-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Jcqf0L6/BfXFxu+wW83l1HtXeFKFnfM1X3/wYKK8Wg1R9dFsm9ZPNpVmoidQQiSi ClwtdpNh5/wyJllnbpIzeQ== 0000912057-02-006331.txt : 20020414 0000912057-02-006331.hdr.sgml : 20020414 ACCESSION NUMBER: 0000912057-02-006331 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20011231 FILED AS OF DATE: 20020214 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-15951 FILM NUMBER: 02549485 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 10-Q 1 a2070662z10-q.txt 10-Q - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2001 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 001-15951 ------------------------ AVAYA INC. A DELAWARE CORPORATION I.R.S. EMPLOYER NO. 22-3713430
211 MOUNT AIRY ROAD, BASKING RIDGE, NEW JERSEY 07920 TELEPHONE NUMBER 908-953-6000 ------------------------ Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / At December 31, 2001, 287,679,085 common shares were outstanding. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS
ITEM DESCRIPTION PAGE ---- ----------- -------- PART I -- FINANCIAL INFORMATION 1. Financial Statements........................................ 3 2. Management's Discussion and Analysis of Financial Condition 24 and Results of Operations................................... 3. Quantitative and Qualitative Disclosures About Market 42 Risk........................................................ PART II -- OTHER INFORMATION 1. Legal Proceedings........................................... 43 2. Changes in Securities and Use of Proceeds................... 43 3. Defaults Upon Senior Securities............................. 43 4. Submission of Matters to a Vote of Security Holders......... 43 5. Other Information........................................... 43 6. Exhibits and Reports on Form 8-K............................ 43 Signatures.................................................. 44
This Quarterly Report on Form 10-Q contains trademarks, service marks and registered marks of Avaya and its subsidiaries and other companies, as indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q, trademarks identified by -Registered Trademark- and -TM- are registered trademarks or trademarks, respectively, of Avaya Inc. or its subsidiaries. All other trademarks are the properties of their respective owners. Liquid Yield Option-TM- Notes is a trademark of Merrill Lynch & Co., Inc. 2 PART I ITEM 1. FINANCIAL STATEMENTS. AVAYA INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 -------- -------- REVENUE Products.................................................. $ 798 $1,286 Services.................................................. 508 499 ------ ------ 1,306 1,785 ------ ------ COSTS Products.................................................. 589 801 Services.................................................. 200 227 ------ ------ 789 1,028 ------ ------ GROSS MARGIN................................................ 517 757 ------ ------ OPERATING EXPENSES Selling, general and administrative....................... 418 568 Business restructuring related expenses................... 6 23 Research and development.................................. 120 140 ------ ------ TOTAL OPERATING EXPENSES.................................. 544 731 ------ ------ OPERATING INCOME (LOSS)..................................... (27) 26 Other income, net......................................... 6 9 Interest expense.......................................... (9) (10) ------ ------ INCOME (LOSS) BEFORE INCOME TAXES........................... (30) 25 Provision (benefit) for income taxes...................... (10) 9 ------ ------ NET INCOME (LOSS)........................................... $ (20) $ 16 ====== ====== Earnings (Loss) Per Common Share: Basic..................................................... $(0.09) $ 0.03 ====== ====== Diluted................................................... $(0.09) $ 0.03 ====== ======
See Notes to Consolidated Financial Statements. 3 AVAYA INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
AS OF AS OF DECEMBER 31, SEPTEMBER 30, 2001 2001 ------------ ------------- ASSETS Current Assets: Cash and cash equivalents................................. $ 252 $ 250 Receivables, less allowances of $74 at December 31, 2001 and $68 at September 30, 2001........................... 906 1,163 Inventory................................................. 627 649 Deferred income taxes, net................................ 207 246 Other current assets...................................... 511 461 ------ ------ TOTAL CURRENT ASSETS........................................ 2,503 2,769 ------ ------ Property, plant and equipment, net........................ 965 988 Deferred income taxes, net................................ 591 529 Goodwill.................................................. 174 175 Intangible assets, net.................................... 69 78 Other assets.............................................. 119 109 ------ ------ TOTAL ASSETS................................................ $4,421 $4,648 ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable.......................................... $ 447 $ 624 Current portion of long-term debt......................... 276 145 Business restructuring reserve............................ 137 179 Payroll and benefit liabilities........................... 273 333 Advance billings and deposits............................. 110 133 Other current liabilities................................. 586 604 ------ ------ TOTAL CURRENT LIABILITIES................................... 1,829 2,018 ------ ------ Long-term debt............................................ 500 500 Benefit obligations....................................... 646 637 Deferred revenue.......................................... 78 84 Other liabilities......................................... 514 533 ------ ------ TOTAL NONCURRENT LIABILITIES................................ 1,738 1,754 ------ ------ Commitments and contingencies Series B convertible participating preferred stock, par value $1.00 per share, 4 million shares authorized, issued and outstanding........................................... 402 395 ------ ------ STOCKHOLDERS' EQUITY Series A junior participating preferred stock, par value $1.00 per share, 7.5 million shares authorized; none issued and outstanding.................................. -- -- Common stock, par value $0.01 per share, 1.5 billion shares authorized, 287,882,465 and 286,851,934 issued and outstanding as of December 31, 2001 and September 30, 2001, respectively.................................. 3 3 Additional paid-in capital................................ 917 905 Accumulated deficit....................................... (406) (379) Accumulated other comprehensive loss...................... (60) (46) Less treasury stock at cost (203,380 and 147,653 shares as of December 31, 2001 and September 30, 2001, respectively)........................................... (2) (2) ------ ------ TOTAL STOCKHOLDERS' EQUITY.................................. 452 481 ------ ------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $4,421 $4,648 ====== ======
See Notes to Consolidated Financial Statements. 4 AVAYA INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, ------------------------- 2001 2000 -------- -------- OPERATING ACTIVITIES: Net income (loss)......................................... $ (20) $ 16 Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Depreciation and amortization......................... 60 66 Provision for uncollectible receivables............... 22 16 Deferred income taxes................................. (22) 52 Adjustments for other non-cash items, net............. 9 -- Changes in operating assets and liabilities: Receivables........................................... 198 141 Inventory............................................. (17) (39) Accounts payable...................................... (177) (44) Payroll and benefits, net............................. (46) 29 Advance billings and deposits......................... (23) (65) Other assets and liabilities.......................... (76) (114) ----- ----- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES........ (92) 58 ----- ----- INVESTING ACTIVITIES: Capital expenditures...................................... (26) (92) Proceeds from the sale of property, plant and equipment... 2 2 Purchases of equity investments........................... -- (18) Other investing activities, net........................... (2) (8) ----- ----- NET CASH USED FOR INVESTING ACTIVITIES...................... (26) (116) ----- ----- FINANCING ACTIVITIES: Issuance of convertible participating preferred stock..... -- 368 Issuance of warrants...................................... -- 32 Issuance of common stock.................................. 7 6 Net decrease in commercial paper.......................... (131) (76) Issuance of LYONs convertible debt........................ 460 -- Payment of debt issuance costs............................ (13) -- Repayment of credit facility borrowing.................... (200) -- Other financing activities, net........................... (1) (1) ----- ----- NET CASH PROVIDED BY FINANCING ACTIVITIES................... 122 329 ----- ----- Effect of exchange rate changes on cash and cash equivalents............................................... (2) 18 ----- ----- Net increase in cash and cash equivalents................... 2 289 Cash and cash equivalents at beginning of fiscal year....... 250 271 ----- ----- Cash and cash equivalents at end of period.................. $ 252 $ 560 ===== =====
See Notes to Consolidated Financial Statements. 5 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BACKGROUND AND BASIS OF PRESENTATION BACKGROUND On September 30, 2000, Avaya Inc. (the "Company" or "Avaya") was spun off from Lucent Technologies Inc. ("Lucent") pursuant to a contribution by Lucent of its enterprise networking businesses to the Company and a distribution of the outstanding shares of the Company's common stock to Lucent stockholders (the "Distribution"). The Company provides communication systems and software for enterprises, including businesses, government agencies and other organizations. The Company offers a broad range of voice, converged voice and data, customer relationship management, messaging, multi-service networking and structured cabling products and services. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of the Company as of December 31, 2001 and for the three months ended December 31, 2001 and 2000, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and Exchange Commission for interim financial statements, and should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2001. In the Company's opinion, the unaudited interim consolidated financial statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated. Certain prior year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year. 2. RECENT ACCOUNTING PRONOUNCEMENTS SFAS 143 In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement No. 143, "Accounting for Asset Retirement Obligations" ("SFAS 143"), which provides the accounting requirements for retirement obligations associated with tangible long-lived assets. This Statement requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. This Statement is effective for the Company's 2003 fiscal year, and early adoption is permitted. The adoption of SFAS 143 is not expected to have a material impact on the Company's consolidated results of operations, financial position or cash flows. SFAS 144 In October 2001, the FASB issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), which excludes from the definition of long-lived assets goodwill and other intangibles that are not amortized in accordance with Statement No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142") noted below. SFAS 144 requires that long-lived assets to be disposed of by sale be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. SFAS 144 also expands the reporting of discontinued operations to include components of an entity that have been or will be disposed of rather than limiting such discontinuance to a segment of a business. This Statement is effective for the 6 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 2. RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED) Company's 2003 fiscal year, and early adoption is permitted. The Company is currently evaluating the impact of SFAS 144 to determine the effect, if any, it may have on the Company's consolidated results of operations, financial position or cash flows. 3. GOODWILL AND INTANGIBLE ASSETS Effective October 1, 2001, the Company adopted SFAS 142, which requires that goodwill and certain other intangible assets having indefinite lives no longer be amortized to earnings, but instead be subject to periodic testing for impairment. Intangible assets determined to have definitive lives will continue to be amortized over their remaining useful lives. In connection with the adoption of SFAS 142, the Company reviewed the classification of its existing goodwill and other intangible assets, reassessed the useful lives previously assigned to other intangible assets, and discontinued amortization of goodwill. During the remainder of fiscal 2002, the Company will complete a transitional review of its goodwill for impairment. Losses, if any, that are identified as a result of this transitional review will be recorded as a change in accounting principle. Any such losses that are recorded after the transitional review will be identified as a separate line item in income from operations. For the three months ended December 31, 2000, the Company reported net income of $16 million and $0.03 for both basic and diluted earnings per share. If the Company had adopted SFAS 142 in the beginning of the first quarter of fiscal 2001 and discontinued goodwill amortization, which amounted to $8 million, net of tax during this period, on a pro forma basis net income would have been $24 million and basic and diluted earnings per share would have been $0.06. The following table presents the components of the Company's intangible assets:
AS OF DECEMBER 31, 2001 AS OF SEPTEMBER 30, 2001 ---------------------------------- ---------------------------------- GROSS GROSS CARRYING ACCUMULATED CARRYING ACCUMULATED AMOUNT AMORTIZATION NET AMOUNT AMORTIZATION NET -------- ------------ -------- -------- ------------ -------- (DOLLARS IN MILLIONS) Existing technology...................... $160 $ 99 $61 $160 $92 $68 Other intangibles........................ 12 4 8 12 2 10 ---- ---- --- ---- --- --- Total intangible assets.................. $172 $103 $69 $172 $94 $78 ==== ==== === ==== === ===
Intangible assets are amortized over a period of three to six years. Amortization expense for intangible assets during the three months ended December 31, 2001 and 2000 was $9 million and 7 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 3. GOODWILL AND INTANGIBLE ASSETS (CONTINUED) $6 million, respectively. Estimated amortization expense for the remainder of fiscal 2002 and the five succeeding fiscal years is as follows:
FISCAL YEAR AMOUNT - ----------- ------ (DOLLARS IN MILLIONS) 2002 (remaining nine months)............................... $26 2003....................................................... 20 2004....................................................... 12 2005....................................................... 8 2006....................................................... 3 --- Total...................................................... $69 ===
The carrying value of goodwill of $174 million as of December 31, 2001 is primarily attributable to the Communications Solutions segment. The decrease in carrying value of goodwill from September 30, 2001 reflects the impact of foreign currency exchange rate fluctuations. 4. COMPREHENSIVE INCOME (LOSS) Other comprehensive income (loss) is recorded directly to a separate section of stockholders' equity in accumulated other comprehensive loss and includes unrealized gains and losses excluded from the Consolidated Statements of Operations. These unrealized gains and losses primarily consist of foreign currency translation adjustments, which are not adjusted for income taxes since they primarily relate to indefinite investments in non-U.S. subsidiaries.
