Agere Systems Inc.
Form 10-K
For the Year Ended September 30, 2002

PART I

FORWARD-LOOKING STATEMENTS

     Certain statements in this Form 10-K are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. The words “estimate,” “plan,” “intend,” “expect,” “anticipate,” “believe” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are found at various places throughout this report and in the documents incorporated herein by reference. Agere disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance that our goals will be achieved. Important factors that could cause our actual results to differ from estimates or projections contained in the forward-looking statements are described under “Factors Affecting Our Future Performance” in Item 7.

PART I

Item 1. Business

General

     We design, develop and manufacture integrated circuits that access, move and store information in a broad range of computing and communications applications. We also offer related software and reference designs, as well as optoelectronic components for communications networks.

     Our business operations are organized into two market-focused groups, the Client Systems group, which serves the consumer communications market, and the Infrastructure Systems group, which serves the network equipment market. Each of these two groups is a reportable operating segment. The segments each include revenue from the licensing of intellectual property assigned to that segment.

     The Client Systems group delivers integrated circuits, software and reference designs for storage, personal computer connectivity and wireless data applications, including hard disk drives and modems for computers, Internet-enabled cellular terminals and wireless local area networking. The Infrastructure Systems group delivers integrated circuit and optoelectronic solutions for multi-service networking to makers of high-speed communications systems, although we are exiting our optoelectronics business as described below.

     Integrated circuits, or chips, are made using semiconductor wafers imprinted with a network of electronic components. They are designed to perform various functions such as processing electronic signals, controlling electronic system functions and processing and storing data. Reference designs are complete specifications for products that a customer can use to build an end product, including components, board layouts and software. By using a reference design, a customer can reduce the amount of product design it must perform and the amount of time to introduce a new product into the market. Optoelectronic components transmit, process, change, amplify and receive light that carries data and voice traffic over optical networks.

     We sell integrated circuit solutions that include physical layer devices, integrated circuits supporting SONET/SDH communication standards, multi-service switching fabrics and network processing devices and broadband access devices, each of which is described below.

     In addition, we currently sell optoelectronic components that are utilized in optical networks, although we are selling or exiting this business. Optical networks transmit information as pulses of light, or optical signals, through optical fibers, which are hair-thin glass strands. We primarily offer active optical components, including lasers, modulators, transmitters and amplifiers. An active component is a device that has both optical and electronic properties.

     Networking Devices

     The majority of our revenue from networking devices is derived from the sale of customized integrated circuits for our customers. These integrated circuits incorporate our intellectual property or combine our intellectual property with our customers’ intellectual property to create a customized solution for these customers. For some customers, we design and manufacture the integrated circuit while the key intellectual property belongs solely to our customers.

     Our systems-level knowledge and integrated circuit design methodologies allow us to turn our customers’ design concepts into a systems solution quickly and effectively. Our intellectual property gives our customers the flexibility to customize their products to meet their individual cost and performance objectives.

     In fiscal 2002, we sold our field-programmable gate array, or FPGA, and field-programmable systems-on-a-chip, or FPSC, business to Lattice Semiconductor Corporation, and we sold our analog line card business to Legerity, Inc. The analog line card business provided integrated circuits to telecommunication equipment manufacturers for use in traditional voice telephone networks.

     Processing, Aggregation and Switching Devices

     Multi-Service Switching Fabrics and Network Processing Devices. Switching devices guide data to different local area networks and wide area networks based on the intended destination. Multi-service switching devices support the transmission of voice and video signals as well as data. We sell switch fabrics and programmable network processors to communications equipment manufacturers. A switch fabric directs the data within a switching device. A network processor is a component that controls how data is sent over a network or over a switch fabric such that the data retains its quality of service without interfering with other data traffic. We also offer supporting software with our switching products.

     We currently offer switching products for asynchronous transfer mode, or ATM, and Internet protocol, or IP. Asynchronous transfer mode and Internet protocol refer to different procedures for the formatting and timing of data transmission between two pieces of equipment. Our switching integrated solutions reduce the number of required integrated circuits needed in a switching device.

     Our sales to Lucent represented 10%, 15% and 21% of our revenue in fiscal 2002, 2001 and 2000, respectively, and our sales to Maxtor represented 13% of our revenue in fiscal 2002. No other customer accounted for 10% or more of our revenue in fiscal 2002, 2001 or 2000.

     Sales and Distribution

     We have a worldwide sales organization with approximately 420 employees as of September 30, 2002, located in 9 domestic and 14 international sales offices. We sell our products globally primarily through our direct sales force. To complement our direct sales force, we also sell our products through distributors, which sales in fiscal 2002 represented approximately 10% of our revenue.

     We aim to have our customers incorporate our products into the end products they design and develop. Typically, manufacturers of computer and communications equipment conduct a competitive process to select suppliers for the parts that they will include in their end products. Our sales, marketing and technical personnel work with customers to demonstrate our products’ ability to satisfy any specific requirements. We call winning the competitive process a design win. A design win is important because it allows us to establish a long-term relationship with the customer, at least through the life-cycle of the product. We generally do not, however, enter into written agreements with our customers after achieving a design win. A customer could terminate its relationship with us or discontinue developing the product. Most of our revenue originates from sales that are the result of design wins.

     After we achieve a design win and negotiate the terms of the sale, we deliver our products to our end customers in a number of ways. Our end customers typically have us ship our products to their facilities directly. In some instances, however, our customer uses a contract manufacturer to manufacture and assemble their end product. When our product is being incorporated into an end product being manufactured by a contract manufacturer, we often ship our product directly to the contract manufacturer and receive payment from that contract manufacturer. To determine our sales to particular customers, however, we recognize this type of transaction as a sale to, and revenue from, the end customer. Sometimes a customer for whom we have achieved a design win will have us sell that product to a distributor or trading company from whom the customer then buys our product. We recognize these transactions as indirect sales.

