<Page>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
------------------------
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 JUNE 30, 2001
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 001-15951
------------------------
AVAYA INC.
<Table>
A DELAWARE I.R.S. EMPLOYER
CORPORATION NO. 22-3713430
211 MOUNT AIRY ROAD, BASKING RIDGE, NEW JERSEY 07920
TELEPHONE NUMBER 908-953-6000
</Table>
------------------------
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 June 30, 2001, 285,409,435 common shares were outstanding.
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<Page>
TABLE OF CONTENTS
<Table>
<Caption>
ITEM DESCRIPTION PAGE
- ---- ----------- ----
PART I
1. Financial Statements........................................ 3
2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 24
3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 40
PART II
1. Legal Proceedings........................................... 42
2. Changes in Securities and Use of Proceeds................... 42
3. Defaults Upon Senior Securities............................. 42
4. Submission of Matters to a Vote of Security Holders......... 42
5. Other Information........................................... 42
6. Exhibits and Reports on Form 8-K............................ 42
</Table>
2
<Page>
PART I
ITEM 1. FINANCIAL STATEMENTS.
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
REVENUE
Products.......................................... $1,193 $1,403 $3,802 $4,242
Services.......................................... 521 496 1,549 1,452
------ ------ ------ ------
1,714 1,899 5,351 5,694
------ ------ ------ ------
COSTS
Products.......................................... 705 831 2,298 2,498
Services.......................................... 278 266 746 763
------ ------ ------ ------
983 1,097 3,044 3,261
------ ------ ------ ------
GROSS MARGIN........................................ 731 802 2,307 2,433
------ ------ ------ ------
OPERATING EXPENSES
Selling, general and administrative............... 482 605 1,606 1,801
Business restructuring and related charges........ 66 -- 271 --
Research and development.......................... 135 126 428 350
Purchased in-process research and development..... 1 -- 32 --
------ ------ ------ ------
TOTAL OPERATING EXPENSES............................ 684 731 2,337 2,151
------ ------ ------ ------
OPERATING INCOME (LOSS)............................. 47 71 (30) 282
Other income, net................................. 4 -- 31 54
Interest expense.................................. (10) (17) (30) (59)
------ ------ ------ ------
INCOME (LOSS) BEFORE INCOME TAXES................... 41 54 (29) 277
Provision (benefit) for income taxes.............. 17 21 (5) 109
------ ------ ------ ------
NET INCOME (LOSS)................................... $ 24 $ 33 $ (24) $ 168
====== ====== ====== ======
EARNINGS (LOSS) PER COMMON SHARE:
Basic............................................. $ 0.06 $ 0.12 $(0.16) $ 0.63
====== ====== ====== ======
Diluted........................................... $ 0.06 $ 0.12 $(0.16) $ 0.60
====== ====== ====== ======
</Table>
See Notes to Consolidated Financial Statements.
3
<Page>
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
JUNE 30, 2001 SEPTEMBER 30, 2000
------------- ------------------
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 243 $ 271
Receivables, less allowances of $61 at June 30, 2001 and
$62 at September 30, 2000............................... 1,203 1,758
Inventory................................................. 685 639
Deferred income taxes, net................................ 283 450
Other current assets...................................... 542 244
------ ------
TOTAL CURRENT ASSETS........................................ 2,956 3,362
------ ------
Property, plant and equipment, net........................ 961 966
Prepaid benefit costs..................................... 268 387
Deferred income taxes, net................................ 143 44
Goodwill and other intangible assets, net................. 277 204
Other assets.............................................. 111 74
------ ------
TOTAL ASSETS................................................ $4,716 $5,037
====== ======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................... $ 485 $ 763
Current portion of long term debt......................... 15 80
Business restructuring reserve............................ 210 499
Payroll and benefit obligations........................... 497 491
Advance billings and deposits............................. 161 253
Other current liabilities................................. 498 503
------ ------
TOTAL CURRENT LIABILITIES................................... 1,866 2,589
------ ------
Long term debt............................................ 638 713
Benefit obligations....................................... 456 421
Deferred revenue.......................................... 71 83
Other liabilities......................................... 494 467
------ ------
TOTAL NONCURRENT LIABILITIES................................ 1,659 1,684
------ ------
Commitments and contingencies
Series B convertible participating preferred stock, par
value $1.00 per share, 4 million shares authorized, issued
and outstanding........................................... 388 --
------ ------
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, 285,409,435 and 282,027,675 issued
and outstanding as of June 30, 2001 and September 30,
2000, respectively...................................... 3 3
Additional paid-in capital................................ 892 825
Retained earnings (deficit)............................... (44) --
Accumulated other comprehensive loss...................... (48) (64)
------ ------
TOTAL STOCKHOLDERS' EQUITY.................................. 803 764
------ ------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $4,716 $5,037
====== ======
</Table>
See Notes to Consolidated Financial Statements.
4
<Page>
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED
JUNE 30,
-------------------
2001 2000
-------- --------
OPERATING ACTIVITIES:
Net income (loss)......................................... $ (24) $ 168
Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities:
Business restructuring and related charges.............. 154 --
Depreciation and amortization........................... 198 160
Provision for uncollectible receivables................. 40 43
Deferred income taxes................................... 68 (5)
Purchased in-process research and development........... 32 --
Gain on businesses sold................................. (6) (45)
Adjustments for other non-cash items, net............... 6 5
Changes in operating assets and liabilities:
Receivables........................................... 188 144
Inventory............................................. (45) 83
Accounts payable...................................... (272) 19
Other assets and liabilities.......................... (558) (225)
----- -----
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES........ (219) 347
----- -----
INVESTING ACTIVITIES:
Capital expenditures...................................... (214) (204)
Proceeds from the sale of property, plant and equipment... 72 9
Disposal of businesses.................................... -- 64
Acquisition of businesses, net of cash acquired........... (120) --
Purchases of equity investments........................... (27) (6)
Other investing activities, net........................... (3) 3
----- -----
NET CASH USED FOR INVESTING ACTIVITIES...................... (292) (134)
----- -----
FINANCING ACTIVITIES:
Issuance of convertible participating preferred stock..... 368 --
Issuance of warrants...................................... 32 --
Issuance of common stock.................................. 36 --
Transfers to Lucent....................................... -- (184)
Decrease in long term debt, net........................... (149) (1)
Proceeds from securitization of accounts receivable....... 200 --
Other financing activities, net........................... -- (5)
----- -----
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES........ 487 (190)
----- -----
Effect of exchange rate changes on cash and cash
equivalents............................................... (4) --
----- -----
Net increase (decrease) in cash and cash equivalents........ (28) 23
Cash and cash equivalents at beginning of period............ 271 194
----- -----
Cash and cash equivalents at end of period.................. $ 243 $ 217
===== =====
</Table>
See Notes to Consolidated Financial Statements.
5
<Page>
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 June 30, 2001 and for the three and nine months ended June 30, 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 nine
months ended June 30, 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 ("FASB") 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. In the third quarter of fiscal 2001, the
Company adopted SFAS 140, which has been applied to the transaction disclosed in
Note 6.