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- (DOLLARS IN MILLIONS) Net income (loss)................................... $(20) $ 16 Other comprehensive income (loss)................... (14) 39 ---- ---- Total comprehensive income (loss)................... $(34) $ 55 ==== ====
5. SUPPLEMENTARY FINANCIAL INFORMATION BALANCE SHEET INFORMATION
AS OF AS OF DECEMBER 31, SEPTEMBER 30, 2001 2001 ------------ ------------- (DOLLARS IN MILLIONS) INVENTORY Completed goods..................................... $420 $420 Work in process and raw materials................... 207 229 ---- ---- Total inventory................................... $627 $649 ==== ====
8 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 5. SUPPLEMENTARY FINANCIAL INFORMATION (CONTINUED) SUPPLEMENTAL CASH FLOW INFORMATION
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- (DOLLARS IN MILLIONS) Non-cash transactions: Accretion of Series B preferred stock............... $ 7 $ 7 ==== ====
6. SECURITIZATION OF ACCOUNTS RECEIVABLE The Company entered into a receivables purchase agreement in June 2001 and transferred a designated pool of qualified trade accounts receivable to a special purpose entity ("SPE"), which in turn sold an undivided ownership interest to an unaffiliated financial institution for cash proceeds of $200 million. The financial institution is an affiliate of Citibank, N.A., a lender and the agent for the other lenders under the revolving credit facilities described in Notes 8 and 13. The Company, through the SPE, has a retained interest in a portion of these receivables, and the financial institution has no recourse to the Company's other assets, stock or other securities of the Company for failure of customers to pay when due. The assets of the SPE are not available to pay creditors of the Company. Collections of receivables are used by the financial institution to purchase, from time to time, new interests in receivables up to an aggregate of $200 million. The receivables purchase agreement expires in June 2002, but may be extended through June 2004 with the financial institution's consent. The Company had a retained interest of $174 million and $153 million as of December 31, 2001 and September 30, 2001, respectively, in the SPE's designated pool of qualified accounts receivable representing collateral for the sale. The carrying amount of the Company's retained interest, which approximates fair value because of the relatively short-term nature of the receivable collections, is recorded in other current assets. The Company is subject to certain receivable collection ratios, among other covenants contained in the receivables purchase agreement. In October 2001, the financial institution participating in the agreement granted the Company a waiver from a covenant that measures the ratio of certain unpaid receivables as a percentage of the aggregate outstanding balance of all designated receivables. The waiver effectively increased the ratio required by the covenant for each of the individual months of September through December 2001, and required compliance with the original ratio thereafter. As of December 31, 2001, the Company was in compliance with such covenants, although in January 2002 the financial institution waived the Company's obligation to comply with the required ratio for the month of January 2002. The Company will be required to comply with the original ratio for the month of February 2002 and thereafter. The receivables purchase agreement initially required that the Company's long-term senior unsecured debt be rated at least BBB- by Standard & Poor's and Baa3 by Moody's. In February 2002, the agreement was amended to lower these ratings triggers to BB+ by Standard & Poor's and Ba1 by Moody's through March 15, 2002, at which time the required ratings will revert back to BBB- by Standard & Poor's and Baa3 by Moody's. As described in Note 13, the Company's long-term senior 9 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 6. SECURITIZATION OF ACCOUNTS RECEIVABLE (CONTINUED) unsecured debt has been recently downgraded and is currently rated Baa3 by Moody's, subject to review for further downgrade, and BB+ by Standard & Poor's, with a negative outlook. The Company is currently in discussions with the financial institution participating in the receivables purchase agreement to restructure the agreement to address, among other things, the collection ratio and the ratings trigger. If the Company does not reach agreement with the financial institution on a restructuring of the agreement, and (i) is unable to maintain the required ratio described above for the month of February 2002 or for any month thereafter, or (ii) its long-term senior unsecured debt is not rated at least BBB- by Standard & Poor's and Baa3 by Moody's after March 15, 2002, the financial institution will be able to exercise its rights under the agreement, including an early termination of the agreement. Upon the expiration, or in the event of an early termination, of the agreement, purchases of interests in receivables by the financial institution under the agreement will cease and collections on receivables constituting the designated pool, including to the extent necessary, those receivables comprising the retained interest, will be used to pay down the financial institution's $200 million investment under the agreement. 7. BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES The Company recorded business restructuring charges in fiscal 2000 related to its separation from Lucent and in fiscal 2001 related to the outsourcing of certain manufacturing facilities and the acceleration of its restructuring plan that was originally adopted in fiscal 2000 to improve profitability and business performance as a stand-alone company. The following table summarizes the status of the Company's business restructuring reserve and related expenses as of and for the three months ended December 31, 2001:
BUSINESS RESTRUCTURING RESERVE OTHER RELATED EXPENSES ------------------------------------------------------ -------------------------- TOTAL BUSINESS EMPLOYEE LEASE TOTAL BUSINESS RESTRUCTURING SEPARATION TERMINATION OTHER EXIT RESTRUCTURING ASSET INCREMENTAL AND RELATED COSTS OBLIGATIONS COSTS RESERVE IMPAIRMENTS PERIOD COSTS EXPENSES ---------- ----------- ---------- -------------- ----------- ------------ -------------- (DOLLARS IN MILLIONS) Balance as of September 30, 2001.... $96 $78 $5 $179 $ -- $ -- $179 Expenses................ -- -- -- -- -- 6 6 Cash payments........... (21) (20) (1) (42) -- (6) (48) --- --- -- ---- --------- --------- ---- Balance as of December 31, 2001..... $75 $58 $4 $137 $ -- $ -- $137 === === == ==== ========= ========= ====
Employee separation costs included in the business restructuring reserve were made through lump sum payments, although certain union-represented employees elected to receive a series of payments extending over a period of up to two years from the date of departure. Payments to employees who elected to receive severance through a series of payments will extend through 2003. This workforce reduction was substantially completed at the end of fiscal 2001. The charges for lease termination obligations, which consisted of real estate and equipment leases, included approximately 2.8 million square feet of excess space of which the Company has vacated 667,000 square feet as of December 31, 2001. Payments on lease termination obligations will be substantially completed by 2003 because, in certain circumstances, the remaining lease payments were less than the termination fees. 10 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 7. BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES (CONTINUED) In the first quarter of fiscal 2002, the Company recorded $6 million of other related expenses primarily associated with the Company's outsourcing of certain manufacturing facilities. In the first quarter of fiscal 2001, the Company recorded $23 million of other related expenses associated with the Company's separation from Lucent related primarily to computer system transition costs such as data conversion activities, asset transfers, and training. In addition, the Company recorded $36 million in selling, general and administrative expenses for additional start-up activities during the first quarter of fiscal 2001 largely resulting from marketing costs associated with continuing to establish the Avaya brand. OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES In connection with the five-year strategic manufacturing agreement to outsource most of the manufacturing of the Company's communications systems and software, Avaya has received substantially all of the $200 million in proceeds for assets transferred to Celestica Inc. The Company deferred $100 million of these proceeds, which are being recognized on a straight-line basis over the term of the agreement. As of December 31, 2001, the unamortized portion of these proceeds amounted to $20 million in other current liabilities and $66 million in other liabilities. The remaining phases of the transaction, which included closing of the Shreveport, Louisiana facility, were completed in the first quarter of fiscal 2002. 8. LONG-TERM DEBT Long-term debt outstanding consisted of the following:
AS OF AS OF DECEMBER 31, SEPTEMBER 30, 2001 2001 ------------ ------------- (DOLLARS IN MILLIONS) Commercial paper............................................ $301 $432 Revolving credit facilities: 364-day facility.......................................... -- -- Five-year facility........................................ -- 200 LYONs convertible debt...................................... 463 -- Other....................................................... 12 13 ---- ---- Total debt.............................................. 776 645 Less: Current portion....................................... 276 145 ---- ---- Total long-term debt.................................... $500 $500 ==== ====
COMMERCIAL PAPER PROGRAM The Company has established a commercial paper program pursuant to which it may issue up to $1.25 billion of commercial paper at market interest rates. Interest rates on the commercial paper obligations are variable due to their short-term nature. The weighted average yield and maturity period for the $301 million and $432 million of commercial paper outstanding as of December 31, 2001 and September 30, 2001 were approximately 3.4% and 3.9% and 87 days and 62 days, respectively. As of December 31, 2001, $37 million of the outstanding commercial paper was classified as long-term debt 11 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 8. LONG-TERM DEBT (CONTINUED) in the Consolidated Balance Sheet since it is supported by the five-year credit facility described below and it is management's intent to refinance it with other debt on a long-term basis. As of September 30, 2001, the entire amount of commercial paper was classified as long-term debt. As described in Note 13, the Company's commercial paper has been recently downgraded and is currently rated P-3 by Moody's, subject to review for further downgrade, and A-3 by Standard & Poor's, with a negative outlook. These recent downgrades make it very difficult, if not impossible, for the Company to access the commercial paper market, which has been its primary source of liquidity in the past. As a result of the impact of these ratings downgrades on the Company's ability to issue commercial paper, in February 2002, the Company borrowed $300 million under its five-year credit facility to repay commercial paper obligations. As of February 13, 2002, approximately $26 million of the Company's commercial paper remains outstanding. Such obligations mature through May 2002 and the Company expects to repay these remaining obligations with available cash or other short-term or long-term debt. REVOLVING CREDIT FACILITIES The Company has two unsecured revolving credit facilities (the "Credit Facilities") with third party financial institutions consisting of a $400 million 364-day credit facility that expires in August 2002 and an $850 million five-year credit facility that expires in September 2005. No amounts were drawn under either credit facility as of December 31, 2001, although in February 2002 the Company borrowed $300 million under the five-year credit facility in order to repay maturing commercial paper obligations. As of September 30, 2001, $200 million was outstanding under the five-year credit facility bearing interest at a fixed rate of approximately 3.5%, which was repaid in October 2001 using the proceeds from the issuance of commercial paper. There were no outstanding borrowings under the 364-day credit facility as of September 30, 2001. The September 2001 borrowing under the credit facility was necessitated by disruptions in the commercial paper markets as a result of the September 11 terrorist attacks. As described in Note 13, in February 2002, the Company and the lenders under the Credit Facilities amended the facilities. In addition, the Company, through its foreign operations, entered into several uncommitted credit facilities totaling $88 million and $118 million, of which letters of credit of $17 million and $10 million were issued and outstanding as of December 31, 2001 and September 30, 2001, respectively. Letters of credit are purchased guarantees that ensure the Company's performance or payment to third parties in accordance with specified terms and conditions. OTHER DEBT As of December 31, 2001 and September 30, 2001, the Company had debt outstanding attributable to its foreign entities of $12 million and $13 million, respectively. LYONS CONVERTIBLE DEBT In the first quarter of fiscal 2002, the Company sold through an underwritten public offering under a shelf registration statement an aggregate principal amount at maturity of approximately $944 million 12 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 8. LONG-TERM DEBT (CONTINUED) of Liquid Yield Option-TM- Notes due 2021 ("LYONs"). The proceeds of approximately $447 million, net of a $484 million discount and $13 million of underwriting fees, were used to refinance a portion of the Company's outstanding commercial paper. The underwriting fees of $13 million were recorded as deferred financing costs and are being amortized on a straight-line basis to interest expense over a three-year period through October 31, 2004, which represents the first date holders may require the Company to purchase all or a portion of their LYONs. The original issue discount of $484 million accrues daily at a rate of 3.625% per year calculated on a semiannual bond equivalent basis. The Company will not make periodic cash payments of interest on the LYONs. Instead, the amortization of the discount is recorded as interest expense and represents the accretion of the LYONs issue price to its maturity value. For the three months ended December 31, 2001, $3 million of interest expense on the LYONs was recorded, resulting in an accreted value of $463 million as of December 31, 2001. The discount will cease to accrue on the LYONs upon maturity, conversion, purchase by the Company at the option of the holder, or redemption by Avaya. The LYONs are unsecured obligations that rank equally in right of payment with all existing and future unsecured and unsubordinated indebtedness of Avaya. The LYONs are convertible into 35,333,073 shares of Avaya common stock at any time on or before the maturity date. The conversion rate may be adjusted for certain reasons, but will not be adjusted for accrued original issue discount. Upon conversion, the holder will not receive any cash payment representing accrued original issue discount. Accrued original issue discount will be considered paid by the shares of common stock received by the holder of the LYONs upon conversion. Avaya may redeem all or a portion of the LYONs for cash at any time on or after October 31, 2004 at a price equal to the sum of the issue price and accrued original issue discount on the LYONs as of the applicable redemption date. Conversely, holders may require the Company to purchase all or a portion of their LYONs on the third, fifth and tenth anniversary from October 31, 2001 at a price equal to the sum of the issue price and accrued original issue discount on the LYONs as of the applicable purchase date. The Company may, at its option, elect to pay the purchase price in cash or shares of common stock, or any combination thereof. The indenture governing the LYONs includes certain covenants, including a limitation on the Company's ability to grant liens on significant domestic real estate properties or the stock of subsidiaries holding such properties. The liens granted under the Amended Credit Facilities described in Note 13 do not extend to any real property and therefore, do not conflict with the terms of the indenture governing the LYONs. 13 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 9. EARNINGS (LOSS) PER SHARE OF COMMON STOCK Basic earnings (loss) per common share was calculated by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per common share was calculated by adjusting net income (loss) available to common stockholders and weighted average outstanding shares, assuming conversion of all potentially dilutive securities including stock options, warrants, convertible participating preferred stock and convertible debt.