Manufacturing

     Our operations support organization is responsible for the supply chain management and manufacturing activities of both integrated circuits devices and optoelectronics components. As of September 30, 2002, we had approximately 5,700 employees devoted to manufacturing and related support activities.

     We believe competition in our industry is based on the following factors:

     Our research and development expenditures were $693 million, $951 million and $827 million for fiscal 2002, 2001 and 2000, respectively. We anticipate that we will continue to make significant research and development expenditures to maintain our competitive position with a continuing flow of innovative products and technology.

Patents, Trademarks And Other Intellectual Property

     We own or have rights to a number of patents, trademarks, copyrights, trade secrets and other intellectual property directly related to and important to our business. We have approximately 5,700 U.S. patents and patent applications and their corresponding foreign patents and patent applications. These patents include patents related to the following technologies:

     Each country has different regulations and a different regulatory process. In order for our customers’ products to be used in some jurisdictions, regulatory approval and, in some cases, specific country compliance testing may be required. The delays inherent in this regulatory approval process may force our customers to reschedule, postpone or cancel the incorporation of our products into their products, which may result in significant reductions in our sales. The failure to comply with current or future regulations or changes in the interpretation of existing regulations in a particular country could result in the suspension or cessation of sales in that country by us or our customers. It also may require us to incur substantial costs to modify our products to aid our customers in complying with the regulations of that country.

     We work with consultants, counsel and testing laboratories to support our compliance efforts as necessary. These individuals work to ensure that our products comply with the requirements of the Federal Communications Commission in the United States and with the requirements of the European Telecommunications Standards Institute in Western Europe, as well as with the various individual regulations of other countries.

     The regulatory environment in which we operate is subject to changes due to political, economic and technical factors. In particular, as use of wireless technology expands and as national governments continue to develop regulations for this technology, we may need to comply with new regulatory standards applicable to our products. Changes in our regulatory environment that generally result from our expansion into new areas or changes in current regulations could increase the cost of manufacturing our products because we must continually modify our products to respond to these changes.

     In addition, domestic and international authorities continue to regulate the allocation and auction of the radio frequency spectrum. These regulations have a direct impact on us because many of our customers’ licensed products can be marketed only if permitted by suitable frequency allocations, auctions and regulations. The implementation of these regulations may delay our end-users in deploying their systems, which could, in turn, lead to delays in orders of our products by our customers and end users. Further, when we license hardware and software designs for mobile telephones that use our integrated circuits, we work with our customers to help them achieve full certification approval for their mobile telephones, which is a prerequisite for them to be able to sell their mobile telephones.

Employees

     As of September 30, 2002, we employed approximately 10,700 active full-time employees, including approximately 8,000 management and non union-represented employees, and approximately 2,400 U.S. union-represented employees covered by collective bargaining agreements. In addition, approximately 75 employees were union-represented employees located in Mexico and covered by a collective bargaining agreement. We expect that the total number of employees will decline as we complete the exit of our optoelectronics business and our other restructuring activities.

     On May 31, 1998, Lucent entered into a collective bargaining agreement with the Communications Workers of America and a separate agreement with the International Brotherhood of Electrical Workers. In connection with our separation from Lucent, we have assumed the obligations under these agreements with respect to our U.S. union-represented employees. These agreements will be effective until May 31, 2003, unless the parties to each agreement reach a mutual agreement to amend the terms.

     John T. Dickson has been our President and Chief Executive Officer since August 2000. Previously, Mr. Dickson was Executive Vice President and Chief Executive Officer of Lucent’s Microelectronics and Communications Technologies Group since October 1999. He joined AT&T in 1993 as Vice President of its Integrated Circuit business unit, moved to Lucent following its spin-off in 1996, and was named Chief Operating Officer of Lucent’s Microelectronics Group in 1997. Before joining AT&T, Mr. Dickson was Chairman and Chief Executive Officer of Shographics from 1992 until 1993, was President and Chief Executive Officer of Headland Technology Incorporated from 1991 to 1992, held various management positions at ICL plc from 1983 until 1991 and held various management positions at Texas Instruments from 1969 until 1983. Mr. Dickson is currently a director of the Semiconductor Industry Association, or SIA, and Mettler-Toledo International Inc. and a member of the board of trustees of Lehigh Valley Health Network.

     Ronald D. Black has been our Executive Vice President, Client Systems since October 2001. Previously, Mr. Black had been Senior Vice President, Strategy and Business Development at Agere from March 2001 to October 2001. Before joining Agere, Mr. Black was Vice President and General Manager, Next-Generation Networks Business Unit of Gemplus from 1998 to 2001. Prior to Gemplus, Mr. Black was the General Manager of the Networking and Communications Systems Division of Motorola’s Semiconductor Products Sector.

     Mark T. Greenquist has been our Executive Vice President and Chief Financial Officer since January 2001. Prior to joining our company, Mr. Greenquist had been Chief Financial Officer of General Motors Europe from January 1999 to January 2001. From October 1998 to January 1999, he was Vice President and Corporate Treasurer of Delta Air Lines, Inc. Prior to joining Delta Air Lines, Mr. Greenquist was at General Motors from 1986 to 1998 where he held a variety of positions, including Assistant Treasurer of General Motors, Managing Director and Finance Director of General Motors Poland and Corporate Treasurer and Manager of Commercial Finance of Saab Automobile AB.

     Peter Kelly has been our Executive Vice President, Operations since October 2001. Previously, Mr. Kelly had been Agere’s Vice President of Operations for Integrated Circuits from September 2000 to October 2001. Mr. Kelly joined Lucent Microelectronics in September 2000 from Fujitsu-ICL Systems Inc., a joint venture of ICL and Fujitsu, where he was Executive Vice President and Chief Operating Officer. Mr. Kelly had been with Fujitsu-ICL for six years.

