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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
<Table>
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
</Table>
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2001
OR
<Table>
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
</Table>
COMMISSION FILE NUMBER 001-15951
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AVAYA INC.
<Table>
A DELAWARE CORPORATION I.R.S. EMPLOYER NO. 22-3713430
</Table>
211 MOUNT AIRY ROAD, BASKING RIDGE, NEW JERSEY 07920
TELEPHONE NUMBER 908-953-6000
------------------------
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 December 31, 2001, 287,679,085 common shares were outstanding.
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<Page>
TABLE OF CONTENTS
<Table>
<Caption>
ITEM DESCRIPTION PAGE
---- ----------- --------
PART I -- FINANCIAL INFORMATION
1. Financial Statements........................................ 3
2. Management's Discussion and Analysis of Financial Condition 24
and Results of Operations...................................
3. Quantitative and Qualitative Disclosures About Market 42
Risk........................................................
PART II -- OTHER INFORMATION
1. Legal Proceedings........................................... 43
2. Changes in Securities and Use of Proceeds................... 43
3. Defaults Upon Senior Securities............................. 43
4. Submission of Matters to a Vote of Security Holders......... 43
5. Other Information........................................... 43
6. Exhibits and Reports on Form 8-K............................ 43
Signatures.................................................. 44
</Table>
This Quarterly Report on Form 10-Q contains trademarks, service marks and
registered marks of Avaya and its subsidiaries and other companies, as
indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q,
trademarks identified by -Registered Trademark- and -TM- are registered
trademarks or trademarks, respectively, of Avaya Inc. or its subsidiaries. All
other trademarks are the properties of their respective owners. Liquid Yield
Option-TM- Notes is a trademark of Merrill Lynch & Co., Inc.
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
DECEMBER 31,
-----------------------
2001 2000
-------- --------
REVENUE
Products.................................................. $ 798 $1,286
Services.................................................. 508 499
------ ------
1,306 1,785
------ ------
COSTS
Products.................................................. 589 801
Services.................................................. 200 227
------ ------
789 1,028
------ ------
GROSS MARGIN................................................ 517 757
------ ------
OPERATING EXPENSES
Selling, general and administrative....................... 418 568
Business restructuring related expenses................... 6 23
Research and development.................................. 120 140
------ ------
TOTAL OPERATING EXPENSES.................................. 544 731
------ ------
OPERATING INCOME (LOSS)..................................... (27) 26
Other income, net......................................... 6 9
Interest expense.......................................... (9) (10)
------ ------
INCOME (LOSS) BEFORE INCOME TAXES........................... (30) 25
Provision (benefit) for income taxes...................... (10) 9
------ ------
NET INCOME (LOSS)........................................... $ (20) $ 16
====== ======
Earnings (Loss) Per Common Share:
Basic..................................................... $(0.09) $ 0.03
====== ======
Diluted................................................... $(0.09) $ 0.03
====== ======
</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>
AS OF AS OF
DECEMBER 31, SEPTEMBER 30,
2001 2001
------------ -------------
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 252 $ 250
Receivables, less allowances of $74 at December 31, 2001
and $68 at September 30, 2001........................... 906 1,163
Inventory................................................. 627 649
Deferred income taxes, net................................ 207 246
Other current assets...................................... 511 461
------ ------
TOTAL CURRENT ASSETS........................................ 2,503 2,769
------ ------
Property, plant and equipment, net........................ 965 988
Deferred income taxes, net................................ 591 529
Goodwill.................................................. 174 175
Intangible assets, net.................................... 69 78
Other assets.............................................. 119 109
------ ------
TOTAL ASSETS................................................ $4,421 $4,648
====== ======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable.......................................... $ 447 $ 624
Current portion of long-term debt......................... 276 145
Business restructuring reserve............................ 137 179
Payroll and benefit liabilities........................... 273 333
Advance billings and deposits............................. 110 133
Other current liabilities................................. 586 604
------ ------
TOTAL CURRENT LIABILITIES................................... 1,829 2,018
------ ------
Long-term debt............................................ 500 500
Benefit obligations....................................... 646 637
Deferred revenue.......................................... 78 84
Other liabilities......................................... 514 533
------ ------
TOTAL NONCURRENT LIABILITIES................................ 1,738 1,754
------ ------
Commitments and contingencies
Series B convertible participating preferred stock, par
value $1.00 per share, 4 million shares authorized, issued
and outstanding........................................... 402 395
------ ------
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, 287,882,465 and 286,851,934 issued
and outstanding as of December 31, 2001 and September
30, 2001, respectively.................................. 3 3
Additional paid-in capital................................ 917 905
Accumulated deficit....................................... (406) (379)
Accumulated other comprehensive loss...................... (60) (46)
Less treasury stock at cost (203,380 and 147,653 shares as
of December 31, 2001 and September 30, 2001,
respectively)........................................... (2) (2)
------ ------
TOTAL STOCKHOLDERS' EQUITY.................................. 452 481
------ ------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $4,421 $4,648
====== ======
</Table>
See Notes to Consolidated Financial Statements.
4
<Page>
AVAYA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-------------------------
2001 2000
-------- --------
OPERATING ACTIVITIES:
Net income (loss)......................................... $ (20) $ 16
Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities:
Depreciation and amortization......................... 60 66
Provision for uncollectible receivables............... 22 16
Deferred income taxes................................. (22) 52
Adjustments for other non-cash items, net............. 9 --
Changes in operating assets and liabilities:
Receivables........................................... 198 141
Inventory............................................. (17) (39)
Accounts payable...................................... (177) (44)
Payroll and benefits, net............................. (46) 29
Advance billings and deposits......................... (23) (65)
Other assets and liabilities.......................... (76) (114)
----- -----
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES........ (92) 58
----- -----
INVESTING ACTIVITIES:
Capital expenditures...................................... (26) (92)
Proceeds from the sale of property, plant and equipment... 2 2
Purchases of equity investments........................... -- (18)
Other investing activities, net........................... (2) (8)
----- -----
NET CASH USED FOR INVESTING ACTIVITIES...................... (26) (116)
----- -----
FINANCING ACTIVITIES:
Issuance of convertible participating preferred stock..... -- 368
Issuance of warrants...................................... -- 32
Issuance of common stock.................................. 7 6
Net decrease in commercial paper.......................... (131) (76)
Issuance of LYONs convertible debt........................ 460 --
Payment of debt issuance costs............................ (13) --
Repayment of credit facility borrowing.................... (200) --
Other financing activities, net........................... (1) (1)
----- -----
NET CASH PROVIDED BY FINANCING ACTIVITIES................... 122 329
----- -----
Effect of exchange rate changes on cash and cash
equivalents............................................... (2) 18
----- -----
Net increase in cash and cash equivalents................... 2 289
Cash and cash equivalents at beginning of fiscal year....... 250 271
----- -----
Cash and cash equivalents at end of period.................. $ 252 $ 560
===== =====
</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 contribution by Lucent of
its enterprise networking businesses to the Company and a distribution of the
outstanding shares of the Company's common stock to Lucent stockholders (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 December 31, 2001 and for the three months ended December 31, 2001 and
2000, have been prepared in accordance with accounting principles generally
accepted in the United States of America for interim financial statements and
the rules and regulations of the Securities and Exchange Commission for interim
financial statements, and should be read in conjunction with the Company's
Annual Report on Form 10-K for the fiscal year ended September 30, 2001. In the
Company's opinion, the unaudited interim consolidated financial statements
reflect all adjustments, consisting of normal and recurring adjustments,
necessary for a fair presentation of the financial condition, results of
operations and cash flows for the periods indicated. Certain prior year amounts
have been reclassified to conform to the current interim period presentation.
The consolidated results of operations for the interim periods reported are not
necessarily indicative of the results to be experienced for the entire fiscal
year.
2. RECENT ACCOUNTING PRONOUNCEMENTS
SFAS 143
In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement No. 143, "Accounting for Asset Retirement Obligations" ("SFAS 143"),
which provides the accounting requirements for retirement obligations associated
with tangible long-lived assets. This Statement requires entities to record the
fair value of a liability for an asset retirement obligation in the period in
which it is incurred. This Statement is effective for the Company's 2003 fiscal
year, and early adoption is permitted. The adoption of SFAS 143 is not expected
to have a material impact on the Company's consolidated results of operations,
financial position or cash flows.
SFAS 144
In October 2001, the FASB issued Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), which excludes from
the definition of long-lived assets goodwill and other intangibles that are not
amortized in accordance with Statement No. 142, "Goodwill and Other Intangible
Assets" ("SFAS 142") noted below. SFAS 144 requires that long-lived assets to be
disposed of by sale be measured at the lower of carrying amount or fair value
less cost to sell, whether reported in continuing operations or in discontinued
operations. SFAS 144 also expands the reporting of discontinued operations to
include components of an entity that have been or will be disposed of rather
than limiting such discontinuance to a segment of a business. This Statement is
effective for the
6
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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
2. RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)
Company's 2003 fiscal year, and early adoption is permitted. The Company is
currently evaluating the impact of SFAS 144 to determine the effect, if any, it
may have on the Company's consolidated results of operations, financial position
or cash flows.
3. GOODWILL AND INTANGIBLE ASSETS
Effective October 1, 2001, the Company adopted 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 remaining useful lives. In connection with the
adoption of SFAS 142, the Company reviewed the classification of its existing
goodwill and other intangible assets, reassessed the useful lives previously
assigned to other intangible assets, and discontinued amortization of goodwill.
During the remainder of fiscal 2002, the Company will complete a transitional
review of its goodwill for impairment. Losses, if any, that are identified as a
result of this transitional review will be recorded as a change in accounting
principle. Any such losses that are recorded after the transitional review will
be identified as a separate line item in income from operations.
For the three months ended December 31, 2000, the Company reported net
income of $16 million and $0.03 for both basic and diluted earnings per share.
If the Company had adopted SFAS 142 in the beginning of the first quarter of
fiscal 2001 and discontinued goodwill amortization, which amounted to
$8 million, net of tax during this period, on a pro forma basis net income would
have been $24 million and basic and diluted earnings per share would have been
$0.06.
The following table presents the components of the Company's intangible
assets:
<Table>
<Caption>
AS OF DECEMBER 31, 2001 AS OF SEPTEMBER 30, 2001
---------------------------------- ----------------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION NET AMOUNT AMORTIZATION NET
-------- ------------ -------- -------- ------------ --------
(DOLLARS IN MILLIONS)
Existing technology...................... $160 $ 99 $61 $160 $92 $68
Other intangibles........................ 12 4 8 12 2 10
---- ---- --- ---- --- ---
Total intangible assets.................. $172 $103 $69 $172 $94 $78
==== ==== === ==== === ===
</Table>
Intangible assets are amortized over a period of three to six years.
Amortization expense for intangible assets during the three months ended
December 31, 2001 and 2000 was $9 million and
7
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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. GOODWILL AND INTANGIBLE ASSETS (CONTINUED)
$6 million, respectively. Estimated amortization expense for the remainder of
fiscal 2002 and the five succeeding fiscal years is as follows:
<Table>
<Caption>
FISCAL YEAR AMOUNT
- ----------- ------
(DOLLARS IN MILLIONS)
2002 (remaining nine months)............................... $26
2003....................................................... 20
2004....................................................... 12
2005....................................................... 8
2006....................................................... 3
---
Total...................................................... $69
===
</Table>
The carrying value of goodwill of $174 million as of December 31, 2001 is
primarily attributable to the Communications Solutions segment. The decrease in
carrying value of goodwill from September 30, 2001 reflects the impact of
foreign currency exchange rate fluctuations.