6
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
2. RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)
SFAS 141
In July 2001, the FASB issued Statement No. 141, "Business Combinations"
("SFAS 141") which requires all business combinations initiated after June 30,
2001 to be accounted for using the purchase method of accounting. As a result,
use of the pooling-of-interests method is prohibited for business combinations
initiated thereafter. SFAS 141 also establishes criteria for the separate
recognition of intangible assets acquired in a business combination. The
adoption of this standard is not expected to have a material impact on the
Company's consolidated results of operations, financial position or cash flows.
SFAS 142
In July 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142") which requires that goodwill and certain other
intangible assets having indefinite lives no longer be amortized to earnings,
but instead be subject to periodic testing for impairment. Intangible assets
determined to have definitive lives will continue to be amortized over their
useful lives. This Standard is effective for the Company's fiscal year beginning
October 1, 2002, although the Company is permitted to early adopt on October 1,
2001. However, goodwill and intangible assets acquired after June 30, 2001 will
be subject immediately to the non-amortization and amortization provisions of
this Statement. The Company is currently evaluating the impact of SFAS 142 to
determine the effect, if any, it may have on the Company's consolidated results
of operations, financial position or cash flows.
3. ACQUISITIONS AND OTHER TRANSACTIONS
ACQUISITIONS
The following table presents information about certain acquisitions by the
Company during the nine months ended June 30, 2001. These acquisitions were
accounted for under the purchase method of accounting, and the acquired
technology valuation included both existing technology and purchased in-process
research and development. The consolidated financial statements include the
results of operations and the estimated fair values of the assets and
liabilities assumed from the respective dates of acquisition. All charges
related to the write-off of purchased in-process research and development were
recorded in the quarter in which the transaction was completed.
<Table>
<Caption>
ALLOCATION OF PURCHASE PRICE(1)
-----------------------------------------------
ACQUISITION PURCHASE EXISTING OTHER PURCHASED
DATE PRICE GOODWILL TECHNOLOGY INTANGIBLE IPR&D
---------------- --------- -------- ---------- ---------- ----------
(DOLLARS IN MILLIONS)
Quintus(2)........... April 11, 2001 $ 29 $ 3 $ 9 $ 3 $ 1
VPNet(3)............. February 6, 2001 $117 $48 $30 $30 $31
<Caption>
AMORTIZATION PERIOD (IN YEARS)
-----------------------------------
EXISTING OTHER
GOODWILL TECHNOLOGY INTANGIBLES
-------- ---------- -----------
(DOLLARS IN MILLIONS)
Quintus(2)........... 5 3 3
VPNet(3)............. 5 5 5
</Table>
- ------------------------------
(1) Excludes amounts allocated to specific tangible assets and liabilities.
(2) Acquisition of substantially all of the assets, including $10 million of
cash acquired, and the assumption of $20 million of certain liabilities of
Quintus Corporation, a provider of comprehensive electronic customer
relationship management solutions. The Company paid $29 million in cash for
this acquisition.
(3) Acquisition of VPNet Technologies, Inc., a privately held distributor of
virtual private network solutions and devices. The total purchase price of
$117 million was in cash and stock options.
7
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. ACQUISITIONS AND OTHER TRANSACTIONS (CONTINUED)
Included in the purchase price for each of the above acquisitions was
purchased in-process research and development. Some of the technology had not
reached technological feasibility and had no future alternative use and,
accordingly, was written off as a charge to earnings immediately upon
consummation of the respective acquisition. The charge related to VPNet
Technologies' purchased in-process research and development was non-tax
deductible. The remaining purchase price was allocated to tangible and
intangible assets, including goodwill, existing technology and other intangible
assets, less liabilities assumed.
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
acquisitions. Actual results could differ from these amounts.
OTHER TRANSACTIONS
AIRCRAFT SALE-LEASEBACK
In June 2001, the Company sold a corporate aircraft for approximately
$34 million and subsequently entered into an agreement to lease it back over a
five year period. At the end of the lease term, the Company has the option to
renew the lease subject to the consent of the lessor and its lessors, or to
purchase the aircraft for a price as defined in the agreement, including the
outstanding lease balance. If the Company elects not to either renew the lease
or purchase the aircraft, the Company must arrange for the sale of the aircraft
to a third-party. Under the sale option, the Company has guaranteed
approximately 60% of the unamortized original cost as the residual value of the
aircraft. The lease is accounted for as an operating lease for financial
statement purposes and as a loan for tax purposes.
8
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. ACQUISITIONS AND OTHER TRANSACTIONS (CONTINUED)
OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES
On May 4, 2001, the Company closed the first phase of a five-year strategic
manufacturing agreement to outsource most of the manufacturing of its
communications systems and software to Celestica Inc. Under the agreement, Avaya
will receive approximately $200 million for the assets it is transferring to
Celestica. The Company has received $38 million for these assets as of June 30,
2001. The Company expects the remaining phases of the transaction, which include
closing the Shreveport, Louisiana facility, to be completed by the end of the
first quarter of fiscal 2002.
SHELF REGISTRATION STATEMENT
On May 24, 2001, the Company's shelf registration statement on Form S-3 was
declared effective by the Securities and Exchange Commission. Under the shelf
registration statement, the Company may 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 $1.44 billion. 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 of the preferred stock and warrants described in
Note 9 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 (LOSS)
Other comprehensive income (loss) is recorded directly to a separate section
of stockholders' equity in accumulated other comprehensive loss and includes
unrealized gains and losses excluded from the Consolidated Statements of
Operations. These unrealized gains and losses primarily consist of foreign
currency translation adjustments, which are not adjusted for income taxes since
they primarily relate to indefinite investments in non-U.S. subsidiaries.