     Sohail A. Khan has been our Executive Vice President, Infrastructure Systems since October 2001. Previously, Mr. Khan had been Executive Vice President of Integrated Circuits since March 2001. Mr. Khan was President of the Integrated Circuits business of Lucent’s Microelectronics and Communications Technologies Group from April 2000 to March 2001. Mr. Khan was the strategy and business development Vice President of Lucent’s Microelectronics and Communications Technologies Group from September 1996 to April 2000. From April 1996 to September 1996, Mr. Khan was Vice President of Marketing for MMC Networks, a developer and supplier of network processing platforms and services. Mr. Khan joined AT&T in 1990 as the director of marketing and applications engineering for the digital signal processing product line and moved to Lucent following its spin off in 1996. While at AT&T, he held a variety of positions, including Vice President and General Manager of the Wireless and Multimedia business unit of AT&T from February 1994 to April 1996.

     All of our outstanding Class B common stock was held by Lucent until June 1, 2002, when Lucent completed our spin-off, distributing to its stockholders all of our Class A common stock and Class B common stock that it held on that date.

     Our Class B common stock has been traded on the New York Stock Exchange under the symbol “AGR.B” since June 3, 2002. The following table sets forth, for the indicated periods, the quarterly high and low sale prices of our Class B common stock, as reported in the consolidated transaction reporting system.

Item 6. Selected Financial Data

     The following table sets forth selected financial information for our company. The financial information for the years ended September 30, 2002, 2001, and 2000, and as of September 30, 2002 and 2001, has been derived from our audited financial statements included in Item 8. The financial information for the years ended September 30, 1999 and 1998, and as of September 30, 2000 and 1999, has been derived from our audited financial statements not included in this report. The financial information as of September 30, 1998 has been derived from our unaudited financial statements not included in this report. The historical selected financial information may not be indicative of our future performance and should be read in conjunction with the information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and the financial statements and the related notes in Item 8.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-Looking Statements” and “Factors Affecting Our Future Performance” for a discussion of the uncertainties, risks and assumptions associated with these statements.

Overview

     We provide advanced integrated circuit solutions that access, move and store information. These solutions form the building blocks for a broad range of communications and computing applications. We also provide optoelectronic components, however, we have entered into an agreement to sell a substantial portion of our optoelectronics business and are seeking a buyer for the remainder of that business. See “Exit from Optoelectronics Business” for additional details.

     Effective October 1, 2001, we realigned our business operations into two market-focused groups, Client Systems and Infrastructure Systems, that target the consumer communications and network equipment markets respectively. Each of these two groups is a reportable operating segment. The segments each include revenue from the licensing of intellectual property assigned to that segment.

     The Client Systems segment delivers integrated circuit solutions for a variety of end-user applications such as hard disk drives and modems for computers, Internet-enabled cellular terminals and wireless local area networking. The segment is comprised of a portion of our former Integrated Circuits segment.

     The Infrastructure Systems segment delivers solutions to makers of high-speed communications systems. The segment is comprised of our former Optoelectronics segment and the remainder of our former Integrated Circuits segment.

     Separation from Lucent

     We were incorporated under the laws of the State of Delaware on August 1, 2000, as a wholly owned subsidiary of Lucent. We had no material assets or activities as a separate corporate entity until the contribution to us by Lucent of its integrated circuits and optoelectronic components businesses. Lucent had previously conducted these businesses through various divisions and subsidiaries. On February 1, 2001, Lucent began the separation of our company by transferring to us the assets and liabilities related to these businesses, other than the pension and postretirement assets and liabilities. In April 2001, we completed our initial public offering. On May 1, 2001, Lucent elected to convert 37 million shares of its Agere Class B common stock to Class A common stock. Following these transactions, Lucent owned approximately 58% of the total outstanding common stock and approximately 84% of the combined voting power of both classes of our voting stock with respect to the election and removal of directors. On June 1, 2002, Lucent completed our spin-off by distributing all of the Agere common stock it then owned to its stockholders. Also in June 2002, Lucent transferred to us the pension and postretirement assets and liabilities related to our employees based on currently available census data. This census data is subject to revisions that may result in additional transfers to or from the Lucent plans. We anticipate finalizing the amounts to be transferred by no later than June 2003.

     In connection with our separation from Lucent, we entered into several agreements with Lucent. For a summary of certain of these agreements, see Note 21 to our financial statements in Item 8.

     Our financial statements include amounts prior to February 1, 2001 that have been derived from the financial statements and accounting records of Lucent using the historical results of operations and historical basis of the assets and liabilities of our businesses. We believe the assumptions underlying our financial statements are reasonable. However, our financial statements that were derived from Lucent’s financial records may not necessarily reflect our results of operations, financial position and cash flows in the future or what our results of operations, financial position and cash flows would have been had we been a stand-alone company. Because a direct ownership relationship did not exist among all the various units comprising Agere, Lucent’s net investment in us is shown in lieu of stockholders’ equity in our financial statements for periods prior to February 1, 2001. We began accumulating retained earnings (losses) on February 1, 2001, the date on which Lucent transferred to us substantially all the assets and liabilities of our business. For periods prior to February 1, 2001, our financial statements include allocations of Lucent’s expenses, assets and liabilities.

