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<SEC-DOCUMENT>0001047469-02-007980.txt : 20021223
<SEC-HEADER>0001047469-02-007980.hdr.sgml : 20021223
<ACCEPTANCE-DATETIME>20021223080121
ACCESSION NUMBER: 0001047469-02-007980
CONFORMED SUBMISSION TYPE: 10-K
PUBLIC DOCUMENT COUNT: 7
CONFORMED PERIOD OF REPORT: 20020930
FILED AS OF DATE: 20021223
FILER:
COMPANY DATA:
COMPANY CONFORMED NAME: AVAYA INC
CENTRAL INDEX KEY: 0001116521
STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661]
IRS NUMBER: 223713430
STATE OF INCORPORATION: DE
FISCAL YEAR END: 0930
FILING VALUES:
FORM TYPE: 10-K
SEC ACT: 1934 Act
SEC FILE NUMBER: 001-15951
FILM NUMBER: 02866025
BUSINESS ADDRESS:
STREET 1: 211 MOUNT AIRY RD
CITY: BASKING RIDGE
STATE: NJ
ZIP: 07920
BUSINESS PHONE: 9089536000
MAIL ADDRESS:
STREET 1: 211 MOUNT AIRY ROAD
CITY: BASKING RIDGE
STATE: NJ
ZIP: 07920
FORMER COMPANY:
FORMER CONFORMED NAME: LUCENT EN CORP
DATE OF NAME CHANGE: 20000612
</SEC-HEADER>
<DOCUMENT>
<TYPE>10-K
<SEQUENCE>1
<FILENAME>a2096723z10-k.txt
<DESCRIPTION>FORM 10-K
<TEXT>
<Page>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-K
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<C> <S>
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2002
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
</Table>
COMMISSION FILE NUMBER 001-15951
------------------------
AVAYA INC.
<Table>
<S> <C>
A DELAWARE I.R.S. EMPLOYER
CORPORATION NO. 22-3713430
</Table>
211 MOUNT AIRY ROAD, BASKING RIDGE, NEW JERSEY 07920
TELEPHONE NUMBER 908-953-6000
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
<Table>
<Caption>
TITLE OF EACH CLASS EXCHANGE ON WHICH REGISTERED
- ------------------- ----------------------------
<S> <C>
Common Stock, par value $.01 per share New York Stock Exchange
Series A Junior Participating Preferred Stock Purchase New York Stock Exchange
Rights
Liquid Yield Option-TM- Notes due 2021 New York Stock Exchange
</Table>
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
None
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 / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
At November 29, 2002, the aggregate market value of the voting common equity
held by non-affiliates was approximately $907 million.
At November 29, 2002, 365,801,780 common shares were outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
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<S> <C>
Portions of the 2002 Annual Report to Shareholders Parts I, II and IV
Portions of the Proxy Statement for the 2003 Annual Meeting
of Shareholders Part III
</Table>
<Page>
TABLE OF CONTENTS
<Table>
<Caption>
ITEM DESCRIPTION PAGE
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<S> <C> <C>
PART I
1. Business.................................................... 4
2. Properties.................................................. 27
3. Legal Proceedings........................................... 27
4. Submission of Matters to a Vote of Security-Holders......... 31
PART II
5. Market for Registrant's Common Equity and Related 31
Stockholder Matters.........................................
6. Selected Financial Data..................................... 31
7. Management's Discussion and Analysis of Financial Condition 31
and Results of Operations...................................
7A. Quantitative and Qualitative Disclosures About Market 31
Risk........................................................
8. Financial Statements and Supplementary Data................. 31
9. Changes in and Disagreements with Accountants on Accounting 31
and Financial Disclosure....................................
PART III
10. Directors and Executive Officers of the Registrant.......... 31
11. Executive Compensation...................................... 33
12. Security Ownership of Certain Beneficial Owners and 33
Management..................................................
13. Certain Relationships and Related Transactions.............. 33
14. Controls and Procedures..................................... 33
PART IV
15. Exhibits, Financial Statement Schedules, and Reports on Form 34
8-K.........................................................
</Table>
This Annual Report on Form 10-K contains trademarks, service marks and
registered marks of Avaya and its subsidiaries and other companies, as
indicated. Unless otherwise provided in this Annual Report on Form 10-K,
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.
Microsoft-Registered Trademark- is a registered trademark of Microsoft
Corporation.
All market share data is based on the most recently available information
from independent industry analysts.
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PART I
ITEM 1. BUSINESS.
OVERVIEW
Avaya Inc. is a leading provider of communications systems, applications and
services for enterprises, including businesses, government agencies and other
organizations. Our product and solution offerings include converged voice and
data networks, traditional voice communications systems, customer relationship
management solutions, unified communications solutions and structured cabling
products. We support our broad customer base with comprehensive global service
offerings that help our customers plan, design, implement and manage their
communications networks. We believe our global service organization is an
important consideration for customers purchasing our products and solutions and
is a source of significant revenue for us, primarily from maintenance contracts.
We were incorporated under the laws of the State of Delaware under the name
"Lucent EN Corp." on February 16, 2000, as a wholly owned subsidiary of Lucent
Technologies Inc. As of June 27, 2000, our name was changed to "Avaya Inc." On
September 30, 2000, Lucent contributed its enterprise networking business to us
and distributed all of the outstanding shares of our capital stock to its
shareowners. We refer to these transactions in this Annual Report on Form 10-K
as the "distribution." Prior to the distribution, we had no material assets or
activities as a separate corporate entity. Following the distribution, we became
an independent public company, and Lucent has no continuing stock ownership
interest in us.
OPERATING SEGMENTS
We offer a broad array of communications systems, solutions and services
that enable enterprises to communicate with their customers, suppliers, partners
and employees through voice, Web, electronic mail, facsimile, Web chat sessions
and other forms of communication, across an array of devices. These devices
include telephones, computers, cell phones and personal digital assistants. Our
broad portfolio of products includes products we have developed internally,
products we have obtained through acquisitions, products manufactured by third
parties which we resell, products and software provided to us by third parties
as components of our offerings and products we have developed through our
strategic alliances with other technology leaders. Our products range from
systems designed for multinational enterprises with multiple locations
worldwide, thousands of employees and advanced communications requirements to
systems designed for businesses with less than ten employees.
Prior to the fourth quarter of fiscal 2002, our businesses were organized
into operating segments based on product groups. In the fourth quarter of fiscal
2002, we reevaluated our business model due to the continued decline in spending
on enterprise communications technology by our customers and redesigned our
operating segments to align them with discrete customer sets and market segment
opportunities in order to optimize revenue growth and profitability. As a
result, we now report our operating results in the following four segments:
Converged Systems and Applications, Small and Medium Business Solutions,
Services and Connectivity Solutions. Please see Note 16 to our Consolidated
Financial Statements for the year ended September 30, 2002, which is
incorporated by reference from our 2002 Annual Report to Shareholders, for
financial information regarding our operating segments.
CONVERGED SYSTEMS AND APPLICATIONS SEGMENT
Our Converged Systems and Applications segment is focused on the sale of
communications solutions to our large enterprise customers. Our primary
offerings for this segment include converged voice and data networks and
traditional voice communications systems, customer relationship management
offerings and unified communications solutions. A critical component of our
strategy is
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our focus on the migration of our customers' circuit-switched voice
communications systems, which we refer to as traditional voice communications
systems, to a converged packet-based network that provides for the integration
of voice, data, video and other application traffic on a single unified network.
Internet Protocol, or IP, telephony systems integrate voice and data
communications traffic for transmission across a single network infrastructure
based on IP technology. Internet protocol is a type of protocol, or set of
standardized procedures, for the formatting and timing of transmission of
communications traffic between two pieces of equipment.
We believe the implementation of a converged network can provide significant
benefits to an enterprise in a number of ways. These benefits include:
- reduced costs through the use of a single unified network;
- simplified administration and least cost routing techniques for call
processing;
- increased worker productivity resulting from enhanced network access to
all communication channels, such as voice, e-mail and fax, from any
device, including computer, telephone, cell phone, fax machine and
personal digital assistant.; and
- enhanced business performance through the integration of IP telephony with
other applications.
In particular, we believe the evolution of converged networks is leading to
converged communications, which is characterized by the integration of real time
communication applications, such as telephony operations and administration,
call processing and call routing, and store and forward communications
applications, such as voice messaging, email and unified communication, with
business applications, such as customer relationship management and supply chain
management, to increase productivity and support end-user needs more
efficiently.
CONVERGED SYSTEMS. We are the U.S. leader in traditional voice telephony
and enterprise telephony, which we define as the market for traditional voice
telephony and IP telephony in the aggregate. We have the third largest share of
each of the U.S. IP telephony market, the global enterprise market and the
global IP telephony markets.
In February 2002, we announced the next generation of our Enterprise Class
Internet Protocol Solutions, or ECLIPS which includes:
- Avaya MultiVantage-TM- Software, our voice application software that
includes call processing and contact center functions and an
application-programming interface that supports a range of Avaya and
third-party applications;
- our media servers, which put voice applications such as call processing on
the customer's local area network;
- our media gateways, which support traffic routing between packet-switched
and circuit-switched networks, providing enterprises with the flexibility
to implement a new IP telephony system or to "IP-enable" their existing
voice communications system, thereby helping to preserve existing
communications technology investments;
- Avaya VisAbility-TM- Management Suite, a Web-based comprehensive set of
tools that manages complex voice and data network infrastructures;
- our IP softphones, which provide the functionality of a digital telephone
on a personal computer or a handheld device and our IP screenphones, which
offer a personal computer's graphic screen in an IP telephone; and
- our Avaya-TM- Extension to Cellular solution, which transparently bridges
any cell phone to any Avaya communications server.
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We also offer a portfolio of products to support converged network
infrastructures which carry voice, video and data traffic over any of the
protocols supported by the Internet on local area, wide area and wireless
networks including gigabit Ethernet, which facilitates the integration of the
enterprise network, the service provider network and next generation switching
systems such as optical networking. These products, which include switches,
virtual private networks and policy management software are offered on a
stand-alone basis, but are used primarily to support our converged systems
offerings. Our family of converged network infrastructure products help provide
a secure, reliable network infrastructure that enables deployment of IP-based
communications applications.
Our most advanced enterprise voice communications system is our
DEFINITY-Registered Trademark- Enterprise Communications Server, which is
offered worldwide in a variety of configurations,. Our DEFINITY product line is
a family of products that provides for a reliable enterprise network for voice
communication that integrates seamlessly with the public subscriber telephony
network, or PSTN, the global collection of voice-oriented public telephone
networks. It also offers integration with an enterprise's data network. Our
DEFINITY servers support a variety of voice and data applications such as call
and customer contact centers, messaging and interactive voice response, or IVR,
systems. IVR systems allow an individual to access information in the
enterprise's computer databases or conduct transactions by voice or using a
touch-tone telephone. IVR systems are often used in conjunction with an
automated attendant service to determine how the call should be routed given the
caller's needs. Our DEFINITY servers support open and standard interfaces for
computer telephony integration applications, which are advanced applications
that assist in the making, receiving and managing of telephone calls. Our
DEFINITY servers facilitate the ongoing transition at many enterprises from
traditional voice telephony systems to advanced systems that integrate voice and
data traffic and deploy increasingly sophisticated communications applications.
CUSTOMER RELATIONSHIP MANAGEMENT. Our customer relationship management
organization is focused on solutions that:
- facilitate interactions between an enterprise and its internal and
external customers across different types of access including voice
communications, email, Internet chat and facsimile;
- manage business and customer information to help ensure consistent
delivery of customer service throughout the enterprise;
- collect, integrate and analyze valuable customer and transaction
information to help the enterprise better meet customer needs; and
- provides reporting and analysis tools that help manage the overall
administration and efficiency of cost center operations.
Our offerings are essential components of many customer relationship
management solutions, including:
- call and customer contact center solutions;
- customer self-service applications, such as IVR systems and software;
- predicative dialing software and systems that manage inbound and outbound
calls, improving the efficiency of an enterprise's agents; and
- agent performance suites, such as call logging and monitoring, workforce
management software and agent analytic tools.
Our core customer relationship management, or CRM, product offerings are
software and hardware systems and software applications for customer contact
centers (including call centers) which are the foundation of many CRM solutions.
We use the term call centers to refer to applications that primarily manage an
enterprise's interactions with customers via the telephone, and the term contact
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centers to refer to applications that allow customers to interact with an
enterprise using multiple mediums of communication, including electronic mail,
access from a Web site, Web chat and collaboration, voice self-service,
telephone calls and facsimiles. We are the leading provider of call center
systems in North America and have the second largest share of the U.S. call
center market. Our strategy is to leverage this leadership position to market a
broader suite of CRM solutions.
Our Avaya-TM- Call Center Solutions for MultiVantage-Registered Trademark-
offer a suite of intelligent call routing alternatives that can accommodate
single call centers or multiple call centers through "virtual" routing over a
converged network. Calls can be routed to customer care agents or self-service
applications based on a variety of criteria, or business rules, including call
volume, workload, agent language or other expertise or across time zones or
countries and in each case, routing is transparent to the customer. Our contact
center solutions include Avaya-TM- Interaction Center, which manages
interactions across a variety of communication channels--including Web, e-mail
and advanced telephony systems. Avaya-TM- Interaction Center allows customers to
contact the enterprise through their preferred mode of communication and,
together with our other contact center components, helps enhance the customer's
experience with the enterprise. Our Operational Analyst solution provides
detailed and summary reporting to assist in efficiently and effectively managing
the contact center's operations. Operational Analyst also provides business
relevant analytical reporting that help facilitate business decisions relevant
to contact center operations.
Avaya CRM is supported by a professional services team of consultants who
are dedicated to assisting enterprises in improving their customer relationship
management, technology and execution. Our services range from designing and
implementing an enterprise's customer relationship management technology
strategy to setting up and integrating software applications that an enterprise
purchases from us as part of its customer contact center. Our consultants also
work with our sales force in selling our customer relationship management
solutions. Typically, a customer that purchases our customer relationship
management solutions purchases consulting services from us. We also provide
subject matter advice to systems integrators as part of an overall customer
relationship management strategy, as well as to provide guidance to achieve the
integration of multi-vendor solutions.
UNIFIED COMMUNICATION. We define Unified Communication as a family of
solutions that allow individuals to collaborate and communicate more effectively
and to move more quickly in a networked infrastructure through a variety of
communications devices, including telephones, computers or personal digital
assistants. Our Unified Communication solutions include our voice messaging and
unified messaging products, our IP-based unified communication solution and
other multimedia collaboration tools. Unified messaging is an advanced messaging
solution that delivers the convenience and benefits of combining the storage of
more than one type of message, including voice, facsimile and email.
We are the worldwide leader in sales of voice messaging, unified messaging
and unified communication solutions. Our messaging systems are configured both
as stand-alone servers or as embedded software or hardware in communications
servers. Many of our messaging systems are compatible with the voice
communications systems of other vendors so that an enterprise may choose our
messaging system as the standard for all its locations.
We offer a wide variety of voice messaging and unified messaging solutions
designed to serve the telephone call answering, facsimile, voice and unified
messaging communications needs of enterprises. Unified messaging facilitates
access to messages through the most convenient device, including Internet
browsers, LAN-based personal computers and wireline or wireless telephones,
using text-to-speech technology for telephonic e-mail retrieval. These products
are marketed under a number of brands, including our primary brands,
Octel-Registered Trademark- Messaging and INTUITY-TM-
AUDIX-Registered Trademark- Messaging. The ease and speed of our voice and
facsimile messaging can improve an enterprise's efficiency by allowing messages
to be sent instantly to teams, groups or an entire workforce across multiple
locations. All of our
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messaging servers can be networked, over the Internet or public or private voice
networks, to provide enterprise-wide voice and facsimile messaging through a
single system.
Our unified messaging capability, which accommodates voice, facsimile and
email messages, is available for our Octel Messaging and INTUITY AUDIX systems
and is also provided by our innovative Avaya Unified Messenger for
Microsoft-Registered Trademark- Exchange, developed in cooperation with
Microsoft Corporation. The Avaya Unified Messenger system is a unified messaging
system software solution that stores voice and facsimile messages directly in a
user's Microsoft Exchange electronic mailbox and enables user access to this
mailbox by telephone or fax machine or a Microsoft Exchange interface on the
user's personal computer.
Our unified communication offering, Avaya-TM- Unified Communication Center,
includes the following features:
- message management--provides access to voice, fax and e-mail messages from
an array of communication devices;
- calling and conferencing management--allows users to initiate calls or
conferences from any phone, including through the use of a voice
recognition application, while leveraging the enterprise's communication
system;
- contact management--connects users to enterprise databases, providing the
dialing capability of an office telephone to a computer or personal
digital assistant; and
- personal efficiency management--allows users to utilize personalized
information filtering to prioritize communication interactions and screen
calls or route them to voice mail.
SMALL AND MEDIUM BUSINESS SOLUTIONS SEGMENT
Our Small and Medium Business Solutions segment develops, markets and sells
communications solutions, including IP telephony, traditional voice systems,
unified communication and contact center solutions, for small and medium-sized
businesses as well as the branch offices of large enterprises. Traditional voice
communications systems designed for small and medium-sized businesses are also
known as key and hybrid telephony systems. We have the second largest market
share in the U.S. key/ hybrid voice market, although the market leader's share
in this market is less than 1% greater than our current share. We have only
recently introduced an IP telephony solution designed to serve the needs of
small and medium-sized businesses.
We launched Avaya-TM- IP Office, our IP telephony solution for small and
medium-sized enterprises, in Europe in January 2002 and in North America in
May 2002. IP Office can be deployed for enterprises with 2 to 256 stations and
features full voice and data remote access, call distribution and alternate call
routing for low cost and highest voice quality. In addition, the IP Office
applications suite offer voice mail, unified messaging, wireless capability and
an array of contact center management tools designed for the small and
medium-sized enterprise.
Our key and hybrid voice communications systems are our Merlin MAGIX system,
which offers telephony, messaging, wireless and call center capability to
enterprises with up to 200 stations and our Partner ACS system, which offers
telephony, messaging and wireless to smaller enterprises with up to 40 stations.
Our Avaya INDeX system is marketed primarily in Europe, Australia and Japan and
can accommodate up to 1,088 stations. All of these systems can be IP enabled.
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SERVICES SEGMENT
Our Services organization provides standard and customized solutions to
enterprises in the following areas:
- network planning and design--including planning, design and assessment of
an enterprise's data network, its readiness for the implementation of IP
telephony and a comprehensive suite of security services for separate
voice and data networks as well as converged networks;
- network implementation--including solution preparation, design, deployment
and installation;
- management and operations--offering enterprises and service providers an
opportunity to outsource their communications systems; and
- maintenance and support--providing maintenance of our customer's networks.
We are the leading U.S. provider of maintenance services for enterprise
voice communications systems.
We deliver our service offerings through our Network Consulting Services,
Managed Services, Data Services, Technical Services and Field Services
organizations. Our Network Consulting team offers network planning and design
services. Our Managed Services organization helps enterprises focus on core
competencies by managing their internal voice communications systems and helps
service providers grow revenues by providing end-to-end messaging and unified
communication solutions. Our Data Services team can assist the enterprise with
the design, implementation, installation, maintenance and management of its data
network. Installation and repair of our products are performed primarily by our
Field Services organization. Technical support and maintenance under contracts
for our voice communications products are provided by our Technical Services and
Field Services organizations.
CONNECTIVITY SOLUTIONS SEGMENT
We market our SYSTIMAX-Registered Trademark- SCS 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 our
ExchangeMAX-Registered Trademark- product line primarily to central offices of
service providers, such as telephone companies or Internet service providers. We
also offer electronic cabinets to enclose and protect an enterprise's electronic
devices and equipment.
SYSTIMAX STRUCTURED CABLING SYSTEMS. We are the worldwide leader in sales
of structured cabling systems to enterprises. We primarily market these products
under the brand name SYSTIMAX. Our SYSTIMAX cabling systems provide a single
cabling solution for a network that integrates voice, video, data and building
controls on one network through an infrastructure of copper or fiber cabling and
associated connecting apparatus. The SYSTIMAX copper and fiber apparatus
solutions can be customized to fit a customer's needs.
EXCHANGEMAX STRUCTURED CABLING SYSTEMS. We sell our ExchangeMAX structured
cabling systems primarily to central offices of service providers such as
telephone companies, original equipment manufacturers and third-party
"engineering, furnish and install vendors. Central offices are locations that
house switches to serve the subscribers of a service provider. Our ExchangeMAX
systems are used to connect transmission and switching and other service
provider topologies to the Public Switched Telephone Network, or PSTN and
include coaxial and fiber cable used for voice frequency and digital and fiber
distribution networks. Equipment includes main distributing frames, digital
signal cross-connect frames, fiber distribution frames and surge protectors.
ELECTRONIC CABINETS. An electronic cabinet is a sturdy environmental
enclosure designed to house electronics devices and passive equipment, both in
the outside plant and inside buildings. Such
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enclosures are designed to meet the specific needs of each equipment
manufacturer's equipment and devices, including thermal characteristics, and are
used mostly by service providers to protect wireless access equipment, switching
equipment and broadband electronic equipment.
CUSTOMERS, SALES AND DISTRIBUTION
CUSTOMERS
Our customers include a broad set of enterprises ranging from large,
multinational enterprises to small and mid-sized enterprises to governments and
schools. We have thousands of customers, and no single end user customer
represented more than 10% of our revenue for fiscal 2002 and 2001 although sales
to our largest dealer, Expanets Inc., were approximately 10% of revenue for the
fiscal year ended September 30, 2001.
SALES AND DISTRIBUTION
Our distribution strategy is to serve our customers through our direct sales
forces and our indirect sales channel, which consists of our global network of
distributors, dealers, value-added resellers and system integrators.
CONVERGED SYSTEMS AND APPLICATIONS. We sell our Converged Systems and
Applications solutions to enterprise customers through our direct sales channel
and our global network of distributors, dealers, solutions providers and systems
integrators. Outside the U.S., we employ a direct sales force in major areas
with large enterprises while customers and geographic areas are served through
our indirect sales channel.
SMALL AND MEDIUM BUSINESS SOLUTIONS. We serve our Small and Medium Business
Solutions customers primarily through our network of dealers and value-added
resellers as well as through service providers. We also sell our solutions for
this segment to other providers of communications solutions to be incorporated
into their offerings. We will utilize a direct sales presence in support of the
smaller offices of our larger enterprise customers and for our largest dealers
and service providers.
SERVICES. Our Services segment serves customers through our direct sales
force and indirect channel partners, including alliance partners, service
providers, distributors and resellers. In addition, sales opportunities for our
Services segment will often arise from sales of our solutions through our
Converged Systems and Applications and Small and Medium Business Solutions
segments.
CONNECTIVITY SOLUTIONS. Our SYSTIMAX structured cabling systems are sold
primarily indirectly through a worldwide network of distributors. Our
ExchangeMAX structured cabling systems and electronic cabinets are sold to
service providers, original equipment manufacturers and distributors.
RESEARCH AND DEVELOPMENT
We invested $459 million, or approximately 9.3% of our total revenue, in
fiscal 2002 and $536 million, or approximately 7.9% of our total revenue, in
fiscal 2001, in research and development. Each of our operating segments has an
independent research and development organization. In addition, the research and
development efforts of our operating segments are supported by Avaya Labs
Research, a world-class basic research organization of approximately 80
professionals focused on technologies that will result in innovative products
and services. The primary focus of Avaya Labs Research is the development of
technologies and products for our Converged Systems and Applications segment
and, to a lesser extent, our Services segment.
We plan on using our substantial investment in research and development to
develop new systems and software related to business communications
applications, customer relationship management innovations, messaging solutions,
personalized information portals, business infrastructure and
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architectures, Web centers, hosted solutions, data networks and services for
Avaya's customers. These new systems and software will augment our current
product offerings so that, together with our strategic alliances and services,
we can offer our customers comprehensive advanced communications solutions. We
are also developing self-service interfaces and tools for use by our customers
and indirect channel partners. Avaya Labs Research will continue to seek
opportunities to work with technology leaders from other companies and
educational and research institutions to develop uniform technological standards
as the building blocks for future communications and related enterprise systems.
MANUFACTURING AND SUPPLIES
In fiscal 2001, we outsourced substantially all of our manufacturing,
including assembly and testing, other than the manufacturing of our Connectivity
Solutions product offerings, to Celestica Inc.. Currently, we are engaged in the
manufacturing of our Connectivity Solutions product offerings in three
facilities located in the United States, Australia and Ireland as well as in a
facility in China operated by a joint venture in which we own a 60% interest.
The success of our manufacturing initiative depends on the willingness and
ability of contract manufacturers to produce our products. We may experience
significant disruption to our operations by outsourcing so much of our
manufacturing. If our contract manufacturers terminate their relationships with
us or are unable to fill our orders on a timely basis, we may be unable to
deliver our products to meet our customers' orders, which could delay or
decrease our revenue.
We believe we have adequate sources for the supply of the components of our
products and for the finished products that we purchase from third parties.
COMPETITION
The market for communications systems, applications and services is quickly
evolving, highly competitive and subject to rapid technological change. Because
we offer a wide range of systems, applications and services for several types of
enterprises, we have a broad range of competitors. Many of our competitors are
substantially larger than we are and have significantly greater financial,
sales, marketing, distribution, technical, manufacturing and other resources.
Competition for our Converged Systems and Applications offerings include
products manufactured or marketed by a number of large communications equipment
suppliers, including Nortel Networks Corporation, Cisco Systems, Inc., Siemens
Aktiengesellschaft, Alcatel S.A. and NEC Corporation, as well as by a number of
other companies, some of which focus on particular segments of the market such
as customer relationship management. Some of the other competitors for our
Converged Systems and Applications offerings include Aspect Communication
Corporation and Captaris Inc. Our Small and Medium Business Solutions segments
has many competitors, including Cisco, Nortel, Alcatel, NEC, Matsushita Electric
Corporation of America, Inter-Tel, Incorporate and 3Com Corp., although the
market for these solutions is fragmented. Our structured cabling systems'
primary competitors are ADC Telecommunications, Inc., Telect Corporation, Siecor
Corporation, Marconi plc, Nordx/CDT, Commscope, Inc. and Belden Inc. Our
Services segment competes with Cisco Systems, Inc., NextiraOne, LLC,
Norstan, Inc., Nortel Networks Corporation, Siemens Aktengesellschaft, Ericsson,
Ameritech Corporation and Verizon Communications Inc as well as many consulting
firms. We expect to face increasing competitive pressures from both current and
future competitors in the markets we serve.
Technological developments and consolidation within the communications
industry result in frequent changes to our group of competitors. The principal
competitive factors applicable to our products and solutions include:
- product features and reliability;
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- customer service and technical support.
- relationships with distributors, value-added resellers and systems
integrators;
- an installed base of similar or related products;
- relationships with buyers and decision makers;
- price;
- the financial condition of the communications technology provider;
- brand recognition;
- the ability to integrate various products into a customer's existing
networsk, including the ability of a provider's products to interoperate
with other providers communications product; and
- the ability to be among the first to introduce new products.
PATENTS, TRADEMARKS AND OTHER INTELLECTUAL PROPERTY
In connection with the distribution, Lucent assigned to us its rights to a
number of patents, trademarks, copyrights, trade secrets and other intellectual
property directly related to and important to our business. In addition, Lucent
and its subsidiaries have also granted rights and licenses to those of their
patents, trademarks, copyrights, trade secrets and other intellectual property
which enable us to manufacture, market and sell all our products. Further,
Lucent has conveyed to us numerous sublicenses under patents of third parties.
We currently hold more than 1,700 U.S. patents and patent applications as a
result of patents and patent applications assigned to us by Lucent in connection
with the distribution, together with patents issued and patent applications we
have filed since the distribution and have obtained through acquisitions. In
addition, we hold corresponding non-US patents and patent applications, as well
as numerous trademarks, both in the United States and in foreign countries.
There are no time restrictions applicable to the patents assigned to us by
Lucent. We have entered into a cross license with Lucent in connection with
these patents.
Our intellectual property policy is to protect our products and processes by
asserting our intellectual property rights where appropriate and prudent. We
will also obtain patents, copyrights, and other intellectual property rights
used in connection with our business when practicable and appropriate.
EMPLOYEES
As of September 30, 2002, we employed approximately 18,800 full-time
employees, of which approximately 11,900 are management and
non-union-represented employees and approximately 6,700 are U.S.
union-represented employees covered by collective bargaining agreements. On
May 31, 1998 Lucent entered into collective bargaining agreements with the
Communications Workers of America and the International Brotherhood of
Electrical Workers. In connection with the distribution, we assumed the
obligations under the agreements with respect to our union-represented
employees. Each agreement is effective until May 31, 2003 unless the parties
reach a mutual agreement to amend its term. We believe that we generally have a
good relationship with our employees and the unions that represent them.
In October 2000, we entered into an agreement with the unions representing
our U.S. Services employees to offer eligible employees the ability to retire
from Lucent as of September 30, 2000 and continue working as on-call support
service technicians at Avaya. The agreement was intended to give us the
flexibility to match our workforce needs with our customers' cyclical service
demands for the design, installation and maintenance of their communications
systems. This agreement is effective until May 31, 2003.
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BACKLOG
Our backlog, which represents the aggregate of the sales price of orders
received from customers, but not yet recognized as revenue, was approximately
$270 million and $320 million on September 30, 2002 and September 30, 2001,
respectively. The majority of these orders are fulfilled within two months.
However, all orders are subject to possible rescheduling by customers. Although
we believe that the orders included in the backlog are firm, some orders may be
cancelled by the customer without penalty, and we may elect to permit
cancellation of orders without penalty where management believes it is in our
best interests to do so.
ENVIRONMENTAL, HEALTH AND SAFETY MATTERS
We are subject to a wide range of governmental requirements relating to
employee safety and health and to the handling and emission into the environment
of various substances used in our operations. We are subject to certain
provisions of environmental laws, particularly in the United States, governing
the cleanup of soil and groundwater contamination. Such provisions impose
liability for the costs of investigating and remediating releases of hazardous
materials at our currently or formerly owned or operated sites. In certain
circumstances, this liability may also include the cost of cleaning up
historical contamination, whether or not caused by us. We are currently
conducting investigation and/or cleanup of known contamination at approximately
seven 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 consolidated financial
position, results of operations or cash flows.
RELATIONSHIP BETWEEN LUCENT AND OUR COMPANY AFTER THE DISTRIBUTION
In connection with the distribution, we entered into a Contribution and
Distribution Agreement and a number of ancillary agreements with Lucent for the
purpose of accomplishing the contribution to us of Lucent's enterprise
networking business and the distribution. These agreements govern the
relationship between Lucent and us subsequent to the distribution and provide
for the allocation of employee benefit, tax and other liabilities and
obligations attributable to periods prior to the distribution.
In addition, the current Federal Tax Allocation Agreement and the current
State and Local Income Tax Allocation Agreement by and among Lucent and its
subsidiaries governing the allocation of income taxes among Lucent and its
subsidiaries continues to apply to us for taxable periods prior to and including
the distribution. The material agreements related to the distribution are
incorporated by reference as exhibits to this Annual Report on Form 10-K and the
summaries of any such agreements set forth below are qualified in their entirety
by reference to the full text of such agreements.
CONTRIBUTION AND DISTRIBUTION AGREEMENT
The Contribution and Distribution Agreement sets forth the agreements
between us and Lucent with respect to the principal corporate transactions
required to effect the distribution, and other agreements governing the
relationship between Lucent and us.
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THE CONTRIBUTION AND THE DISTRIBUTION
To effect the contribution, Lucent transferred, or agreed to transfer, or to
cause its subsidiaries to transfer, the assets of its enterprise networking
businesses. In general, we assumed, or agreed to assume, and perform and fulfill
all of the liabilities of the contributed businesses in accordance with their
respective terms. Pursuant to the Contribution and Distribution Agreement, the
distribution was effected as of 11:59 p.m. on September 30, 2000.
RELEASES AND INDEMNIFICATION
The Contribution and Distribution Agreement provides for a full and complete
release and discharge of all liabilities existing or arising from all acts and
events occurring or failing to occur or alleged to have occurred or to have
failed to occur and all conditions existing or alleged to have existed on or
before the date of the Contribution and Distribution Agreement, between or among
us or any of our subsidiaries or affiliates, on the one hand, and Lucent or any
of its subsidiaries or affiliates other than us, on the other hand, except as
expressly set forth in the Contribution and Distribution Agreement.
We have agreed to indemnify, hold harmless and defend Lucent, each of its
affiliates and each of their respective directors, officers and employees, from
and against certain liabilities relating to, arising out of or resulting from
the contribution and the distribution or any material breach by us of the
Contribution and Distribution Agreement or any of the ancillary agreements.
Lucent has agreed to indemnify, hold harmless and defend us, each of our
affiliates and each of our respective directors, officers and employees from and
against all liabilities related to Lucent's businesses other than the
contributed businesses and any material breach by Lucent of the agreement or any
of the ancillary agreements. Also, each party has indemnified the other party
and its affiliates, subject to limited exceptions, against any claims of patent,
copyright or trademark infringement or trade secret misappropriation with
respect to any product, software or other material provided by or ordered from
such party.
CONTINGENT LIABILITIES AND CONTINGENT GAINS
The Contribution and Distribution Agreement provides for liability sharing
by us and Lucent with respect to contingenciesprimarily relating to our
respective businesses or otherwise assigned to each of us. The Contribution and
Distribution Agreement requires Lucent to bear 50% of all losses in excess of
$50 million incurred by us in connection with a contingent liability primarily
related to our businesses. In addition, we are required to bear 10% of all
losses in excess of $50 million incurred by Lucent in connection with a
contingent liability primarily related to Lucent's businesses.
The Contribution and Distribution Agreement also provides that we will bear
10% and Lucent will bear 90% of all losses incurred in connection with shared
contingent liabilities, which are defined as:
- any contingent liabilities that are not primarily contingent liabilities
of Lucent or contingent liabilities associated with the contributed
businesses;
- some specifically identified liabilities, including liabilities relating
to terminated, divested or discontinued businesses or operations; and
- shared contingent liabilities within the meaning of the 1996 separation
and distribution agreement among Lucent, AT&T Corp. and NCR Corporation.
Lucent will assume the defense of, and may seek to settle or compromise, any
third party claim that is a shared contingent liability, and those costs and
expenses will be included in the amount to be shared by us and Lucent.
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The Contribution and Distribution Agreement provides that we and Lucent will
have the exclusive right to any benefit received with respect to any contingent
gain that primarily relates to the business of, or that is expressly assigned
to, us or Lucent, respectively.
Please see "Legal Proceedings" for a description of certain matters
involving Lucent for which we have assumed responsibility under the Contribution
and Distribution Agreement.
RESTRICTIONS ON BUSINESS TRANSACTIONS
Subject to Lucent's ability to terminate some of the rights, including
important intellectual property rights granted to us and our affiliates under
the ancillary agreements, the Contribution and Distribution Agreement provides
that none of Lucent, us, or our respective subsidiaries or affiliates will have
any duty to refrain from engaging in similar activities or lines of business, or
from doing business with any potential or actual supplier or customer of any
other person.
PROVISIONS RELATING TO THIRD-PARTY INTELLECTUAL PROPERTY LICENSE AGREEMENTS
The Contribution and Distribution Agreement provides, generally, for the
grant by Lucent to us of a sublicense under numerous third-party intellectual
property license agreements. The Patent and Technology License agreement
provides similar grants to us from Lucent's subsidiary, Lucent Technologies GRL
Corporation, with respect to third party patent license agreements executed by
that subsidiary.
CHANGE OF CONTROL
In the event that, at any time prior to the third anniversary of the
distribution, there is a change of control of us as defined in the Contribution
and Distribution Agreement, then Lucent could terminate or cause us to reconvey
some of the rights, including important intellectual property rights, granted to
us under the Intellectual Property Agreements.
COMMERCIAL AGREEMENTS
We and Lucent entered into a Global Purchase and Service Agreement, a
General Sales Agreement, a Microelectronics Product Purchase Agreement, two
Reseller Agreements, a Master Subcontracting Agreement, a Master Services
Agreement and an Original Equipment Manufacturing and Value Added Reseller
Agreement. The pricing terms for the products and services covered by the Global
Purchase and Service Agreement and all other ancillary commercial agreements
reflected current market prices at the time of the transaction. Each of these
agreements commenced October 1, 2000 and has a three-year term, subject to
extension.
INTELLECTUAL PROPERTY AGREEMENTS
We entered into a series of agreements with Lucent pursuant to which Lucent
transferred to us the primary trademarks used in the sale of our products and
services, except for Lucent's name and logo and the Bell Laboratories name; we
and Lucent divided ownership of technology, patents, patent applications and
non-U.S. counterparts between us and Lucent; and we and Lucent granted cross-
licenses to each other with respect to patents and technology.
TAX SHARING AGREEMENT
We and Lucent entered into a Tax Sharing Agreement which governs Lucent's
and our respective rights, responsibilities and obligations after the
distribution with respect to taxes for the periods ending on or before the
distribution. Generally, pre-distribution taxes that are clearly attributable to
the business of one party will be borne solely by that party, and other
pre-distribution taxes will be shared
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by the parties based on a formula set forth in the Tax Sharing Agreement. In
addition, the Tax Sharing Agreement addresses the allocation of liability for
taxes that are incurred as a result of restructuring activities undertaken to
implement the distribution. If the distribution fails to qualify as a tax-free
distribution under Section 355 of the Internal Revenue Code because of an
acquisition of our stock or assets, or some other actions of ours, then we will
be solely liable for any resulting corporate taxes.
FORWARD LOOKING STATEMENTS
(Cautionary Statements Under the Private Securities Litigation Reform Act of
1995)
Our disclosure and analysis in this report and in our 2002 Annual Report to
Shareholders contain some forward-looking statements. Forward-looking statements
give our current expectations or forecasts of future events. You can identify
these statements by the fact that they do not relate strictly to historical or
current facts. They use words such as "anticipate," "estimate," "expect,"
"project," "intend," "plan," "believe," and other words and terms of similar
meaning in connection with any discussion of future operating or financial
performance. From time to time, we also may provide oral or written
forward-looking statements in other materials we release to the public.
Any or all of our forward-looking statements in this report, in the 2002
Annual Report to Shareholders and in any other public statements we make MAY
TURN OUT TO BE WRONG. They can be affected by inaccurate assumptions we might
make or by known or unknown risks and uncertainties. Many factors mentioned in
the discussion below will be important in determining future results.
Consequently, no forward-looking statement can be guaranteed. Actual future
results may vary materially.
Except as may be required under the federal securities laws, we undertake no
obligation to publicly update forward-looking statements, whether as a result of
new information, future events or otherwise. You are advised, however, to
consult any further disclosures we make on related subjects in our Form 10-Q and
8-K reports to the SEC. Also note that we provide the following cautionary
discussion of risks, uncertainties and possibly inaccurate assumptions relevant
to our businesses. These are factors that we think could cause our actual
results to differ materially from expected and historical results. Other factors
besides those listed here could also adversely affect us. This discussion is
provided as permitted by the Private Securities Litigation Reform Act of 1995.
The risks and uncertainties referred to above include, but are not limited
to, price and product competition, rapid technological development, dependence
on new product development, the mix of our products and services, customer
demand for our products and services, the ability to successfully integrate
acquired companies, control of costs and expenses, the ability to form and
implement alliances, the ability to implement in a timely manner our
restructuring plan, the economic, political and other risks associated with
international sales and operations, U.S. and non-U.S. government regulation,
general industry and market conditions and growth rates and general domestic and
international economic conditions including interest rate and currency exchange
rate fluctuations. In addition, set forth below is a more detailed discussion of
the risks and uncertainties we face.
The categorization of risks set forth below is meant to help you better
understand the risks facing our business and are not intended to limit your
consideration of the possible effects of these risks to the listed categories.
Any adverse effects related to the risks discussed below may, and likely will,
adversely affect many aspects of our business.
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RISKS RELATED TO OUR REVENUE AND BUSINESS STRATEGY
OUR REVENUE HAS DECLINED SIGNIFICANTLY DURING THE PAST SEVERAL QUARTERS AND
IF BUSINESS CAPITAL SPENDING, PARTICULARLY FOR ENTERPRISE COMMUNICATIONS
PRODUCTS AND SERVICES, DOES NOT IMPROVE OR DETERIORATES, OUR REVENUE MAY
CONTINUE TO DECLINE AND OUR OPERATING RESULTS MAY BE ADVERSELY AFFECTED.
Our revenue for the quarter ended September 30, 2002 was $1,152 million, a
decrease of 20.1%, or $290 million, from $1,442 million for the quarter ended
September 30, 2001, a sequential decrease of 5.5%, or $67 million, from
$1,219 million for the quarter ended June 30, 2002, and a decrease of 9.9%, or
$127 million, from $1,279 for the quarter ended March 31, 2002.
Our operating results are significantly affected by the impact of economic
conditions on the willingness of enterprises to make capital investments,
particularly in enterprise communications technology and related services.
Although general economic conditions have shown some signs of improvement
recently, we have seen a continued decline in spending on enterprise
communications technology and services by our customers. We believe that
enterprises continue to be concerned about their ability to increase revenues
and thereby increase their profitability. Accordingly, they have tried to
maintain or improve profitability through cost reduction and reduced capital
spending. Because we do not believe that enterprise communications spending will
improve significantly in the near term, we expect there to be continued pressure
on our ability to generate revenue.
To the extent that enterprise communications spending does not improve or
deteriorates, our revenue and operating results will continue to be adversely
affected and we may not be able to comply with the financial covenants included
in our credit facility.