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
Net income (loss)........................................ $24 $33 $(24) $168
Other comprehensive income............................... 5 12 16 6
--- --- ---- ----
Total comprehensive income (loss)...................... $29 $45 $ (8) $174
=== === ==== ====
</Table>
9
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
5. SUPPLEMENTARY FINANCIAL INFORMATION
STATEMENT OF OPERATIONS INFORMATION
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
OTHER INCOME, NET
Gain (loss) on foreign currency transactions.............. $ -- $ 3 $ (1) $ --
Gain on businesses sold................................... -- -- 6 45
Interest income........................................... 7 -- 22 --
Miscellaneous, net........................................ (3) (3) 4 9
---- ---- ---- ----
Total other income, net................................. $ 4 $ -- $ 31 $ 54
==== ==== ==== ====
</Table>
BALANCE SHEET INFORMATION
<Table>
<Caption>
JUNE 30, SEPTEMBER 30,
2001 2000
-------- -------------
(DOLLARS IN MILLIONS)
INVENTORY
Completed goods............................................. $472 $472
Work in process and raw materials........................... 213 167
---- ----
Total inventory........................................... $685 $639
==== ====
</Table>
SUPPLEMENTAL CASH FLOW INFORMATION
<Table>
<Caption>
NINE MONTHS ENDED
JUNE 30, 2001
---------------------
(DOLLARS IN MILLIONS)
ACQUISITION OF BUSINESSES:
Fair value of assets acquired, net of cash acquired....... $192
Less: Fair value of liabilities assumed................... (72)
----
Acquisition of businesses, net of cash acquired......... $120
====
NON-CASH TRANSACTIONS:
Accretion on Series B Preferred Stock (Note 9)............ $ 20
Fair market value of stock options issued in connection
with acquisition (Note 3)............................... 16
ADJUSTMENTS TO ORIGINAL CONTRIBUTION BY LUCENT (Note 14):
Accounts receivable..................................... 8
Property, plant and equipment, net...................... 7
----
Total non-cash transactions........................... $ 51
====
</Table>
10
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. SECURITIZATION OF ACCOUNTS RECEIVABLE
In June 2001, the Company entered into a securitization agreement and
transferred a designated pool of qualified trade accounts receivable to a wholly
owned bankruptcy-remote subsidiary, a special purpose entity (``SPE"), which in
turn sold an undivided ownership interest to an unaffiliated financial
institution. The Company, through the SPE, has a retained interest in a portion
of the receivables, and the financial institution has no recourse to the
Company's other assets for failure of customers to pay when due. The assets of
the SPE are not available to pay creditors of the Company. The Company is
responsible for defined fees payable monthly to the financial institution for
costs associated with the outstanding capital issued by the financial
institution to fund the purchase of receivables and a backstop liquidity
commitment. The Company will continue to service, administer and collect the
receivables on behalf of the financial institution and receive a fee for
performance of these services. Collections of receivables are used by the
financial institution to purchase, from time to time, new interests in
receivables up to an aggregate of $200 million. The receivables securitization
agreement expires in June 2002, but may be extended through June 2004 with the
financial institution's consent.
In connection with the transaction, the Company received cash proceeds of
$200 million from the sale and securitization of these receivables. The accounts
receivable balances were removed from the Consolidated Balance Sheet and the
proceeds received from the sale were reflected as cash provided by financing
activities in the Consolidated Statement of Cash Flows. As of June 30, 2001, the
Company had a retained interest of $131 million in the SPE's designated pool of
qualified accounts receivable representing collateral for the sale. The carrying
amount of the Company's retained interest, which approximates fair value because
of the relatively short-term nature of the receivable collections, was
reclassified to other current assets.
The Company did not record an asset or liability related to any servicing
obligations because the initial measure for servicing was determined to be just
adequate to compensate the Company for its servicing responsibilities. Although
not material, costs associated with the sale of the receivables were recorded in
other income, net in the Consolidated Statement of Operations. No significant
gain or loss resulted from this transaction.
The Company will review the fair value assigned to the retained interest at
each reporting date subsequent to the date of the transfer. Fair value will be
reviewed using similar valuation techniques as those used to initially measure
the retained interest, and, if a change in events or circumstances warrants, the
fair value will be adjusted.
11
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
7. REPLACEMENT OF CERTAIN STOCK OPTION GRANTS
On June 26, 2001, the Company commenced an offer to eligible employees to
exchange (the "Exchange") certain employee stock options for restricted stock
units representing common shares. The Exchange was based on a predetermined
exchange value divided by $12.85 per common share, which was the average of the
high and low trading price of Avaya common stock on the New York Stock Exchange
("NYSE") on July 26, 2001. As a result of the Exchange, approximately
19.5 million options were cancelled and approximately 3.4 million restricted
stock units were granted on July 31, 2001. The restricted stock units resulting
from the Exchange will vest in three succeeding annual anniversary dates
beginning on August 1, 2002, subject to acceleration of vesting upon certain
events.
The Company anticipates recording approximately $43 million as non-cash
deferred compensation expense for the intrinsic value of the restricted stock
units on the effective date of the Exchange. The expense is calculated by
multiplying the number of restricted stock units by $12.62 which was the average
of the high and low trading price of the Company's common stock on the NYSE on
July 31, 2001. The non-cash deferred compensation expense associated with the
restricted stock units will be recognized on a straight-line basis over the
three-year vesting period.
8. 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 of which $21 million in payments, primarily
related to employee separation costs, were made during fiscal 2000 to reduce the
related reserve. Components of the business restructuring costs, as well as
amounts and adjustments recorded to the related reserve as of June 30, 2001,
were as follows:
<Table>
<Caption>
RESERVE BALANCE NET ADJUSTMENTS EXPENDITURES RESERVE
AS OF MADE DURING THE MADE DURING THE BALANCE
SEPTEMBER 30, NINE MONTHS ENDED NINE MONTHS ENDED AS OF
2000 JUNE 30, 2001 JUNE 30, 2001 JUNE 30, 2001
--------------- ----------------- ----------------- --------------
(DOLLARS IN MILLIONS)
Employee separation costs........ $345 $(21) $(219) $105
Lease obligations................ 127 -- (46) 81
Other related exit costs......... 27 -- (3) 24
---- ---- ----- ----
Total.......................... $499 $(21) $(268) $210
==== ==== ===== ====
</Table>
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. The
Company has substantially completed the outsourcing of its manufacturing
operations in Westminster, Colorado and its repair and distribution operations
located in Little Rock, Arkansas. Products currently manufactured in Shreveport,
Louisiana are being transitioned to Westminster or other Celestica facilities.
The Company expects all Shreveport operations to be phased out by the end of the
first quarter of fiscal 2002.
As a result of the outsourcing transaction, in the second quarter of fiscal
2001, 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
12
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
8. BUSINESS RESTRUCTURING AND RELATED CHARGES (CONTINUED)
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 and, accordingly, such amount was reclassified out of the
business restructuring reserve. 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 reserve in the second quarter
of fiscal 2001.
During the third quarter of fiscal 2001, in accordance with the Company's
plans to exit the Shreveport facility, management determined that the existing
fixed assets will no longer be used to manufacture product at their intended
capacity over their remaining useful lives and are not feasible to use as
currently configured. Accordingly, the Company recorded a $20 million asset
impairment charge related to the associated buildings, land and equipment that
it expects to dispose of during fiscal 2002. The fair market value used to
calculate the impairment charge was based on an independent third party
appraisal. The impairment charge is included in business restructuring and
related charges in the Consolidated Statement of Operations.
Business restructuring costs that were accrued in September 2000 for
employee separations related to approximately 3,750 union-represented and
salaried employees, adjusted for approximately 1,150 employees related to the
Shreveport location who were included in the contract manufacturing transaction.
As of June 30, 2001, 3,662 of these employees worldwide have departed the
Company and were located predominately in the United States. In connection with
the contract manufacturing transaction with Celestica, approximately 1,930
union-represented and 430 salaried employees will receive involuntary employee
termination benefits. As of June 30, 2001, approximately 1,482 employees
primarily at the Westminster and Little Rock locations have departed the
Company. Employee separation payments that are included in the business
restructuring reserve 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 each employee's option.