     Costs and gross margin. Costs decreased 38%, or $1,158 million, to $1,926 million in fiscal 2002 from $3,084 million in fiscal 2001. Gross margin decreased to 11.5% in fiscal 2002 from 24.4% in fiscal 2001, a decrease of 12.9 percentage points. Gross margin for the Client segment increased to 27.8% in the current fiscal year from 23.8% in the prior fiscal year. This increase was primarily due to improved manufacturing capacity utilization as a result of actions taken under our restructuring and cost saving initiatives and lower inventory provisions of $22 million, partially offset by the effects of product price reductions. Gross margin for the Infrastructure segment decreased to (10.8)% in the current fiscal year from 24.8% in the prior fiscal year. The decrease was due to excess manufacturing capacity as a result of the decline in sales volume, which was partially offset by lower inventory provisions of $306 million. This excess manufacturing capacity was especially prevalent in our optoelectronics business that we are exiting, as the Infrastructure gross margin was approximately 14% in fiscal 2002, excluding this business.

     Selling, general and administrative. Selling, general and administrative expenses decreased 43%, or $256 million, from $597 million in fiscal 2001 to $341 million in the current fiscal year. The decrease was primarily due to reduced salary, benefit and other expenditures as a result of our restructuring and cost saving initiatives.

     Research and development. Research and development expenses decreased 27%, or $258 million, from $951 million in fiscal 2001 to $693 million in the current fiscal year. The decrease was primarily due to reduced expenditures as we focused our product development efforts and realized savings from our restructuring and cost saving initiatives.

     Amortization of goodwill and other acquired intangibles. Amortization expense decreased 86%, or $356 million, from $415 million in fiscal 2001 to $59 million in fiscal 2002. The decrease is due to impairments of goodwill and other acquired intangibles of $2,762 million recognized in the second half of fiscal 2001 and $220 million recognized during fiscal 2002. These impairments significantly reduced our goodwill and other acquired intangibles and therefore, our current fiscal year amortization.

     Restructuring and other charges – net. Net restructuring and other charges increased 48%, or $316 million, to $978 million in fiscal 2002 from $662 million in fiscal 2001. Net restructuring and related expenses increased 72%, or $408 million, to $971 million in the current fiscal year from $563 million in the prior fiscal year. Expenses associated with the separation from Lucent decreased 93%, or $92 million, to $7 million in the current fiscal year from $99 million in the prior fiscal year, as the separation was mostly completed in fiscal 2001.

     Impairment of goodwill and other acquired intangibles. During fiscal 2002, we recorded a charge of $220 million to reduce goodwill and other acquired intangibles, consisting of $113 million and $107 million related to the acquisitions of Ortel and Herrmann, respectively. During fiscal 2001, we recorded a charge of $2,762 million to reduce goodwill and other acquired intangibles, consisting of $2,220 million, $275 million, $240 million and $27 million related to Ortel, Herrmann, Agere and Enable, respectively.

     (Gain) loss on sale of operating assets – net. (Gain) loss on sale of operating assets – net increased $299 million, to a gain of $294 million in fiscal 2002 from a loss of $5 million in fiscal 2001. The fiscal 2002 amount consists principally of a $243 million gain related to the sale of our field-programmable gate array business and a $58 million gain related to the sale of our wireless local area network equipment business.

     During fiscal 2001 revenues decreased sequentially each quarter due to declining market conditions compared to sequential revenue growth each quarter in fiscal 2000. Client revenues declined $181 million, or 37%, to $302 million in the fourth quarter of fiscal 2001 from the peak quarterly revenue level of $483 million experienced in the fourth quarter of fiscal 2000. Infrastructure revenues declined $708 million, or 70%, to $298 million in the fourth quarter of fiscal 2001 from the peak quarterly revenue level of $1,006 million experienced in the fourth quarter of fiscal 2000.

     Costs and gross margin. Costs increased 21%, or $529 million, to $3,084 million in fiscal 2001 from $2,555 million in the prior fiscal year. Gross margin decreased 21.3 percentage points to 24.4% in fiscal 2001 from 45.7% in fiscal 2000, primarily due to lower manufacturing capacity utilization and the impact of inventory provisions of $409 million in fiscal 2001 compared to inventory provisions of $29 million in fiscal 2000. Gross margin for the Client segment decreased to 23.8% in fiscal 2001 from 38.3% in fiscal 2000 due to lower manufacturing capacity utilization. Gross margin for the Infrastructure segment declined to 24.8% in fiscal 2001 from 49.8% in fiscal 2000 primarily due to lower manufacturing capacity utilization, inventory provisions of $378 million in fiscal 2001 compared to inventory provisions of $20 million in fiscal 2000, and a change in product mix, from higher margin components to lower margin components.

     Selling, general and administrative. Selling, general and administrative expenses increased 12%, or $62 million, to $597 million in fiscal 2001 from $535 million in fiscal 2000. This was primarily due to increases in general and administrative expenses associated with being a stand-alone company, which were partially offset by lower bonus accruals of approximately $35 million.

     Research and development. Research and development expenses increased 15%, or $124 million, to $951 million in fiscal 2001 from $827 million in fiscal 2000. The increase was due to new and ongoing product development expenses, including a full year of expenses associated with acquisitions during fiscal 2000, partially offset by lower bonus accruals of approximately $40 million.

     Amortization of goodwill and other acquired intangibles. Amortization expense increased $226 million to $415 million in fiscal 2001 from $189 million in fiscal 2000 due to the recognition in fiscal 2001 of amortization associated with acquisitions completed during fiscal 2000.

     Purchased in-process research and development. Purchased in-process research and development decreased to zero in fiscal 2001 from $446 million in fiscal 2000. This was the result of no significant acquisitions being made in fiscal 2001, while a number of acquisitions were completed in fiscal 2000.

     Restructuring and other charges – net. Restructuring and other charges of $662 million were incurred in fiscal 2001, which consisted of $563 million of restructuring and related expenses and $99 million of expenses in connection with our separation from Lucent. There were no such charges in fiscal 2000.

     Impairment of goodwill and other acquired intangibles. During fiscal 2001, we recorded a charge of $2,762 million to reduce goodwill and other acquired intangibles, primarily associated with Ortel. There were no such charges in fiscal 2000.