REVENUE GENERATED BY OUR TRADITIONAL BUSINESS, ENTERPRISE VOICE
COMMUNICATIONS PRODUCTS, HAS BEEN DECLINING FOR THE LAST SEVERAL YEARS AND IF WE
DO NOT SUCCESSFULLY IMPLEMENT OUR STRATEGY TO EXPAND OUR SALES IN MARKET
SEGMENTS WITH HIGHER GROWTH RATES, OUR REVENUE AND OPERATING RESULTS MAY
CONTINUE TO BE ADVERSELY AFFECTED.
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 or no growth in the future in the market segments for
these traditional products. We are implementing a strategy to capitalize on the
higher growth opportunities in our market, including converged voice and data
network products, customer relationship management solutions and unified
communication applications. This strategy requires us to make a significant
change in the direction and operations of our company to focus on the
development and sales of these 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;
- our competitors introduce new products before we do and achieve a
competitive advantage by being among the first to market;
- capital spending by our customers on communications products and services
continues to decline.
Our traditional enterprise voice communications products and the advanced
communications solutions described above are a part of our Converged Systems and
Applications and Small and Medium Business Solutions segments. If we are
unsuccessful in implementing our strategy, the contribution to our results from
these segments may decline, reducing our overall operating results and thereby
requiring a greater need for external capital resources and our Services segment
may be adversely affected to the extent that Services revenues are related to
sales of these products and solutions.
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WE ARE SIGNIFICANTLY CHANGING THE FOCUS OF OUR COMPANY IN ORDER TO
CONCENTRATE ON THE DEVELOPMENT AND MARKETING OF ADVANCED COMMUNICATIONS
SOLUTIONS, INCLUDING CONVERGED VOICE AND DATA NETWORK PRODUCTS, AND THIS CHANGE
IN FOCUS MAY NOT BE SUCCESSFUL OR MAY ADVERSELY AFFECT OUR BUSINESS.
We are making a significant change in the direction and strategy of our
company to focus on the development and sales of converged voice and data
networks and other advanced communications solutions. In order to implement this
change, we must:
- retrain our sales staff to sell new types of products and services and
improve our marketing of such products and services;
- retrain our Services employees to service the new products and solutions;
- develop relationships with new types of distribution partners;
- research and develop more converged voice and data products and products
using communications media other than voice traffic, which has
historically been our core area of expertise; and
- build credibility among customers that we are capable of delivering
advanced communications solutions beyond our historic product lines; and
- expand our current customer base by selling our advanced communications
solutions to enterprises who have not previously purchased our products.
If we do not successfully implement this change in focus, our operating
results may be adversely affected. However, even if we successfully address
these challenges, our operating results may still be adversely affected if the
market opportunity for advanced communications solutions, including converged
voice and data network products, does not develop in the ways that we
anticipate. Because this market opportunity is in its early stages, we cannot
predict whether:
- the demand for advanced communications solutions and converged voice and
data products will grow as fast as we anticipate;
- new technologies will cause the market to evolve in a manner different
than we expect; or
- we will be able to obtain a leadership or profitable position as this
opportunity develops.
The recent introduction of new IP telephony products demonstrates some of
the risks associated with entering new markets or introducing new technologies.
According to a recent industry study, shipments of IP telephony products dropped
sequentially for the first time in the first calendar quarter of 2002. Some
industry analysts have indicated that the recent introduction of the next
generation of our ECLIPS portfolio of IP hardware and software may have caused
many enterprises who were considering implementing IP telephony systems to
reconsider their deployment plans while they evaluate our ECLIPS announcement as
well a subsequent product announcement from a key competitor.
In addition, as a part of the change in our focus from traditional voice
communications to move advanced communications solutions, we realigned our
operating segments twice during fiscal 2002. Effective January 1, 2002, we
implemented an internal reorganization designed to enable us to understand and
manage our product groups with greater precision. As a result of that
reorganization, our Communications Solutions segments was divided into two
separate segments--Systems and Applications. In the fourth quarter of fiscal
2002, we reevaluated our business model in light of the continued decline in
spending on enterprise communications technology by our customers. This
reevaluation resulted in moving forward in the design of our then existing
operating segments to focus more firmly on aligning them with discrete customer
sets and market segment opportunities in order to optimize revenue growth and
profitability. Accordingly, we reorganized the Systems and Applications segments
to form the Converged Systems and Applications segments and the Small and Medium
Business Solutions segment. We cannot assure that the reorganization of our
businesses will yield the
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desired benefits or that the implementation of the reorganization will not
disrupt our operations and adversely affect our operating results.
WE MAY NOT BE ABLE TO DISPOSE OF OUR CONNECTIVITY SOLUTIONS BUSINESS ON
TERMS SATISFACTORY TO US OR AT ALL.
In February 2002, we engaged Salomon Smith Barney Inc. to explore
alternatives for our Connectivity Solutions segment, including the possible sale
of the business. Our goal in exploring alternatives for our Connectivity
Solutions segment is to strengthen our focus on higher growth opportunities by
emphasizing our Converged Systems and Applications, Small and Medium Sized
Business Solutions and Services offerings, such as converged voice and data
network products and unified communication and customer relationship management
solutions. In addition, we believe that the proceeds from any sale of our
Connectivity Solutions segment would help enhance our liquidity. We have had
discussions with interested parties concerning a possible sale of Connectivity
Solutions, however, current market conditions make it difficult for us to
realize fair value for this business. Accordingly, we may not be able to dispose
of our Connectivity Solutions segment on terms satisfactory to us or at all. If
we are unable to dispose of our Connectivity Solutions segment on terms
satisfactory to us or at all, our operating results and liquidity may suffer and
we may not be able to focus our business on our Converged Systems and
Applications, Small and Medium Sized Business Solutions and Services offerings,
which also may adversely affect our business.
IF WE DISPOSE OF OUR CONNECTIVITY SOLUTIONS BUSINESS, OUR OPERATING RESULTS
MAY BE ADVERSELY AFFECTED.
Prior to fiscal 2001, our Connectivity Solutions segment provided a
significant contribution to our operating results. Any disposition of our
Connectivity Solutions segment could result in the loss of a historically
significant contributor to our operating results, which could adversely affect
our consolidated operating results. See the segment information included in
Note 16--Operating Segments included in our accompanying Notes to our
Consolidated Financial Statements included elsewhere in this report for further
information regarding the contribution of Connectivity Solutions to our
consolidated operating results.
RISKS RELATED TO OUR LIQUIDITY AND CAPITAL RESOURCES
WE MAY NOT HAVE ADEQUATE OR COST-EFFECTIVE LIQUIDITY OR CAPITAL RESOURCES.
Our cash needs include making payments on and refinancing our indebtedness
and funding working capital, capital expenditures, strategic acquisitions,
business restructuring charges related expenses, employee benefit obligations
and for general corporate purposes. In addition, holders of our Liquid Yield
Option Notes due 2021, or LYONs, may require us to purchase all or a portion of
their LYONs on October 31, 2004, 2006 and 2011 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. Under the terms of the indenture governing the LYONs,
we may, at our option, elect to pay the purchase price in cash or shares of
common stock or any combination of cash and shares of common stock, although our
credit facility prohibits us from using more than $100 million in cash to redeem
or repurchase the LYONs. Further, upon the occurrence of specific kinds of
change in control events, we may have substantial repayment obligations under
existing debt agreements. Our ability to satisfy our cash needs depends on our
ability to generate cash from operations and access the financial markets, both
of which are subject to general economic, financial, competitive, legislative,
regulatory and other factors that are beyond our control.
Our ability to generate cash from operations is affected by the terms of our
credit agreement, the indenture governing our LYONs, and the indenture governing
our Senior Secured Notes. These instruments impose, and any future indebtedness
may impose, various restrictions and covenants, including financial covenants,
that may limit our ability to respond to market conditions, provide for
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unanticipated capital investments, make strategic acquisitions or take advantage
of business opportunities.
If we do not generate sufficient cash from operations, we will need to
access the financial markets. External financing may not be available to us on
acceptable terms or at all. Under the terms of any external financing, we may
incur higher than expected financing expenses, and become subject to additional
restrictions and covenants. In addition, our ability to obtain external
financing is affected by the terms of our debt agreements. Our existing debt
agreements include covenants that limit our ability to incur additional
indebtedness. In addition, our credit facility requires us to comply with
certain financial covenants. We have in the past been required to seek
amendments of our credit facilities in order to ensure our compliance with the
financial covenants. If we are unable to comply with our financial covenants and
cannot amend or waive those covenants, an event of default under the credit
facility would occur. If a default occurs, the lenders under our credit facility
could accelerate the maturity of our debt obligations and terminate their
commitments to lend to us. If such a default occurs when our debt obligations
under the credit facility exceed $100 million, our debt obligations in respect
of the $200 million interest rate swaps, the LYONs and the Senior Secured Notes
could be accelerated. In addition, although we currently have a $561 million
five-year credit facility, the terms of the facility require mandatory
commitment reductions over the remaining term of the facility and additional
commitment reductions upon the issuance of debt, sales of assets or repurchase
or redemption of the LYONs, thereby reducing our available liquidity. Currently
there are no funds drawn under our credit facility.
Our ability to obtain external financing and, in particular, debt financing,
is also affected by our debt ratings, which are periodically reviewed by the
major credit rating agencies. Our corporate credit is rated BB- and our
long-term senior unsecured debt is rated B by Standard & Poor's, each with a
negative outlook, and our long-term senior unsecured debt is rated B3 by Moody's
with 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. These downgrades, among other factors, could impair our
ability to secure additional financing on acceptable terms, and we cannot assure
you that we will be successful in raising any of the new financing on acceptable
terms.
Our ability to obtain equity financing is dependent upon the performance of
our stock price. The market for technology stocks, including our common stock,
has been extremely volatile recently. As of November 29, 2002, the closing price
of our common stock on the New York Stock Exchange was $2.90 per share and the
52-week low trading price for our common stock as of that date was $1.12 per
share. The current trading price of our common stock may hinder our ability in
the near term to obtain equity financing on cost-effective terms or at all.
HOLDERS OF OUR COMMON STOCK COULD EXPERIENCE SUBSTANTIAL DILUTION IF HOLDERS
OF OUR LYONS REQUIRE US TO REPURCHASE A SIGNIFICANT PORTION OF OUR LYONS IN
OCTOBER 2004.
Holders of our LYONs may require us to purchase all or a portion of their
LYONs on October 31, 2004, 2006 and 2011 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. Under the terms of the indenture governing the LYONs,
we may, at our option, elect to pay the purchase price in cash or, subject to
certain conditions, in shares of common stock or any combination of cash and
common stock, although our existing credit facility prohibits us from using more
than $100 million to redeem or repurchase the LYONs. If the trading price of our
common stock does not improve or deteriorates and we pay a substantial portion
of the purchase price of any LYONs we are required to purchase in October 2004
in shares of our common stock, our stockholders could may suffer significant
dilution.
THE VALUE OF THE ASSETS IN OUR PENSION PLANS HAS DECREASED SIGNIFICANTLY IN
FISCAL 2002 AND AS A RESULT, WE WILL LIKELY INCUR ADDITIONAL EXPENSE AND FUNDING
OBLIGATIONS THAT MAY HAVE AN ADVERSE EFFECT ON OUR FINANCIAL POSITION, RESULTS
OF OPERATIONS AND CASH FLOWS.
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The recent decline in the global equity markets has resulted in a decrease
in the value of the assets in our pension plans. This decline will likely
adversely affect our related accounting results in future periods through higher
pension expense, additional minimum liabilities with corresponding reductions in
stockholders' equity, and increased cash funding requirements. Based on the
value of the assets in our pension plans as of January 1, 2002, we will be
required to fund approximately $45 million to the plans in fiscal 2003. We
estimate that for fiscal 2004, we will be required to fund more than
$45 million to our pension plans.
OUR LARGEST DEALER MAY NOT BE ABLE TO SATISFY IN FULL ITS OBLIGATIONS TO US
UNDER A SHORT-TERM LINE OF CREDIT.
As of September 30, 2002, Expanets Inc., currently our largest dealer, owed
us approximately $35 million under a short-term line of credit we provided to
Expanets in 2001. The remaining balance under the line of credit was originally
due on December 31, 2002 and under the terms of the related credit agreement,
may be offset by certain obligations we have to Expanets related to the
March 2000 sale of our primary distribution function for voice communications
systems for small and medium-sized enterprises to Expanets. We have had, and
continue to have, discussions with Expanets regarding operational issues related
to the March 2000 sale. Although these issues are unrelated to Expanets' and
Northwestern's obligations under the credit agreement, because of the importance
to us of our relationship with Expanets and the customer base served by
Expanets, in December 2002, we agreed to extend the term of the credit agreement
to February 2003.
Outstanding amounts under the line of credit are secured by Expanets'
accounts receivable and inventory. In addition, Expanets' parent company,
NorthWestern Corporation, has guaranteed up to $50 million of Expanets'
obligations under the credit agreement. A default by NorthWestern of its
guarantee obligations under the credit agreement would constitute a default
under Expanets' dealer agreement with Avaya, resulting in a termination of the
non-competition provisions contained in such agreement and permitting us to sell
products to Expanets' customers.
There can be no assurance that Expanets will be able to comply with the
remaining terms of the credit agreement. In the event Expanets is unable to
comply with the terms of the credit agreement and a default occurs, it may be
costly and time consuming to exercise the remedies available to us. We cannot
assure you that the exercise of such remedies will yield an amount sufficient to
satisfy in full all of Expanets' obligations to us.
RISKS RELATED TO OUR OPERATING RESULTS
DISRUPTION OF, OR CHANGES IN THE MIX OF, OUR PRODUCT DISTRIBUTION MODEL OR
CUSTOMER BASE COULD AFFECT OUR REVENUES AND GROSS MARGINS.
If we fail to manage distribution of our products and services properly, or
if our distributors' financial condition or operations weaken, our revenues and
gross margins could be adversely affected. Furthermore, a change in mix of
direct sales and indirect sales could adversely affect our revenues and gross
margins.
We use a variety of channels to bring our products to customers, including
direct sales, distributors, dealers, value-added resellers and system
integrators. Since each distribution channel has a distinct profile, the failure
to achieve the most advantageous balance in the delivery model for our products
and services could adversely affect our gross margins and operating results.
For example:
- As we respond to demand from certain categories of customers to sell
directly to them, we could risk alienating channel partners and adversely
affecting our distribution model.
- Some of our system integrators may demand that we absorb a greater share
of the risks that their customers may ask them to bear, affecting our
gross margins.
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- Some of our channel partners may have insufficient financial resources and
may not be able to withstand changes in business conditions, including the
recent economic slowdown. Revenues from indirect sales could suffer if our
distributors' financial condition or operations weaken.
We must manage inventory effectively, particularly with respect to sales to
distributors. Distributors may increase orders during periods of product
shortages, cancel orders if their inventory is too high, or delay orders in
anticipation of new products. Distributors also may adjust their orders in
response to the supply of our products and the products of our competitors that
are available to the distributor and to seasonal fluctuations in end-user
demand. If we have excess inventory, we may have to reduce our prices and write
down inventory, which in turn could result in lower gross margins. In addition,
if sales through indirect channels increase, this may lead to greater difficulty
in forecasting the mix of our products, and to a certain degree, the timing of
orders from our customers.
OUR GROSS MARGINS MAY BE NEGATIVELY AFFECTED, WHICH IN TURN COULD NEGATIVELY
AFFECT OUR OPERATING RESULTS.
Our gross margins have been decreasing recently and may be negatively
affected as result of a number of factors, including:
- increased price competition;
- excess capacity;
- higher material or labor costs;
- warranty costs;
- obsolescence charges;
- loss of cost savings on future inventory purchases as a result of high
inventory levels;
- introductions of new products and costs of entering new markets;
- increased levels of customer services;
- changes in distribution channels; and
- changes in product and geographic mix.
CHANGES IN EFFECTIVE TAX RATES OR THE RECORDING OF INCREASED DEFERRED TAX
ASSET VALUATION ALLOWANCES IN THE FUTURE COULD AFFECT OUR OPERATING RESULTS.
Our effective tax rates in the future could be adversely affected by
earnings being lower or losses being higher than anticipated in countries where
we have tax rates that are lower than the U.S. statutory rate and earnings being
higher or losses lower than anticipated in countries where we have tax rates
that are higher than the U.S. statutory tax rate, changes in our net deferred
tax assets valuation allowance, or by changes in tax laws or interpretations
thereof.
For example, during fiscal 2002 our effective tax rate was adversely
effected by an unfavorable geographic distribution of earnings and losses and we
recorded an increase in our net deferred tax assets valuation allowance of
$364 million. If the geographic distribution of our earnings and losses
continues to be unfavorable in the future, our effective tax rate could be
adversely affected. In addition, based on our assessment of our deferred tax
assets, we determined, based on certain available tax planning strategies, that
$532 million of our deferred tax assets will more likely than not be realized in
the future and no valuation allowance is currently required for this portion of
our deferred tax assets. Should we determine in the future that it is no longer
more likely than not that these assets will be realized, we will be required to
record an additional valuation allowance in connection with these deferred tax
assets and our operating results would be adversely affected in the period such
determination is made.
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RISKS RELATED TO OUR OPERATIONS
WE PLAN TO EXPAND OUR INTERNATIONAL SALES, WHICH WILL SUBJECT US TO
ADDITIONAL BUSINESS RISKS THAT MAY ADVERSELY AFFECT OUR OPERATING RESULTS DUE TO
INCREASED COSTS.
We intend to continue to pursue growth opportunities internationally. In
many countries outside the United States, long-standing relationships between
our potential customers and their local providers and protective regulations,
including local content requirements and type approvals, create barriers to
entry. In addition, pursuit of such international growth opportunities may
require us to make significant investments for an extended period before returns
on such investments, if any, are realized. International operations are subject
to a number of risks and potential costs, including:
- expenditure of significant amounts of time and money to build a brand
identity in locations where our new brand is not recognized currently
without certainty that we will be successful;
- unexpected changes in regulatory requirements;
- the need to customize marketing and product capabilities to reach
localized customer requirements;
- inadequate protection of intellectual property in certain countries
outside the U.S;
- adverse tax consequences;
- dependence on developing relationships with qualified local distributors,
dealers, value-added resellers and systems integrators; and
- political and economic instability.
Any of these factors could prevent us from increasing our revenue and
otherwise adversely affect our operating results in international markets. We
may not be able to overcome some of these barriers and may incur significant
costs in addressing others. Sales to our international customers are denominated
in either local currency or U.S. dollars, depending on the country or channel
used to fulfill the customers' order. We manage our net currency exposure
through currency forward contracts and currency options which requires us to
incur additional cost for this protection, although we did recognize a loss on
foreign currency transactions of $12 million for the quarter ended June 30, 2002
due to the decline in the U.S. dollar as compared to several other currencies.
In addition to the foreign currency risk for our receivables, there is
additional risk associated with the fact that most of our products or components
are manufactured or sourced from the United States. Should the U.S. dollar
strengthen against a local currency, the impact may hamper our ability to
compete with other competitors, preventing us from increasing our revenue and
otherwise adversely affect our operating results in international markets.
WE HAVE RESTRUCTURED OUR BUSINESS TO RESPOND TO INDUSTRY AND MARKET
CONDITIONS, HOWEVER, THE ASSUMPTIONS UNDERLYING OUR RESTRUCTURING EFFORTS MAY
PROVE TO BE INACCURATE AND WE MAY HAVE TO RESTRUCTURE OUR BUSINESS AGAIN IN THE
FUTURE.
In response to changes in industry and market conditions, we have
restructured our business in the past, are currently restructuring our business
and may again restructure our business in the future to achieve certain cost
savings and to strategically realign our resources. We have based our
restructuring plans on certain assumptions regarding the cost structure of our
business and the nature, severity and duration of the current slowdown in
enterprise communications technology spending which may not prove to be
accurate. We will continue to assess our cost structure and restructuring
efforts based on an ongoing assessment of industry conditions.
Our restructuring initiatives may not be sufficient to meet the changes in
industry and market conditions, and such conditions may continue to deteriorate
or last longer than we expect. In addition, we may not be able to successfully
implement our restructuring initiatives and may be required to refine, expand or
extend our restructuring initiatives, which may require the recording of
additional
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charges. Furthermore, our workforce reductions may impair our ability to realize
our current or future business objectives. Lastly, costs incurred in connection
with restructuring actions may be higher than the estimated costs of such
actions and/or may not lead to the anticipated cost savings. As a result, our
restructuring efforts may not result in our return to profitability within the
currently expected timeframe.
OUR COLLECTIVE BARGAINING AGREEMENTS EXPIRE DURING FISCAL 2003 AND THE
RENEGOTIATION OF THESE AGREEMENTS MAY ADVERSELY AFFECT OUR OPERATING RESULTS.
Our collective bargaining agreements with the Communications Workers of
America and the International Brotherhood of Electrical Workers and the labor
agreement related to our variable Services workforce each expire on May 31,
2003. If we are unsuccessful in renegotiating new labor agreements, our
operations may be disrupted and our operating results may be adversely affected.
Even if we successfully renegotiate these agreements, the terms of any new
agreements may be less favorable than our current labor agreements, thereby
adversely affecting our operating results.
WE DEPEND ON CONTRACT MANUFACTURERS TO PRODUCE MOST OF OUR PRODUCTS AND IF
THESE MANUFACTURERS ARE UNABLE TO FILL OUR ORDERS ON A TIMELY AND RELIABLE
BASIS, WE WILL LIKELY BE UNABLE TO DELIVER OUR PRODUCTS TO MEET CUSTOMER ORDERS
OR SATISFY THEIR REQUIREMENTS.
We have outsourced substantially all of our manufacturing operations related
to our Converged Systems and Applications and Small and Medium Business
Solutions segments. Our ability to realize the intended benefits of our
manufacturing outsourcing initiative will depend on the willingness and ability
of contract manufacturers to produce our products. We may experience significant
disruption to our operations by outsourcing so much of our manufacturing. If our
contract manufacturers terminate their relationships with us or are unable to
fill our orders on a timely basis, we may be unable to deliver our products to
meet our customers' orders, which could delay or decrease our revenue or
otherwise have an adverse effect on our operations.
THE TERMINATION OF STRATEGIC ALLIANCES OR THE FAILURE TO FORM ADDITIONAL
STRATEGIC ALLIANCES COULD LIMIT OUR ACCESS TO CUSTOMERS AND HARM OUR REPUTATION
WITH CUSTOMERS.
Our strategic alliances are important to our success because they provide us
the ability to offer comprehensive advanced communications solutions, reach a
broader customer base and strengthen brand awareness. We may not be successful
in creating new strategic alliances on acceptable terms or at all. In addition,
most of our current strategic alliances can be terminated under various
circumstances, some of which may be beyond our control. Further, our alliances
are generally non-exclusive, which means our partners may develop alliances with
some of our competitors. We may rely more on strategic alliances in the future,
which would increase the risk to our business of losing these alliances.
IF WE ARE UNABLE TO PROTECT OUR PROPRIETARY RIGHTS, OUR BUSINESS AND FUTURE
PROSPECTS MAY BE HARMED.
Although we attempt to protect our intellectual property through patents,
trademarks, trade secrets, copyrights, confidentiality and nondisclosure
agreements and other measures, intellectual property is difficult to protect and
these measures may not provide adequate protection for our proprietary rights.
Patent filings by third parties, whether made before or after the date of our
filings, could render our intellectual property less valuable. Competitors may
misappropriate our intellectual property, disputes as to ownership of
intellectual property may arise and our intellectual property may otherwise
become known or independently developed by competitors. The failure to protect
our intellectual property could seriously harm our business and future prospects
because we believe that developing new products and technology that are unique
to us is critical to our success. If we do not obtain sufficient international
protection for our intellectual property, our competitiveness in international
markets could be significantly impaired, which would limit our growth and future
revenue.
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WE MAY ACQUIRE OTHER BUSINESSES OR FORM JOINT VENTURES THAT COULD NEGATIVELY
AFFECT OUR OPERATING RESULTS.
The pursuit of additional technology, services or distribution channels
through acquisitions or joint ventures is a component of our business strategy.
We may not identify or complete these transactions in a timely manner, on a cost
effective basis or at all. Even if we do identify and complete these
transactions, we may not be able to successfully integrate such technology,
services or distribution channels into our existing operations and we may not
realize the benefits of any such acquisition or joint venture. We have limited
experience with acquisition activities and may have to devote substantial time
and resources in order to complete acquisitions. There may also be risks of
entering markets in which we have no or limited experience. In addition, by
making acquisitions, we could assume unknown or contingent liabilities.
WE MAY NOT BE ABLE TO HIRE AND RETAIN HIGHLY SKILLED EMPLOYEES, WHICH COULD
AFFECT OUR ABILITY TO COMPETE EFFECTIVELY AND MAY ADVERSELY AFFECT OUR OPERATING
RESULTS.
We depend on highly skilled technical personnel to research and develop,
market and service new products. To succeed, we must hire and retain employees
who are highly skilled in rapidly changing communications technologies In
particular, as we implement our strategy of focusing on advanced communications
solutions and the convergence of voice and data networks, we will need to:
- retain our researchers in order to maintain a group sufficiently large to
support our strategy to continue to introduce innovative products and to
offer comprehensive advanced communications solutions;
- hire more employees with experience developing and providing advanced
communications products and services; and
- retrain our existing sales force to sell converged and advanced
communications products and services and maintain a workforce for our
Services group with the requisite skills to service these products.
Individuals who have these skills and can perform the services we need to
provide our products and services are scarce. Because the competition for
qualified employees in our industry is intense, hiring and retaining employees
with the skills we need is both time-consuming and expensive. We might not be
able to hire enough of them or to retain the employees we currently employ. Our
inability to hire and retain the individuals we need could hinder our ability to
sell our existing products, systems, software or services or to develop and sell
new products, systems, software or services. If we are not able to attract and
retain qualified individuals, we will not be able to successfully implement many
of our strategies and our business will be harmed.
OUR INDUSTRY IS HIGHLY COMPETITIVE AND IF WE CANNOT EFFECTIVELY COMPETE, OUR
REVENUE MAY DECLINE.
The market for our products and services is very competitive and subject to
rapid technological advances. We expect the intensity of competition to continue
to increase in the future as existing competitors enhance and expand their
product and service offerings and as new participants enter the market.
Increased competition also may result in price reductions, reduced gross margins
and loss of market share. Our failure to maintain and enhance our competitive
position would adversely affect our business and prospects.
We compete with a number of equipment manufacturers and software companies
in selling our communications systems and software. Further, our customer
relationship management professional services consultants compete against a
number of professional services firms. Some of our customers and strategic
partners are also competitors of ours. We expect to face increasing competitive
pressures from both existing and future competitors in the markets we serve and
we may not be able to compete successfully against these competitors.
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The sizes of our competitors vary across our market segments, Many of our
competitors have greater financial, personnel, capacity and other resources than
we have in each of our market segments or overall. As a result, our competitors
may be in a stronger position to respond quickly to potential acquisitions and
other market opportunities, new or emerging technologies and changes in client
requirements. Competitors with greater financial resources also may be able to
offer lower prices, additional products or services or other incentives that we
cannot match or do not offer. These competitors may be in a stronger position to
respond quickly to new or emerging technologies and may be able to undertake
more extensive marketing campaigns, adopt more aggressive pricing policies and
make more attractive offers to potential customers, employees and strategic
partners.
RISKS RELATED TO CONTINGENT LIABILITIES
WE MAY INCUR LIABILITIES AS A RESULT OF OUR OBLIGATION TO INDEMNIFY, AND TO
SHARE CERTAIN LIABILITIES WITH, LUCENT TECHNOLOGIES INC. IN CONNECTION WITH OUR
SPIN-OFF FROM LUCENT IN SEPTEMBER 2000.
Pursuant to the contribution and distribution agreement we entered into with
Lucent in connection with our spin-off from Lucent on September 30, 2000, Lucent
contributed to us substantially all of the assets, liabilities and operations
associated with its enterprise networking businesses and distributed all of the
outstanding shares of our common stock to its stockholders. The contribution and
distribution agreement, among other things, provides that, in general, we will
indemnify Lucent for all liabilities including certain pre-distribution tax
obligations of Lucent relating to our businesses and all contingent liabilities
primarily relating to our businesses or otherwise assigned to us. In addition,
the contribution and distribution agreement provides that certain contingent
liabilities not directly identifiable with one of the parties will be shared in
the proportion of 90% by Lucent and 10% by us. 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
and 10% by us and contingent liabilities in excess of $50 million that are
primarily related to our businesses shall be borne equally by the parties.
Please see "Legal Proceedings" for a description of certain matters
involving Lucent for which we have assumed responsibility under the contribution
and distribution agreement and a description of other matters for which we may
be obligated to indemnify or share the cost with Lucent. We cannot assure you we
will not have to make indemnification or other cost sharing payments to Lucent
in connection with these matters or that Lucent will not submit a claim for
indemnification or cost sharing to us in connection with any future matter. In
addition, our ability to assess the impact of matters for which we may have to
indemnify or share the cost with Lucent is made more difficult by the fact that
we do not control the defense of these matters.
WE MAY BE SUBJECT TO LITIGATION AND INFRINGEMENT CLAIMS, WHICH COULD CAUSE
US TO INCUR SIGNIFICANT EXPENSES OR PREVENT US FROM SELLING OUR PRODUCTS OR
SERVICES.
We cannot assure you that others will not claim that our proprietary or
licensed products, systems and software are infringing their intellectual
property rights or that we do not in fact infringe those intellectual property
rights. We may be unaware of intellectual property rights of others that may
cover some of our technology. If someone claimed that our proprietary or
licensed systems and software infringed their intellectual property rights, any
resulting litigation 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. We also may be subject to significant damages
or an injunction against use of our proprietary or licensed systems. A
successful claim of patent or other intellectual property infringement against
us could materially adversely affect our operating results.
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In addition, third parties may claim that a customer's use of our product's,
systems or software infringes the third party's intellectual property rights.
Under certain circumstances, we may be required to indemnify our customers for
some of the costs and damages related to such an infringement claim. Any
indemnification requirement could have a material adverse effect on our business
and our operating results.
Please see "--Legal Proceedings" for a description of patent infringement
indemnification claims made by three customers of our managed services business.
IF THE DISTRIBUTION DOES NOT QUALIFY FOR TAX-FREE TREATMENT, WE COULD BE
REQUIRED TO PAY LUCENT OR THE INTERNAL REVENUE SERVICE A SUBSTANTIAL AMOUNT OF
MONEY.
Lucent has received a private letter ruling from the Internal Revenue
Service stating, based on certain assumptions and representations, that the
distribution would not be taxable to Lucent. Nevertheless, Lucent could incur
significant tax liability if the distribution did not qualify for tax-free
treatment because any of those assumptions or representations were not correct.
Although any U.S. federal income taxes imposed in connection with the
distribution generally would be imposed on Lucent, we could be liable for all or
a portion of any taxes owed for the reasons described below. First, as part of
the distribution, we and Lucent entered into a tax sharing agreement. This
agreement generally allocates between Lucent and us the taxes and liabilities
relating to the failure of the distribution to be tax-free. Under the tax
sharing agreement, if the distribution fails to qualify as a tax-free
distribution to Lucent under Section 355 of the Internal Revenue Code because of
an issuance or an acquisition of our stock or an acquisition of our assets, or
some other actions of ours, then we will be solely liable for any resulting
taxes to Lucent.
Second, aside from the tax sharing agreement, under U.S. federal income tax
laws, we and Lucent are jointly and severally liable for Lucent's U.S. federal
income taxes resulting from the distribution being taxable. This means that even
if we do not have to indemnify Lucent under the tax sharing agreement, we may
still be liable to the Internal Revenue Service for all or part of these taxes
if Lucent fails to pay them. These liabilities of Lucent could arise from
actions taken by Lucent over which we have no control, including an issuance or
acquisition of stock (or acquisition of assets) of Lucent.
ITEM 2. PROPERTIES.
As of September 30, 2002, we operated three manufacturing facilities and one
warehouse location in the United States and three other countries. We also have
557 offices located in 52 countries and twelve research and development
facilities located in Australia, India, Israel, France, Singapore, the United
Kingdom and the United States. Our principal manufacturing facilities are
located in Australia, Ireland and the United States. We also have a 25.5%
interest in a joint venture located in Gandhinagar, India and a 60% interest in
a joint venture in China. Both of these joint ventures are predominantly used as
manufacturing sites and are mostly on owned property. Our facilities have
aggregate floor space of approximately 11.5 million square feet, of which
approximately 4.5 million square feet is owned and approximately 7.0 million
square feet is leased. Our lease terms range from monthly leases to 17 years. We
believe that all of our facilities and equipment are in good condition and are
well maintained and able to operate at present levels.
ITEM 3. 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 against us that could have, individually or in the
aggregate, a material adverse effect on our financial position, results of
operations or cash flows.
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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 recently been certified in the West Virginia state court matter.
The certified class in the West Virginia action includes those persons or
entities that purchased, leased or financed the products in question. In
addition, the court also certified as a subclass all class members who had
service protection plans or other service or extended warranty contracts with
Lucent in effect as of April 1, 1998, as to which Lucent failed to offer a Year
2000-compliant solution. The federal court in the New York action has issued a
decision and order denying class certification, dismissing all but certain fraud
claims by one representative plaintiff. No class claims remain in the case at
this time. The federal court in the California action has issued an opinion and
order granting class certification on a provisional basis, pending submission by
plaintiffs of certain proof requirements mandated by the Y2K Act. The class
includes any entities that purchased or leased certain products on or after
January 1, 1990, excluding those entities who did not have a New Jersey choice
of law provision in their contracts and those who did not purchase equipment
directly from the defendants. The complaints seek, among other remedies,
compensatory damages, punitive damages and counsel fees in amounts that have not
yet been specified. At this time, we cannot determine whether that the outcome
of these actions will have a material adverse effect on our financial position,
results of operations or cash flows. In addition, if these cases are not
resolved in a timely manner, they will require expenditure of significant legal
costs related to their defense.
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's motion to dismiss the Fifth Consolidated Amended and
Supplemental Class Action Complaint in the consolidated action was denied by the
court in June 2002. As a result of the denial of its motion to dismiss, we
understand that Lucent has filed a motion for partial summary judgment, seeking
a dismissal of a portion of the Fifth Consolidated Amended and Supplemental
Class Action Complaint. 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
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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.
We understand that the federal district court in New Jersey has issued
orders staying all securities actions, as well as those related to the
securities cases, so the parties may discuss a potential global settlement of
claims. We also understand that the parties have had preliminary meetings to
discuss settlement of these cases.
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 still in the
relatively 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 ARBITRATION
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. This matter is currently in arbitration. 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 held on February 26, 2002. At the annual
meeting, we obtained 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 the proposed method of valuing the fractional interests, and further,
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. In June 2002, the court denied the
plaintiff's motion for summary judgment and granted our cross-motion for summary
judgment. The plaintiff has appealed the Chancery Court's decision to the
Delaware Supreme Court and, in November 2002, the Delaware Supreme Court
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affirmed the lower court's ruling in our favor. Subsequently, the plaintiff
filed a motion for re-hearing by the Delaware Supreme Court, arguing that the
court misapplied the law concerning fractional "shares" versus fractional
"interests" to the facts of the case. We have filed our response to the
plaintiff's motion with the Delaware Supreme Court and await its ruling. We
cannot provide assurance that this lawsuit will not impair our ability to
implement any of the transactions.
In April 2002, a complaint was filed against us in the Superior Court of New
Jersey, Somerset County, in connection with the reverse/forward stock splits
described above. 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, injunctive relief enjoining us from effecting the
transactions. In recognition of the then pending action in the Delaware Court of
Chancery, the plaintiff voluntarily dismissed his complaint without prejudice,
pending the outcome of the Delaware action.
COMMISSION ARBITRATION DEMAND
In July 2002, a third party representative made formal demand for
arbitration for alleged unpaid commissions in an amount in excess of
$10 million, stemming from the sale of products from our businesses that were
formerly owned by Lucent involving the Ministry of Russian Railways. As the
sales of products continue, the third party representative may likely increase
its commission demand. The viability of this asserted claim is based on the
applicability and interpretation of a representation agreement and an amendment
thereto, which provides for binding arbitration. This matter is currently
proceeding to arbitration. The matter is in the early stages and an outcome in
the arbitration proceeding cannot be predicted. 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.
LUCENT CONSUMER PRODUCTS CLASS ACTIONS
In several class action cases (the first of which was filed on June 24,
1996), plaintiffs claim that AT&T and Lucent engaged in fraud and deceit in
continuing to lease residential telephones to consumers without adequate notice
that the consumers would pay well in excess of the purchase price of a telephone
by continuing to lease. The cases were removed and consolidated in federal court
in Alabama, and were subsequently remanded to their respective state courts
(Illinois, Alabama, New Jersey, New York and California). In July 2001, the
Illinois state court certified a nationwide class of plaintiffs. The case in
Illinois was scheduled for trial on August 5, 2002. Prior to commencement of
trial, however, we had been advised that the parties agreed to a settlement of
the claims on a class-wide basis. The settlement was approved by the court on
November 4, 2002. Claims from class members must be filed on or about
January 15, 2003.
Any liability incurred by Lucent in connection with these class action cases
will be considered an exclusive Lucent liability under the Contribution and
Distribution Agreement between Lucent and us and, as a result, we are
responsible for 10% of any such liability in excess of $50 million. The amount
for which we may be responsible will not be finally determined until the class
claims period expires.
PATENT INFRINGEMENT INDEMNIFICATION CLAIMS
A patent owner has sued three customers of our managed services business for
alleged infringement of a single patent based on the customers' voicemail
service. These customers' voicemail service offerings are partially or wholly
provided by our managed services business. As a consequence, these customers are
requesting defense and indemnification from us in the lawsuits under their
managed services contracts. This matter is in the early stages and we cannot yet
determine whether the outcome of this matter will have a material adverse effect
on its financial position, results of operations and cash flows.
30
<Page>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS.
During the fourth quarter of the fiscal year covered by this Annual Report
on Form 10-K, no matter was submitted to a vote of security-holders.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Information required by this item is incorporated by reference from Note 19
to the Consolidated Financial Statements on page 74 of our 2002 Annual Report.
ITEM 6. SELECTED FINANCIAL DATA.
Information required by this item is incorporated by reference from SELECTED
FINANCIAL DATA on page 17 of our 2002 Annual Report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Information required by this item is incorporated by reference from
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS on pages 18 through 41 of our 2002 Annual Report.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Information required by this item is incorporated by reference from the
discussion under the heading "FINANCIAL INSTRUMENTS" in MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS on pages 37
through 39 of our 2002 Annual Report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Information required by this item is incorporated by reference from the
REPORT OF INDEPENDENT ACCOUNTANTS on page 42 of our 2002 Annual Report and from
our consolidated financial statements and related notes on pages 43 through 75
of our 2002 Annual Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth information as to persons who serve as our
executive officers.
<Table>
<Caption>
NAME AGE POSITION
- ---- -------- ------------------------------------------
<S> <C> <C>
Donald K. Peterson........................ 53 Chairman and Chief Executive Officer
Stephan Clark............................. 49 Group Vice President, Connectivity
Solutions
Pamela F. Craven.......................... 49 Senior Vice President, General Counsel and
Secretary
Louis J. D'Ambrosio....................... 38 Group Vice President, Worldwide Services
Michael A. Dennis......................... 44 Senior Vice President, Services Strategy
and Business Development
Maryanne DiMarzo.......................... 51 Senior Vice President, Human Resources
David P. Johnson.......................... 42 Group Vice President, Small and Medium
Business Solutions
Garry K. McGuire, Sr...................... 56 Chief Financial Officer and Senior Vice
President, Operations
</Table>
31
<Page>
<Table>
<Caption>
NAME AGE POSITION
- ---- -------- ------------------------------------------
<S> <C> <C>
Michael Thurk............................. 50 Group Vice President, Converged Systems
and Applications
</Table>
Information about our Directors, including Mr. Peterson, is incorporated by
reference from the discussion under Proposal 1 set forth in our Proxy Statement
for the 2003 Annual Meeting of Shareholders.
STEPHAN CLARK has been our Group Vice President, Connectivity Solutions
since August 1, 2002. From September 30, 2000 until July 31, 2002, Mr. Clark was
our Vice President, Connectivity Solutions. From January 2000 until
September 30, 2000, he was responsible for global management of Lucent
Technologies Inc.'s ("Lucent") Connectivity Solutions business. From 1994 to
1999, Mr. Clark served as Sales and Marketing Vice President for Lucent's Power
Systems business.
PAMELA F. CRAVEN has been our Senior Vice President, General Counsel and
Secretary since August 1, 2002. From September 30, 2000 until July 31, 2002,
Mrs. Craven was our Vice President, General Counsel and Secretary. Mrs. Craven
was a director of Avaya from its inception until September 30, 2000 and was Vice
President, General Counsel and Secretary of Lucent Technologies Inc.'s
("Lucent") Enterprise Networks Group from March 2000 until September 30, 2000.
Mrs. Craven served as Vice President, Law for Lucent from November 1995 to
April 2000 and was also Secretary of Lucent from February 1, 1999 until
April 2000.
LOUIS J. D'AMBROSIO has been our Group Vice President, Worldwide Services,
since December 19, 2002. Prior to December 19, 2002, Mr. D'Ambrosio served in a
number of executive positions with International Business Machines Corporation,
including most recently as Vice President of Worldwide, Sales and Global
Operations-Software Business. Mr. D'Ambrosio joined IBM in 1985.
MICHAEL A. DENNIS has been our Senior Vice President, Services Strategy and
Business Development since December 19, 2002. From August 1, 2002 through
December 18, 2002, Mr. Dennis was our Group Vice President, Worldwide Services.