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 -------- -------- (DOLLARS AND SHARES IN MILLIONS, EXCEPT PER SHARE AMOUNTS) Net income (loss)........................................ $ (20) $ 16 Accretion of Series B preferred stock.................... (7) (7) ------ ----- Net income (loss) available to common stockholders....... $ (27) $ 9 ====== ===== SHARES USED IN COMPUTING EARNINGS (LOSS) PER COMMON SHARE: Basic.................................................. 287 282 ====== ===== Diluted................................................ 287 282 ====== ===== EARNINGS (LOSS) PER COMMON SHARE: Basic.................................................. $(0.09) $0.03 ====== ===== Diluted................................................ $(0.09) $0.03 ====== ===== SECURITIES EXCLUDED FROM THE COMPUTATION OF DILUTED EARNINGS (LOSS) PER COMMON SHARE: Options(1)............................................. 46 72 Series B preferred stock(2)............................ 16 15 Warrants(1)............................................ 12 12 Convertible debt(2).................................... 28 -- ------ ----- Total................................................ 102 99 ====== =====
- ------------------------ (1) These securities have been excluded from the diluted earnings (loss) per common share calculation since their inclusion would have been antidilutive because the option and warrant exercise prices are greater than the average market value of the underlying stock. (2) In applying the "if-converted" method, the Series B convertible participating preferred stock and LYONs convertible debt were excluded from the diluted earnings (loss) per common share calculation since the effect of their inclusion would have been antidilutive. 10. OPERATING SEGMENTS The Company reports its operations in three segments: Communications Solutions, Services and Connectivity Solutions. The Communications Solutions segment represents the Company's core business, composed of enterprise voice communications systems and software, communications 14 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 10. OPERATING SEGMENTS (CONTINUED) applications, professional services for customer relationship management, converged voice and data networks and unified communication, multi-service networking products and product installation services. The Services segment represents maintenance, value-added and data services. The Connectivity Solutions segment represents structured cabling systems and electronic cabinets. The costs of shared services and other corporate center operations managed on a common basis represent business activities that do not qualify for separate operating segment reporting and are aggregated in the Corporate and other category. In the first quarter of fiscal 2001, the Company discontinued allocating costs of shared services and other corporate center operations managed outside of the operating segments. Operating income (loss) for the three months ended December 31, 2000 has been restated to reflect these costs in Corporate and other. Intersegment sales approximate fair market value and are not significant. OPERATING SEGMENTS
THREE MONTHS ENDED DECEMBER 31, ------------------------- 2001 2000 -------- -------- (DOLLARS IN MILLIONS) COMMUNICATIONS SOLUTIONS: Total revenue...................................... $663 $928 Operating income................................... 109 227 SERVICES: Total revenue...................................... $508 $499 Operating income................................... 284 243 CONNECTIVITY SOLUTIONS: Total revenue...................................... $135 $356 Operating income (loss)............................ (27) 88
15 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 10. OPERATING SEGMENTS (CONTINUED) RECONCILING ITEMS A reconciliation of the totals reported for the operating segments to the corresponding line items in the consolidated financial statements is as follows:
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 -------- -------- (DOLLARS IN MILLIONS) REVENUE Total operating segments............................... $1,306 $1,783 Corporate and other.................................... -- 2 ------ ------ Total revenue.......................................... $1,306 $1,785 ====== ====== OPERATING INCOME (LOSS) Total operating segments............................... $ 366 $ 558 Corporate and other: Business restructuring related expenses and start-up expenses........................................... (6) (59) Corporate and unallocated shared expenses............ (387) (473) ------ ------ Total operating income (loss)...................... $ (27) $ 26 ====== ======
Corporate and unallocated shared expenses include costs such as selling, research and development, marketing, information technology and finance that are not directly managed by or identified with the operating segments. GEOGRAPHIC INFORMATION
THREE MONTHS ENDED DECEMBER 31, ----------------------- 2001 2000 -------- -------- (DOLLARS IN MILLIONS) REVENUE(1) U.S.................................................... $ 944 $1,346 International.......................................... 362 439 ------ ------ Total................................................ $1,306 $1,785 ====== ======
- ------------------------ (1) Revenue is attributed to geographic areas based on the location of customers. CONCENTRATIONS No single customer accounted for more than 10% of the Company's revenue for the three months ended December 31, 2001. For the three months ended December 31, 2000, sales to Avaya's largest distributor, which are included in Communications Solutions, were approximately 11% of the 16 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 10. OPERATING SEGMENTS (CONTINUED) Company's revenue. Receivables from this distributor, including amounts outstanding under the line of credit described below, totaled $170 million and $198 million as of December 31, 2001 and September 30, 2001, respectively. As of December 31, 2001, $71 million and $99 million were included in receivables and other current assets, respectively. As of September 30, 2001, $117 million and $81 million were included in receivables and other current assets, respectively. Amounts recorded in receivables represent trade receivables due from this distributor on sales of products. Amounts recorded in other current assets represent receivables due from this distributor for maintenance services provided by the Company to the distributor's customers. During fiscal 2001, the Company granted a short-term line of credit for the purchase of Avaya products and services to this distributor. The credit line applies to certain unpaid and outstanding receivables and the maximum amount available under the credit agreement is $125 million. Outstanding amounts under the credit agreement, which expires in March 2002, are secured by the distributor's accounts receivable and inventory and accrue interest at an annual rate of 12%. Interest payments are due to the Company monthly. Upon the occurrence of an event of default, the Company has certain rights under the credit agreement, including, without limitation, the right to require the distributor to immediately assign the collateral to the Company to the extent borrowings under the credit agreement exceed $100 million. The Company may then require the parent company of the distributor to purchase up to $25 million of the assigned collateral. On or prior to the termination of this agreement, the distributor is required to obtain a collateralized commercial credit facility to replace the existing credit line and repay in full all amounts due under the credit line. As of December 31, 2001, the amount outstanding under the line of credit was $123 million, of which $56 million is included in receivables and $67 million is included in other current assets. The Company is currently in discussions with the distributor to restructure the agreement, but there can be no assurance that the Company will reach agreement on a restructured line of credit on terms favorable to the Company, or that the distributor will have obtained the necessary financing to satisfy its obligations under the line of credit on the March 31, 2002 expiration date. 11. TRANSACTIONS WITH LUCENT AND OTHER RELATED PARTY TRANSACTIONS CONTRIBUTION AND DISTRIBUTION AGREEMENT In connection with the Distribution, the Company and Lucent executed and delivered the Contribution and Distribution Agreement and certain related agreements. Pursuant to the Contribution and Distribution Agreement, Lucent contributed to the Company substantially all of the assets, liabilities and operations associated with its enterprise networking businesses (the "Company's Businesses"). The Contribution and Distribution Agreement, among other things, provides that, in general, the Company will indemnify Lucent for all liabilities including certain pre-Distribution tax obligations of Lucent relating to the Company's Businesses and all contingent liabilities primarily relating to the Company's Businesses or otherwise assigned to the Company. In addition, the Contribution and Distribution Agreement provides that certain contingent liabilities not allocated to one of the parties will be shared contingent liabilities and borne 90% by Lucent and 10% by the Company. The Contribution and Distribution Agreement also provides that contingent liabilities in excess of $50 million that are primarily related to Lucent's businesses shall be borne 90% by Lucent 17 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 11. TRANSACTIONS WITH LUCENT AND OTHER RELATED PARTY TRANSACTIONS (CONTINUED) and 10% by the Company and contingent liabilities in excess of $50 million that are primarily related to the Company's business shall be borne equally by the parties. In addition, if the Distribution fails to qualify as a tax-free distribution under Section 355 of the Internal Revenue Code because of an acquisition of the Company's stock or assets, or some other actions of the Company, then the Company will be solely liable for any resulting corporate taxes. OTHER RELATED PARTY TRANSACTIONS Jeffrey A. Harris has been a director of Avaya since October 2000. Mr. Harris is a member and senior managing director of Warburg Pincus LLC and a general partner of Warburg, Pincus & Co. Each of Warburg Pincus LLC and Warburg, Pincus & Co. is an affiliate of Warburg Pincus Equity Partners L.P. Mr. Harris was designated for election to the Company's board of directors by Warburg Pincus Equity Partners, L.P. and its affiliates pursuant to the terms of their equity investment in the Company. Henry B. Schacht has been a director of Avaya since September 2000. Mr. Schacht is currently on a leave of absence as a managing director and senior advisor of Warburg Pincus LLC. 12. COMMITMENTS AND CONTINGENCIES LEGAL PROCEEDINGS From time to time the Company is involved in legal proceedings arising in the ordinary course of business. Other than as described below, the Company believes there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on its financial position, results of operations or cash flows. YEAR 2000 ACTIONS Three separate purported class action lawsuits are pending against Lucent, one in state court in West Virginia, one in federal court in the Southern District of New York and another in federal court in the Southern District of California. The case in New York was filed in January 1999 and, after being dismissed, was refiled in September 2000. The case in West Virginia was filed in April 1999 and the case in California was filed in June 1999, and amended in 2000 to include Avaya as a defendant. The Company may also be named a party to the other actions and, in any event, has assumed the obligations of Lucent for all of these cases under the Contribution and Distribution Agreement. All three actions are based upon claims that Lucent sold products that were not Year 2000 compliant, meaning that the products were designed and developed without considering the possible impact of the change in the calendar from December 31, 1999 to January 1, 2000. The complaints allege that the sale of these products violated statutory consumer protection laws and constituted breaches of implied warranties. A class has not been certified in any of the three cases and, to the extent a class is certified in any of the cases, the Company expects that class to constitute those enterprises that purchased the products in question. The complaints seek, among other remedies, compensatory damages, punitive damages and counsel fees in amounts that have not yet been specified. Although the Company believes that the outcome of these actions will not adversely affect its financial position, results of operations or cash flows, if these cases are not resolved in a timely manner, they will require expenditure of significant legal costs related to their defense. 18 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) COUPON PROGRAM CLASS ACTION In April 1998, a class action was filed against Lucent in state court in New Jersey, alleging that Lucent improperly administered a coupon program resulting from the settlement of a prior class action. The plaintiffs allege that Lucent improperly limited the redemption of the coupons from dealers by not allowing them to be combined with other volume discount offers, thus limiting the market for the coupons. The Company has assumed the obligations of Lucent for these cases under the Contribution and Distribution Agreement. The complaint alleges breach of contract, fraud and other claims and the plaintiffs seek compensatory and consequential damages, interest and attorneys' fees. The parties have entered into a proposed settlement agreement, pending final approval by the court. LUCENT SECURITIES LITIGATION In November 2000, three purported class actions were filed against Lucent in the Federal District Court for the District of New Jersey alleging violations of the federal securities laws as a result of the facts disclosed in Lucent's announcement on November 21, 2000 that it had identified a revenue recognition issue affecting its financial results for the fourth quarter of fiscal 2000. The actions purport to be filed on behalf of purchasers of Lucent common stock during the period from October 10, 2000 (the date Lucent originally reported these financial results) through November 21, 2000. The above actions have been consolidated with other purported class actions filed against Lucent on behalf of its stockholders in January 2000 and are pending in the Federal District Court for the District of New Jersey. The Company understands that Lucent has filed a motion to dismiss the Fifth Consolidated Amended and Supplemental Class Action Complaint in the consolidated action. The plaintiffs allege that they were injured by reason of certain alleged false and misleading statements made by Lucent in violation of the federal securities laws. The consolidated cases were initially filed on behalf of stockholders of Lucent who bought Lucent common stock between October 26, 1999 and January 6, 2000, but the consolidated complaint was amended to include purported class members who purchased Lucent common stock up to November 21, 2000. A class has not yet been certified in the consolidated actions. The plaintiffs in all these stockholder class actions seek compensatory damages plus interest and attorneys' fees. Any liability incurred by Lucent in connection with these stockholder class action lawsuits may be deemed a shared contingent liability under the Contribution and Distribution Agreement and, as a result, the Company would be responsible for 10% of any such liability. All of these actions are in the early stages of litigation and an outcome cannot be predicted and, as a result, there can be no assurance that these cases will not have a material adverse effect on the Company's financial position, results of operations or cash flows. 