
Inventory............................................. (103) (15)
Accounts payable...................................... (211) (23)
Other assets and liabilities.......................... (307) (257)
---- ----
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES........ (21) 188
---- ----
INVESTING ACTIVITIES:
Capital expenditures...................................... (160) (145)
Proceeds from the sale of property, plant and equipment... 2 9
Disposal of businesses.................................... -- 64
Acquisition of business, net of cash acquired............. (101) --
Other investing activities, net........................... (16) (11)
---- ----
NET CASH USED FOR INVESTING ACTIVITIES...................... (275) (83)
---- ----
FINANCING ACTIVITIES:
Issuance of convertible participating preferred stock..... 368 --
Issuance of warrants...................................... 32 --
Issuance of common stock.................................. 22 --
Transfers to Lucent....................................... -- (137)
Decrease in long term debt, net........................... (79) --
Other financing activities, net........................... -- (3)
---- ----
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES........ 343 (140)
---- ----
Effect of exchange rate changes on cash and cash
equivalents............................................... (6) --
---- ----
Net increase (decrease) in cash and cash equivalents........ 41 (35)
Cash and cash equivalents at beginning of period............ 271 194
---- ----
Cash and cash equivalents at end of period.................. $312 $159
==== ====
See Notes to Consolidated Financial Statements.
5
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BACKGROUND AND BASIS OF PRESENTATION
BACKGROUND
On September 30, 2000, Avaya Inc. (the "Company" or "Avaya") was spun off
from Lucent Technologies Inc. ("Lucent") pursuant to a distribution of all
outstanding shares of the Company's common stock to Lucent shareowners (the
"Distribution"). The Company provides communication systems and software for
enterprises, including businesses, government agencies and other organizations.
The Company offers a broad range of voice, converged voice and data, customer
relationship management, messaging, multi-service networking and structured
cabling products and services.
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of the Company
as of March 31, 2001 and for the three and six months ended March 31, 2001 and
2000, 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, 2000. 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.
The unaudited consolidated financial statements for the three and six months
ended March 31, 2000 represent the results of operations and cash flows of the
Company as if it were a separate entity. These consolidated financial statements
include allocations of certain Lucent corporate headquarters' assets,
liabilities, and expenses relating to the Company's businesses that were
transferred to the Company from Lucent as well as an allocation of costs of
basic research and development activities. Management believes the costs of
these services and research charged to the Company are a reasonable
representation of the costs that would have been incurred if the Company had
performed these functions as a stand-alone entity. The Company currently
performs these functions and basic research requirements using its own resources
or purchased services.
2. RECENT ACCOUNTING PRONOUNCEMENTS
SFAS 140
In September 2000, the Financial Accounting Standards Board issued Statement
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 140"). This Standard replaced SFAS 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities," and provides consistent standards for distinguishing transfers
of financial assets that are sales from transfers representing secured
borrowings. This Standard will be applied prospectively, with certain
exceptions, and is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001. The adoption of
SFAS 140 is not expected to have a material impact on the Company's results of
operations, financial position or cash flows.
6
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. ACQUISITION AND OTHER TRANSACTIONS
ACQUISITION OF VPNET TECHNOLOGIES, INC.
On February 6, 2001, the Company acquired VPNet Technologies, Inc., a
privately held developer of virtual private network solutions and devices, for
an aggregate purchase price of $117 million in cash and stock options. The
acquisition was accounted for by the purchase method of accounting and,
accordingly, the consolidated financial statements include the results of
operations and the estimated fair values of the assets and liabilities assumed
from the date of acquisition. In the second quarter of fiscal 2001, the Company
paid-off $9 million of VPNet's long term debt.
Included in the purchase price for this acquisition was purchased in-process
research and development. As some of the technology had not reached
technological feasibility and had no future alternative use, approximately
$31 million was written off as a non-tax-deductible charge to earnings in the
second quarter of fiscal 2001. The remaining purchase price was allocated to
both tangible and intangible assets, less liabilities assumed. The Company
allocated approximately $48 million to goodwill, $30 million to existing
technology and $16 million to other intangible assets. These intangible assets,
which are included in goodwill and other intangible assets, net, will be
amortized over periods not exceeding 5 years.
The value allocated to purchased in-process research and development was
determined utilizing an income approach that included an excess earnings
analysis reflecting the appropriate cost of capital for the investment.
Estimates of future cash flows related to the purchased in-process research and
development were made for each project based on the Company's estimates of
revenue, operating expenses and income taxes from the project. These estimates
were consistent with historical pricing, margins and expense levels for similar
products.
Revenue was estimated based on relevant market size and growth factors,
expected industry trends, individual product sales cycles and the estimated life
of each product's underlying technology. Estimated operating expenses, income
taxes, and charges for the use of contributory assets were deducted from
estimated revenue to determine estimated after-tax cash flows for each project.
Estimated operating expenses include cost of goods sold, selling, general and
administrative expenses, and research and development expenses. The research and
development expenses include estimated costs to maintain the products once they
have been introduced into the market and generate revenue and costs to complete
the purchased in-process research and development.
The rates utilized to discount the projected cash flows were based on
consideration of the Company's weighted average cost of capital, as well as
other factors including the useful life of each project, the anticipated
profitability of each project, the uncertainty of technology advances that were
known at the time and the stage of completion of each project.
Management is primarily responsible for estimating the fair value of the
assets and liabilities acquired, and has conducted due diligence in determining
the fair value. Management has made estimates and assumptions that affect the
reported amounts of assets, liabilities and expenses resulting from such
acquisition. Actual results could differ from these amounts.
OTHER TRANSACTIONS
OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES
On February 20, 2001, the Company announced a five-year agreement to
outsource most of the manufacturing of its communications systems and software
to Celestica Inc. The Company will receive approximately $200 million for the
assets it is transferring to Celestica. The first phase of the
7
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. ACQUISITION AND OTHER TRANSACTIONS (CONTINUED)
transaction closed on May 4, 2001, with the remaining phases expected to be
completed by the end of the first quarter of fiscal 2002.
SHELF REGISTRATION STATEMENT
On March 30, 2001, the Company filed a Registration Statement on Form S-3
with the Securities and Exchange Commission as part of a shelf registration
process. Upon effectiveness of the Registration Statement, the Company will be
able to offer common stock, preferred stock, debt securities or warrants to
purchase debt securities, or any combination of these securities, in one or more
offerings with a total initial offering price of up to $940 million. The Company
intends to use the proceeds from the sale of the securities for general
corporate purposes, including debt repayment and refinancing, capital
expenditures and acquisitions.
Under the shelf registration statement, the Company has also registered for
resale by the Warburg Funds the preferred stock and warrants described in
Note 7 to the Consolidated Financial Statements, and shares of common stock
issuable upon conversion or exercise thereof. The Company will not receive any
proceeds from the sale by the Warburg Funds of these securities.
4. COMPREHENSIVE INCOME
Comprehensive income (loss) includes, in addition to net income (loss),
unrealized gains and losses excluded from the Consolidated Statements of
Operations that are recorded directly to a separate section of stockholders'
equity in "Accumulated other comprehensive loss." These unrealized gains and
losses are referred to as other comprehensive income (loss) and primarily
consist of foreign currency translation adjustments, which are not adjusted for
income taxes since they relate to indefinite investments in non-U.S.
subsidiaries.
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------ ----------------
2001 2000 2001 2000
---- ---- ---- ----
(DOLLARS IN MILLIONS)
Net income (loss)................... $(64) $ 66 $(48) $135
Other comprehensive income (loss)... (28) (34) 11 (6)
---- ---- ---- ----
Total comprehensive income (loss)... $(92) $ 32 $(37) $129
==== ==== ==== ====
5. SUPPLEMENTARY FINANCIAL INFORMATION
STATEMENT OF OPERATIONS INFORMATION
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------ ----------------
2001 2000 2001 2000
---- ---- ---- ----
(DOLLARS IN MILLIONS)
OTHER INCOME, NET
Gain (loss) on foreign currency
transactions........................ $ 2 $(5) $(1) $(3)
Gain on businesses sold............... 4 45 6 45
Interest income....................... 8 -- 15 --
Miscellaneous, net.................... 4 10 7 12
--- --- --- ---
Total other income, net........... $18 $50 $27 $54
=== === === ===
8
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
5. SUPPLEMENTARY FINANCIAL INFORMATION (CONTINUED)
BALANCE SHEET INFORMATION
MARCH 31, SEPTEMBER 30,
2001 2000
--------- -------------
(DOLLARS IN MILLIONS)
INVENTORY
Completed goods....................................... $527 $472
Work in process and raw materials..................... 220 167
---- ----
Total inventory..................................... $747 $639
==== ====
SUPPLEMENTAL CASH FLOW INFORMATION
MARCH 31,
2001
---------
(DOLLARS
IN MILLIONS)
ACQUISITION OF BUSINESS:
Fair value of assets acquired, net of cash acquired....... $153
Less: Fair value of liabilities assumed................... (52)
----
Acquisition of business, net of cash acquired........... $101
====
NON-CASH TRANSACTIONS:
Accretion on Series B Preferred Stock (Note 7)............ $ 13
Fair market value of stock options issued in connection
with acquisition (Note 3)............................... 16
ADJUSTMENTS TO ORIGINAL CONTRIBUTION BY LUCENT (Note 12):
Accounts receivable....................................... 8
Property, plant and equipment, net........................ 7
----
Total non-cash transactions............................. $ 44
====
9
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. BUSINESS RESTRUCTURING AND RELATED CHARGES
In September 2000, the Company adopted a restructuring plan to improve
profitability and business performance as a stand-alone company and recorded a
pretax charge of $520 million. Components of the business restructuring costs,
as well as amounts and adjustments recorded to the related reserve as of
March 31, 2001, were as follows:
NET
ADJUSTMENTS EXPENDITURES
MADE MADE
DURING THE DURING THE RESERVE
COSTS EXPENDITURES RESERVE SIX MONTHS SIX MONTHS BALANCE
ACCRUED MADE BALANCE AS OF ENDED ENDED AS OF
DURING DURING SEPTEMBER 30, MARCH 31, MARCH 31, MARCH 31,
FISCAL 2000 FISCAL 2000 2000 2001 2001 2001
----------- ------------ ------------- ----------- ------------ ---------
(DOLLARS IN MILLIONS)
Employee separation costs... $365 $(20) $345 $(21) $(195) $129
Lease obligations........... 127 -- 127 -- (32) 95
Other related exit costs.... 28 (1) 27 -- -- 27
---- ---- ---- ---- ----- ----
Total................... $520 $(21) $499 $(21) $(227) $251
==== ==== ==== ==== ===== ====
In the second quarter of fiscal 2001, as part of the Company's overall
restructuring effort, Avaya entered into an agreement to outsource most of its
manufacturing of communication systems and software to Celestica Inc. As a
result, approximately 1,930 union-represented and 430 salaried employees will
receive involuntary employee termination benefits. Under the agreement with
Celestica, the Company will outsource its manufacturing operations currently
performed in Westminster, Colorado as well as its repair and distribution
operations located in Little Rock, Arkansas. Employees at the Westminster and
Little Rock locations were transitioned from Avaya to Celestica on May 4, 2001.