Mr. Dennis was our Vice President of Worldwide Operations and Services from
September 30, 2000 until July 31, 2002. Mr. Dennis was Vice President of U.S.
Services for Lucent Technologies Inc.'s ("Lucent") Enterprise Networks Group
from April 2000 until September 30, 2000. He joined AT&T Corp. in July 1981 and
moved to Lucent following its spin-off in 1996. Mr. Dennis has held various
positions at Lucent including Sales Vice President and Field Services Vice
President.
MARYANNE DIMARZO has been our Senior Vice President, Human Resources since
August 1, 2002. Ms. DiMarzo was our Vice President, Human Resources from
September 30, 2000 until June 30, 2002. Ms. DiMarzo was Vice President, Human
Resources, for Lucent Technologies Inc.'s ("Lucent") Enterprise Networks Group
from April 2000 until September 30, 2000. From 1997 until March 200,
Ms. DiMarzo was Human Resources Vice Presidentof the Corporate Centers at
Lucent.
DAVID P. JOHNSON has been our Group Vice President, Small and Medium
Business Solutions since August 1, 2002. Mr. Johnson was our Vice President of
Worldwide Sales from September 30, 2000 until July 31, 2002. Mr. Johnson was
Vice President of Worldwide Sales for Lucent Technologies Inc.'s ("Lucent")
Enterprise Networks Group from April 2000 until September 30, 2000. He joined
AT&T Corp. in 1982 and moved to Lucent following its spin-off in 1996.
Mr. Johnson has held various positions at Lucent, including International
President of Enterprise Networks and Regional President of Asia/Pacific Region.
GARRY K. MCGUIRE, SR. has been our Chief Financial Officer since
September 30, 2000 and our Senior Vice President, Operations, since January 1,
2002. Mr. McGuire was Chief Financial Officer for Lucent Technologies Inc.'s
("Lucent") Enterprise Networks Group from May 2000 until September 30, 2000.
Mr. McGuire was a consultant to Kleiner, Perkins, Caufield and Byers/Broadband
Office from August 1999 to December 1999. He was President and Chief Executive
Officer of Williams
32
<Page>
Communications Solutions, LLC, from April 1997 to July 1999, and was President
of Nortel Communications Systems, LLC ("Nortel"), from September 1995 until
April 1997.
MICHAEL THURK has been our Group Vice President, Converged Systems and
Applications since August 1, 2002. Mr. Thurk was our GroupVice President,
Systems, from January 2002 until July 31, 2002. From June 1998 until
December 2001, Mr. Thurk held various positions at Ericsson Datacom Inc.,
including President and Executive Vice President, Division Data Backbone and
Optical Networks. Mr. Thurk was President of Xyplex Networks from June 1996
until June 1998.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this item is incorporated by reference from the
discussion under the heading EXECUTIVE COMPENSATION AND OTHER INFORMATION in our
Proxy Statement for the 2003 Annual Meeting of Shareholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information required by this item is incorporated by reference from the
discussion under the heading SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT and under the heading EXECUTIVE COMPENSATION AND OTHER INFORMATION-
EQUITY COMPENSATION PLAN INFORMATION AS OF SEPTEMBER 30, 2002 in our Proxy
Statement for the 2003 Annual Meeting of Shareholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information required by this item is incorporated by reference from the
discussion under the heading CORPORATE GOVERNANCE AND RELATED MATTERS, CERTAIN
RELATIONSHIPS AND RELATED PARTY TRANSACTIONS in our Proxy Statement for the 2003
Annual Meeting of Shareholders.
ITEM 14. CONTROLS AND PROCEDURES.
We have established disclosure controls and procedures to ensure that
material information relating to the Company, including its consolidated
subsidiaries, is made known to the officers who certify the Company's financial
reports and to other members of senior management and the Board of Directors.
Based on their evaluation as of a date within 90 days of the filing date of
this Annual Report on Form 10-K, the principal executive officer and principal
financial officer of Avaya Inc. have concluded that Avaya Inc.'s disclosure
controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the
Securities Exchange Act of 1934) are effective to ensure that the information
required to be disclosed by Avaya Inc. in reports that it files or submits under
the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in SEC rules and forms.
There were no significant changes in Avaya Inc.'s internal controls or in
other factors that could significantly affect those controls subsequent to the
date of their most recent evaluation.
33
<Page>
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Documents filed as a part of this Annual Report on Form 10-K:
(1) Financial Statements:
<Table>
<Caption>
PAGE(S) IN OUR 2002
ANNUAL REPORT
TO SHAREHOLDERS
-------------------
<S> <C> <C>
(i) Consolidated Statements of Operations....................... 43
(ii) Consolidated Balance Sheets................................. 44
(iii) Consolidated Statements of Changes in Stockholders' Equity
and of Comprehensive Income (Loss).......................... 45
(iv) Consolidated Statements of Cash Flows....................... 46
(v) Notes to Consolidated Financial Statements.................. 47-75
</Table>
(2) Financial Statement Schedules:
<Table>
<S> <C> <C>
(i) Schedule II--Valuation and Qualifying Accounts.............. Page 38 of
this Annual
Report on
Form 10-K
</Table>
34
<Page>
REPORT OF INDEPENDENT ACCOUNTANTS ON
FINANCIAL STATEMENT SCHEDULE
To the Board of Directors of Avaya Inc.:
Our audits of the consolidated financial statements referred to in our
report dated November 27, 2002 appearing in the 2002 Annual Report to
Shareholders of Avaya Inc. (which report and consolidated financial statements
are incorporated by reference in this Annual Report on Form 10-K) also included
an audit of the financial statement schedule listed in Item 15(a)(2) of this
Form 10-K. In our opinion, this financial statement schedule presents fairly, in
all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.
/s/ PRICEWATERHOUSECOOPERS LLP
PricewaterhouseCoopers LLP
New York, New York
November 27, 2002
Separate financial statements of subsidiaries not consolidated and
50 percent or less owned persons are omitted since no such entity constitutes a
"significant subsidiary" pursuant to the provisions of Regulation S-X,
Article 3-09.
(3) Exhibits:
The following documents are filed as Exhibits to this Annual Report on
Form 10-K or incorporated by reference herein:
<Table>
<Caption>
EXHIBIT
NUMBER
- ---------------------
<C> <S>
2 Contribution and Distribution Agreement+
3.1 Restated Certificate of Incorporation of Avaya Inc.+
3.2 Amended and Restated By-laws of Avaya Inc., as amended on
July 18, 2002(4)
4.1 Specimen Common Stock certificate+
4.2 Restated Certificate of Incorporation of Avaya Inc.
(incorporated by reference as Exhibit 3.1 hereto)+
4.3 Amended and Restated By-laws of Avaya Inc. (filed as Exhibit
3.2 hereto)(4)
4.4 Rights Agreement between Avaya Inc. and The Bank of New
York, as Rights Agent+
4.5 Amendment No. 1 to Rights Agreement between Avaya Inc. and
the Bank of New York as Rights Agent (5)
4.6 Form of Certificate of Designations of Series A Junior
Participating Preferred Stock (attached as Exhibit A to the
Rights Agreement filed as Exhibit 4.4 hereto)+
4.7 Form of Right Certificate (attached as Exhibit B to the
Rights Agreement incorporated by reference as Exhibit 4.4
hereto)+
4.8 Preferred Stock Certificate(1)
4.9 Series A Warrant(1)
4.10 Series B Warrant(1)
4.11 Form of Indenture between Avaya Inc. and The Bank of New
York, as Trustee(1)
</Table>
35
<Page>
<Table>
<Caption>
EXHIBIT
NUMBER
- ---------------------
<C> <S>
4.12 Form of Supplemental Indenture between the Company and The
Bank of New York, as Trustee, relating to the Liquid Yield
Options Notes due 2021 (Zero Coupon-Senior)(3)
4.13 Series C Warrant(13)
10.22 Second Supplemental Indenture, dated as of March 28, 2002,
between the Company and The Bank of New York, as Trustee(6)
10.23 Form of Global Note(6)
10.1 Contribution and Distribution Agreement (incorporated by
reference as Exhibit 2 hereto)+
10.2 Interim Services and Systems Replication Agreement+
10.3 Employee Benefits Agreement+
10.4 Tax Sharing Agreement+
10.5 Avaya Inc. Short Term Incentive Plan+
10.6 Avaya Inc. 2000 Long Term Incentive Plan+
10.7 Avaya Inc. 2000 Long Term Incentive Plan Restricted Stock
Unit Award Agreement+
10.8 Avaya Inc. 2000 Long Term Incentive Plan Nonstatutory Stock
Option Agreement+
10.9 Avaya Inc. Deferred Compensation Plan+
10.10 Employment Agreement of Mr. Peterson, dated August 8, 1995+
10.11 Avaya Inc. Supplemental Pension Plan+
10.12 Avaya Inc. 2000 Stock Compensation Plan for Non-Employee
Directors+
10.13 Trademark License Agreement+
10.14 Patent and Technology License Agreement+
10.15 Technology Assignment and Joint Ownership Agreement+
10.16 Development Project Agreement+
10.17 Preferred Stock and Warrant Purchase Agreement+
10.18 Certificate of Designations, Preferences and Rights of
Series B Convertible Participating Preferred Stock of Avaya
Inc. (attached as Exhibit A to the Preferred Stock and
Warrant Purchase Agreement incorporated by reference as
Exhibit 10.17 hereto)+
10.20 364-Day Competitive Advance and Revolving credit facility
Agreement, dated as of August 28, 2001 among Avaya Inc.,
Citibank, N.A., as Agent, Salomon Smith Barney, as Lead
Arranger, The Chase Manhattan Bank and Deutsche Bank AG New
York Branch and Credit Suisse First Boston, as
Co-Syndication Agents, and the Lenders party thereto(7)
10.24 Five Year Competitive Advance and Revolving credit facility
Agreement, dated as of September 25, 2000 among Lucent
Technologies Inc., Avaya Inc., Citibank, N.A., as Agent,
Salomon Smith Barney, as Lead Arranger, Bank One, NA, The
Chase Manhattan Bank and Deutsche Bank AG New York and/or
Cayman Islands Branches, as Co-Syndication Agents and
Co-Arrangers, Commerzbank AG, as Co-Arranger and the Lenders
party thereto(8)
10.25 Letter Amendment No. 1, dated as of August 10, 2001, to the
Five Year Credit Agreement by and among Avaya Inc.,
Citibank, N.A., As Agent and the Lenders party thereto(2)
</Table>
36
<Page>
<Table>
<Caption>
EXHIBIT
NUMBER
- ---------------------
<C> <S>
10.26 Severance Agreement, dated as of September 1, 2001, between
the Company and Donald K. Peterson(9)
10.27 Stock Purchase Agreement by and among the Company and the
Warburg Entities, dated as of March 10, 2002(10)
10.28 Conversion Agreement by and among the Company and the
Warburg Entities, dated as of March 10, 2002(10)
10.29 Security Agreement, dated as of March 25, 2002, among the
Company, certain subsidiaries of the Company and The Bank of
New York, as Collateral Trustee.(6)
10.30 Collateral Agreement, dated as of March 25, 2002, among the
Company, certain subsidiaries of the Company and The Bank of
New York, as Collateral Trustee.(6)
10.31 Avaya Involuntary Separation Plan for Senior Officers(11)
10.32 Amended and Restated Five Year Competitive Advance and
Revolving Credit Facility Agreement, dated as of
September 3, 2002 among Avaya Inc., the lenders party to the
Credit Agreement and Citibank, N.A., as Agent for such
lenders(12)
10.33 Backstop Agreement, by and among the Company and the Warburg
Entities, dated as of December 28, 2002(13)
13 The 2001 Annual Report to Shareholders, which, except for
those portions incorporated by reference, is furnished
solely for the information of the Commission and is not
deemed "filed."*
21 List of Subsidiaries of Avaya Inc.*
23 Consent of PricewaterhouseCoopers LLP*
24 Power of Attorney*
99.1 Certification of Donald K. Peterson pursuant to Section 906
of the Sarbanes-Oxley Act of 2002*
99.2 Certification of Garry K. McGuire Sr. pursuant to Section
906 of the Sarbanes-Oxley Act of 2002*
</Table>
- ------------------------
+ Incorporated by reference from Avaya's Registration Statement on Form 10
(Reg. No. 1-15951), declared effective by the Securities and Exchange
Commission on September 15, 2000.
* Filed herewith
(1) Incorporated by reference from Avaya's Registration Statement on Form S-3
(Reg. No. 333-57962), declared effective by the Commission on May 24, 2001.
(2) Incorporated by reference from Avaya's Quarterly Report on Form 10-Q for the
quarter ended June 30, 2001.
(3) Incorporated by reference from Avaya's Registration Statement on Form 8-A
dated October 30, 2001.
(4) Incorporated by reference from Avaya's Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002.
(5) Incorporated by reference from Avaya's Current Report on Form 8-K dated
February 27, 2002.
37
<Page>
(6) Incorporated by reference from Avaya's Current Report on Form 8-K dated
March 28, 2002.
(7) Incorporated by reference from Avaya's Annual Report on Form 10-K for the
year ended September 30, 2001.
(8) Incorporated by reference from Avaya's Annual Report on Form 10-K for the
year ended September 30, 2000.
(9) Incorporated by referemce from Avaya's Quarterly Report on Form 10-Q for the
quarter ended December 31, 2001.
(10) Incorporated by reference from Avaya's Current Report on Form 8-K dated
March 11, 2002.
(11) Incorporated by referemce from Avaya's Quarterly Report on Form 10-Q for
the quarter ended June 30, 2002.
(12) Incorporated by reference from Avaya's Quarterly Report on Form 8-K dated
September 4, 2002.
(13) Incorporated by reference from Avaya's Registration Statement on Form S-4
filed on December 23, 2002.
(b) Reports on Form 8-K during the last quarter of the fiscal year covered by
this Report:
1. August 12, 2002--Item 9. Regulation FD Disclosure--Avaya furnished
information regarding adjustments to its previously announced
financial results for the fiscal quarter ended June 30, 2002.
2. August 14, 2002--Item 9. Regulation FD Disclosure--Avaya furnished
copies of the sworn statements of its principal executive officer and
principal financial officer pursuant to SEC Order No. 4-460.
3. September 3, 2002--Item 5. Other Events--Avaya disclosed amendments
to its five-year credit facility.
38
<Page>
AVAYA INC. AND SUBSIDIARIES
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(DOLLARS IN MILLIONS)
<Table>
<Caption>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E
- -------- ------------ ---------- -------- ----------
ADDITIONS
BALANCE AT CHARGED CHARGED
BEGINNING OF TO COSTS & TO OTHER BALANCE AT
PERIOD EXPENSES ACCOUNTS DEDUCTIONS END OF PERIOD
------------ ---------- -------- ---------- -------------
<S> <C> <C> <C> <C> <C>
YEAR 2002
Allowance for doubtful accounts....... $68 $ 53 -- $94 $ 27
Deferred tax asset valuation
allowance........................... 49 364 202 3 612
YEAR 2001
Allowance for doubtful accounts....... $62 $ 53 $ -- $47 $ 68
Deferred tax asset valuation
allowance........................... 49 -- -- -- 49
YEAR 2000
Allowance for doubtful accounts....... 58 36 -- 32 62
Deferred tax asset valuation
allowance........................... 73 -- -- 24 49
</Table>
39
<Page>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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>
<S> <C> <C>
AVAYA INC.
By: /s/ GARRY K MCGUIRE SR
--------------------------------------------
Garry K. McGuire
CHIEF FINANCIAL OFFICER AND SENIOR VICE
PRESIDENT, OPERATIONS
</Table>
December 23, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons in the capacities and on
the date indicated.
<Table>
<Caption>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
Principal Executive Officer:
/s/ DONALD K. PETERSON
- ------------------------------------ Chairman and Chief Executive December 23, 2002
Donald K. Peterson Officer
Principal Financial Officer:
/s/ GARRY K. MCGUIRE Chief Financial Officer and
- ------------------------------------ Senior Vice President, December 23, 2002
Garry K. McGuire Sr. Operations
Principal Accounting Officer:
/s/ CHARLES D. PEIFFER
- ------------------------------------ Vice President and Controller December 23, 2002
Charles D. Peiffer
Directors:
/s/ GARRY K. MCGUIRE SR.,
ATTORNEY-IN-FACT
- ------------------------------------ Director December 23, 2002
Mark Leslie
/s/ GARRY K. MCGUIRE SR.,
ATTORNEY-IN-FACT
- ------------------------------------ Director December 23, 2002
Philip Odeen
/s/ GARRY K. MCGUIRE SR.,
ATTORNEY-IN-FACT
- ------------------------------------ Director December 23, 2002
Daniel C. Stanzione
</Table>
40
<Page>
<Table>
<Caption>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ GARRY K. MCGUIRE SR.,
ATTORNEY-IN-FACT
- ------------------------------------ Director December 23, 2002
Paula Stern
/s/ GARRY K. MCGUIRE SR.,
ATTORNEY-IN-FACT
- ------------------------------------ Director December 23, 2002
Ronald Zarrella
</Table>
41
<Page>
CERTIFICATION
I, Donald K. Peterson, certify that:
1. I have reviewed this annual report on Form 10-K of Avaya Inc.
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
annual report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: December 23, 2002
42
<Page>
CERTIFICATION
I, Garry K. McGuire Sr., certify that:
1. I have reviewed this annual report on Form 10-K of Avaya Inc;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
annual report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: December 23, 2002
43
<Page>
EXHIBIT INDEX
<Table>
<Caption>
EXHIBIT PAGE
NUMBER NUMBER
------- ------
<C> <S> <C>
2 Contribution and Distribution Agreement+
3.1 Restated Certificate of Incorporation of Avaya Inc.+
3.2 Amended and Restated By-laws of Avaya Inc., as amended on
July 18, 2002(4)
4.1 Specimen Common Stock certificate+
4.2 Restated Certificate of Incorporation of Avaya Inc.
(incorporated by reference as Exhibit 3.1 hereto)+
4.3 Amended and Restated By-laws of Avaya Inc. (filed as Exhibit
3.2 hereto)(4)
4.4 Rights Agreement between Avaya Inc. and The Bank of New
York, as Rights Agent+
4.5 Amendment No. 1 to Rights Agreement between Avaya Inc. and
the Bank of New York as Rights Agent(5)
4.6 Form of Certificate of Designations of Series A Junior
Participating Preferred Stock (attached as Exhibit A to the
Rights Agreement filed as Exhibit 4.4 hereto)+
4.7 Form of Right Certificate (attached as Exhibit B to the
Rights Agreement incorporated by reference as Exhibit 4.4
hereto)+
4.8 Preferred Stock Certificate(1)
4.9 Series A Warrant(1)
4.10 Series B Warrant(1)
4.11 Form of Indenture between Avaya Inc. and The Bank of New
York, as Trustee(1)
4.12 Form of Supplemental Indenture between the Company and The
Bank of New York, as Trustee, relating to the Liquid Yield
Options Notes due 2021 (Zero Coupon-Senior)(3)
4.13 Series C Warrant (13)
10.22 Second Supplemental Indenture, dated as of March 28, 2002,
between the Company and The Bank of New York, as Trustee(6)
10.23 Form of Global Note(6)
10.1 Contribution and Distribution Agreement (incorporated by
reference as Exhibit 2 hereto)+
10.2 Interim Services and Systems Replication Agreement+
10.3 Employee Benefits Agreement+
10.4 Tax Sharing Agreement+
10.5 Avaya Inc. Short Term Incentive Plan+
10.6 Avaya Inc. 2000 Long Term Incentive Plan+
10.7 Avaya Inc. 2000 Long Term Incentive Plan Restricted Stock
Unit Award Agreement+
10.8 Avaya Inc. 2000 Long Term Incentive Plan Nonstatutory Stock
Option Agreement+
10.9 Avaya Inc. Deferred Compensation Plan+
10.10 Employment Agreement of Mr. Peterson, dated August 8, 1995+
10.11 Avaya Inc. Supplemental Pension Plan+
10.12 Avaya Inc. 2000 Stock Compensation Plan for Non-Employee
Directors+
10.13 Trademark License Agreement+
</Table>
44
<Page>
<Table>
<Caption>
EXHIBIT PAGE
NUMBER NUMBER
------- ------
<C> <S> <C>
10.14 Patent and Technology License Agreement+
10.15 Technology Assignment and Joint Ownership Agreement+
10.16 Development Project Agreement+
10.17 Preferred Stock and Warrant Purchase Agreement+
10.18 Certificate of Designations, Preferences and Rights of
Series B Convertible Participating Preferred Stock of Avaya
Inc. (attached as Exhibit A to the Preferred Stock and
Warrant Purchase Agreement incorporated by reference as
Exhibit 10.17 hereto)+
10.20 364-Day Competitive Advance and Revolving credit facility
Agreement, dated as of August 28, 2001 among Avaya Inc.,
Citibank, N.A., as Agent, Salomon Smith Barney, as Lead
Arranger, The Chase Manhattan Bank and Deutsche Bank AG New
York Branch and Credit Suisse First Boston, as
Co-Syndication Agents, and the Lenders party thereto(7)
10.24 Five Year Competitive Advance and Revolving credit facility
Agreement, dated as of September 25, 2000 among Lucent
Technologies Inc., Avaya Inc., Citibank, N.A., as Agent,
Salomon Smith Barney, as Lead Arranger, Bank One, NA, The
Chase Manhattan Bank and Deutsche Bank AG New York and/or
Cayman Islands Branches, as Co-Syndication Agents and
Co-Arrangers, Commerzbank AG, as Co-Arranger and the Lenders
party thereto(8)
10.25 Letter Amendment No. 1, dated as of August 10, 2001, to the
Five Year Credit Agreement by and among Avaya Inc.,
Citibank, N.A., As Agent and the Lenders party thereto(2)
10.26 Severance Agreement, dated as of September 1, 2001, between
the Company and Donald K. Peterson(9)
10.27 Stock Purchase Agreement by and among the Company and the
Warburg Entities, dated as of March 10, 2002(10)
10.28 Conversion Agreement by and among the Company and the
Warburg Entities, dated as of March 10, 2002(10)
10.29 Security Agreement, dated as of March 25, 2002, among the
Company, certain subsidiaries of the Company and The Bank of
New York, as Collateral Trustee.(6)
10.30 Collateral Agreement, dated as of March 25, 2002, among the
Company, certain subsidiaries of the Company and The Bank of
New York, as Collateral Trustee.(6)
10.31 Avaya Involuntary Separation Plan for Senior Officers(11)
10.32 Amended and Restated Five Year Competitive Advance and
Revolving Credit Facility Agreement, dated as of September
3, 2002 among Avaya Inc., the lenders party to the Credit
Agreement and Citibank, N.A., as Agent for such lenders(12)
10.33 Backstop Agreement, by and among the Company and the Warburg
Entities, dated as of December 28, 2002(13)
13 The 2001 Annual Report to Shareholders, which, except for
those portions incorporated by reference, is furnished
solely for the information of the Commission and is not
deemed "filed."*
21 List of Subsidiaries of Avaya Inc.*
23 Consent of PricewaterhouseCoopers LLP*
24 Power of Attorney*
</Table>
45
<Page>
<Table>
<Caption>
EXHIBIT PAGE
NUMBER NUMBER
------- ------
<C> <S> <C>
99.1 Certification of Donald K. Peterson pursuant to Section 906
of the Sarbanes-Oxley Act of 2002*
99.2 Certification of Garry K. McGuire Sr. pursuant to Section
906 of the Sarbanes-Oxley Act of 2002*
</Table>
- ------------------------
<Table>
<S> <C> <C>
+ Incorporated by reference from Avaya's Registration
Statement on Form 10 (Reg. No. 1-15951), declared effective
by the Securities and Exchange Commission on September 15,
2000.
* Filed herewith
(1) Incorporated by reference from Avaya's Registration
Statement on Form S-3 (Reg. No. 333-57962), declared
effective by the Commission on May 24, 2001.
(2) Incorporated by reference from Avaya's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2001.
(3) Incorporated by reference from Avaya's Registration
Statement on Form 8-A dated October 30, 2001.
(4) Incorporated by reference from Avaya's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2002.
(5) Incorporated by reference from Avaya's Current Report on
Form 8-K dated February 27, 2002.
(6) Incorporated by reference from Avaya's Current Report on
Form 8-K dated March 28, 2002.
(7) Incorporated by reference from Avaya's Annual Report on Form
10-K for the year ended September 30, 2001.
(8) Incorporated by reference from Avaya's Annual Report on Form
10-K for the year ended September 30, 2000.
(9) Incorporated by referemce from Avaya's Quarterly Report on
Form 10-Q for the quarter ended December 31, 2001.
(10) Incorporated by reference from Avaya's Current Report on
Form 8-K dated March 11, 2002.
(11) Incorporated by referemce from Avaya's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2002.
(12) Incorporated by reference from Avaya's Quarterly Report on
Form 8-K dated September 4, 2002.
(13) Incorporated by reference from Avaya's Registration
Statement on Form S-4 filed on December 23, 2002.
</Table>
46
</TEXT>
</DOCUMENT>
<DOCUMENT>
<TYPE>EX-13
<SEQUENCE>3
<FILENAME>a2096723zex-13.txt
<DESCRIPTION>EXHIBIT 13
<TEXT>
<Page>
EXHIBIT 13
FINANCIAL REVIEW
Avaya Inc. and Subsidiaries
TABLE OF CONTENTS Selected Financial Data 17 Management's Discussion and
Analysis of Financial Condition and Results of Operations 18 Report of
Independent Accountants 42 Consolidated Statements of Operations 43 Consolidated
Balance Sheets 44 Consolidated Statements of Changes in Stockholders' Equity and
of Comprehensive Loss 45 Consolidated Statements of Cash Flows 46 Notes to
Consolidated Financial Statements 47
SELECTED FINANCIAL DATA
The following table sets forth selected financial information derived from our
audited consolidated financial statements as of and for the fiscal years ended
September 30, 2002, 2001, 2000, 1999 and 1998. On September 30, 2000, we were
spun off from Lucent Technologies Inc. ("Lucent"). The consolidated financial
statements as of and for each of the fiscal years ended prior to September 30,
2001 include allocations of certain Lucent corporate headquarters' assets,
liabilities, and expenses relating to the businesses that were transferred to us
from Lucent. Therefore, the selected financial information for the fiscal years
ended September 30, 2000, 1999 and 1998, during which time we were a business
unit of Lucent, may not be indicative of our future performance as an
independent company. The selected financial information for all periods should
be read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations," and the consolidated financial statements
and the notes included elsewhere in this annual report.
In reviewing the selected financial information, please note the following:
- - Commencing in fiscal 2002, we discontinued amortization of goodwill pursuant
to the adoption of a new accounting pronouncement.
- - Purchased in-process research and development is attributable to the
acquisitions of VPNet Technologies, Inc. ("VPNet") and substantially all of
the assets and certain liabilities of Quintus Corporation ("Quintus") in 2001,
and Lannet Ltd., SDX Business Systems PLC and Prominet Corporation in 1998.
- - We merged with Mosaix, Inc. in July 1999.
- - In October 1999, we adopted Statement of Position 98-1, "Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use," and
prospectively capitalized certain costs of computer software developed or
obtained for internal use, which had been previously expensed as incurred.
Accordingly, we began amortizing these costs on a straight-line basis over
three to seven years.
- - Effective October 1, 1998, we changed our method for calculating the
market-related value of plan assets used in determining the expected
return-on-asset component of annual net pension and postretirement benefit
costs, which was recorded as a cumulative effect of accounting change.
- - Total debt as of September 30, 2000 represents commercial paper obligations we
assumed following the separation from Lucent and debt attributable to our
foreign entities. During fiscal 2002, we repaid our commercial paper
obligations and issued long-term convertible debt and senior secured notes.
- - In October 2000, we sold four million shares of our Series B convertible
participating preferred stock and warrants to purchase our common stock for
$400 million. In March 2002, all shares of the Series B preferred stock were
converted into approximately 38 million shares of our common stock. In
connection with these transactions, we sold an additional 14.38 million shares
of our common stock. The conversion of the Series B preferred stock and the
exercise of warrants resulted in a charge to accumulated deficit of $125
million, which was included in the calculation of net income (loss) available
to common stockholders for fiscal 2002.
- - In March 2002, we sold 19.55 million shares of common stock in a public
offering.
<Table>
<Caption>
Year Ended September 30,
---------------------------------------------------------
(dollars in millions, except per share amounts) 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS INFORMATION:
Revenue $ 4,956 $ 6,793 $ 7,732 $ 8,268 $ 7,754
Business restructuring charges and related
expenses, net of reversals 209 837 684 (33) --
Goodwill and intangibles impairment charge 71 -- -- -- --
Purchased in-process research and development -- 32 -- -- 306
Income (loss) before cumulative effect of
accounting change (666) (352) (375) 186 43
Cumulative effect of accounting change -- -- -- 96 --
- -------------------------------------------------------------------------------------------------------------
Net income (loss) $ (666) $ (352) $ (375) $ 282 $ 43
=============================================================================================================
EARNINGS (LOSS) PER COMMON SHARE-- BASIC:
Income (loss) available to common stockholders $ (2.44) $ (1.33) $ (1.39) $ 0.72 $ 0.17
Cumulative effect of accounting change -- -- -- 0.37 --
- -------------------------------------------------------------------------------------------------------------
Net income (loss) available to common stockholders $ (2.44) $ (1.33) $ (1.39) $ 1.09 $ 0.17
=============================================================================================================
EARNINGS (LOSS) PER COMMON SHARE-- DILUTED:
Income (loss) available to common stockholders $ (2.44) $ (1.33) $ (1.39) $ 0.68 $ 0.17
Cumulative effect of accounting change -- -- -- 0.35 --
- -------------------------------------------------------------------------------------------------------------
Net income (loss) available to common stockholders $ (2.44) $ (1.33) $ (1.39) $ 1.03 $ 0.17
=============================================================================================================
</Table>
<Table>
<Caption>
As of September 30,
---------------------------------------------------------
(dollars in millions) 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET INFORMATION:
Total assets $ 3,897 $ 4,648 $ 5,037 $ 4,239 $ 4,177
Total debt 933 645 793 10 14
Series B convertible participating
preferred stock -- 395 -- -- --
</Table>
<Page>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Avaya Inc. and Subsidiaries
The following section should be read in conjunction with the consolidated
financial statements and the notes included elsewhere in this annual report. 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 those described under "Forward-Looking
Statements" in our Annual Report on Form 10-K.
OVERVIEW
We are a leading provider of communications systems, applications and services
for enterprises, including businesses, government agencies and other
organizations. Our product and solution offerings include converged voice and
data networks, traditional voice communication systems, customer relationship
management solutions, unified communications solutions and structured cabling
products. We support our broad customer base with comprehensive global service
offerings that help our customers plan, design, implement and manage their
communications networks. We believe our global service organization is an
important consideration for customers purchasing our products and solutions and
is a source of significant revenue for us, primarily from maintenance contracts.
OPERATING SEGMENTS
In the fourth quarter of fiscal 2002, we reevaluated our business model due to
the continued decline in spending on enterprise communications technology by our
customers and redesigned our operating segments to align them with discrete
customer sets and market segment opportunities in order to optimize revenue
growth and profitability. As a result, we now report our results in four rather
than three operating segments and, accordingly, we have restated fiscal 2001 and
2000 amounts to reflect this change.
The following table sets forth the allocation of our revenue among our
operating segments, expressed as a percentage of total external revenue:
<Table>
<Caption>
Year Ended September 30,
----------------------------
Revenue 2002 2001 2000
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating Segments:
Converged Systems and Applications 42.0% 42.3% 46.3%
Small and Medium Business Solutions 4.8 4.6 5.1
Services 41.7 33.6 30.2
Connectivity Solutions 11.5 19.5 18.4
- --------------------------------------------------------------------------------
Total 100.0% 100.0% 100.0%
================================================================================
</Table>
The four operating segments are Converged Systems and Applications ("CSA"),
Small and Medium Business Solutions ("SMBS"), Services and Connectivity
Solutions. The CSA segment is focused on large enterprises and includes our
converged systems products, unified communications solutions and customer
relationship management offerings. Our SMBS segment develops, markets and sells
converged and traditional voice communications solutions for small and mid-sized
enterprises and includes all key and Internet Protocol ("IP") telephony systems
and applications, as well as messaging products. The Services segment offers a
comprehensive portfolio of services to help customers plan, design, build and
manage their communications networks. The Connectivity Solutions segment
includes our structured cabling systems and electronic cabinets.
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 or no growth in the future in the
market segments for these traditional products. We are implementing a
strategy to capitalize on the expected higher growth opportunities in our
market, including advanced communications solutions such as converged voice
and data networks, server-based IP telephony systems, customer relationship
management and unified communication applications. This strategy requires us
to make a significant change in the direction and operations of our company
to focus on the development and sales of these 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;
- - our competitors introduce new products before we do and achieve a competitive
advantage by being among the first to market; or
- - capital spending by our customers on communications products and services
continues to decline.
Our traditional enterprise voice communications products and the advanced
communications solutions described above are a part of our CSA and SMBS
segments. If we are unsuccessful in implementing our strategy, the contribution
to our results from these segments may decline, reducing our overall operating
results, thereby requiring a greater need for external capital resources.
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. Following the distribution, we became an
independent public company, and Lucent no longer has a continuing stock
ownership interest in us.
Our consolidated financial statements as of and for the fiscal year ended
September 30, 2000 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 the enterprise networking
businesses transferred to us immediately prior to the distribution. We believe
these consolidated financial statements are a reasonable representation of the
financial position, results
18 Avaya Inc.
<Page>
of operations, cash flows and changes in stockholders' equity of such businesses
as if Avaya were a separate entity prior to the distribution.
Our consolidated financial statements for the fiscal year ended September
30, 2000 include allocations of certain Lucent corporate headquarters' assets,
liabilities, and expenses relating to the businesses that were transferred to us
from Lucent. General corporate overhead has been allocated either based on the
ratio of our costs and expenses to Lucent's costs and expenses, or based on our
revenue as a percentage of Lucent's total revenue. General corporate overhead
primarily includes cash management, legal, accounting, tax, insurance, public
relations, advertising and data services and amounted to $398 million in fiscal
2000. In addition, the consolidated financial statements for fiscal 2000 include
an allocation from Lucent to fund a portion of the costs of basic research
conducted by Lucent's Bell Laboratories. This allocation was based on our
revenue as a percentage of Lucent's total revenue and amounted to $75 million in
fiscal 2000. We believe the costs of corporate services and research charged to
us are a reasonable representation of the costs that would have been incurred if
we had performed these functions as a stand-alone entity at that time. We
currently perform these corporate functions and basic research requirements
using our own resources or purchased services.
Prior to the distribution, cash deposits from our businesses were
transferred to Lucent on a regular basis. As a result, none of Lucent's cash,
cash equivalents or debt at the corporate level had been allocated to us.
Although our Consolidated Statements of Operations include interest expense for
the fiscal year ended September 30, 2000, the Consolidated Balance Sheets for
periods prior to the distribution do not include an allocation of Lucent debt at
the corporate level because Lucent used a centralized approach to cash
management and the financing of its operations. We have assumed for purposes of
calculating interest expense that we would have had an average debt balance of
$962 million and an average interest rate of 7.9% per annum for fiscal 2000. We
believe the average interest rate and average debt balance used in the
calculation of interest expense reasonably reflect the cost of financing our
assets and operations during fiscal 2000.
Income taxes were calculated in fiscal 2000 as if we filed separate tax
returns. However, Lucent was managing its tax position for the benefit of its
entire portfolio of businesses, and its tax strategies were not necessarily
reflective of the tax strategies that we would have followed or are following as
a stand-alone company. Commencing with fiscal 2001, we began filing our own
consolidated income tax returns.
We have resolved all of the contribution and distribution issues with
Lucent related to the settlement of certain employee obligations and the
transfer of certain assets. Accordingly, in fiscal 2001, we recorded a $42
million net reduction to additional paid-in capital. Following the distribution,
we had identified approximately $15 million recorded in our Consolidated Balance
Sheets that was primarily related to certain accounts receivable balances due
from Lucent and certain fixed assets, which we agreed would remain with Lucent.
Also in connection with the distribution, we had recorded estimates in our
Consolidated Balance Sheets at September 30, 2000 in prepaid benefit costs and
benefit obligations of various existing Lucent benefit plans related to
employees for whom we assumed responsibility. Following an actuarial review, we
received a valuation, agreed upon by us and Lucent, that provided for a
reduction of approximately $44 million in prepaid benefit costs and $17 million
in pension and postretirement benefit obligations. We recorded the net effect of
these adjustments as a reduction to additional paid-in capital in fiscal 2001
because the transactions relate to the original capital contribution from
Lucent.
Several third party legal actions are pending against Lucent as of
September 30, 2002. In connection with the Contribution and Distribution
Agreement, we may be required to indemnify Lucent for certain obligations
resulting from the resolution of such proceedings.
GOODWILL AND INTANGIBLE ASSETS
Effective October 1, 2001, we adopted Statement of Financial Accounting
Standards ("SFAS") 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 definite
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
goodwill and other intangible assets, reassessed the useful lives previously
assigned to other intangible assets, and discontinued amortization of goodwill.
We also tested goodwill for impairment by comparing the fair values of our
reporting units to their carrying values as of October 1, 2001 and determined
that there was no goodwill impairment at that time. Based on this review, as of
September 30, 2001, we classified $175 million as goodwill, $78 million as
intangible assets, net and $2 million as other assets. We did not identify any
intangible assets having indefinite lives. In fiscal 2002, we recorded a
goodwill impairment charge of $44 million as an operating expense related to our
SMBS operating segment.
For the fiscal years ended September 30, 2001 and 2000, goodwill
amortization, net of tax, amounted to $38 million and $31 million, respectively.
If we had adopted SFAS 142 as of the beginning of the first quarter of fiscal
2000 and discontinued goodwill amortization, our net loss and loss per common
share on a pro forma basis would have been as follows:
<Table>
<Caption>
Year Ended September 30,
Pro Forma Results -------------------------
(dollars in millions, except per share amounts) 2001 2000
- --------------------------------------------------------------------------------
<S> <C> <C>
Adjusted net loss $ (314) $ (344)
Accretion of Series B preferred stock (27) --
- --------------------------------------------------------------------------------
Adjusted loss available to common stockholders $ (341) $ (344)
================================================================================
Adjusted loss per common share:
Basic and Diluted $(1.20) $(1.28)
================================================================================
</Table>
As a result of the significant downturn in the communications technology
industry, we noted a steep decline in the marketplace assumptions for virtual
private networks in the fourth quarter of fiscal 2002 as compared with the
assumptions used when we acquired this existing technology. These circumstances
also caused us to review the
Avaya Inc. 19
<Page>
recoverability of our acquired intellectual property and trademarks. We applied
the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of" ("SFAS 121"), to our
intangible assets with definite lives and determined that the carrying value of
these assets was impaired. Accordingly, we recorded a $27 million intangibles
impairment charge as an operating expense in fiscal 2002 to write-down the
carrying value of these intangible assets to an amount representing their
discounted future cash flows. The $27 million impairment charge is attributed
$24 million to CSA and $3 million to SMBS.
Acquired intangible assets with definite lives are amortized over a period
of three to six years. Amortization expense for such intangible assets was $35
million and $32 million for the fiscal years ended September 30, 2002 and 2001,
respectively. We estimate remaining amortization expense will be (i) $12 million
in 2003, (ii) $5 million in 2004 and (iii) $1 million in 2005.
In addition, included in other assets as of September 30, 2002 is an
intangible asset of $35 million representing an unrecognized prior service cost
associated with the recording of a minimum pension liability in fiscal 2002.
This intangible asset may be eliminated or adjusted as necessary when the amount
of minimum pension liability is reassessed, which is conducted at least
annually.
INTERNAL USE SOFTWARE
In the second quarter of fiscal 2002, we changed the estimated useful life of
certain internal use software from three to seven years to reflect actual
experience as a stand-alone company based on the utilization of such software.
This change lowered amortization expense by approximately $13 million ($8
million after-tax), equivalent to $0.02 per diluted share, for the fiscal year
ended September 30, 2002.
BUSINESS RESTRUCTURING CHARGES AND RELATED EXPENSES
The following table summarizes the status of our business restructuring reserve
and other related expenses during fiscal 2002, 2001 and 2000:
<Table>
<Caption>
Business Restructuring Reserve Other Related Expenses
--------------------------------------------- -----------------------------------------
Total Business
Total Restructuring
Employee Lease Other Business Reserve
Separation Termination Exit Restructuring Asset Incremental and Related
(dollars in millions) Costs Obligations Costs Reserve Impairments Period Costs Expenses
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
FISCAL 2000:
Charges $ 365 $ 127 $ 28 $ 520 $ 75 $ 89 $ 684
Cash payments (20) -- (1) (21) -- (89) (110)
Asset impairments -- -- -- -- (75) -- (75)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2000 $ 345 $ 127 $ 27 $ 499 $ -- $ -- $ 499
- -----------------------------------------------------------------------------------------------------------------------------------
FISCAL 2001:
Charges $ 650 $ 24 $ -- $ 674 $ 20 $ 178 $ 872
Reversals (17) (7) (11) (35) -- -- (35)
Decrease in prepaid benefit
costs/increase in benefit obligations,
net (577) -- -- (577) -- -- (577)
Cash payments (250) (66) (11) (327) -- (178) (505)
Asset impairments -- -- -- -- (20) -- (20)
Reclassification (55) -- -- (55) -- -- (55)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2001 $ 96 $ 78 $ 5 $ 179 $ -- $ -- $ 179
- -----------------------------------------------------------------------------------------------------------------------------------
FISCAL 2002:
Charges $ 116 $ 84 $ 1 $ 201 $ 7 $ 21 $ 229
Reversals (13) (4) (3) (20) -- -- (20)
Net increase in benefit obligations (3) -- -- (3) -- -- (3)
Cash payments (128) (56) (3) (187) -- (21) (208)
Asset impairments -- -- -- -- (7) -- (7)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2002 $ 68 $ 102 $ -- $ 170 $ -- $ -- $ 170
===================================================================================================================================
</Table>
20 Avaya Inc.
<Page>
FISCAL 2002
We have been experiencing a decrease in our revenue as a result of the continued
decline in spending on information technology by our customers, specifically for
enterprise communications products and services. Despite the unpredictability of
the current business environment, we remain focused on our strategy to return to
profitability by focusing on sustainable cost and expense reduction, among other
things. To achieve that goal, we initiated restructuring actions in fiscal 2002
to enable us to reduce costs and expenses further in order to lower the amount
of revenue needed to reach our profitability break-even point. As a result, we
recorded a pretax charge of $229 million in fiscal 2002 for business
restructuring and related expenses. The components of the charge included $116
million of employee separation costs, $84 million of lease termination costs, $1
million of other exit costs, and $28 million of other related expenses. This
charge was partially offset by a $20 million reversal to income primarily
attributable to fewer employee separations than originally anticipated. The $209
million net charge is attributed $70 million to CSA, $3 million to SMBS, $84
million to Services, $25 million to Connectivity Solutions and $27 million to
Corporate. Amounts included in Corporate represent real estate and information
technology lease termination obligations and other related expenses not directly
managed by or identified with the reportable segments.