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 ENDED
DECEMBER 31,
-----------------------
2001 2000
---------- ----------
(DOLLARS IN MILLIONS)
Net income (loss)................................... $(20) $ 16
Other comprehensive income (loss)................... (14) 39
---- ----
Total comprehensive income (loss)................... $(34) $ 55
==== ====
</Table>
5. SUPPLEMENTARY FINANCIAL INFORMATION
BALANCE SHEET INFORMATION
<Table>
<Caption>
AS OF AS OF
DECEMBER 31, SEPTEMBER 30,
2001 2001
------------ -------------
(DOLLARS IN MILLIONS)
INVENTORY
Completed goods..................................... $420 $420
Work in process and raw materials................... 207 229
---- ----
Total inventory................................... $627 $649
==== ====
</Table>
8
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
5. SUPPLEMENTARY FINANCIAL INFORMATION (CONTINUED)
SUPPLEMENTAL CASH FLOW INFORMATION
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-----------------------
2001 2000
---------- ----------
(DOLLARS IN MILLIONS)
Non-cash transactions:
Accretion of Series B preferred stock............... $ 7 $ 7
==== ====
</Table>
6. SECURITIZATION OF ACCOUNTS RECEIVABLE
The Company entered into a receivables purchase agreement in June 2001 and
transferred a designated pool of qualified trade accounts receivable to a
special purpose entity ("SPE"), which in turn sold an undivided ownership
interest to an unaffiliated financial institution for cash proceeds of
$200 million. The financial institution is an affiliate of Citibank, N.A., a
lender and the agent for the other lenders under the revolving credit facilities
described in Notes 8 and 13. The Company, through the SPE, has a retained
interest in a portion of these receivables, and the financial institution has no
recourse to the Company's other assets, stock or other securities of the Company
for failure of customers to pay when due. The assets of the SPE are not
available to pay creditors of the Company. 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 purchase
agreement expires in June 2002, but may be extended through June 2004 with the
financial institution's consent.
The Company had a retained interest of $174 million and $153 million as of
December 31, 2001 and September 30, 2001, respectively, 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,
is recorded in other current assets.
The Company is subject to certain receivable collection ratios, among other
covenants contained in the receivables purchase agreement. In October 2001, the
financial institution participating in the agreement granted the Company a
waiver from a covenant that measures the ratio of certain unpaid receivables as
a percentage of the aggregate outstanding balance of all designated receivables.
The waiver effectively increased the ratio required by the covenant for each of
the individual months of September through December 2001, and required
compliance with the original ratio thereafter. As of December 31, 2001, the
Company was in compliance with such covenants, although in January 2002 the
financial institution waived the Company's obligation to comply with the
required ratio for the month of January 2002. The Company will be required to
comply with the original ratio for the month of February 2002 and thereafter.
The receivables purchase agreement initially required that the Company's
long-term senior unsecured debt be rated at least BBB- by Standard & Poor's and
Baa3 by Moody's. In February 2002, the agreement was amended to lower these
ratings triggers to BB+ by Standard & Poor's and Ba1 by Moody's through
March 15, 2002, at which time the required ratings will revert back to BBB- by
Standard & Poor's and Baa3 by Moody's. As described in Note 13, the Company's
long-term senior
9
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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. SECURITIZATION OF ACCOUNTS RECEIVABLE (CONTINUED)
unsecured debt has been recently downgraded and is currently rated Baa3 by
Moody's, subject to review for further downgrade, and BB+ by Standard & Poor's,
with a negative outlook.
The Company is currently in discussions with the financial institution
participating in the receivables purchase agreement to restructure the agreement
to address, among other things, the collection ratio and the ratings trigger. If
the Company does not reach agreement with the financial institution on a
restructuring of the agreement, and (i) is unable to maintain the required ratio
described above for the month of February 2002 or for any month thereafter, or
(ii) its long-term senior unsecured debt is not rated at least BBB- by
Standard & Poor's and Baa3 by Moody's after March 15, 2002, the financial
institution will be able to exercise its rights under the agreement, including
an early termination of the agreement. Upon the expiration, or in the event of
an early termination, of the agreement, purchases of interests in receivables by
the financial institution under the agreement will cease and collections on
receivables constituting the designated pool, including to the extent necessary,
those receivables comprising the retained interest, will be used to pay down the
financial institution's $200 million investment under the agreement.
7. BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES
The Company recorded business restructuring charges in fiscal 2000 related
to its separation from Lucent and in fiscal 2001 related to the outsourcing of
certain manufacturing facilities and the acceleration of its restructuring plan
that was originally adopted in fiscal 2000 to improve profitability and business
performance as a stand-alone company. The following table summarizes the status
of the Company's business restructuring reserve and related expenses as of and
for the three months ended December 31, 2001:
<Table>
<Caption>
BUSINESS RESTRUCTURING RESERVE OTHER RELATED EXPENSES
------------------------------------------------------ -------------------------- TOTAL BUSINESS
EMPLOYEE LEASE TOTAL BUSINESS RESTRUCTURING
SEPARATION TERMINATION OTHER EXIT RESTRUCTURING ASSET INCREMENTAL AND RELATED
COSTS OBLIGATIONS COSTS RESERVE IMPAIRMENTS PERIOD COSTS EXPENSES
---------- ----------- ---------- -------------- ----------- ------------ --------------
(DOLLARS IN MILLIONS)
Balance as of
September 30, 2001.... $96 $78 $5 $179 $ -- $ -- $179
Expenses................ -- -- -- -- -- 6 6
Cash payments........... (21) (20) (1) (42) -- (6) (48)
--- --- -- ---- --------- --------- ----
Balance as of
December 31, 2001..... $75 $58 $4 $137 $ -- $ -- $137
=== === == ==== ========= ========= ====
</Table>
Employee separation costs included in the business restructuring reserve
were made through lump sum payments, although certain union-represented
employees elected to receive a series of payments extending over a period of up
to two years from the date of departure. Payments to employees who elected to
receive severance through a series of payments will extend through 2003. This
workforce reduction was substantially completed at the end of fiscal 2001. The
charges for lease termination obligations, which consisted of real estate and
equipment leases, included approximately 2.8 million square feet of excess space
of which the Company has vacated 667,000 square feet as of December 31, 2001.
Payments on lease termination obligations will be substantially completed by
2003 because, in certain circumstances, the remaining lease payments were less
than the termination fees.
10
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AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
7. BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES (CONTINUED)
In the first quarter of fiscal 2002, the Company recorded $6 million of
other related expenses primarily associated with the Company's outsourcing of
certain manufacturing facilities. In the first quarter of fiscal 2001, the
Company recorded $23 million of other related expenses associated with the
Company's separation from Lucent related primarily to computer system transition
costs such as data conversion activities, asset transfers, and training. In
addition, the Company recorded $36 million in selling, general and
administrative expenses for additional start-up activities during the first
quarter of fiscal 2001 largely resulting from marketing costs associated with
continuing to establish the Avaya brand.
OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES
In connection with the five-year strategic manufacturing agreement to
outsource most of the manufacturing of the Company's communications systems and
software, Avaya has received substantially all of the $200 million in proceeds
for assets transferred to Celestica Inc. The Company deferred $100 million of
these proceeds, which are being recognized on a straight-line basis over the
term of the agreement. As of December 31, 2001, the unamortized portion of these
proceeds amounted to $20 million in other current liabilities and $66 million in
other liabilities. The remaining phases of the transaction, which included
closing of the Shreveport, Louisiana facility, were completed in the first
quarter of fiscal 2002.
8. LONG-TERM DEBT
Long-term debt outstanding consisted of the following:
<Table>
<Caption>
AS OF AS OF
DECEMBER 31, SEPTEMBER 30,
2001 2001
------------ -------------
(DOLLARS IN MILLIONS)
Commercial paper............................................ $301 $432
Revolving credit facilities:
364-day facility.......................................... -- --
Five-year facility........................................ -- 200
LYONs convertible debt...................................... 463 --
Other....................................................... 12 13
---- ----
Total debt.............................................. 776 645
Less: Current portion....................................... 276 145
---- ----
Total long-term debt.................................... $500 $500
==== ====
</Table>
COMMERCIAL PAPER PROGRAM
The Company has established a commercial paper program pursuant to which it
may issue up to $1.25 billion of commercial paper at market interest rates.
Interest rates on the commercial paper obligations are variable due to their
short-term nature. The weighted average yield and maturity period for the
$301 million and $432 million of commercial paper outstanding as of
December 31, 2001 and September 30, 2001 were approximately 3.4% and 3.9% and
87 days and 62 days, respectively. As of December 31, 2001, $37 million of the
outstanding commercial paper was classified as long-term debt
11
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
8. LONG-TERM DEBT (CONTINUED)
in the Consolidated Balance Sheet since it is supported by the five-year credit
facility described below and it is management's intent to refinance it with
other debt on a long-term basis. As of September 30, 2001, the entire amount of
commercial paper was classified as long-term debt.
As described in Note 13, the Company's commercial paper has been recently
downgraded and is currently rated P-3 by Moody's, subject to review for further
downgrade, and A-3 by Standard & Poor's, with a negative outlook. These recent
downgrades make it very difficult, if not impossible, for the Company to access
the commercial paper market, which has been its primary source of liquidity in
the past. As a result of the impact of these ratings downgrades on the Company's
ability to issue commercial paper, in February 2002, the Company borrowed
$300 million under its five-year credit facility to repay commercial paper
obligations. As of February 13, 2002, approximately $26 million of the Company's
commercial paper remains outstanding. Such obligations mature through May 2002
and the Company expects to repay these remaining obligations with available cash
or other short-term or long-term debt.
REVOLVING CREDIT FACILITIES
The Company has two unsecured revolving credit facilities (the "Credit
Facilities") with third party financial institutions consisting of a
$400 million 364-day credit facility that expires in August 2002 and an
$850 million five-year credit facility that expires in September 2005. No
amounts were drawn under either credit facility as of December 31, 2001,
although in February 2002 the Company borrowed $300 million under the five-year
credit facility in order to repay maturing commercial paper obligations. As of
September 30, 2001, $200 million was outstanding under the five-year credit
facility bearing interest at a fixed rate of approximately 3.5%, which was
repaid in October 2001 using the proceeds from the issuance of commercial paper.
There were no outstanding borrowings under the 364-day credit facility as of
September 30, 2001. The September 2001 borrowing under the credit facility was
necessitated by disruptions in the commercial paper markets as a result of the
September 11 terrorist attacks.
As described in Note 13, in February 2002, the Company and the lenders under
the Credit Facilities amended the facilities.
In addition, the Company, through its foreign operations, entered into
several uncommitted credit facilities totaling $88 million and $118 million, of
which letters of credit of $17 million and $10 million were issued and
outstanding as of December 31, 2001 and September 30, 2001, respectively.
Letters of credit are purchased guarantees that ensure the Company's performance
or payment to third parties in accordance with specified terms and conditions.
OTHER DEBT
As of December 31, 2001 and September 30, 2001, the Company had debt
outstanding attributable to its foreign entities of $12 million and
$13 million, respectively.
LYONS CONVERTIBLE DEBT
In the first quarter of fiscal 2002, the Company sold through an
underwritten public offering under a shelf registration statement an aggregate
principal amount at maturity of approximately $944 million
12
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
8. LONG-TERM DEBT (CONTINUED)
of Liquid Yield Option-TM- Notes due 2021 ("LYONs"). The proceeds of
approximately $447 million, net of a $484 million discount and $13 million of
underwriting fees, were used to refinance a portion of the Company's outstanding
commercial paper. The underwriting fees of $13 million were recorded as deferred
financing costs and are being amortized on a straight-line basis to interest
expense over a three-year period through October 31, 2004, which represents the
first date holders may require the Company to purchase all or a portion of their
LYONs.
The original issue discount of $484 million accrues daily at a rate of
3.625% per year calculated on a semiannual bond equivalent basis. The Company
will not make periodic cash payments of interest on the LYONs. Instead, the
amortization of the discount is recorded as interest expense and represents the
accretion of the LYONs issue price to its maturity value. For the three months
ended December 31, 2001, $3 million of interest expense on the LYONs was
recorded, resulting in an accreted value of $463 million as of December 31,
2001. The discount will cease to accrue on the LYONs upon maturity, conversion,
purchase by the Company at the option of the holder, or redemption by Avaya. The
LYONs are unsecured obligations that rank equally in right of payment with all
existing and future unsecured and unsubordinated indebtedness of Avaya.
The LYONs are convertible into 35,333,073 shares of Avaya common stock at
any time on or before the maturity date. The conversion rate may be adjusted for
certain reasons, but will not be adjusted for accrued original issue discount.