In addition, products currently manufactured in Shreveport, Louisiana will be
transitioned to the Westminster or other Celestica facilities. All Shreveport
operations are expected to be phased out by the end of the first quarter of
fiscal 2002.
In connection with the outsourcing of these facilities, the Company recorded
a pretax charge of $134 million related to employee separation costs as a
business restructuring and related charge in the Consolidated Statement of
Operations. The $134 million charge resulted in a $34 million increase in the
business restructuring reserve, a $69 million reduction in prepaid benefit costs
for enhanced severance and pension benefits, and an increase of $31 million of
post-retirement benefits other than pension included in benefit obligations. The
charge for post-retirement benefits other than pension represents the cost of
curtailment in accordance with SFAS 88, "Employers' Accounting for Settlements
and Curtailments of Defined Benefit Pension Plans and for Termination Benefits."
In connection with the contract manufacturing transaction, previously
accrued separation costs of $55 million for union-represented employees at
Shreveport will be paid as enhanced severance benefits from existing pension and
benefit assets. This $55 million reduction offset by the $34 million increase
related to severance payments that will be made using cash, resulted in a net
adjustment of $21 million to the business restructuring reserve.
As of September 30, 2000, accrued business restructuring costs for employee
separations of $365 million related to approximately 4,900 union-represented and
salaried employees, of which 3,662 employees worldwide have departed as of
March 31, 2001 predominately in the United States. In
10
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. BUSINESS RESTRUCTURING AND RELATED CHARGES (CONTINUED)
connection with the contract manufacturing transaction with Celestica, there
were no employee separations as of March 31, 2001. Employee separation payments
will be made either through lump sum or a series of payments extending over a
period of up to two years from the date of departure, at the employees' option.
Payments on lease obligations, which consist of real estate and equipment
leases, will extend through 2003. Other related exit costs will be paid by the
end of the current fiscal year.
For the three and six months ended March 31, 2001, the Company recorded
incremental period costs of $48 million and $71 million, respectively, which are
included in business restructuring and related charges in the Consolidated
Statement of Operations, associated with the Company's separation from Lucent.
These costs relate primarily to computer system transition costs such as data
conversion activities, asset transfers, and training. The Company also recorded
$6 million and $42 million, respectively, in selling, general and administrative
expenses for additional start-up activities largely resulting from marketing
costs associated with continuing to establish the Avaya brand.
During the remainder of fiscal 2001, the Company expects to incur additional
period costs of approximately $80 million as a result of the Company's
separation from Lucent and establishment as an independent company. Additional
period costs related to the Company's outsourcing of certain of its
manufacturing facilities are expected to total approximately $45 million, most
of which are expected to be incurred during the remainder of fiscal 2001. The
Company expects to fund these restructuring and start-up activities through a
combination of debt and internally generated funds.
7. CONVERTIBLE PARTICIPATING PREFERRED STOCK
On October 2, 2000, the Company sold to Warburg, Pincus Equity Partners,
L.P. and related investment funds ("the Warburg Funds") 4 million shares of the
Company's Series B convertible participating preferred stock and warrants to
purchase the Company's common stock for an aggregate purchase price of
$400 million. Based on a conversion price of $26.71, the Series B preferred
stock is convertible into 15,466,328 shares of the Company's common stock as of
March 31, 2001.
The warrants have an exercise price of $34.73 representing 130% of the
conversion price for the Series B preferred stock. Of these warrants, warrants
exercisable for 6,883,933 shares of common stock have a four-year term and
warrants exercisable for 5,507,146 shares of common stock have a five-year term.
During a period commencing no later than June 30, 2001, until the second
anniversary of their issuance, if the market price of the Company's common stock
exceeds 200%, in the case of the four-year warrants, and 225%, in the case of
the five-year warrants, of the exercise price of the warrants for 20 consecutive
trading days, the Company can force the exercise of up to 50% of the four-year
warrants and the five-year warrants, respectively.
The shares of Series B preferred stock had an aggregate initial liquidation
value of $400 million and will accrete for the first ten years at an annual rate
of 6.5% and 12% thereafter, compounded quarterly. After the third anniversary of
the original issue date of the Series B preferred stock, 50% of the amount
accreted for the year may be paid in cash as a dividend on a quarterly basis, at
the Company's option. After the fifth anniversary of the issue date through the
tenth anniversary, the Company may elect to pay 100% of the amount accreted for
the year as a cash dividend on a quarterly
11
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
7. CONVERTIBLE PARTICIPATING PREFERRED STOCK (CONTINUED)
basis. The liquidation value calculated on each quarterly dividend payment date,
which includes the accretion for the dividend period, will be reduced by the
amount of any cash dividends paid. Following the tenth anniversary of the issue
date, the Company will pay quarterly cash dividends at an annual rate of 12% of
the then accreted liquidation value of the Series B preferred stock, compounded
quarterly. The Series B preferred shares also participate, on an as-converted
basis, in dividends paid on the Company's common stock. For the six months ended
March 31, 2001, accretion of the Series B preferred stock was $13.1 million
resulting in a liquidation value of $413.1 million as of March 31, 2001. The
total number of shares of common stock into which the Series B preferred stock
are convertible is determined by dividing the liquidation value in effect at the
time of conversion by the conversion price.
The $400 million proceeds from the Warburg Pincus investment were initially
allocated between the Series B preferred stock and warrants based upon the
relative fair market value of each security, with $368 million allocated to the
Series B preferred stock and $32 million to the warrants. The fair value
allocated to the Series B preferred stock including the amount accreted for the
six months ended March 31, 2001 was recorded in the mezzanine section of the
Consolidated Balance Sheet because the investors may require the Company, upon
the occurrence of any change-of-control in the Company during the first five
years from the investment, to redeem the Series B preferred stock. As of
March 31, 2001, the Company recorded a $13.1 million reduction in retained
earnings (deficit) representing the amount accreted for the dividend period. The
fair value allocated to the warrants was included in additional paid-in capital.
The Emerging Issues Task Force of the Financial Accounting Standards Board
has deliberated on the accounting for convertible securities with beneficial
conversion features. A beneficial conversion feature would exist if the
conversion price (accounting basis) for the Series B preferred stock or warrants
was less than the fair value of the Company's common stock at the commitment
date. The Company has determined that no beneficial conversion features
currently exist and therefore there is no impact on its results of operations
associated with the Series B preferred stock or with the warrants. The
beneficial conversion features, if any, associated with dividends paid in kind,
where it is the Company's option to pay dividends on the Series B preferred
stock in cash or in kind, will be measured when dividends are declared and
recorded as a reduction to net income attributable to common shareowners.
At any time after the fifth anniversary of their issuance, the Company may
force conversion of the shares of Series B preferred stock. If the Company gives
notice of a forced conversion, the investors will be able to require the Company
to redeem the Series B preferred shares at 100% of the then current liquidation
value, plus accrued and unpaid dividends. Following a change-in-control of the
Company during the first five years after the investment, other than a change of
control transaction that is a business combination involving solely the issuance
of common stock, the accretion of some or all the liquidation value of the
Series B preferred stock through the fifth anniversary of the issue date will be
accelerated, subject to the Company's ability to pay a portion of the
accelerated accretion in cash in some instances. In addition, for 60 days
following the occurrence of any change-of-control of the Company during the
first five years after the investment, the investors will be able to require the
12
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
7. CONVERTIBLE PARTICIPATING PREFERRED STOCK (CONTINUED)
Company to redeem the Series B preferred stock at 101% of the liquidation value,
including any accelerated accretion of the liquidation value, plus accrued and
unpaid dividends.
8. EARNINGS PER SHARE OF COMMON STOCK
Basic earnings per common share are calculated by dividing net income (loss)
available to common shareowners by the weighted average number of common shares
outstanding during the period. Diluted earnings per common share are calculated
by adjusting net income (loss) available to common shareowners and weighted
average outstanding shares, assuming conversion of all potentially dilutive
securities including stock options, warrants and convertible participating
preferred stock.
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------ ----------------
2001 2000 2001 2000
---- ---- ---- ----
(DOLLARS AND SHARES IN MILLIONS,
EXCEPT PER SHARE AMOUNTS)
Net income (loss)............................. $ (64) $ 66 $ (48) $ 135
Accretion of Series B preferred stock......... (6) -- (13) --
------ ----- ------ -----
Net income (loss) available to common
shareowners................................. $ (70) $ 66 $ (61) $ 135
------ ----- ------ -----
SHARES USED IN COMPUTING EARNINGS PER COMMON
SHARE:
Basic....................................... 283 265 283 264
====== ===== ====== =====
Diluted..................................... 283 280 283 280
====== ===== ====== =====
EARNINGS PER COMMON SHARE:
Basic....................................... $(0.25) $0.25 $(0.21) $0.51
====== ===== ====== =====
Diluted..................................... $(0.25) $0.24 $(0.21) $0.48
====== ===== ====== =====
SECURITIES EXCLUDED FROM THE COMPUTATION OF
DILUTED EARNINGS PER COMMON SHARE:
Options(a).................................. 66 5 67 2
Series B preferred stock(b)................. 15 -- 15 --
Warrants(a)................................. 12 -- 12 --
------ ----- ------ -----
Total..................................... 93 5 94 2
====== ===== ====== =====
- ------------------------
(a) These securities have been excluded from the diluted earnings per common
share calculation since their inclusion would be anti-dilutive because the
option and warrant exercise prices are greater than the average market value
of the underlying stock.