The charge for employee separation costs was composed of $113 million for
severance and other such costs as well as $3 million primarily related to the
cost of curtailment in accordance with SFAS No.88, "Employers' Accounting for
Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefits" ("SFAS 88"). Lease termination costs included
approximately $72 million for real estate and $12 million for information
technology lease termination payments. The $28 million of other related expenses
include relocation and consolidation costs, computer transition expenditures,
and asset impairments associated with our ongoing restructuring initiatives.
The employee separation costs in fiscal 2002 were incurred in connection
with the elimination of approximately 4,240 management and union-represented
employee positions worldwide, of which approximately 2,900 employees had
departed as of September 30, 2002. Employee separation costs included in the
business restructuring reserve are 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 fiscal 2004.
The $72 million charge for real estate lease termination obligations
includes approximately one million square feet of excess sales and services
support, research and development, call center and administrative offices
located primarily in the U.S., which have been substantially vacated as of
September 30, 2002. The real estate charge also includes an adjustment to
increase the accrued amount for previously reserved sites due to a recent
deterioration in the commercial real estate market. As a result, we have
extended our estimates as to when we will be able to begin subleasing certain
vacated sites and established additional accruals for lease payments originally
estimated to have been offset by sublease rental income. Payments on lease
termination obligations will be substantially completed by 2011 because, in
certain circumstances, the remaining lease payments were less than the
termination fees.
FISCAL 2001
In fiscal 2001, we outsourced certain manufacturing facilities and accelerated
our restructuring plan that was originally adopted in September 2000 to improve
profitability and business performance as a stand-alone company. As a result, we
recorded a pretax charge of $872 million in fiscal 2001 for business
restructuring and related expenses. This charge was partially offset by a
$35 million reversal to income primarily attributable to fewer employee
separations than originally anticipated and more favorable than expected real
estate lease termination costs.
The components of the fiscal 2001 charge included $650 million of employee
separation costs, $24 million of lease termination costs, and $198 million of
other related expenses. The charge for employee separation costs was composed of
$577 million primarily related to enhanced pension and postretirement benefits,
which represented the cost of curtailment in accordance with SFAS 88 and $73
million for severance, special benefit payments and other employee separation
costs. The $198 million of other related expenses was composed of $178 million
for incremental period expenses primarily to facilitate the separation from
Lucent, including computer system transition costs, and $20 million for an asset
impairment charge related to land, buildings and equipment at our Shreveport
manufacturing facility. Employee separation costs of $55 million established in
fiscal 2000 for union-represented employees at Shreveport were paid as enhanced
severance benefits from existing pension and benefit assets and, accordingly,
such amount was reclassified in fiscal 2001 out of the business restructuring
reserve and recorded as a reduction to prepaid benefit costs.
The employee separation costs in fiscal 2001 were incurred in connection
with the elimination of 6,810 employee positions of which 5,600 were through a
combination of involuntary and voluntary separations, including an early
retirement program targeted at U.S. management employees, and a workforce
reduction of 1,210 employees due to the outsourcing of certain of the Company's
manufacturing operations. Employee separation payments that are included in the
business restructuring reserve were made either through a lump sum or a series
of payments extending over a period of up to two years from the date of
departure, which is an option available to certain union-represented employees.
This workforce reduction was substantially completed as of September 30, 2001.
Real estate lease termination costs have been incurred primarily in the
U.S., Europe and Asia, and have been reduced for sublease income that management
believes is probable. Payments on lease obligations, which consist of real
estate and equipment leases, will extend through 2003. In fiscal 2001, accrued
costs for lease obligations represent approximately 666,000 square feet of
excess sales and services support offices, materials, stocking and logistics
warehouses, and Connectivity Solutions facilities. As of September 30, 2002, we
have entirely vacated this space.
Avaya Inc. 21
<Page>
FISCAL 2000
In fiscal 2000, we recorded a pretax business restructuring charge of $684
million in connection with our separation from Lucent. The components of the
charge included $365 million of employee separation costs, $127 million of lease
termination costs, $28 million of other exit costs, and $164 million of other
related expenses.
The charge for employee separation costs in fiscal 2000 included severance,
medical and other benefits attributable to the worldwide reduction of 4,900
union-represented and management positions. This charge was the result of
redesigning the services organization by reducing the number of field
technicians to a level needed for non-peak workloads, consolidating and closing
certain U.S. and European manufacturing facilities and realigning the sales
effort to focus the direct sales force on strategic accounts and address smaller
accounts through indirect sales channels. This workforce reduction was
substantially completed as of September 30, 2001. The charge for lease
termination obligations included approximately two million square feet of excess
manufacturing, distribution and administrative space, which we have entirely
vacated as of September 30, 2002. Other exit costs consisted of decommissioning
legacy computer systems in connection with our separation from Lucent and
terminating other contractual obligations.
The $164 million of other related expenses in fiscal 2000 was composed of
$89 million for incremental period expenses related to the separation from
Lucent, including computer system transition costs, and a $75 million asset
impairment charge that was primarily related to an outsourcing contract with a
major customer. With respect to the asset impairment, we terminated our
obligation under a leasing arrangement and purchased the underlying equipment,
which had been used to support a contract with a customer to provide
outsourcing and related services. Based on the terms of this contract, the
estimated undiscounted cash flows from the equipment's use and eventual
disposition was determined to be less than the equipment's carrying value, and
resulted in an impairment charge of $50 million to write such equipment down to
its fair value.
OUTSOURCING OF CERTAIN MANUFACTURING OPERATIONS
As a result of our contract manufacturing initiative in fiscal 2001, Celestica
Inc. ("Celestica") exclusively manufactures a significant portion of our CSA and
SMBS products at various facilities in the U.S. and Mexico. We believe that
outsourcing these operations will allow us to improve our cash flow over the
next few years through a reduction of inventory and reduced capital
expenditures.
We are not obligated to purchase products from Celestica in any specific
quantity, except as we outline in forecasts or orders for products. 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 effect on our financial position, results of operations or cash flows.
ACQUISITIONS
As part of our continued efforts to broaden our portfolio of product offerings,
we completed the following acquisitions during fiscal 2001. There were no
material acquisitions in fiscal 2002 and 2000.
APRIL 2001 - Acquisition of substantially all of the assets, including $10
million of cash acquired, and the assumption of $20 million of certain
liabilities of Quintus Corporation, a provider of comprehensive electronic
customer relationship management solutions. We paid $29 million in cash for
these assets. This transaction was accounted for as a purchase combination.
FEBRUARY 2001 - Acquisition of VPNet Technologies, Inc. ("VPNet"), a privately
held distributor of virtual private network solutions and devices. The total
purchase price of $117 million was paid in cash and stock options. This
transaction was accounted for as a purchase combination.
DIVESTITURES
In March 2000, we completed the sale of our U.S. sales division that served
small- and mid-sized businesses to Expanets, Inc. ("Expanets"). Under the
agreement, approximately 1,800 of our sales and sales support employees were
transferred to Expanets, which became a distributor of our products to this
market and a significant customer of ours. A gain of $45 million was recognized
in fiscal 2000 to the extent of cash proceeds received related to the sale of
this business and is included in other income (expense), net.
REVENUE
We derive revenue primarily from the sales of communication systems and
applications. We sell our products both directly through our worldwide sales
force and indirectly through our global network of distributors, dealers,
value-added resellers and system integrators. The purchase price of our systems
and applications typically includes installation and a one-year warranty. We
also derive revenue from: (i) maintenance services, including services provided
under contracts and on a time and materials basis; (ii) professional services
for customer relationship management, converged voice and data networks, network
security, and unified communications; and (iii) value-added services for
outsourcing messaging and other parts of communication systems.
Maintenance contracts typically have terms that range from one to five
years. Contracts for professional services typically have terms that range from
two to four weeks for standard solutions and from six months to one year for
customized solutions. Contracts for value-added services typically have terms
that range from one to seven years. Revenue from sales of communications systems
and applications is recognized when contractual obligations have been satisfied,
title and risk of loss have been transferred to the customer, and collection of
the resulting receivable is reasonably assured. Revenue from the direct sales of
products that include installation services is recognized at the time the
products are installed, after satisfaction of all the terms and conditions of
the underlying customer contract. Our indirect sales to distribution partners
generally are recognized at the time of shipment if all contractual obligations
have been satisfied. We provide for estimated sales returns and other allowances
and deferrals as a reduction
22 Avaya Inc.
<Page>
of revenue at the time of revenue recognition, as required. Revenue from
services performed under our value-added service arrangements, professional
services and services performed under maintenance contracts are recognized over
the term of the underlying customer contract or at the end of the contract, when
obligations have been satisfied. For services performed on a time and materials
basis, revenue is recognized upon performance.
COSTS AND OPERATING EXPENSES
Our costs of products consist primarily of materials and components, labor and
manufacturing overhead. Our costs of services consist primarily of labor, parts
and service overhead. Our selling, general and administrative expenses and
research and development expenses consist primarily of salaries, commissions,
benefits and other miscellaneous items. Please see "Business Restructuring
Charges and Related Expenses, net of reversals," "Goodwill and Intangibles
Impairment Charge" and "Purchased In-Process Research and Development" below for
a discussion of these line items.
RESULTS OF OPERATIONS
The following table sets forth certain line items from our Consolidated
Statements of Operations as a percentage of revenue for the years indicated:
<Table>
<Caption>
Year Ended September 30,
------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Revenue 100.0% 100.0% 100.0%
Costs 60.7 57.4 58.0
- --------------------------------------------------------------------------------
Gross margin 39.3 42.6 42.0
- --------------------------------------------------------------------------------
Operating expenses:
Selling, general and administrative 31.4 30.3 32.8
Business restructuring charges and related expenses,
net of reversals 4.2 12.3 8.8
Goodwill and intangibles impairment charge 1.4 -- --
Research and development 9.3 7.9 6.1
Purchased in-process research and development -- 0.5 --
- --------------------------------------------------------------------------------
Total operating expenses 46.3 51.0 47.7
- --------------------------------------------------------------------------------
Operating loss (7.0) (8.4) (5.7)
Other income (expense), net (0.1) 0.5 0.9
Interest expense (1.0) (0.5) (1.0)
Provision (benefit) for income taxes 5.3 (3.2) (1.0)
- --------------------------------------------------------------------------------
Net loss (13.4)% (5.2)% (4.8)%
================================================================================
</Table>
- - FISCAL YEAR ENDED SEPTEMBER 30, 2002 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER
30, 2001
The following table shows the change in external revenue, both in dollars and in
percentage terms:
<Table>
<Caption>
Year Ended September 30, Change
------------------------ ------------------
(dollars in millions) 2002 2001 $ %
- --------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Operating Segments:
Converged Systems and
Applications $ 2,080 $ 2,871 $ (791) (27.6)%
Small and Medium Business
Solutions 236 313 (77) (24.6)
Services 2,068 2,286 (218) (9.5)
Connectivity Solutions 572 1,323 (751) (56.8)
-----------------------------------
Total $ 4,956 $ 6,793 $ (1,837) (27.0)%
===================================
</Table>
REVENUE - Revenue decreased 27.0%, or $1,837 million, from $6,793 million in
fiscal 2001, to $4,956 million for fiscal 2002 due to decreases across each of
our operating segments. Revenue declines in our core business, which is made up
of CSA, SMBS, and Services, reflects a continued decline in spending on
enterprise information technology in general, and on communications products and
services in particular. In fiscal 2000 and 1999, the communications technology
industry experienced strong economic growth and significant investing by
enterprises in related products and services. In fiscal 2001, growth within this
industry began to slow particularly in the U.S. as our customers' focus changed
from building new networks to limiting capital spending and concentrating on
extracting maximum value from existing systems. This trend has continued in
fiscal 2002 as the protracted economic and business uncertainty has led to
reluctance by our customers to resume capital spending for telephony products
and services. In addition, widespread layoffs, high vacancy rates in commercial
real estate, a lack of business start-ups and excess capacity within the
communications technology industry have adversely impacted our revenues.
GEOGRAPHIC SALES - Revenue within the U.S. decreased 29.3%, or $1,511 million,
from $5,158 million in fiscal 2001 to $3,647 million for the same period in
fiscal 2002. Revenue outside the U.S. decreased 19.9%, or $326 million, from
$1,635 million in fiscal 2001 to $1,309 million in fiscal 2002. As a percentage
of total revenue, sales outside the U.S. increased slightly in fiscal 2002 to
26.4% of total revenue compared with 24.1% in the same period of fiscal 2001.
Sales within the U.S., as a percentage of total revenue, decreased in fiscal
2002 to 73.6% from 75.9% in fiscal 2001.
CONVERGED SYSTEMS AND APPLICATIONS - CSA's revenues, which represented 42.0% and
42.3% of our total revenues in fiscal 2002 and 2001, respectively, declined by
$791 million in fiscal 2002 predominantly due to declines of $551 million in
converged systems, $158 million in customer relationship management, and
$63 million
Avaya Inc. 23
<Page>
in unified communications solutions. Although revenues in regions outside of the
U.S. declined, the majority of the reduction, or $592 million, was seen in the
U.S. This is consistent with the current industry trend occurring in the U.S. as
enterprises have restrained capital spending due to economic uncertainty. In
addition, enterprises have been hesitant to commit to investments in
next-generation products as they evaluate technological advances made in the
industry and several new IP telephony products introduced by us and certain
competitors in fiscal 2002. In particular, in fiscal 2002 we introduced our next
generation enterprise class IP telephony solution. This trend was compounded by
the continued decline in demand for our traditional, more mature product lines.
Sales through our indirect channel increased to 46.8% of total CSA revenue in
fiscal 2002 from 43.0% in fiscal 2001.
SMALL AND MEDIUM BUSINESS SOLUTIONS - Although revenues in this segment declined
by $77 million from fiscal 2001, the reduction was mitigated partially by the
impact of the introduction in the second quarter of fiscal 2002 of IP Office,
our IP telephony offering for small and mid-sized enterprises. SMBS' revenues
within the U.S. declined by $48 million as compared with fiscal 2001. Sales from
the SMBS segment, which were almost entirely indirect, represented 4.8% and 4.6%
of Avaya's total revenue in fiscal 2002 and 2001, respectively.
SERVICES - Services revenue, which represented 41.7% and 33.6% of Avaya's total
revenues in fiscal 2002 and 2001, respectively, decreased by $218 million from
fiscal 2001 largely as a result of the renegotiation of a maintenance contract
with a major distributor in March 2002, which extended the term of the agreement
but lowered the monthly revenues, and the loss of a major services contract in
our Europe/Middle East/Africa region. In addition, the economic constraint on
discretionary spending resulted in a depressed demand for maintenance billed on
a time and materials basis, and cuts in capital expenditures resulted in lower
demand for equipment adds, moves and changes. Lower product sales and financial
difficulties of certain service providers resulted in fewer installations as
well as less training and consulting services delivered to our customers. Sales
through our indirect channel decreased to 16.8% of total Services revenue in
fiscal 2002 from 20.1% in fiscal 2001. The $218 million decline in this
segment's revenues was seen almost entirely in the U.S., where revenues fell by
$209 million from fiscal 2001 levels.
CONNECTIVITY SOLUTIONS - Connectivity Solutions revenue, which represented 11.5%
and 19.5% of Avaya's total revenue in fiscal 2002 and 2001, respectively,
decreased by $751 million due to declines of $303 million in sales of
ExchangeMAX(R) cabling for service providers, $283 million in sales of
SYSTIMAX(R) structured cabling systems for enterprises, and $165 million in
sales related to electronic cabinets. ExchangeMAX sales, which accounted for $87
million of total Connectivity Solutions' revenues in fiscal 2002, dropped
significantly due to a decline in sales volumes caused by a lack of capital
spending by telecommunications service providers. The main contributors to the
decline in SYSTIMAX revenues, which represent $414 million of total Connectivity
Solutions' revenues in fiscal 2002, were a constraint on spending by our
customers on large infrastructure projects, combined with the implementation of
our strategic initiative that began in the first half of fiscal 2002 to lower
cable prices. Pricing pressure resulting from excess cable manufacturing
capacity was another contributing factor. Revenues from electronic cabinets, a
service provider offering, were $71 million in fiscal 2002. In response to a
decline in DSL (Digital Subscriber Line) and wireless site installations, which
are two main drivers behind sales of electronic cabinets, service providers have
pulled back on spending related to electronic cabinets. Sales through our
indirect channel increased to 78.6% of total Connectivity Solutions revenue in
fiscal 2002 from 60.9% in fiscal 2001. The majority of the decline in this
segment's revenues, or $662 million, occurred within the U.S.
COSTS AND GROSS MARGIN - Total costs decreased 22.8%, or $887 million, from
$3,897 million in fiscal 2001 to $3,010 million in fiscal 2002. Gross margin
percentage decreased from 42.6% in fiscal 2001 as compared with 39.3% in fiscal
2002. The decrease in gross margin was attributable to declines in CSA,
Connectivity Solutions, and SMBS, partially offset by an increase in Services'
gross margin. Because sales within the U.S., including both direct and indirect
channels, typically have higher margins than those sales made internationally,
the drop in U.S. sales adversely impacted all segments. The decline of
Connectivity Solutions' gross margin was attributable to the sharp decline in
sales volumes while factory costs remained relatively fixed. The decline was
somewhat offset by cost cutting initiatives including headcount reductions.
CSA's gross margin decline was predominantly attributable to an unfavorable
geographic sales mix. Our Services segment's gross margin percentage increased
due to improved efficiencies gained from reducing headcount and employing a
variable workforce approach to meet periods of higher demand.
SELLING, GENERAL AND ADMINISTRATIVE - Selling, general and administrative
("SG&A") expenses decreased 24.3%, or $500 million, from $2,055 million in
fiscal 2001 to $1,555 million in fiscal 2002. The decrease was primarily due to
savings associated with our business restructuring initiatives, including lower
staffing levels and terminated real estate lease obligations. The decline was
also due to higher costs incurred during fiscal 2001 including higher incentive
compensation expense related to performance bonuses and higher marketing and
promotional costs. During fiscal 2001, we also incurred start-up expenses of $48
million related to establishing our brand in the marketplace.
The decrease in SG&A is also attributable to our adoption of SFAS 142.
Accordingly, we did not record any goodwill amortization in fiscal 2002 as
compared with $40 million in fiscal 2001. In addition, we increased the
estimated useful life of certain internal use software during the second quarter
of fiscal 2002, which lowered depreciation expense by $13 million in fiscal
2002.
BUSINESS RESTRUCTURING CHARGES AND RELATED EXPENSES, NET OF REVERSALS - Business
restructuring charges and related expenses of $209 million in fiscal 2002
include (1) $201 million of charges that are primarily related to employee
separations and real estate and information technology lease terminations, (2)
$21 million for incremental period costs including relocation and consolidation
costs and
24 Avaya Inc.
<Page>
computer transition expenditures, and (3) $7 million of asset impairments,
partially offset by (4) a $20 million reversal of business restructuring
liabilities primarily related to fewer employee separations than originally
anticipated.
The $837 million of business restructuring charges and related expenses in
fiscal 2001 include (1) $540 million for our accelerated restructuring plan,
which was composed primarily of enhanced pension and healthcare benefits that
were offered through an early retirement program, severance and terminated lease
obligations, (2) $134 million primarily for employee separation costs associated
with the outsourcing of certain manufacturing operations to Celestica, (3)
$178 million representing incremental period costs largely associated with our
separation from Lucent including computer system transition costs such as data
conversion activities, asset transfers and training, and (4) a $20 million asset
impairment charge related to assets to be disposed of in association with our
manufacturing outsourcing initiative, partially offset by (5) a $35 million
reversal of business restructuring liabilities originally recorded in September
2000, primarily related to fewer employee separations than originally
anticipated.
GOODWILL AND INTANGIBLES IMPAIRMENT CHARGE - The $71 million impairment charge
for goodwill and intangibles was recorded in the fourth quarter of fiscal 2002
to write down the carrying value of goodwill and intangible assets to an amount
representing their discounted future cash flows in accordance with SFAS 142 and
SFAS 121, respectively. The charge is composed of $44 million for goodwill
attributed to SMBS, and $27 million for intangibles attributed $24 million to
CSA and $3 million to SMBS.
RESEARCH AND DEVELOPMENT - Research and development ("R&D") expenses decreased
14.4%, or $77 million, from $536 million in fiscal 2001 to $459 million in
fiscal 2002. Although R&D spending decreased, our investment in R&D as a
percentage of total revenue increased from 7.9% in fiscal 2001 to 9.3% in fiscal
2002 due to a greater rate of decline in our revenue than in R&D spending.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT - The $32 million expense recorded
in fiscal 2001 reflects charges associated with our acquisitions of VPNet in
February 2001, and the purchase of substantially all of the assets of Quintus in
April 2001. The purchase price for these acquisitions included certain
technologies that had not reached technological feasibility and had no future
alternative use and, accordingly, the value allocated to these technologies was
capitalized and immediately expensed at acquisition. There was no charge in
fiscal 2002 for purchased in-process research and development.
OTHER INCOME (EXPENSE), NET - Other income, net decreased from $31 million of
income in fiscal 2001 to $2 million of expense in fiscal 2002. The decrease of
$33 million is attributable primarily to an impairment loss recognized in fiscal
2002 of $17 million on cost investments that are generally concentrated in the
emerging communications technology industry. In addition, interest income on
cash balances was higher in the prior year as a result of higher interest rates,
as well as the recognition of gains on assets sold in fiscal 2001. The decrease
in fiscal 2002 was partially offset by an increase in interest income earned on
a customer line of credit for the entire year of fiscal 2002, while the prior
year reflects interest income earned on the line of credit for a portion of the
year beginning in May 2001.
INTEREST EXPENSE - Interest expense increased 37.8%, or $14 million, from $37
million in fiscal 2001 to $51 million in fiscal 2002. The increase in interest
expense is largely attributed to a higher amount of weighted average debt
outstanding. During the first and second quarters of fiscal 2002, we replaced
our commercial paper with long-term debt, which carried a higher rate of
interest. In addition, we incurred financing costs in fiscal 2002 related to
these debt issuances, which have been deferred and are being amortized to
interest expense. The increase in interest expense was partially offset by a
$4 million favorable impact resulting from our interest rate swap agreements
entered into during fiscal 2002.
PROVISION (BENEFIT) FOR INCOME TAXES - The effective tax provision rate for
fiscal 2002 was higher than the U.S. statutory rate due to an increase in the
net deferred tax asset valuation allowance of $364 million. The effective tax
benefit rate excluding this charge would have been 24.7%, which was
substantially lower than the U.S. statutory rate primarily due to an unfavorable
geographic distribution of earnings and losses.
The effective tax benefit rate of 38.3% in fiscal 2001 was higher than the
U.S. statutory rate primarily due to acquisition related costs.
- - FISCAL YEAR ENDED SEPTEMBER 30, 2001 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER
30, 2000
The following table shows the change in external revenue, both in dollars and in
percentage terms:
<Table>
<Caption>
Year Ended September 30, Change
------------------------ ------------------
(dollars in millions) 2001 2000 $ %
- --------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Operating Segments:
Converged Systems and
Applications $ 2,871 $ 3,581 $ (710) (19.8)%
Small and Medium Business
Solutions 313 398 (85) (21.4)
Services 2,286 2,334 (48) (2.1)
Connectivity Solutions 1,323 1,419 (96) (6.8)
------------------------------------
Total $ 6,793 $ 7,732 $ (939) (12.1)%
====================================
</Table>
REVENUE - Revenue decreased 12.1% or $939 million, from $7,732 million in fiscal
2000 to $6,793 million in fiscal 2001, due to decreases in revenue across all
operating segments. The overall reduction in revenue was mainly attributable to
a marked change in our customers' behavior that became evident in fiscal 2001.
In fiscal 2000, enterprises were focused on investing in new communication
products and services and our revenues reflected this strong demand. However, in
fiscal 2001, our customers began to limit their capital spending and rely on
their existing systems, which resulted in a declining demand for telephony
equipment and related products.
Avaya Inc. 25
<Page>
GEOGRAPHIC SALES - Revenue within the U.S. decreased 15.6% or $952 million, from
$6,110 million in fiscal 2000 to $5,158 million in fiscal 2001. However, revenue
outside the U.S. increased slightly by 0.8%, or $13 million, from $1,622 million
in fiscal 2000, to $1,635 million in fiscal 2001. Revenue outside the U.S.
represented 24.1% of revenue in fiscal 2001 compared with 21.0% in fiscal 2000.
We continued to expand our business outside of the U.S. with marginal
growth across most regions, primarily led by the Asia-Pacific region. Our
largest increases in sales outside of the U.S. were made in Services, CSA's
multi-service networking products and professional services, and Connectivity
Solutions' ExchangeMAX product.
CONVERGED SYSTEMS AND APPLICATION AND SMALL AND MEDIUM BUSINESS SOLUTIONS - The
decrease in CSA was largely due to declines of $617 million in converged systems
and $157 million in unified communications solutions, partially offset by an
increase of $87 million in customer relationship management. The declines in CSA
as well as in SMBS occurred predominantly in the U.S. and were attributable to a
shift, which began in the third quarter of fiscal 2000, in the sales effort to
focus our direct sales force on strategic accounts while indirect sales channels
were used to address smaller accounts. Changes in product mix and the effects of
customers having purchased systems in fiscal 2000 in anticipation of Year 2000
concerns also contributed to the decline in revenues in these two segments.
SERVICES - The decrease in the Services segment was mainly attributable to lower
installation revenues resulting from a reduction in product sales, as well as a
decline in revenues from our maintenance services provided to customers. The
decline in installation revenues was partially offset by an increase of $142
million attributable to the introduction of data services in the U.S. during
fiscal 2001.
CONNECTIVITY SOLUTIONS - The decrease in revenues within the Connectivity
Solutions segment was attributed to a reduction in purchases of $164 million in
our ExchangeMAX cabling systems for service providers due to a reduction in
capital spending by customers, as well as certain Federal Communications
Commission regulatory changes that permitted common exchange carriers access to
local exchange carrier networks. The decrease in revenues from ExchangeMAX was
partially offset by an increase of $47 million in revenues from sales primarily
in the U.S. of our SYSTIMAX structured cabling systems for enterprises,
including the introduction of new apparatus products, and increased sales of $21
million of electronic cabinets predominantly in the U.S.
COSTS AND GROSS MARGIN - Total costs decreased 13.1% or $586 million, from
$4,483 million in fiscal 2000 to $3,897 million in fiscal 2001. The gross margin
percentage increased slightly from 42.0% in fiscal 2000 to 42.6% in fiscal 2001.
The increase in gross margin was primarily attributed to favorable product mix
and lower discounts in Connectivity Solutions combined with the ongoing savings
from business restructuring initiatives, including the improvement to the cost
structure within the Services segment. This increase was largely offset by a
decrease in gross margin within CSA due to lower sales volumes, a less favorable
product mix, and a shift to an indirect sales channel.
SELLING, GENERAL AND ADMINISTRATIVE - SG&A expenses decreased 19.1% or $485
million, from $2,540 million in fiscal 2000 to $2,055 million in fiscal 2001.
The decrease is primarily due to savings associated with our business
restructuring plan, including lower staffing levels, terminated real estate
lease obligations, cost improvements associated with the implementation of our
new SAP information technology system, process improvements in sales and sales
operations, and streamlining delivery of several corporate functions, including
the outsourcing of payroll and procurement services. The reduction in SG&A was
also attributable to lower start-up activities of 34.2% or $25 million, from $73
million in fiscal 2000 to $48 million in fiscal 2001 related to establishing
independent operations, which are composed of advertising costs associated with
establishing our brand in each fiscal period as well as fees for investment
banking and other professional advisors in fiscal 2000. The reduction in SG&A
expenses was partially offset by an increase in ongoing marketing expense.
BUSINESS RESTRUCTURING CHARGES AND RELATED EXPENSES, NET OF REVERSALS - Business
restructuring charges and related expenses of $837 million in fiscal 2001
include (1) $540 million for our accelerated restructuring plan, which is
essentially composed of enhanced pension and healthcare benefits that were
offered through an early retirement program, severance and terminated lease
obligations, (2) $134 million primarily for employee separation costs associated
with the outsourcing of certain manufacturing operations to Celestica, (3)
$178 million representing incremental period costs largely associated with our
separation from Lucent including computer system transition costs such as data
conversion activities, asset transfers and training, and (4) a $20 million asset
impairment charge related to assets to be disposed of in association with our
manufacturing outsourcing initiative, partially offset by (5) a $35 million
reversal of business restructuring liabilities originally recorded in September
2000, primarily related to fewer employee separations than originally
anticipated.
Business restructuring and related charges of $684 million in fiscal 2000
include $520 million principally for employee separations and lease obligations,
$75 million of asset impairment charges primarily related to an outsourcing
contract, and $89 million of incremental period costs associated with our
separation from Lucent, including computer system transition costs.
RESEARCH AND DEVELOPMENT - R&D expenses increased 14.5% or $68 million, from
$468 million in fiscal 2000 to $536 million in fiscal 2001. Our investment in
R&D represented 7.9% of revenue in fiscal 2001 as compared with 6.1% in fiscal
2000. This increased investment supports our plan to shift spending to high
growth areas of our business and reduce spending on more mature product lines.
These investments represent a significant increase over our investments in
R&D for the fiscal years prior to the distribution, which were approximately 6%
of total revenue. As a part of Lucent, we were allocated a portion of Lucent's
basic research, which did not necessarily directly benefit our business. Our
current and future investments in R&D will have a greater focus on our products.
26 Avaya Inc.
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PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT - In fiscal 2001, we acquired
VPNet and substantially all of the assets of Quintus. The purchase prices for
these acquisitions included certain technologies that had not reached
technological feasibility and had no future alternative use and, accordingly,
the value allocated to these technologies was capitalized and immediately
expensed at acquisition. There was no charge in fiscal 2000 for purchased
in-process research and development.
OTHER INCOME (EXPENSE), NET - Other income, net decreased 56.3% or $40 million,
from $71 million in fiscal 2000 to $31 million in fiscal 2001. This decrease was
primarily due to a $45 million gain recorded in March 2000 on the sale of our
U.S. sales division serving small- and mid-sized enterprises, which was
partially offset by interest income earned on higher cash balances during fiscal
2001.
INTEREST EXPENSE - Interest expense decreased 51.3% or $39 million, from $76
million in fiscal 2000 to $37 million in fiscal 2001. The decrease is primarily
attributable to higher weighted average interest rates and assumed debt levels
utilized in fiscal 2000 to reflect the level of financing that was thought to be
needed to fund our operations as a stand-alone entity.
PROVISION (BENEFIT) FOR INCOME TAXES - The effective tax rates in fiscal 2001
and 2000 reflect a benefit of 38.3% and 16.3%, respectively. The difference
between the rates is due primarily to a favorable change in the tax differential
on foreign earnings and lower non deductible restructuring costs offset by an
increase in purchased in-process research and development expense. Excluding
purchased in-process research and development and other acquisition related
costs, the adjusted effective tax rates in fiscal 2001 and 2000 would have been
benefits of 40.7% and 16.3%, respectively.
LIQUIDITY AND CAPITAL RESOURCES
- - STATEMENT OF CASH FLOWS DISCUSSION
Avaya's cash and cash equivalents increased to $597 million at September 30,
2002 from $250 million at September 30, 2001. The increase resulted primarily
from $255 million and $198 million of net cash provided by financing and
operating activities, respectively, partially offset by $109 million of net cash
used for investing activities. In fiscal 2001, Avaya's cash and cash equivalents
decreased to $250 million at September 30, 2001, from $271 million at September
30, 2000. The decrease resulted from $365 million and $133 million of net cash
used for investing and operating activities, respectively, partially offset by
$483 million of net cash provided by financing activities.
- - OPERATING ACTIVITIES
Our net cash provided by operating activities was $198 million in fiscal 2002
compared with $133 million of net cash used for operating activities in fiscal
2001. Net cash provided by operating activities in fiscal 2002 was composed of a
net loss of $666 million adjusted for non-cash items of $878 million, and net
cash used for changes in operating assets and liabilities of $14 million. Net
cash provided by operating activities is mainly attributed to receipts of cash
on amounts due from our customers and a decrease in our inventory balance, as
well as $82 million of installment payments of principal and interest received
from Expanets, our largest dealer, pursuant to a credit line. These increases in
cash were partially offset by payments made on our accounts payable and other
short-term liabilities. Usage of cash in fiscal 2002 for operating activities
also resulted from payments made for our business restructuring related
activities and a net reduction in our payroll related liabilities.
Days sales outstanding in accounts receivable for fiscal 2002, excluding
the effect of the securitization transaction discussed below, was 78 days versus
95 days for fiscal 2001. The improvement in the level of days sales outstanding
is primarily attributable to the implementation of process improvements that
resulted in increased collections on past due amounts and lower sales. Days
sales of inventory on-hand for fiscal 2002 were 63 days versus 70 days for
fiscal 2001. This decrease is primarily due to improved inventory management as
a result of outsourcing our contract manufacturing, as well as a decrease in
unit costs.
In fiscal 2001, net cash used for operating activities was $133 million in
fiscal 2001 compared with net cash provided by operating activities of
$485 million in fiscal 2000. Net cash used for operating activities in fiscal
2001 was composed of a net loss of $352 million adjusted for non-cash items of
$779 million, and net cash used for changes in operating assets and liabilities
of $560 million. Net cash used for operating activities is primarily attributed
to cash payments made for our business restructuring related activities
resulting from our separation from Lucent and our establishment as an
independent company. The net usage of cash for operating activities is also
attributable to decreases in our payroll related liabilities, accounts payable
and deferred revenue. These usages of cash were partially offset by receipts of
cash on amounts due from our customers.
Days sales outstanding in accounts receivable for fiscal 2001, excluding
the effect of the securitization transaction, was 95 days versus 74 days for
fiscal 2000. This increase is primarily attributable to transition issues
resulting from the consolidation of our customer collection facilities coupled
with the temporary effects of the September 11, 2001 tragedy on our customers
and business partners. Days sales of inventory on-hand for fiscal 2001 were 70
days versus 51 days for fiscal 2000. The increase in days sales of inventory
on-hand is primarily due to lower than expected sales volumes.
- - INVESTING ACTIVITIES
Our net cash used for investing activities was $109 million in fiscal 2002
compared with $365 million and $428 million in fiscal 2001 and 2000,
respectively. The usage of cash in each year resulted primarily from capital
expenditures. Capital expenditures in fiscal 2002 included payments made for the
renovation of our corporate headquarters facility, purchase of a corporate
aircraft due to a terminated sale-leaseback agreement and upgrades of our
information technology systems, including the purchase of internal use software.
The significant reduction in capital expenditures in fiscal 2002 is attributable
to a concerted effort to restrain spending in the face of significant revenue
decreases during the year. Capital expenditures in fiscal 2001 and 2000 were due
mainly to Avaya establishing itself as a stand-alone entity, including the
implementation of SAP, establishing and upgrading
Avaya Inc. 27
<Page>
our information technology systems and other corporate infrastructure
expenditures. In addition, in the current year, we used $6 million of cash for
our acquisition of Conita Technologies, a leading supplier of voice-driven
software applications for business, which occurred in the third quarter of
fiscal 2002. In fiscal 2001, we used $120 million of cash for our acquisitions
of VPNet, a privately held developer of virtual private network solutions and
devices, and substantially all of the assets of Quintus, a provider of
comprehensive electronic customer relationship management solutions, which
occurred in the second and third quarters of fiscal 2001, respectively. The net
cash used for investing activities in fiscal 2001 was partially offset by the
receipt of proceeds from the sale-leaseback of an aircraft, the sale of
manufacturing equipment and the sale of other corporate infrastructure assets.
- - FINANCING ACTIVITIES
Net cash provided by financing activities was $255 million in fiscal 2002
compared with $483 million for the same period in fiscal 2001. Cash flows from
financing activities in the current year were mainly attributed to the issuance
of long-term debt and common stock. During fiscal 2002, we received gross
proceeds of $460 million from the issuance of Liquid Yield Option(TM) Notes
("LYONs") and $435 million from the issuance of Senior Secured Notes, as
described below. Cash proceeds received from the issuance of common stock
amounted to $235 million in connection with (i) the sale of 19.55 million shares
for $5.90 per share in a public offering, resulting in gross proceeds of
approximately $115 million, (ii) the equity transactions entered into with the
Warburg Entities described below, resulting in gross proceeds of $100 million,
and (iii) $20 million primarily in connection with the sale of shares under our
employee stock purchase plan. The receipt of cash from these debt and equity
offerings was partially offset by the payment of $29 million of issuance costs.
In addition, we made net payments of $432 million for the retirement of
commercial paper, $200 million towards the repayment of borrowings under our
five-year Credit Facility outstanding on September 30, 2001, and $13 million for
the repayment of other short-term borrowings. In connection with our election to
terminate the accounts receivable securitization in March 2002, $200 million of
collections of qualified trade accounts receivable were used to liquidate the
financial institution's investment as described below in "Securitization of
Accounts Receivable."
Net cash provided by financing activities was $483 million in fiscal 2001
compared with $42 million in fiscal 2000. Cash flows from financing activities
in fiscal 2001 were mainly due to (i) $400 million in proceeds from the sale of
our Series B convertible participating preferred stock and warrants to purchase
our common stock described below, (ii) $200 million of proceeds from the
securitization of certain trade receivables, (iii) a $200 million drawdown on
our Credit Facility, which was used to repay maturing commercial paper, and (iv)
$40 million in proceeds resulting from the issuance of our common stock,
primarily through our employee stock purchase plan. The receipt of cash from
financing activities in fiscal 2001 was partially offset by $348 million in net
payments for the retirement of commercial paper and $9 million of debt assumed
from our acquisition of VPNet.
- - DEBT RATINGS
Our ability to obtain external financing and the related cost of borrowing is
affected by our debt ratings, which are periodically reviewed by the major
credit rating agencies. During the second and fourth quarters of fiscal 2002,
our commercial paper and long-term debt ratings were downgraded. Ratings as of
September 30, 2002 and 2001 are as follows (all ratings include a negative
outlook):
<Table>
<Caption>
As of September 30,
-----------------------
2002 2001
- --------------------------------------------------------------------------------
<S> <C> <C>
Moody's:
Commercial paper NO RATING P-2
Long-term senior unsecured debt BA3 Baa1
Senior secured notes BA2 No Rating
Standard & Poor's:
Commercial paper NO RATING A-2
Long-term senior unsecured debt B No Rating
Senior secured notes B+ No Rating
Corporate credit BB- BBB
</Table>
In November 2002, Moody's downgraded our long-term senior unsecured debt rating
to "B3" with a negative outlook and the senior secured notes rating to "B2" with
a stable 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 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.
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 had a commercial paper program (the "CP Program") pursuant to which we were
able to issue up to $1.25 billion of commercial paper at market interest rates
with maturities not exceeding one year. Commercial paper issued under the CP
Program bore interest at the London Interbank Offering Rate ("LIBOR") for the
related maturity period plus a fixed spread.
During fiscal 2002, Standard& Poor's and Moody's downgraded our commercial
paper rating several times and eventually withdrew their ratings of our
commercial paper at our request. This withdrawal of our commercial paper rating
made it impossible for us to access the commercial paper market, which had been
our primary source of liquidity. As a result of the impact of the ratings
downgrades on our ability to issue commercial paper, in February 2002, we
borrowed $300 million under our five-year Credit Facility, described below, to
repay commercial paper obligations. We repaid the $300 million borrowing in
March 2002 using proceeds from the issuance of Senior Secured Notes also
described below. As of June 30, 2002, all remaining commercial paper obligations
had been repaid using proceeds from the offering of the Senior Secured Notes.
The weighted average yield and maturity period for the commercial paper
outstanding during fiscal 2002 was approximately 3.4% and 65 days, respectively.
As of September 30, 2001, $432 million in commercial paper was classified
as long-term debt in the Consolidated Balance Sheets since it was supported by
the five-year Credit Facility and it was our intention
28 Avaya Inc.
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to reissue the commercial paper on a long-term basis. The weighted average yield
and maturity period for the commercial paper outstanding during fiscal 2001 was
approximately 3.9% and 62 days, respectively.