     (Gain) loss on sale of operating assets – net. We realized a loss on the sale of operating assets of $5 million in fiscal to 2001 related to the sale of property, plant and equipment. There was no such gain or loss in the prior fiscal year.

     Operating income (loss). Operating loss was $4,396 million in fiscal 2001 compared to $156 million of operating income in fiscal 2000. This change was driven primarily by the impairment of goodwill and other acquired intangibles, a decline in gross profit, restructuring and other charges and an increase in the amortization of goodwill and other acquired intangibles, partially offset by the absence of purchased in-process research and development costs in fiscal 2001. Although performance measurement and resource allocation for the reportable segments are based on many factors, the primary financial measure used is operating income (loss) by segment, exclusive of amortization of goodwill and other acquired intangibles, purchased in-process research and development costs, restructuring and other charges – net, the impairment of goodwill and other acquired intangibles, and (gain) loss on sale of operating assets – net, which is shown in the following table:

     Net cash provided by investing activities was $368 million in fiscal 2002 compared to net cash used in investing activities of $723 million and $829 million in fiscal 2001 and 2000, respectively. The increase in cash flow from investing activities in fiscal 2002 is primarily due to proceeds of $382 million from the sale of the field-programmable gate array, wireless local area networking equipment and analog line card businesses, proceeds of $142 million from the sale of property, plant and equipment, which includes the sale of the Madrid, Spain facility and proceeds from sale-leaseback transactions, proceeds of $55 million from the sale of investments and a reduced level of capital expenditures in the current period. Prior to fiscal 2002, capital expenditures had historically been the primary component of our investing activities. However, in response to adverse market conditions that began fiscal 2001, we significantly reduced our capital spending in fiscal 2002. Capital expenditures were $195 million, $723 million and $672 million in fiscal 2002, 2001 and 2000, respectively. The majority of our fiscal 2002 capital expenditures were related to the completion of a new office facility adjacent to our existing Allentown facility and facility consolidation activities. In fiscal 2003, we expect to continue to limit our capital expenditures.

     Net cash used in financing activities was $1,970 million in fiscal 2002 compared to net cash provided by financing activities of $3,607 million and $67 million in fiscal 2001 and 2000, respectively. The current year reflects the repayment of $2,500 million under our credit facility, offset in part by net proceeds of $396 million from the issuance of convertible notes and $163 million in net borrowings under our accounts receivable securitization facility. The fiscal 2001 amount is primarily from the receipt of $3,448 million of net cash proceeds from the sale of our common stock in our initial public offering. Prior to our initial public offering, we relied on Lucent to provide financing for our operations.

     On October 4, 2001, we amended our $2,500 million credit facility. In connection with the amendment, we repaid $1,000 million from cash on hand, thereby reducing the facility to $1,500 million, and extended the maturity of the facility to September 30, 2002. We also paid $21 million in fees in connection with the amendment, which were amortized over the life of the facility. The interest rate applicable to borrowings under the facility was based on a scale indexed to our credit rating.

     Subsequent to October 4, 2001, we repaid the remaining $1,500 million of borrowings under the credit facility and on September 30, 2002 the facility expired in accordance with its terms. The amounts used to make these repayments were from the following sources: $634 million from existing cash on hand, $250 million from the sale of our field-programmable gate array business, $198 million from our convertible subordinated notes offering, $179 million from our accounts receivables securitization, $67 million from the sale of our manufacturing facility and related equipment located in Spain, $64 million from the sale of our wireless local area networking equipment business, $55 million from the sale of investments and $53 million from sale-leaseback and various other transactions.

     Agere Systems Inc. and certain of its subsidiaries have entered into a securitization transaction relating to certain accounts receivable, which was amended on November 12, 2002. As part of the transaction, Agere Systems Inc. and certain of its subsidiaries irrevocably transfer accounts receivable on a daily basis to a wholly-owned, fully consolidated, bankruptcy-remote subsidiary. When we say that the subsidiary is bankruptcy remote, we mean that it is unlikely that it will be voluntarily placed into bankruptcy proceedings by us. In the event we were to be the subject of bankruptcy proceedings, it is unlikely that our creditors would have a claim on the subsidiary’s assets, even though the subsidiary is wholly owned by us. This is because we have taken a number of steps, including the appointment of an independent director and the requirement of unanimous board approval to commence bankruptcy proceedings, that we believe under current law will result in the assets of this subsidiary not being available to our creditors until the claims of the subsidiary’s creditors are satisfied. The subsidiary has entered into a loan agreement with certain financial institutions, pursuant to which the financial institutions agreed to make loans to the subsidiary secured by the accounts receivable. The financial institutions have commitments under the loan agreement of up to $200 million; however, the amount that the subsidiary can actually borrow at any time depends on the amount and nature of the accounts receivable that we have transferred to the subsidiary. The loan agreement expires on November 11, 2003. As of September 30, 2002, $163 million was outstanding under this agreement.

Acquisitions

     During fiscal 2000 we completed the acquisitions described below as part of our efforts to broaden our portfolio of product offerings. We did not have any significant acquisitions during fiscal 2002 and 2001.

     In June 2000, we acquired Herrmann, a developer and manufacturer of passive optical filters that can be used in conjunction with active optoelectronic components in products such as amplifiers. The purchase price was $432 million in Lucent common stock and options. In connection with this acquisition, certain former stockholders of Herrmann also received 677,019 additional shares of Lucent common stock based on retention and the achievement of specified milestones.

     In April 2000, we acquired Ortel, a developer and manufacturer of semiconductor optoelectronic components used in fiber optic systems for cable television and data communications networks. The purchase price was $2,998 million in Lucent common stock and options.

     In April 2000, we acquired Agere, Inc., a developer and supplier of network processor integrated circuits. Network processors control how data is sent over a network. The purchase price was $377 million in Lucent common stock and options.