(b) In applying the "if-converted" method, the Series B convertible
participating preferred stock was excluded from the diluted earnings per
common share calculation since the effect of its inclusion would have been
anti-dilutive.
13
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
9. DERIVATIVE FINANCIAL INSTRUMENTS
The Company conducts its business on a multinational basis in a wide variety
of foreign currencies, and, as such, uses derivative financial instruments to
reduce earnings and cash flow volatility associated with foreign exchange rate
changes. The Company uses foreign currency forward contracts, and to a lesser
extent, foreign currency options, to mitigate the effects of fluctuations of
exchange rates on intercompany loans which are denominated in currencies other
than the subsidiary's functional currency, and to reduce exposure to the risk
that the eventual net cash flows resulting from the purchase or sale of products
to or from non-U.S. customers will be adversely affected by changes in exchange
rates. The Company uses derivative financial instruments as risk management
tools and not for speculative or trading purposes. Although not material, these
derivatives represent assets and liabilities and are classified as "Other
current assets" or "Other current liabilities" on the accompanying Consolidated
Balance Sheets. Gains and losses on the changes in the fair values of the
Company's derivative instruments are included in "Other income, net" on the
Consolidated Statement of Operations.
RECORDED TRANSACTIONS
Foreign currency forward contracts are used primarily to manage exchange
rate exposures on intercompany loans residing on foreign subsidiaries' books,
which are denominated in currencies other than the subsidiary's functional
currency. When these loans are translated into the subsidiary's functional
currency at the month end exchange rates, the fluctuations in the exchange rates
are recognized in earnings as other income or expense. Gains and losses
resulting from the impact of currency exchange rate movements on foreign
currency forward contracts designated to offset these non-functional currency
denominated loans are also recognized in earnings as other income or expense in
the period in which the exchange rates change and are generally offset by the
foreign currency losses and gains on the loans. For the three and six months
ended March 31, 2001, the net effect of the gains and losses from the change in
the fair value of the foreign currency forward contracts and the translation of
the non-functional currency denominated loans were not material to the Company's
results of operations.
FORECASTED TRANSACTIONS
Foreign currency forward and option contracts are used to offset certain
forecasted foreign currency transactions primarily related to the purchase or
sale of product expected to occur during the ensuing twelve months. The gains
and losses resulting from the impact of currency exchange rate movements on
these foreign currency forward and option contracts are recognized as other
income or expense in the period in which the exchange rates change. For the
three and six months ended March 31, 2001, these gains and losses were not
material to the Company's results of operations.
Electing to not use hedge accounting under SFAS 133 could result in a gain
or loss from fluctuations in exchange rates related to a derivative contract,
which is different from the loss or gain recognized from the underlying
forecasted transaction. However, the Company has procedures to manage risks
associated with its derivative instruments, which include limiting the duration
of the contracts, typically six months or less, and the amount of the underlying
exposures that can be economically hedged. Historically, the gains and losses on
these transactions have not been significant.
14
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. OPERATING SEGMENTS
The Company reports its operations in three segments: Communications
Solutions, Services and Connectivity Solutions. The Communications Solutions
segment represents the Company's core business, comprised of enterprise voice
communications systems and software, communications applications, professional
services for customer and enterprise relationship management, multi-service
networking products and product installation services. The purchase prices of
the Company's products typically include installation costs, which are included
in the Communications Solutions segment. The Services segment represents
maintenance, value-added and data services. The Connectivity Solutions segment
represents structured cabling systems and electronic cabinets. The costs of
shared services and other corporate center operations managed on a common basis
represent business activities that do not qualify for separate operating segment
reporting and are aggregated in the Corporate and other category.
In the first quarter of fiscal 2001, the Company realigned the method of
allocating costs of shared services and other corporate center operations
managed outside of the reportable operating segments. Financial data for the
periods prior to the realignment have been restated to conform to the current
presentation.
REPORTABLE SEGMENTS
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------ ----------------
2001 2000 2001 2000
---- ---- ---- ----
(DOLLARS IN MILLIONS)
COMMUNICATIONS SOLUTIONS:
External revenue............................ $932 $1,132 $1,860 $2,240
Intersegment revenue........................ -- 2 -- 7
---- ------ ------ ------
Total Revenue............................. 932 1,134 1,860 2,247
Operating income............................ 202 349 429 756
SERVICES:
External revenue............................ $529 $ 486 $1,028 $ 956
Intersegment revenue........................ -- -- -- --
---- ------ ------ ------
Total Revenue............................. 529 486 1,028 956
Operating income............................ 254 195 497 381
CONNECTIVITY SOLUTIONS:
External revenue............................ $391 $ 326 $ 747 $ 597
Intersegment revenue........................ -- -- -- 1
---- ------ ------ ------
Total Revenue............................. 391 326 747 598
Operating income............................ 156 56 244 89
15
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
RECONCILING ITEMS
A reconciliation of the totals reported for the operating segments to the
corresponding line items in the consolidated financial statements is as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
EXTERNAL REVENUE
Total reportable segments............. $1,852 $1,944 $3,635 $3,793
Corporate and other................... -- 1 2 2
------ ------ ------ ------
Total External Revenue.............. $1,852 $1,945 $3,637 $3,795
====== ====== ====== ======
OPERATING INCOME
Total reportable segments............. $ 612 $ 600 $1,170 $1,226
Corporate and other:
Business restructuring related
charges and start-up expenses..... (188) (47) (247) (94)
Corporate and unallocated shared
expenses.......................... (527) (474) (1,000) (921)
------ ------ ------ ------
Total Operating Income (Loss)..... $ (103) $ 79 $ (77) $ 211
====== ====== ====== ======
Corporate and unallocated shared expenses include costs such as selling,
research and development, marketing, information technology and finance that are
not directly managed by or identified with the reportable operating segments.
GEOGRAPHIC INFORMATION
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
EXTERNAL REVENUE(1)
U.S................................... $1,395 $1,513 $2,741 $2,999
Foreign countries..................... 457 432 896 796
------ ------ ------ ------
Totals.............................. $1,852 $1,945 $3,637 $3,795
====== ====== ====== ======
- ------------------------
(1) Revenue is attributed to geographic areas based on the location of
customers.
CONCENTRATIONS
For the six months ended March 31, 2001, sales to the Company's largest
distributor were approximately 11% of revenue. No single customer accounted for
more than 10% of the Company's consolidated revenue for the six months ended
March 31, 2000.
16
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
The completion of the outsourcing agreement with Celestica could result in a
concentration that, if suddenly eliminated, could have an adverse effect on the
Company's operations. While the Company believes that alternative sources of
supply would be available, disruption of its primary source of supply could
create a temporary, adverse effect on product shipments. The Company is not
aware of any other significant concentration of business transacted with a
particular supplier that could, if suddenly eliminated, have a material adverse
affect on the Company's financial position, results of operations or cash flows.
11. BENEFIT OBLIGATIONS
In connection with the distribution, the Company recorded estimates in its
balance sheet at September 30, 2000 in prepaid benefit assets and accrued
benefit obligations of various existing Lucent benefit plans related to
employees for whom we assumed responsibility. Following a review that was
conducted by an independent actuarial consulting firm, the Company received a
preliminary valuation that provides for a reduction of approximately
$35 million in its net benefit assets. The Company and Lucent are currently
reviewing the valuation. Upon final agreement between Lucent and the Company on
the valuation, the Company will record the net effect of the adjustment to
additional paid-in capital because the transfer of the net benefit assets
relates to the original capital contribution from Lucent.
12. TRANSACTIONS WITH LUCENT
In connection with the Distribution, 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
relating to the Company's Businesses and for 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.
The Company has resolved substantially all of the contribution and
distribution issues with Lucent that relate primarily to the settlement of
certain obligations associated with the employees transferred to the Company by
Lucent, receivables of the Company's business, and the transfer of other assets
and liabilities by Lucent to the Company. Accordingly, the Company has
identified approximately $15 million recorded on its balance sheet that was
attributable primarily to certain accounts receivable balances due from Lucent
and certain fixed assets, which the Company has subsequently agreed will remain
with Lucent. Since these assets relate to the original capital contribution by
Lucent, the Company has reduced additional paid-in capital at March 31, 2001 for
the net effect of these adjustments.
17
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
13. COMMITMENTS AND CONTINGENCIES
RISKS AND UNCERTAINTIES
The Company has limited history operating as an independent company, and it
may be unable to make the changes necessary to operate as a stand alone
business, or it may incur greater costs as a stand-alone company that may cause
its profitability to decline. Prior to the Distribution, the Company's business
was operated by Lucent as a segment of its broader corporate organization rather
than as a separate stand-alone company. Lucent assisted the Company by providing
financing, particularly of acquisitions, as well as providing corporate
functions such as identifying and negotiating acquisitions, and legal and tax
functions. Following the Distribution, Lucent has no obligation to provide
assistance to the Company other than certain interim and transitional services.
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 that should have, individually or in the
aggregate, a material adverse effect on its financial position, results of
operations or cash flows.
Three separate purported class action lawsuits are pending against Lucent in
state court in New York and West Virginia and in federal court in California.
The case in New York was filed in January 1999, and after being dismissed, was
re-filed in September 2000. The case in West Virginia was filed in April 1999
and the case in California was filed in June 1999. The Company may be named a
party to these actions and has assumed the obligations of Lucent for these cases
under the Contribution and Distribution Agreement. 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 not been certified in any of the three cases, and to the extent a class is
certified in any of the cases, the Company expects that class to constitute
those enterprises that purchased the products in question. The complaints seek,
among other remedies, compensatory damages, punitive damages and counsel fees in
amounts that have not yet been specified. Although the Company believes that the
outcome of these actions will not adversely affect its financial position,
results of operations or cash flows, if these cases are not resolved in a timely
manner, they will require expenditure of significant legal costs related to
their defense.
From time to time the Company is subject to unfair labor charges filed by
the unions representing its employees with the National Labor Relations Board.