- - REVOLVING CREDIT FACILITIES
As of September 30, 2001, we had two revolving credit facilities (the "Credit
Facilities") with third party financial institutions. These Credit Facilities
consisted of a $400 million 364-day Credit Facility that expired in August 2002
and an $850 million five-year Credit Facility that expires in September 2005. As
required by the terms of the Credit Facilities, upon the closing of the offering
of the Senior Secured Notes in March 2002, the Credit Facilities were reduced
proportionately by an amount equal to the $425 million of proceeds, net of
certain deferred financing costs, realized from the offering. Accordingly, the
364-day Credit Facility was reduced to $264 million and the five-year Credit
Facility was reduced to $561 million. We did not renew the 364-day Credit
Facility when it expired in August 2002.
As of September 30, 2002, the total commitments under the five-year Credit
Facility were $561 million, but will be subject to mandatory reduction as
follows:
- - reduced to $500 million on December 1, 2003;
- - reduced to $425 million on March 1, 2004;
- - reduced to $350 million on June 1, 2004; and
- - reduced to $250 million on September 1, 2004.
We are required to reduce the commitments by an amount equal to 100% of the
net cash proceeds realized from the sale of any assets, with certain exceptions,
and by an amount equal to 50% of the net cash proceeds realized from the
issuance of debt, other than refinancing debt; provided, however, that in each
case, we are not required to reduce the commitments below an amount equal to
$250 million less the amount of any cash used to redeem or repurchase the
convertible debt described below.
Our Credit Facilities were most recently amended in September 2002.
Borrowings under the five-year Credit Facility are available for general
corporate purposes and, subject to certain conditions, for acquisitions up to
$75 million. The five-year Credit Facility provides, at our option, for fixed
and floating rate borrowings from committed loans by the lenders who are party
to the credit facility agreement and through a competitive bid procedure.
Fixed rate committed loans under the amended five-year Credit Facility bear
interest at a rate equal to (i) the greater of (a) Citibank, N.A.'s base rate,
which was 4.75% at September 30, 2002, and (b) the federal funds rate, which was
1.75% at September 30, 2002, plus 0.5% plus (ii) a margin based on our long-term
debt rating (the "Applicable Margin"). Floating rate committed loans bear
interest at a rate equal to LIBOR plus the Applicable Margin. A utilization fee
based on our long-term debt rating (the "Applicable Utilization Fee") is added
to fixed and floating rate committed loans when the aggregate of such borrowings
exceeds 50% of the amount available under the credit facility. Based on our
current long-term debt rating, the Applicable Margins for the five-year Credit
Facility are 1.5% for fixed rate committed loans and 3.0% for floating rate
committed loans, and the Applicable Utilization Fee for both fixed and floating
rate committed loans is 0.5%. Funds are also available through competitive bid
at a fixed rate determined by the lender or at a floating interest rate equal to
LIBOR plus a margin specified by the lender.
As of September 30, 2002, no amounts were outstanding under the Credit
Facilities. As of September 30, 2001, $200 million was outstanding under the
five-year Credit Facility bearing interest at a floating rate of approximately
3.5%. This amount was repaid in October 2001.
The five-year Credit Facility contains certain covenants, including
limitations on our ability to incur liens, incur debt or make restricted
payments. In addition, we are required to maintain certain financial covenants
relating to a minimum amount of earnings before interest, taxes, depreciation
and amortization ("EBITDA") and a minimum ratio of EBITDA to interest expense.
In particular, we are required to maintain minimum EBITDA of:
- - $70 million for the three quarter period ending September 30, 2002;
- - $100 million for the four quarter period ending December 31, 2002;
- - $115 million for the four quarter period ending March 31, 2003;
- - $150 million for the four quarter period ending June 30, 2003;
- - $250 million for the four quarter period ending September 30, 2003;
- - $350 million for the four quarter period ending December 31, 2003; and
- - $400 million for each of the four quarter periods thereafter.
In addition, the five-year Credit Facility requires us to maintain a ratio
of EBITDA to interest expense of:
- - 1.70 to 1 for each of the four quarter periods ending September 30, 2002,
December 31, 2002 and March 31, 2003;
- - 2.25 to 1 for the four quarter period ending June 30, 2003;
- - 3.50 to 1 for the four quarter period ending September 30, 2003; and
- - 4.00 to 1 for the four quarter period ending December 31, 2003 and each four
quarter period thereafter.
The covenants permit us to exclude up to a certain amount of business
restructuring charges and related expenses from the calculation of EBITDA in
fiscal years 2003 and 2002. In addition, the definition of EBITDA in the
five-year Credit Facility excludes all other non-cash charges except to the
extent any such non-cash charge represents an accrual for cash expenditures in a
future period. The covenants under the five-year Credit Facility permit us to
exclude from the calculation of EBITDA our business restructuring charges and
related expenses, including asset impairment charges, of an additional
$60 million to be taken no later than June 30, 2003. We were in compliance with
all required covenants as of September 30, 2002.
Based on our current debt ratings, any borrowings under the five-year
Credit Facility are secured, subject to certain exceptions, by security
interests in our equipment, accounts receivable, inventory, and our U.S.
intellectual property rights and that of any of our subsidiaries guaranteeing
our obligations under the amended five-year Credit Facility. Borrowings are also
secured by a pledge of the stock of most of our domestic subsidiaries and 65% of
the stock of a foreign subsidiary that, together with its subsidiaries, holds
the beneficial and economic right to utilize certain of our domestic
intellectual property rights outside of North America. The security interests
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 at least
Baa2 by Moody's, in each case with a stable outlook.
Avaya Inc. 29
<Page>
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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 five-year Credit
Facility. There are no Avaya subsidiaries that currently meet these criteria.
The five-year Credit Facility provides that we may use up to $100 million
of cash to redeem or repurchase our convertible debt at any time as long as no
default or event of default exists under the facility, no amounts are
outstanding under the facility, the commitments are reduced in an amount equal
to the cash amount used to redeem or repurchase the convertible debt, and our
cash balance is not less than $300 million after giving pro forma effect to the
redemption or repurchase of the convertible debt.
While we believe we will be able to meet these financial covenants, our
revenue has been declining and any further decline in revenue may affect our
ability to meet these financial covenants in the future.
- - UNCOMMITTED CREDIT FACILITIES
We have entered into several uncommitted credit facilities totaling $61 million
and $100 million, of which letters of credit of $25 million and $20 million were
issued and outstanding as of fiscal 2002 and 2001, respectively. Letters of
credit are purchased guarantees that ensure our performance or payment to third
parties in accordance with specified terms and conditions.
- - LYONS CONVERTIBLE DEBT
In the first quarter of fiscal 2002, we sold through an underwritten public
offering under a shelf registration statement an aggregate principal amount at
maturity of approximately $944 million of LYONs due 2021. The proceeds of
approximately $448 million, net of a $484 million discount and $12 million of
underwriting fees, were used to refinance a portion of our outstanding
commercial paper. The underwriting fees of $12 million were recorded as deferred
financing costs and are being amortized 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. In fiscal 2002, $4
million of deferred financing costs were recorded as interest expense.
The original issue discount of $484 million accretes 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 their maturity value. In fiscal 2002, $16 million of
interest expense on the LYONs was recorded, resulting in an accreted value of
$476 million as of September 30, 2002. The discount will cease to accrete 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 October 31, 2004, 2006 and 2011 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. If we were to
purchase all of the LYONs at the option of the holders, the aggregate purchase
price would be approximately $512 million on October 31, 2004, $550 million on
October 31, 2006 and $659 million on October 31, 2011. If we elected to pay the
purchase price in shares of our common stock, the number of shares would be
equal to the purchase price divided by the average of the market prices of our
common stock for the five trading day period ending on the third business day
prior to the applicable purchase date.
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 our subsidiaries holding such properties.
On December 23, 2002, we and the Warburg Entities described below
commenced an exchange offer to purchase up to approximately $661 million
aggregate principal amount at maturity, or 70%, of our outstanding LYONs.
Under the terms of the offer, holders of LYONs may elect to receive, for
each LYON exchanged, either (i) $389.61 in cash (the "Cash Consideration")
or (ii) a combination of $203.87 in cash plus shares of our common stock
(the "Mixed Consideration") having a value equal to $203.87, based on the
volume-weighted average trading price of a share of our common stock on the
New York Stock Exchange (the "NYSE") during the five trading days ending on
and including the second NYSE trading day prior to the expiration of the
exchange offer; subject to a maximum of 102 shares and a minimum of
76 shares.
The total amount of cash available for the Cash Consideration and the Mixed
Consideration is $200 million, of which no more than $100 million will be paid
by us and no more than $100 million will be paid by the Warburg Entities. We
have the right to determine, subject to these limitations, how much of the
consideration paid in cash will be paid by us and how much will be paid by the
Warburg Entities. We will issue all of the shares of common stock.
LYONs tendered for the Mixed Consideration will be accepted for tender
first and, subject to the cash usage limitations described above, LYONs tendered
for the Cash Consideration will be accepted second. The exchange offer is
subject to certain conditions and we, acting alone or together with the Warburg
Entities, may terminate the offer for any or no reason. The offer will expire at
midnight, New York time, on January 22, 2002, unless extended.
In addition, if the Warburg Entities purchase LYONs in the exchange
offer (1) we will grant the Warburg Entities additional warrants to purchase
our common stock; (2) we will increase the number of shares of common stock
that may be purchased under, and decrease to $0.01 the exercise price of,
warrants currently held by the Warburg Entities; (3) the Warburg Entities
will convert all LYONs they purchase into shares of common stock that will be
determined based on the amount of cash the Warburg Entities use to purchase
LYONs in the exchange offer; (4) the Warburg Entities will exercise for cash
warrants to purchase a number of shares of our common stock that will be
determined based on the amount of cash the Warburg Entities use to purchase
LYONs in the exchange offer; and (5) following the exercise described in
clause (4) above, the adjusted exercise price of the unexercised warrants
held by the Warburg Entities will be readjusted to the exercise price in
effect prior to the commencement of the offer. The intended net effect of the
transactions described in clauses (1) through (3) above is that, in
consideration for the amount of cash that the Warburg Entities use to
purchase LYONs in the exchange offer plus the amount of cash paid to us upon
exercise of the warrants, the Warburg Entities will receive an aggregate
number of shares of our common stock equal to the quotient of (i) the sum of
the amount of cash that the Warburg Entities use to purchase LYONs in the
exchange offer plus the amount of cash paid by the Warburg Entities to us
upon exercise of the warrants, divided by (ii) 90% of the volume-weighted
trading price of a share of our common stock on the NYSE during the five NYSE
trading days ending on and including the second NYSE trading day prior to the
expiration of the offer, but in no event less than $1.78 or more than $2.68.
Under the agreement we entered into with the Warburg Entities in
connection with the exchange offer, the Warburg Entities have the right to
nominate one individual for election to our board of directors, which
individual may be affiliated with the Warburg Entities. In the event the
Warburg Entities pay more than $25 million in exchange for LYONs in the
exchange offer, the Warburg Entities will have the right to nominate one
individual to our board of directors, which individual may not be affiliated
with the Warburg Entities.
30 Avaya Inc.
<Page>
- - SENIOR SECURED NOTES
In March 2002, we issued through an underwritten public offering under a shelf
registration statement $440 million aggregate principal amount of 11 1/8% Senior
Secured Notes due April2009 (the "Senior Secured Notes") and received net
proceeds of approximately $425 million, net of a $5 million discount and $10
million of issuance costs. Interest on the Senior Secured Notes is payable on
April 1 and October 1 of each year beginning on October 1, 2002. We recorded
interest expense of $25 million for fiscal 2002. The $5 million discount is
being amortized to interest expense over the seven-year term to maturity. The
$10 million of issuance costs were recorded as deferred financing costs and are
also being amortized to interest expense over the term of the Senior Secured
Notes. The proceeds from the issuance were used to repay amounts outstanding
under the five-year Credit Facility and for general corporate purposes. As of
September 30, 2002, the carrying value of the Senior Secured Notes was $457
million, which includes $22 million related to the increase in the fair market
value of the hedged portion of such debt.
The Company may redeem the Senior Secured Notes, in whole or from time to
time in part, at the redemption prices expressed as a percentage of the
principal amount plus accrued and unpaid interest to the applicable redemption
date, if redeemed during the twelve-month period beginning on April 1 of the
following years: (i) 105.563% in 2006; (ii) 102.781% in 2007; and (iii) 100.0%
in 2008.
The Senior Secured Notes are secured by a second priority security interest
in the collateral securing our obligations under the five-year Credit Facility
and our obligations under the interest rate swap agreements. In the event that
(i) our corporate credit is rated at least BBB by Standard & Poor's and our
long-term senior unsecured debt is rated at least Baa2 by Moody's, each without
a negative outlook or its equivalent, or (ii) subject to certain conditions, at
least $400 million of unsecured indebtedness is outstanding or available under
the five-year Credit Facility or a bona fide successor credit facility, the
security interest in the collateral securing the Senior Secured Notes will
terminate. The indenture governing the Senior Secured Notes includes negative
covenants that limit our ability to incur secured debt and enter into
sale/leaseback transactions. In addition, the indenture also includes
conditional covenants that limit our ability to incur debt, enter into affiliate
transactions, or make restricted payments or investments and advances. These
conditional covenants will apply to us until such time that the Senior Secured
Notes are rated at least BBB- by Standard & Poor's and Baa3 by Moody's, in each
case without a negative outlook or its equivalent.
- - FAIR VALUE
The carrying amounts of cash and cash equivalents, accounts receivable, accounts
payable, accrued liabilities, commercial paper and other short-term borrowings
approximate fair value because of their short-term maturity and variable rates
of interest. The carrying value of debt outstanding under the five-year Credit
Facility approximates fair value as interest rates on these borrowings
approximate current market rates. The fair value of the LYONs and Senior Secured
Notes as of September 30, 2002 are estimated to be $193 million and $279
million, respectively, and are based on 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. As of
September 30, 2002, the fair value of our interest rate swaps described below
was $22 million based upon a mark-to-market valuation performed by an
independent financial institution.
As of September 30, 2002, our foreign currency forward exchange contracts
and options were assets and had a net carrying value of $10 million, which
represented their estimated fair value based on market quotes obtained through
independent pricing sources.
- - WARBURG TRANSACTIONS
In October 2000, we sold to Warburg Pincus Equity Partners, L.P. and certain of
its investment funds (the "Warburg Entities") 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. In March 2002, we
completed a series of transactions pursuant to which the Warburg Entities (i)
converted all four million shares of the Series B preferred stock into
38,329,365 shares of our common stock based on a conversion price of $11.31 per
share, which was reduced from the original conversion price of $26.71 per share,
(ii) purchased an additional 286,682 shares of common stock by exercising a
portion of the warrants at an exercise price of $34.73 per share resulting in
gross proceeds of approximately $10 million, and (iii) purchased 14,383,953
shares of our common stock for $6.26 per share, which was the reported closing
price of our common stock on the New York Stock Exchange on March 8, 2002,
resulting in gross proceeds of approximately $90 million. In connection with
these transactions, we incurred approximately $4 million of financing costs,
which were recorded as a reduction to additional paid-in capital. As of
September 30, 2002, there were no shares of Series B preferred stock outstanding
and, accordingly, the Series B preferred stock has ceased accruing dividends.
As a result of these transactions, the Warburg Entities hold approximately
53 million shares of our common stock, which represents approximately 15% of our
outstanding common stock, and warrants to
Avaya Inc. 31
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purchase approximately 12 million additional shares of common stock. These
warrants have an exercise price of $34.73 of which warrants exercisable for
6,724,665 shares of common stock expire on October 2, 2004, and warrants
exercisable for 5,379,732 shares of common stock expire on October 2, 2005.
The conversion of the Series B preferred stock and the exercise of the
warrants resulted in a charge to accumulated deficit of approximately $125
million. This charge primarily represents the impact of reducing the preferred
stock conversion price from $26.71 per share as originally calculated to $11.31
per share, as permitted under the purchase agreement.
The shares of Series B preferred stock had an aggregate initial liquidation
value of $400 million and accreted at an annual rate of 6.5%, compounded
quarterly. The purchase agreement had provided for determining the total number
of shares of common stock that the Series B preferred stock was convertible by
dividing the liquidation value in effect at the time of conversion by the
conversion price. We recorded a total of $12 million of accretion for the period
from October 1, 2001 through the date of conversion. As of September 30, 2001,
we recorded a $27 million reduction in accumulated deficit representing the
amount accreted for the dividend period.
The $400 million proceeds from the Warburg Entities' investment were
initially allocated between the Series B preferred stock and warrants based upon
the relative fair market value of each security, with $368 million allocated to
the Series B preferred stock and $32 million to the warrants. The fair value
allocated to the Series B preferred stock including the amount accreted for the
fiscal year ended September 30, 2001 was recorded in the mezzanine section of
the Consolidated Balance Sheet because the investors could have required us,
upon the occurrence of any change of control in us during the first five years
from the investment, to redeem the Series B preferred stock. The fair value
allocated to the warrants was included in additional paid-in capital.
A beneficial conversion feature would have existed 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. We determined that no beneficial conversion
features existed at the commitment date and therefore there was no impact on our
results of operations associated with the Series B preferred stock or with the
warrants.
- - PUBLIC OFFERING OF COMMON STOCK
In March 2002, we sold 19.55 million shares of common stock for $5.90 per share
in a public offering. We received proceeds of approximately $112 million, which
is net of approximately $3 million of underwriting fees reflected as a reduction
to additional paid-in capital.
- - DEALER LINE OF CREDIT
In March 2000, as part of our strategy to strengthen our distribution network,
we sold our primary distribution function for voice communications systems for
small and mid-sized enterprises to Expanets, Inc., currently our largest dealer.
The terms of the sale provided that we would provide billing, collection and
maintenance services to Expanets for a transitional period. In 2001, the dealer
agreement was restructured to define more precisely the customer base to be
serviced by each party, including small or branch offices of larger enterprises.
At the time the dealer agreement was restructured, Expanets' efforts to
obtain a commercial credit facility were hampered by the fact that its billing
and collection function had not yet been migrated to its information systems.
Because of the importance to Avaya of the Expanets relationship and the customer
base served by Expanets, we agreed to provide a $125 million short-term line of
credit (as amended as described below, the "Dealer Credit Agreement"). The
Dealer Credit Agreement applies to certain unpaid and outstanding receivables
for amounts due us by Expanets. A delay in the migration of the billing and
collection function until December 2001 affected Expanets' ability to obtain a
collateralized commercial credit facility by the original March 31, 2002
expiration date of the Dealer Credit Agreement.
Accordingly, in March 2002, we entered into an amendment to the Dealer
Credit Agreement with Expanets and its parent company, NorthWestern Corporation.
The Dealer Credit Agreement provides for installment payments under the credit
line in the amounts of $25 million in March 2002, $20 million in April 2002, and
$25 million in August 2002 with the remaining balance due on December 31, 2002.
As of September 30, 2002, we had received the first three installment payments.
The Dealer Credit Agreement provides that the borrowing limit shall be reduced
by the amount of each installment payment upon the receipt of such payment and
may also be offset by certain obligations we have to Expanets related to the
March 2000 sale of the distribution function to Expanets. As of September 30,
2002 and 2001, the borrowing limit was $35 million and $121 million,
respectively. Amounts outstanding under the line of credit accrued interest at
an annual rate of 12% through August 31, 2002, and increased to 15% on September
1, 2002.
The following table summarizes all amounts receivable from Expanets,
including amounts outstanding under the line of credit, as of September 30, 2002
and 2001:
<Table>
<Caption>
As of September 30,
-------------------
(dollars in millions) 2002 2001
- --------------------------------------------------------------------------------
<S> <C> <C>
Receivables $ 65 $ 117
Other current assets 1 81
- --------------------------------------------------------------------------------
Total amounts receivable from Expanets $ 66 $ 198
================================================================================
Secured and unsecured components of the amounts receivable
are as follows:
Secured line of credit (included in receivables) $ 35 $ 71
Secured line of credit (included in other current assets) -- 50
- --------------------------------------------------------------------------------
Total secured line of credit 35 121
Unsecured 31 77
- --------------------------------------------------------------------------------
Total amounts receivable from Expanets $ 66 $ 198
================================================================================
</Table>
Amounts recorded in receivables represent trade receivables due from Expanets on
sales of products and maintenance services. Amounts recorded in other current
assets represent receivables due from Expanets for transitional services
provided under a related agreement.
32 Avaya Inc.
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Outstanding amounts under the line of credit are secured by Expanets'
accounts receivable and inventory. In addition, NorthWestern has guaranteed up
to $50 million of Expanets' obligations under the Dealer Credit Agreement. A
default by NorthWestern of its guarantee obligations under the Dealer Credit
Agreement would constitute a default under the Expanets' dealer agreement with
Avaya, resulting in a termination of the non-competition provisions contained in
such agreement and permitting us to sell products to Expanets' customers.
We have had, and continue to have, discussions with Expanets regarding
operational issues related to the March 2000 sale to them of our primary
distribution function for voice communications systems for small and
mid-sized enterprises. Although these issues are unrelated to Expanets' and
Northwestern's obligations under the Dealer Credit Agreement, because of the
importance to us of our relationship with Expanets and the customer base
served by Expanets, in December 2002 we agreed to extend the term of the
Dealer Credit Agreement to February 2003.
There can be no assurance that Expanets will be able to comply with the
remaining terms of the Dealer Credit Agreement. In the event Expanets is unable
to comply with the terms of the Dealer Credit Agreement and a default occurs,
the remedies available to Avaya under such agreement may be insufficient to
satisfy in full all of Expanets' obligations to us.
- - SECURITIZATION OF ACCOUNTS RECEIVABLE
In June 2001, we entered into a receivables purchase agreement and transferred a
designated pool of qualified trade accounts receivable to a special purpose
entity ("SPE"), which in turn sold an undivided ownership interest in the pool
of receivables to an unaffiliated financial institution for cash proceeds of
$200 million. The receivables purchase agreement was terminated in March 2002 as
described below. The designated pool of qualified receivables held by the SPE
was pledged as collateral to secure the obligations to the financial
institution. During the term of the receivables purchase agreement, we had a
retained interest in the designated pool of receivables to the extent the value
of the receivables exceeded the outstanding amount of the financial
institution's investment. The carrying amount of our retained interest, which
approximates fair value because of the short-term nature of the receivables, was
recorded in other current assets.
In March 2002, we elected to terminate the receivables purchase agreement, which
was scheduled to expire in June 2002. As a result of the early termination,
purchases of interests in receivables by the financial institution ceased, and
collections on receivables that constituted the designated pool of trade
accounts receivable were used to repay the financial institution's $200 million
investment, which has been entirely liquidated as of September 30, 2002. No
portion of the retained interest was used to liquidate the financial
institution's investment. Upon liquidation in full in April 2002, we had
reclassified the remaining $109 million retained interest to receivables. As of
September 30, 2001, we had a retained interest of $153 million in the SPE's
designated pool of qualified accounts receivable.
- - 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.
In March2002, we elected to terminate the aircraft sale-leaseback agreement and,
pursuant to the terms of the agreement, we purchased the aircraft in April 2002
from the lessor for a purchase price equal to the unamortized lease balance of
approximately $33 million.
- - CROSS ACCELERATION/CROSS DEFAULT PROVISIONS
The agreement governing our $50 million interest rate swap, our $150 million
interest rate swap, and the indentures governing the LYONs and the Senior
Secured Notes 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 five-year Credit Facility provides 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.
- - PRODUCT FINANCING ARRANGEMENTS
We sell products to various resellers that may obtain financing from certain
unaffiliated third party lending institutions.
For our U.S. product financing arrangements with resellers, in the event
the lending institution repossesses the reseller's inventory of our products, we
are obligated under certain circumstances to repurchase such inventory from the
lending institution. Our obligation to repurchase inventory from the lending
institution terminates 180 days from our date of invoicing to the reseller. The
repurchase amount is equal to the price originally paid to us by the lending
institution for the inventory. The amount reported to us from the two resellers
who participate in these arrangements as their inventory on-hand was
approximately $64 million as of September 30, 2002. We are unable to determine
how much of this inventory was financed and, if so, whether any amounts have
been paid to the lending institutions. Therefore, our repurchase obligation
could be less than the amount of inventory on-hand. While there have not been
any repurchases made by us under such agreements, we cannot assure you that we
will not be obligated to repurchase inventory under these arrangements in the
future.
For our product financing arrangements with resellers outside the U.S., in
the event participating resellers default on their payment obligation to the
lending institution, we are obligated under certain circumstances to guarantee
repayment to the lending institution. The repayment amount fluctuates with the
level of product financing activity. The guarantee repayment amount reported to
us from the lending institutions was approximately $18 million as of September
30, 2002. We review and set the maximum credit limit for each reseller
participating in these financing arrangements. While there have not been any
guarantee repayments by us under such arrangements, there can be no assurance
that we will not be obligated to make these repayments in the future.
- - FUTURE CASH NEEDS
Our primary future cash needs will be to fund working capital, capital
expenditures, debt service, employee benefit obligations and our business
restructuring charges and related expenses. We foresee a further reduction in
cash usage on capital expenditures in fiscal 2003 as compared with fiscal 2002
as we continue to restrain our spending as a result of the continued economic
and business uncertainty. Beginning in fiscal 2003, we will commence making
semiannual payments on the fixed interest rate Senior Secured Notes of
approximately $25 million; however, the interest rate swaps associated with this
debt may require additional payments or generate additional receipts depending
on the market performance of these swaps. Based on the current value
Avaya Inc. 33
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of the assets in our benefit plans, we expect to make cash contributions of $45
million in fiscal 2003 to fund our pension obligation. Lastly, we expect to make
cash payments in fiscal 2003 related to our business restructuring initiatives
of approximately $124 million which are expected to be composed of $65 million
for employee separation costs, $47 million for lease obligations, and $12
million for incremental period costs, including computer transition
expenditures, relocation and consolidation costs. We believe that our existing
cash and cash flows from operations will be sufficient to meet these needs. If
we do not generate sufficient cash from operations, we may need to incur
additional debt.
In order to meet our cash needs, we may from time to time, borrow under our
five-year Credit Facility 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 Facility and the indentures governing the
LYONs and the Senior Secured Notes 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.
We may from time to time seek to retire our outstanding debt through cash
purchases and/or exchanges for equity securities, in open market purchases,
privately negotiated transactions or otherwise. Such repurchases or exchanges,
if any, will depend on the prevailing market conditions, our liquidity
requirements, contractual restrictions and other factors. The amounts involved
may be material.
The following are summaries of our contractual obligations and other
commercial commitments as of September 30, 2002:
<Table>
<Caption>
Payments Due by Fiscal Period
-------------------------------------------------------------
Contractual Obligations Total 2003 2004-2005 2006-2007 Thereafter
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Long-Term Debt(1) $ 1,384 $ -- $ -- $ -- $ 1,384
Operating Leases 753 185 209 109 250
- ---------------------------------------------------------------------------------------------------------
Total Contractual Obligations $ 2,137 $ 185 $ 209 $ 109 $ 1,634
=========================================================================================================
</Table>
<Table>
<Caption>
Amount of Commitment Expiration Per Fiscal Period
-------------------------------------------------------------
Other Commercial Commitments Total 2003 2004-2005 2006-2007 Thereafter
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Committed Lines of Credit $ 561 $ -- $ 561 $ -- $ --
Uncommitted Lines of Credit(2) 36 36 -- -- --
Letters of Credit 25 22 3 -- --
Conditional Repurchase Obligations 64 64 -- -- --
Guarantees 18 18 -- -- --
- ---------------------------------------------------------------------------------------------------------
Total Other Commercial Commitments $ 704 $ 140 $ 564 $ -- $ --
=========================================================================================================
</Table>
(1) Assumes all long-term debt is held to maturity.
(2) Uncommitted lines of credit do not have an expiration date since the lending
institutions may renew or revoke such commitments at any time. Therefore,
these amounts are presented in the table as expiring within a one-year
period and are included in the fiscal 2003 period.
We do not expect that any of our commercial commitments will have a material
adverse effect on our consolidated results of operations, financial position or
liquidity.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT
In connection with our acquisitions in fiscal 2001, a portion of the purchase
price, $31 million for VPNet and $1 million for Quintus was allocated to
purchased in-process research and development ("IPR&D"). As part of the process
of analyzing these acquisitions, we made a decision to buy technology that had
not yet been commercialized rather than develop the technology internally. We
based this decision on a number of factors including the amount of time it would
take to bring the technology to market. We also considered our internal research
resource allocation and our progress on comparable technology, if any. We expect
to use a similar decision process in the future.
At the date of each acquisition, the IPR&D projects had not yet reached
technological feasibility and had no future alternative use. Accordingly, the
value allocated to these projects was capitalized and immediately expensed at
acquisition. If the projects are not successful or completed in a timely manner,
our product pricing and growth rates may not be achieved and we may not realize
the financial benefits expected from the projects.
The value allocated to purchased IPR&D for the acquisitions was determined
using an income approach. This involved estimating the fair value of the IPR&D,
using the present value of the estimated after-tax cash flows expected to be
generated by the purchased IPR&D, using risk-adjusted discount rates and revenue
forecasts as appropriate. Where appropriate, we deducted an amount reflecting
the contribution of the core technology from the anticipated cash flows from an
IPR&D project. The selection of the discount rate was based
34 Avaya Inc.
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on consideration of our weighted average cost of capital, as well as other
factors, including the useful life of each technology, profitability levels of
each technology, the uncertainty of technology advances that were known at the
time, and the stage of completion of each technology. We believe that the
estimated IPR&D amounts so determined represent fair value and do not exceed the
amount a third party would have paid for the projects.
Revenue forecasts were estimated based on relevant market size and growth
factors, expected industry trends, individual product sales cycles and the
estimated life of each product's underlying technology. Estimated operating
expenses, income taxes, and charges for the use of contributory assets were
deducted from estimated revenue to determine estimated after-tax cash flows for
each project. Estimated operating expenses include cost of goods sold, selling,
general and administrative expenses, and research and development expenses. The
research and development expenses include estimated costs to maintain the
products once they have been introduced into the market and generate revenue and
costs to complete the purchased IPR&D.
The actual results to date have been consistent, in all material respects,
with our assumptions at the time of the acquisition, except as noted below.
Set forth below are descriptions of the significant acquired IPR&D projects
related to our acquisition of VPNet.
In February 2001, we completed the purchase of VPNet and allocated
approximately $31 million to IPR&D projects, using the income approach described
above, to the following projects: low-end technologies for $5 million and
high-end technologies for $26 million. These projects under development at the
valuation date represent next-generation technologies that are expected to
address emerging market demands for low- and high-end network data security
needs.
At the acquisition date, the low-end technologies under development were
approximately 80% complete based on engineering data and technological progress.
Revenue attributable to the developmental low-end VPNet technologies was
estimated to be $8 million in 2002 and $13 million in 2003. Revenue was
estimated to grow at a compounded annual growth rate of approximately 60% for
the six years following introduction, assuming the successful completion and
market acceptance of the major research and development programs. Revenue was
expected to peak in 2004 and decline thereafter through the end of the
technologies' life in 2007 as new product technologies were expected to be
introduced.
At the acquisition date, the high-end technologies under development were
approximately 60% complete, based on engineering data and technological
progress. Revenue attributable to the developmental high-end VPNet technologies
was estimated to be $52 million in 2002 and $86 million in 2003. Revenue was
estimated to grow at a compounded annual growth rate of approximately 50% for
the seven years following introduction, assuming the successful completion and
market acceptance of the major research and development programs. Revenue was
expected to peak in 2004 and decline thereafter through the end of the
technologies' life in 2008 as new product technologies were expected to be
introduced.
VPNet had spent approximately $4 million on these in-process technology
projects, and expected to spend approximately $4 million to complete all phases
of research and development.
The rates utilized to discount the net cash flows to their present value
were based on estimated cost of capital calculations. Due to the nature of the
forecasts and the risks associated with the successful development of the
projects, a discount rate of 25% was used to value the IPR&D. The discount rate
utilized was higher than our weighted average cost of capital due to the
inherent uncertainties surrounding the successful development of the purchased
in-process technology, the useful life of such technology, the profitability
levels of the technology, and the uncertainty of technological advances that
were unknown at that time.
During fiscal 2002, the business environment in which the acquired VPNet
technologies were to be commercialized changed and the marketplace assumptions
originally utilized in the acquisition models were updated accordingly.
Consequently, we did not realize all of the original forecasted revenues in
fiscal 2002, and we do not expect to realize all of the forecasted revenues in
subsequent fiscal years from these acquired technologies. During fiscal 2002, we
wrote off $21 million of net acquired intangible assets related to the purchase
of VPNet, which is included in the $71 million goodwill and intangibles
impairment charge included in our Consolidated Statement of Operations.
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 seven 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 against us that could have, individually
Avaya Inc. 35
<Page>
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 recently been certified in the West Virginia state court
matter. The certified class in the West Virginia matter includes those persons
or entities that purchased, leased or financed the products in question. In
addition, the court also certified as a subclass all class members who had
service protection plans or other service or extended warranty contracts with
Lucent in effect as of April 1, 1998, as to which Lucent failed to offer a Year
2000-compliant solution. The federal court in the New York action has issued a
decision and order denying class certification, dismissing all but certain fraud
claims by one representative plaintiff. No class claims remain in this case at
this time. The federal court in the California action has issued an opinion and
order granting class certification on a provisional basis, pending submission by
plaintiffs of certain proof requirements mandated by the Y2K Act. The class
includes any entities that purchased or leased certain products on or after
January 1, 1990, excluding those entities who did not have a New Jersey choice
of law provision in their contracts and those who did not purchase equipment
directly from defendants. The complaints seek, among other remedies,
compensatory damages, punitive damages and counsel fees in amounts that have not
yet been specified. At this time, we cannot determine whether the outcome of
these actions will have a material adverse effect on our financial position,
results of operations or cash flows. In addition, if these cases are not
resolved in a timely manner, they will require expenditure of significant legal
costs related to their defense.
- - 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's motion to dismiss the Fifth Consolidated Amended and
Supplemental Class Action Complaint in the consolidated action was denied by the
court in June 2002. As a result of the denial of its motion to dismiss, we
understand that Lucent has filed a motion for partial summary judgment, seeking
a dismissal of a portion of the Fifth Consolidated Amended and Supplemental
Class Action Complaint. 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.
We understand that the federal district court in New Jersey has issued
orders staying all securities actions against Lucent, as well as those related
to the securities cases, so the parties may discuss a potential global
settlement of claims. We also understand that the parties have had preliminary
meetings to discuss settlement of these cases.
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 still in the
relatively 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 ARBITRATION
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. This matter is currently in arbitration. 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 held
36 Avaya Inc.
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on February 26, 2002. At the annual meeting, we obtained 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 the proposed method of valuing the fractional interests, and further,
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. In June 2002, the court denied the
plaintiff's motion for summary judgment and granted our cross-motion for summary
judgment. The plaintiff appealed the Chancery Court's decision to the Delaware
Supreme Court and, in November 2002, the Delaware Supreme Court affirmed the
lower court's ruling in our favor. Subsequently, the plaintiff filed a motion
for re-hearing by the Delaware Supreme Court, arguing that the court misapplied
the law concerning fractional "shares" versus fractional "interests" to the
facts of the case. We have filed our response to the plaintiff's motion with the
Delaware Supreme Court and await its ruling. We cannot provide assurance that
this lawsuit will not impair our ability to implement any of the transactions.
In April 2002, a complaint was filed against us in the Superior Court of
New Jersey, Somerset County, in connection with the reverse/forward stock splits
described above. 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, injunctive relief enjoining us from effecting the
transactions. In recognition of the then pending action in the Delaware Court of
Chancery, the plaintiff voluntarily dismissed his complaint without prejudice,
pending outcome of the Delaware action.
- - COMMISSION ARBITRATION DEMAND
In July 2002, a third party representative made formal demand for arbitration
for alleged unpaid commissions in an amount in excess of $10 million, stemming
from the sale of products from our businesses that were formerly owned by Lucent
involving the Ministry of Russian Railways. As the sales of products continue,
the third party representative may likely increase its commission demand. The
viability of this asserted claim is based on the applicability and
interpretation of a representation agreement and an amendment thereto, which
provides for binding arbitration. This matter is currently proceeding to
arbitration. The matter is in the early stages and an outcome in the arbitration
proceeding cannot be predicted. 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.
- - LUCENT CONSUMER PRODUCTS CLASS ACTIONS
In several class action cases (the first of which was filed on June 24, 1996),
plaintiffs claim that AT&T and Lucent engaged in fraud and deceit in continuing
to lease residential telephones to consumers without adequate notice that the
consumers would pay well in excess of the purchase price of a telephone by
continuing to lease. The cases were removed and consolidated in federal court in
Alabama, and were subsequently remanded to their respective state courts
(Illinois, Alabama, New Jersey, New York and California). In July 2001, the
Illinois state court certified a nationwide class of plaintiffs. The case in
Illinois was scheduled for trial on August 5, 2002. Prior to commencement of
trial, however, we had been advised that the parties agreed to a settlement of
the claims on a class-wide basis. The settlement was approved by the court on
November 4, 2002. Claims from class members must be filed on or about January
15, 2003.
Any liability incurred by Lucent in connection with these class action
cases will be considered an exclusive Lucent liability under the Contribution
and Distribution Agreement between Lucent and us and, as a result, we are
responsible for 10% of any such liability in excess of $50 million. The amount
for which we may be responsible will not be finally determined until the class
claims period expires.
- - PATENT INFRINGEMENT INDEMNIFICATION CLAIMS
A patent owner has sued three customers of our managed services business for
alleged infringement of a single patent based on the customers' voicemail
service. These customers' voicemail service offerings are partially or wholly
provided by our managed services business. As a consequence, these customers are
requesting defense and indemnification from us in the lawsuits under their
managed services contracts. This matter is in the early stages and we cannot yet
determine whether the outcome of this matter will have a material adverse effect
on our financial position, results of operations or cash flows.
FINANCIAL INSTRUMENTS
We conduct our business on a multi-national basis in a wide variety of foreign
currencies. We are, therefore, subject to the risk associated with foreign
currency exchange rates and interest rates that could affect our results of
operations, financial position or cash flows. We manage our exposure to these
market risks through our regular operating and financing activities and, when
deemed appropriate, through the use of derivative financial instruments. We use
derivative financial instruments to reduce earnings and cash flow volatility
associated with foreign exchange rate changes. Specifically, we utilize foreign
currency forward contracts, and to a lesser extent, foreign currency options to
mitigate the effects of fluctuations of exchange rates associated with certain
existing assets and liabilities that are denominated in nonfunctional
currencies, and periodically to reduce anticipated net foreign currency cash
flows resulting from normal business operations. In addition, we use interest
rate swap agreements to manage our proportion of fixed and floating rate debt
and to reduce interest expense. Derivative financial instruments are used as
risk management tools and not for speculative or trading purposes.
Avaya Inc. 37
<Page>
- - FOREIGN CURRENCY TRANSACTIONS
RECORDED TRANSACTIONS - We utilize foreign currency forward contracts primarily
to manage short-term exchange rate exposures on certain receivables, payables
and loans residing on our foreign subsidiaries' books, which are denominated in
currencies other than the subsidiary's functional currency. When these items are
revalued into the subsidiary's functional currency at the month-end exchange
rates, the fluctuations in the exchange rates are recognized in earnings as
other income or expense. Changes in the fair value of our foreign currency
forward contracts used to offset these exposed items are also recognized in
earnings as other income or expense in the period in which the exchange rates
change. For the fiscal years ended September 30, 2002 and 2001, changes in the
fair value of the foreign currency forward and option contracts were
substantially offset by changes resulting from the revaluation of the hedged
items.
The fair value of foreign currency forward contracts is sensitive to
changes in foreign currency exchange rates. As of September 30, 2002 and 2001, a
10% appreciation in foreign currency exchange rates from the prevailing market
rates would increase our related net unrealized gain for fiscal 2002 and 2001 by
$6 million and $13 million, respectively. Conversely, a 10% depreciation in
these currencies from the prevailing market rates would decrease our related net
unrealized gain for fiscal 2002 and 2001 by $6 million and $13 million,
respectively. Consistent with the nature of the economic hedge of such foreign
currency forward contracts, such unrealized gains or losses would be offset by
corresponding decreases or increases, respectively, of the underlying asset,
liability or transaction being hedged.
FORECASTED TRANSACTIONS - From time to time, we use foreign currency forward and
option contracts to offset certain forecasted foreign currency transactions
primarily related to the purchase or sale of product expected to occur during
the ensuing twelve months. The change in the fair value of foreign currency
forward and option contracts is recognized as other income or expense in the
period in which the exchange rates change. We did not use any foreign currency
forward or option contracts for forecasted transactions in fiscal 2002. For the
fiscal year ended September 30, 2001, these gains and losses were not material
to our results of operations. As permitted under SFAS133, we have elected not to
designate our forward and option contracts as hedges thereby precluding the use
of hedge accounting for these instruments. Such treatment could result in a gain
or loss from fluctuations in exchange rates related to a derivative contract
that is different from the loss or gain recognized from the underlying
forecasted transaction. However, we have procedures to manage the risks
associated with our derivative instruments, which include limiting the duration
of the contracts, typically six months or less, and the amount of the underlying
exposures that can be economically hedged. Historically, the gains and losses on
these transactions have not been significant.
By their nature, all derivative instruments involve, to varying degrees,
elements of market risk and credit risk not recognized in our financial
statements. The market risk associated with these instruments resulting from
currency exchange rate movements is expected to offset the market risk of the
underlying transactions, assets and liabilities being economically hedged. The
counterparties to the agreements relating to our foreign exchange instruments
consist of a diversified group of major financial institutions. We do not
believe that there is significant risk of loss in the event of non-performance
of the counterparties because we control our exposure to credit risk through
credit approvals and limits, and continual monitoring of the credit ratings of
such counterparties. In addition, we limit the financial exposure and the
amount of agreements entered into with any one financial institution.