Upon conversion, the holder will not receive any cash payment representing
accrued original issue discount. Accrued original issue discount will be
considered paid by the shares of common stock received by the holder of the
LYONs upon conversion.
Avaya may redeem all or a portion of the LYONs for cash at any time on or
after October 31, 2004 at a price equal to the sum of the issue price and
accrued original issue discount on the LYONs as of the applicable redemption
date. Conversely, holders may require the Company to purchase all or a portion
of their LYONs on the third, fifth and tenth anniversary from October 31, 2001
at a price equal to the sum of the issue price and accrued original issue
discount on the LYONs as of the applicable purchase date. The Company may, at
its option, elect to pay the purchase price in cash or shares of common stock,
or any combination thereof.
The indenture governing the LYONs includes certain covenants, including a
limitation on the Company's ability to grant liens on significant domestic real
estate properties or the stock of subsidiaries holding such properties. The
liens granted under the Amended Credit Facilities described in Note 13 do not
extend to any real property and therefore, do not conflict with the terms of the
indenture governing the LYONs.
13
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
9. EARNINGS (LOSS) PER SHARE OF COMMON STOCK
Basic earnings (loss) per common share was calculated by dividing net income
(loss) available to common stockholders by the weighted average number of common
shares outstanding during the period. Diluted earnings (loss) per common share
was calculated by adjusting net income (loss) available to common stockholders
and weighted average outstanding shares, assuming conversion of all potentially
dilutive securities including stock options, warrants, convertible participating
preferred stock and convertible debt.
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-----------------------
2001 2000
-------- --------
(DOLLARS AND SHARES IN
MILLIONS, EXCEPT PER
SHARE AMOUNTS)
Net income (loss)........................................ $ (20) $ 16
Accretion of Series B preferred stock.................... (7) (7)
------ -----
Net income (loss) available to common stockholders....... $ (27) $ 9
====== =====
SHARES USED IN COMPUTING EARNINGS (LOSS) PER COMMON
SHARE:
Basic.................................................. 287 282
====== =====
Diluted................................................ 287 282
====== =====
EARNINGS (LOSS) PER COMMON SHARE:
Basic.................................................. $(0.09) $0.03
====== =====
Diluted................................................ $(0.09) $0.03
====== =====
SECURITIES EXCLUDED FROM THE COMPUTATION OF DILUTED
EARNINGS (LOSS) PER COMMON SHARE:
Options(1)............................................. 46 72
Series B preferred stock(2)............................ 16 15
Warrants(1)............................................ 12 12
Convertible debt(2).................................... 28 --
------ -----
Total................................................ 102 99
====== =====
</Table>
- ------------------------
(1) These securities have been excluded from the diluted earnings (loss) per
common share calculation since their inclusion would have been antidilutive
because the option and warrant exercise prices are greater than the average
market value of the underlying stock.
(2) In applying the "if-converted" method, the Series B convertible
participating preferred stock and LYONs convertible debt were excluded from
the diluted earnings (loss) per common share calculation since the effect of
their inclusion would have been antidilutive.
10. OPERATING SEGMENTS
The Company reports its operations in three segments: Communications
Solutions, Services and Connectivity Solutions. The Communications Solutions
segment represents the Company's core business, composed of enterprise voice
communications systems and software, communications
14
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. OPERATING SEGMENTS (CONTINUED)
applications, professional services for customer relationship management,
converged voice and data networks and unified communication, multi-service
networking products and product installation services. 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 discontinued allocating
costs of shared services and other corporate center operations managed outside
of the operating segments. Operating income (loss) for the three months ended
December 31, 2000 has been restated to reflect these costs in Corporate and
other. Intersegment sales approximate fair market value and are not significant.
OPERATING SEGMENTS
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-------------------------
2001 2000
-------- --------
(DOLLARS IN MILLIONS)
COMMUNICATIONS SOLUTIONS:
Total revenue...................................... $663 $928
Operating income................................... 109 227
SERVICES:
Total revenue...................................... $508 $499
Operating income................................... 284 243
CONNECTIVITY SOLUTIONS:
Total revenue...................................... $135 $356
Operating income (loss)............................ (27) 88
</Table>
15
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. 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 ENDED
DECEMBER 31,
-----------------------
2001 2000
-------- --------
(DOLLARS IN MILLIONS)
REVENUE
Total operating segments............................... $1,306 $1,783
Corporate and other.................................... -- 2
------ ------
Total revenue.......................................... $1,306 $1,785
====== ======
OPERATING INCOME (LOSS)
Total operating segments............................... $ 366 $ 558
Corporate and other:
Business restructuring related expenses and start-up
expenses........................................... (6) (59)
Corporate and unallocated shared expenses............ (387) (473)
------ ------
Total operating income (loss)...................... $ (27) $ 26
====== ======
</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 operating segments.
GEOGRAPHIC INFORMATION
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-----------------------
2001 2000
-------- --------
(DOLLARS IN MILLIONS)
REVENUE(1)
U.S.................................................... $ 944 $1,346
International.......................................... 362 439
------ ------
Total................................................ $1,306 $1,785
====== ======
</Table>
- ------------------------
(1) Revenue is attributed to geographic areas based on the location of
customers.
CONCENTRATIONS
No single customer accounted for more than 10% of the Company's revenue for
the three months ended December 31, 2001. For the three months ended
December 31, 2000, sales to Avaya's largest distributor, which are included in
Communications Solutions, were approximately 11% of the
16
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. OPERATING SEGMENTS (CONTINUED)
Company's revenue. Receivables from this distributor, including amounts
outstanding under the line of credit described below, totaled $170 million and
$198 million as of December 31, 2001 and September 30, 2001, respectively. As of
December 31, 2001, $71 million and $99 million were included in receivables and
other current assets, respectively. As of September 30, 2001, $117 million and
$81 million were included in receivables and other current assets, respectively.
Amounts recorded in receivables represent trade receivables due from this
distributor on sales of products. Amounts recorded in other current assets
represent receivables due from this distributor for maintenance services
provided by the Company to the distributor's customers.
During fiscal 2001, the Company granted a short-term line of credit for the
purchase of Avaya products and services to this distributor. The credit line
applies to certain unpaid and outstanding receivables and the maximum amount
available under the credit agreement is $125 million. Outstanding amounts under
the credit agreement, which expires in March 2002, are secured by the
distributor's accounts receivable and inventory and accrue interest at an annual
rate of 12%. Interest payments are due to the Company monthly. Upon the
occurrence of an event of default, the Company has certain rights under the
credit agreement, including, without limitation, the right to require the
distributor to immediately assign the collateral to the Company to the extent
borrowings under the credit agreement exceed $100 million. The Company may then
require the parent company of the distributor to purchase up to $25 million of
the assigned collateral. On or prior to the termination of this agreement, the
distributor is required to obtain a collateralized commercial credit facility to
replace the existing credit line and repay in full all amounts due under the
credit line. As of December 31, 2001, the amount outstanding under the line of
credit was $123 million, of which $56 million is included in receivables and
$67 million is included in other current assets. The Company is currently in
discussions with the distributor to restructure the agreement, but there can be
no assurance that the Company will reach agreement on a restructured line of
credit on terms favorable to the Company, or that the distributor will have
obtained the necessary financing to satisfy its obligations under the line of
credit on the March 31, 2002 expiration date.
11. TRANSACTIONS WITH LUCENT AND OTHER RELATED PARTY TRANSACTIONS
CONTRIBUTION AND DISTRIBUTION AGREEMENT
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
including certain pre-Distribution tax obligations of Lucent relating to the
Company's Businesses and all contingent liabilities primarily relating to the
Company's Businesses or otherwise assigned to the Company. In addition, the
Contribution and Distribution Agreement provides that certain contingent
liabilities not allocated to one of the parties will be shared contingent
liabilities and borne 90% by Lucent and 10% by the Company. The Contribution and
Distribution Agreement also provides that contingent liabilities in excess of
$50 million that are primarily related to Lucent's businesses shall be borne 90%
by Lucent
17
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
11. TRANSACTIONS WITH LUCENT AND OTHER RELATED PARTY TRANSACTIONS (CONTINUED)
and 10% by the Company and contingent liabilities in excess of $50 million that
are primarily related to the Company's business shall be borne equally by the
parties.
In addition, if the Distribution fails to qualify as a tax-free distribution
under Section 355 of the Internal Revenue Code because of an acquisition of the
Company's stock or assets, or some other actions of the Company, then the
Company will be solely liable for any resulting corporate taxes.
OTHER RELATED PARTY TRANSACTIONS
Jeffrey A. Harris has been a director of Avaya since October 2000.
Mr. Harris is a member and senior managing director of Warburg Pincus LLC and a
general partner of Warburg, Pincus & Co. Each of Warburg Pincus LLC and Warburg,
Pincus & Co. is an affiliate of Warburg Pincus Equity Partners L.P. Mr. Harris
was designated for election to the Company's board of directors by Warburg
Pincus Equity Partners, L.P. and its affiliates pursuant to the terms of their
equity investment in the Company. Henry B. Schacht has been a director of Avaya
since September 2000. Mr. Schacht is currently on a leave of absence as a
managing director and senior advisor of Warburg Pincus LLC.
12. COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
From time to time the Company is involved in legal proceedings arising in
the ordinary course of business. Other than as described below, the Company
believes there is no litigation pending that could have, individually or in the
aggregate, a material adverse effect on its financial position, results of
operations or cash flows.
YEAR 2000 ACTIONS
Three separate purported class action lawsuits are pending against Lucent,
one in state court in West Virginia, one in federal court in the Southern
District of New York and another in federal court in the Southern District of
California. The case in New York was filed in January 1999 and, after being
dismissed, was refiled in September 2000. The case in West Virginia was filed in
April 1999 and the case in California was filed in June 1999, and amended in
2000 to include Avaya as a defendant. The Company may also be named a party to
the other actions and, in any event, has assumed the obligations of Lucent for
all of these cases under the Contribution and Distribution Agreement. 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.
18
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
COUPON PROGRAM CLASS ACTION
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 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 parties have
entered into a proposed settlement agreement, pending final approval by the
court.
LUCENT SECURITIES LITIGATION
In November 2000, three purported class actions were filed against Lucent in
the Federal District Court for the District of New Jersey alleging violations of
the federal securities laws as a result of the facts disclosed in Lucent's
announcement on November 21, 2000 that it had identified a revenue recognition
issue affecting its financial results for the fourth quarter of fiscal 2000. The
actions purport to be filed on behalf of purchasers of Lucent common stock
during the period from October 10, 2000 (the date Lucent originally reported
these financial results) through November 21, 2000.
The above actions have been consolidated with other purported class actions
filed against Lucent on behalf of its stockholders in January 2000 and are
pending in the Federal District Court for the District of New Jersey. The
Company understands that Lucent has filed a motion to dismiss the Fifth
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 stockholders of Lucent who bought Lucent common stock between October 26,
1999 and January 6, 2000, but the consolidated complaint was amended to include
purported class members who purchased Lucent common stock up to November 21,
2000. A class has not yet been certified in the consolidated actions. The
plaintiffs in all these stockholder class actions seek compensatory damages plus
interest and attorneys' fees.
Any liability incurred by Lucent in connection with these stockholder 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. 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.
19
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
LICENSING MEDIATION
In March 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
claims that the Company owes royalty payments for software integrated into
certain of the Company's products. The licensor 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
licensor has demanded arbitration of this matter, which the Company expects to
occur within the next several months. At this point, an outcome in the
arbitration proceeding 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.
REVERSE/FORWARD STOCK SPLIT COMPLAINTS
In January 2002, a complaint was filed in the Court of Chancery of the State
of Delaware against the Company seeking to enjoin it from effectuating a reverse
stock split followed by a forward stock split described in its proxy statement
for its 2002 Annual Meeting of Shareholders to be held on February 26, 2002. At
the annual meeting, the Company is seeking the approval of its shareholders of
each of three alternative transactions:
- a reverse 1-for-30 stock split followed immediately by a forward 30-for-1
stock split of the Company's common stock;
- a reverse 1-for-40 stock split followed immediately by a forward 40-for-1
stock split of the Company's common stock;
- a reverse 1-for-50 stock split followed immediately by a forward 50-for-1
stock split of the Company's common stock.