The National Labor Relations Board has approved the withdrawal of a previously
issued complaint alleging that Lucent refused to bargain over the outsourcing of
certain of its manufacturing activities, including facilities subsequently
transferred to the Company in connection with the spin-off.
In April 1998, a class action was filed against Lucent in state court in New
Jersey, alleging that Lucent improperly administered a coupon program resulting
from the settlement of a prior class action. The plaintiffs allege that Lucent
improperly limited the redemption of the coupons from dealers by not allowing
them to be combined with other volume discount offers, thus limiting the market
for the coupons. The Company has assumed the obligations of Lucent for these
cases under the Contribution
18
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
and Distribution Agreement. The complaint alleges breach of contract, fraud and
other claims and the plaintiffs seek compensatory and consequential damages,
interest and attorneys' fees. The state court has recently certified a class in
this action. There can be no assurance that this case will not have a material
adverse effect on the Company's financial position, results of operations or
cash flows.
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 will most likely be consolidated with other purported
class actions filed against Lucent on behalf of shareholders in January 2000.
Those January 2000 actions have been consolidated and are pending in the Federal
District Court for the District of New Jersey. The Company understands that
Lucent has filed its Answer to the Fourth Consolidated Amended and Supplemental
Class Action Complaint in the consolidated action. The plaintiffs allege that
they were injured by reason of certain alleged false and misleading statements
made by Lucent in violation of the federal securities laws. The consolidated
cases were initially filed on behalf of shareholders 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 November 21, 2000. A class has not yet been certified in the
consolidated actions. The plaintiffs in all these shareholder class actions seek
compensatory damages plus interest and attorneys' fees.
Any liability incurred by Lucent in connection with these shareholder class
action lawsuits may be deemed a shared contingent liability under the
Contribution and Distribution Agreement and as a result, the Company would be
responsible for 10% of any such liability in excess of $50 million. All of these
actions are in the early stages of litigation and an outcome cannot be
predicted, and as a result, there can be no assurance that these cases will not
have a material adverse effect on the Company's financial position, results of
operations or cash flows.
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 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 of the
Company. 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 five of the Company's facilities either
voluntarily or pursuant to government directives.
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,
19
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
13. COMMITMENTS AND CONTINGENCIES (CONTINUED)
depending on the site, based primarily upon internal or third-party
environmental studies and the extent of contamination and the type of required
cleanup. Although the Company believes that its reserves are adequate to cover
known environmental liabilities, 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
financial position, results of operations or cash flows.
14. SUBSEQUENT EVENT
QUINTUS ASSET ACQUISITION
On April 11, 2001, the Company acquired substantially all of the assets of
Quintus Corporation for approximately $29 million in cash and assumed
approximately $19 million of Quintus' liabilities. Quintus provides a
comprehensive electronic customer relationship management (eCRM) solution that
enables companies to increase revenue potential by improving customer
satisfaction and loyalty. Quintus offers products that manage all customer
interactions, such as customer orders, inquiries and service requests, and allow
delivery of consistent customer service across multiple communications channels,
including the Internet, e-mail and telephone. The Company will account for the
acquisition under the purchase method of accounting. The Company is in the
process of obtaining an independent third party appraisal of the intangible
assets acquired and expects a portion of the purchase price to be allocated to
these intangible assets.
20
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 thereto included elsewhere in this Quarterly
Report on Form 10-Q. The matters discussed in Management's Discussion and
Analysis of Financial Condition and Results of Operations contain certain
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Statements made that are not historical facts are
forward-looking and are based on estimates, forecasts and assumptions involving
risks and uncertainties that could cause actual results or outcomes to differ
materially from those expressed in the forward-looking statements.
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; the ability to successfully integrate
acquired companies; control of costs and expenses; the ability to form and
implement alliances; the economic, political and other risks associated with
international sales and operations; U.S. and foreign 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.
Our accompanying unaudited consolidated financial statements as of
March 31, 2001 and for the three and six months ended March 31, 2001 and 2000,
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, 2000. 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.
OVERVIEW
We are a leading provider of communications systems and software for
enterprises, including businesses, government agencies and other organizations.
We offer voice, converged voice and data, customer relationship management,
messaging, multi-service networking and structured cabling products and
services. Multi-service networking products are those products that support
network infrastructures which carry voice, video and data traffic over any of
the protocols, or set of procedures, supported by the Internet on local area and
wide area data networks. A structured cabling system is a flexible cabling
system designed to connect phones, workstations, personal computers, local area
networks and other communications devices through a building or across one or
more campuses. We are a worldwide leader in sales of messaging and structured
cabling systems and a United States leader in sales of enterprise voice
communications and call center systems. We are not a leader in multi-service
networking products or in converged voice and data products. We have entered
these product areas relatively recently, and our multi-service networking
product portfolio is less complete than the portfolios of some of our
competitors. We are implementing a strategy focused on these products.
We report our operations in three segments: Communications Solutions,
Services and Connectivity Solutions. The Communications Solutions segment
represents our core business, comprised of our enterprise voice communications
systems and software, communications applications, professional services for
customer and enterprise relationship management, multi-servicing networking
products and product installation services. The purchase prices of our products
typically include installation costs, which are included in the Communications
Solutions segment. The Services segment represents our
21
maintenance, value-added and data services. The Connectivity Solutions segment
represents our structured cabling systems and our electronic cabinets. The costs
of shared services and other corporate center operations managed on a common
basis represent business activities that do not qualify for separate operating
segment reporting and are aggregated in the Corporate and other category.
We have been experiencing declines in revenue from our traditional business,
enterprise voice communications products. We expect, based on various industry
reports, the growth rate of the market segments for these traditional products
to be extremely low. We are implementing a strategy to capitalize on the higher
growth opportunities in our market, such as eBusiness communications solutions,
including converged voice and data products. By eBusiness, we mean the internal
and external use of communications tools and electronic networks, to interact,
collaborate and transact business with an enterprise's customers, suppliers,
partners and employees. 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 advanced products. The success of this strategy, however, is
subject to many risks, including risks that:
- we do not develop new products or enhancements to our current products on
a timely basis to meet the changing needs of our customers;
- customers do not accept our products or new technology or industry
standards develop that make our products obsolete; or
- our competitors introduce new products before we do and achieve a
competitive advantage by being among the first to market.
Our traditional enterprise voice communications products and our eBusiness
solutions are a part of our Communications Solutions segment. If we are
unsuccessful in implementing our strategy, the contribution to our results from
Communications Solutions may decline, reducing our overall profitability and
requiring a greater need for capital resources.
The following table sets forth the allocation of our revenue among our
operating segments, expressed as a percentage of total external revenue,
excluding corporate and other revenue:
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
---------------------- ----------------------
2001 2000 2001 2000
---- ---- ---- ----
(PERCENTAGES)
OPERATING SEGMENT:
Communications Solutions.............. 50.3% 58.2% 51.2% 59.1%
Services.............................. 28.6 25.0 28.3 25.2
Connectivity Solutions................ 21.1 16.8 20.5 15.7
----- ----- ----- -----
Total............................... 100.0% 100.0% 100.0% 100.0%
===== ===== ===== =====
SEPARATION FROM LUCENT
We were incorporated under the laws of the State of Delaware on
February 16, 2000, as a wholly owned subsidiary of Lucent Technologies Inc. As
of June 27, 2000, our name was changed to "Avaya Inc". On September 30, 2000,
under the terms of a Contribution and Distribution Agreement between us and
Lucent, Lucent contributed its enterprise networking business to us and
distributed all of the outstanding shares of our capital stock to its
shareowners. We refer to these transactions in this quarterly report as the
contribution and the distribution. We had no material assets or activities until
the contribution to us by Lucent of its enterprise networking businesses, which
occurred immediately prior to the distribution. Lucent conducted such businesses
through various divisions and subsidiaries. Following the distribution, we
became an independent public company, and Lucent no longer has a
22
continuing stock ownership interest in us. Prior to the distribution, we entered
into several agreements with Lucent in connection with, among other things,
intellectual property, interim services and a number of ongoing commercial
relationships, including product supply arrangements. The interim services
agreement had set forth charges generally intended to allow the providing
company to fully recover the allocated direct costs of providing the services,
plus all out-of-pocket costs and expenses, but without any profit. With limited
exceptions, these interim services expired on March 31, 2001. The pricing terms
for goods and services covered by the commercial agreements reflect current
market prices.
We have resolved substantially all of the contribution and distribution
issues with Lucent that relate primarily to the settlement of certain
obligations associated with the employees transferred to us by Lucent,
receivables of our business, and the transfer of other assets and liabilities by
Lucent to us. Accordingly, we have identified approximately $15 million recorded
on our balance sheet, that was attributable primarily to certain accounts
receivable balances due from Lucent and certain fixed assets, which we have
subsequently agreed will remain with Lucent. Since these assets relate to the
original capital contribution by Lucent, we have reduced additional paid-in
capital at March 31, 2001 for the net effect of these adjustments.
In addition, Avaya and Lucent have amended the contribution and distribution
agreement to remove the provisions restricting us from entering into strategic
alliances with Nortel Networks Corporation and Cisco Systems, Inc.
In connection with the distribution, we recorded estimates in our balance
sheet at September 30, 2000 in prepaid benefit assets and accrued benefit
obligations of various existing Lucent benefit plans related to employees for
whom we assumed responsibility. Following a review that was conducted by an
independent actuarial consulting firm, we received a preliminary valuation that
provides for a reduction of approximately $35 million in our net benefit assets.
Avaya and Lucent are currently reviewing the valuation. Upon final agreement by
Lucent and us on the valuation, we will record the net effect of the adjustment
to additional paid-in capital because the transfer of the net benefit assets
relates to the original capital contribution from Lucent.
Our unaudited consolidated financial statements for the three and six months
ended March 31, 2000 reflect the historical results of operations and cash flows
of the businesses transferred to us from Lucent as part of the contribution.
These consolidated financial statements may not necessarily reflect our results
of operations and cash flows in the future or what our results of operations and
cash flows would have been had we been a stand-alone company during this period.