- - INTEREST RATE SWAP AGREEMENTS
In April 2002, we entered into two interest rate swap agreements with a total
notional amount of $200 million that qualify and are designated as fair value
hedges in accordance with SFAS 133, "Accounting for Derivative Instruments and
Hedging Activities." The swap agreements mature in April 2009 and were executed
in order to: (i) convert a portion of the Senior Secured Notes fixed-rate debt
into floating-rate debt; (ii) maintain a capital structure containing
appropriate amounts of fixed and floating-rate debt; and (iii) reduce net
interest payments and expense in the near-term.
Under these agreements, we receive a fixed interest rate of 11.125% and pay
a floating interest rate based on LIBOR plus an agreed-upon spread, which was
equal to a weighted average interest rate of 6.8% as of September 30, 2002. The
amount paid and the amount received is calculated based on the total notional
amount of $200 million. Since the relevant terms of the swap agreements match
the corresponding terms of the Senior Secured Notes, there is no hedge
ineffectiveness. Accordingly, as required by SFAS 133, gains and losses on the
swap agreements will fully offset the losses and gains on the hedged portion of
the Senior Secured Notes, which are marked to market at each reporting date. As
of September 30, 2002, we recorded the fair market value of the swaps of $22
million as other assets along with a corresponding increase to the hedged debt,
with equal and offsetting unrealized gains and losses included in other income
(expense), net.
Interest payments are recognized through interest expense and are made and
received on the first day of each April and October, commencing on October 1,
2002 and ending on the maturity date. On the last day of each semi-annual
interest payment period, the interest rate payment for the previous six months
will be made based upon the six-month LIBOR rate (in arrears) on that day, plus
the applicable margin, as shown in the table below. Since the interest rate is
not known until the end of each semi-annual interest period, estimates are used
during such period based upon published forward-looking LIBOR rates. Any
differences between the estimated interest expense and the actual interest
payment are recorded to interest expense at the end of each semi-annual interest
period. These interest rate swaps resulted in a reduction to actual interest
expense in fiscal 2002 of $4 million.
38 Avaya Inc.
<Page>
The following table outlines the terms of the swap agreements:
<Table>
<Caption>
Notional Receive
Amount Fixed
(dollars Interest
Maturity Date in millions) Rate Pay Variable Interest Rate
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
April 2009 $ 150 11.125% Six-month LIBOR (in arrears)
plus 5.055% spread
April 2009 50 11.125% Six-month LIBOR (in arrears)
----- plus 5.098% spread
Total $ 200
=====
</Table>
Each counterparty to the swap agreements is a lender under the five-year Credit
Facility. Our obligations under these swap agreements are secured on the same
basis as our obligations under the five-year Credit Facility.
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. SFAS 143 requires entities to record the fair
value of a liability for an asset retirement obligation in the period in which
it is incurred and is effective for our 2003 fiscal year. The adoption of SFAS
143 is not expected to have a material impact on our consolidated results of
operations, financial position or cash flows.
- - SFAS 144
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("SFAS 144"), which requires that long-lived
assets to be disposed of by sale be measured at the lower of the 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. SFAS 144
excludes from the definition of long-lived assets goodwill and other intangibles
that are not amortized in accordance with SFAS 142. SFAS 144 is effective for
our 2003 fiscal year. The adoption of SFAS 144 is not expected to have a
material impact on our consolidated results of operations, financial position or
cash flows.
- - SFAS 145
In May 2001, the FASB issued Statement No. 145, which rescinds SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," SFAS No. 44,
"Accounting for Intangible Assets of Motor Carriers," and SFAS No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements" ("SFAS
145"). SFAS 145 also amends SFAS No. 13, "Accounting for Leases," to eliminate
an inconsistency between the required accounting for sale-leaseback transactions
and the required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. As a result of the
rescission of SFAS 4 and SFAS 64, the criteria in Accounting Principles Board
Opinion No. 30 will be used to classify gains and losses from debt
extinguishment. SFAS 145 also amends other existing authoritative pronouncements
to make various technical corrections, clarify meanings, or describe their
applicability under changed conditions. SFAS 145 is effective for our 2003
fiscal year. The adoption of SFAS 145 is not expected to have a material impact
on our consolidated results of operations, financial position or cash flows.
- - SFAS 146
In June 2002, the FASB issued Statement No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"), which addresses
financial accounting and reporting for costs associated with exit or disposal
activities, and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)" which
previously governed the accounting treatment for restructuring activities. SFAS
146 applies to costs associated with an exit activity that does not involve an
entity newly acquired in a business combination or with a disposal activity
covered by SFAS 144. Those costs include, but are not limited to, the following:
(1) termination benefits provided to current employees that are involuntarily
terminated under the terms of a benefit arrangement that, in substance, is not
an ongoing benefit arrangement or an individual deferred-compensation contract,
(2) costs to terminate a contract that is not a capital lease, and (3) costs to
consolidate facilities or relocate employees. SFAS 146 does not apply to costs
associated with the retirement of long-lived assets covered by SFAS 143. SFAS
146 will be applied prospectively and is effective for exit or disposal
activities initiated after December 31, 2002. Early adoption is permitted.
- - FASB INTERPRETATION NO. 45
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("Interpretation"). This Interpretation elaborates on
the existing disclosure requirements for most guarantees, including loan
guarantees such as standby letters of credit. It also clarifies that at the time
a company issues a guarantee, the company must recognize an initial liability
for the fair market value of the obligations it assumes under that guarantee and
must disclose that information in its interim and annual financial statements.
The initial recognition and measurement provisions of the Interpretation apply
on a prospective basis to guarantees issued or modified after December 31, 2002.
THE APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements are based on the selection and application
of accounting principles generally accepted in the United States of America,
which require us to make estimates and assumptions about future events that
affect the amounts reported in our financial statements and the accompanying
notes. Future events and their effects cannot be determined with absolute
certainty. Therefore,
Avaya Inc. 39
<Page>
the determination of estimates requires the exercise of judgment. Actual results
could differ from those estimates, and any such differences may be material to
the financial statements. We believe that the following policies may involve a
higher degree of judgment and complexity in their application and represent the
critical accounting policies used in the preparation of our financial
statements. If different assumptions or conditions were to prevail, the results
could be materially different from our reported results.
- - REVENUE RECOGNITION
Most of our sales require judgments principally in the areas of customer
acceptance, returns assessments and collectibility. The assessment of
collectibility is particularly critical in determining whether or not revenue
should be recognized in the current market environment. In addition, a
significant amount of our revenue is generated from sales of product to
distributors. As such, our provision for estimated sales returns and other
allowances and deferrals requires significant judgment.
- - COLLECTIBILITY OF ACCOUNTS RECEIVABLE
In order to record our accounts receivable at their net realizable value, we
must assess their collectibility. A considerable amount of judgment is required
in order to make this assessment including an analysis of historical bad debts
and other adjustments, a review of the aging of our receivables and the current
creditworthiness of our customers. We have recorded allowances for receivables
which we feel are uncollectible, including amounts for the resolution of
potential credit and other collection issues such as disputed invoices, customer
satisfaction claims and pricing discrepancies. However, depending on how such
potential issues are resolved, or if the financial condition of any of our
customers was to deteriorate and their ability to make required payments became
impaired, increases in these allowances may be required. We actively manage our
accounts receivable to minimize credit risk and as of September 30, 2002, we
have no individual customer that constitutes more than 10% of our accounts
receivable.
- - INVENTORIES
In order to record our inventory at its lower of cost or market, we assess the
ultimate realizability of our inventory, which requires us to make judgments as
to future demand and compare that with the current or committed inventory
levels. Where we have determined that the future demand is lower than our
current inventory levels, we have adjusted our inventory forecasts to reflect
that demand. Additionally, we review our usage and inventory levels and record a
provision to adjust our inventory balance based on our historical usage and
inventory turnover. It is possible that we may need to adjust our inventory
balance in the future based on the dynamic nature of this relationship. In
addition, we have outsourced the manufacturing of substantially all of our CSA
and SMBS products. We are not obligated to purchase products from our outsourced
manufacturer in any specific quantity, except as we outline in forecasts or
orders for products required to be manufactured by the outsourced manufacturer.
We may be obligated to purchase certain excess inventory levels from our
outsourced manufacturer that could result from our actual sales of product
varying from forecast.
- - LONG-LIVED ASSETS
We have recorded property, plant and equipment, intangible assets, and
capitalized software costs at cost less accumulated depreciation or
amortization. The determination of useful lives and whether or not these assets
are impaired involves significant judgment.
We conducted the required annual goodwill impairment review during the
fourth quarter of fiscal 2002. Due to a significant downward movement in the
U.S. stock market and communications technology market, in particular, we
experienced a decline in our market capitalization that negatively impacted the
fair value of our reporting units as determined in accordance with the
provisions of SFAS 142. Updated valuations were completed for all reporting
units with goodwill as of September 30, 2002 using a discounted cash flow
approach based on forward-looking information regarding market share, revenues
and costs for each reporting unit as well as appropriate discount rates. As a
result, we recorded a goodwill impairment charge of $44 million as an operating
expense in fiscal 2002 related to our SMBS operating segment. A considerable
amount of judgment is required in calculating this impairment charge,
principally in determining discount rates, market premiums, financial forecasts,
and allocation methodology.
- - DEFERRED TAX ASSETS
We currently have significant net deferred tax assets resulting from tax credit
carryforwards, net operating losses and other deductible temporary differences,
which are available to reduce taxable income in future periods. We recorded an
increase of $563 million to our net deferred tax assets valuation allowance in
the fourth quarter of fiscal 2002. The increase in the valuation allowance is
composed of a $364 million charge included in the tax provision and a $202
million reduction in accumulated other comprehensive loss associated with the
minimum pension liability recorded in accordance with SFAS No.87, "Employers'
Accounting for Pensions." The increase in the valuation allowance was partially
offset by $3 million of net operating losses that expired during the year. The
valuation allowance was calculated in accordance with the provisions of SFAS No.
109, "Accounting for Income Taxes" ("SFAS 109"), which place primary importance
on a company's cumulative operating results for the current and preceding years.
Although we believe that our results for those periods were heavily
affected by deliberate and planned restructuring activities aimed to right-size
our cost structure, the cumulative losses in those periods represented negative
evidence sufficient to require a valuation allowance under the provisions of
SFAS 109.
40 Avaya Inc.
<Page>
We intend to maintain a valuation allowance until sufficient positive
evidence exists to support its reversal. Although realization is not assured, we
have concluded that the remaining net deferred tax assets as of September 30,
2002 in the amount of $532 million will be realized based on the scheduling of
deferred tax liabilities and on certain distinct tax planning strategies that we
intend to implement in a timely manner, if necessary, which will allow us to
recognize the future tax attributes. The amount of net deferred tax assets
determined to be realizable was measured by calculating the tax effect of the
planning strategies, which include the potential sale of assets and liabilities.
The amount of the deferred tax assets actually realized, however, could vary if
there are differences in the timing or amount of future reversals of existing
deferred tax liabilities or in future income. Should Avaya determine that it
would not be able to realize all or part of its deferred tax assets in the
future, an adjustment to the deferred tax assets valuation allowance would be
charged to income in the period such determination was made.
- - BUSINESS RESTRUCTURING CHARGES
During each of fiscal 2002, 2001, and 2000, we recorded $201 million, $674
million and $499 million, respectively, of charges and established related
business restructuring reserves in connection with our spin off from Lucent, the
outsourcing of certain manufacturing facilities, the acceleration of our
restructuring plan originally adopted in September 2000, and our efforts to
improve our business performance in response to the continued industry-wide
slowdown. These reserves include estimates related to employee separation costs,
lease termination obligations and other exit costs. In fiscals 2002 and 2001, we
reversed $20 million and $35 million, respectively, of business restructuring
reserves primarily related to fewer employee separations than originally
anticipated.
- - PENSION AND POSTRETIREMENT BENEFIT COSTS
Our pension and postretirement benefit costs are developed from actuarial
valuations. Inherent in these valuations are key assumptions provided by us to
our actuaries, including the discount rate and expected long-term rate of return
on plan assets. Material changes in our pension and postretirement benefit costs
may occur in the future due to changes in these assumptions, changes in the
number of plan participants, and changes in the level of benefits provided.
The discount rate is subject to change each year, consistent with changes
in applicable high-quality, long-term corporate bond indices. Based on the
expected duration of the benefit payments for our pension plans, we refer to
applicable indices such as the Moody's AA Corporate Bond Index and the Salomon
Brothers Pension Discount Curve to select a rate at which we believe the pension
benefits could be effectively settled. Based on the published rates as of
September 30, 2002, we used a discount rate of 6.5%, a decline of 50 basis
points from the 7% rate used in fiscal year 2001. This had the effect of
increasing our accumulated pension benefit obligation by approximately $149
million for the fiscal year ended September 30, 2002, and increasing our
estimated pension expense for fiscal 2003 by $1.5 million.
The expected long-term rate of return on pension plan assets is selected by
taking into account the expected duration of the projected benefit obligation
for the plans, the asset mix of the plans, and the fact that the plan assets are
actively managed to mitigate downside risk. Based on these factors, our expected
long-term rate of return as of September 30, 2002 is 9%, consistent with the
prior year. A 25 basis point change in the expected long-term rate of return
would result in approximately a $6 million change in our pension expense.
On September 30, 2002, our annual measurement date, the accumulated benefit
obligation related to our pension plans exceeded the fair value of the pension
plan assets (such excess is referred to as an unfunded accumulated benefit
obligation). This difference is attributed to (1) an increase in the accumulated
benefit obligation that resulted from the decrease in the interest rate used to
discount the projected benefit obligation to its present settlement amount from
7% to 6.5% and (2) a decline in the fair value of the plan assets due to a sharp
decrease in the equity markets at September 30, 2002. As a result, in accordance
with SFAS 87, we recognized an additional minimum pension liability of
$548 million included in benefit obligations, recorded a charge to accumulated
other comprehensive loss of $513 million which decreased stockholders' equity,
and recognized an intangible asset included in other assets of $35 million up to
the amount of unrecognized prior service cost. The charge to stockholders'
equity for the excess of additional pension liability over the unrecognized
prior service cost represents a net loss not yet recognized as pension expense.
- - COMMITMENTS AND CONTINGENCIES
We are subject to legal proceedings related to environmental, product,
employment, intellectual property, licensing and other matters. In addition, we
are subject to indemnification and liability sharing claims by Lucent under the
terms of the Contribution and Distribution Agreement. In order to determine the
amount of reserves required, we assess the likelihood of any adverse judgments
or outcomes to these matters as well as potential ranges of probable losses. A
determination of the amount of reserves required for these contingencies is made
after analysis of each individual issue. The required reserves may change in the
future due to new developments in each matter or changes in approach such as a
change in settlement strategy. Assessing the adequacy of any reserve for matters
for which we may have to indemnify Lucent is especially difficult, as we do not
control the defense of those matters. In addition, estimates are made for our
repurchase obligations related to products sold to various distributors who
obtain financing from certain third party lending institutions.
Avaya Inc. 41
<Page>
REPORT OF INDEPENDENT ACCOUNTANTS
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF AVAYA INC.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in stockholders' equity and of
comprehensive loss, and of cash flows present fairly, in all material respects,
the financial position of Avaya Inc. and its subsidiaries (the "Company") 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. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements 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.
Until September 30, 2000, the Company was a fully integrated business of
Lucent Technologies Inc. ("Lucent"); consequently, as indicated in Note 1, the
consolidated statements of operations, of changes in stockholders' equity and of
comprehensive loss, and of cash flows for the year ended September 30, 2000 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, prior to September 30, 2000, the Company relied on Lucent
and its other businesses for administrative, management and other services.
Accordingly, the consolidated statements of operations, of changes in
stockholders' equity and of comprehensive loss, and of cash flows for the year
ended September 30, 2000 do not necessarily reflect the results of operations,
changes in stockholders' equity and cash flows of the Company had it been a
separate stand-alone entity, independent of Lucent during the period.
As discussed in Note 2 to the consolidated financial statements, on October
1, 2001, the Company adopted the provisions of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets."
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
New York, New York
November 27, 2002
42 Avaya Inc.
<Page>
CONSOLIDATED STATEMENTS OF OPERATIONS
Avaya Inc. and Subsidiaries
<Table>
<Caption>
Year Ended September 30,
---------------------------
(dollars in millions, except per share amounts) 2002 2001 2000
- -----------------------------------------------------------------------------------
<S> <C> <C> <C>
REVENUE
Products $ 2,888 $ 4,507 $ 5,774
Services 2,068 2,286 1,958
- -----------------------------------------------------------------------------------
4,956 6,793 7,732
- -----------------------------------------------------------------------------------
COSTS
Products 1,748 2,331 3,471
Services 1,262 1,566 1,012
- -----------------------------------------------------------------------------------
3,010 3,897 4,483
- -----------------------------------------------------------------------------------
GROSS MARGIN 1,946 2,896 3,249
- -----------------------------------------------------------------------------------
OPERATING EXPENSES
Selling, general and administrative 1,555 2,055 2,540
Business restructuring charges and related expenses,
net of reversals 209 837 684
Goodwill and intangibles impairment charge 71 -- --
Research and development 459 536 468
Purchased in-process research and development -- 32 --
- -----------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 2,294 3,460 3,692
- -----------------------------------------------------------------------------------
OPERATING LOSS (348) (564) (443)
Other income (expense), net (2) 31 71
Interest expense (51) (37) (76)
- -----------------------------------------------------------------------------------
LOSS BEFORE INCOME TAXES (401) (570) (448)
Provision (benefit) for income taxes 265 (218) (73)
- -----------------------------------------------------------------------------------
NET LOSS $ (666) $ (352) $ (375)
===================================================================================
Net loss available to common stockholders:
Net loss $ (666) $ (352) $ (375)
Accretion of Series B preferred stock (12) (27) --
Conversion charge related to Series B preferred stock (125) -- --
- -----------------------------------------------------------------------------------
Net loss available to common stockholders $ (803) $ (379) $ (375)
===================================================================================
LOSS PER COMMON SHARE:
Basic and Diluted $ (2.44) $ (1.33) $ (1.39)
===================================================================================
</Table>
See Notes to Consolidated Financial Statements.
Avaya Inc. 43
<Page>
CONSOLIDATED BALANCE SHEETS
Avaya Inc. and Subsidiaries
<Table>
<Caption>
As of September 30,
-------------------
(dollars in millions, except per share amounts) 2002 2001
- ------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 597 $ 250
Receivables, less allowances of $121 in 2002 and $105 in 2001 876 1,163
Inventory 467 649
Deferred income taxes, net 160 246
Other current assets 203 461
- ------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 2,303 2,769
- ------------------------------------------------------------------------------------
Property, plant and equipment, net 887 988
Deferred income taxes, net 372 529
Goodwill 144 175
Other assets 191 187
- ------------------------------------------------------------------------------------
TOTAL ASSETS $ 3,897 $ 4,648
====================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 374 $ 624
Short-term borrowings -- 145
Business restructuring reserve 170 179
Payroll and benefit obligations 309 349
Deferred revenue 91 206
Other current liabilities 380 604
- ------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 1,324 2,107
- ------------------------------------------------------------------------------------
Long-term debt 933 500
Benefit obligations 1,110 621
Other liabilities 530 544
- ------------------------------------------------------------------------------------
TOTAL NON-CURRENT LIABILITIES 2,573 1,665
- ------------------------------------------------------------------------------------
Commitments and contingencies
Series B convertible participating preferred stock, par value
$1.00 per share, 4 million shares authorized, issued and
outstanding as of September 30, 2001 -- 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, 364,752,178 and 286,851,934 issued (including
557,353 and 147,653 treasury shares) as of September 30,
2002 and 2001, respectively 4 3
Additional paid-in capital 1,693 905
Accumulated deficit (1,182) (379)
Accumulated other comprehensive loss (512) (46)
Treasury stock at cost (3) (2)
- ------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY -- 481
- ------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 3,897 $ 4,648
====================================================================================
</Table>
See Notes to Consolidated Financial Statements.
44 Avaya Inc.
<Page>
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND OF COMPREHENSIVE
LOSS
Avaya Inc. and Subsidiaries
<Table>
<Caption>
Year Ended September 30,
-----------------------------
(dollars in millions) 2002 2001 2000
- ------------------------------------------------------------------------------------
<S> <C> <C> <C>
FORMER PARENT'S NET INVESTMENT:
Beginning balance $ -- $ -- $ 1,871
Net loss -- -- (375)
Transfers to Lucent -- -- (7,783)
Transfers from Lucent -- -- 7,115
Recapitalization upon Distribution -- -- (828)
- ------------------------------------------------------------------------------------
Ending balance $ -- $ -- $ --
- ------------------------------------------------------------------------------------
COMMON STOCK:
Beginning balance $ 3 $ 3 $ --
Issuance of stock 1 -- 3
- ------------------------------------------------------------------------------------
Ending balance $ 4 $ 3 $ 3
- ------------------------------------------------------------------------------------
ADDITIONAL PAID-IN CAPITAL:
Beginning balance $ 905 $ 825 $ --
Additional paid-in capital resulting from the
Distribution -- -- 825
Issuance of warrants -- 32 --
Issuance of common stock for options exercised 2 7 --
Issuance of common stock to employees under the stock
purchase plan 18 33 --
Issuance of other stock unit awards 24 28 --
Issuance of common stock in connection with the
Warburg Transactions 628 -- --
Issuance of common stock through a public offering 112 -- --
Other stock transactions 4 22 --
Adjustment to Lucent capital contribution -- (42) --
- ------------------------------------------------------------------------------------
Ending balance $ 1,693 $ 905 $ 825
- ------------------------------------------------------------------------------------
ACCUMULATED DEFICIT:
Beginning balance $ (379) $ -- $ --
Preferred stock accretion (12) (27) --
Preferred stock conversion and exercise of warrants
charge (125) -- --
Net loss (666) (352) --
- ------------------------------------------------------------------------------------
Ending balance $ (1,182) $ (379) $ --
- ------------------------------------------------------------------------------------
ACCUMULATED OTHER COMPREHENSIVE LOSS:
Beginning balance $ (46) $ (64) $ (54)
Foreign currency translation 47 18 (10)
Minimum pension liability (513) -- --
Tax effect of minimum pension liability 202 -- --
Valuation allowance related to minimum pension
liability (202) -- --
- ------------------------------------------------------------------------------------
Ending balance $ (512) $ (46) $ (64)
- ------------------------------------------------------------------------------------
TREASURY STOCK:
Beginning balance $ (2) $ -- $ --
Purchase of treasury stock at cost (1) (2) --
- ------------------------------------------------------------------------------------
Ending balance $ (3) $ (2) $ --
- ------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY $ -- $ 481 $ 764
====================================================================================
COMPREHENSIVE LOSS:
Net loss $ (666) $ (352) $ (375)
Minimum pension liability, net of tax and valuation
allowance (513) -- --
Foreign currency translations 47 18 (10)
- ------------------------------------------------------------------------------------
COMPREHENSIVE LOSS $ (1,132) $ (334) $ (385)
====================================================================================
</Table>
See Notes to Consolidated Financial Statements.
Avaya Inc. 45
<Page>
CONSOLIDATED STATEMENTS OF CASH FLOWS
Avaya Inc. and Subsidiaries
<Table>
<Caption>
Year Ended September 30,
-----------------------------
(dollars in millions) 2002 2001 2000
- ------------------------------------------------------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (666) $ (352) $ (375)
Adjustments to reconcile net loss from continuing
operations to net cash provided by (used for)
operating activities:
Business restructuring charges, net of reversals 188 659 595
Depreciation and amortization 229 273 220
Provision for uncollectible receivables 53 53 36
Deferred income taxes (121) (264) (288)
Purchased in-process research and development -- 32 --
Gain on assets sold (2) (6) (44)
Amortization of debt discount and deferred
financing costs 21 -- --
Amortization of restricted stock units 23 10 7
Impairment of goodwill, intangible assets and
investments 88 -- --
Deferred tax valuation allowance 364 -- --
Adjustments for other non-cash items, net 35 22 12
Changes in operating assets and liabilities, net of
effects of acquired and divested businesses:
Receivables 586 198 (50)
Inventory 133 (6) 131
Accounts payable (249) (138) 298
Payroll and benefits, net (98) (215) (372)
Business restructuring reserve (187) (327) (21)
Deferred revenue (98) (132) 50
Other assets and liabilities (101) 60 286
- ------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 198 (133) 485
- ------------------------------------------------------------------------------------
INVESTING ACTIVITIES:
Capital expenditures (111) (341) (499)
Proceeds from the sale of property, plant and
equipment 5 108 14
Disposal of businesses -- -- 82
Acquisitions of businesses, net of cash acquired (6) (120) --
Purchases of equity investments -- (27) --
Other investing activities, net 3 15 (25)
- ------------------------------------------------------------------------------------
NET CASH USED FOR INVESTING ACTIVITIES (109) (365) (428)
- ------------------------------------------------------------------------------------
FINANCING ACTIVITIES:
Issuance of convertible participating preferred stock -- 368 --
Issuance of warrants -- 32 --
Issuance of common stock 235 40 --
Transfers to Lucent, net -- -- (741)
Proceeds from (termination of) accounts receivable
securitization (200) 200 --
Borrowings (repayments) under credit facility (200) 200 --
Net decrease in commercial paper (432) (348) --
Assumption of commercial paper from Lucent -- -- 780
Repayment of other short-term borrowings (13) -- --
Issuance (repayment) of long-term borrowings 895 (9) --
Payment of issuance costs related to debt and equity
offerings (29) -- --
Other financing activities, net (1) -- 3
- ------------------------------------------------------------------------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 255 483 42
- ------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash
equivalents 3 (6) (22)
- ------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 347 (21) 77
Cash and cash equivalents at beginning of fiscal year 250 271 194
- ------------------------------------------------------------------------------------
Cash and cash equivalents at end of fiscal year $ 597 $ 250 $ 271
====================================================================================
</Table>
See Notes to Consolidated Financial Statements.
46 Avaya Inc.
<Page>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Avaya Inc. and Subsidiaries
NOTE 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" or "Former Parent") 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 applications for enterprises, including businesses, government
agencies and other organizations. The Company offers a broad range of
traditional voice communication systems, converged voice and data networks,
customer relationship management solutions, unified communications solutions and
structured cabling products.
The Company was incorporated in Delaware in February 2000 as a wholly owned
subsidiary of Lucent. The Company's authorized capital stock consists of 200
million shares of preferred stock, par value $1.00 per share, of which the
Company has designated 7.5 million shares as Series A junior participating
preferred stock and 1.5 billion shares of common stock, par value $0.01 per
share.
The Company adopted a rights agreement prior to the Distribution date. The
issuance of a share of the Company's common stock also constitutes the issuance
of a Series A junior participating preferred stock purchase right associated
with such share. These rights may have anti-takeover effects in that the
existence of the rights may deter a potential acquirer from making a takeover
proposal or a tender offer.
- - BASIS OF PRESENTATION
The accompanying consolidated financial statements as of and for the fiscal
years ended September 30, 2002 and 2001 each depict Avaya's results as a
stand-alone company.
The consolidated financial statements for the fiscal year ended September
30, 2000 include the Company and its subsidiaries as well as certain assets,
liabilities, and related operations transferred to the Company from Lucent
immediately prior to the Distribution. These consolidated financial statements
have been derived from the accounting records of Lucent using the historical
results of operations and historical basis of the assets and liabilities of the
enterprise networking businesses transferred to the Company. Since no direct
ownership existed among all of the various units comprising the Company prior to
the Distribution, Lucent's net investment in Avaya is shown in place of
stockholders' equity in the Consolidated Statements of Changes in Stockholders'
Equity in fiscal 2000. Management believes these consolidated financial
statements are a reasonable representation of the financial position, results of
operations, cash flows and changes in stockholders' equity of such businesses as
if Avaya were a separate entity during such periods.
The consolidated financial statements for the fiscal year ended September
30, 2000 include allocations of certain Lucent corporate headquarters' assets,
liabilities, and expenses relating to these businesses that were transferred to
Avaya from Lucent. General corporate overhead has been allocated either based on
the ratio of the Company's costs and expenses to Lucent's costs and expenses, or
based on the Company's revenue as a percentage of Lucent's total revenue.
General corporate overhead primarily includes cash management, legal,
accounting, tax, insurance, public relations, advertising and data services and
amounted to $398 million in fiscal 2000. In addition, the consolidated financial
statements for fiscal 2000 include an allocation from Lucent to fund a portion
of the costs of basic research conducted by Lucent's Bell Laboratories. This
allocation was based on the Company's revenue as a percentage of Lucent's total
revenue and amounted to $75 million in fiscal 2000. Management believes the
costs of corporate services and research charged to the Company were a
reasonable representation of the costs that would have been incurred if the
Company had performed these functions as a stand-alone entity during such
period. The Company currently performs these corporate functions and basic
research requirements using its own resources or purchased services.
During the period covered by the consolidated financial statements for the
fiscal year ended September 30, 2000, Lucent used a centralized approach to cash
management and the financing of its operations. Prior to the Distribution, cash
deposits from the Company's businesses were transferred to Lucent on a regular
basis and were netted against Lucent's net investment account. As a result, none
of Lucent's cash or cash equivalents at the corporate level had been allocated
to the Company. Changes in stockholders' equity in fiscal 2000 represent funding
required from Lucent for working capital, acquisitions or capital expenditures
after giving effect to the Company's transfers to or from Lucent of its cash
flows from operations and other non-cash transactions between the Company and
Lucent.
The Company's Consolidated Statements of Operations include interest
expense for the fiscal year ended September 30, 2000. The Company has assumed
for purposes of calculating interest expense that it would have had an average
debt balance of $962 million and an average interest rate of 7.9% per annum for
fiscal 2000. The Company believes the interest rate and average debt balance
used in the calculation of interest expense reasonably reflect the cost of
financing its assets and operations during fiscal 2000.
Income taxes were calculated in fiscal 2000 as if the Company filed
separate tax returns. However, Lucent was managing its tax position for the
benefit of its entire portfolio of businesses, and its tax strategies were not
necessarily reflective of the tax strategies that the Company would have
followed or is following as a stand-alone company. Commencing with fiscal 2001,
the Company began filing consolidated income tax returns for Avaya and its
subsidiaries.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- - PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include all majority-owned subsidiaries in
which the Company exercises control. Investments in which the Company exercises
significant influence, but which it does not control (generally a 20%-50%
ownership interest), are accounted for under the equity method of accounting.
All intercompany transactions and balances between and among the Company's
businesses have been eliminated. Transactions between any of the Company's
businesses and Lucent are included in these financial statements.
Avaya Inc. 47
<Page>
- - USE OF ESTIMATES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements and revenue and expenses
during the period reported. These estimates include an allocation of costs by
Lucent in fiscal 2000, assessing the collectibility of accounts receivable, the
use and recoverability of inventory, the realization of deferred tax assets,
restructuring reserves, pension and postretirement obligations, and useful lives
and impairment of tangible and intangible assets, among others. The markets for
the Company's products are characterized by intense competition, rapid
technological development and frequent new product introductions, all of which
could affect the future realizability of the Company's assets. Estimates and
assumptions are reviewed periodically and the effects of revisions are reflected
in the consolidated financial statements in the period they are determined to be
necessary. Actual results could differ from these estimates.
- - FOREIGN CURRENCY TRANSLATION
Balance sheet accounts of the Company's foreign operations are translated from
foreign currencies into U.S. dollars at period-end exchange rates while income
and expenses are translated at average exchange rates during the period.
Translation gains or losses related to net assets located outside the U.S. are
shown as a component of accumulated other comprehensive loss in stockholders'
equity. Gains and losses resulting from foreign currency transactions, which are
denominated in a currency other than the entity's functional currency, are
included in the Consolidated Statements of Operations.
- - REVENUE RECOGNITION
Revenue from sales of communications systems and applications is recognized when
contractual obligations have been satisfied, title and risk of loss have been
transferred to the customer, and collection of the resulting receivable is
reasonably assured. Revenue from the direct sales of products that include
installation services is recognized at the time the products are installed,
after satisfaction of all the terms and conditions of the underlying customer
contract. The Company's indirect sales to distribution partners are generally
recognized at the time of shipment if all contractual obligations have been
satisfied. The Company accrues a provision for estimated sales returns and other
allowances and deferrals as a reduction of revenue at the time of revenue
recognition, as required. Revenue from services performed under value-added
service arrangements, professional services and services performed under
maintenance contracts is recognized over the term of the underlying customer
contract or at the end of the contract, when obligations have been satisfied.
For services performed on a time and materials basis, revenue is recognized upon
performance.
- - RESEARCH AND DEVELOPMENT COSTS AND SOFTWARE DEVELOPMENT COSTS
Research and development costs are charged to expense as incurred. The costs
incurred for the development of computer software that will be sold, leased or
otherwise marketed, however, are capitalized when technological feasibility has
been established. These capitalized costs are subject to an ongoing assessment
of recoverability based on anticipated future revenues and changes in hardware
and software technologies. Costs that are capitalized include direct labor and
related overhead.
Amortization of capitalized software development costs begins when the
product is available for general release to customers. Amortization is
recognized on a product-by-product basis on the greater of either the ratio of
current gross revenues to the total of current and anticipated future gross
revenues, or the straight-line method over a period of up to three years.
Unamortized capitalized software development costs determined to be in excess of
net realizable value of the product are expensed immediately.
- - CASH AND CASH EQUIVALENTS
All highly liquid investments with original maturities of three months or less
are considered to be cash equivalents. These short-term investments are stated
at cost, which approximates market value. The Company's cash and cash
equivalents are invested in various investment grade institutional money market
accounts.
- - INVENTORY
Inventory is stated at the lower of cost, determined on a first-in, first-out
basis, or market.
- - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost less accumulated depreciation.
Depreciation is determined using a straight-line method over the estimated
useful lives of the various asset classes. Estimated lives range from three to
10 years for machinery and equipment, and up to 40 years for buildings.
Major improvements are capitalized and minor replacements, maintenance and
repairs are charged to expense as incurred. Upon retirement or disposal of
assets, the cost and related accumulated depreciation are removed from the
Consolidated Balance Sheets and any gain or loss is reflected in the
Consolidated Statements of Operations.
Certain costs of computer software developed or obtained for internal use
are capitalized and amortized on a straight-line basis over three to seven
years. Costs for general and administrative, overhead, maintenance and training,
as well as the cost of software that does not add functionality to the existing
system, are expensed as incurred. As of September 30, 2002 and 2001, the Company
had unamortized internal use software costs of $71 million and $68 million,
respectively.
In the second quarter of fiscal 2002, the Company changed the estimated
useful life of certain internal use software from three to seven years to
reflect actual experience as a stand-alone company based on the utilization of
such software. This change lowered amortization expense by approximately $13
million ($8 million after-tax), equivalent to $0.02 per diluted share, for the
fiscal year ended September 30, 2002.
- - GOODWILL, OTHER INTANGIBLE AND LONG-LIVED ASSETS
Goodwill is the excess of the purchase price over the fair value of
identifiable net assets acquired in business combinations accounted for
48 Avaya Inc.
<Page>
as purchases. The Company adopted Statement of Financial Accounting Standards
("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142") in October
2001. Goodwill and certain other intangible assets having indefinite lives,
which were previously amortized on a straight-line basis over the periods
benefited, are no longer being amortized to earnings, but instead are subject to
periodic testing for impairment. Intangible assets determined to have definite
lives are amortized over their remaining useful lives. Goodwill of a reporting
unit is tested for impairment on an annual basis or between annual tests if an
event occurs or circumstances change that would reduce the fair value of a
reporting unit below its carrying amount.
Intangible and other long-lived assets are reviewed for impairment whenever
events such as product discontinuance, plant closures, product dispositions or
other changes in circumstances indicate that the carrying amount may not be
recoverable. In reviewing for impairment, the Company compares the carrying
value of such assets to the estimated undiscounted future cash flows expected
from the use of the assets and their eventual disposition. When the estimated
undiscounted future cash flows are less than their carrying amount, an
impairment loss is recognized equal to the difference between the assets' fair
value and their carrying value.
- - INVESTMENTS
The Company's investment portfolio consists primarily of investments accounted
for under the cost and equity methods that are generally concentrated in the
emerging communications technology industry. The carrying value of these
investments is included in other assets. The Company's share of earnings or
losses from equity method investments is recorded in other income (expense),
net. All investments are periodically reviewed for impairment and a write down
is recorded whenever declines in fair value below carrying value are considered
to be other than temporary. In making this determination, the Company considers,
among other factors, sustained decreases in quoted market prices and a series of
historic and projected operating losses by the investee. If the decline in fair
value is determined to be other than temporary, an impairment loss is recorded
and the respective investment is written down to an adjusted carrying value. As
of September 30, 2002 and 2001, the Company had investments of $12 million and
$28 million, respectively. In fiscal 2002, the Company recorded a $17 million
impairment charge in other income (expense), net related to its cost method
investments.
- - FINANCIAL INSTRUMENTS
The Company uses various financial instruments, including interest rate swap
agreements and foreign currency forward and option contracts, to manage and
reduce risk to the Company by generating cash flows which offset the cash flows
of certain transactions in foreign currencies or underlying financial
instruments in relation to their amount and timing. The Company's derivative
financial instruments are used as risk management tools and not for speculative
or trading purposes. Although not material, these derivatives represent assets
and liabilities and are classified as other current assets or other current
liabilities on the accompanying Consolidated Balance Sheets, except for the
interest rate swaps discussed below. Gains and losses on the changes in the fair
values of the Company's derivative instruments are included in other income
(expense), net.
As permitted under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities," ("SFAS 133"), the Company has elected not to designate its
forward and option contracts as hedges thereby precluding the use of hedge
accounting for these instruments. Such treatment could result in a gain or loss
from fluctuations in exchange rates related to a derivative contract which is
different from the loss or gain recognized from the underlying forecasted
transaction. However, the Company has procedures to manage risks associated with
its derivative instruments, which include limiting the duration of the
contracts, typically six months or less, and the amount of the underlying
exposures that can be economically hedged. Historically, the gains and losses on
these transactions have not been significant.
In April 2002, the Company entered into two interest rate swap agreements
with a total notional amount of $200 million that qualify and are designated as
fair value hedges in accordance with SFAS 133. These arrangements generally
involve the exchange of fixed and floating rate interest payments without the
exchange of the underlying principal. Net amounts paid or received are reflected
as adjustments to interest expense. The Company records the fair market value of
the swaps as other assets along with a corresponding increase to the hedged
debt, both of which are recorded through other income (expense), net.
The Company also utilizes non-derivative financial instruments including
letters of credit and commitments to extend credit.
- - BUSINESS RESTRUCTURING CHARGES AND RELATED EXPENSES
Business restructuring charges and related expenses are incurred when management
commits to a plan to make significant changes in the Company's fundamental
business strategy, operations or organizational structure anticipating improved
results of future operations. Liabilities are recognized on the commitment date
only for probable and reasonably estimable costs resulting from a restructuring
plan that are not associated with or do not: (i) benefit activities that will be
continued, (ii) generate revenues after the commitment date, and (iii) are
either (1) incremental to other costs incurred by the Company in the conduct of
its activities prior to the commitment date and will be incurred as a direct
result of the restructuring plan, or (2) represent amounts to be incurred under
a contractual obligation that existed prior to the commitment date and will
either continue after the restructuring plan is completed with no economic
benefit to the Company or require payment by the Company of a penalty to cancel
the contractual obligation. The Company also recognizes other related expenses
including asset impairments and incremental period costs when such expenses are
incurred. The Company periodically evaluates its business restructuring reserve
to ensure that any accrued amount no longer needed for its originally intended
purpose is reversed in a timely manner. A reversal of the liability, if any, is
recorded through the same statement of operations line item that was used when
the liability was initially recorded.
Avaya Inc. 49
<Page>
- - PENSION AND POSTRETIREMENT BENEFIT OBLIGATIONS
The Company maintains defined benefit pension plans covering the majority of its
employees, which provide benefit payments to vested participants upon
retirement. The Company also provides certain postretirement healthcare and life
insurance benefits to eligible employees. The plans use different factors,
including age, years of service, and eligible compensation, to determine the
benefit amount for eligible participants. The Company funds its pension plans in
compliance with applicable law.
- - INCOME TAXES
Income taxes are accounted for under the asset and liability method. Under this
method, deferred tax assets and liabilities are recognized for the estimated
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases, and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates in effect for
the year in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in the Consolidated Statement of Operations in the period
that includes the enactment date. A valuation allowance is recorded to reduce
the carrying amounts of deferred tax assets if it is more likely than not that
such assets will not be realized.
- - OTHER 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 consist of adjustments to the
minimum pension liability, net of income taxes, and foreign currency
translation, which are not adjusted for income taxes since they primarily relate
to indefinite investments in non-U.S. subsidiaries. The minimum pension
liability adjustment represents the excess of the additional pension liability
over the unrecognized prior service cost.
- - RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
NOTE 3 RECENT ACCOUNTING PRONOUNCEMENTS
- - SFAS 143
In August 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No.143, "Accounting for Asset Retirement Obligations" ("SFAS 143"), which
provides the accounting requirements for retirement obligations associated with
tangible long-lived assets. SFAS 143 requires entities to record the fair value
of a liability for an asset retirement obligation in the period in which it is
incurred and is effective for the Company's 2003 fiscal year. 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 SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("SFAS 144"), which requires that long-lived
assets to be disposed of by sale be measured at the lower of the 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. SFAS 144
excludes from the definition of long-lived assets goodwill and other intangibles
that are not amortized in accordance with SFAS 142. SFAS 144 is effective for
the Company's 2003 fiscal year. The adoption of SFAS 144 is not expected to have
a material impact on the Company's consolidated results of operations, financial
position or cash flows.