As of June 30, 2001, the Company vacated real estate locations consisting of
approximately 596,000 square feet of excess manufacturing, distribution and
administrative space, the cost of which is included in the business
restructuring reserve. The vacated square footage does not include approximately
1.4 million square feet associated with the Westminster and Little Rock
facilities since they were either sold or leased to Celestica in connection with
the contract manufacturing transaction, and accordingly were not included in the
reserve. Payments on lease obligations, which consist of real estate and
equipment leases, will extend through 2003. The Company expects to pay the other
related exit costs by the end of the current fiscal year.
For the three and nine months ended June 30, 2001, the Company recorded
incremental period costs of $46 million and $117 million, respectively, which
are included in business restructuring and related charges in the Consolidated
Statement of Operations, and are primarily associated with the Company's
separation from Lucent. These costs relate mostly to computer system transition
costs such
13
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
8. BUSINESS RESTRUCTURING AND RELATED CHARGES (CONTINUED)
as data conversion activities, asset transfers, and training. The Company also
recorded $42 million for the nine months ended June 30, 2001 in selling, general
and administrative expenses for additional start-up activities largely resulting
from marketing costs associated with continuing to establish the Avaya brand.
9. 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 15,717,656 shares of the Company's common stock as of
June 30, 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 expiring
on October 2, 2004 and warrants exercisable for 5,507,146 shares of common stock
have a five-year term expiring on October 2, 2005. During a period commencing on
May 24, 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 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 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 nine months ended
June 30, 2001, accretion of the Series B preferred stock was $19.8 million
resulting in a liquidation value of $419.8 million as of June 30, 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
nine months ended June 30, 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
June 30, 2001, the Company recorded a $19.8 million reduction in retained
earnings (deficit) representing the
14
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
9. CONVERTIBLE PARTICIPATING PREFERRED STOCK (CONTINUED)
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 FASB 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 determined that no
beneficial conversion features existed at the commitment date and therefore
there was 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
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.
10. EARNINGS (LOSS) PER SHARE OF COMMON STOCK
Basic earnings (loss) per common share was calculated by dividing net income
(loss) available to common shareowners by the weighted average number of common
shares outstanding during the period. Diluted earnings (loss) per common share
was 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.
15
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. EARNINGS (LOSS) PER SHARE OF COMMON STOCK (CONTINUED)
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS AND SHARES IN MILLIONS,
EXCEPT PER SHARE AMOUNTS)
Net income (loss)........................................... $ 24 $ 33 $ (24) $ 168
Accretion of Series B preferred stock....................... (7) -- (20) --
----- ----- ------ -----
Net income (loss) available to common shareowners........... $ 17 $ 33 $ (44) $ 168
===== ===== ====== =====
SHARES USED IN COMPUTING EARNINGS (LOSS) PER COMMON SHARE:
Basic..................................................... 285 270 283 266
===== ===== ====== =====
Diluted................................................... 286 284 285 281
===== ===== ====== =====
EARNINGS (LOSS) PER COMMON SHARE:
Basic..................................................... $0.06 $0.12 $(0.16) $0.63
===== ===== ====== =====
Diluted................................................... $0.06 $0.12 $(0.16) $0.60
===== ===== ====== =====
SECURITIES EXCLUDED FROM THE COMPUTATION OF DILUTED EARNINGS
(LOSS) PER COMMON SHARE:
Options(a)................................................ 66 13 66 6
Series B preferred stock(b)............................... 16 -- 16 --
Warrants(a)............................................... 12 -- 12 --
----- ----- ------ -----
Total................................................... 94 13 94 6
===== ===== ====== =====
</Table>
- ------------------------
(a) These securities have been excluded from the diluted earnings (loss) 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 (loss)
per common share calculation since the effect of its inclusion would have
been anti-dilutive.
11. 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
16
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
11. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED)
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 Statements 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 nine months
ended June 30, 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 nine months ended June 30, 2001, these gains and losses were not
material to the Company's results of operations.
Electing to not use hedge accounting under SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," 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.
FAIR VALUE
The Company's foreign currency forward exchange contracts and options were
assets and had a net carrying amount of $2 million and an estimated fair value
of $3 million as of June 30, 2001. Market quotes were used to estimate the fair
value of foreign currency forward contracts and options.
17
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. 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
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
COMMUNICATIONS SOLUTIONS:
External revenue.......................................... $821 $1,033 $2,681 $3,273
Intersegment revenue...................................... -- 2 -- 9
---- ------ ------ ------
Total Revenue........................................... 821 1,035 2,681 3,282
Operating income.......................................... 193 338 622 1,094
SERVICES:
External revenue.......................................... $521 $ 496 $1,549 $1,452
Intersegment revenue...................................... -- -- -- --
---- ------ ------ ------
Total Revenue........................................... 521 496 1,549 1,452
Operating income.......................................... 214 197 711 578
CONNECTIVITY SOLUTIONS:
External revenue.......................................... $372 $ 370 $1,119 $ 967
Intersegment revenue...................................... -- -- -- 1
---- ------ ------ ------
Total Revenue........................................... 372 370 1,119 968
Operating income.......................................... 139 63 383 152
</Table>
18
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. OPERATING SEGMENTS (CONTINUED)
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:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
EXTERNAL REVENUE
Total reportable segments................................. $1,714 $1,899 $5,349 $5,692
Corporate and other....................................... -- -- 2 2
------ ------ ------ ------
Total External Revenue.................................. $1,714 $1,899 $5,351 $5,694
====== ====== ====== ======
OPERATING INCOME (LOSS)
Total reportable segments................................. $ 546 $ 598 $1,716 $1,824
Corporate and other:
Business restructuring related charges and start-up
expenses.............................................. (66) -- (313) --
Corporate and unallocated shared expenses............... (433) (527) (1,433) (1,542)
------ ------ ------ ------
Total Operating Income (Loss)......................... $ 47 $ 71 $ (30) $ 282
====== ====== ====== ======
</Table>
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
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
EXTERNAL REVENUE(1)
U.S....................................................... $1,280 $1,494 $4,021 $4,492
Foreign countries......................................... 434 405 1,330 1,202
------ ------ ------ ------
Totals.................................................. $1,714 $1,899 $5,351 $5,694
====== ====== ====== ======
</Table>
- ------------------------
(1) Revenue is attributed to geographic areas based on the location of
customers.
CONCENTRATIONS
The Company sells its products and services to a broad set of enterprises
ranging from large, multinational enterprises, to small and mid-sized
enterprises, governments agencies and schools. Management believes that the
Company is exposed to minimal risk since the majority of its business is
conducted with companies within numerous industries. The Company performs
periodic credit
19
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. OPERATING SEGMENTS (CONTINUED)
evaluations of its customers' financial condition and generally does not require
collateral for its accounts receivables. In some cases, the Company will require
payment in advance or security in the form of a letter of credit or third-party
guarantees.
For the nine months ended June 30, 2001, sales to the Company's largest
distributor were approximately 10% of revenue. No single customer accounted for
more than 10% of the Company's revenue for the nine months ended June 30, 2000.
As a result of the contract manufacturing transaction, Celestica exclusively
manufactures substantially all of the Company's Communications Solutions
products at various facilities in the United States and Mexico. The Company is
not obligated to purchase products from Celestica in any specific quantity,
except as the Company outlines in forecasts or orders for products required to
be manufactured by Celestica. In addition, Avaya may be obligated to purchase
certain excess inventory levels from Celestica that could result from the
Company's actual sales of product varying from forecast. The Company's
outsourcing agreement with Celestica results 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.