The complaint alleges, among other things, that the manner in which the
Company plans to implement the transactions, as described in its proxy
statement, violates certain aspects of Delaware law with regard to the treatment
of fractional shares and that the description of the proposed transactions in
the proxy statement is misleading to the extent it reflects such violations. The
action purports to be a class action on behalf of all holders of less than 50
shares of the Company's common stock. The plaintiff is seeking, among other
things, damages as well as injunctive relief enjoining the Company from
effecting the transactions and requiring the Company to make corrective,
supplemental disclosure. Although the transactions will be submitted to the
Company's shareholders for approval at the annual meeting, this matter is in the
early stages and the Company cannot provide assurance that this lawsuit will not
impair its ability to implement any of the transactions upon obtaining such
approval.
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 U.S., governing
the cleanup of soil and groundwater contamination. Such provisions impose
liability for
20
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
the costs of investigating and remediating releases of hazardous materials at
currently or formerly owned or operated sites. In certain circumstances, this
liability may also include the cost of cleaning up historical contamination,
whether or not caused by the Company. The Company is currently conducting
investigation and/or cleanup of known contamination at approximately five of its
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.
CONDITIONAL REPURCHASE OBLIGATIONS
Avaya sells products to various distributors that may obtain financing from
unaffiliated third party lending institutions. In the event the lending
institution repossesses the distributor's inventory of Avaya products, Avaya is
obligated to repurchase such inventory from the lending institution. The
repurchase amount is equal to the price originally paid to Avaya by the lending
institution for the inventory. The Company's obligation to repurchase inventory
from the lending institution terminates 180 days from the date of invoicing by
Avaya to the distributor. During the three months ended December 31, 2001, there
were no repurchases made by the Company under such agreements. There can be no
assurance that the Company will not be obligated to repurchase inventory under
these arrangements in the future.
13. SUBSEQUENT EVENTS
REVOLVING CREDIT FACILITIES
In February 2002, the Company and the lenders under the Credit Facilities
described in Note 8 amended the facilities ("Amended Credit Facilities"). Funds
are available under the Amended Credit Facilities for general corporate
purposes, the repayment of commercial paper obligations, and for acquisitions up
to $150 million. The Amended Credit Facilities provide that in the event the
Company's corporate credit rating falls below BBB- by Standard & Poor's or its
long-term senior unsecured debt rating falls below Baa3 by Moody's, any
borrowings under the Amended Credit Facilities will be secured, subject to
certain exceptions, by security interests in the U.S. equipment, accounts
receivable, inventory, and intellectual property rights of the Company and that
of any of its subsidiaries guaranteeing its obligations under the Amended Credit
Facilities as described below. Borrowings would also be secured by a pledge of
the stock of certain of the Company's domestic subsidiaries and 65% of the stock
of a foreign subsidiary. The security interests would be granted to the extent
permitted by the indenture governing the LYONs and would be suspended in the
event the Company's corporate credit rating was at least BBB by Standard &
Poor's and its long-term senior unsecured debt rating was at least Baa2 by
Moody's, in each case with a stable outlook. As described below, the Company's
debt ratings have been recently downgraded and its long-term senior unsecured
debt is currently rated Baa3 by Moody's, subject to review for further
downgrade, and its corporate credit is currently rated BBB-
21
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
13. SUBSEQUENT EVENTS (CONTINUED)
by Standard & Poor's, with a negative outlook. Based on these long-term debt
ratings, borrowings under the Amended Credit Facilities are currently unsecured.
The Amended Credit Facilities also provide that up to $500 million of the
net proceeds of offerings of debt securities and $200 million of the net
proceeds of any real property financings must be used to reduce the commitments
under the 364-day and five-year facilities on a pro rata basis. In addition, to
the extent that the Company obtains proceeds from asset sales or dispositions at
a time when the aggregate commitments under the Amended Credit Facilities exceed
$850 million, the Company is required to use such proceeds to reduce the
commitments under such facilities on a pro rata basis.
Any current or future domestic subsidiaries (other than certain excluded
subsidiaries) whose revenues constitute 5% or greater of the Company's
consolidated revenues or whose assets constitute 5% or greater of the Company's
consolidated total assets will be required to guarantee its obligations under
the Amended Credit Facilities. There are no Avaya subsidiaries that currently
meet these criteria.
The Amended Credit Facilities also include negative covenants, including
limitations on affiliate transactions, restricted payments and investments and
advances. The Amended Credit Facilities also restrict the Company's ability and
that of its subsidiaries to incur debt, subject to certain exceptions. The
Company is permitted to use the Amended Credit Facilities to fund acquisitions
in an aggregate amount not to exceed $150 million and can make larger
acquisitions so long as the facilities are not used to fund the purchase price,
no default under the facilities shall have occurred and be continuing or would
result from such acquisition, and the Company shall be in compliance with the
financial ratio test described below after giving pro forma effect to such
acquisition.
The Amended Credit Facilities require the Company to maintain a ratio of
consolidated Earnings Before Interest, Taxes, Depreciation and Amortization
("EBITDA") to interest expense of three to one for each of the four quarter
periods ending March 31, 2002, June 30, 2002 and September 30, 2002 and a ratio
of four to one for each four quarter period thereafter. The Company is also
required to maintain consolidated EBITDA of:
- $20 million for the quarter ended March 31, 2002;
- $80 million for the two quarter period ended June 30, 2002;
- $180 million for the three quarter period ended September 30, 2002;
- $300 million for the four quarter period ended December 31, 2002; and
- $400 million for each four quarter period thereafter.
For purposes of these calculations, the Company is permitted to exclude from
the computation of consolidated EBITDA up to $163 million of restructuring
charges, including asset impairment and other one time expenses to be taken no
later than the fourth quarter of fiscal 2002. In addition, the Company may
exclude certain business restructuring charges and related expenses taken in
fiscal 2001.
The Amended Credit Facilities provide, at the Company's option, for fixed
interest rate and floating interest rate borrowings. Fixed rate borrowings under
the facilities bear interest at a rate equal to (i) the greater of
(A) Citibank, N.A.'s base rate and (B) the federal funds rate plus 0.5% plus
(ii) a margin based on the Company's long-term senior unsecured debt rating (the
"Applicable Margin"). Floating rate borrowings bear interest at a rate equal to
the LIBOR rate plus the Applicable Margin
22
<Page>
AVAYA INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
13. SUBSEQUENT EVENTS (CONTINUED)
and, if borrowings under a facility exceed 50% of the commitments under such
facility, a utilization fee based on the Company's long-term senior unsecured
debt rating (the "Applicable Utilization Fee"). Based on the Company's current
long-term debt rating, the Applicable Margins for the 364-day credit facility
and the five-year credit facility are 1.075% and 1.05%, respectively, and the
Applicable Utilization Fee for both facilities is 0.25%.
DEBT RATINGS
In January and February 2002, the Company's commercial paper and long-term
debt ratings were downgraded as follows:
<Table>
<Caption>
AS OF CURRENT RATINGS
DECEMBER 31, 2001 JANUARY 2002 FEBRUARY 2002
----------------- ------------ ---------------
Moody's:
Commercial paper................................ P-2 P-2 P-3 (1)
Long-term senior unsecured debt................. Baa1 Baa2 Baa3 (1)
Standard & Poor's:
Commercial paper................................ A-2 (2) A-3(2) A-3 (2)
Long-term senior unsecured debt................. BBB (2) BBB-(2) BB+ (2)
Corporate credit................................ BBB (2) BBB-(2) BBB- (2)
</Table>
- ------------------------
(1) Subject to review for further downgrade.
(2) Includes a negative outlook.
CONNECTIVITY SOLUTIONS
In February 2002, the Company announced that it has engaged Salomon Smith
Barney to explore alternatives for the Company's Connectivity Solutions segment,
including the possible sale of the business. The Connectivity Solutions segment
markets (i) the SYSTIMAX-Registered Trademark- product line of structured
cabling systems primarily to enterprises of various sizes for wiring phones,
workstations, personal computers, local area networks and other communications
devices through their buildings or across their campuses and (ii) the
ExchangeMax-Registered Trademark- product line primarily to central offices of
service providers, such as telephone companies or Internet service providers.
Connectivity Solutions also offers electronic cabinets to enclose an
enterprise's electronic devices and equipment. The Company's goal in exploring
alternatives for Connectivity Solutions is to maximize its core business both by
enhancing liquidity and by strengthening its focus on the higher growth
opportunities for Avaya, including converged voice and data, unified
communications, and customer relationship management. Connectivity Solutions
comprised $1,322 million, or 19.5%, of the Company's total revenue in the fiscal
year ended September 30, 2001.
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 ability to implement
in a timely manner our restructuring plans; the economic, political and other
risks associated with international sales and operations; U.S. and foreign
government regulation; general industry and market conditions; growth rates and
general domestic and international economic conditions including interest rate
and currency exchange rate fluctuations and the impact of recent decreases in
our revenue on our operating results, our credit ratings and our ability to
access the financial markets.
Our accompanying unaudited consolidated financial statements as of
December 31, 2001 and for the three months ended December 31, 2001 and 2000,
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial statements and the rules
and regulations of the Securities and Exchange Commission for interim financial
statements, and should be read in conjunction with our Annual Report on
Form 10-K for the fiscal year ended September 30, 2001, including the more
detailed discussion of risks facing our business described in the Form 10-K. 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 U.S. leader in sales of enterprise voice communications
and call center systems. We are not a leader in multi-service networking
products, and our product portfolio in this area is less complete than the
portfolios of some of our competitors. In addition, we are not a leader in sales
of certain converged voice and data products, including server-based Internet
Protocol telephony systems. We are implementing a strategy focused on these and
other advanced communications solutions.
We report our operations in three segments: Communications Solutions,
Services and Connectivity Solutions. The Communications Solutions segment
represents our core business, which consists of our
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enterprise voice communications systems and software, communications
applications, professional services for customer relationship management,
converged voice and data networks and unified communication, multi-servicing
networking products and product installation services. The Services segment
represents our 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. In the first quarter of fiscal 2001, we discontinued allocating
costs of shared services and other corporate center operations managed outside
of the operating segments. Operating income (loss) for the three months ended
December 31, 2000 has been restated to reflect these costs in Corporate and
other.
Effective January 1, 2002, we implemented an internal reorganization of our
company in which we will assess performance and allocate resources among four
rather than three operating segments. The most significant component of this
reorganization is that we will divide our Communications Solutions segment into
two business reporting groups: Applications and Systems. Our objective is to
give us the ability to understand and manage our product groups with greater
precision, and to give investors better insight and visibility into what could
roughly be viewed as the hardware versus software pieces of our business.
Beginning in the second quarter of fiscal 2002, we will be reporting our
financial data in the following operating segments: Applications, Systems,
Connectivity Solutions and Services.
We have been experiencing declines in revenue from our traditional business,
enterprise voice communications products. We expect, based on various industry
reports, a low growth rate in the market segments for these traditional
products. We are implementing a strategy to capitalize on the higher growth
opportunities in our market, including advanced communications solutions such as
converged voice and data networks, customer relationship management solutions,
unified communication applications and multi-service networking products. 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 the
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 the advanced
communications solutions described above 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, the economic slowdown that began in the first half of calendar
2001, particularly in the U.S., which was exacerbated by the events of
September 11, 2001 and the aftermath of such events, has had and continues to
have an adverse effect on our operating results. Our revenue for the quarter
ended December 31, 2001 was $1,306 million, a decrease of 26.8%, or
$479 million from $1,785 million for the quarter ended December 31, 2000 and a
sequential decrease of 9.4%, or $136 million from $1,442 million for the quarter
ended September 30, 2001. In addition, our revenue may decline sequentially for
the quarter ending March 31, 2002 compared to the quarter ended December 31,
2001. If the global economy, and in particular the U.S. economy, does not
improve, our revenues and
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operating results will continue to be adversely affected or we may not be able
to comply with the financial covenants included in our amended credit
facilities, as described in "--Liquidity and Capital Resources."