19 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) LICENSING MEDIATION In March 2001, a third party licensor made formal demand for alleged royalty payments which it claims the Company owes as a result of a contract between the licensor and the Company's predecessors, initially entered into in 1995, and renewed in 1997. The contract provides for mediation of disputes followed by binding arbitration if the mediation does not resolve the dispute. The licensor claims that the Company owes royalty payments for software integrated into certain of the Company's products. The licensor also alleges that the Company has breached the governing contract by not honoring a right of first refusal related to development of fax software for next generation products. The licensor has demanded arbitration of this matter, which the Company expects to occur within the next several months. At this point, an outcome in the arbitration proceeding cannot be predicted and, as a result, there can be no assurance that this case will not have a material adverse effect on the Company's financial position, results of operations or cash flows. REVERSE/FORWARD STOCK SPLIT COMPLAINTS In January 2002, a complaint was filed in the Court of Chancery of the State of Delaware against the Company seeking to enjoin it from effectuating a reverse stock split followed by a forward stock split described in its proxy statement for its 2002 Annual Meeting of Shareholders to be held on February 26, 2002. At the annual meeting, the Company is seeking the approval of its shareholders of each of three alternative transactions: - a reverse 1-for-30 stock split followed immediately by a forward 30-for-1 stock split of the Company's common stock; - a reverse 1-for-40 stock split followed immediately by a forward 40-for-1 stock split of the Company's common stock; - a reverse 1-for-50 stock split followed immediately by a forward 50-for-1 stock split of the Company's common stock. The complaint alleges, among other things, that the manner in which the Company plans to implement the transactions, as described in its proxy statement, violates certain aspects of Delaware law with regard to the treatment of fractional shares and that the description of the proposed transactions in the proxy statement is misleading to the extent it reflects such violations. The action purports to be a class action on behalf of all holders of less than 50 shares of the Company's common stock. The plaintiff is seeking, among other things, damages as well as injunctive relief enjoining the Company from effecting the transactions and requiring the Company to make corrective, supplemental disclosure. Although the transactions will be submitted to the Company's shareholders for approval at the annual meeting, this matter is in the early stages and the Company cannot provide assurance that this lawsuit will not impair its ability to implement any of the transactions upon obtaining such approval. ENVIRONMENTAL MATTERS The Company is subject to a wide range of governmental requirements relating to employee safety and health and to the handling and emission into the environment of various substances used in its operations. The Company is subject to certain provisions of environmental laws, particularly in the U.S., governing the cleanup of soil and groundwater contamination. Such provisions impose liability for 20 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) the costs of investigating and remediating releases of hazardous materials at currently or formerly owned or operated sites. In certain circumstances, this liability may also include the cost of cleaning up historical contamination, whether or not caused by the Company. The Company is currently conducting investigation and/or cleanup of known contamination at approximately five of its facilities either voluntarily or pursuant to government directives. It is often difficult to estimate the future impact of environmental matters, including potential liabilities. The Company has established financial reserves to cover environmental liabilities where they are probable and reasonably estimable. Reserves for estimated losses from environmental matters are, depending on the site, based primarily upon internal or third party environmental studies and the extent of contamination and the type of required cleanup. Although the Company believes that its reserves are adequate to cover known environmental liabilities, there can be no assurance that the actual amount of environmental liabilities will not exceed the amount of reserves for such matters or will not have a material adverse effect on the Company's financial position, results of operations or cash flows. CONDITIONAL REPURCHASE OBLIGATIONS Avaya sells products to various distributors that may obtain financing from unaffiliated third party lending institutions. In the event the lending institution repossesses the distributor's inventory of Avaya products, Avaya is obligated to repurchase such inventory from the lending institution. The repurchase amount is equal to the price originally paid to Avaya by the lending institution for the inventory. The Company's obligation to repurchase inventory from the lending institution terminates 180 days from the date of invoicing by Avaya to the distributor. During the three months ended December 31, 2001, there were no repurchases made by the Company under such agreements. There can be no assurance that the Company will not be obligated to repurchase inventory under these arrangements in the future. 13. SUBSEQUENT EVENTS REVOLVING CREDIT FACILITIES In February 2002, the Company and the lenders under the Credit Facilities described in Note 8 amended the facilities ("Amended Credit Facilities"). Funds are available under the Amended Credit Facilities for general corporate purposes, the repayment of commercial paper obligations, and for acquisitions up to $150 million. The Amended Credit Facilities provide that in the event the Company's corporate credit rating falls below BBB- by Standard & Poor's or its long-term senior unsecured debt rating falls below Baa3 by Moody's, any borrowings under the Amended Credit Facilities will be secured, subject to certain exceptions, by security interests in the U.S. equipment, accounts receivable, inventory, and intellectual property rights of the Company and that of any of its subsidiaries guaranteeing its obligations under the Amended Credit Facilities as described below. Borrowings would also be secured by a pledge of the stock of certain of the Company's domestic subsidiaries and 65% of the stock of a foreign subsidiary. The security interests would be granted to the extent permitted by the indenture governing the LYONs and would be suspended in the event the Company's corporate credit rating was at least BBB by Standard & Poor's and its long-term senior unsecured debt rating was at least Baa2 by Moody's, in each case with a stable outlook. As described below, the Company's debt ratings have been recently downgraded and its long-term senior unsecured debt is currently rated Baa3 by Moody's, subject to review for further downgrade, and its corporate credit is currently rated BBB- 21 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 13. SUBSEQUENT EVENTS (CONTINUED) by Standard & Poor's, with a negative outlook. Based on these long-term debt ratings, borrowings under the Amended Credit Facilities are currently unsecured. The Amended Credit Facilities also provide that up to $500 million of the net proceeds of offerings of debt securities and $200 million of the net proceeds of any real property financings must be used to reduce the commitments under the 364-day and five-year facilities on a pro rata basis. In addition, to the extent that the Company obtains proceeds from asset sales or dispositions at a time when the aggregate commitments under the Amended Credit Facilities exceed $850 million, the Company is required to use such proceeds to reduce the commitments under such facilities on a pro rata basis. Any current or future domestic subsidiaries (other than certain excluded subsidiaries) whose revenues constitute 5% or greater of the Company's consolidated revenues or whose assets constitute 5% or greater of the Company's consolidated total assets will be required to guarantee its obligations under the Amended Credit Facilities. There are no Avaya subsidiaries that currently meet these criteria. The Amended Credit Facilities also include negative covenants, including limitations on affiliate transactions, restricted payments and investments and advances. The Amended Credit Facilities also restrict the Company's ability and that of its subsidiaries to incur debt, subject to certain exceptions. The Company is permitted to use the Amended Credit Facilities to fund acquisitions in an aggregate amount not to exceed $150 million and can make larger acquisitions so long as the facilities are not used to fund the purchase price, no default under the facilities shall have occurred and be continuing or would result from such acquisition, and the Company shall be in compliance with the financial ratio test described below after giving pro forma effect to such acquisition. The Amended Credit Facilities require the Company to maintain a ratio of consolidated Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") to interest expense of three to one for each of the four quarter periods ending March 31, 2002, June 30, 2002 and September 30, 2002 and a ratio of four to one for each four quarter period thereafter. The Company is also required to maintain consolidated EBITDA of: - $20 million for the quarter ended March 31, 2002; - $80 million for the two quarter period ended June 30, 2002; - $180 million for the three quarter period ended September 30, 2002; - $300 million for the four quarter period ended December 31, 2002; and - $400 million for each four quarter period thereafter. For purposes of these calculations, the Company is permitted to exclude from the computation of consolidated EBITDA up to $163 million of restructuring charges, including asset impairment and other one time expenses to be taken no later than the fourth quarter of fiscal 2002. In addition, the Company may exclude certain business restructuring charges and related expenses taken in fiscal 2001. The Amended Credit Facilities provide, at the Company's option, for fixed interest rate and floating interest rate borrowings. Fixed rate borrowings under the facilities bear interest at a rate equal to (i) the greater of (A) Citibank, N.A.'s base rate and (B) the federal funds rate plus 0.5% plus (ii) a margin based on the Company's long-term senior unsecured debt rating (the "Applicable Margin"). Floating rate borrowings bear interest at a rate equal to the LIBOR rate plus the Applicable Margin 22 AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 13. SUBSEQUENT EVENTS (CONTINUED) and, if borrowings under a facility exceed 50% of the commitments under such facility, a utilization fee based on the Company's long-term senior unsecured debt rating (the "Applicable Utilization Fee"). Based on the Company's current long-term debt rating, the Applicable Margins for the 364-day credit facility and the five-year credit facility are 1.075% and 1.05%, respectively, and the Applicable Utilization Fee for both facilities is 0.25%. DEBT RATINGS In January and February 2002, the Company's commercial paper and long-term debt ratings were downgraded as follows:
AS OF CURRENT RATINGS DECEMBER 31, 2001 JANUARY 2002 FEBRUARY 2002 ----------------- ------------ --------------- Moody's: Commercial paper................................ P-2 P-2 P-3 (1) Long-term senior unsecured debt................. Baa1 Baa2 Baa3 (1) Standard & Poor's: Commercial paper................................ A-2 (2) A-3(2) A-3 (2) Long-term senior unsecured debt................. BBB (2) BBB-(2) BB+ (2) Corporate credit................................ BBB (2) BBB-(2) BBB- (2)