13. BENEFIT OBLIGATIONS
In connection with the Distribution, the Company recorded estimates in its
Consolidated 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 the Company 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.
14. 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
20
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
14. TRANSACTIONS WITH LUCENT (CONTINUED)
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 had
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 reduced additional paid-in capital for the net effect of
these adjustments which is reflected in the Consolidated Balance Sheet as of
June 30, 2001.
15. COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
From time to time the Company is involved in legal proceedings arising in
the ordinary course of business. Other than as described below, the Company
believes there is no litigation pending 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,
one in state court in West Virginia, one in federal court in the Southern
District of New York and another in federal court in the Southern District of
California. The case in New York was filed in January 1999, and after being
dismissed, was 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.
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
21
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
15. 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 its 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.
In March 2001, a third party filed a complaint in the State Court of
Georgia, Fulton County, against Lucent, the Company and another defendant. The
complaint alleges that the Company (or its predecessor, Lucent) breached certain
purported agreements related to the plaintiff's engagement as an agent of the
Company for a number of years. The complaint alleges breach of contract, breach
of implied duty of good faith and fair dealing, quantum meruit, promissory
estoppel, unjust enrichment, negligent misrepresentation and negligent
supervision. The Company assumed the obligations of this complaint as it relates
to Lucent and the Company, and is currently engaged in the discovery process.
This action is in the early stages of litigation and an outcome cannot be
predicted, and as a result, 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 April 2001, a third party licensor made formal demand for alleged royalty
payments which it claims the Company owes as a result of a contract between the
licensor and the Company's predecessors, initially entered into in 1995, and
renewed in 1997. The contract provides for mediation of disputes followed by
binding arbitration if the mediation does not resolve the dispute. The licensor
22
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
15. COMMITMENTS AND CONTINGENCIES (CONTINUED)
claims that the Company owes royalty payments for software integrated into
certain of the Company's products. It also alleges that the Company has breached
the governing contract by not honoring a right of first refusal related to
development of fax software for next generation products. The Company is
currently in mediation with the licensor. This action is in the early stages of
mediation and an outcome cannot be predicted, and as a result, 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.
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, 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.
23
<Page>
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 successful introduction of new products; 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 June 30,
2001 and for the three and nine months ended June 30, 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
24
<Page>
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,
thereby requiring a greater need for external capital resources.
In addition, in July 2001, we announced that current economic conditions are
continuing to slow customer purchase decisions, accelerating a previously
announced downward trend. We also announced that we now expect revenues for the
fourth quarter of fiscal 2001 to be approximately 20 percent below revenues for
the fourth quarter of fiscal 2000, driven by an expected year over year decline
of about $225 million in Connectivity Solutions revenues primarily from service
provider customers, and by delays in customer purchases of traditional voice
products.
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:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
OPERATING SEGMENT:
Communications Solutions.................................. 47.9% 54.4% 50.1% 57.5%
Services.................................................. 30.4 26.1 29.0 25.5
Connectivity Solutions.................................... 21.7 19.5 20.9 17.0
----- ----- ----- -----
Total................................................... 100.0% 100.0% 100.0% 100.0%
===== ===== ===== =====
</Table>
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. and
our name was later changed to "Avaya Inc". On September 30, 2000, under the
terms of a Contribution and Distribution Agreement between us and
25
<Page>
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 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 reflected current
market prices at the time of the transaction.
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 had 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 for the net effect of these adjustments, which is reflected in our
consolidated balance sheet as of June 30, 2001.
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
between 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 nine
months ended June 30, 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.
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 of which $21 million in payments, primarily related to employee
separation costs, were made during fiscal 2000
26
<Page>
to reduce the related reserve. Components of the business restructuring costs,
as well as amounts and adjustments recorded to the related reserve as of
June 30, 2001, were as follows:
<Table>
<Caption>
NET
ADJUSTMENTS MADE EXPENDITURES
RESERVE BALANCE DURING THE NINE MADE DURING THE RESERVE BALANCE
AS OF MONTHS ENDED NINE MONTHS ENDED AS OF
SEPTEMBER 30, JUNE 30, JUNE 30, JUNE 30,
2000 2001 2001 2001
--------------- ---------------- ----------------- ---------------
(DOLLARS IN MILLIONS)
Employee separation costs....... $345 $(21) $(219) $105
Lease obligations............... 127 -- (46) 81
Other related exit costs........ 27 -- (3) 24
---- ---- ----- ----
Total........................... $499 $(21) $(268) $210
==== ==== ===== ====
</Table>
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. We have substantially
completed the outsourcing of our manufacturing operations in Westminster,
Colorado and our repair and distribution operations located in Little Rock,
Arkansas. Products currently manufactured in Shreveport, Louisiana are being
transitioned to Westminster or other Celestica facilities. We expect all
Shreveport operations to be phased out by the end of the first quarter of fiscal
2002.
As a result of the outsourcing transaction, in the second quarter of fiscal
2001, 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 and, accordingly, such amount was reclassified out of the
business restructuring reserve. 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 reserve in the second quarter
of fiscal 2001.
During the third quarter of fiscal 2001, in accordance with our plan to exit
the Shreveport facility, we determined that the existing fixed assets will no
longer be used to manufacture product at their intended capacity over their
remaining useful lives and are not feasible to use as currently configured.
Accordingly, we recorded a $20 million asset impairment charge related to the
associated buildings, land and equipment that we expect to dispose of during
fiscal 2002. The fair market value used to calculate the impairment charge was
based on an independent third party appraisal. The impairment charge is included
in business restructuring and related charges in the Consolidated Statement of
Operations.
Business restructuring costs that were accrued in September 2000 for
employee separations related to approximately 3,750 union-represented and
salaried employees, adjusted for approximately 1,150 employees related to the
Shreveport location who were included in the contract manufacturing transaction.
As of June 30, 2001, 3,662 of these employees worldwide have departed and were
located predominately in the United States. In connection with the contract
manufacturing transaction with
27
<Page>
Celestica, approximately 1,930 union-represented and 430 salaried employees will
receive involuntary employee termination benefits. As of June 30, 2001,
approximately 1,482 employees have departed primarily at the Westminster and
Little Rock locations. Employee separation payments that are included in the
business restructuring reserve 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 each employee's option.
As of June 30, 2001, we vacated real estate locations consisting of
approximately 596,000 square feet of excess manufacturing, distribution and
administrative space, the cost of which is included in the business
restructuring reserve. The vacated square footage does not include approximately
1.4 million square feet associated with the Westminster and Little Rock
facilities since they were either sold or leased to Celestica in connection with
the contract manufacturing transaction, and accordingly were not included in the
reserve. Payments on lease obligations, which consist of real estate and
equipment leases, will extend through 2003. We expect to pay the other related
exit costs by the end of the current fiscal year.