     In March 2000, we acquired substantially all the assets of VTC, a supplier of integrated circuits to computer hard disk drive manufacturers. The purchase price was $104 million in cash. In connection with this acquisition, stockholders of VTC also received additional cash consideration of $50 million as a result of meeting certain performance measures. The $50 million payment resulted in additional goodwill related to the acquisition.

     During fiscal 2002 and 2001, we performed impairment evaluations of the goodwill and other acquired intangibles from recent acquisitions because events and changes in circumstances occurred that indicated the carrying amount of the assets may not be fully recoverable. See “Impairment of Goodwill and Other Acquired Intangibles.”

   Purchased In-process Research and Development

     In connection with the acquisitions of Agere, Inc., Herrmann and Ortel, a portion of each purchase price was allocated to purchased in-process research and development. In analyzing these acquisitions, we made decisions to buy technology that had not yet been commercialized rather than develop the technology internally. We relied on factors such as the amount of time it would take to bring the technology to market in making these decisions. We also considered Lucent’s Bell Laboratories’ resource allocation and its progress on comparable technology, if any. Our management expects to use a similar decision process in the future.

     We estimated the fair value of in-process research and development for the above acquisitions using an income approach. This involved estimating the fair value of the in-process research and development using the present value of the estimated after-tax cash flows expected to be generated by the purchased in-process research and development, using risk-adjusted discount rates and revenue forecasts as appropriate. The selection of the discount rate was based on consideration of Lucent’s weighted average cost of capital, as well as other factors known at the time, including the projected useful life of each technology, profitability levels of each technology, the uncertainty of technology advances and the stage of completion of each technology. We believe that the estimated in-process research and development amounts so determined represented fair value and did not exceed the amount a third party would have paid for the projects.

     Core technology is a product, service or process that exists at the date of the acquisition and may contribute to the value of any product resulting from in-process research and development. We deducted an amount representing the estimated value of any core technology’s contribution from the estimated cash flows used to value in-process research and development. At the date of acquisition, the in-process research and development projects had not yet reached technological feasibility and had no alternative future uses. Accordingly, the value allocated to these projects was capitalized and immediately expensed at acquisition.

     The 1550 Products had four distinct product lines. Of these product lines, one has been completed and three have been cancelled. Product development costs for the 1550 products since acquisition have been $1.5 million. There were no revenues attributable to these products in fiscal 2001. Actual revenues in fiscal 2002 were less than $1 million.

     At the time of acquisition, revenue attributable to the CATV Products was estimated to be $28 million in fiscal 2001 and $58 million in fiscal 2002. CATV Products are receivers and return path products for cable television network applications. The return path allows cable system operators to offer Internet and telephone services, in direct competition with network services providers. Revenue was expected to peak in fiscal 2004 and decline thereafter through the end of the products’ life as new product technologies were expected to be introduced by us. Revenue growth was expected to decrease from 107% in fiscal 2002 to 4% in fiscal 2004 and be negative for the remainder of the projection period. At the acquisition date, costs to complete the research and development efforts related to the CATV Products were expected to be $1 million.

     The CATV Products were completed in fiscal 2001 at a cost of $2 million. Actual revenues were $35 million and $44 million in fiscal 2002 and 2001, respectively.

     Herrmann Technology, Inc.

     On June 16, 2000, we completed the acquisition of Herrmann, which was a developer and supplier of passive optical filters that can be used in conjunction with active optoelectronic components in products such as amplifiers. The allocation to in-process research and development of $34 million represented its estimated fair value using the methodology described above. The $34 million was allocated primarily to the development of manufacturing processes.

     At the time of acquisition, revenue attributable to the products using these manufacturing processes was estimated to be $59 million in fiscal 2001 and $91 million in fiscal 2002. Revenue was expected to peak in fiscal 2005 and decline thereafter through the end of the products’ life as new technologies were expected to be introduced by us. Revenue growth was expected to decrease from 54.7% in 2002 to 0.7% in fiscal 2005, and be negative for the remainder of the projection period. At the acquisition date, costs to complete the research and development efforts related to the processes were expected to be $0.5 million.

     Herrmann’s in-process research and development projects ranged from 20% to 60% complete at the time of acquisition. Herrmann’s in-process research and development projects were expected to be completed during the period from August 2000 to June 2001 after approximately two to six years of research and development effort. Following completion, the projects were expected to begin generating economic benefits. In total, costs to complete Herrmann’s in-process research and development were expected to equal approximately $1.8 million. Projected future net cash flows attributable to Herrmann’s in-process research and development, assuming successful development, were discounted to net present value using a discount rate of 27.5%.

     Hermann’s in-process research and development projects were either completed by July of 2001 or discontinued due to market conditions. Actual costs to complete the projects were $1.3 million. Actual revenue attributable to these products was significantly lower than anticipated at $2 million and $3 million in fiscal 2002 and 2001, respectively.

Recent Pronouncements

     In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” Statement 142 provides guidance on the financial accounting and reporting for acquired goodwill and other intangible assets. Under Statement 142, goodwill and indefinite lived intangible assets will no longer be amortized. Intangible assets with finite lives will continue to be amortized over their useful lives, which will no longer be limited to a maximum life of forty years. The criteria for recognizing an intangible asset have also been revised. Statement 142 requires that goodwill be tested for impairment at least annually. The goodwill impairment test is a two-step process that requires goodwill to be allocated to reporting units. In the first step, the fair value of the reporting unit is compared to the carrying value of the reporting unit. If the fair value of the reporting unit is less than the carrying value of the reporting unit, a goodwill impairment may exist, and the second step of the test is performed. In the second step, the implied fair value of the goodwill is compared to the carrying value of the goodwill and an impairment loss is recognized to the extent that the carrying value of the goodwill exceeds the implied fair value of the goodwill. We adopted Statement 142 effective October 1, 2002. As a result, we have re-assessed the classification and useful lives of our previously acquired goodwill and other intangible assets. The assessment did not result in any adjustments to previously recorded amounts. In addition, we have completed the first step of the goodwill impairment test. Since the carrying value of each of our reporting units did not exceed their fair value, no goodwill impairment charges were recorded upon the adoption of Statement 142. At September 30, 2002, we had $84 of goodwill that will no longer be amortized and $17 of other acquired intangible assets that will continue to be amortized over their useful lives.