23
BUSINESS RESTRUCTURING AND RELATED CHARGES
In September 2000, we adopted a restructuring plan to improve profitability
and business performance as a stand-alone company and recorded a pretax charge
of $520 million. Components of the business restructuring costs, as well as
amounts and adjustments recorded to the related reserve as of March 31, 2001,
were as follows:
EXPENDITURES
NET ADJUSTMENTS MADE
RESERVE MADE DURING THE RESERVE
COSTS EXPENDITURES BALANCE DURING THE SIX SIX MONTHS BALANCE
ACCRUED MADE AS OF MONTHS ENDED ENDED AS OF
DURING DURING SEPTEMBER 30, MARCH 31, MARCH 31, MARCH 31,
FISCAL 2000 FISCAL 2000 2000 2001 2001 2001
----------- ------------ -------------- --------------- ------------ ----------
(DOLLARS IN MILLIONS)
Employee separation
costs.................. $365 $(20) $345 $(21) $(195) $129
Lease obligations........ 127 -- 127 -- (32) 95
Other related exit
costs.................. 28 (1) 27 -- -- 27
---- ---- ---- ---- ----- ----
Total.................. $520 $(21) $499 $(21) $(227) $251
==== ==== ==== ==== ===== ====
In the second quarter of fiscal 2001, as part of our overall restructuring
effort, we entered into an agreement to outsource most of our manufacturing of
communication systems and software to Celestica Inc. As a result, approximately
1,930 union-represented and 430 salaried employees will receive involuntary
employee termination benefits. Under the agreement with Celestica, we will
outsource our manufacturing operations currently performed in Westminster,
Colorado as well as our repair and distribution operations located in Little
Rock, Arkansas. Employees at the Westminster and Little Rock locations were
transitioned from Avaya to Celestica on May 4, 2001. In addition, products
currently manufactured in Shreveport, Louisiana will be transitioned to the
Westminster or other Celestica facilities. All Shreveport operations are
expected to be phased out by the end of the first quarter of fiscal 2002.
In connection with the outsourcing of these facilities, we recorded a pretax
charge of $134 million related to employee separation costs as a business
restructuring and related charge in the Consolidated Statement of Operations.
The $134 million charge resulted in a $34 million increase in the business
restructuring reserve, a $69 million reduction in prepaid benefit costs for
enhanced severance and pension benefits, and an increase of $31 million of
post-retirement benefits other than pension included in benefit obligations. The
charge for post-retirement benefits other than pension represents the cost of
curtailment in accordance with SFAS 88, "Employers' Accounting for Settlements
and Curtailments of Defined Benefit Pension Plans and for Termination Benefits."
In connection with the contract manufacturing transaction, previously
accrued separation costs of $55 million for union-represented employees at
Shreveport will be paid as enhanced severance benefits from existing pension and
benefit assets. This $55 million reduction offset by the $34 million increase
related to severance payments that will be made using cash, resulted in a net
adjustment of $21 million to the business restructuring reserve.
As of September 30, 2000, accrued business restructuring costs for employee
separations of $365 million related to approximately 4,900 union-represented and
salaried employees, of which 3,662 employees worldwide have departed as of
March 31, 2001 predominately located in the United States. In connection with
the contract manufacturing transaction with Celestica, there were no employee
separations as of March 31, 2001. Employee separation payments will be made
either through lump sum or a series of payments extending over a period of up to
two years from the date of departure, at the employees' option. Payments on
lease obligations, which consist of real estate and equipment leases, will
extend through 2003. Other related exit costs will be paid by the end of the
current fiscal year.
24
For the three and six months ended March 31, 2001, we recorded incremental
period costs associated with our separation from Lucent of $48 million and
$71 million, respectively, which are included in business restructuring and
related charges in the Consolidated Statement of Operations. These costs relate
primarily to computer system transition costs such as data conversion
activities, asset transfers, and training. We also recorded $6 million and
$42 million, respectively, in selling, general and administrative expenses for
additional start-up activities largely resulting from marketing costs associated
with continuing to establish the Avaya brand.
During the remainder of fiscal 2001, we expect to incur additional period
costs of approximately $80 million as a result of our separation from Lucent and
establishment as an independent company. Additional period costs related to the
outsourcing of certain of our manufacturing facilities are expected to total
approximately $45 million, most of which are expected to be incurred during the
remainder of fiscal 2001. We expect to fund these restructuring and start-up
activities through a combination of debt and internally generated funds.
We believe that outsourcing our manufacturing will allow us to improve our
cash flow over the next few years through a reduction of inventory and reduced
capital expenditures. We cannot assure you that the implementation of this
manufacturing initiative will achieve these anticipated benefits.
RESULTS OF OPERATIONS
The following table sets forth line items from our consolidated statements
of operations as a percentage of revenue for the periods indicated:
THREE MONTHS ENDED SIX MONTHS ENDED
MARCH 31, MARCH 31,
---------------------- ----------------------
2001 2000 2001 2000
-------- -------- -------- --------
Revenue......................... 100.0% 100.0% 100.0% 100.0%
Costs........................... 55.8 59.0 56.7 57.0
----- ----- ----- -----
Gross margin.................. 44.2 41.0 43.3 43.0
----- ----- ----- -----
Operating expenses:
Selling, general and
administrative.............. 30.0 30.8 30.9 31.5
Business restructuring and
related charges............. 9.8 -- 5.6 --
Research and development...... 8.3 6.1 8.1 5.9
Purchased in-process research
and development............. 1.7 -- 0.8 --
----- ----- ----- -----
Total operating expenses........ 49.8 36.9 45.4 37.4
----- ----- ----- -----
Operating income (loss)......... (5.6) 4.1 (2.1) 5.6
Other income, net............... 1.0 2.6 0.7 1.4
Interest expense................ (0.5) (1.1) (0.5) (1.1)
Provision (benefit) for income
taxes......................... (1.7) 2.2 (0.6) 2.3
----- ----- ----- -----
Net income (loss)............... (3.4)% 3.4% (1.3)% 3.6%
===== ===== ===== =====
25
THREE MONTHS ENDED MARCH 31, 2001 COMPARED TO THREE MONTHS ENDED MARCH 31, 2000
The following table shows the change in external revenue, both in dollars
and in percentage terms:
THREE MONTHS ENDED
MARCH 31,
---------------------- CHANGE
2001 2000 $ %
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
Operating Segment:
Communication Solutions.............. $ 932 $1,132 $(200) (17.7)%
Services............................. 529 486 43 8.8
Connectivity Solutions............... 391 326 65 19.9
Corporate and other.................. -- 1 (1) (100.0)
------ ------ ----- ------
Total.............................. $1,852 $1,945 $ (93) (4.8)%
====== ====== ===== ======
REVENUE. Revenue decreased 4.8% or $93 million, from $1,945 million for the
three months ended March 31, 2000, to $1,852 million for the same period in
fiscal 2001. The decrease in the Communications Solutions segment was largely
attributed to an overall sales reduction in our enterprise voice communications
systems and customer relationship management businesses predominately in the
United States, partially offset by strong growth worldwide in the multi-service
networking business. The revenue decline in the Communications Solutions segment
was primarily due to the effects of a slowing U.S. economy combined with a move
to a more indirect sales channel, changes in product mix, and a decrease in
installation revenue as a result of the reduction in product sales. The
Connectivity Solutions segment increase was the result of strong demand in the
U.S. for our structured cabling systems and electronic cabinets as well as price
and volume increases, lower discounts and product mix. The increase in the
Services segment was mainly the result of the positive effects in the U.S. of
introducing data services as well as the strong growth outside of the U.S. in
maintenance and value added services.
Revenue within the United States decreased 7.8% or $118 million, from
$1,513 million for the three months ended March 31, 2000, to $1,395 million for
the same period in fiscal 2001. Revenue outside the United States increased 5.8%
or $25 million, from $432 million for the three months ended March 31, 2000, to
$457 million for the same period in fiscal 2001. Revenue outside the United
States in the three months ended March 31, 2001 represented 24.7% of revenue
compared with 22.2% in the same period in fiscal 2000. We continued to expand
our business outside of the United States with growth across all regions.
COSTS AND GROSS MARGIN. Total costs decreased 9.9% or $114 million, from
$1,147 million for three months ended March 31, 2000, to $1,033 million for the
same period in fiscal 2001. Gross margin percentage increased 3.2% from 41.0% in
the three months ended March 31, 2000 as compared with 44.2% in the same period
in fiscal 2001. The increase in gross margin was primarily attributed to higher
volume and favorable product mix in Connectivity Solutions and the ongoing
savings from the business restructuring, including the improvement to the cost
structure within the Services segment. This increase was partially offset by the
decrease in gross margin within Communications Solutions due to a shift from a
direct retail market to an indirect distribution channel resulting from our sale
of our U.S. sales division serving small to mid-sized businesses and a less
favorable mix of products.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
(SG&A) expenses decreased 7.3% or $44 million, from $600 million for the three
months ended March 31, 2000, to $556 million for the same period in fiscal 2001.
The decrease is primarily due to savings associated with our business
restructuring plan, including lower staffing levels and terminated real estate
lease obligations. The reduction in SG&A expenses was largely offset by
increases in ongoing marketing expenses associated with establishing our brand.
26
BUSINESS RESTRUCTURING AND RELATED CHARGES. Business restructuring and
related charges for the three months ended March 31, 2001 represent costs
associated with our restructuring plan to improve profitability and business
performance as a stand-alone company. The components of the charge include
$134 million primarily for employee separation costs associated with the
outsourcing of certain manufacturing operations to Celestica Inc. and
$48 million representing incremental period costs associated with our separation
from Lucent related primarily to computer system transition costs such as data
conversion activities, asset transfers, and training.
RESEARCH AND DEVELOPMENT. Research and development (R&D) expenses increased
28.6% or $34 million, from $119 million for three months ended March 31, 2000,
to $153 million for the same period in fiscal 2001. This planned increase in R&D
is primarily due to higher expenditures in support of new products, which were
partially offset by reduced spending on more mature product lines. Our
investment in R&D represented 8.3% of revenue in the three months ended
March 31, 2001 as compared with 6.1% in the prior period, which is consistent
with our plan to increase R&D spending in high growth markets.