In addition to the decline in revenue from our traditional enterprise voice
communications products, the economic slowdown has been an important factor in
the significant decrease in revenues from our Connectivity Solutions segment
over the last two quarters. Revenue from Connectivity Solutions for the quarter
ended December 31, 2001 was $135 million, a decrease of 62.1%, or $221 million
from $356 million for the quarter December 31, 2000 and a sequential decrease of
33.5%, or $68 million, from $203 million for the quarter ended September 30,
2001.
In February 2002, we announced that the Company has engaged Salomon Smith
Barney to explore alternatives for our Connectivity Solutions segment, including
the possible sale of the business. The Connectivity Solutions segment markets
(i) the SYSTIMAX-Registered Trademark- product line of structured cabling
systems primarily to enterprises of various sizes for wiring phones,
workstations, personal computers, local area networks and other communications
devices through their buildings or across their campuses and (ii) the
ExchangeMax-Registered Trademark- product line primarily to central offices of
service providers, such as telephone companies or Internet service providers.
Connectivity Solutions also offers electronic cabinets to enclose an
enterprise's electronic devices and equipment. Our goal in exploring
alternatives for Connectivity Solutions is to maximize our core business both by
enhancing liquidity and by strengthening our focus on the higher growth
opportunities for Avaya, including converged voice and data, unified
communications, and customer relationship management. Connectivity Solutions
comprised $1,322 million, or 19.5%, of our total revenue in the fiscal year
ended September 30, 2001
Effective October 1, 2001, we adopted Statement of Financial Accounting
Standards 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 remaining useful lives. In connection
with the adoption of SFAS 142, we reviewed the classification of our existing
goodwill and other intangible assets, reassessed the useful lives previously
assigned to other intangible assets, and discontinued amortization of goodwill.
During the remainder of fiscal 2002, we will complete a transitional review of
our goodwill for impairment. Losses, if any, that are identified as a result of
this transitional review will be recorded as a change in accounting principle.
Any such losses that are recorded after the transitional review will be
identified as a separate line item in income from operations. See our "Results
of Operations" discussion noted below for the impact on selling, general and
administrative expense associated with adopting SFAS 142.
For the three months ended December 31, 2000, we reported net income of
$16 million and $0.03 for both basic and diluted earnings per share. If we had
adopted SFAS 142 in the beginning of the first quarter of fiscal 2001 and
discontinued goodwill amortization, which amounted to $8 million, net of tax
during this period, on a pro forma basis net income would have been $24 million
and basic and diluted earnings per share would have been $0.06.
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The following table sets forth the allocation of our revenue among our
operating segments, expressed as a percentage of total revenue, excluding
corporate and other revenue:
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31,
-------------------
2001 2000
-------- --------
OPERATING SEGMENTS:
Communications Solutions.............................. 50.8% 52.0%
Services.............................................. 38.9 28.0
Connectivity Solutions................................ 10.3 20.0
----- -----
Total............................................... 100.0% 100.0%
===== =====
</Table>
SEPARATION FROM LUCENT TECHNOLOGIES INC.
On September 30, 2000, under the terms of a Contribution and Distribution
Agreement between Lucent and us, Lucent contributed its enterprise networking
business to us and distributed all of the outstanding shares of our capital
stock to its stockholders. We refer to these transactions as the contribution
and the distribution, respectively. We had no material assets or activities
until the contribution, 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 set forth charges generally intended to allow the
providing company to fully recover the allocated direct costs of providing the
services, plus all out-of-pocket costs and expenses, but without any profit.
With limited exceptions, these interim services expired on March 31, 2001. The
pricing terms for goods and services covered by the commercial agreements
reflect current market prices at the time of the transaction.
BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES
We recorded business restructuring charges in fiscal 2000 related to our
separation from Lucent and in fiscal 2001 related to the outsourcing of certain
manufacturing facilities and the acceleration of our restructuring plan that was
originally adopted in fiscal 2000 to improve profitability and business
performance as a stand-alone company. The following table summarizes the status
of our business restructuring reserve and related expenses as of and for the
three months ended December 31, 2001:
<Table>
<Caption>
BUSINESS RESTRUCTURING RESERVE OTHER RELATED EXPENSES
------------------------------------------------------ -------------------------- TOTAL BUSINESS
EMPLOYEE LEASE TOTAL BUSINESS RESTRUCTURING
SEPARATION TERMINATION OTHER EXIT RESTRUCTURING ASSET INCREMENTAL AND RELATED
COSTS OBLIGATIONS COSTS RESERVE IMPAIRMENTS PERIOD COSTS EXPENSES
---------- ----------- ---------- -------------- ----------- ------------ --------------
(DOLLARS IN MILLIONS)
Balance as of
September 30, 2001... $ 96 $ 78 $ 5 $179 $ -- $-- $179
Expenses............... -- -- -- -- -- 6 6
Cash payments.......... (21) (20) (1) (42) -- (6) (48)
---- ---- --- ---- --------- --- ----
Balance as of
December 31, 2001.... $ 75 $ 58 $ 4 $137 $ -- $-- $137
==== ==== === ==== ========= === ====
</Table>
Employee separation costs included in the business restructuring reserve
were made through lump sum payments, although certain union-represented
employees elected to receive a series of payments extending over a period of up
to two years from the date of departure. Payments to employees who
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elected to receive severance through a series of payments will extend through
2003. This workforce reduction was substantially completed at the end of fiscal
2001. The charges for lease termination obligations, which consisted of real
estate and equipment leases, included approximately 2.8 million square feet of
excess space of which we have vacated 667,000 square feet as of December 31,
2001. Payments on lease termination obligations will be substantially completed
by 2003 because, in certain circumstances, the remaining lease payments were
less than the termination fees.
In the first quarter of fiscal 2002, we recorded $6 million of other related
expenses primarily associated with our outsourcing of certain manufacturing
facilities. In the first quarter of fiscal 2001, we recorded $23 million of
other related expenses associated with our separation from Lucent related
primarily to computer system transition costs such as data conversion
activities, asset transfers, and training. In addition, we recorded $36 million
in selling, general and administrative expenses for additional start-up
activities during the first quarter of fiscal 2001 largely resulting from
marketing costs associated with continuing to establish the Avaya brand.
During the remainder of fiscal 2002, we expect to incur additional period
costs of approximately $17 million and $23 million related to our outsourcing of
certain of our manufacturing facilities and our accelerated restructuring
program, respectively. We are also considering other restructuring actions to be
taken in fiscal 2002 designed to yield additional cost savings. Our amended
credit facilities permit us to exclude from the computation of certain financial
ratios up to $163 million of restructuring charges, including asset impairment
and other one time expenses to be taken no later than the fourth quarter of
fiscal 2002. We expect to fund these expenses through a combination of debt and
internally generated funds.
OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES
In connection with the five-year strategic manufacturing agreement to
outsource most of the manufacturing of our communications systems and software,
we have received substantially all of the $200 million in proceeds for assets
transferred to Celestica Inc. We deferred $100 million of these proceeds, which
are being recognized on a straight-line basis over the term of the agreement. As
of December 31, 2001, the unamortized portion of these proceeds amounted to
$20 million in other current liabilities and $66 million in other liabilities.
The remaining phases of the transaction, which included closing of the
Shreveport, Louisiana facility, were completed in the first quarter of fiscal
2002.
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.
As a result of the contract manufacturing transaction, Celestica exclusively
manufactures substantially all of our Communications Solutions products at
various facilities in the U.S. and Mexico. We are not obligated to purchase
products from Celestica in any specific quantity, except as we outline in
forecasts or orders for products required to be manufactured by Celestica. In
addition, we may be obligated to purchase certain excess inventory levels from
Celestica that could result from our actual sales of product varying from
forecast. Our outsourcing agreement with Celestica results in a concentration
that, if suddenly eliminated, could have an adverse effect on our operations.
While we believe that alternative sources of supply would be available,
disruption of our primary source of supply could create a temporary, adverse
effect on product shipments. There is no other significant concentration of
business transacted with a particular supplier that could, if suddenly
eliminated, have a material adverse affect on our financial position, results of
operations or cash flows.
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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 ENDED
DECEMBER 31,
-------------------------
2001 2000
-------- --------
Revenue..................................................... 100.0% 100.0%
Costs....................................................... 60.4 57.6
----- -----
Gross margin................................................ 39.6 42.4
----- -----
Operating expenses:
Selling, general and administrative....................... 32.0 31.8
Business restructuring related expenses................... 0.5 1.3
Research and development.................................. 9.2 7.8
----- -----
Total operating expenses.................................... 41.7 40.9
----- -----
Operating income (loss)..................................... (2.1) 1.5
Other income, net........................................... 0.5 0.5
Interest expense............................................ (0.7) (0.6)
Provision (benefit) for income taxes........................ (0.8) 0.5
----- -----
Net income (loss)........................................... (1.5)% 0.9%
===== =====
</Table>
THREE MONTHS ENDED DECEMBER 31, 2001 COMPARED TO THREE MONTHS ENDED
DECEMBER 31, 2000
The following table shows the change in revenue, both in dollars and in
percentage terms:
<Table>
<Caption>
THREE MONTHS ENDED
DECEMBER 31, CHANGE
------------------------- -------------------
2001 2000 $ %
-------- -------- -------- --------
(DOLLARS IN MILLIONS)
Communications Solutions......................... $ 663 $ 928 $(265) (28.6)%
Services......................................... 508 499 9 1.8
Connectivity Solutions........................... 135 356 (221) (62.1)
------ ------ -----
Total operating segments....................... 1,306 1,783 (477) (26.8)
Corporate and other.............................. -- 2 (2) (100.0)
------ ------ -----
Total.......................................... $1,306 $1,785 $(479) (26.8)%
====== ====== =====
</Table>
REVENUE. Revenue decreased 26.8%, or $479 million, from $1,785 million for
the first quarter of fiscal 2001, to $1,306 million for the same period in
fiscal 2002 due to a decrease in the Communications Solutions and Connectivity
Solutions segments, offset slightly by an increase in the Services segment
revenues. The overall reduction in revenue was mainly attributable to the
continued economic deterioration in the technology sector that resulted in
decreased demand for telephony equipment and related products. Slower economic
activity led to widespread layoffs, high vacancy rates in commercial real
estate, and a slowdown in business start-ups, each of which had a negative
impact on our revenues.
The decrease in the Communications Solutions segment was largely due to a
decline in customer purchases of $144 million in enterprise voice communications
systems, a $55 million decrease in communications applications primarily driven
by a reduction in messaging systems, many of which are sold with voice systems,
and customer relationship management product sales, a $36 million decrease in
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data products and a $25 million decrease in installation revenue as a result of
the reduction in product sales. The economic downturn in the U.S. contributed to
a slowdown of sales volume in both data and telephony switch markets as
companies found themselves with sufficient capacity in their networks to meet
the needs of a reduced workforce. In addition, due to the uncertain economic
climate and reduced revenue and profit expectations of many businesses,
expansion and relocation plans were placed on hold, which negatively impacted
our traditional voice and data sales and related messaging products, as well as
our customer relationship management solutions. Within the Connectivity
Solutions segment, revenues from our SYSTIMAX-Registered Trademark- structured
cabling systems for enterprises declined by $95 million, sales of our
ExchangeMAX-Registered Trademark- cabling for service providers declined by
$90 million, and electronic cabinets revenues declined by $44 million. The key
drivers behind the sharp decline in SYSTIMAX revenues were the high vacancy
rates of commercial real estate in the U.S. and a decrease in office moves,
additions and changes. Sales of our ExchangeMAX cabling and electronic cabinets
dropped significantly as our customers deferred capital spending and
concentrated on extracting maximum value from existing systems. Our Services
segment revenues increased marginally as a result of an increase in value-added
services of $17 million, as well as an increase of $3 million in data services
revenues with the majority of these increases coming from our international
operations. These increases were somewhat offset by a decline of $9 million in
maintenance revenues stemming mostly from within the U.S.