     Further, some of our competitors are currently selling commercial quantities of products that we are sampling to our customers, that are still in the initial stages of development or that we may develop in the future. By being able to offer these products in commercial quantities before we do, our competitors can establish significant market share, acquire design wins in customer equipment programs and create a market position that we may be unable to overcome once we have completed development and testing of that product.

Joint ventures and other third-parties manufacture some of our products for us. If these manufacturers are unable to fill our orders on a timely and reliable basis, our revenue may be adversely affected.

     We currently manufacture our integrated circuits through a combination of internal capability, joint ventures and external sourcing with contract manufacturers. In fiscal 2002, approximately 35% of our revenue was derived from integrated circuits manufactured at joint ventures or through other external sourcing arrangements. To the extent we rely on joint ventures and third-party manufacturing relationships, with respect to integrated circuits, we face the following risks:

The demand for components in the communications equipment industry has recently declined, and we cannot predict the duration or extent of this trend. Our revenue will depend in part on demand for these types of components.

     We derive, and expect to continue to derive, a significant portion of our revenue from the sale of integrated circuits used in communications networks. Since early 2001, communications equipment makers have significantly reduced purchases of components for their products, including the components we sell. If demand for these components declines further, our revenues may be adversely affected.

If we do not complete our announced restructuring and facility consolidation activities as expected, or even if we do so, we may not achieve all the benefits we anticipate.

     We are in the process of consolidating our manufacturing and office facilities, and exiting our optoelectronics business, in an effort to reduce our costs. The process of moving manufacturing lines from one facility to another can be complicated, involving initiating operations in a new facility and having customers qualify the new manufacturing lines before shutting down operations in the original facility. While we believe our restructuring and consolidation actions will reduce our cost structure, if we encounter delays in moving operations or completing the exit of our optoelectronics business, we may not achieve the cost reductions we are expecting. Because of the extensive nature of our restructuring activities, we may find that even if we complete these activities as planned, we may not realize all the benefits we expected.

Our revenue and operating results may fluctuate because we expect to derive most of our revenue from semiconductor devices and the integrated circuits industry is highly cyclical, and because of other characteristics of our business, and these fluctuations may cause our stock price to fall.

     We expect to derive most of our revenue from the sale of integrated circuits. Because the integrated circuits market segment is highly cyclical, we may experience declines in our revenue that are primarily related to industry conditions and not our products. This industry has experienced significant downturns, often in connection with, or in anticipation of, excess manufacturing capacity worldwide, maturing product cycles and declines in general economic conditions, and we are currently experiencing such a downturn.

     We focus primarily on winning competitive selection processes to develop products for use in our customers’ equipment. These selection processes can be lengthy. After winning and beginning a product design for a customer, that customer may not begin volume production of their equipment for a period of up to two years, if at all. Due to this lengthy design and development cycle, we may experience delays from the time we begin incurring expenses until the time we generate revenue from our products. We have no assurances that our customers will ultimately market and sell their equipment or that such efforts by our customers will be successful. Thus, we may never generate any revenue from our products after incurring significant design and development expenditures.

If we fail to attract, hire and retain qualified personnel, we may not be able to develop, market or sell our products or successfully manage our business.

     In some of our fields of operation, there are only a limited number of people in the job market who possess the requisite skills. In the past we have experienced difficulty in identifying and hiring qualified engineers in many areas of our business as well as in retaining our current employees. The loss of the services of any key personnel or our inability to hire new personnel with the requisite skills could restrict our ability to develop new products or enhance existing products in a timely manner, sell products to our customers or manage our business effectively.

Because we are subject to order and shipment uncertainties, any significant cancellations or deferrals could cause our revenue to decline or fluctuate.

     We generally sell products pursuant to purchase orders that customers may cancel or defer on short notice without incurring a significant penalty. Cancellations or deferrals could cause us to hold excess inventory, which could adversely affect our results of operations and restrict our ability to fund our operations. If a customer cancels or defers product shipments, we may incur unanticipated reductions or delays in our revenue. If a customer refuses to accept shipped products or does not timely pay for these products, we could incur significant charges against our income, which could materially and adversely affect our operating results.

If we do not achieve adequate manufacturing utilization, yields, volumes or sufficient product reliability, our gross margins will be reduced.

     Because the manufacturing costs at our owned and joint venture manufacturing facilities are relatively fixed, efficient utilization of manufacturing facilities and manufacturing yields are critical to our results of operations. Some of our manufacturing facilities have been underutilized in recent periods, which has reduced our gross margins. Lower than expected manufacturing yields could impair our gross margins and delay product shipments.

     The manufacture of our products involves highly complex and precise processes, requiring production in highly controlled and clean environments. Changes in our manufacturing processes or those of our suppliers or contractors, or their inadvertent use of defective or contaminated materials, could significantly reduce our manufacturing yields and product reliability.

We are subject to environmental, health and safety laws, which could increase our costs and restrict our operations in the future.

     We are subject to a variety of laws relating to the use, disposal, clean-up of, and human exposure to, hazardous chemicals. Any failure by us to comply with present and future environmental, health and safety requirements could subject us to future liabilities or the suspension of production. In addition, compliance with these or future laws could restrict our ability to expand our facilities or require us to acquire costly pollution control equipment, incur other significant expenses or modify our manufacturing processes. If additional contaminants are discovered or the additional cleanup obligations imposed at these or other sites, we could be adversely affected.