We intend to invest an amount equal to approximately 9% of our total revenue
in fiscal 2001 in R&D. These investments represent a significant increase over
our investments in R&D for the fiscal years prior to the distribution, which
were approximately 6% of total revenue. As a part of Lucent, we were allocated a
portion of Lucent's basic research, which did not necessarily directly benefit
our business. Our current and future investments in R&D will have a greater
focus on our products.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT. These expenses reflect
charges associated with our acquisition of VPNet Technologies, Inc. on
February 6, 2001. There was no charge in the three months ended March 31, 2000
for purchased in-process research and development.
OTHER INCOME, NET. Other income, net decreased from $50 million for the
three months ended March 31, 2000 to $18 million for the same period in fiscal
2001. This decrease was primarily due to a gain recorded in March 2000 on the
sale of our U.S. sales division serving small and mid-sized enterprises, which
was partially offset by interest income earned on higher cash balances.
PROVISION FOR INCOME TAXES. The effective tax rate for the three months
ended March 31, 2001 was a benefit rate of 33.1% compared to a provision rate of
38.9% in the same period last year. The difference between the tax rates is
attributed to the tax impact of acquisition related costs and business
restructuring reserves.
SIX MONTHS ENDED MARCH 31, 2001 COMPARED TO SIX MONTHS ENDED MARCH 31, 2000
The following table shows the change in external revenue, both in dollars
and in percentage terms:
SIX MONTHS ENDED
MARCH 31,
---------------------- CHANGE
2001 2000 $ %
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
OPERATING SEGMENT:
Communication Solutions................... $1,860 $2,240 $(380) (17.0)%
Services.................................. 1,028 956 72 7.5
Connectivity Solutions.................... 747 597 150 25.1
Corporate and other....................... 2 2 -- --
------ ------ ----- -----
Total................................... $3,637 $3,795 $(158) (4.2)%
====== ====== ===== =====
REVENUE. Revenue decreased 4.2% or $158 million, from $3,795 million for
the six months ended March 31, 2000, to $3,637 million for the same period in
fiscal 2001, due to a decrease in the
27
Communications Solutions segment, partially offset by increases in the
Connectivity Solutions and Services segments. The decrease in the Communications
Solutions segment was largely attributed to an overall sales reduction in
enterprise voice communications systems, messaging systems and customer
relationship management businesses predominately in the United States partially
offset by strong growth worldwide in the multi-service networking business. The
revenue decline in the Communications Solutions segment was primarily due to the
effects of a slowing U.S. economy combined with a move to a more indirect sales
channel, changes in product mix, a decrease in installation revenue as a result
of the reduction in product sales, and the effects of customers having purchased
systems last year in anticipation of year 2000 concerns. The Connectivity
Solutions segment increase was the result of strong demand in the U.S. across
all product lines as well as price and volume increases, lower discounts and
product mix. The increase in the Services segment was mainly the result of the
positive effects in the U.S. of introducing data services as well as the strong
growth outside of the U.S. in maintenance and value added services.
Revenue within the United States decreased 8.6% or $258 million, from
$2,999 million for the six months ended March 31, 2000, to $2,741 million for
the same period in fiscal 2001. Revenue outside the United States increased
12.6% or $100 million, from $796 million for the six months ended March 31,
2000, to $896 million for the same period in fiscal 2001. Revenue outside the
United States in the six months ended March 31, 2001 represented 24.6% of
revenue compared with 21.0% in the same period in fiscal 2000. We continued to
expand our business outside of the United States with growth across all regions.
COSTS AND GROSS MARGIN. Total costs decreased 4.8% or $103 million, from
$2,164 million for the six months ended March 31, 2000, to $2,061 million for
the same period in fiscal 2001. The gross margin percentage remained essentially
unchanged at 43.0% in the six months ended March 31, 2000 as compared with 43.3%
in the same period in fiscal 2001. The increase in gross margin was primarily
attributed to higher volume, favorable product mix and lower discounts in
Connectivity Solutions and the ongoing savings from the business restructuring,
including the improvement to the cost structure within the Services segment.
This increase was largely offset by the decrease in gross margin within
Communications Solutions due to a shift from a direct retail market to an
indirect distribution channel resulting from our sale of this distribution
function and a less favorable mix of products.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
(SG&A) expenses decreased 6.0% or $72 million, from $1,196 million for the six
months ended March 31, 2000, to $1,124 million for the same period in fiscal
2001. The decrease is primarily due to savings associated with our business
restructuring plan, including lower staffing levels and terminated real estate
lease obligations. The reduction in SG&A expenses was partially offset by an
increase in ongoing marketing expense and additional charges for start-up
activities related to establishing independent operations, which are primarily
comprised of advertising costs associated with establishing our brand.
BUSINESS RESTRUCTURING AND RELATED CHARGES. Business restructuring and
related charges of $205 million for the six months ended March 31, 2001
represent costs associated with our restructuring plan to improve profitability
and business performance as a stand-alone company. The components of the charge
include $134 million primarily for employee separation costs associated with the
outsourcing of certain manufacturing operations to Celestica Inc. and
$71 million representing incremental period costs associated with our separation
from Lucent related primarily to computer system transition costs such as data
conversion activities, asset transfers, and training.
RESEARCH AND DEVELOPMENT. Research and development (R&D) expenses increased
30.8% or $69 million, from $224 million for six months ended March 31, 2000, to
$293 million for the same period in fiscal 2001. This planned increase in R&D is
primarily due to higher expenditures in support of new products, which were
partially offset by reduced spending on more mature product lines. Our
investment in R&D represented 8.1% of revenue in the six months ended March 31,
2001 as compared
28
with 5.9% in the prior period, which is consistent with our plan to increase R&D
spending in high growth markets.
We intend to invest an amount equal to approximately 9% of our total revenue
in fiscal 2001 in R&D. These investments represent a significant increase over
our investments in R&D for the fiscal years prior to the distribution, which
were approximately 6% of total revenue. As a part of Lucent, we were allocated a
portion of Lucent's basic research, which did not necessarily directly benefit
our business. Our current and future investments in R&D will have a greater
focus on our products.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT. These expenses reflect
charges associated with our acquisition of VPNet Technologies on February 6,
2001. There was no charge in the six months ended March 31, 2000 for purchased
in-process research and development.
OTHER INCOME, NET. Other income, net decreased from $54 million for the six
months ended March 31, 2000 to $27 million for the same period in fiscal 2001.
This decrease was primarily due to a gain recorded in March 2000 on the sale of
our U.S. sales division serving small and mid-sized enterprises, which was
partially offset by interest income earned on higher cash balances.
PROVISION FOR INCOME TAXES. The effective tax rate for the six months ended
March 31, 2001 was a benefit rate of 31.3% compared to a provision rate of 39.5%
in the same period last year. The difference between the tax rates is attributed
to the tax impact of acquisition related costs and business restructuring
reserves.
LIQUIDITY AND CAPITAL RESOURCES
Avaya's cash and cash equivalents increased to $312 million at March 31,
2001, from $271 million at September 30, 2000. The increase primarily resulted
from $343 million of net cash provided by financing activities, offset primarily
by $275 million of net cash used in investing activities.
Our net cash used for operating activities was $21 million for the six
months ended March 31, 2001 compared with net cash provided by operating
activities of $188 million for the same period in fiscal 2000. Net cash used for
operating activities for the six months ended March 31, 2001 was comprised of a
net loss adjusted for non-cash charges of $366 million, and net cash used for
changes in operating assets and liabilities of $339 million. Net cash used for
operating activities is primarily attributed to cash payments made for our
business restructuring related activities resulting from our separation from
Lucent and our establishment as an independent company. In addition, we have
decreased our accounts payable and have increased our inventory levels. This
usage of cash was somewhat offset by receipts of cash on our amounts due from
our customers. Days sales outstanding in accounts receivable for the second
quarter of fiscal 2001 was 75 days versus 86 days for the first quarter of
fiscal 2001. This decrease is primarily attributed to settlement of third party
receivables with Lucent pursuant to the Contribution and Distribution Agreement.
Days sales of inventory on-hand for the second quarter of fiscal 2001 were
63 days versus 58 days for the first quarter of fiscal 2001. The increase in
days sales in inventory is primarily due to lower sales volumes.
Our net cash used for investing activities was $275 million for the six
months ended March 31, 2001 compared with $83 million for the same period in
fiscal 2000. Capital expenditures, which account for the largest component of
investing activities in both periods, relate mainly to Avaya establishing itself
as a stand-alone entity, including information technology upgrades and corporate
infrastructure expenditures in the current period as compared with expenditures
for equipment and facilities used in manufacturing and research and development
in the same period last year. In addition, we used $101 million of cash for our
acquisition of VPNet, a privately held developer of virtual private network
solutions and devices, which occurred in the second quarter of the current
fiscal year. The prior year usage of cash was partially offset by the receipt of
proceeds from the sale of our U.S. sales division serving small and mid-sized
enterprises.
29
Net cash provided by financing activities was $343 million for the six
months ended March 31, 2001 compared with net cash used in financing activities
of $140 million for the same period in fiscal 2000. Cash flows from financing in
the current period was mainly due to the receipt of $400 million in proceeds
from the sale of our Series B convertible participating preferred stock and
warrants to purchase our common stock described below, as well as proceeds from
the issuance of our common stock, primarily through our Employee Stock Purchase
Plan, which was partially offset by $79 million in payments for the retirement
of commercial paper and long term debt.
Our commercial paper program is comprised of short-term borrowings in the
commercial paper market at market interest rates. Interest rates on our
commercial paper obligations are variable due to their short-term nature. As of
March 31, 2001, $700 million in commercial paper was classified as long term
debt in the consolidated balance sheet since it is supported by the five-year
credit facility described below and management intends to reissue the commercial
paper on a long term basis. The weighted average interest rate and maturity
period for the commercial paper outstanding as of March 31, 2001 was
approximately 6.0% and 11 days, respectively.
We have two unsecured revolving credit facilities with third party financial
institutions consisting of an $850 million 364-day credit facility that expires
in September 2001 and an $850 million five-year credit facility that expires in
September 2005. Funds are available under these revolving credit facilities for
general corporate purposes, to backstop commercial paper, and for acquisitions.