- ------------------------ (1) Subject to review for further downgrade. (2) Includes a negative outlook. CONNECTIVITY SOLUTIONS In February 2002, the Company announced that it has engaged Salomon Smith Barney to explore alternatives for the Company's Connectivity Solutions segment, including the possible sale of the business. The Connectivity Solutions segment markets (i) the SYSTIMAX-Registered Trademark- product line of structured cabling systems primarily to enterprises of various sizes for wiring phones, workstations, personal computers, local area networks and other communications devices through their buildings or across their campuses and (ii) the ExchangeMax-Registered Trademark- product line primarily to central offices of service providers, such as telephone companies or Internet service providers. Connectivity Solutions also offers electronic cabinets to enclose an enterprise's electronic devices and equipment. The Company's goal in exploring alternatives for Connectivity Solutions is to maximize its core business both by enhancing liquidity and by strengthening its focus on the higher growth opportunities for Avaya, including converged voice and data, unified communications, and customer relationship management. Connectivity Solutions comprised $1,322 million, or 19.5%, of the Company's total revenue in the fiscal year ended September 30, 2001. 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following section should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q. The matters discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements made that are not historical facts are forward-looking and are based on estimates, forecasts and assumptions involving risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. The risks and uncertainties referred to above include, but are not limited to, price and product competition; rapid technological development; dependence on new product development; the successful introduction of new products; the mix of our products and services; customer demand for our products and services; the ability to successfully integrate acquired companies; control of costs and expenses; the ability to form and implement alliances; the ability to implement in a timely manner our restructuring plans; the economic, political and other risks associated with international sales and operations; U.S. and foreign government regulation; general industry and market conditions; growth rates and general domestic and international economic conditions including interest rate and currency exchange rate fluctuations and the impact of recent decreases in our revenue on our operating results, our credit ratings and our ability to access the financial markets. Our accompanying unaudited consolidated financial statements as of December 31, 2001 and for the three months ended December 31, 2001 and 2000, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and Exchange Commission for interim financial statements, and should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2001, including the more detailed discussion of risks facing our business described in the Form 10-K. In our opinion, the unaudited interim consolidated financial statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated. Certain prior year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year. OVERVIEW We are a leading provider of communications systems and software for enterprises, including businesses, government agencies and other organizations. We offer voice, converged voice and data, customer relationship management, messaging, multi-service networking and structured cabling products and services. Multi-service networking products are those products that support network infrastructures which carry voice, video and data traffic over any of the protocols, or set of procedures, supported by the Internet on local area and wide area data networks. A structured cabling system is a flexible cabling system designed to connect phones, workstations, personal computers, local area networks and other communications devices through a building or across one or more campuses. We are a worldwide leader in sales of messaging and structured cabling systems and a U.S. leader in sales of enterprise voice communications and call center systems. We are not a leader in multi-service networking products, and our product portfolio in this area is less complete than the portfolios of some of our competitors. In addition, we are not a leader in sales of certain converged voice and data products, including server-based Internet Protocol telephony systems. We are implementing a strategy focused on these and other advanced communications solutions. We report our operations in three segments: Communications Solutions, Services and Connectivity Solutions. The Communications Solutions segment represents our core business, which consists of our 24 enterprise voice communications systems and software, communications applications, professional services for customer relationship management, converged voice and data networks and unified communication, multi-servicing networking products and product installation services. The Services segment represents our maintenance, value-added and data services. The Connectivity Solutions segment represents our structured cabling systems and our electronic cabinets. The costs of shared services and other corporate center operations managed on a common basis represent business activities that do not qualify for separate operating segment reporting and are aggregated in the corporate and other category. In the first quarter of fiscal 2001, we discontinued allocating costs of shared services and other corporate center operations managed outside of the operating segments. Operating income (loss) for the three months ended December 31, 2000 has been restated to reflect these costs in Corporate and other. Effective January 1, 2002, we implemented an internal reorganization of our company in which we will assess performance and allocate resources among four rather than three operating segments. The most significant component of this reorganization is that we will divide our Communications Solutions segment into two business reporting groups: Applications and Systems. Our objective is to give us the ability to understand and manage our product groups with greater precision, and to give investors better insight and visibility into what could roughly be viewed as the hardware versus software pieces of our business. Beginning in the second quarter of fiscal 2002, we will be reporting our financial data in the following operating segments: Applications, Systems, Connectivity Solutions and Services. We have been experiencing declines in revenue from our traditional business, enterprise voice communications products. We expect, based on various industry reports, a low growth rate in the market segments for these traditional products. We are implementing a strategy to capitalize on the higher growth opportunities in our market, including advanced communications solutions such as converged voice and data networks, customer relationship management solutions, unified communication applications and multi-service networking products. This strategy requires us to make a significant change in the direction and strategy of our company to focus on the development and sales of these advanced products. The success of this strategy, however, is subject to many risks, including the risks that: - we do not develop new products or enhancements to our current products on a timely basis to meet the changing needs of our customers; - customers do not accept our products or new technology, or industry standards develop that make our products obsolete; or - our competitors introduce new products before we do and achieve a competitive advantage by being among the first to market. Our traditional enterprise voice communications products and the advanced communications solutions described above are a part of our Communications Solutions segment. If we are unsuccessful in implementing our strategy, the contribution to our results from Communications Solutions may decline, reducing our overall profitability, thereby requiring a greater need for external capital resources. In addition, the economic slowdown that began in the first half of calendar 2001, particularly in the U.S., which was exacerbated by the events of September 11, 2001 and the aftermath of such events, has had and continues to have an adverse effect on our operating results. Our revenue for the quarter ended December 31, 2001 was $1,306 million, a decrease of 26.8%, or $479 million from $1,785 million for the quarter ended December 31, 2000 and a sequential decrease of 9.4%, or $136 million from $1,442 million for the quarter ended September 30, 2001. In addition, our revenue may decline sequentially for the quarter ending March 31, 2002 compared to the quarter ended December 31, 2001. If the global economy, and in particular the U.S. economy, does not improve, our revenues and 25 operating results will continue to be adversely affected or we may not be able to comply with the financial covenants included in our amended credit facilities, as described in "--Liquidity and Capital Resources." In addition to the decline in revenue from our traditional enterprise voice communications products, the economic slowdown has been an important factor in the significant decrease in revenues from our Connectivity Solutions segment over the last two quarters. Revenue from Connectivity Solutions for the quarter ended December 31, 2001 was $135 million, a decrease of 62.1%, or $221 million from $356 million for the quarter December 31, 2000 and a sequential decrease of 33.5%, or $68 million, from $203 million for the quarter ended September 30, 2001. In February 2002, we announced that the Company has engaged Salomon Smith Barney to explore alternatives for our Connectivity Solutions segment, including the possible sale of the business. The Connectivity Solutions segment markets (i) the SYSTIMAX-Registered Trademark- product line of structured cabling systems primarily to enterprises of various sizes for wiring phones, workstations, personal computers, local area networks and other communications devices through their buildings or across their campuses and (ii) the ExchangeMax-Registered Trademark- product line primarily to central offices of service providers, such as telephone companies or Internet service providers. Connectivity Solutions also offers electronic cabinets to enclose an enterprise's electronic devices and equipment. Our goal in exploring alternatives for Connectivity Solutions is to maximize our core business both by enhancing liquidity and by strengthening our focus on the higher growth opportunities for Avaya, including converged voice and data, unified communications, and customer relationship management. Connectivity Solutions comprised $1,322 million, or 19.5%, of our total revenue in the fiscal year ended September 30, 2001 Effective October 1, 2001, we adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), which requires that goodwill and certain other intangible assets having indefinite lives no longer be amortized to earnings, but instead be subject to periodic testing for impairment. Intangible assets determined to have definitive lives will continue to be amortized over their remaining useful lives. In connection with the adoption of SFAS 142, we reviewed the classification of our existing goodwill and other intangible assets, reassessed the useful lives previously assigned to other intangible assets, and discontinued amortization of goodwill. During the remainder of fiscal 2002, we will complete a transitional review of our goodwill for impairment. Losses, if any, that are identified as a result of this transitional review will be recorded as a change in accounting principle. Any such losses that are recorded after the transitional review will be identified as a separate line item in income from operations. See our "Results of Operations" discussion noted below for the impact on selling, general and administrative expense associated with adopting SFAS 142. For the three months ended December 31, 2000, we reported net income of $16 million and $0.03 for both basic and diluted earnings per share. If we had adopted SFAS 142 in the beginning of the first quarter of fiscal 2001 and discontinued goodwill amortization, which amounted to $8 million, net of tax during this period, on a pro forma basis net income would have been $24 million and basic and diluted earnings per share would have been $0.06. 26 The following table sets forth the allocation of our revenue among our operating segments, expressed as a percentage of total revenue, excluding corporate and other revenue:
THREE MONTHS ENDED DECEMBER 31, ------------------- 2001 2000 -------- -------- OPERATING SEGMENTS: Communications Solutions.............................. 50.8% 52.0% Services.............................................. 38.9 28.0 Connectivity Solutions................................ 10.3 20.0 ----- ----- Total............................................... 100.0% 100.0% ===== =====
SEPARATION FROM LUCENT TECHNOLOGIES INC. On September 30, 2000, under the terms of a Contribution and Distribution Agreement between Lucent and us, Lucent contributed its enterprise networking business to us and distributed all of the outstanding shares of our capital stock to its stockholders. We refer to these transactions as the contribution and the distribution, respectively. We had no material assets or activities until the contribution, which occurred immediately prior to the distribution. Lucent conducted such businesses through various divisions and subsidiaries. Following the distribution, we became an independent public company, and Lucent no longer has a continuing stock ownership interest in us. Prior to the distribution, we entered into several agreements with Lucent in connection with, among other things, intellectual property, interim services and a number of ongoing commercial relationships, including product supply arrangements. The interim services agreement set forth charges generally intended to allow the providing company to fully recover the allocated direct costs of providing the services, plus all out-of-pocket costs and expenses, but without any profit. With limited exceptions, these interim services expired on March 31, 2001. The pricing terms for goods and services covered by the commercial agreements reflect current market prices at the time of the transaction. BUSINESS RESTRUCTURING RESERVE AND RELATED EXPENSES We recorded business restructuring charges in fiscal 2000 related to our separation from Lucent and in fiscal 2001 related to the outsourcing of certain manufacturing facilities and the acceleration of our restructuring plan that was originally adopted in fiscal 2000 to improve profitability and business performance as a stand-alone company. The following table summarizes the status of our business restructuring reserve and related expenses as of and for the three months ended December 31, 2001:
BUSINESS RESTRUCTURING RESERVE OTHER RELATED EXPENSES ------------------------------------------------------ -------------------------- TOTAL BUSINESS EMPLOYEE LEASE TOTAL BUSINESS RESTRUCTURING SEPARATION TERMINATION OTHER EXIT RESTRUCTURING ASSET INCREMENTAL AND RELATED COSTS OBLIGATIONS COSTS RESERVE IMPAIRMENTS PERIOD COSTS EXPENSES ---------- ----------- ---------- -------------- ----------- ------------ -------------- (DOLLARS IN MILLIONS) Balance as of September 30, 2001... $ 96 $ 78 $ 5 $179 $ -- $-- $179 Expenses............... -- -- -- -- -- 6 6 Cash payments.......... (21) (20) (1) (42) -- (6) (48) ---- ---- --- ---- --------- --- ---- Balance as of December 31, 2001.... $ 75 $ 58 $ 4 $137 $ -- $-- $137 ==== ==== === ==== ========= === ====
Employee separation costs included in the business restructuring reserve were made through lump sum payments, although certain union-represented employees elected to receive a series of payments extending over a period of up to two years from the date of departure. Payments to employees who 27 elected to receive severance through a series of payments will extend through 2003. This workforce reduction was substantially completed at the end of fiscal 2001. The charges for lease termination obligations, which consisted of real estate and equipment leases, included approximately 2.8 million square feet of excess space of which we have vacated 667,000 square feet as of December 31, 2001. Payments on lease termination obligations will be substantially completed by 2003 because, in certain circumstances, the remaining lease payments were less than the termination fees. In the first quarter of fiscal 2002, we recorded $6 million of other related expenses primarily associated with our outsourcing of certain manufacturing facilities. In the first quarter of fiscal 2001, we recorded $23 million of other related expenses associated with our separation from Lucent related primarily to computer system transition costs such as data conversion activities, asset transfers, and training. In addition, we recorded $36 million in selling, general and administrative expenses for additional start-up activities during the first quarter of fiscal 2001 largely resulting from marketing costs associated with continuing to establish the Avaya brand. During the remainder of fiscal 2002, we expect to incur additional period costs of approximately $17 million and $23 million related to our outsourcing of certain of our manufacturing facilities and our accelerated restructuring program, respectively. We are also considering other restructuring actions to be taken in fiscal 2002 designed to yield additional cost savings. Our amended credit facilities permit us to exclude from the computation of certain financial ratios up to $163 million of restructuring charges, including asset impairment and other one time expenses to be taken no later than the fourth quarter of fiscal 2002. We expect to fund these expenses through a combination of debt and internally generated funds. OUTSOURCING OF CERTAIN MANUFACTURING FACILITIES In connection with the five-year strategic manufacturing agreement to outsource most of the manufacturing of our communications systems and software, we have received substantially all of the $200 million in proceeds for assets transferred to Celestica Inc. We deferred $100 million of these proceeds, which are being recognized on a straight-line basis over the term of the agreement. As of December 31, 2001, the unamortized portion of these proceeds amounted to $20 million in other current liabilities and $66 million in other liabilities. The remaining phases of the transaction, which included closing of the Shreveport, Louisiana facility, were completed in the first quarter of fiscal 2002. We believe that outsourcing our manufacturing will allow us to improve our cash flow over the next few years through a reduction of inventory and reduced capital expenditures. As a result of the contract manufacturing transaction, Celestica exclusively manufactures substantially all of our Communications Solutions products at various facilities in the U.S. and Mexico. We are not obligated to purchase products from Celestica in any specific quantity, except as we outline in forecasts or orders for products required to be manufactured by Celestica. In addition, we may be obligated to purchase certain excess inventory levels from Celestica that could result from our actual sales of product varying from forecast. Our outsourcing agreement with Celestica results in a concentration that, if suddenly eliminated, could have an adverse effect on our operations. While we believe that alternative sources of supply would be available, disruption of our primary source of supply could create a temporary, adverse effect on product shipments. There is no other significant concentration of business transacted with a particular supplier that could, if suddenly eliminated, have a material adverse affect on our financial position, results of operations or cash flows. 28 RESULTS OF OPERATIONS The following table sets forth line items from our Consolidated Statements of Operations as a percentage of revenue for the periods indicated:
THREE MONTHS ENDED DECEMBER 31, ------------------------- 2001 2000 -------- -------- Revenue..................................................... 100.0% 100.0% Costs....................................................... 60.4 57.6 ----- ----- Gross margin................................................ 39.6 42.4 ----- ----- Operating expenses: Selling, general and administrative....................... 32.0 31.8 Business restructuring related expenses................... 0.5 1.3 Research and development.................................. 9.2 7.8 ----- ----- Total operating expenses.................................... 41.7 40.9 ----- ----- Operating income (loss)..................................... (2.1) 1.5 Other income, net........................................... 0.5 0.5 Interest expense............................................ (0.7) (0.6) Provision (benefit) for income taxes........................ (0.8) 0.5 ----- ----- Net income (loss)........................................... (1.5)% 0.9% ===== =====
THREE MONTHS ENDED DECEMBER 31, 2001 COMPARED TO THREE MONTHS ENDED DECEMBER 31, 2000 The following table shows the change in revenue, both in dollars and in percentage terms:
THREE MONTHS ENDED DECEMBER 31, CHANGE ------------------------- ------------------- 2001 2000 $ % -------- -------- -------- -------- (DOLLARS IN MILLIONS) Communications Solutions......................... $ 663 $ 928 $(265) (28.6)% Services......................................... 508 499 9 1.8 Connectivity Solutions........................... 135 356 (221) (62.1) ------ ------ ----- Total operating segments....................... 1,306 1,783 (477) (26.8) Corporate and other.............................. -- 2 (2) (100.0) ------ ------ ----- Total.......................................... $1,306 $1,785 $(479) (26.8)% ====== ====== =====
REVENUE. Revenue decreased 26.8%, or $479 million, from $1,785 million for the first quarter of fiscal 2001, to $1,306 million for the same period in fiscal 2002 due to a decrease in the Communications Solutions and Connectivity Solutions segments, offset slightly by an increase in the Services segment revenues. The overall reduction in revenue was mainly attributable to the continued economic deterioration in the technology sector that resulted in decreased demand for telephony equipment and related products. Slower economic activity led to widespread layoffs, high vacancy rates in commercial real estate, and a slowdown in business start-ups, each of which had a negative impact on our revenues. The decrease in the Communications Solutions segment was largely due to a decline in customer purchases of $144 million in enterprise voice communications systems, a $55 million decrease in communications applications primarily driven by a reduction in messaging systems, many of which are sold with voice systems, and customer relationship management product sales, a $36 million decrease in 29 data products and a $25 million decrease in installation revenue as a result of the reduction in product sales. The economic downturn in the U.S. contributed to a slowdown of sales volume in both data and telephony switch markets as companies found themselves with sufficient capacity in their networks to meet the needs of a reduced workforce. In addition, due to the uncertain economic climate and reduced revenue and profit expectations of many businesses, expansion and relocation plans were placed on hold, which negatively impacted our traditional voice and data sales and related messaging products, as well as our customer relationship management solutions. Within the Connectivity Solutions segment, revenues from our SYSTIMAX-Registered Trademark- structured cabling systems for enterprises declined by $95 million, sales of our ExchangeMAX-Registered Trademark- cabling for service providers declined by $90 million, and electronic cabinets revenues declined by $44 million. The key drivers behind the sharp decline in SYSTIMAX revenues were the high vacancy rates of commercial real estate in the U.S. and a decrease in office moves, additions and changes. Sales of our ExchangeMAX cabling and electronic cabinets dropped significantly as our customers deferred capital spending and concentrated on extracting maximum value from existing systems. Our Services segment revenues increased marginally as a result of an increase in value-added services of $17 million, as well as an increase of $3 million in data services revenues with the majority of these increases coming from our international operations. These increases were somewhat offset by a decline of $9 million in maintenance revenues stemming mostly from within the U.S. Revenue within the U.S. decreased 29.9%, or $402 million, from $1,346 million for the first quarter of fiscal 2001 to $944 million for the same period in fiscal 2002. This decrease was primarily due to decreases of $205 million in Communications Solutions, $188 million in Connectivity Solutions and $8 million in Services. Outside the U.S., revenue decreased 17.5%, or $77 million, from $439 million for the first quarter of fiscal 2001 to $362 million for the same period in fiscal 2002. This decrease is primarily due to declines of $60 million in Communications Solutions and $33 million in Connectivity Solutions partially offset by an increase of $17 million in Services revenue. Revenue outside the U.S. in the first quarter of fiscal 2002 represented 27.7% of revenue compared with 24.6% in the same period of fiscal 2001. COSTS AND GROSS MARGIN. Total costs decreased 23.2%, or $239 million, from $1,028 million for the first quarter of fiscal 2001 to $789 million for the same period in fiscal 2002. Gross margin percentage decreased 2.8% from 42.4% in the first quarter of fiscal 2001 as compared with 39.6% in the same period of fiscal 2002. The decrease in gross margin was attributed mainly to the Connectivity Solutions segment which experienced a sharp decline in sales volumes while factory costs remained relatively fixed. This segment's gross margin experienced additional pressure due to aggressive discounting aimed at stimulating sales in a market negatively impacted by economic conditions. The Communications Solutions and Services segments also experienced some decline in gross margin, although to a much lesser extent than the Connectivity Solutions segment, due to factors including volume, discount and product mix. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative ("SG&A") expenses decreased 26.4%, or $150 million, from $568 million for the first quarter of fiscal 2001 to $418 million for the same period of fiscal 2002. The decrease was primarily due to savings associated with our business restructuring plan including lower staffing levels and terminated real estate lease obligations. In addition, during the first quarter of fiscal 2001, we incurred higher incentive compensation expense and start-up expenses of $36 million related to establishing independent operations. These start-up expenses were comprised primarily of marketing costs associated with establishing our brand. Amortization of intangible assets included in SG&A in the first quarter of fiscal 2002 amounted to $9 million, compared with $6 million in the first quarter of fiscal 2001. In connection with adopting SFAS 142, we did not record any goodwill amortization in the first quarter of fiscal 2002 as compared with $8 million of goodwill amortization included in SG&A for the first quarter of fiscal 2001. 