We may be subject to intellectual property litigation and infringement claims, which could cause us to incur significant expenses or prevent us from selling our products. If we are unable to protect our intellectual property rights, our business and prospects may be harmed.

     Like other companies in the semiconductor industry, we are frequently involved in litigation regarding patent and other intellectual property rights. From time to time, we receive notices from third parties of potential infringement and receive claims of potential infringement when we attempt to license our intellectual property to others. Defending these claims could be costly and time consuming and would divert the attention of management and key personnel from other business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement also might require us to enter into costly royalty or license agreements. However, we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. In addition, third parties may attempt to appropriate the confidential information and proprietary technologies and processes used in our business, which we may be unable to prevent and which would harm our business and prospects.

We believe that financing has recently been difficult to obtain for companies in our industry and if we need additional cash to fund our operations or to finance future strategic initiatives, we may not be able to obtain it on acceptable terms or at all.

     We believe that lenders have recently become less willing to extend credit to companies in the telecommunications and semiconductor industries, making debt financing difficult to obtain. As described below under “Risks Associated with Our Separation from Lucent—We are limited in the amount of stock that we can issue to raise capital because of potential adverse tax consequences,” in connection with our spin-off from Lucent, we are significantly restricted in our ability to issue stock in order to raise capital.

     If we are not able to obtain sufficient funds on acceptable terms, we may not have sufficient funds to take advantage of market opportunities or to finance future strategic initiatives, such as to fill gaps in our product portfolio.

     We believe that our cash and cash equivalents will be sufficient to fund our operations until such time as we are able to generate sufficient cash internally to fund our operations. If, however, the market for our products is worse than we expect, we may need additional funds, without which we will have to reduce our expenditures, which may harm our business.

We could incur significant tax liabilities and payment obligations if Lucent fails to pay the tax liabilities attributable to Lucent under our tax sharing agreement.

     We have entered into a tax sharing agreement with Lucent that allocates responsibility for tax liabilities between them and us. For a description of this agreement, see note 21 to our financial statements in Item 8. Under U.S. federal income tax laws, Lucent and we are jointly and severally liable for Lucent’s federal income taxes attributable to periods prior to and including Lucent’s taxable year ended September 30, 2001. This means that if Lucent were to fail to pay the taxes attributable to it under the tax sharing agreement for those periods, we may be liable for all or any part of these liabilities.

Because the Division of Enforcement of the Securities and Exchange Commission is investigating matters brought to its attention by Lucent, our business may be affected in a manner we cannot foresee at this time.

     On November 21, 2000, and again on December 21, 2000, Lucent brought to the attention of the staff of the Securities and Exchange Commission matters relating to its recognition of revenue. Lucent also publicly disclosed these matters in press releases on those dates. Although Lucent has informed us that it has no reason to believe that this investigation by the Division of Enforcement of the Securities and Exchange Commission into these matters concerns our business and we are not aware of any reason why the investigation would affect us, it is possible that the results of the investigation may have an impact on us. Although the investigation could result in no action being taken by the Securities and Exchange Commission, if an action were taken and the investigation is found to concern our business, the action could result in monetary fines or changes in some of our financial and other practices and procedures that we are unable to foresee at this time.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Risk Management

     We are exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact our results of operations and financial position. We manage our exposure to these market risks through our regular operating and financing activities and, when deemed appropriate, through the use of derivative financial instruments. We use derivative financial instruments as risk management tools and not for speculative purposes. In addition, derivative financial instruments are entered into with a diversified group of major financial institutions in order to manage our exposure to nonperformance on such instruments. Our risk management objective is to minimize the effects of volatility on our cash flows by identifying the recognized assets and liabilities or forecasted transactions exposed to these risks and appropriately hedging the risks.

     We use foreign currency forward contracts, and may from time to time use foreign currency options, to manage the volatility of non-functional currency cash flows resulting from changes in exchange rates. Foreign currency exchange contracts are designated for recorded, firmly committed or anticipated purchases and services. The use of these derivative financial instruments allows us to reduce our overall exposure to exchange rate movements, since the gains and losses on these contracts substantially offset losses and gains on the assets, liabilities and transactions being hedged. As of September 30, 2002, our primary net foreign currency market exposures included Singapore dollars, British Pounds Sterling, and Euros and were not material.

   Report of Independent Accountants

To the Board of Directors and
Stockholders of Agere Systems Inc.:

     In our opinion, the consolidated and combined financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Agere Systems Inc. and its subsidiaries at September 30, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated and combined financial statements. These financial statements and the financial statement schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     Prior to its separation from Lucent Technologies Inc. (“Lucent”) on February 1, 2001 the Company was comprised of businesses which were integrated with the businesses of Lucent; consequently, as indicated in Note 1, the financial statement amounts prior to this date have been derived from the consolidated financial statements and accounting records of Lucent, and reflect significant assumptions and allocations. Moreover, as indicated in Note 1, the Company relied on Lucent and its other businesses for administrative, management, research and other services. Accordingly, these financial statements do not necessarily reflect the financial position, results of operations, and cash flows of the Company had it been a stand-alone company.

     As discussed in Note 3 to the consolidated and combined financial statements, effective October 1, 2001, the Company changed its accounting method for the impairment or disposal of long-lived assets. As discussed in Note 4 to the consolidated and combined financial statements, effective October 1, 2000, the Company changed its accounting method for derivative instruments and hedging activity.

PricewaterhouseCoopers LLP
Florham Park, New Jersey
October 22, 2002

AGERE SYSTEMS INC. AND SUBSIDIARIES

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AGERE SYSTEMS INC. AND SUBSIDIARIES

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