On October 2, 2000, we sold to Warburg, Pincus Equity Partners, L.P. and
related investment funds 4 million shares of our Series B convertible
participating preferred stock and warrants to purchase our common stock for an
aggregate purchase price of $400 million. Based on a conversion price of $26.71,
the Series B preferred stock is convertible into 15,466,328 shares of our common
stock as of March 31, 2001.
The warrants have an exercise price of $34.73 representing 130% of the
conversion price for the Series B preferred stock. Of these warrants, warrants
exercisable for 6,883,933 shares of common stock have a four-year term and
warrants exercisable for 5,507,146 shares of common stock have a five-year term.
During a period commencing no later than June 30, 2001, until the second
anniversary of their issuance, if the market price of our common stock exceeds
200%, in the case of the four-year warrants, and 225%, in the case of the
five-year warrants, of the exercise price of the warrants for 20 consecutive
trading days, we can force the exercise of up to 50% of the four-year warrants
and the five-year warrants, respectively.
The shares of Series B preferred stock had an aggregate initial liquidation
value of $400 million and will accrete for the first ten years at an annual rate
of 6.5% and 12% thereafter, compounded quarterly. After the third anniversary of
the original issue date of the Series B preferred stock, 50% of the amount
accreted for the year may be paid in cash as a dividend on a quarterly basis, at
our option. After the fifth anniversary of the issue date through the tenth
anniversary, we may elect to pay 100% of the amount accreted for the year as a
cash dividend on a quarterly basis. The liquidation value calculated on each
quarterly dividend payment date, which includes the accretion for the dividend
period, will be reduced by the amount of any cash dividends paid. Following the
tenth anniversary of the issue date, we will pay quarterly cash dividends at an
annual rate of 12% of the then accreted liquidation value of the Series B
preferred stock, compounded quarterly. The Series B preferred shares also
participate, on an as-converted basis, in dividends paid on our common stock.
For the six months ended March 31, 2001, accretion of the Series B preferred
stock was $13.1 million resulting in a liquidation value of $413.1 million as of
March 31, 2001. The total number of shares of common stock into which the
Series B preferred stock are convertible is determined by dividing the
liquidation value in effect at the time of conversion by the conversion price.
The Emerging Issues Task Force of the Financial Accounting Standards Board
has deliberated on the accounting for convertible securities with beneficial
conversion features. A beneficial conversion
30
feature would exist if the conversion price (accounting basis) for the Series B
preferred stock or warrants was less than the fair value of our common stock at
the commitment date. We determined that no beneficial conversion features
currently exist and therefore there is no impact on the results of operations
associated with the Series B preferred stock or with the warrants. The
beneficial conversion features, if any, associated with dividends paid in kind,
where it is our option to pay dividends on the Series B preferred stock in cash
or in kind, will be measured when dividends are declared and recorded as a
reduction to net income attributable to common shareowners.
At any time after the fifth anniversary of their issuance, we may force
conversion of the shares of Series B preferred stock. If we give notice of a
forced conversion, the investors will be able to require us to redeem the
Series B preferred shares at 100% of the then current liquidation value, plus
accrued and unpaid dividends. Following a change-in-control of us during the
first five years after the investment, other than a change of control
transaction that is a business combination involving solely the issuance of
common stock, the accretion of some or all the liquidation value of the
Series B preferred stock through the fifth anniversary of the issue date will be
accelerated, subject to our ability to pay a portion of the accelerated
accretion in cash in some instances. In addition, for 60 days following the
occurrence of any change-of-control of us during the first five years after the
investment, the investors will be able to require us to redeem the Series B
preferred stock at 101% of the liquidation value, including any accelerated
accretion of the liquidation value, plus accrued and unpaid dividends.
Our cost of capital and ability to obtain external financing is affected by
our debt ratings, which are periodically reviewed by the major credit rating
agencies. Our commercial paper is currently rated P-2 by Moody's and A-2 by
Standard & Poor's, and our long term debt rating is Baa1 by Moody's and BBB by
Standard & Poor's.
Our ability to issue additional equity is constrained because certain
issuances of additional common stock may cause the distribution to be taxable to
Lucent under Section 355(e) of the Internal Revenue Code, and under the tax
sharing agreement between Lucent and us, we would be required to indemnify
Lucent against that tax.
On March 30, 2001, we filed a Registration Statement on Form S-3 with the
Securities and Exchange Commission as part of a shelf registration process. Upon
effectiveness of the Registration Statement, we will be able to offer common
stock, preferred stock, debt securities or warrants to purchase debt securities,
or any combination of these securities, in one or more offerings with a total
initial offering price of up to $940 million. We intend to use the proceeds from
the sale of the securities for general corporate purposes, including debt
repayment and refinancing, capital expenditures and acquisitions.
Under the shelf registration statement, we have also registered for resale
by the Warburg Funds the preferred stock and warrants described above, and
shares of common stock issuable upon conversion or exercise thereof. We will not
receive any proceeds from the sale by the Warburg Funds of these securities.
Our primary future cash needs on a recurring basis will be to fund working
capital, capital expenditures and debt service, and we believe that our cash
flows from operations will be sufficient to meet these needs. We expect to fund
our business restructuring and separation costs through a combination of debt
and internally generated funds. If we do not generate sufficient cash from
operations, we may need to incur additional debt. We currently anticipate
spending approximately $218 million for business restructuring and approximately
$80 million for additional expenditures resulting from our continuing
establishment as an independent company. Additionally, we anticipate spending
approximately $33 million for business restructuring and approximately
$45 million for additional expenditures resulting from the outsourcing of
certain manufacturing facilities. In order to meet our cash needs, we may from
time to time issue additional commercial paper, if the market
31
permits such borrowings, or issue long or short-term debt, if available. We may
also refinance all or a portion of the commercial paper program with long-term
or other short-term debt instruments.
We cannot assure you that any such financings will be available to us on
acceptable terms or at all. Our ability to make payments on and to refinance our
indebtedness, and to fund working capital, capital expenditures and strategic
acquisitions, will depend on our ability to generate cash in the future, which
is subject to general economic, financial, competitive, legislative, regulatory
and other factors that are beyond our control. Our credit facilities contain,
and any future debt agreements we may enter into may contain, various
restrictions and covenants which could limit our ability to respond to market
conditions, to provide for unanticipated capital investments or to take
advantage of business opportunities.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT
In connection with the acquisition of VPNet Technologies, Inc. ("VPNet"), a
portion of the purchase price was allocated to purchased in-process research and
development. As part of the process of analyzing this acquisition, we made a
decision to buy technology that had not yet been commercialized rather than
develop the technology internally. We based this decision on factors such as the
amount of time it would take to bring the technology to market. We also
considered VPNet's resource allocation and its progress on comparable
technology, if any. Our management expects to use a similar decision process in
the future.
We estimated the fair value of in-process research and development for the
above acquisition using an income approach. This involved estimating the fair
value of the in-process research and development using the present value of the
estimated after-tax cash flows expected to be generated by the purchased
in-process research and development, using risk-adjusted discount rates and
revenue forecasts as appropriate. The selection of the discount rate was based
on consideration of our weighted average cost of capital, as well as other
factors, including the useful life of each technology, profitability levels of
each technology, the uncertainty of technology advances that were known at the
time, and the stage of completion of each technology. We believe that the
estimated in-process research and development amounts so determined represent
fair value and do not exceed the amount a third party would have paid for the
projects.
Where appropriate, we deducted an amount reflecting the contribution of the
core technology from the anticipated cash flows from an in-process research and
development project. At the date of acquisition, the in-process research and
development projects had not yet reached technological feasibility and had no
alternative future uses. Accordingly, the value allocated to these projects was
capitalized and immediately expensed at acquisition. If the projects are not
successful or completed in a timely manner, management's product pricing and
growth rates may not be achieved and we may not realize the financial benefits
expected from the projects.
The development efforts related to the majority of the purchased in-process
technology projects are progressing in accordance with the assumptions
underlying the appraisals. As expected in the normal course of product
development, a number of projects have experienced delays and other projects are
being evaluated due to changes in strategic direction and market conditions.
These factors are not expected to have a material adverse effect on our results
of operations and financial position in future periods.
Set forth below are descriptions of the significant acquired in-process
research and development projects related to our acquisition of VPNet.
On February 6, 2001, we completed the purchase of VPNet for an aggregate
purchase price of $117 million in cash and stock options. VPNet was a privately
held developer of virtual private network solutions and devices. We allocated
approximately $31 million to in-process research and development
32
projects, using the income approach described above, to the following projects:
low-end technologies for $5 million and high-end technologies for $26 million.
These projects under development at the valuation date represent next-generation
technologies that are expected to address emerging market demands for low and
high-end network data security needs.
At the acquisition date, the low-end technologies under development were
approximately 80 percent complete based on engineering man-month data and
technological progress. Revenue attributable to the developmental low-end VPNet
technologies was estimated to be $8 million in 2002 and $13 million in 2003.
Revenue was estimated to grow at a compounded annual growth rate of
approximately 60 percent for the six years following introduction, assuming the
successful completion and market acceptance of the major research and
development programs. Revenue was expected to peak in 2004 and decline
thereafter through the end of the technologies' life in 2007 as new product
technologies were expected to be introduced.
At the acquisition date, the high-end technologies under development were
approximately 60 percent complete, based on engineering man-month data and
technological progress. Revenue attributable to the developmental high-end VPNet
technologies was estimated to be $52 million in 2002 and $86 million in 2003.
Revenue was estimated to grow at a compounded annual growth rate of
approximately 50 percent for the seven years following introduction, assuming
the successful completion and market acceptance of the major research and
development programs. Revenue was expected to peak in 2004 and decline
thereafter through the end of the technologies' life in 2008 as new product
technologies were expected to be introduced.
VPNet had spent approximately $3.8 million on these in-process technology
projects, and expected to spend approximately $4.4 million to complete all
phases of research and development.
The rates utilized to discount the net cash flows to their present value
were based on estimated cost of capital calculations. Due to the nature of the
forecast and the risks associated with the successful development of the
projects, a discount rate of 25% was used to value the in-process research and
development. The discount rate utilized was higher than our weighted average
cost of capital due to the inherent uncertainties surrounding the successful
development of the purchased in-process technology, the useful life of such
technology, the profitability levels of the technology, and the uncertainty of
technological advances that are unknown at this time.