30 BUSINESS RESTRUCTURING RELATED EXPENSES. Business restructuring related expenses of $6 million in the first quarter of fiscal 2002 represent expenses associated primarily with the outsourcing of certain of our manufacturing facilities. The $23 million of expenses in the first quarter of fiscal 2001 represent incremental period costs associated with our separation from Lucent related primarily to computer system transition costs such as data conversion activities, asset transfers and training. RESEARCH AND DEVELOPMENT. Research and development ("R&D") expenses decreased 14.3%, or $20 million, from $140 million in the first quarter of fiscal 2001 to $120 million in the same quarter of fiscal 2002. Although R&D spending decreased, our investment in R&D as a percentage of revenue increased from 7.8% to 9.2% which supports our plan to shift spending to high growth areas of our business and reduce spending on more mature product lines. This investment is also consistent with our target to spend an amount equal to approximately 8% to 10% of our total revenue in R&D by the end of fiscal 2003. OTHER INCOME, NET. Other income, net decreased from $9 million in the first quarter of fiscal 2001 to $6 million in the same period of fiscal 2002. In both periods, interest income earned on cash balances accounts for the majority of other income. INTEREST EXPENSE. Interest expense remained relatively flat from the first quarter of fiscal 2001 at $10 million compared with $9 million in the same period of fiscal 2002. The decrease in interest expense is due to a lesser amount of outstanding commercial paper carrying a lower interest rate partially offset by a higher average outstanding debt balance attributable to borrowings associated with the issuance of our Liquid Yield Option-TM- Notes due 2021 ("LYONs") in the first quarter of fiscal 2002. PROVISION (BENEFIT) FOR INCOME TAXES. The effective tax rate in the first quarter of fiscal 2002 was a benefit of 35.0% as compared with an expense of 38.0% in the first quarter of fiscal 2001. The change in the effective tax rate is primarily due to our adoption of SFAS 142, which had a favorable impact because the effective tax rate calculation for the first quarter of fiscal 2002 excludes nondeductible goodwill while the calculation for the first quarter of fiscal 2001 does not. In addition, a change in the earnings mix generated increased earnings from outside the U.S. in jurisdictions that have lower income tax rates. LIQUIDITY AND CAPITAL RESOURCES STATEMENT OF CASH FLOWS DISCUSSION Avaya's cash and cash equivalents increased to $252 million at December 31, 2001, from $250 million at September 30, 2001. The increase resulted from $122 million of net cash provided by financing activities, partially offset by $92 million and $26 million of net cash used for operating and investing activities, respectively. Our net cash used for operating activities was $92 million for the three months ended December 31, 2001 compared with net cash provided by operating activities of $58 million for the same period in fiscal 2001. Net cash used for operating activities for the three months ended December 31, 2001 was composed of a net loss of $20 million adjusted for non-cash items of $69 million, and net cash used for changes in operating assets and liabilities of $141 million. Net cash used for operating activities is mainly attributed to cash payments made on our accounts payable and other short term liabilities. In addition, usage of cash also resulted from payments made for our business restructuring related activities resulting from our separation from Lucent, our outsourcing of certain manufacturing facilities and the acceleration of our restructuring plan. Furthermore, we reduced our payroll related liabilities and advance billings and deposits. These changes were partially offset by receipts of cash on amounts due from our customers. For the first quarter in fiscal 2001, net cash provided by operating activities of $58 million was comprised of net income of $16 million adjusted for non-cash charges of 31 $134 million, and net cash used for changes in operating assets and liabilities of $92 million. Net cash used for operating assets and liabilities was primarily attributed to cash receipts for our accounts receivables and an increase in our payroll related liabilities, offset by a reduction in our advance billings and deposits, cash payments made on our accounts payable, business restructuring and start-up activities, and an increase in our work in process and raw materials inventory. Days sales outstanding in accounts receivable for the first quarter of fiscal 2002, excluding the effect of the securitization transaction discussed below, was 96 days versus 95 days for the fourth quarter of fiscal 2001. This level of days sales outstanding is primarily attributable to transition issues resulting from the consolidation of our customer collection facilities. Days sales of inventory on-hand for the first quarter of fiscal 2002 were 73 days versus 70 days for the fourth quarter of fiscal 2001. This increase is primarily due to lower than expected sales volumes. Our net cash used for investing activities was $26 million for the three months ended December 31, 2001 compared with $116 million for the same period in fiscal 2001. The usage of cash in both periods resulted primarily from capital expenditures. The first quarter of fiscal 2002 included payments made for the renovation of our corporate headquarters facility and upgrading our information technology systems. Capital expenditures in the first quarter of fiscal 2001 is due mainly to Avaya establishing itself as a stand-alone entity, including information technology upgrades and corporate infrastructure expenditures. Net cash provided by financing activities was $122 million for the three months ended December 31, 2001 compared with $329 million for the same period in fiscal 2001. Cash flows from financing activities in the current period were mainly due to $447 million in proceeds from the issuance of LYONs convertible debt, net of payments for debt issuance costs, partially offset by $131 million of net payments for the retirement of commercial paper and a $200 million repayment on the five-year credit facility. Net cash provided by financing activities in the first quarter of fiscal 2001 was mainly due to the receipt of $400 million in proceeds from the sale of our Series B convertible participating preferred stock and warrants to purchase our common stock described below, partially offset by $76 million of net payments for the retirement of commercial paper. DEBT RATINGS Our ability to obtain external financing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. In January and February 2002, our commercial paper and long-term debt ratings were downgraded as follows:
AS OF CURRENT RATINGS DECEMBER 31, 2001 JANUARY 2002 FEBRUARY 2002 ----------------- ------------ --------------- Moody's: Commercial paper................................ P-2 P-2 P-3 (1) Long-term senior unsecured debt................. Baa1 Baa2 Baa3 (1) Standard & Poor's: Commercial paper................................ A-2 (2) A-3(2) A-3 (2) Long-term senior unsecured debt................. BBB (2) BBB-(2) BB+ (2) Corporate credit................................ BBB (2) BBB-(2) BBB- (2)
- ------------------------ (1) Subject to review for further downgrade. (2) Includes a negative outlook. Any increase in our level of indebtedness or deterioration of our operating results may cause a further reduction in our current debt ratings. A further reduction in our current long-term debt rating 32 by Moody's or Standard & Poor's could affect our ability to access the long-term debt markets, significantly increase our cost of external financing, and result in additional restrictions on the way we operate and finance our business. In particular, you should review carefully the description of the impact of our current debt ratings and any future downgrade of those ratings on certain of our financing sources, as described under "--COMMERCIAL PAPER PROGRAM," "--REVOLVING CREDIT FACILITIES," and "--SECURITIZATION OF ACCOUNTS RECEIVABLE." A security rating by the major credit rating agencies is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the rating agencies. Each rating should be evaluated independently of any other rating. COMMERCIAL PAPER PROGRAM We have established a commercial paper program pursuant to which we may issue up to $1.25 billion of commercial paper at market interest rates. Interest rates on our commercial paper obligations are variable due to their short-term nature. The weighted average yield and maturity period for the $301 million and $432 million of commercial paper outstanding as of December 31, 2001 and September 30, 2001, were approximately 3.4% and 3.9% and 87 days and 62 days, respectively. As of December 31, 2001, $37 million of the outstanding commercial paper was classified as long-term debt in the Consolidated Balance Sheet since it is supported by the five-year credit facility described below and it is our intent to refinance it with other debt on a long-term basis. As of September 30, 2001, the entire amount of commercial paper was classified as long-term debt. Our commercial paper has been recently downgraded and is currently rated P-3 by Moody's, subject to review for further downgrade, and A-3 by Standard & Poor's, with a negative outlook. These recent downgrades make it very difficult, if not impossible, for us to access the commercial paper market, which has been our primary source of liquidity in the past. As a result of the impact of these ratings downgrades on our ability to issue commercial paper, in February 2002, we borrowed $300 million under our five-year credit facility to repay commercial paper obligations. As of February 13, 2002, approximately $26 million of our commercial paper remains outstanding. Such obligations mature through May 2002 and we expect to repay these remaining obligations with available cash or other short-term or long-term debt. REVOLVING CREDIT FACILITIES We have two unsecured revolving credit facilities (the "Credit Facilities") with third party financial institutions consisting of a $400 million 364-day credit facility that expires in August 2002 and an $850 million five-year credit facility that expires in September 2005. No amounts were drawn down under either credit facility as of December 31, 2001, although in February 2002 we borrowed $300 million under the five-year credit facility in order to repay maturing commercial paper obligations. In September 2001, we borrowed $200 million under the five-year credit facility and used the proceeds to repay maturing commercial paper. The borrowing carried a fixed interest rate of approximately 3.5% and was repaid in October 2001 using proceeds from the issuance of commercial paper. The September 2001 borrowing under the credit facility was necessitated by disruptions in the commercial paper markets as a result of the September 11 terrorist attacks. In February 2002, we and the lenders under our Credit Facilities amended the facilities ("Amended Credit Facilities"). Funds are available under the Amended Credit Facilities for general corporate purposes, the repayment of commercial paper obligations, and for acquisitions up to $150 million. The Amended Credit Facilities provide that in the event our corporate credit rating falls below BBB- by Standard & Poor's or our long-term senior unsecured debt rating falls below Baa3 by Moody's, any borrowings under the Amended Credit Facilities will be secured, subject to certain exceptions, by security interests in our U.S. equipment, accounts receivable, inventory, and intellectual property rights 33 and that of any of our subsidiaries guaranteeing our obligations under the Amended Credit Facilities as described below. Borrowings would also be secured by a pledge of the stock of certain of our domestic subsidiaries and 65% of the stock of a foreign subsidiary. The security interests would be granted to the extent permitted by the indenture governing the LYONs and would be suspended in the event our corporate credit rating was at least BBB by Standard & Poor's and our long-term senior unsecured debt rating was a least Baa2 by Moody's, in each case with a stable outlook. Our debt ratings have been recently downgraded and our long-term senior unsecured debt is currently rated Baa3 by Moody's, subject to review for further downgrade, and our corporate credit is currently rated BBB- by Standard & Poor's, with a negative outlook. Based on these long-term debt ratings, borrowings under the Amended Credit Facilities are currently unsecured. The Amended Credit Facilities also provide that up to $500 million of the net proceeds of offerings of debt securities and $200 million of the net proceeds of any real property financings must be used to reduce the commitments under the 364-day and five-year facilities on a pro rata basis. In addition, to the extent that we obtain proceeds from asset sales or dispositions at a time when the aggregate commitments under the Amended Credit Facilities exceed $850 million, we are required to use such proceeds to reduce the commitments under such facilities on a pro rata basis. Any current or future domestic subsidiaries (other than certain excluded subsidiaries) whose revenues constitute 5% or greater of our consolidated revenues or whose assets constitute 5% or greater of our consolidated total assets will be required to guarantee our obligations under the Amended Credit Facilities. None of our subsidiaries currently meet these criteria. The Amended Credit Facilities also include negative covenants, including limitations on affiliate transactions, restricted payments and investments and advances. The Amended Credit Facilities also restrict our ability and that of our subsidiaries to incur debt, subject to certain exceptions. We are permitted to use the Amended Credit Facilities to fund acquisitions in an aggregate amount not to exceed $150 million and can make larger acquisitions so long as the facilities are not used to fund the purchase price, no default under the facilities shall have occurred and be continuing or would result from such acquisition, and we shall be in compliance with the financial ratio described below after giving pro forma effect to such acquisition. The Amended Credit Facilities require us to maintain a ratio of consolidated Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") to interest expense of three to one for each of the four quarter periods ending March 31, 2002, June 30, 2002 and September 30, 2002 and a ratio of four to one for each four quarter period thereafter. We are also required to maintain consolidated EBITDA of: - $20 million for the quarter ended March 31, 2002; - $80 million for the two quarter period ended June 30, 2002; - $180 million for the three quarter period ended September 30, 2002; - $300 million for the four quarter period ended December 31, 2002; and - $400 million for each four quarter period thereafter. For purposes of these calculations, we are permitted to exclude from the computation of consolidated EBITDA up to $163 million of restructuring charges, including asset impairment and other one time expenses to be taken no later than the fourth quarter of fiscal 2002. These charges are attributable to actions we may take in fiscal 2002 in order to improve our profitability. In addition, we may exclude certain business restructuring charges and related expenses taken in fiscal 2001. 