Revenue within the U.S. decreased 29.9%, or $402 million, from
$1,346 million for the first quarter of fiscal 2001 to $944 million for the same
period in fiscal 2002. This decrease was primarily due to decreases of
$205 million in Communications Solutions, $188 million in Connectivity Solutions
and $8 million in Services. Outside the U.S., revenue decreased 17.5%, or
$77 million, from $439 million for the first quarter of fiscal 2001 to
$362 million for the same period in fiscal 2002. This decrease is primarily due
to declines of $60 million in Communications Solutions and $33 million in
Connectivity Solutions partially offset by an increase of $17 million in
Services revenue. Revenue outside the U.S. in the first quarter of fiscal 2002
represented 27.7% of revenue compared with 24.6% in the same period of fiscal
2001.
COSTS AND GROSS MARGIN. Total costs decreased 23.2%, or $239 million, from
$1,028 million for the first quarter of fiscal 2001 to $789 million for the same
period in fiscal 2002. Gross margin percentage decreased 2.8% from 42.4% in the
first quarter of fiscal 2001 as compared with 39.6% in the same period of fiscal
2002. The decrease in gross margin was attributed mainly to the Connectivity
Solutions segment which experienced a sharp decline in sales volumes while
factory costs remained relatively fixed. This segment's gross margin experienced
additional pressure due to aggressive discounting aimed at stimulating sales in
a market negatively impacted by economic conditions. The Communications
Solutions and Services segments also experienced some decline in gross margin,
although to a much lesser extent than the Connectivity Solutions segment, due to
factors including volume, discount and product mix.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
("SG&A") expenses decreased 26.4%, or $150 million, from $568 million for the
first quarter of fiscal 2001 to $418 million for the same period of fiscal 2002.
The decrease was primarily due to savings associated with our business
restructuring plan including lower staffing levels and terminated real estate
lease obligations. In addition, during the first quarter of fiscal 2001, we
incurred higher incentive compensation expense and start-up expenses of
$36 million related to establishing independent operations. These start-up
expenses were comprised primarily of marketing costs associated with
establishing our brand.
Amortization of intangible assets included in SG&A in the first quarter of
fiscal 2002 amounted to $9 million, compared with $6 million in the first
quarter of fiscal 2001. In connection with adopting SFAS 142, we did not record
any goodwill amortization in the first quarter of fiscal 2002 as compared with
$8 million of goodwill amortization included in SG&A for the first quarter of
fiscal 2001.
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BUSINESS RESTRUCTURING RELATED EXPENSES. Business restructuring related
expenses of $6 million in the first quarter of fiscal 2002 represent expenses
associated primarily with the outsourcing of certain of our manufacturing
facilities. The $23 million of expenses in the first quarter of fiscal 2001
represent incremental period costs associated with our separation from Lucent
related primarily to computer system transition costs such as data conversion
activities, asset transfers and training.
RESEARCH AND DEVELOPMENT. Research and development ("R&D") expenses
decreased 14.3%, or $20 million, from $140 million in the first quarter of
fiscal 2001 to $120 million in the same quarter of fiscal 2002. Although R&D
spending decreased, our investment in R&D as a percentage of revenue increased
from 7.8% to 9.2% which supports our plan to shift spending to high growth areas
of our business and reduce spending on more mature product lines. This
investment is also consistent with our target to spend an amount equal to
approximately 8% to 10% of our total revenue in R&D by the end of fiscal 2003.
OTHER INCOME, NET. Other income, net decreased from $9 million in the first
quarter of fiscal 2001 to $6 million in the same period of fiscal 2002. In both
periods, interest income earned on cash balances accounts for the majority of
other income.
INTEREST EXPENSE. Interest expense remained relatively flat from the first
quarter of fiscal 2001 at $10 million compared with $9 million in the same
period of fiscal 2002. The decrease in interest expense is due to a lesser
amount of outstanding commercial paper carrying a lower interest rate partially
offset by a higher average outstanding debt balance attributable to borrowings
associated with the issuance of our Liquid Yield Option-TM- Notes due 2021
("LYONs") in the first quarter of fiscal 2002.
PROVISION (BENEFIT) FOR INCOME TAXES. The effective tax rate in the first
quarter of fiscal 2002 was a benefit of 35.0% as compared with an expense of
38.0% in the first quarter of fiscal 2001. The change in the effective tax rate
is primarily due to our adoption of SFAS 142, which had a favorable impact
because the effective tax rate calculation for the first quarter of fiscal 2002
excludes nondeductible goodwill while the calculation for the first quarter of
fiscal 2001 does not. In addition, a change in the earnings mix generated
increased earnings from outside the U.S. in jurisdictions that have lower income
tax rates.
LIQUIDITY AND CAPITAL RESOURCES
STATEMENT OF CASH FLOWS DISCUSSION
Avaya's cash and cash equivalents increased to $252 million at December 31,
2001, from $250 million at September 30, 2001. The increase resulted from
$122 million of net cash provided by financing activities, partially offset by
$92 million and $26 million of net cash used for operating and investing
activities, respectively.
Our net cash used for operating activities was $92 million for the three
months ended December 31, 2001 compared with net cash provided by operating
activities of $58 million for the same period in fiscal 2001. Net cash used for
operating activities for the three months ended December 31, 2001 was composed
of a net loss of $20 million adjusted for non-cash items of $69 million, and net
cash used for changes in operating assets and liabilities of $141 million. Net
cash used for operating activities is mainly attributed to cash payments made on
our accounts payable and other short term liabilities. In addition, usage of
cash also resulted from payments made for our business restructuring related
activities resulting from our separation from Lucent, our outsourcing of certain
manufacturing facilities and the acceleration of our restructuring plan.
Furthermore, we reduced our payroll related liabilities and advance billings and
deposits. These changes were partially offset by receipts of cash on amounts due
from our customers. For the first quarter in fiscal 2001, net cash provided by
operating activities of $58 million was comprised of net income of $16 million
adjusted for non-cash charges of
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$134 million, and net cash used for changes in operating assets and liabilities
of $92 million. Net cash used for operating assets and liabilities was primarily
attributed to cash receipts for our accounts receivables and an increase in our
payroll related liabilities, offset by a reduction in our advance billings and
deposits, cash payments made on our accounts payable, business restructuring and
start-up activities, and an increase in our work in process and raw materials
inventory.
Days sales outstanding in accounts receivable for the first quarter of
fiscal 2002, excluding the effect of the securitization transaction discussed
below, was 96 days versus 95 days for the fourth quarter of fiscal 2001. This
level of days sales outstanding is primarily attributable to transition issues
resulting from the consolidation of our customer collection facilities. Days
sales of inventory on-hand for the first quarter of fiscal 2002 were 73 days
versus 70 days for the fourth quarter of fiscal 2001. This increase is primarily
due to lower than expected sales volumes.
Our net cash used for investing activities was $26 million for the three
months ended December 31, 2001 compared with $116 million for the same period in
fiscal 2001. The usage of cash in both periods resulted primarily from capital
expenditures. The first quarter of fiscal 2002 included payments made for the
renovation of our corporate headquarters facility and upgrading our information
technology systems. Capital expenditures in the first quarter of fiscal 2001 is
due mainly to Avaya establishing itself as a stand-alone entity, including
information technology upgrades and corporate infrastructure expenditures.
Net cash provided by financing activities was $122 million for the three
months ended December 31, 2001 compared with $329 million for the same period in
fiscal 2001. Cash flows from financing activities in the current period were
mainly due to $447 million in proceeds from the issuance of LYONs convertible
debt, net of payments for debt issuance costs, partially offset by $131 million
of net payments for the retirement of commercial paper and a $200 million
repayment on the five-year credit facility. Net cash provided by financing
activities in the first quarter of fiscal 2001 was mainly due to the receipt of
$400 million in proceeds from the sale of our Series B convertible participating
preferred stock and warrants to purchase our common stock described below,
partially offset by $76 million of net payments for the retirement of commercial
paper.
DEBT RATINGS
Our ability to obtain external financing is affected by our debt ratings,
which are periodically reviewed by the major credit rating agencies. In January
and February 2002, our commercial paper and long-term debt ratings were
downgraded as follows:
<Table>
<Caption>
AS OF CURRENT RATINGS
DECEMBER 31, 2001 JANUARY 2002 FEBRUARY 2002
----------------- ------------ ---------------
Moody's:
Commercial paper................................ P-2 P-2 P-3 (1)
Long-term senior unsecured debt................. Baa1 Baa2 Baa3 (1)
Standard & Poor's:
Commercial paper................................ A-2 (2) A-3(2) A-3 (2)
Long-term senior unsecured debt................. BBB (2) BBB-(2) BB+ (2)
Corporate credit................................ BBB (2) BBB-(2) BBB- (2)
</Table>
- ------------------------
(1) Subject to review for further downgrade.
(2) Includes a negative outlook.
Any increase in our level of indebtedness or deterioration of our operating
results may cause a further reduction in our current debt ratings. A further
reduction in our current long-term debt rating
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by Moody's or Standard & Poor's could affect our ability to access the long-term
debt markets, significantly increase our cost of external financing, and result
in additional restrictions on the way we operate and finance our business. In
particular, you should review carefully the description of the impact of our
current debt ratings and any future downgrade of those ratings on certain of our
financing sources, as described under "--COMMERCIAL PAPER PROGRAM," "--REVOLVING
CREDIT FACILITIES," and "--SECURITIZATION OF ACCOUNTS RECEIVABLE."
A security rating by the major credit rating agencies is not a
recommendation to buy, sell or hold securities and may be subject to revision or
withdrawal at any time by the rating agencies. Each rating should be evaluated
independently of any other rating.
COMMERCIAL PAPER PROGRAM
We have established a commercial paper program pursuant to which we may
issue up to $1.25 billion of commercial paper at market interest rates. Interest
rates on our commercial paper obligations are variable due to their short-term
nature. The weighted average yield and maturity period for the $301 million and
$432 million of commercial paper outstanding as of December 31, 2001 and
September 30, 2001, were approximately 3.4% and 3.9% and 87 days and 62 days,
respectively. As of December 31, 2001, $37 million of the outstanding 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 it is our
intent to refinance it with other debt on a long-term basis. As of
September 30, 2001, the entire amount of commercial paper was classified as
long-term debt.
Our commercial paper has been recently downgraded and is currently rated P-3
by Moody's, subject to review for further downgrade, and A-3 by Standard &
Poor's, with a negative outlook. These recent downgrades make it very difficult,
if not impossible, for us to access the commercial paper market, which has been
our primary source of liquidity in the past. As a result of the impact of these
ratings downgrades on our ability to issue commercial paper, in February 2002,
we borrowed $300 million under our five-year credit facility to repay commercial
paper obligations. As of February 13, 2002, approximately $26 million of our
commercial paper remains outstanding. Such obligations mature through May 2002
and we expect to repay these remaining obligations with available cash or other
short-term or long-term debt.
REVOLVING CREDIT FACILITIES
We have two unsecured revolving credit facilities (the "Credit Facilities")
with third party financial institutions consisting of a $400 million 364-day
credit facility that expires in August 2002 and an $850 million five-year credit
facility that expires in September 2005. No amounts were drawn down under either
credit facility as of December 31, 2001, although in February 2002 we borrowed
$300 million under the five-year credit facility in order to repay maturing
commercial paper obligations. In September 2001, we borrowed $200 million under
the five-year credit facility and used the proceeds to repay maturing commercial
paper. The borrowing carried a fixed interest rate of approximately 3.5% and was
repaid in October 2001 using proceeds from the issuance of commercial paper. The
September 2001 borrowing under the credit facility was necessitated by
disruptions in the commercial paper markets as a result of the September 11
terrorist attacks.