For the three and nine months ended June 30, 2001, we recorded incremental
period costs of $46 million and $117 million, respectively, which are included
in business restructuring and related charges in the Consolidated Statement of
Operations, and are primarily associated with our separation from Lucent. These
costs relate mostly to computer system transition costs such as data conversion
activities, asset transfers, and training. We also recorded $42 million for the
nine months ended June 30, 2001 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 $43 million and $15 million related to our separation
from Lucent, including establishment as an independent company, and outsourcing
of certain of our manufacturing facilities, respectively. Additional period
costs of approximately $13 million related to the contract manufacturing
transaction are expected to be incurred in fiscal 2002. 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.
In response to the current industry-wide economic slowdown, we have
accelerated our restructuring program and as a result, anticipate eliminating
over 5,000 positions through a combination of involuntary and voluntary
separations, including an early retirement program targeted to the U.S.
management employees. In connection with this effort, we have initiated a
strategic redesign of our Connectivity Solutions business that will result in a
consolidation of its U.S. operations and have also consolidated certain of our
customer care and field service operations. As a result of these actions, we
expect to record a pretax restructuring charge of approximately $500 million in
the fourth quarter of fiscal 2001. We expect approximately $440 million of the
restructuring charge to be non-cash at the time the charge is taken as such
payments will be made through prepaid benefit costs, and the remaining
$60 million to be cash.
28
<Page>
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:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2001 2000 2001 2000
-------- -------- -------- --------
Revenue................................................. 100.0% 100.0% 100.0% 100.0%
Costs................................................... 57.4 57.8 56.9 57.3
----- ----- ----- -----
Gross margin............................................ 42.6 42.2 43.1 42.7
----- ----- ----- -----
Operating expenses:
Selling, general and administrative..................... 28.1 31.9 30.0 31.6
Business restructuring and related charges.............. 3.8 -- 5.1 --
Research and development................................ 7.9 6.6 8.0 6.1
Purchased in-process research and development........... 0.1 -- 0.6 --
----- ----- ----- -----
Total operating expenses................................ 39.9 38.5 43.7 37.7
----- ----- ----- -----
Operating income (loss)................................. 2.7 3.7 (0.6) 5.0
Other income, net....................................... 0.2 -- 0.6 0.9
Interest expense........................................ (0.5) (0.9) (0.6) (1.0)
Provision (benefit) for income taxes.................... 1.0 1.1 (0.1) 1.9
----- ----- ----- -----
Net income (loss)....................................... 1.4% 1.7% (0.5)% 3.0%
===== ===== ===== =====
</Table>
THREE MONTHS ENDED JUNE 30, 2001 COMPARED TO THREE MONTHS ENDED JUNE 30, 2000
The following table shows the change in external revenue, both in dollars
and in percentage terms:
<Table>
<Caption>
THREE MONTHS
ENDED
JUNE 30, CHANGE
------------------- -------------------
2001 2000 $ %
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
OPERATING SEGMENT:
Communications Solutions.................................. $ 821 $1,033 $(212) (20.5)%
Services.................................................. 521 496 25 5.0
Connectivity Solutions.................................... 372 370 2 0.5
Corporate and other....................................... -- -- -- --
------ ------ ----- -----
Total................................................... $1,714 $1,899 $(185) (9.7)%
====== ====== ===== =====
</Table>
REVENUE. Revenue decreased 9.7% or $185 million, from $1,899 million for
the three months ended June 30, 2000, to $1,714 million for the same period in
fiscal 2001. The decrease was attributable to a decline in the Communications
Solutions segment, and was mainly attributable to a worsening economic
environment, especially in the technology sector. This decrease was largely due
to a decline in customer purchases of our enterprise voice communications
systems and customer relationship management businesses predominately in the
United States, partially offset by growth worldwide in the multi-service
networking business. The revenue decline in the Communications Solutions segment
resulted primarily from the effects of the continued slowing U.S. economy,
changes in product mix, and a decrease in installation revenue as a result of
the reduction in product sales. Within the Services segment, revenues increased
mainly as a result of the positive effects in the U.S. from the introduction of
data services, as well as the growth in value added services, partially offset
by a decline in domestic
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<Page>
maintenance revenues. Connectivity Solutions segment revenues were essentially
flat compared with the same period in fiscal 2000. Within this segment,
worldwide revenue growth in SYSTIMAX, our structured cabling systems for
enterprises, was offset by a decline in purchases of ExchangeMAX, our cabling
for service providers, in the United States.
Revenue within the United States decreased 14.3% or $214 million, from
$1,494 million for the three months ended June 30, 2000, to $1,280 million for
the same period in fiscal 2001. However, revenue outside the United States
increased 7.2% or $29 million, from $405 million for the three months ended
June 30, 2000, to $434 million for the same period in fiscal 2001. Revenue
outside the United States represented 25.3% of revenue compared with 21.3% in
the same period in fiscal 2000. We continued to expand our business outside of
the United States with growth across all regions, primarily led by the
Caribbean / Latin America and Asia Pacific regions. Our largest increases in
sales outside of the U.S. were made in Services, Communications Solutions'
multi-service networking products and professional services, and Connectivity
Solutions' SYSTIMAX product.
COSTS AND GROSS MARGIN. Total costs decreased 10.4% or $114 million, from
$1,097 million for three months ended June 30, 2000, to $983 million for the
same period in fiscal 2001. The gross margin percentage increased slightly from
42.2% for the three months ended June 30, 2000 to 42.6% for the same period in
fiscal 2001. The increase in gross margin was primarily attributed to the
Connectivity Solutions segment and the ongoing savings from the business
restructuring. This increase was partially offset by a decrease in gross margin
within Communications Solutions due to a less favorable product mix and higher
discounts resulting from lower sales volumes. The Services segment gross margin
percentage remained essentially flat.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
("SG&A") expenses decreased 20.3% or $123 million, from $605 million for the
three months ended June 30, 2000, to $482 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, terminated real estate
lease obligations, cost savings associated with the implementation of SAP,
process improvements in sales and sales operations, and streamlining delivery of
several corporate functions, including the outsourcing of payroll and
procurement services. The reduction in SG&A expenses was partially offset by
increases in ongoing marketing expenses associated with establishing our brand.
BUSINESS RESTRUCTURING AND RELATED CHARGES. Business restructuring and
related charges for the three months ended June 30, 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
$46 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, and a $20 million asset
impairment charge for the Shreveport facility in connection with our outsourcing
of certain manufacturing operations to Celestica.
RESEARCH AND DEVELOPMENT. Research and development ("R&D") expenses
increased 7.1% or $9 million, from $126 million for the three months ended
June 30, 2000, to $135 million for the same period in fiscal 2001. Our
investment in R&D represented 7.9% of revenue in the three months ended
June 30, 2001 as compared with 6.6% in the prior period. This increased
investment supports our plan to shift spending to high growth areas of our
business and reduce spending on more mature product lines.
We intend to invest an amount equal to approximately 8% 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.
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<Page>
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT. This expense reflects
charges associated with our acquisition of substantially all of the assets of
Quintus Corporation in April 2001. There was no charge in the three months ended
June 30, 2000 for purchased in-process research and development.