- - SFAS 145
In May 2001, the FASB issued SFAS No. 145, which rescinds SFAS No. 4, "Reporting
Gains and Losses from Extinguishment of Debt," SFAS No. 44, "Accounting for
Intangible Assets of Motor Carriers," and SFAS No.64, "Extinguishments of Debt
Made to Satisfy Sinking-Fund Requirements" ("SFAS 145"). SFAS 145 also amends
SFAS No. 13, "Accounting for Leases," to eliminate an inconsistency between the
required accounting for sale-leaseback transactions and the required accounting
for certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. As a result of the rescission of SFAS No. 4 and
SFAS No. 64, the criteria in Accounting Principles Board Opinion No. 30 will be
used to classify gains and losses from debt extinguishment. SFAS 145 also amends
other existing authoritative pronouncements to make various technical
corrections, clarify meanings, or describe their applicability under changed
conditions. SFAS 145 is effective for the Company's 2003 fiscal year. The
adoption of SFAS 145 is not expected to have a material impact on the Company's
consolidated results of operations, financial position or cash flows.
- - SFAS 146
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146"), which addresses financial
accounting and reporting for costs associated with exit or disposal activities,
and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)" which previously governed
the accounting treatment for restructuring activities. SFAS 146 applies to costs
associated with an exit activity that does not involve an entity newly acquired
in a business combination or with a disposal activity covered by SFAS 144. Those
costs include, but are not limited to, the following: (1) termination benefits
provided to current employees that are involuntarily terminated under the terms
of a benefit arrangement that, in substance, is not an ongoing benefit
arrangement or an individual deferred-compensation contract, (2)costs to
terminate a contract that is not a capital lease, and (3)costs to consolidate
facilities or relocate
50 Avaya Inc.
<Page>
employees. SFAS 146 does not apply to costs associated with the retirement of
long-lived assets covered by SFAS 143. SFAS 146 will be applied prospectively
and is effective for exit or disposal activities initiated after December 31,
2002. Early adoption is permitted.
- - FASB INTERPRETATION NO. 45
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("Interpretation"). This Interpretation elaborates on
the existing disclosure requirements for most guarantees, including loan
guarantees such as standby letters of credit. It also clarifies that at the time
a company issues a guarantee, the company must recognize an initial liability
for the fair market value of the obligations it assumes under that guarantee and
must disclose that information in its interim and annual financial statements.
The initial recognition and measurement provisions of the Interpretation apply
on a prospective basis to guarantees issued or modified after December 31, 2002.
NOTE 4 GOODWILL AND INTANGIBLE ASSETS
In connection with the Company's adoption of SFAS 142 on October 1, 2001, the
Company reviewed the classification of its goodwill and other intangible assets,
reassessed the useful lives previously assigned to other intangible assets, and
discontinued amortization of goodwill. The Company also tested goodwill for
impairment by comparing the fair values of the Company's reporting units to
their carrying values as of October 1, 2001 and determined that there was no
goodwill impairment at that time. Based on this review, as of September 30,
2001, the Company classified $175 million as goodwill, $78 million as intangible
assets, net and $2 million as other assets. The Company did not identify any
intangible assets having indefinite lives.
The Company conducted the required annual impairment review during the fourth
quarter of fiscal 2002. Due to a significant downward movement in the U.S. stock
market and, in particular, communications technology stocks, the Company
experienced a decline in its market capitalization that negatively impacted the
fair value of its reporting units. Updated valuations were completed for all
reporting units with goodwill as of September 30, 2002 using a discounted cash
flow approach based on forward-looking information regarding market shares,
revenues and costs for each reporting unit as well as appropriate discount
rates. As a result, the Company recorded a goodwill impairment charge of $44
million as an operating expense in fiscal 2002 related to its Small and Medium
Business Solutions ("SMBS") operating segment.
The changes in the carrying value of goodwill for fiscal 2002 by operating
segment are as follows:
<Table>
<Caption>
Small and
Converged Medium
Systems and Business
(dollars in millions) Applications Solutions Total
- ----------------------------------------------------------------------------
<S> <C> <C> <C>
Balance as of
September 30, 2001 $ 108 $ 67 $ 175
Goodwill acquired 6 -- 6
Purchase accounting adjustment 5 -- 5
Impact of foreign currency
exchange rate fluctuations (1) 3 2
Impairment loss -- (44) (44)
- ----------------------------------------------------------------------------
Balance as of
September 30, 2002 $ 118 $ 26 $ 144
============================================================================
</Table>
For the fiscal year ended September 30, 2001 and 2000, goodwill amortization,
net of tax, amounted to $38 million and $31 million, respectively. If Avaya had
adopted SFAS 142 as of the beginning of the first quarter of fiscal 2000 and
discontinued goodwill amortization, the Company's net loss and loss per common
share on a pro forma basis would have been as follows:
<Table>
<Caption>
Year Ended September 30,
Pro Forma Results ------------------------
(dollars in millions, except per share amounts) 2001 2000
- -----------------------------------------------------------------------------
<S> <C> <C>
Adjusted net loss $ (314) $ (344)
Accretion of Series B preferred stock (27) --
- -----------------------------------------------------------------------------
Adjusted loss available to
common stockholders $ (341) $ (344)
=============================================================================
Adjusted loss per common share:
Basic and Diluted $(1.20) $(1.28)
=============================================================================
</Table>
The following table presents the components of the Company's acquired intangible
assets with definite lives, which are included in other assets in the
Consolidated Balance Sheets.
<Table>
<Caption>
AS OF SEPTEMBER 30, 2002 As of September 30, 2001
----------------------------------- -------------------------------------
GROSS Gross
Amortized Intangible Assets CARRYING ACCUMULATED Carrying Accumulated
(dollars in millions) AMOUNT AMORTIZATION NET Amount Amortization Net
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Existing technology $ 123 $ 105 $ 18 $ 160 $ 92 $ 68
Other intangibles -- -- -- 12 2 10
- --------------------------------------------------------------------------------------------------------------------------
Total intangible assets $ 123 $ 105 $ 18 $ 172 $ 94 $ 78
==========================================================================================================================
</Table>
Avaya Inc. 51
<Page>
As a result of the significant downturn in the communications technology
industry, the Company noted a steep decline in the marketplace assumptions for
virtual private networks in the fourth quarter of fiscal 2002 as compared with
the assumptions used when Avaya acquired this existing technology. These
circumstances also caused the Company to review the recoverability of its
acquired intellectual property and trademarks. The Company applied the
provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of" ("SFAS 121") to its intangible
assets with definite lives and determined that the carrying value of these
assets was impaired. Accordingly, the Company recorded a $27 million intangibles
impairment charge as an operating expense in fiscal 2002 to write-down the
carrying value of these intangible assets to an amount representing their
discounted future cash flows. At the same time, the Company removed $49 million
from its Consolidated Balance Sheet representing the gross carrying amount and
accumulated amortization of the related impaired intangible assets. The $27
million impairment charge, which was recorded as accumulated amortization on the
Consolidated Balance Sheet, is attributed $24 million to Converged Systems and
Applications ("CSA") and $3 million to SMBS.
Acquired intangible assets with definite lives are amortized over a period of
three to six years. Amortization expense for such intangible assets was $35
million and $32 million for the fiscal years ended September 30, 2002 and 2001,
respectively. Foreign currency exchange rate fluctuations accounted for a $2
million increase in intangibles assets, net as of September 30, 2002 and a $1
million increase as of September 30, 2001. Estimated amortization expense
remaining for the succeeding fiscal years is (i) $12 million in 2003; (ii) $5
million in 2004; and (iii) $1 million in 2005.
In addition, included in other assets in the Consolidated Balance Sheets as
of September 30, 2002 is an intangible asset of $35 million representing an
unrecognized prior service cost associated with the recording of a minimum
pension liability in fiscal 2002. This intangible asset may be eliminated or
adjusted as necessary when the amount of minimum pension liability is
reassessed, which is conducted at least annually.
NOTE 5 BUSINESS COMBINATIONS AND OTHER TRANSACTIONS
- - ACQUISITIONS
The following table presents historical information about certain acquisitions
by the Company during the fiscal years ended September 30, 2002 and 2001. These
acquisitions were accounted for under the purchase method of accounting, and the
acquired technology valuation included existing technology, purchased in-process
research and development ("IPR&D") and other intangibles. The consolidated
financial statements include the results of operations and the estimated fair
values of the assets and liabilities assumed from the respective dates of
acquisition. All charges related to the write-off of purchased IPR&D were
recorded in the quarter in which the transaction was completed. There were no
material acquisitions accounted for under the purchase method in fiscal 2002 and
2000.
<Table>
<Caption>
Allocation of Purchase Price(1) Amortization Period (in years)
----------------------------------------------- -----------------------------
Acquisition Purchase Existing Other Purchased Existing Other
(dollars in millions) Date Price Goodwill Technology Intangibles IPR&D Technology Intangibles
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Quintus(2) April 11, 2001 $ 29 $ 11 $ 9 $ -- $ 1 3 3
VPNet(3) February 6, 2001 $ 117 $ 60 $ 30 $ 6 $ 31 5 5
</Table>
(1) Excludes amounts allocated to specific tangible assets and liabilities.
Certain amounts have been adjusted to reflect the Company's review of the
classification of its goodwill and intangible assets in connection with its
adoption of SFAS 142. All amounts reflect the historical carrying values from
the date of acquisition.
(2) Acquisition of substantially all of the assets, including $10 million of
cash acquired, and the assumption of $20 million of certain liabilities of
Quintus Corporation ("Quintus"), a provider of comprehensive electronic
customer relationship management solutions. The Company paid $29 million in cash
for these assets. As a result of finalizing acquisition-related liabilities, a
purchase accounting adjustment was recorded in fiscal 2002 that increased the
historical carrying value of goodwill by $5 million.
(3) Acquisition of VPNet Technologies, Inc. ("VPNet"), a privately held
distributor of virtual private network solutions and devices. The total purchase
price of $117 million was paid in cash and stock options. In fiscal 2002, the
Company recorded a goodwill and intangibles impairment charge, which included
$21 million in existing technology and $3 million in other intangibles related
to the VPNet acquisition. This impairment charge has not been reflected in the
allocation of purchase price.
Included in the purchase price for each of the above acquisitions was purchased
IPR&D. At the date of each acquisition, the IPR&D projects had not yet reached
technological feasibility and had no future alternative use. Accordingly, the
value allocated to these projects was capitalized and immediately expensed at
acquisition. The charge related to VPNet purchased IPR&D was not tax-deductible.
The remaining purchase price was allocated to tangible and intangible assets,
goodwill, and existing technology, less liabilities assumed.
The value allocated to purchased IPR&D for the acquisitions was determined
using an income approach. This involved estimating the fair value of the
IPR&D, using the present value of the estimated after-tax cash flows expected to
be generated by the purchased IPR&D, using risk-adjusted discount rates and
revenue forecasts as appropriate. Where appropriate, the Company deducted an
amount reflecting the contribution of the core technology from the anticipated
cash flows from an IPR&D project. The selection of the discount rate was based
on consideration of the Company's weighted average cost of capital, as well as
other factors, including the useful life of each technology, profitability
levels of each technology, the uncertainty of technology advances that were
known at the time, and the stage of completion of each technology. The Company
believes that the estimated IPR&D amounts so determined represent fair value and
do not exceed the amount a third party would have paid for the projects.
52 Avaya Inc.
<Page>
Revenue forecasts were estimated based on relevant market size and growth
factors, expected industry trends, individual product sales cycles and the
estimated life of each product's underlying technology. Estimated operating
expenses, income taxes, and charges for the use of contributory assets were
deducted from estimated revenue to determine estimated after-tax cash flows for
each project. Estimated operating expenses include cost of goods sold, selling,
general and administrative expenses, and research and development expenses. The
research and development expenses include estimated costs to maintain the
products once they have been introduced into the market and generate revenue and
costs to complete the purchased IPR&D.
Management is primarily responsible for estimating the fair value of the
assets and liabilities acquired, and has conducted due diligence in determining
the fair value. Management has made estimates and assumptions that affect the
reported amounts of assets, liabilities and expenses resulting from such
acquisitions. Actual results could differ from these amounts.
- - DIVESTITURES
In March 2000, the Company completed the sale of its U.S. sales division that
served small- and mid-sized businesses to Expanets, Inc. ("Expanets"). Under the
agreement, approximately 1,800 of the Company's sales and sales support
employees were transferred to Expanets, which became a distributor of the
Company's products to this market and a significant customer of the Company. A
gain of $45 million was recognized in fiscal 2000 to the extent of cash proceeds
received related to the sale of this business and is included in other income,
net.
- - OTHER TRANSACTIONS
AIRCRAFT SALE-LEASEBACK - In June 2001, the Company sold a corporate aircraft
for approximately $34 million and subsequently entered into an agreement to
lease it back over a five-year period. In March 2002, the Company elected to
terminate the aircraft sale-lease-back agreement and, pursuant to the terms of
the agreement, purchased the aircraft in April 2002 from the lessor for a
purchase price equal to the unamortized lease balance of approximately
$33 million.
OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES - In May 2001, the Company
closed the first phase of a five-year strategic manufacturing agreement to
outsource most of the manufacturing of its communications systems and
applications to Celestica Inc. ("Celestica"). Avaya received $200 million in
proceeds for assets transferred to Celestica and deferred $100 million of these
proceeds, which are being recognized on a straight-line basis over the term of
the agreement. As of September 30, 2002 and 2001, the unamortized portion of
these proceeds amounted to $20 million in other current liabilities for both
periods and $52 million and $71 million in other liabilities, respectively. The
remaining phases of the transaction, which included closing the Shreveport,
Louisiana facility, were completed in the first quarter of fiscal 2002.
NOTE 6 SUPPLEMENTARY FINANCIAL INFORMATION
- - STATEMENT OF OPERATIONS INFORMATION
<Table>
<Caption>
Year Ended September 30,
--------------------------------------
(dollars in millions) 2002 2001 2000
- --------------------------------------------------------------------------------------
<S> <C> <C> <C>
DEPRECIATION AND AMORTIZATION
INCLUDED IN COSTS:
Amortization of software
development costs $ 20 $ 24 $ 24
INCLUDED IN SELLING, GENERAL
AND ADMINISTRATIVE EXPENSES:
Amortization of goodwill -- 40 34
Amortization of intangible assets 35 32 21
INCLUDED IN COSTS AND
OPERATING EXPENSES:
Depreciation and amortization of
property, plant and equipment
and internal use software 174 177 141
- --------------------------------------------------------------------------------------
Total depreciation
and amortization $ 229 $ 273 $ 220
- --------------------------------------------------------------------------------------
OTHER INCOME (EXPENSE), NET
Loss on foreign
currency transactions $ (6) $ (5) $ (10)
Gain on assets sold 2 6 44
Interest income 20 27 7
Impairment of cost investments (17) -- --
Miscellaneous, net (1) 3 30
- --------------------------------------------------------------------------------------
Total other income
(expense), net $ (2) $ 31 $ 71
======================================================================================
</Table>
- - BALANCE SHEET INFORMATION
<Table>
<Caption>
As of September 30,
------------------------
(dollars in millions) 2002 2001
- ------------------------------------------------------------------------
<S> <C> <C>
INVENTORY
Completed goods $ 347 $ 420
Work in-process and raw materials 120 229
- ------------------------------------------------------------------------
Total inventory $ 467 $ 649
========================================================================
PROPERTY, PLANT AND EQUIPMENT, NET
Land and improvements $ 45 $ 46
Buildings and improvements 531 485
Machinery and equipment 1,001 1,126
Assets under construction 16 47
Internal use software 105 89
Total property, plant and equipment 1,698 1,793
Less: Accumulated depreciation
and amortization (811) (805)
- ------------------------------------------------------------------------
Property, plant and equipment, net $ 887 $ 988
========================================================================
</Table>
Avaya Inc. 53
<Page>
- - RECEIVABLES, LESS ALLOWANCES
The receivables allowance as of September 30, 2001, which previously represented
a reserve for uncollectible accounts, also includes an estimate of $37 million
for the resolution of potential issues such as disputed invoices, customer
satisfaction claims and pricing discrepancies. This amount had previously been
included as a direct reduction to receivables, but was reclassified to conform
to the September 30, 2002 presentation.
- - SUPPLEMENTAL CASH FLOW INFORMATION
<Table>
<Caption>
Year Ended September 30,
------------------------
(dollars in millions) 2002 2001
- --------------------------------------------------------------------------
<S> <C> <C>
ACQUISITION OF BUSINESSES:
Fair value of assets acquired,
net of cash acquired $ 8 $ 192
Less: Fair value of liabilities assumed (2) (72)
- --------------------------------------------------------------------------
Acquisition of businesses, net of cash acquired $ 6 $ 120
==========================================================================
</Table>
In the second quarter of fiscal 2001, the Company paid off $9 million of debt
assumed from its acquisition of VPNet.
<Table>
<Caption>
Year Ended
(dollars in millions) September 30, 2000
- --------------------------------------------------------------------------
<S> <C>
DISPOSITION OF BUSINESS:
Cash proceeds $ 64
Less: Basis in net assets sold (19)
- --------------------------------------------------------------------------
Gain on business sold $ 45
==========================================================================
</Table>
<Table>
<Caption>
Year Ended September 30,
------------------------
(dollars in millions) 2002 2001
- --------------------------------------------------------------------------
<S> <C> <C>
Interest payments, net of amounts capitalized $ 8 $ 41
==========================================================================
Income tax payments $ 20 $ 66
==========================================================================
</Table>
<Table>
<Caption>
Year Ended September 30,
------------------------
(dollars in millions) 2002 2001
- --------------------------------------------------------------------------
<S> <C> <C>
NON-CASH TRANSACTIONS:
Accretion of Series B preferred stock $ 12 $ 27
Book value of converted Series B
preferred stock 395 --
Conversion charge related to Series B
preferred stock 125 --
Issuance of common stock in connection
with the Warburg transactions (532) --
Deferred taxes on stock options 4 --
Fair market value of stock options issued
in connection with acquisition -- 16
Adjustments to Contribution by Lucent:
Accounts receivable -- 8
Property, plant and equipment, net -- 7
Net benefit assets -- 27
- --------------------------------------------------------------------------
Total non-cash transactions $ 4 $ 85
==========================================================================
</Table>
Payments for interest and income taxes prior to the Distribution were paid by
Lucent on behalf of the Company and do not necessarily reflect what the Company
would have paid had it been a stand-alone company.
Net transfers to Lucent in fiscal 2000 are composed predominantly of the
following non-cash transactions: (1) a $528 million increase in Former Parent's
net investment due to prepaid pension costs and other assets and (2) a $439
million decrease from benefit obligations and other accrued liabilities assumed
by the Company from Lucent on the Distribution date.
NOTE 7 SECURITIZATION OF ACCOUNTS RECEIVABLE
In June 2001, the Company entered into a receivables purchase agreement and
transferred a designated pool of qualified trade accounts receivable to a
special purpose entity ("SPE"), which in turn sold an undivided ownership
interest in the pool of receivables to an unaffiliated financial institution
for cash proceeds of $200 million. The designated pool of qualified receivables
held by the SPE was pledged as collateral to secure the obligations to the
financial institution. During the term of the receivables purchase agreement,
the Company had a retained interest in the designated pool of receivables to the
extent the value of the receivables exceeded the outstanding amount of the
financial institution's investment. The carrying amount of the Company's
retained interest, which approximated fair value because of the short-term
nature of the receivables, was recorded in other current assets. Collections of
receivables were used by the SPE to repay the financial institution's investment
in accordance with the receivables purchase agreement, and the financial
institution in turn purchased, from time to time, new interests in receivables
up to an aggregate investment at any time of $200 million.
In March 2002, the Company elected to terminate the receivables purchase
agreement, which was scheduled to expire in June 2002. As a result of the early
termination, purchases of interests in receivables by the financial institution
ceased, and collections on receivables that constituted the designated pool of
trade accounts receivable were used to repay the financial institution's $200
million investment, which had been entirely liquidated as of September 30, 2002.
No portion of the retained interest was used to liquidate the financial
institution's investment. Upon liquidation in full in April 2002, the Company
reclassified the remaining $109 million retained interest to receivables. As of
September 30, 2001, the Company had a retained interest of $153 million in the
SPE's designated pool of qualified accounts receivable.
54 Avaya Inc.
<Page>
NOTE 8 BUSINESS RESTRUCTURING CHARGES AND RELATED EXPENSES
The following table summarizes the status of the Company's business
restructuring reserve and other related expenses during fiscal 2002, 2001 and
2000:
<Table>
<Caption>
Business Restructuring Reserve
------------------------------------------------------------
Total
Employee Lease Other Business
Separation Termination Exit Restructuring
(dollars in millions) Costs Obligations Costs Reserve
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
FISCAL 2000:
Charges $ 365 $ 127 $ 28 $ 520
Cash payments (20) -- (1) (21)
Asset impairments -- -- -- --
- ------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2000 $ 345 $ 127 $ 27 $ 499
- ------------------------------------------------------------------------------------------------------------
FISCAL 2001:
Charges $ 650 $ 24 $ -- $ 674
Reversals (17) (7) (11) (35)
Decrease in prepaid benefit costs/
increase in benefit obligations, net (577) -- -- (577)
Cash payments (250) (66) (11) (327)
Asset impairments -- -- -- --
Reclassification (55) -- -- (55)
- ------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2001 $ 96 $ 78 $ 5 $ 179
- ------------------------------------------------------------------------------------------------------------
FISCAL 2002:
Charges $ 116 $ 84 $ 1 $ 201
Reversals (13) (4) (3) (20)
Net increase in benefit obligations (3) -- -- (3)
Cash payments (128) (56) (3) (187)
Asset impairments -- -- -- --
- ------------------------------------------------------------------------------------------------------------
Balance as of September 30, 2002 $ 68 $ 102 $ -- $ 170
============================================================================================================
<Caption>
Other Related Expenses
----------------------------
Total Business
Restructuring
Reserve
Asset Incremental and Related
(dollars in millions) Impairments Period Costs Expenses
- ----------------------------------------------------------------------------------------------
<S> <C> <C> <C>
FISCAL 2000:
Charges $ 75 $ 89 $ 684
Cash payments -- (89) (110)
Asset impairments (75) -- (75)
- ----------------------------------------------------------------------------------------------
Balance as of September 30, 2000 $ -- $ -- $ 499
- ----------------------------------------------------------------------------------------------
FISCAL 2001:
Charges $ 20 $ 178 $ 872
Reversals -- -- (35)
Decrease in prepaid benefit costs/
increase in benefit obligations, net -- -- (577)
Cash payments -- (178) (505)
Asset impairments (20) -- (20)
Reclassification -- -- (55)
- ----------------------------------------------------------------------------------------------
Balance as of September 30, 2001 $ -- $ -- $ 179
- ----------------------------------------------------------------------------------------------
FISCAL 2002:
Charges $ 7 $ 21 $ 229
Reversals -- -- (20)
Net increase in benefit obligations -- -- (3)
Cash payments -- (21) (208)
Asset impairments (7) -- (7)
- ----------------------------------------------------------------------------------------------
Balance as of September 30, 2002 $ -- $ -- $ 170
==============================================================================================
</Table>
- - FISCAL 2002
The Company has been experiencing a decrease in its revenue as a result of the
continued decline in spending on information technology by its customers,
specifically for enterprise communications products and services. Despite the
unpredictability of the current business environment, the Company remains
focused on its strategy to return to profitability by focusing on sustainable
cost and expense reduction, among other things. To achieve that goal, the
Company initiated restructuring actions in fiscal 2002 to enable it to reduce
costs and expenses further in order to lower the amount of revenue needed to
reach the Company's profitability break-even point. As a result, the Company
recorded a pretax charge of $229 million in fiscal 2002 for business
restructuring and related expenses. The components of the charge included $116
million of employee separation costs, $84 million of lease termination costs, $1
million of other exit costs, and $28 million of other related expenses. This
charge was partially offset by a $20 million reversal to income primarily
attributable to fewer employee separations than originally anticipated.
The charge for employee separation costs was composed of $113 million for
severance and other such costs as well as $3 million primarily related to the
cost of curtailment in accordance with SFAS No.88, "Employers' Accounting for
Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefits" ("SFAS 88"). Lease termination costs included
approximately $72 million of real estate, net of anticipated sublease income and
$12 million of information technology lease termination payments. The $28
million of other related expenses include relocation and consolidation costs,
computer transition expenditures, and asset impairments associated with the
Company's ongoing restructuring initiatives.
The employee separation costs were incurred in connection with the
elimination of approximately 4,240 management and union-represented employee
positions worldwide, of which approximately 2,900 employees had departed the
Company as of September 30, 2002. Employee separation costs included in the
business restructuring reserve are made through lump sum payments, although
certain union-represented employees elected to receive a series of payments
Avaya Inc. 55
<Page>
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 fiscal 2004.
The $72 million charge for real estate lease termination obligations includes
approximately one million square feet of excess sales and services support,
research and development, call center and administrative offices located
primarily in the U.S., which have been substantially vacated as of September 30,
2002. The real estate charge also includes an adjustment to increase the accrued
amount for previously reserved sites due to a recent deterioration in the
commercial real estate market. As a result, the Company has extended its
estimates as to when it will be able to begin subleasing certain vacated sites
and established an additional accrual for lease payments originally estimated to
have been offset by sublease rental income. Payments on lease termination
obligations will be substantially completed by 2011 because, in certain
circumstances, the remaining lease payments were less than the termination fees.
- - FISCAL 2001
In fiscal 2001, the Company outsourced certain manufacturing facilities and
accelerated its restructuring plan that was originally adopted in September 2000
to improve profitability and business performance as a stand-alone company. As a
result, the Company recorded a pretax charge of $872 million in fiscal 2001 for
business restructuring and related expenses. This charge was partially offset by
a $35 million reversal to income primarily attributable to fewer employee
separations than originally anticipated and more favorable than expected real
estate lease termination costs.
The components of the fiscal 2001 charge included $650 million of employee
separation costs, $24 million of lease termination costs, and $198 million of
other related expenses. The charge for employee separation costs was composed of
$577 million primarily related to enhanced pension and postretirement benefits,
which represented the cost of curtailment in accordance with SFAS 88, and $73
million for severance, special benefit payments and other employee separation
costs. The $198 million of other related expenses was composed of $178 million
for incremental period expenses primarily to facilitate the separation from
Lucent, including computer system transition costs, and $20 million for an asset
impairment charge related to land, buildings and equipment at the Shreveport
manufacturing facility. Employee separation costs of $55 million established in
fiscal 2000 for union-represented employees at Shreveport were paid as enhanced
severance benefits from existing pension and benefit assets and, accordingly,
such amount was reclassified in fiscal 2001 out of the business restructuring
reserve and recorded as a reduction to prepaid benefit costs.
The employee separation costs in fiscal 2001 were incurred in connection
with the elimination of 6,810 employee positions of which 5,600 were through a
combination of involuntary and voluntary separations, including an early
retirement program targeted at U.S. management employees, and a workforce
reduction of 1,210 employees due to the outsourcing of certain of the Company's
manufacturing operations. Employee separation payments that are included in the
business restructuring reserve were made either through a lump sum or a series
of payments extending over a period of up to two years from the date of
departure, which is an option available to certain union-represented employees.
This workforce reduction was substantially completed as of September 30, 2001.
Real estate lease termination costs have been incurred primarily in the
U.S., Europe and Asia, and have been reduced for sublease income that management
believes is probable. Payments on lease obligations, which consist of real
estate and equipment leases, will extend through 2003. In fiscal 2001, accrued
costs for lease obligations represent approximately 666,000 square feet of
excess sales and services support offices, materials, stocking and logistics
warehouses, and Connectivity Solutions facilities. As of September 30, 2002, the
Company has entirely vacated this space.
- - FISCAL 2000
In fiscal 2000, the Company recorded a pretax business restructuring charge of
$684 million in connection with its separation from Lucent. The components of
the charge included $365 million of employee separation costs, $127 million of
lease termination costs, $28 million of other exit costs, and $164 million of
other related expenses.
The charge for employee separation costs in fiscal 2000 included severance,
medical and other benefits attributable to the worldwide reduction of 4,900
union-represented and management positions. This charge was the result of
redesigning the services organization by reducing the number of field
technicians to a level needed for non-peak workloads, consolidating and closing
certain U.S. and European manufacturing facilities and realigning the sales
effort to focus the direct sales force on strategic accounts and address smaller
accounts through indirect sales channels. This workforce reduction was
substantially completed as of September 30, 2001. The charge for lease
termination obligations included approximately two million square feet of excess
manufacturing, distribution and administrative space, which the Company has
entirely vacated as of September 30, 2002. Other exit costs consisted of
decommissioning legacy computer systems in connection with the Company's
separation from Lucent and terminating other contractual obligations.
The $164 million of other related expenses in fiscal 2000 was composed of
$89 million for incremental period expenses related to the separation from
Lucent, including computer system transition costs, and a $75 million asset
impairment charge that was primarily related to an outsourcing contract with a
major customer. With respect to the asset impairment, the Company terminated its
obligation under a leasing arrangement and purchased the underlying equipment,
which had been used to support a contract with a customer to provide outsourcing
and related services. Based on the terms of this contract, the estimated
undiscounted cash flows from the equipment's use and eventual disposition was
determined to be less than the equipment's carrying value, and resulted in an
impairment charge of $50 million to write such equipment down to its fair value.
56 Avaya Inc.
<Page>
NOTE 9 SHORT-TERM BORROWINGS AND LONG-TERM DEBT
Short-term borrowings and long-term debt outstanding consisted of the following:
<Table>
<Caption>
As of September 30,
-----------------------
(dollars in millions) 2002 2001
- -----------------------------------------------------------------------
<S> <C> <C>
Short-term borrowings:
Five-year revolving credit facility $ -- $ 132
Other short-term borrowings -- 13
- -----------------------------------------------------------------------
Total short-term borrowings,
including current maturities -- 145
- -----------------------------------------------------------------------
Long-term debt:
Commercial paper -- 432
Five-year revolving credit facility -- 68
LYONs convertible debt, net of discount 476 --
Senior Secured Notes, net of discount 457 --
- -----------------------------------------------------------------------
Total long-term debt 933 500
- -----------------------------------------------------------------------
Total short-term borrowings
and long-term debt $ 933 $ 645
=======================================================================
</Table>
- - DEBT RATINGS
The Company's ability to obtain external financing and the related cost of
borrowing is affected by the Company's debt ratings, which are periodically
reviewed by the major credit rating agencies. During the second and fourth
quarters of fiscal 2002, the Company's commercial paper and long-term debt
ratings were downgraded. Ratings as of September 30, 2002 and 2001 are as
follows (all ratings include a negative outlook):
<Table>
<Caption>
As of September 30,
----------------------------
2002 2001
- ------------------------------------------------------------------------------
<S> <C> <C>
Moody's:
Commercial paper NO RATING P-2
Long-term senior unsecured debt BA3 Baa1
Senior secured notes BA2 NO RATING
Standard & Poor's:
Commercial paper NO RATING A-2
Long-term senior unsecured debt B NO RATING
Senior secured notes B+ NO RATING
Corporate credit BB- BBB
</Table>
In November 2002, Moody's downgraded the Company's long-term senior unsecured
debt rating to "B3" with a negative outlook and the senior secured notes rating
to "B2" with a stable outlook.
- - COMMERCIAL PAPER PROGRAM
The Company had a commercial paper program (the "CP Program") pursuant to which
the Company was able to issue up to $1.25 billion of commercial paper at market
interest rates with maturities not exceeding one year. Commercial paper issued
under the CP Program bore interest at the London Interbank Offering Rate
("LIBOR") for the related maturity period plus a fixed spread.
During fiscal 2002, Standard & Poor's and Moody's downgraded the Company's
commercial paper rating several times and eventually withdrew their ratings of
the Company's commercial paper at the Company's request. This withdrawal of the
Company's commercial paper rating made it impossible for the Company to access
the commercial paper market, which had been the Company's primary source of
liquidity. As a result of the impact of the 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, described below, to repay
commercial paper obligations. The Company repaid the $300 million borrowing in
March 2002 using proceeds from the issuance of Senior Secured Notes also
described below. As of June 30, 2002, all remaining commercial paper obligations
had been repaid using proceeds from the offering of the Senior Secured Notes.
The weighted average yield and maturity period for the commercial paper
outstanding during fiscal 2002 was approximately 3.4% and 65 days, respectively.
As of September 30, 2001, $432 million in commercial paper was classified
as long-term debt since it was supported by the five-year Credit Facility and it
was management's intent to reissue the commercial paper on a long-term basis.
The weighted average yield and maturity period for the commercial paper
outstanding during fiscal 2001 was approximately 3.9% and 62 days, respectively.
- - REVOLVING CREDIT FACILITIES
As of September 30, 2001, the Company had two revolving credit facilities (the
"Credit Facilities") with third party financial institutions. These Credit
Facilities consisted of a $400 million 364-day Credit Facility that expired in
August 2002 and an $850 million five-year Credit Facility that expires in
September 2005. As required by the terms of the Credit Facilities, upon the
closing of the offering of the Senior Secured Notes in March 2002, the Credit
Facilities were reduced proportionately by an amount equal to the $425 million
of proceeds, net of certain deferred financing costs, realized from the
offering. Accordingly, the 364-day Credit Facility was reduced to $264 million
and the five-year Credit Facility was reduced to $561 million. The Company did
not renew the 364-day Credit Facility when it expired in August 2002.
As of September 30, 2002, the total commitments under the five-year Credit
Facility were $561 million, but will be subject to mandatory reduction as
follows:
- - reduced to $500 million on December 1, 2003;
- - reduced to $425 million on March 1, 2004;
- - reduced to $350 million on June 1, 2004; and
- - reduced to $250 million on September 1, 2004.
The Company is required to reduce the commitments by an amount equal to
100% of the net cash proceeds realized from the sale of any assets, with certain
exceptions, and by an amount equal to 50% of the net cash proceeds realized from
the issuance of debt, other than refinancing debt; provided, however, that in
each case, the Company is not required to reduce the commitments below an amount
equal to $250 million less the amount of any cash used to redeem or repurchase
the convertible debt described below.
Avaya Inc. 57
<Page>
The Company's Credit Facilities were most recently amended in September
2002. Borrowings under the five-year Credit Facility are avail-able for general
corporate purposes and, subject to certain conditions, for acquisitions up to
$75 million. The five-year Credit Facility pro-vides, at the Company's option,
for fixed and floating rate borrowings from committed loans by the lenders who
are party to the Credit
Facility agreement and through competitive bid procedure. Fixed rate
committed loans under the amended five-year Credit Facility bear interest at a
rate equal to (i) the greater of (a) Citibank, N.A.'s base rate, which was 4.75%
at September 30, 2002 and (b) the federal funds rate, which was 1.75% at
September 30, 2002, plus 0.5% plus (ii) a margin based on the Company's
long-term debt rat-ing (the "Applicable Margin"). Floating rate committed loans
bear interest at a rate equal to LIBOR plus the Applicable Margin. A
uti-lization fee based on the Company's long-term debt rating (the "Applicable
Utilization Fee") is added to fixed and floating rate com-mitted loans when the
aggregate of such borrowings exceed 50% of the amount available under the Credit
Facility. Based on the Company's current long-term debt rating, the Applicable
Margins for the five-year Credit Facility are 1.5% for fixed rate committed
loans and 3.0% for floating rate committed loans, and the Applicable Utilization
Fee for both fixed and floating rate committed loans is 0.5%. Funds are also
available through competitive bid at a fixed rate determined by the lender or at
a floating interest rate equal to LIBOR plus a margin spec-ified by the lender.
As of September 30, 2002, no amounts were outstanding under the Credit
Facilities. As of September 30, 2001, $200 million was outstanding under the
five-year Credit Facility bearing interest at a floating rate of approximately
3.5%. This amount was repaid in October 2001.
The five-year Credit Facility contains certain covenants, including
limitations on the Company's ability to incur liens in certain circum-stances or
enter into certain change of control transactions. In addition, the Company is
required to maintain certain financial covenants relating to a minimum amount of
earnings before interest, taxes, depreciation and amortization ("EBITDA") and a
minimum ratio of EBITDA to interest expense. In particular, the Company is
required to maintain a minimum EBITDA of:
o $70 million for the three quarter period ending September 30, 2002;
o $100 million for the four quarter period ending December 31, 2002;
o $115 million for the four quarter period ending March 31, 2003;
o $150 million for the four quarter period ending June 30, 2003;
o $250 million for the four quarter period ending September 30, 2003;
o $350 million for the four quarter period ending December 31, 2003; and
o $400 million for each of the four quarter periods thereafter.
In addition, the five-year Credit Facility requires the Company to
maintain a ratio of EBITDA to interest expense of:
o 1.70 to 1 for each of the four quarter periods ending September 30, 2002,
December 31, 2002 and March 31, 2003;
o 2.25 to 1 for the four quarter period ending June 30, 2003;
o 3.50 to 1 for the four quarter period ending September 30, 2003; and
o 4.00 to 1 for the four quarter period ending December 31, 2003 and each
four quarter period thereafter.
The covenants permit the Company to exclude up to a certain amount of
business restructuring charges and related expenses from the calculation of
EBITDA in fiscal years 2003 and 2002. In addition, the definition of EBITDA in
the five-year Credit Facility excludes all other non-cash charges except to the
extent any such non-cash charge represents an accrual for cash expenditures in a
future period. The covenants under the five-year Credit Facility permit the
Company to exclude from the calculation of EBITDA business restructuring charges
and related expenses, including asset impairment charges, of an addi-tional $60
million to be taken no later than June 30, 2003. The Company was in compliance
with all required covenants as of September 30, 2002.
Based on the Company's current debt ratings, any borrowings under the
five-year Credit Facility are secured, subject to certain exceptions, by
security interests in the Company's equipment, accounts receiv-able, inventory,
and U.S. intellectual property rights of the Company and that of any of its
subsidiaries guaranteeing its obligations under the amended five-year Credit
Facility. Borrowings are also secured by a pledge of the stock of most of the
Company's domestic subsidiaries and 65% of the stock of a foreign subsidiary
that, together with its subsidiaries, holds the beneficial and economic right to
utilize certain of the Company's domestic intellectual property rights outside
of North America. The security interests 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.
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 five-year Credit Facility. There are no Avaya subsidiaries that currently
meet these criteria. The five-year Credit Facility provides that the Company may
use up to $100 million of cash to redeem or repurchase its convertible debt at
any time as long as no default or event of default exists under the facility, no
amounts are outstanding under the facility, the commit-ments are reduced in an
amount equal to the cash amount used to redeem or repurchase the convertible
debt, and the Company's cash balance is not less than $300 million after giving
pro forma effect to the redemption or repurchase of the convertible debt.
> UNCOMMITTED CREDIT FACILITIES
The Company has entered into several uncommitted credit facilities totaling $61
million and $100 million, of which letters of credit of $25 million and $20
million were issued and outstanding as of fiscal 2002 and 2001, respectively.
Letters of credit are purchased guaran-tees that ensure the Company's
performance or payment to third parties in accordance with specified terms and
conditions.
> 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 of Liquid Yield Option (TM)
Notes due 2021 ("LYONs"). The proceeds of approximately $448 million, net of a
$484 million discount and
58 Avaya Inc.
<Page>
$12 million of underwriting fees, were used to refinance a portion of the
Company's outstanding commercial paper. The underwriting fees of $12 million
were recorded as deferred financing costs and are being amortized 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. In fiscal 2002, $4 million of deferred financing costs were recorded as
inter-est expense.
The original issue discount of $484 million accretes 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 inter-est expense and represents the
accretion of the LYONs issue price to their maturity value. In fiscal 2002, $16
million of interest expense on the LYONs was recorded resulting in an accreted
value of $476 mil-lion as of September 30, 2002. The discount will cease to
accrete on the LYONs upon maturity, conversion, purchase by the Company at the
option of the holder, or redemption by Avaya. The LYONs are unse-cured
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 com-mon 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 October 31, 2004, 2006 and 2011 at a price equal to the sum of
the issue price and accrued original issue discount on the LYONs as of the
applica-ble 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. If
the Company were to purchase all of the LYONs at the option of the holders, the
aggregate purchase price would be approximately $512 million on October 31,
2004, $550 million on October 31, 2006 and $659 million on October 31, 2011. If
the Company elected to pay the purchase price in shares of Avaya common stock,
the num-ber of shares would be equal to the purchase price divided by the
average of the market prices of Avaya common stock for the five trad-ing day
period ending on the third business day prior to the applicable purchase date.
The indenture governing the LYONs includes certain covenants, including a
limitation on the Company's ability to grant liens on sig-nificant domestic real
estate properties or the stock of its subsidiaries holding such properties.
> SENIOR SECURED NOTES
In March 2002, the Company issued through an underwritten public offering under
a shelf registration statement $440 million aggregate principal amount of
11.125% Senior Secured Notes due April 2009 (the "Senior Secured Notes") and
received net proceeds of approxi-mately $425 million, net of a $5 million
discount and $10 million of issuance costs. Interest on the Senior Secured Notes
is payable on April 1 and October 1 of each year beginning on October 1, 2002.