In February 2002, we and the lenders under our Credit Facilities amended the
facilities ("Amended Credit Facilities"). Funds are available under the Amended
Credit Facilities for general corporate purposes, the repayment of commercial
paper obligations, and for acquisitions up to $150 million. The Amended Credit
Facilities provide that in the event our corporate credit rating falls below
BBB- by Standard & Poor's or our long-term senior unsecured debt rating falls
below Baa3 by Moody's, any borrowings under the Amended Credit Facilities will
be secured, subject to certain exceptions, by security interests in our U.S.
equipment, accounts receivable, inventory, and intellectual property rights
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and that of any of our subsidiaries guaranteeing our obligations under the
Amended Credit Facilities as described below. Borrowings would also be secured
by a pledge of the stock of certain of our domestic subsidiaries and 65% of the
stock of a foreign subsidiary. The security interests would be granted to the
extent permitted by the indenture governing the LYONs and would be suspended in
the event our corporate credit rating was at least BBB by Standard & Poor's and
our long-term senior unsecured debt rating was a least Baa2 by Moody's, in each
case with a stable outlook. Our debt ratings have been recently downgraded and
our long-term senior unsecured debt is currently rated Baa3 by Moody's, subject
to review for further downgrade, and our corporate credit is currently rated
BBB- by Standard & Poor's, with a negative outlook. Based on these long-term
debt ratings, borrowings under the Amended Credit Facilities are currently
unsecured.
The Amended Credit Facilities also provide that up to $500 million of the
net proceeds of offerings of debt securities and $200 million of the net
proceeds of any real property financings must be used to reduce the commitments
under the 364-day and five-year facilities on a pro rata basis. In addition, to
the extent that we obtain proceeds from asset sales or dispositions at a time
when the aggregate commitments under the Amended Credit Facilities exceed
$850 million, we are required to use such proceeds to reduce the commitments
under such facilities on a pro rata basis.
Any current or future domestic subsidiaries (other than certain excluded
subsidiaries) whose revenues constitute 5% or greater of our consolidated
revenues or whose assets constitute 5% or greater of our consolidated total
assets will be required to guarantee our obligations under the Amended Credit
Facilities. None of our subsidiaries currently meet these criteria.
The Amended Credit Facilities also include negative covenants, including
limitations on affiliate transactions, restricted payments and investments and
advances. The Amended Credit Facilities also restrict our ability and that of
our subsidiaries to incur debt, subject to certain exceptions. We are permitted
to use the Amended Credit Facilities to fund acquisitions in an aggregate amount
not to exceed $150 million and can make larger acquisitions so long as the
facilities are not used to fund the purchase price, no default under the
facilities shall have occurred and be continuing or would result from such
acquisition, and we shall be in compliance with the financial ratio described
below after giving pro forma effect to such acquisition.
The Amended Credit Facilities require us to maintain a ratio of consolidated
Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") to
interest expense of three to one for each of the four quarter periods ending
March 31, 2002, June 30, 2002 and September 30, 2002 and a ratio of four to one
for each four quarter period thereafter. We are also required to maintain
consolidated EBITDA of:
- $20 million for the quarter ended March 31, 2002;
- $80 million for the two quarter period ended June 30, 2002;
- $180 million for the three quarter period ended September 30, 2002;
- $300 million for the four quarter period ended December 31, 2002; and
- $400 million for each four quarter period thereafter.
For purposes of these calculations, we are permitted to exclude from the
computation of consolidated EBITDA up to $163 million of restructuring charges,
including asset impairment and other one time expenses to be taken no later than
the fourth quarter of fiscal 2002. These charges are attributable to actions we
may take in fiscal 2002 in order to improve our profitability. In addition, we
may exclude certain business restructuring charges and related expenses taken in
fiscal 2001.
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While we believe we will be able to meet these financial covenants, our
revenues have been declining and any further decline in revenues may affect our
ability to meet these financial covenants in the future.
The Amended Credit Facilities provide, at our option, for fixed interest
rate and floating interest rate borrowings. Fixed rate borrowings under the
facilities bear interest at a rate equal to (i) the greater of (A) Citibank,
N.A.'s base rate and (B) the federal funds rate plus 0.5% plus (ii) a margin
based on our long-term senior unsecured debt rating (the "Applicable Margin").
Floating rate borrowings bear interest at a rate equal to the LIBOR rate plus
the Applicable Margin and, if borrowings under a facility exceed 50% of the
commitments under such facility, a utilization fee based on our long-term senior
unsecured debt rating (the "Applicable Utilization Fee"). Based on our current
long-term debt rating, the Applicable Margins for the 364-day credit facility
and the five-year credit facility are 1.075% and 1.05%, respectively, and the
Applicable Utilization Fee for both facilities is 0.25%.
SECURITIZATION OF ACCOUNTS RECEIVABLE
We entered into a receivables purchase agreement in June 2001 and
transferred a designated pool of qualified trade accounts receivable to a
special purpose entity ("SPE"), which in turn sold an undivided ownership
interest to an unaffiliated financial institution for cash proceeds of
$200 million. The financial institution is an affiliate of Citibank, N.A., a
lender and the agent for the other lenders under our revolving credit
facilities. We, through the SPE, have a retained interest in a portion of these
receivables, and the financial institution has no recourse to our other assets,
stock or other securities for failure of customers to pay when due. The assets
of the SPE are not available to pay our creditors. 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
purchase agreement expires in June 2002, but may be extended through June 2004
with the financial institution's consent.
We had a retained interest of $174 million and $153 million as of
December 31, 2001 and September 30, 2001, respectively, in the SPE's designated
pool of qualified accounts receivable representing collateral for the sale.
We are subject to certain receivable collection ratios, among other
covenants contained in the receivables purchase agreement. In October 2001, the
financial institution participating in the agreement granted us a waiver from a
covenant that measures the ratio of certain unpaid receivables as a percentage
of the aggregate outstanding balance of all designated receivables. The waiver
effectively increased the ratio required by the covenant for each of the
individual months of September through December 2001, and required compliance
with the original ratio thereafter. As of December 31, 2001, we were in
compliance with such covenants, although in January 2002 the financial
institution waived our obligation to comply with the required ratio for the
month of January 2002. We will be required to comply with the original ratio for
the month of February 2002 and thereafter.
The receivables purchase agreement initially required that our long-term
senior unsecured debt be rated at least BBB- by Standard & Poor's and Baa3 by
Moody's. In February 2002, the agreement was amended to lower these ratings
triggers to BB+ by Standard & Poor's and Ba1 by Moody's through March 15, 2002,
at which time the required ratings will revert back to BBB- by Standard & Poor's
and Baa3 by Moody's. Our long-term senior unsecured debt has been recently
downgraded and is currently rated Baa3 by Moody's, subject to review for further
downgrade, and BB+ by Standard & Poor's, with a negative outlook.
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We are currently in discussions with the financial institution participating
in the receivables purchase agreement to restructure the agreement to address,
among other things, the collection ratio and the ratings trigger. If we do not
reach agreement with the financial institution on a restructuring of the
agreement, and (i) we are unable to maintain the required ratio described above
for the month of February 2002 or for any month thereafter, or (ii) our
long-term senior unsecured debt is not rated at least BBB- by Standard & Poor's
and Baa3 by Moody's after March 15, 2002, the financial institution will be able
to exercise its rights under the agreement, including an early termination of
the agreement. Upon the expiration, or in the event of an early termination, of
the agreement, purchases of interests in receivables by the financial
institution under the agreement will cease and collections on receivables
constituting the designated pool, including to the extent necessary, those
receivables comprising the retained interest, will be used to pay down the
financial institution's $200 million investment under the agreement. If payment
were made using collections from the retained interest, such amounts would then
be unavailable to us for general corporate purposes and we may need to incur
additional debt to fund the shortfall in working capital resulting from this
usage.
PREFERRED STOCK INVESTMENT
We have sold to Warburg, Pincus Equity Partners, L.P. and related investment
funds (collectively, the "Warburg Funds") four 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. This initial liquidation
value will accrete for the first 10 years beginning in October 2000 at an annual
rate of 6.5% and 12% thereafter, compounded quarterly. For first quarter of
fiscal 2002, accretion of the Series B preferred stock was $7 million, resulting
in a liquidation value of $434 million as of December 31, 2001. The total number
of shares of common stock into which the Series B preferred stock are
convertible is determined by dividing the liquidation value in effect at the
time of conversion by the conversion price. Based on a conversion price of
$26.71, the Series B preferred stock is convertible into 16,232,630 shares of
our common stock as of December 31, 2001.
The warrants have an exercise price of $34.73 and are exercisable in two
allotments. 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 the period from May 24, 2001 until October 2, 2002, 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.
Beginning in October 2003, 50% of the amount accreted for the year may be
paid in cash as a dividend on a quarterly basis at our option. From
October 2005 through September 2010, we may elect to pay 100% of the amount
accreted for the year as a cash dividend on a quarterly basis. The liquidation
value calculated on each quarterly dividend payment date, which includes the
accretion for the dividend period, will be reduced by the amount of any cash
dividends paid. Following the tenth anniversary of October 2010, 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.
A beneficial conversion feature would exist if the conversion price for the
Series B preferred stock or warrants was less than the fair value of our common
stock at the commitment date. 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 available to
common stockholders.
At any time after October 2005, 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
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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 involving
solely the issuance of common stock, the accretion of some or all of the
liquidation value of the Series B preferred stock through October 2005 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.
EQUITY CONSTRAINT
Our ability to issue additional equity may be constrained because our
issuance of additional equity 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.
LYONS
In the first quarter of fiscal 2002, we sold through an underwritten public
offering under a shelf registration statement discussed below an aggregate
principal amount at maturity of approximately $944 million of LYONs due 2021.
The proceeds of approximately $447 million, net of a $484 million discount and
$13 million of underwriting fees, were used to refinance a portion of our
outstanding commercial paper. The underwriting fees of $13 million were recorded
as deferred financing costs and are being amortized on a straight-line basis to
interest expense over a three-year period through October 31, 2004, which
represents the first date holders may require us to purchase all or a portion of
their LYONs.
The original issue discount of $484 million accrues daily at a rate of
3.625% per year calculated on a semiannual bond equivalent basis. We will not
make periodic cash payments of interest on the LYONs. Instead, the amortization
of the discount is recorded as interest expense and represents the accretion of
the LYONs issue price to its maturity value. For the three months ended
December 31, 2001, $3 million of interest expense on the LYONs was recorded,
resulting in an accreted value of $463 million as of December 31, 2001. The
discount will cease to accrue on the LYONs upon maturity, conversion, purchase
by us at the option of the holder, or redemption by Avaya. The LYONs are
unsecured obligations that rank equally in right of payment with all existing
and future unsecured and unsubordinated indebtedness of Avaya.
The LYONs are convertible into 35,333,073 shares of Avaya common stock at
any time on or before the maturity date. The conversion rate may be adjusted for
certain reasons, but will not be adjusted for accrued original issue discount.
Upon conversion, the holder will not receive any cash payment representing
accrued original issue discount. Accrued original issue discount will be
considered paid by the shares of common stock received by the holder of the
LYONs upon conversion.
We may redeem all or a portion of the LYONs for cash at any time on or after
October 31, 2004 at a price equal to the sum of the issue price and accrued
original issue discount on the LYONs as of the applicable redemption date.
Conversely, holders may require us to purchase all or a portion of their LYONs
on the third, fifth and tenth anniversary from October 31, 2001 at a price equal
to the sum of the issue price and accrued original issue discount on the LYONs
as of the applicable purchase date. We may, at our option, elect to pay the
purchase price in cash or shares of common stock, or any combination thereof.
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The fair value of the LYONs as of December 31, 2001 is estimated to be
$508 million and is based on using quoted market prices and yields obtained
through independent pricing sources for the same or similar types of borrowing
arrangements taking into consideration the underlying terms of the debt.
The indenture governing the LYONs includes certain covenants, including a
limitation on our ability to grant liens on significant domestic real estate
properties or the stock of subsidiaries holding such properties. The liens
granted under the Amended Credit Facilities do not extend to any real property
and therefore, do not conflict with the terms of the indenture governing the
LYONs.
SHELF REGISTRATION STATEMENT
In May 2001, the Securities and Exchange Commission ("SEC") declared
effective our shelf registration statement on Form S-3 registering
$1.44 billion of common stock, preferred stock, debt securities or warrants to
purchase debt securities, or any combination of these securities, in one or more
offerings through May 2003. We have $980 million remaining as of December 31,
2001 under this registration statement for additional offerings and intend to
use the proceeds from any sale of such securities for general corporate
purposes, debt repayment and refinancing, capital expenditures and acquisitions.