OTHER INCOME, NET. Other income, net increased to $4 million for the three
months ended June 30, 2001. This increase was primarily due to interest income
earned on higher cash balances during the quarter.
PROVISION FOR INCOME TAXES. The effective tax rates for the three months
ended June 30, 2001 and 2000 were 42.2% and 38.9%, respectively. The difference
between the tax rates was primarily attributable to the tax impact of business
restructuring reserves.
NINE MONTHS ENDED JUNE 30, 2001 COMPARED TO NINE MONTHS ENDED JUNE 30, 2000
The following table shows the change in external revenue, both in dollars
and in percentage terms:
<Table>
<Caption>
NINE MONTHS
ENDED
JUNE 30, CHANGE
------------------- -------------------
2001 2000 $ %
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
OPERATING SEGMENT:
Communications Solutions.................................. $2,681 $3,273 $(592) (18.1)%
Services.................................................. 1,549 1,452 97 6.7
Connectivity Solutions.................................... 1,119 967 152 15.7
Corporate and other....................................... 2 2 -- --
------ ------ ----- -----
Total................................................... $5,351 $5,694 $(343) 6.0%
====== ====== ===== =====
</Table>
REVENUE. Revenue decreased 6.0% or $343 million, from $5,694 million for
the nine months ended June 30, 2000, to $5,351 million for the same period in
fiscal 2001, due to a decrease in the Communications Solutions segment,
partially offset by increases in the Services and Connectivity Solutions
segments, and was mainly attributable to a worsening economic environment,
especially in the technology sector. The decrease in the Communications
Solutions segment was largely attributable to a decline in customer purchases of
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 primarily resulted from
the effects of the continued slowing U.S. economy combined with a move to a more
indirect sales channel in the third quarter of fiscal 2000, 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 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, partially offset by a decrease in maintenance revenues
domestically. The Connectivity Solutions segment increase was the result of
strong demand worldwide for SYSTIMAX, our structured cabling systems for
enterprises, and increased sales domestically of electronic cabinets, partially
offset by a decline in purchases of ExchangeMAX, our cabling systems for service
providers, in the United States.
Revenue within the United States decreased 10.5% or $471 million, from
$4,492 million for the nine months ended June 30, 2000, to $4,021 million for
the same period in fiscal 2001. However, revenue outside the United States
increased 10.6% or $128 million, from $1,202 million for the nine months ended
June 30, 2000, to $1,330 million for the same period in fiscal 2001. Revenue
outside the United States represented 24.9% of revenue compared with 21.1% in
the same period in fiscal 2000.
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We continued to expand our business outside of the United States with growth
across all regions, primarily led by the Asia Pacific and Canada regions. Our
largest increases in sales outside of the U.S. were made in Services,
Communications Solutions' multi-service networking products and professional
services, and Connectivity Solutions' SYSTIMAX product.
COSTS AND GROSS MARGIN. Total costs decreased 6.7% or $217 million, from
$3,261 million for the nine months ended June 30, 2000, to $3,044 million for
the same period in fiscal 2001. The gross margin percentage increased slightly
from 42.7% for the nine months ended June 30, 2000 to 43.1% for 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
less favorable mix of products and higher discounts due to lower sales volumes.
SELLING, GENERAL AND ADMINISTRATIVE. SG&A expenses decreased 10.8% or
$195 million, from $1,801 million for the nine months ended June 30, 2000, to
$1,606 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, terminated real estate lease obligations, cost improvements
associated with the implementation of SAP, process improvements in sales and
sales operations, and streamlining delivery of several corporate functions,
including the outsourcing of payroll and procurement services. 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 $271 million for the nine months ended June 30, 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, $117 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, and a $20 million asset impairment
charge for the Shreveport facility in connection with our outsourcing of certain
manufacturing operations to Celestica.
RESEARCH AND DEVELOPMENT. R&D expenses increased 22.3% or $78 million, from
$350 million for the nine months ended June 30, 2000, to $428 million for the
same period in fiscal 2001. Our investment in R&D represented 8.0% of revenue in
the nine months ended June 30, 2001 as compared with 6.1% in the prior period.
This increased investment supports our plan to shift spending to high growth
areas of our business and reduce spending on more mature product lines.
We intend to invest an amount equal to approximately 8% 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.
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PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT. This expense reflects
charges associated with our acquisitions of VPNet Technologies in
February 2001, and substantially all of the assets of Quintus Corporation in
April 2001. There was no charge in the nine months ended June 30, 2000 for
purchased in-process research and development.
OTHER INCOME, NET. Other income, net decreased 42.6% or $23 million, from
$54 million for the nine months ended June 30, 2000 to $31 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 during the period.
PROVISION FOR INCOME TAXES. The effective tax rate for the nine months
ended June 30, 2001 was a benefit rate of 16.3% compared to a provision rate of
39.4% in the same period last year. The difference between the tax rates was
attributable to the tax impact of acquisition related costs and business
restructuring reserves.
LIQUIDITY AND CAPITAL RESOURCES
Avaya's cash and cash equivalents decreased to $243 million at June 30,
2001, from $271 million at September 30, 2000. The decrease resulted from
$219 million and $292 million of net cash used for operating and investing
activities, respectively, offset by $487 million of net cash provided by
financing activities.
Our net cash used for operating activities was $219 million for the nine
months ended June 30, 2001 compared with net cash provided by operating
activities of $347 million for the same period in fiscal 2000. Net cash used for
operating activities for the nine months ended June 30, 2001 was comprised of a
net loss adjusted for non-cash items of $492 million, and net cash used for
changes in operating assets and liabilities of $687 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 third
quarter of fiscal 2001, excluding the effect of the securitization transaction
defined below, was 78 days versus 75 days for the second quarter of fiscal 2001.
This increase is primarily attributable to the decrease in quarterly revenue,
which was heavily weighted to the month of June 2001, exceeding the decrease in
accounts receivable. Days sales of inventory on-hand for the third quarter of
fiscal 2001 were 66 days versus 63 days for the second quarter of fiscal 2001.
The increase in days sales in inventory is primarily due to lower sales volumes
as well as a temporary increase in small business systems inventory to cover the
time period over which the Shreveport operations will be transitioned to
Celestica.
Our net cash used for investing activities was $292 million for the nine
months ended June 30, 2001 compared with $134 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 establishing ourself 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 $120 million of cash for our
acquisitions of VPNet Technologies, a privately held developer of virtual
private network solutions and devices, and substantially all the assets of
Quintus Corporation, a provider of comprehensive electronic customer
relationship management solutions, which occurred in the second and third
quarters of the current fiscal year, respectively. The net cash used for
investing activities in fiscal 2001 was partially offset by the receipt of
proceeds from the sale-leaseback of an aircraft and the sale of manufacturing
equipment to Celestica. The prior year usage of cash was
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partially offset by the receipt of proceeds from the sale of our U.S. sales
division serving small and mid-sized enterprises.