ENVIRONMENTAL, HEALTH AND SAFETY MATTERS
We are 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 our operations. We are subject to certain
provisions of environmental laws, particularly in the 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 our 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 us. We are currently
conducting investigation and/or cleanup of known contamination at approximately
five of our facilities either voluntarily or pursuant to government directives.
It is often difficult to estimate the future impact of environmental
matters, including potential liabilities. We have established financial reserves
to cover environmental liabilities where they are probable and reasonably
estimable. Reserves for estimated losses from environmental matters 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. Although we believe that our reserves are adequate to cover known
environmental liabilities, 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 our financial position,
results of operations or cash flows.
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LEGAL PROCEEDINGS
From time to time we are involved in legal proceedings arising in the
ordinary course of business. Other than as described below, we believe there is
no litigation pending that should have, individually or in the aggregate, a
material adverse effect on our financial position, results of operations or cash
flows.
Three separate purported class action lawsuits are pending against Lucent in
state court in New York and West Virginia and in federal court in California.
The case in New York was filed in January 1999, and, after being dismissed, was
re-filed in September 2000. The case in West Virginia was filed in April 1999
and the case in California was filed in June 1999. We may be named a party to
these actions and have assumed the obligations of Lucent for these cases under
the Contribution and Distribution Agreement. 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 not
been certified in any of the three cases, and to the extent a class is certified
in any of the cases, we expect that class to constitute those enterprises that
purchased the products in question. The complaints seek, among other remedies,
compensatory damages, punitive damages and counsel fees in amounts that have not
yet been specified. Although we believe that the outcome of these actions will
not adversely affect our financial position, results of operations or cash
flows, if these cases are not resolved in a timely manner, they will require
expenditure of significant legal costs related to their defense.
From time to time we are subject to unfair labor charges filed by the unions
representing our employees with the National Labor Relations Board. The National
Labor Relations Board has approved the withdrawal of a previously issued
complaint alleging that Lucent refused to bargain over the outsourcing of
certain of its manufacturing activities, including facilities subsequently
transferred to us in connection with the spin-off.
In April 1998, a class action was filed against Lucent in state court in New
Jersey, alleging that Lucent improperly administered a coupon program resulting
from the settlement of a prior class action. The plaintiffs allege that Lucent
improperly limited the redemption of the coupons from dealers by not allowing
them to be combined with other volume discount offers, thus limiting the market
for the coupons. We have assumed the obligations of Lucent for these cases under
the Contribution and Distribution Agreement. The complaint alleges breach of
contract, fraud and other claims and the plaintiffs seek compensatory and
consequential damages, interest and attorneys' fees. The state court has
recently certified a class in this action. We cannot assure you that this case
will not have a material adverse effect on our financial position, results of
operations or cash flows.
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 will most likely be consolidated with other purported
class actions filed against Lucent on behalf of shareholders in January 2000.
Those January 2000 actions have been consolidated and are pending in the Federal
District Court for the District of New Jersey. We understand that Lucent has
filed its Answer to the Fourth Consolidated Amended and Supplemental Action
Complaint in the consolidated action. The plaintiffs allege that they were
injured by reason of certain alleged false and misleading statements made by
Lucent in violation of the federal securities laws. The consolidated cases were
initially filed on behalf of shareholders of Lucent who bought Lucent common
stock
34
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 November 21, 2000. A class has not yet been certified in the consolidated
actions. The plaintiffs in all these shareholder class actions seek compensatory
damages plus interest and attorneys' fees.
Any liability incurred by Lucent in connection with these shareholder class
action lawsuits may be deemed a shared contingent liability under the
Contribution and Distribution Agreement and as a result, we would be responsible
for 10% of any such liability in excess of $50 million. All of these actions are
in the early stages of litigation and an outcome cannot be predicted, and as a
result, we cannot assure you that these cases will not have a material adverse
effect on our financial position, results of operations or cash flows.
EUROPEAN MONETARY UNION (EURO)
Several member countries of the European Union have established fixed
conversion rates between their existing sovereign currencies, and adopted the
EURO as their new common legal currency. The EURO is currently trading on
currency exchanges and the legacy currencies will remain legal tender in the
participating countries for a transition period extending through January 1,
2002. During the transition period, cashless payments can be made in the EURO,
and parties can elect to pay for goods and services and transact business using
either the EURO or a legacy currency. Between January 1, 2002 and July 1, 2002,
the participating countries will introduce EURO notes and coins and permanently
withdraw all legacy currencies.
The Euro conversion may affect cross-border competition by creating
cross-border price transparency. We will continue to evaluate the accounting,
tax, legal and regulatory requirements associated with the EURO introduction.
Based on current information and our current assessment, we do not expect that
the EURO conversion will have a material adverse effect on our consolidated
financial position, results of operations or cash flows.
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS 140
In September 2000, the Financial Accounting Standards Board issued Statement
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 140"). This Standard replaced SFAS 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities," and provides consistent standards for distinguishing transfers
of financial assets that are sales from transfers that are secured borrowings.
This Standard will be applied prospectively, with certain exceptions, and is
effective for transfers and servicing of financial assets and extinguishments of
liabilities occurring after March 31, 2001. The adoption of SFAS 140 is not
expected to have a material impact on our results of operations, financial
position or cash flows.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to risk from changes in foreign currency exchange rates and
interest rates that could impact our results of operations, financial position
or cash flows. We manage our exposure to these market risks through our regular
operating and financing activities and, when deemed appropriate, through the use
of derivative financial instruments. We conduct our business on a multinational
basis in a wide variety of foreign currencies, and, as such, use derivative
financial instruments to reduce earnings and cash flow volatility associated
with foreign exchange rate changes. We use foreign currency forward contracts,
and to a lesser extent, foreign currency options, to mitigate the effects of
fluctuations of exchange rates on intercompany loans which are denominated in
currencies other than the subsidiary's functional currency, and to reduce the
exposure to the risk that the eventual net cash flows resulting from the
purchase or sale of products to or from non-U.S.
35
customers will be adversely affected by changes in exchange rates. Derivative
financial instruments are used as risk management tools and not for speculative
or trading purposes.
RECORDED TRANSACTIONS
We use foreign currency forward contracts primarily to manage exchange rate
exposures on intercompany loans residing on our foreign subsidiaries' books
which are denominated in currencies other than the subsidiary's functional
currency. When these loans are translated into the subsidiary's functional
currency at the month end exchange rates, the fluctuations in the exchange rates
are recognized in earnings as other income or expense. Gains and losses
resulting from the impact of currency exchange rate movements on foreign
currency forward contracts designated to offset these non-functional currency
denominated loans are also recognized in earnings as other income or expense in
the period in which the exchange rates change and are generally offset by the
foreign currency losses and gains on the loans. For the three and six months
ended March 31, 2001, the net effect of the gains and losses on the change in
the fair value of the foreign currency forward contracts and the translation of
the non-functional currency denominated loans were not material to our results
of operations.
FORECASTED TRANSACTIONS
We use foreign currency forward and option contracts to offset certain
forecasted foreign currency transactions primarily related to the purchase or
sale of product expected to occur during the ensuing twelve months. The gains
and losses resulting from the impact of currency exchange rate movements on
these foreign currency forward and option contracts are recognized as other
income or expense in the period in which the exchange rates change. For the
three and six months ended March 31, 2001, these gains and losses were not
material to our results of operations.
Electing to not use hedge accounting under SFAS 133 could result in a gain
or loss from fluctuations in exchange rates related to a derivative contract
which is different from the loss or gain recognized from the underlying
forecasted transaction. However, we have procedures to manage the risks
associated with our derivative instruments which include limiting the duration
of the contracts, typically six months or less, and the amount of the underlying
exposures that can be economically hedged. Historically, the gains and losses on
these transactions have not been significant.
We may enter into interest rate swap agreements to manage the risk between
fixed, floating and variable interest rates and long-term and short-term
maturity debt instruments. There were no interest rate swap agreements in effect
during the six months ended March 31, 2001.
While we hedge many foreign currency transactions, the decline in value of
non-U.S. dollar currencies may, if not reversed, adversely affect our ability to
contract for product sales in U.S. dollars because our products may become more
expensive to purchase in U.S. dollars for local customers doing business in the
countries of the affected currencies.
By their nature, all derivative instruments involve, to varying degrees,
elements of market risk and credit risk not recognized in our financial
statements. The market risk associated with these instruments resulting from
currency exchange rate movements is expected to offset the market risk of the
underlying transactions, assets and liabilities being economically hedged. The
counterparties to the agreements relating to our foreign exchange instruments
consist of a diversified group of major financial institutions. We do not
believe that there is significant risk of loss in the event of nonperformance of
the counterparties because we control our exposure to credit risk through credit
approvals and limits, and continual monitoring of the credit ratings of such
counterparties. In addition, we limit the financial exposure and the amount of
agreements entered into with any one financial institution.
36
PART II
ITEM 1. LEGAL PROCEEDINGS.
See Note 13--"Commitments and Contingencies" to the unaudited interim
consolidated financial statements.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM 5. OTHER INFORMATION.
The Company has determined that any stockholder proposal to be included in
the Company's proxy statement to be delivered in connection with the Annual
Meeting of Stockholders to be held after the end of fiscal 2001 must be received
by the Company no later than August 31, 2001.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits:
None.
(b) Reports on Form 8-K:
The following Current Reports on Form 8-K were filed by us during the fiscal
quarter ended March 31, 2001:
1. January 8, 2001--Item 9. Regulation FD Disclosure--Avaya furnished
certain information in connection with a presentation to an investor
conference by Donald K. Peterson, its President and Chief Executive
Officer.
2. February 20, 2001--Item 5. Other Events--Announcement of outsourcing
agreement with Celestica Inc.
3. March 12, 2001--Item 9. Regulation FD Disclosure--Avaya furnished
certain information in connection with a presentation to an investor
conference by Garry K. McGuire, its Chief Financial Officer.
No financial statements were included in any of these Current Reports.
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
AVAYA INC.
By: /s/ CHARLES D. PEIFFER
-----------------------------------------
Charles D. Peiffer
CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
May 15, 2001
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