The Company recorded interest expense of $25 million for fiscal 2002. The $5
million discount is being amortized to interest expense over the seven-year term
to maturity. The $10 million of issuance costs were recorded as deferred
financing costs and are also being amortized to interest expense over the term
of the Senior Secured Notes. The pro-ceeds from the issuance were used to repay
amounts outstanding under the five-year Credit Facility and for general
corporate purposes. As of September 30, 2002, the carrying value of the Senior
Secured Notes was $457 million, which includes $22 million related to the
increase in the fair market value of the hedged portion of such debt.
The Company may redeem the Senior Secured Notes, in whole or from time to
time in part, at the redemption prices expressed as a per-centage of the
principal amount plus accrued and unpaid interest to the applicable redemption
date, if redeemed during the twelve-month period beginning on April 1 of the
following years: (i) 2006 at 105.563%; (ii) 2007 at 102.781%; and (iii) 2008 at
100.0%.
The Senior Secured Notes are secured by a second priority security
interest in the collateral securing the Company's obligations under the
five-year Credit Facility and its obligations under the interest rate swap
agreements. In the event that (i) the Company's corporate credit is rated at
least BBB by Standard & Poor's and its long-term senior unsecured debt is rated
at least Baa2 by Moody's, each without a neg-ative outlook or its equivalent, or
(ii) subject to certain conditions, at least $400 million of unsecured
indebtedness is outstanding or avail-able under the Credit Facilities or a bona
fide successor credit facility, the security interest in the collateral securing
the Senior Secured Notes will terminate. The indenture governing the Senior
Secured Notes includes negative covenants that limit the Company's ability to
incur secured debt and enter into sale/leaseback transactions. In addition, the
indenture also includes conditional covenants that limit the Company's ability
to incur debt, enter into affiliate transactions, or make restricted payments or
investments and advances. These conditional covenants will apply to the Company
until such time that the Senior Secured Notes are rated at least BBB- by
Standard & Poor's and Baa3 by Moody's, in each case without a negative outlook
or its equivalent.
NOTE 10 DERIVATIVES AND OTHER FINANCIAL INSTRUMENTS
The Company conducts its business on a multi-national basis in a wide variety of
foreign currencies and, as such, uses derivative financial instruments to reduce
earnings and cash flow volatility associated with foreign exchange rate changes.
Specifically, the Company uses foreign currency forward contracts, and to a
lesser extent, foreign currency options to mitigate the effects of fluctuations
of exchange rates asso-ciated with certain existing assets and liabilities that
are denominated in non-functional currencies and, from time to time, to reduce
antic-ipated net foreign currency cash flows resulting from normal business
operations. In addition, the Company uses interest rate swap agree-ments to
manage its proportion of fixed and floating rate debt and to reduce interest
expense.
Avaya Inc. 59
<Page>
The Company engages in foreign currency hedging activities to reduce the
risk that changes in exchange rates will adversely affect the eventual net cash
flows resulting from the sale of products to for-eign customers and purchases
from foreign suppliers. The Company believes that it has achieved risk reduction
and hedge effectiveness because the gains and losses on its derivative
instruments substan-tially offset the losses and gains on the assets,
liabilities and transactions being hedged. Hedge effectiveness is periodically
meas-ured by comparing the change in fair value of each hedged foreign currency
exposure at the applicable market rate with the change in market value of the
corresponding derivative instrument.
> RECORDED TRANSACTIONS
The Company utilizes foreign currency forward contracts primarily to manage
short-term exchange rate exposures on certain receivables, payables and loans
residing on foreign subsidiaries' books, which are denominated in currencies
other than the subsidiary's functional cur-rency. When these items are revalued
into the subsidiary's functional currency at the month-end exchange rates, the
fluctuations in the exchange rates are recognized in earnings as other income or
expense. Changes in the fair value of the Company's foreign currency forward
contracts used to offset these exposed items are also recognized in earnings as
other income or expense in the period in which the exchange rates change. For
the fiscal years ended September 30, 2002 and 2001, the changes in the fair
value of the foreign currency forward and option contracts were substantially
offset by changes resulting from the revaluation of the hedged items.
> FORECASTED TRANSACTIONS
From time to time, the Company uses foreign currency forward and option
contracts to offset certain forecasted foreign currency transactions primarily
related to the purchase or sale of product expected to occur during the ensuing
twelve months. The change in the fair value of foreign currency forward and
option contracts is recognized as other income or expense in the period in which
the exchange rates change. The Company did not use any foreign currency forward
or option con-tracts for forecasted transactions in fiscal 2002. For the fiscal
year ended September 30, 2001, these gains and losses were not material to the
Company's results of operations. As permitted under SFAS 133, we have elected
not to designate our forward and option contracts as hedges thereby precluding
the use of hedge accounting for these instruments.
The notional amounts as of September 30, 2002 and 2001 of the Company's
foreign currency forward contracts were $271 million and $175 million,
respectively, and foreign currency option contracts were $20 million and $17
million, respectively. In fiscal 2002, these notional amounts principally
represent the equivalent in U.S. dollars for contracts in British pounds
sterling of $121 million, euros of $116 million, Canadian dollars of $11 million
and Brazilian reals of $2 million. In fiscal 2001, the notional amounts
principally represent the equivalent in U.S. dollars for contracts in British
pounds sterling of $146 million, Australian dollars of $16 million and Canadian
dollars of $11 million. Notional amounts represent the face amount of the
contractual arrangements and the basis on which U.S. dollars are to be exchanged
and are not a measure of market or credit exposure.
> INTEREST RATE SWAP AGREEMENTS
In April 2002, the Company entered into two interest rate swap agree-ments with
a total notional amount of $200 million that mature in April 2009 and were
executed in order to: (i) convert a portion of the Senior Secured Notes
fixed-rate debt into floating-rate debt; (ii) main-tain a capital structure
containing appropriate amounts of fixed and floating-rate debt; and (iii) reduce
net interest payments and expense in the near-term. Under these agreements, the
Company receives a fixed interest rate of 11.125% and pays a floating interest
rate based on LIBOR plus an agreed-upon spread, which was equal to a weighted
average interest rate of 6.8% as of September 30, 2002. The amounts paid and
received are calculated based on the total notional amount of $200 million.
Since the relevant terms of the swap agreements match the corresponding terms of
the Senior Secured Notes, there is no hedge ineffectiveness. Accordingly, as
required by SFAS 133, gains and losses on the swap agreements will fully offset
the losses and gains on the hedged portion of the Senior Secured Notes, which
are marked to market at each reporting date. As of September 30, 2002, the
Company recorded the fair market value of the swaps of $22 million as other
assets along with a corresponding increase to the hedged debt with equal and
offsetting unrealized gains and losses included in other income (expense), net.
Interest payments are recognized through interest expense and are made and
received on the first day of each April and October, com-mencing on October 1,
2002 and ending on the maturity date. On the last day of each semi-annual
interest payment period, the interest pay-ment for the previous six months will
be made based upon the six-month LIBOR rate (in arrears) on that day, plus the
applicable mar-gin, as shown in the table below. Since the interest rate is not
known until the end of each semi-annual interest period, estimates are used
during such period based upon published forward-looking LIBOR rates. Any
differences between the estimated interest expense and the actual interest
payment are recorded to interest expense at the end of each semi-annual interest
period. These interest rate swaps resulted in a reduction to actual interest
expense in fiscal 2002 of $4 million.
The following table outlines the terms of the swap agreements:
<Table>
<Caption>
Notional Receive
Amount Fixed
(dollars Interest
Maturity Date in millions) Rate Pay Variable Interest Rate
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C>
April 2009 $ 150 11.125% Six-month LIBOR (in arrears)
plus 5.055% spread
April 2009 50 11.125% Six-month LIBOR (in arrears)
----- plus 5.098% spread
Total $ 200
=====
</Table>
60 Avaya Inc.
<Page>
Each counterparty to the swap agreements is a lender under the five-year Credit
Facility. The Company's obligations under these swap agreements are secured on
the same basis as its obligations under the five-year Credit Facility.
> FAIR VALUE
The carrying amounts of cash and cash equivalents, accounts receivable, accounts
payable, accrued liabilities, commercial paper and other short-term borrowings
approximate fair value because of their short-term maturity and variable rates
of interest. Except for the LYONs and Senior Secured Notes, the carrying value
of debt outstanding under the Credit Facilities approximates fair value as
interest rates on these borrowings approximate current market rates. The fair
value of the LYONs and Senior Secured Notes as of September 30, 2002 are
estimated to be $193 million and $279 million, respectively, and are 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. As of September 30, 2002, the
fair value of the Company's inter-est rate swaps was $22 million based upon a
mark-to-market valuation performed by an independent financial institution.
As of September 30, 2002, the Company's foreign currency forward contracts
and options were assets and had a net carrying value of $10 million, which
represented their estimated fair value based on market quotes obtained through
independent pricing sources.
> NON-DERIVATIVE AND OFF-BALANCE-SHEET INSTRUMENTS
Requests for providing commitments to extend credit and financial guarantees are
reviewed and approved by senior management. Management regularly reviews all
outstanding commitments, letters of credit and financial guarantees, and the
results of these reviews are considered in assessing the adequacy of the
Company's reserve for possible credit and guarantee losses.
NOTE 11 CONVERTIBLE PARTICIPATING PREFERRED STOCK AND OTHER
RELATED EQUITY TRANSACTIONS
> WARBURG TRANSACTIONS
In October 2000, the Company sold to Warburg Pincus Equity Partners, L.P. and
certain of its investment funds (the "Warburg Entities") four million shares of
the Company's Series B convertible participating preferred stock and warrants to
purchase the Company's common stock for an aggregate purchase price of $400
million. In March 2002, the Company completed a series of transactions pur-suant
to which the Warburg Entities (i) converted all four million shares of the
Series B preferred stock into 38,329,365 shares of Avaya's com-mon stock based
on a conversion price of $11.31 per share, which was reduced from the original
conversion price of $26.71 per share, (ii) purchased an additional 286,682
shares of common stock by exercising a portion of the warrants at an exercise
price of $34.73 per share result-ing in gross proceeds of approximately $10
million, and (iii) purchased 14,383,953 shares of the Company's common stock for
$6.26 per share, which was the reported closing price of Avaya's common stock
NOTE 11 on the New York Stock Exchange on the March 8, 2002, resulting in gross
proceeds of approximately $90 million. In connection with these transactions,
the Company incurred approximately $4 million of trans-action costs, which were
recorded as a reduction to additional paid-in capital. As of September 30, 2002,
there were no shares of Series B preferred stock outstanding and, accordingly,
the Series B preferred stock has ceased accruing dividends.
As a result of these transactions, the Warburg Entities hold approximately
53 million shares of the Company's common stock, which represents approximately
15% of the Company's outstanding common stock, and warrants to purchase
approximately 12 million additional shares of common stock. These warrants have
an exercise price of $34.73 of which warrants exercisable for 6,724,665 shares
of com-mon stock expire on October 2, 2004, and warrants exercisable for
5,379,732 shares of common stock expire on October 2, 2005.
The conversion of the Series B preferred stock and the exercise of the
warrants resulted in a charge to accumulated deficit of approxi-mately $125
million, in addition to the $5 million accretion of the Series B preferred stock
from January 1, 2002 through the date of conversion. This charge primarily
represents the impact of reducing the preferred stock conversion price from
$26.71 per share as origi-nally calculated to $11.31 per share, as permitted
under the purchase agreement. The Company recorded a total of $12 million of
accretion for the period from October 1, 2001 through the date of conversion.
The shares of Series B preferred stock had an aggregate initial
liquidation value of $400 million and accreted at an annual rate of 6.5%,
compounded quarterly. The purchase agreement had provided for determining the
total number of shares of common stock that the Series B preferred stock was
convertible by dividing the liquidation value in effect at the time of
conversion by the conversion price. As of September 30, 2001, the Company
recorded a $27 million reduction in accumulated deficit representing the amount
accreted for the divi-dend period.
The $400 million proceeds from the Warburg Entities' investment were
initially allocated between the Series B preferred stock and warrants based upon
the relative fair market value of each security, with $368 million allocated to
the Series B preferred stock and $32 million to the warrants. The fair value
allocated to the Series B preferred stock including the amount accreted for the
fiscal year ended September 30, 2001 was recorded in the mezzanine section of
the Consolidated Balance Sheet because the investors could have required the
Company, upon the occurrence of any change of control in the Company during the
first five years from the investment, to redeem the Series B preferred stock.
The fair value allocated to the warrants was included in additional paid-in
capital.
A beneficial conversion feature would have existed if the conversion price
for the Series B preferred stock or warrants was less than the fair value of the
Company's common stock at the commitment date. The Company determined that no
beneficial conversion features existed at the commitment date and therefore
there was no impact on its results of operations associated with the Series B
preferred stock or with the warrants.
Avaya Inc. 61
<Page>
> PUBLIC OFFERING OF COMMON STOCK
In March 2002, the Company sold 19.55 million shares of common stock for $5.90
per share in a public offering. The Company received proceeds of approximately
$112 million, which is net of approximately $3 million of underwriting fees
reflected as a reduction to additional paid-in capital.
NOTE 12 LOSS PER SHARE OF COMMON STOCK
Basic earnings (loss) per common share is calculated by dividing net loss
available to common stockholders by the weighted average num-ber of common
shares outstanding during the year. Since the Distribution was not effective
until September 30, 2000, the weighted average number of common shares
outstanding during fiscal 2000 was calculated based on a twelve-to-one ratio of
Lucent's weighted average number of shares to Avaya's weighted average number of
shares. Diluted earnings (loss) per common share is calculated by adjusting net
income 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.
Net loss available to common stockholders for both the basic and diluted
loss per common share calculations for the fiscal year ended September 30, 2002
includes the $125 million conversion charge related to the Series B preferred
stock.
<Table>
<Caption>
Year Ended September 30,
--------------------------------------
(dollars in millions, except per share amounts) 2002 2001 2000
- -------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net loss available to common stockholders $(803) $(379) $(375)
===========================================================================================
SHARES USED IN COMPUTING LOSS PER COMMON SHARE:
Basic and Diluted 330 284 269
===========================================================================================
LOSS PER COMMON SHARE:
Basic and Diluted $(2.44) $(1.33) $(1.39)
===========================================================================================
SECURITIES EXCLUDED FROM THE COMPUTATION OF
DILUTED LOSS PER COMMON SHARE:
Options (1) 45 52 9
Series B preferred stock (2) 38 16 --
Warrants (1) 12 12 --
Convertible debt (1) 93 -- --
- -------------------------------------------------------------------------------------------
Total 188 80 9
===========================================================================================
</Table>
(1) These securities have been excluded from the diluted loss per common share
calculation since the effect of their inclusion would have been antidilutive.
(2) As a result of the conversion of the Series B convertible participating
preferred stock during fis-cal 2002, the conversion price was decreased from
$26.71 per share to $11.31 per share. When applying the "if-converted" method in
fiscal 2002, the shares are assumed to have been converted from October 1, 2001
through the date of conversion.
NOTE 13 INCOME TAXES
Commencing with fiscal 2001, the Company began filing its own tax returns. Prior
to the Distribution, the Company's income taxes were reflected on a separate tax
return basis and included as part of Lucent's consolidated income tax returns.
The following table pres-ents the principal reasons for the difference between
the effective tax rate and the U.S. federal statutory income tax rate:
<Table>
<Caption>
Year Ended September 30,
----------------------------------
2002 2001 2000
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
U.S. federal statutory income tax rate (benefit) (35.0%) (35.0%) (35.0%)
State and local income taxes, net of federal income tax effect (3.4) (4.3) (4.8)
Tax differentials on foreign earnings 13.6 (2.2) 3.7
Purchased in-process research and development and other
acquisition-related costs -- 2.4 --
Non-deductible restructuring costs 2.7 2.3 18.2
Other differences--net (2.6) (1.5) 1.6
Valuation allowance 90.7 -- --
- -----------------------------------------------------------------------------------------------------
Effective tax rate (benefit) 66.0% (38.3%) (16.3%)
=====================================================================================================
</Table>
The following table presents the U.S. and foreign components of loss before
income taxes and the provision (benefit) for income taxes:
<Table>
<Caption>
Year Ended September 30,
---------------------------------
(dollars in millions) 2002 2001 2000
- ---------------------------------------------------------------------------
<S> <C> <C> <C>
LOSS BEFORE INCOME TAXES:
U.S. $(352) $(456) $(588)
Foreign (49) (114) 140
- ---------------------------------------------------------------------------
Loss before income taxes $(401) $(570) $(448)
===========================================================================
PROVISION (BENEFIT) FOR INCOME TAXES:
CURRENT
Federal $ -- $ -- $ 130
State and local -- -- 11
Foreign 22 46 74
- ---------------------------------------------------------------------------
Subtotal 22 46 215
- ---------------------------------------------------------------------------
DEFERRED
Federal 199 (219) (244)
State and local 45 (38) (44)
Foreign (1) (7) --
- ---------------------------------------------------------------------------
Subtotal 243 (264) (288)
- ---------------------------------------------------------------------------
Provision (benefit) for income taxes $ 265 $(218) $ (73)
===========================================================================
</Table>
62 Avaya Inc.
<Page>
The components of deferred tax assets and liabilities as of September 30, 2002
and 2001 are as follows:
As of September 30,
----------------------
(dollars in millions) 2002 2001
- -------------------------------------------------------------------
DEFERRED INCOME TAX ASSETS
Benefit obligations $ 523 $ 249
Accrued liabilities 387 353
Net operating loss/credit carryforwards 241 280
Other 82 50
- -------------------------------------------------------------------
Gross deferred tax assets 1,233 932
- -------------------------------------------------------------------
DEFERRED INCOME TAX LIABILITIES
Property, plant and equipment (5) (37)
Other (84) (71)
- -------------------------------------------------------------------
Gross deferred tax liabilities (89) (108)
- -------------------------------------------------------------------
Valuation allowance (612) (49)
- -------------------------------------------------------------------
NET DEFERRED TAX ASSET $ 532 $ 775
===================================================================
As of September 30, 2002, the Company had tax credit carryforwards of $41
million and federal, state and local and foreign net operating loss
carryforwards (after-tax) of $200 million. The various tax credit carryforwards
of $9 million, $15 million and $17 million expire within 5 years, between 5 and
ten years and in excess of ten years, respec-tively. Federal and state net
operating loss carryforwards expire through the year 2022, the majority of which
expire in excess of ten years. The majority of foreign net operating loss
carryforwards have no expiration.
The Company recorded an increase of $563 million to its net deferred tax
asset valuation allowance. The increase in the valuation allowance is comprised
of a $364 million charge included in the pro-vision for income taxes and a $202
million reduction in accumulated other comprehensive loss associated with the
minimum pension lia-bility recorded in accordance with SFAS No. 87, "Employers'
Accounting for Pensions," ("SFAS 87"). The increase in the valuation allowance
was partially offset with $3 million of net operating losses that expired during
the year. The valuation allowance was calculated in accordance with the
provisions of SFAS No. 109, "Accounting for Income Taxes," which place primary
importance on the Company's cumulative operating results.
In assessing the realizability of deferred tax assets, the Company
considers whether it is more likely than not that some portion or all of the
deferred tax assets will not be realized. The Company considered the scheduled
reversal of deferred tax liabilities, projected future tax-able income, and
certain distinct tax planning strategies in making this assessment. The amount
of net deferred tax determined to be real-izable was measured by calculating the
tax effect of the tax planning strategies, which include potential sale of
assets and liabilities. Based on this assessment, the Company determined that it
is more likely than not that $532 million of such assets will be realized,
therefore resulting in a valuation allowance of $612 million. If changes occur
in the assumptions underlying the Company's tax planning strategies or in the
scheduling of the reversal of the Company's deferred tax lia-bilities, the
valuation allowance may need to be adjusted in the future.
The Company has not provided for U.S. deferred income taxes or foreign
withholding taxes on $632 million of undistributed earnings of its non-U.S.
subsidiaries as of September 30, 2002, since the Company intends to reinvest
these earnings indefinitely.
NOTE 14 BENEFIT OBLIGATIONS
> PENSION AND POSTRETIREMENT BENEFITS
The Company maintains
defined benefit pension plans covering the majority of its employees and
retirees, and postretirement benefit plans for retirees that include healthcare
benefits and life insurance coverage. In fiscal year 2002, the Company recorded
pension and postretirement expense of $6 million and $23 million, respectively,
including charges for curtailment and special termination benefits of $1 million
each related to its pension plan, in connection with the Company's business
restructuring efforts. During fiscal 2002, the Company amended its pension plan
for represented employees by increasing the pension benefit for certain
employees, which resulted in an increase of $11 million to the projected benefit
obligation.
On September 30, 2002, the Company's annual measurement date, the
accumulated benefit obligation related to Avaya's pension plans exceeded the
fair value of the pension plan assets (such excess is referred to as an unfunded
accumulated benefit obligation). This difference is attributed to (1) an
increase in the accumulated benefit obligation that resulted from a decrease in
the interest rate used to discount the projected benefit obligation to its
present settlement amount from 7% to 6.5% and (2) a decline in the fair value of
the plan assets due to a sharp decrease in the equity markets at September 30,
2002. As a result, in accordance with SFAS 87, the Company recognized an
additional minimum pension liability of $548 million included in benefit
obligations, recorded a charge to accumu-lated other comprehensive loss of $513
million which decreased stockholders' equity, and recognized an intangible asset
included in other assets of $35 million up to the amount of unrecognized prior
service cost. The charge to stockholders' equity for the excess of additional
pension liability over the unrecognized prior service cost represents a net loss
not yet recognized as pension expense.
In conjunction with the recognition of the additional minimum pension
liability, the Company also recorded in fiscal 2002 a deferred tax asset of $202
million for which a full valuation allowance was established. Both the deferred
tax asset and related valuation allowance were recorded through accumulated
other comprehensive loss.
In fiscal 2001, the Company recorded pension and postretirement expense of
$457 million and $138 million, respectively, including charges for curtailment
and special termination benefits of $474 mil-lion and $112 million,
respectively, in connection with the Company's business restructuring efforts.
The Company's pension plans experienced significant decreases in the number of
active employees due to these restructuring initiatives related to the
manufacturing outsourcing transaction and an early retirement program. As a
result, interim measurements were performed and curtailment accounting was
imple-mented. The Company recognized a charge from curtailment and special
termination benefits related to its pension plan of $26 million and $448
million, respectively. The Company has several non-pension postretirement
benefit plans. Consistent with the curtailment account-ing recorded for pensions
during fiscal 2001, the Company recorded curtailment and special termination
benefit charges of $91 million
Avaya Inc. 63
<Page>
and $21 million, respectively. The special termination benefits pro-vided
employees with improved pension benefits and earlier eligibility for
postretirement benefits.
In addition, effective August 1, 2001, the Company amended its pension
plan for salaried employees by increasing the minimum retirement age which
resulted in a $76 million decrease to the projected benefit obligation.
Effective August 1, 2001, the Company also amended its postretirement benefits
for salaried employees by decreasing the maximum employer contribution to
retiree healthcare coverage from 90% to 75%. In addition, the Company amended
the point in time when life insurance begins to be reduced. Under the amended
plan, retiree life insurance will be reduced by 10% a year beginning one year
after retirement, until 50% of the original coverage amount is reached.
Previously, this reduction started when the retiree reached age 66. The net
effect of these amendments resulted in a decrease in the accumulated
postretirement benefit obligation of $35 million.
In connection with the Distribution, the Company recorded esti-mates in
its Consolidated Balance Sheet at September 30, 2000 in prepaid benefit costs
and benefit obligations of various existing Lucent benefit plans related to
employees for whom the Company assumed responsibility. Following an actuarial
review, the Company received a valuation, agreed upon by the Company and Lucent,
that reduced pre-paid benefit costs by $44 million and pension and
postretirement benefit obligations by $17 million. The Company recorded the net
effect of these adjustments as a reduction to additional paid-in capital in
fiscal 2001 because the transfer of the net benefit assets relates to the
original capital contribution from Lucent.
The pension and postretirement costs incurred by Lucent for employees who
performed services for the Company were based on estimated plan assets being
equal to a proportional share of plan obli-gations incurred by Lucent for
employees who performed services for the Company. In relation to the Lucent
plans, in fiscal 2000, the Company recorded postretirement expense of $49
million, as adjusted through the Former Parent's net investment and pension
expense of $170 million, of which $55 million was attributed to enhanced
sev-erance benefits related to the Company's fiscal 2000 restructuring
initiative. The enhanced severance benefits charge was originally incurred as a
business restructuring expense in fiscal 2000 related to the manufacturing
outsourcing transaction and was subsequently reclassified in fiscal 2001 out of
the business restructuring reserve and recorded as a reduction to prepaid
benefit costs.
The following table shows the activity in Avaya's defined benefit pension
and postretirement plans:
<Table>
<Caption>
Pension Benefits Postretirement Benefits
As of September 30, As of September 30,
--------------------- -----------------------
(dollars in millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
CHANGE IN BENEFIT OBLIGATION
Benefit obligation as of October 1 $ 2,518 $ 1,758 $ 513 $ 412
Adjustment for final obligation assumed from Lucent -- (174) -- (48)
Service cost 54 79 6 11
Interest cost 171 128 36 30
Amendments 11 (76) -- (35)
Actuarial loss (gain) 177 399 58 124
Special termination benefits 1 448 -- 21
Reclassification -- 55 -- --
Benefits paid (193) (99) (27) (2)
- ---------------------------------------------------------------------------------------------------------------------------
Benefit obligation as of September 30 $ 2,739 $ 2,518 $ 586 $ 513
- ---------------------------------------------------------------------------------------------------------------------------
CHANGE IN PLAN ASSETS
Fair value of plan assets as of October 1 $ 2,371 $ 2,985 $ 174 $ 255
Actual return on plan assets (241) (255) (13) (44)
Adjustment for final assets assumed from Lucent -- (260) -- (36)
Employer contributions 4 -- 14 1
Benefits paid (193) (99) (28) (2)
- ---------------------------------------------------------------------------------------------------------------------------
Fair value of plan assets as of September 30 $ 1,941 $ 2,371 $ 147 $ 174
- ---------------------------------------------------------------------------------------------------------------------------
UNFUNDED STATUS OF THE PLAN $ (798) $ (147) $ (439) $ (339)
Unrecognized prior service cost 1 (5) (16) (16)
Unrecognized transition asset (1) (7) --
Unrecognized net (gain)/loss 626 (11) 124 34
- ---------------------------------------------------------------------------------------------------------------------------
Accrued benefit cost $ (172) $ (170) $ (331) $ (321)
===========================================================================================================================
AMOUNT RECOGNIZED IN THE CONSOLIDATED BALANCE SHEETS CONSISTS OF:
Accrued benefit cost $ (720) $ (170) $ (331) $ (321)
Intangible asset 35 -- -- --
Accumulated other comprehensive loss 513 -- -- --
- ---------------------------------------------------------------------------------------------------------------------------
Net amount recognized $ (172) $ (170) $ (331) $ (321)
===========================================================================================================================
</Table>
64 Avaya Inc.
<Page>
<Table>
<Caption>
As of September 30,
-------------------
2002 2001
- -----------------------------------------------------------------------------------------
<S> <C> <C>
PENSION AND POSTRETIREMENT BENEFITS WEIGHTED AVERAGE ASSUMPTIONS
Discount rate 6.5% 7.0%
Expected return on plan assets 9.0% 9.0%
Rate of compensation increase 4.0% 4.5%
</Table>
For postretirement healthcare, an 11.1% annual rate of increase in the per
capita cost of covered healthcare benefits was assumed for fis- cal year 2003.
The rate was assumed to decline gradually to 5.0% by the year 2009, and remain
at that level thereafter.
<Table>
<Caption>
Pension Benefits Postretirement Benefits
Year ended September 30, Year ended September 30,
----------------------------- -----------------------------
(dollars in millions) 2002 2001 2000 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost $ 54 $ 79 $ 115 $ 6 $ 11 $ 16
Interest cost 171 128 195 37 30 44
Expected return on plan assets (217) (208) (200) (19) (18) (17)
Amortization of unrecognized prior service cost 4 16 23 -- 5 7
Recognized net actuarial loss (1) (19) (1) (1) (2) (1)
Amortization of transition asset (7) (13) (17) -- -- --
Curtailment expense 1 26 -- -- 91 --
Special termination benefits 1 448 -- -- 21 --
Enhanced severance benefits -- -- 55 -- -- --
- ----------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $ 6 $ 457 $ 170 $ 23 $ 138 $ 49
======================================================================================================================
</Table>
As of September 30, 2002 and 2001, the Company's pension and postretirement plan
assets did not hold any direct investment in Avaya common stock.
A one-percentage-point change in the Company's healthcare cost trend rate would
not have had an effect on the total of service and interest cost components nor
the postretirement benefit obligation.
> SAVINGS PLANS
The majority of the Company's employees are eligible to participate in savings
plans sponsored by the Company. The plans allow employees to contribute a
portion of their compensation on a pre-tax and after-tax basis in accordance
with specified guidelines. Avaya matches a percentage of employee contributions
up to certain limits. The Company's expense related to these savings plans was
$24 million and $58 million in fiscal 2002 and 2001, respectively. Lucent had
similar plans prior to the Distribution of which the Company's expense was $54
million in 2000.
NOTE 15 STOCK COMPENSATION PLANS
The Company has stock compensation plans, which provide for the issuance to
eligible employees of nonqualified stock options and restricted stock units
representing Avaya common stock. In addition, the Company has a stock purchase
plan under which eligible employ-ees have the ability to purchase shares of
Avaya common stock at 85% of market value.
> STOCK OPTIONS
Stock options are generally granted with an exercise price equal to the market
value of a share of common stock on the date of grant, have a term of 10 years
or less and vest within four years from the date of grant. As of September 30,
2002, there were approximately 38 million stock options authorized for grant to
purchase Avaya common stock under the Company's stock compensation plans.
In connection with certain of the Company's acquisitions, outstanding
stock options held by employees of acquired companies became exercisable for
Avaya's common stock, according to their terms, effective at the acquisition
date. For acquisitions accounted for as purchases, the fair value of these
options was included as part of the purchase price.
Prior to fiscal 2001, certain employees of the Company were granted stock
options and other equity-based awards under Lucent's stock-based compensation
plans. At the time of the Distribution, unvested awards outstanding under
Lucent's stock plans that were held by Lucent employees who transferred to the
Company were converted to awards to acquire stock of Avaya. Vested Lucent stock
options remained options to acquire Lucent common stock, subject to adjustments
as described below. The Avaya stock options and other awards as converted have
the same vesting provisions, option periods, and other terms and conditions as
the Lucent options and awards they replaced. The number of shares and exercise
price of each stock option
Avaya Inc. 65
<Page>
was adjusted so that each option, whether a Lucent option or an Avaya option,
had the same ratio of the exercise price per share to the market value per
share, and the same aggregate difference between market value and exercise price
(intrinsic value), as the Lucent stock options prior to the Distribution. Upon
conversion, the stock options retained the measurement date from the original
issuance.
The following table summarizes information concerning options outstanding
including the related transactions for the fiscal years ended September 30, 2002
and 2001 and a summary for the fiscal year ended September 30, 2000 of the
Lucent stock options held by employees for whom the Company has assumed
responsibility. Stock option activity for fiscal 2000 may not necessarily be
indicative of what the activity would have been had the Company been a
stand-alone entity during that period.
<Table>
<Caption>
Weighted
Average
Shares Exercise
(000's) Price
- ---------------------------------------------------------------------------
<S> <C> <C>
OPTIONS OUTSTANDING AS OF SEPTEMBER 30, 1999 31,601 $ 27.87
Granted/Assumed 18,431 52.66
Exercised (5,124) 12.26
Forfeited/Expired/Transferred (1) (7,176) 28.37
--------
OPTIONS OUTSTANDING AS OF SEPTEMBER 30, 2000
(IMMEDIATELY PRIOR TO DISTRIBUTION) 37,732 41.90
Less: Lucent vested options (7,147) 17.50
--------
Lucent unvested options to be converted 30,585 47.61
========
AVAYA OPTIONS CONVERTED AT DISTRIBUTION DATE,
SEPTEMBER 30, 2000 44,971 31.63
Granted/Assumed 31,626 15.00
Exercised (1,384) 4.81
Forfeited/Expired/Exchanged (2) (26,890) 30.35
--------
OPTIONS OUTSTANDING AS OF SEPTEMBER 30, 2001 48,323 19.83
Granted 10,391 6.53
Exercised (153) 3.84
Forfeited and Expired (3) (13,733) 24.23
--------
Options Outstanding as of September 30, 2002 44,828 $ 15.46
========
</Table>
(1) Includes 7,133 options attributable to the movement of employees between
Avaya and Lucent during the year.
(2) Includes the exchange of 19,506 employee stock options for restricted
stock units, as noted below.
(3) Primarily represents normal option expiration and forfeitures attributed
to employee departures resulting from the Company's business restructuring
initiatives.
The weighted average fair value of Avaya's stock options granted dur-ing the
fiscal years ended September 30, 2002 and 2001 and Lucent's stock options
granted during the fiscal year ended September 30, 2000, calculated using the
Black-Scholes option-pricing model, was $3.14, $5.86, and $15.75 per share,
respectively.
The following table summarizes the status of the Company's stock options
as of September 30, 2002:
<Table>
<Caption>
Stock Options Outstanding Stock Options Exercisable
--------------------------------------- -------------------------
Average Weighted Weighted
Remaining Average Average
Shares Contractual Exercise Shares Exercise
Range of Exercise Prices (000's) Life (Years) Price (000's) Price
- -----------------------------------------------------------------------------------------------------
<C> <C> <C> <C> <C> <C>
$0.01 to $6.54 9,085 6.60 $ 6.12 165 $ 2.38
$6.55 to $9.70 1,090 7.01 7.87 357 7.91
$9.71 to $14.52 4,872 7.60 12.09 1,697 12.15
$14.53 to $21.45 21,337 7.97 15.48 8,123 15.21
$21.46 to $51.21 8,444 6.27 28.36 7,740 27.54
------ ------
Total 44,828 $ 15.46 18,082 $ 19.94
====== ======
</Table>
66 Avaya Inc.
<Page>
At September 30, 2001, there were 13.4 million exercisable out-standing stock
options with a weighted average exercise price of $26.03. There were no stock
options exercisable as of September 30, 2000.
> EMPLOYEE STOCK PURCHASE PLAN
Under the terms of the Avaya Inc. 2000 Employee Stock Purchase Plan ("2000
ESPP"), eligible employees may have up to 10% of eli-gible compensation deducted
from their pay to purchase Avaya common stock. The termination date of the 2000
ESPP is March 1, 2003, but a replacement plan with the same terms and conditions
is set to take effect on January 1, 2003, subject to shareholder approval. As a
result, no purchases will be permitted under the 2000 ESPP after December 31,
2002.
Under the 2000 ESPP, the per share purchase price is 85% of the average
high and low per share trading price of Avaya's common stock on the New York
Stock Exchange ("NYSE") on the last trading day of each month. During the fiscal
years ended September 30, 2002 and 2001, 3.8 million and 3.0 million shares were
purchased under the 2000 ESPP at a weighted average price of $4.85 and $10.95,
respec-tively. In fiscal 2000, 1.3 million Lucent shares were purchased under
the Lucent Employee Stock Purchase Plan by employees who were transferred to the
Company upon the Distribution, at a weighted aver-age price of $45.50.
In October 2002, the Company's Board of Directors approved the Avaya Inc.
2003 Employee Stock Purchase Plan ("2003 ESPP"), which has terms virtually
identical to the 2000 ESPP. The 2003 ESPP is effec-tive January 1, 2003, subject
to shareholder approval at the Company's 2003 annual meeting in February 2003,
and expires March 1, 2006. The initial purchase period under the 2003 ESPP will
extend from January 1, 2003 through February 28, 2003 with the first purchase
commencing on the last day of the period. If the Company's shareholders do not
approve the 2003 ESPP, it will terminate immediately, no purchases of Avaya
common stock will be made and all contributions collected under the 2003 ESPP
will be returned to employees.
> SFAS NO. 123 PRO FORMA DISCLOSURE
The Company has adopted the disclosure requirements of SFAS No. 123, "Accounting
for Stock-Based Compensation"("SFAS 123") and, as permitted under SFAS 123,
applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25") and related interpretations in accounting for its stock
compensation plans. Under APB 25, the Company does not recognize compensation
expense upon the issuance of its stock options because the exercise price equals
the market price of the underlying stock on the grant date. If the Company had
elected to adopt the optional recognition provisions of SFAS 123, which uses the
fair value-based method for its stock option plans and Employee Stock Purchase
Plan, net loss and basic and diluted loss per common share would have been
changed to the pro forma amounts indicated below:
Year Ended September 30,
----------------------------------------
(dollars in millions) 2002 2001 2000
- --------------------------------------------------------------------------------
NET LOSS
As reported $ (666) $ (352) $ (375)
Pro forma $ (701) $ (429) $ (469)
LOSS PER SHARE--BASIC AND DILUTED
As reported $ (2.44) $ (1.33) $ (1.39)
Pro forma $ (2.54) $ (1.60) $ (1.74)
The fair value of stock options used to compute pro forma net loss dis-closures
is the estimated fair value at grant date using the Black-Scholes option-pricing
model with the following assumptions:
Year Ended September 30,
----------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
WEIGHTED AVERAGE ASSUMPTIONS
Dividend yield 0% 0% 0.20%
Expected volatility 61.5% 50.4% 38.4%
Risk-free interest rate 4.3% 5.7% 6.3%
Expected holding period (in years) 3.9 3.3 2.8
> RESTRICTED STOCK UNITS
The Company's stock compensation plans permit the granting of restricted stock
units to eligible employees at fair market value at the date of grant and
typically become fully vested over a three-year period. Restricted stock units
are payable in shares of the Company's com-mon stock upon vesting. Compensation
expense recorded under APB 25 related to restricted stock units, which uses the
intrinsic-value method, was $24 million, $17 million and $7 million for the
years ended September 30, 2002, 2001 and 2000, respectively, of which $1 million
and $7 million was recorded as business restructuring charges in fiscal 2002 and
2001, respectively.
Avaya Inc. 67
<Page>
The following table presents the total number of shares of common stock
represented by restricted stock units granted to Company employees, including
those granted in connection with the Exchange described below:
Year Ended September 30,
----------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Restricted stock units granted (000's) 526 4,394 496
Weighted average market value of
shares granted during the period $ 7.11 $ 13.06 $ 57.83
In connection with the amounts recorded as a business restructuring charge for
the vesting of restricted stock units, the Company issued 93,000 and 326,000
common shares to employees who departed the business in fiscal 2002 and 2001,
respectively.
In June 2001, the Company commenced an offer to eligible employees to
exchange (the "Exchange") certain employee stock options for restricted stock
units representing common shares. The Exchange was based on a predetermined
exchange value divided by $12.85 per common share, which was the average of the
high and low trading prices of Avaya common stock on the NYSE on July 26, 2001.
As a result of the Exchange, approximately 19.5 million options were cancelled
and approximately 3.4 million restricted stock units were granted on July 31,
2001. The restricted stock units resulting from the Exchange will vest in three
succeeding annual anniversary dates beginning on August 1, 2002, subject to
acceleration of vesting upon certain events.
The Company recorded approximately $43 million as non-cash deferred
compensation for the intrinsic value of the restricted stock units on the
effective date of the Exchange. This amount was calculated by multiplying the
number of restricted stock units by $12.62, which was the average of the high
and low trading price of the Company's common stock on the NYSE on July 31,
2001, the date of grant of the restricted stock units. The non-cash deferred
compensation associated with the restricted stock units will be recognized as
compensation expense recorded under APB 25, on a straight-line basis over the
three-year vesting period.
NOTE 16 OPERATING SEGMENTS
In the fourth quarter of fiscal 2002, the Company reevaluated its busi-ness
model due to the continued restrained spending by customers on enterprise
communications technology investments and redesigned its operating segments to
align them with discrete customer sets and market segment opportunities in order
to optimize revenue growth and profitability. As a result, the Company now
reports its results in four rather than three operating segments and,
accordingly, it has restated fiscal 2001 and 2000 amounts to reflect this
change.
The four operating segments are: (1) Converged Systems and Applications
("CSA"), (2) Small and Medium Business Solutions ("SMBS"), (3) Services and (4)
Connectivity Solutions. The CSA segment is focused on large enterprises and
includes converged systems products, unified communications solutions and
customer relationship management offerings. The SMBS segment develops, markets
and sells converged and traditional voice communications solutions for small and
mid-sized enterprises and includes all key and Internet Protocol telephony
systems and applications, as well as messaging products. The Services segment
offers a comprehensive portfolio of services to help customers plan, design,
build and manage their com-munications networks. The Connectivity Solutions
segment represents structured cabling systems and electronic cabinets.
The current segments are operated as four functional businesses and, as a
result, each operating segment's results contain certain additional costs and
expenses including amounts that have been historically reported in the other
unallocated category, such as selling expense, research and development,
marketing, information technology and finance. Costs remaining in the other
unallocated category represent expenses that are not identified with the
operating segments and do not qualify for separate operating segment reporting
including costs incurred to maintain vacant real estate facilities and other
unallocated expenses. In addition, the other unallocated category portion of
operating income (loss) includes a $71 million goodwill and intangibles
impairment charge recorded in fiscal 2002 and a $32 million purchased in-process
research and development charge recorded in fiscal 2001. Intersegment sales
approximate fair market value and are not significant.
68 Avaya Inc.
<Page>
> REPORTABLE SEGMENTS
Summarized financial information concerning the Company's reportable segments is
shown in the following table:
<Table>
<Caption>
Reportable Segments Corporate
---------------------------------------- --------------------------
Business
Restructuring
Small and (Charges),
Converged Medium Reversals Other
Systems and Business Connectivity and Related Unallocated Total
(dollars in millions) Applications Solutions Services Solutions Expenses Amounts Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C>