Net cash provided by financing activities was $487 million for the nine
months ended June 30, 2001 compared with net cash used in financing activities
of $190 million for the same period in fiscal 2000. Cash flows from financing
activities in the current period were 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
$200 million of proceeds from the securitization of certain trade receivables to
an unaffiliated financial institution and $36 million in proceeds resulting from
the issuance of our common stock, primarily through our Employee Stock Purchase
Plan. The receipt of proceeds in fiscal 2001 was partially offset by
$149 million in payments for the retirement of commercial paper and long term
debt. Cash used for financing activities in fiscal 2000 principally reflects the
change in Lucent's investment in us prior to the distribution.
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
June 30, 2001, $638 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 June 30, 2001 was approximately 4.9% and
10 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.
In August 2001, we and the lenders under our five-year credit facility entered
into an amendment to the facility which revised the definition of "Consolidated
EBIT" to exclude up to $450 million of non-cash business restructuring charges
during such period to be taken no later than the fourth quarter of fiscal 2001.
The credit facility requires us to maintain at all times a ratio of Consolidated
EBIT to interest expense during the previous four consecutive fiscal quarters of
not less than three to one. In addition, we are currently in negotiations to
enter into a new credit facility to replace the existing 364-day credit facility
expiring on September 24, 2001.
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 15,717,656 shares of our common
stock as of June 30, 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 expiring
on October 2, 2004, and warrants exercisable for 5,507,146 shares of common
stock have a five-year term expiring on October 2, 2005. During a period
commencing on May 24, 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 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%
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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 nine months ended June 30, 2001,
accretion of the Series B preferred stock was $19.8 million resulting in a
liquidation value of $419.8 million as of June 30, 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 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 existed at the commitment date
and therefore there was 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 may be 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 may be 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 May 24, 2001, our shelf registration statement on Form S-3 was declared
effective by the Securities and Exchange Commission. Under the shelf
registration statement, we may 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 $1.44 billion. 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 of the preferred stock and warrants described above, and
shares of common stock issuable upon
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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 $190 million for business restructuring and approximately
$43 million for additional expenditures resulting from our continuing
establishment as an independent company. Additionally, we anticipate spending
approximately $20 million for employee separation costs and approximately
$28 million for additional expenditures resulting from the outsourcing of
certain manufacturing facilities. Cash payments of approximately $60 million are
also estimated from the anticipated charge in the fourth quarter of fiscal 2001
that will be recorded following our accelerated restructuring program. In order
to meet our cash needs, we may from time to time issue additional commercial
paper, if the market 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., 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 Technologies' 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
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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
Technologies.
On February 6, 2001, we completed the purchase of VPNet Technologies for an
aggregate purchase price of $117 million in cash and stock options. VPNet
Technologies was a privately held developer of virtual private network solutions
and devices. We allocated approximately $31 million to in-process research and
development 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 Technologies 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.
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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.
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,
one in state court in West Virginia, one in federal court in the Southern
District of New York and another in federal court in the Southern District of
California. The case in New York was filed in January 1999, and, after being
dismissed, was 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.
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
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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 its 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 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.
In March 2001, a third party filed a complaint in the State Court of
Georgia, Fulton County, against Lucent, us and another defendant. The complaint
alleges that we (or our predecessor, Lucent) breached certain purported
agreements related to the plaintiff's engagement as an agent of ours for a
number of years. The complaint alleges breach of contract, breach of implied
duty of good faith and fair dealing, quantum meruit, promissory estoppel, unjust
enrichment, negligent misrepresentation and negligent supervision. We assumed
the obligations of this complaint as it relates to Lucent and us, and are
currently engaged in the discovery process. This action is in the early stages
of litigation and an outcome cannot be predicted, and as a result, there can be
no assurance that this case will not have a material adverse effect on our
financial position, results of operations or cash flows.
In April 2001, a third party licensor made formal demand for alleged royalty
payments which it claims we owe as a result of a contract between the licensor
and our predecessors, initially entered into in 1995, and renewed in 1997. The
contract provides for mediation of disputes followed by binding arbitration if
the mediation does not resolve the dispute. The licensor claims that we owe
royalty payments for software integrated into certain of our products. It also
alleges that we have breached the governing contract by not honoring a right of
first refusal related to development of fax software for next generation
products. We are currently in mediation with the licensor. This action is in the
early stages of mediation and an outcome cannot be predicted, and as a result,
there can be no assurance that this case will not have a material adverse effect
on our financial position, results of operations or cash flows.
EUROPEAN MONETARY UNIT ("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
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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 ("FASB") 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. In the third quarter of fiscal 2001, we adopted
SFAS 140, which has been applied to the transaction disclosed in Note 6 to the
consolidated financial statements.
SFAS 141
In July 2001, the FASB issued Statement No. 141, "Business Combinations"
("SFAS 141") which requires all business combinations initiated after June 30,
2001 to be accounted for using the purchase method of accounting. As a result,
use of the pooling-of-interests method is prohibited for business combinations
initiated thereafter. SFAS 141 also establishes criteria for the separate
recognition of intangible assets acquired in a business combination. The
adoption of this standard is not expected to have a material impact on our
consolidated results of operations, financial position or cash flows.
SFAS 142
In July 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142") which requires that goodwill and certain other
intangible assets having indefinite lives no longer be amortized to earnings,
but instead be subject to periodic testing for impairment. Intangible assets
determined to have definitive lives will continue to be amortized over their
useful lives. This Standard is effective for our fiscal year beginning
October 1, 2002, although we are permitted to early adopt on October 1, 2001.
However, goodwill and intangible assets acquired after June 30, 2001 will be
subject immediately to the non-amortization and amortization provisions of this
Statement. We are currently evaluating the impact of SFAS 142 to determine the
effect, if any, it may have on our consolidated 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
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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. 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 nine months
ended June 30, 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 nine months ended June 30, 2001, these gains and losses were not
material to our results of operations.
Electing to not use hedge accounting under SFAS 133, "Accounting for
Derivative Investments and Hedging Activities", 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 nine months ended June 30, 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.
41
<Page>
PART II
ITEM 1. LEGAL PROCEEDINGS.
See Note 15--"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:
<Table>
<Caption>
EXHIBIT PAGE
NUMBER DESCRIPTION NUMBER
- ------- ----------- --------
10.25 Letter Amendment No. 1, dated as of August 10, 2001, to the
Five Year Credit Agreement by and among Avaya Inc.,
Citibank, N.A., as Agent and the Lenders party thereto.
</Table>
(b) Reports on Form 8-K:
The following Current Report on Form 8-K was filed by us during the fiscal
quarter ended June 30, 2001:
1. May 2, 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.
No financial statements were included in this Current Report.
42
<Page>
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.
<Table>
AVAYA INC.
By: /s/ CHARLES D. PEIFER
-----------------------------------------
Charles D. Peiffer
CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
</Table>
August 14, 2001
43
<Page>
EXHIBIT INDEX
<Table>
<Caption>
EXHIBIT PAGE
NUMBER DESCRIPTION NUMBER
- ------- ----------- --------
10.25 Letter Amendment No. 1, dated as of August 10, 2001, to the
Five Year Credit Agreement by and among Avaya Inc.,
Citibank, N.A., as Agent and the Lenders party thereto.
</Table>