We also registered with the SEC for resale by the Warburg Funds, the preferred
stock and warrants described above and shares of common stock issuable upon
conversion or exercise thereof. We will not receive any proceeds from the sale
by the Warburg Funds of these securities.
AIRCRAFT SALE-LEASEBACK
In June 2001, we 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, we have the option to renew the lease subject to
the consent of the lessors, or to purchase the aircraft for a price as defined
in the agreement. If we elect not to either renew the lease or purchase the
aircraft, we must arrange for the sale of the aircraft to a third party. Under
the sale option, we have 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.
The agreements governing the aircraft sale-leaseback transaction contain
certain covenants, including limitations on our ability to incur liens in
certain circumstances. In particular, the agreements prohibit us from incurring
secured indebtedness, subject to certain exceptions, in excess of $500 million.
In the event amounts outstanding under our revolving credit facilities were to
exceed $500 million at a time when borrowings under the facilities were secured
as described above under "--REVOLVING CREDIT FACILITIES," we would be in
violation of the lien covenant under the sale-leaseback agreements. In addition,
for the three consecutive quarters ended June 30, 2001, we had to maintain a
ratio of annualized consolidated Earnings Before Interest and Taxes ("EBIT") to
annualized consolidated interest expense of at least three to one. Commencing in
the fourth quarter of fiscal 2001 and each fiscal quarter thereafter, we had to
maintain such ratio for the previous four consecutive fiscal quarters. The
covenant permitted us to exclude up to $950 million of business restructuring
and related charges and $300 million of start-up expenses from the calculation
of consolidated EBIT to be taken no later than September 30, 2001. In
September 2001, the covenant was amended to permit us to exclude up to an
additional $450 million of non-cash business restructuring and related charges
from the calculation of EBIT during such period to be taken no later than the
fourth quarter of fiscal 2001. The Company was in compliance with this covenant
as of December 31, 2001, although based on our current estimates, we believe we
may not be able to comply with this covenant for the quarter ended March 31,
2002.
We are in discussions with the financial institution participating in the
sale-leaseback transaction to restructure the agreements to address any
potential conflict between our credit facilities and the lien covenant included
in the sale-leaseback agreements and our ability to meet the financial covenant
described above. If we are unable to reach an agreement with the financial
institution on restructuring
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these agreements, we may not be able to comply with these covenants and may be
required to purchase the aircraft from the financial institution for a purchase
price equal to the unamortized lease balance, which was approximately
$33 million as of January 31, 2002. We may need to incur additional debt to the
extent we are required to satisfy this obligation prior to the lease term.
CROSS ACCELERATION/CROSS DEFAULT PROVISIONS
The agreements governing the sale-leaseback transaction, the receivables
purchase agreement governing the securitization of accounts receivable and the
indenture governing the LYONs provide generally that an event of default under
such agreements would result (i) if we fail to pay any obligation in respect of
debt in excess of $100 million in the aggregate when such obligation becomes due
and payable or (ii) if any such debt is declared to be due and payable prior to
its stated maturity.
The amended credit facilities provide generally that an event of default
under such agreements would result (i) if we fail to pay any obligation in
respect of any debt in excess of $100 million in the aggregate when such
obligation becomes due and payable or (ii) if any event occurs or condition
exists that would result in the acceleration, or permit the acceleration, of the
maturity of such debt prior to the stated term.
CONDITIONAL REPURCHASE OBLIGATIONS
We sell products to various distributors that may obtain financing from
unaffiliated third party lending institutions. In the event the lending
institution repossesses the distributor's inventory of our products, we are
obligated to repurchase such inventory from the lending institution. The
repurchase amount is equal to the price originally paid to us by the lending
institution for our inventory. Our obligation to repurchase inventory from the
lending institution terminates 180 days from our date of invoicing to the
distributor. During the three months ended December 31, 2001, there were no
repurchases made by us under such agreements. There can be no assurance that we
will not be obligated to repurchase inventory under these arrangements in the
future.
FUTURE CASH NEEDS
Our primary future cash needs on a recurring basis will be to fund working
capital, capital expenditures and debt service. We believe that our cash flows
from operations will be sufficient to meet these needs. In addition, funding our
business restructuring and related expenses has required, and is expected to
continue to require, significant amounts of cash. We expect to fund our business
restructuring and related charges 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 making additional cash
payments of approximately $159 million in the remaining portion of fiscal 2002
related to our business restructuring. These cash payments are planned to be
composed of $84 million for employee separation costs, $36 million for lease
obligations, $4 million for other exit costs and $35 million for incremental
period costs, including computer transition expenditures, relocation and
consolidation costs.
In order to meet our cash needs, we may from time to time, borrow under our
revolving credit facilities or issue other long or short-term debt, if the
market permits such borrowings. 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, strategic acquisitions, and our business restructuring
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 and the indenture
governing the LYONs impose and any future indebtedness may impose, 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. As a result of the recent downgrades of our
long-term debt ratings, borrowings under credit facilities, and other short-term
or long-term debt we may issue to repay our remaining commercial paper
obligations will likely be made available to us at a higher interest rate than
our commercial paper and cause a decrease in our profitability.
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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 U.S., governing the
cleanup of soil and groundwater contamination. Such provisions impose liability
for the costs of investigating and remediating releases of hazardous materials
at currently or formerly owned or operated sites. In certain circumstances, this
liability may also include the cost of cleaning up historical contamination,
whether or not caused by 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 could have, individually or in the aggregate, a
material adverse effect on our financial position, results of operations or cash
flows.
YEAR 2000 ACTIONS
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 refiled in September 2000. The case in West Virginia was filed in
April 1999 and the case in California was filed in June 1999, and amended in
2000 to include Avaya as a defendant. We may also be named a party to the other
actions and, in any event, have assumed the obligations of Lucent for all of
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.
COUPON PROGRAM CLASS ACTION
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
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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 parties have
entered into a proposed settlement agreement, pending final approval by the
court.
LUCENT SECURITIES LITIGATION
In November 2000, three purported class actions were filed against Lucent in
the Federal District Court for the District of New Jersey alleging violations of
the federal securities laws as a result of the facts disclosed in Lucent's
announcement on November 21, 2000 that it had identified a revenue recognition
issue affecting its financial results for the fourth quarter of fiscal 2000. The
actions purport to be filed on behalf of purchasers of Lucent common stock
during the period from October 10, 2000 (the date Lucent originally reported
these financial results) through November 21, 2000.
The above actions have been consolidated with other purported class actions
filed against Lucent on behalf of its stockholders in January 2000 and are
pending in the Federal District Court for the District of New Jersey. We
understand that Lucent has filed a motion to dismiss the Fifth 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 stockholders of
Lucent who bought Lucent common stock between October 26, 1999 and January 6,
2000, but the consolidated complaint was amended to include purported class
members who purchased Lucent common stock up to November 21, 2000. A class has
not yet been certified in the consolidated actions. The plaintiffs in all these
stockholder class actions seek compensatory damages plus interest and attorneys'
fees.
Any liability incurred by Lucent in connection with these stockholder 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. 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.
LICENSING MEDIATION
In March 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. The
licensor 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. The licensor has demanded arbitration of this matter,
which we expect to occur within the next several months. At this point, an
outcome in the arbitration proceeding 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.
REVERSE/FORWARD STOCK SPLIT COMPLAINTS
In January 2002, a complaint was filed in the Court of Chancery of the State
of Delaware against us seeking to enjoin us from effectuating a reverse stock
split followed by a forward stock split described in our proxy statement for our
2002 Annual Meeting of Shareholders to be held on
41
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February 26, 2002. At the annual meeting, we are seeking the approval of our
shareholders of each of three alternative transactions:
- a reverse 1-for-30 stock split followed immediately by a forward 30-for-1
stock split of our common stock;
- a reverse 1-for-40 stock split followed immediately by a forward 40-for-1
stock split of our common stock;
- a reverse 1-for-50 stock split followed immediately by a forward 50-for-1
stock split of our common stock.
The complaint alleges, among other things, that the manner in which we plan
to implement the transactions, as described in our proxy statement, violates
certain aspects of Delaware law with regard to the treatment of fractional
shares and that the description of the proposed transactions in the proxy
statement is misleading to the extent it reflects such violations. The action
purports to be a class action on behalf of all holders of less than 50 shares of
our common stock. The plaintiff is seeking, among other things, damages as well
as injunctive relief enjoining us from effecting the transactions and requiring
us to make corrective, supplemental disclosure. Although the transactions will
be submitted to our shareholders for approval at the annual meeting, this matter
is in the early stages and we cannot provide assurance that this lawsuit will
not impair our ability to implement any of the transactions upon obtaining such
approval.
EUROPEAN MONETARY UNIT ("EURO")
In 1999, most member countries of the European Union established fixed
conversion rates between their existing sovereign currencies and the European
Union's new currency, the euro. This conversion permitted transactions to be
conducted in either the euro or the participating countries' national currencies
through December 31, 2001. In January 2002, the new currency was issued, and
legacy currencies are currently being withdrawn from circulation. By
February 28, 2002, all member countries are expected to have permanently
withdrawn their national currencies as legal tender and replaced their
currencies with euro notes and coins. As of December 31, 2001, all of the member
countries of the European Union in which we conduct business have converted to
the euro. The conversion has not had, and we do not expect it to have, a
material adverse effect on our consolidated financial position, results of
operations or cash flows.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
See Avaya's Annual Report filed on Form 10-K for the fiscal year ended
September 30, 2001 (Item 7A). At December 31, 2001, there has been no material
change in this information.
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PART II
ITEM 1. LEGAL PROCEEDINGS.
See Note 12--"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.
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits:
EXHIBIT PAGE
NUMBER DESCRIPTION NUMBER
---- ---------------------------------------- ---
10.1 Severance Agreement, dated as of
September 1, 2001, between the Company
and Donald K. Peterson.
10.2 Amendment No. 1, dated as of February 8,
2002, to the 364-Day Competitive Advance
and Revolving Credit Agreement, dated as
of August 28, 2001 among the Company,
the lenders party to the Credit
Agreement and Citibank, N.A., as Agent
for such lenders.*
10.3 Amendment No. 2, dated as of February 8,
2002, to the Five-Year Competitive
Advance and Revolving Credit Agreement,
dated as of September 25, 2000 among the
Company, the lenders party to the Credit
Agreement and Citibank, N.A., as Agent
for such lenders.*
- ------------------------
* Incorporated by reference to the Current Report on Form 8-K filed by the
Company on February 13, 2002.
(b) Reports on Form 8-K:
The following Current Report on Form 8-K was filed by us during the fiscal
quarter ended December 31, 2001:
1. October 24, 2001--Item 5. Other Events--Avaya furnished (i) its
computation of the Ratio of Earnings to Fixed Charges and Ratio of
Earnings to Fixed Charges and Preferred Stock Accretion for the nine
month period ended June 30, 2001 and 2000, the fiscal years ended
September 30, 2000, 1999, 1998 and 1997 and the nine month period ended
September 30, 1996, and (ii) a press release disclosing the financial
results for the quarter and fiscal year ended September 30, 2001.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
<Table>
AVAYA INC.
By: /s/ CHARLES D. PEIFFER
-----------------------------------------
Charles D. Peiffer
CONTROLLER
(PRINCIPAL ACCOUNTING OFFICER)
</Table>
February 14, 2002
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<Page>
EXHIBIT INDEX
EXHIBIT PAGE
NUMBER DESCRIPTION NUMBER
---- ---------------------------------------- ---
10.1 Severance Agreement, dated as of
September 1, 2001, between the Company
and Donald K. Peterson.
10.2 Amendment No. 1, dated as of February 8,
2002, to the 364-Day Competitive Advance
and Revolving Credit Agreement, dated as
of August 28, 2001 among the Company,
the lenders party to the Credit
Agreement and Citibank, N.A., as Agent
for such lenders.*
10.3 Amendment No. 2, dated as of February 8,
2002, to the Five-Year Competitive
Advance and Revolving Credit Agreement,
dated as of September 25, 2000 among the
Company, the lenders party to the Credit
Agreement and Citibank, N.A., as Agent
for such lenders.*
- ------------------------
* Incorporated by reference to the Current Report on Form 8-K filed by the
Company on February 13, 2002.