34 While we believe we will be able to meet these financial covenants, our revenues have been declining and any further decline in revenues may affect our ability to meet these financial covenants in the future. The Amended Credit Facilities provide, at our option, for fixed interest rate and floating interest rate borrowings. Fixed rate borrowings under the facilities bear interest at a rate equal to (i) the greater of (A) Citibank, N.A.'s base rate and (B) the federal funds rate plus 0.5% plus (ii) a margin based on our long-term senior unsecured debt rating (the "Applicable Margin"). Floating rate borrowings bear interest at a rate equal to the LIBOR rate plus the Applicable Margin and, if borrowings under a facility exceed 50% of the commitments under such facility, a utilization fee based on our long-term senior unsecured debt rating (the "Applicable Utilization Fee"). Based on our current long-term debt rating, the Applicable Margins for the 364-day credit facility and the five-year credit facility are 1.075% and 1.05%, respectively, and the Applicable Utilization Fee for both facilities is 0.25%. SECURITIZATION OF ACCOUNTS RECEIVABLE We entered into a receivables purchase agreement in June 2001 and transferred a designated pool of qualified trade accounts receivable to a special purpose entity ("SPE"), which in turn sold an undivided ownership interest to an unaffiliated financial institution for cash proceeds of $200 million. The financial institution is an affiliate of Citibank, N.A., a lender and the agent for the other lenders under our revolving credit facilities. We, through the SPE, have a retained interest in a portion of these receivables, and the financial institution has no recourse to our other assets, stock or other securities for failure of customers to pay when due. The assets of the SPE are not available to pay our creditors. Collections of receivables are used by the financial institution to purchase, from time to time, new interests in receivables up to an aggregate of $200 million. The receivables purchase agreement expires in June 2002, but may be extended through June 2004 with the financial institution's consent. We had a retained interest of $174 million and $153 million as of December 31, 2001 and September 30, 2001, respectively, in the SPE's designated pool of qualified accounts receivable representing collateral for the sale. We are subject to certain receivable collection ratios, among other covenants contained in the receivables purchase agreement. In October 2001, the financial institution participating in the agreement granted us a waiver from a covenant that measures the ratio of certain unpaid receivables as a percentage of the aggregate outstanding balance of all designated receivables. The waiver effectively increased the ratio required by the covenant for each of the individual months of September through December 2001, and required compliance with the original ratio thereafter. As of December 31, 2001, we were in compliance with such covenants, although in January 2002 the financial institution waived our obligation to comply with the required ratio for the month of January 2002. We will be required to comply with the original ratio for the month of February 2002 and thereafter. The receivables purchase agreement initially required that our long-term senior unsecured debt be rated at least BBB- by Standard & Poor's and Baa3 by Moody's. In February 2002, the agreement was amended to lower these ratings triggers to BB+ by Standard & Poor's and Ba1 by Moody's through March 15, 2002, at which time the required ratings will revert back to BBB- by Standard & Poor's and Baa3 by Moody's. Our long-term senior unsecured debt has been recently downgraded and is currently rated Baa3 by Moody's, subject to review for further downgrade, and BB+ by Standard & Poor's, with a negative outlook. 35 We are currently in discussions with the financial institution participating in the receivables purchase agreement to restructure the agreement to address, among other things, the collection ratio and the ratings trigger. If we do not reach agreement with the financial institution on a restructuring of the agreement, and (i) we are unable to maintain the required ratio described above for the month of February 2002 or for any month thereafter, or (ii) our long-term senior unsecured debt is not rated at least BBB- by Standard & Poor's and Baa3 by Moody's after March 15, 2002, the financial institution will be able to exercise its rights under the agreement, including an early termination of the agreement. Upon the expiration, or in the event of an early termination, of the agreement, purchases of interests in receivables by the financial institution under the agreement will cease and collections on receivables constituting the designated pool, including to the extent necessary, those receivables comprising the retained interest, will be used to pay down the financial institution's $200 million investment under the agreement. If payment were made using collections from the retained interest, such amounts would then be unavailable to us for general corporate purposes and we may need to incur additional debt to fund the shortfall in working capital resulting from this usage. PREFERRED STOCK INVESTMENT We have sold to Warburg, Pincus Equity Partners, L.P. and related investment funds (collectively, the "Warburg Funds") four million shares of our Series B convertible participating preferred stock and warrants to purchase our common stock for an aggregate purchase price of $400 million. This initial liquidation value will accrete for the first 10 years beginning in October 2000 at an annual rate of 6.5% and 12% thereafter, compounded quarterly. For first quarter of fiscal 2002, accretion of the Series B preferred stock was $7 million, resulting in a liquidation value of $434 million as of December 31, 2001. The total number of shares of common stock into which the Series B preferred stock are convertible is determined by dividing the liquidation value in effect at the time of conversion by the conversion price. Based on a conversion price of $26.71, the Series B preferred stock is convertible into 16,232,630 shares of our common stock as of December 31, 2001. The warrants have an exercise price of $34.73 and are exercisable in two allotments. Warrants exercisable for 6,883,933 shares of common stock have a four-year term expiring on October 2, 2004, and warrants exercisable for 5,507,146 shares of common stock have a five-year term expiring on October 2, 2005. During the period from May 24, 2001 until October 2, 2002, if the market price of our common stock exceeds 200%, in the case of the four-year warrants, and 225%, in the case of the five-year warrants, of the exercise price of the warrants for 20 consecutive trading days, we can force the exercise of up to 50% of the four-year and the five-year warrants, respectively. Beginning in October 2003, 50% of the amount accreted for the year may be paid in cash as a dividend on a quarterly basis at our option. From October 2005 through September 2010, we may elect to pay 100% of the amount accreted for the year as a cash dividend on a quarterly basis. The liquidation value calculated on each quarterly dividend payment date, which includes the accretion for the dividend period, will be reduced by the amount of any cash dividends paid. Following the tenth anniversary of October 2010, we will pay quarterly cash dividends at an annual rate of 12% of the then accreted liquidation value of the Series B preferred stock, compounded quarterly. The Series B preferred shares also participate, on an as-converted basis, in dividends paid on our common stock. A beneficial conversion feature would exist if the conversion price for the Series B preferred stock or warrants was less than the fair value of our common stock at the commitment date. The beneficial conversion features, if any, associated with dividends paid in-kind, where it is our option to pay dividends on the Series B preferred stock in cash or in-kind, will be measured when dividends are declared and recorded as a reduction to net income available to common stockholders. At any time after October 2005, we may force conversion of the shares of Series B preferred stock. If we give notice of a forced conversion, the investors will be able to require us to redeem the Series B 36 preferred shares at 100% of the then current liquidation value, plus accrued and unpaid dividends. Following a change in control of us during the first five years after the investment, other than a change of control transaction involving solely the issuance of common stock, the accretion of some or all of the liquidation value of the Series B preferred stock through October 2005 will be accelerated, subject to our ability to pay a portion of the accelerated accretion in cash in some instances. In addition, for 60 days following the occurrence of any change of control of us during the first five years after the investment, the investors will be able to require us to redeem the Series B preferred stock at 101% of the liquidation value, including any accelerated accretion of the liquidation value, plus accrued and unpaid dividends. EQUITY CONSTRAINT Our ability to issue additional equity may be constrained because our issuance of additional equity may cause the distribution to be taxable to Lucent under Section 355(e) of the Internal Revenue Code, and under the tax-sharing agreement between Lucent and us, we would be required to indemnify Lucent against that tax. LYONS In the first quarter of fiscal 2002, we sold through an underwritten public offering under a shelf registration statement discussed below an aggregate principal amount at maturity of approximately $944 million of LYONs due 2021. The proceeds of approximately $447 million, net of a $484 million discount and $13 million of underwriting fees, were used to refinance a portion of our outstanding commercial paper. The underwriting fees of $13 million were recorded as deferred financing costs and are being amortized on a straight-line basis to interest expense over a three-year period through October 31, 2004, which represents the first date holders may require us to purchase all or a portion of their LYONs. The original issue discount of $484 million accrues daily at a rate of 3.625% per year calculated on a semiannual bond equivalent basis. We will not make periodic cash payments of interest on the LYONs. Instead, the amortization of the discount is recorded as interest expense and represents the accretion of the LYONs issue price to its maturity value. For the three months ended December 31, 2001, $3 million of interest expense on the LYONs was recorded, resulting in an accreted value of $463 million as of December 31, 2001. The discount will cease to accrue on the LYONs upon maturity, conversion, purchase by us at the option of the holder, or redemption by Avaya. The LYONs are unsecured obligations that rank equally in right of payment with all existing and future unsecured and unsubordinated indebtedness of Avaya. The LYONs are convertible into 35,333,073 shares of Avaya common stock at any time on or before the maturity date. The conversion rate may be adjusted for certain reasons, but will not be adjusted for accrued original issue discount. Upon conversion, the holder will not receive any cash payment representing accrued original issue discount. Accrued original issue discount will be considered paid by the shares of common stock received by the holder of the LYONs upon conversion. We may redeem all or a portion of the LYONs for cash at any time on or after October 31, 2004 at a price equal to the sum of the issue price and accrued original issue discount on the LYONs as of the applicable redemption date. Conversely, holders may require us to purchase all or a portion of their LYONs on the third, fifth and tenth anniversary from October 31, 2001 at a price equal to the sum of the issue price and accrued original issue discount on the LYONs as of the applicable purchase date. We may, at our option, elect to pay the purchase price in cash or shares of common stock, or any combination thereof. 37 The fair value of the LYONs as of December 31, 2001 is estimated to be $508 million and is based on using quoted market prices and yields obtained through independent pricing sources for the same or similar types of borrowing arrangements taking into consideration the underlying terms of the debt. The indenture governing the LYONs includes certain covenants, including a limitation on our ability to grant liens on significant domestic real estate properties or the stock of subsidiaries holding such properties. The liens granted under the Amended Credit Facilities do not extend to any real property and therefore, do not conflict with the terms of the indenture governing the LYONs. SHELF REGISTRATION STATEMENT In May 2001, the Securities and Exchange Commission ("SEC") declared effective our shelf registration statement on Form S-3 registering $1.44 billion of common stock, preferred stock, debt securities or warrants to purchase debt securities, or any combination of these securities, in one or more offerings through May 2003. We have $980 million remaining as of December 31, 2001 under this registration statement for additional offerings and intend to use the proceeds from any sale of such securities for general corporate purposes, debt repayment and refinancing, capital expenditures and acquisitions. We also registered with the SEC for resale by the Warburg Funds, the preferred stock and warrants described above and shares of common stock issuable upon conversion or exercise thereof. We will not receive any proceeds from the sale by the Warburg Funds of these securities. AIRCRAFT SALE-LEASEBACK In June 2001, we sold a corporate aircraft for approximately $34 million and subsequently entered into an agreement to lease it back over a five-year period. At the end of the lease term, we have the option to renew the lease subject to the consent of the lessors, or to purchase the aircraft for a price as defined in the agreement. If we elect not to either renew the lease or purchase the aircraft, we must arrange for the sale of the aircraft to a third party. Under the sale option, we have guaranteed approximately 60% of the unamortized original cost as the residual value of the aircraft. The lease is accounted for as an operating lease for financial statement purposes and as a loan for tax purposes. The agreements governing the aircraft sale-leaseback transaction contain certain covenants, including limitations on our ability to incur liens in certain circumstances. In particular, the agreements prohibit us from incurring secured indebtedness, subject to certain exceptions, in excess of $500 million. In the event amounts outstanding under our revolving credit facilities were to exceed $500 million at a time when borrowings under the facilities were secured as described above under "--REVOLVING CREDIT FACILITIES," we would be in violation of the lien covenant under the sale-leaseback agreements. In addition, for the three consecutive quarters ended June 30, 2001, we had to maintain a ratio of annualized consolidated Earnings Before Interest and Taxes ("EBIT") to annualized consolidated interest expense of at least three to one. Commencing in the fourth quarter of fiscal 2001 and each fiscal quarter thereafter, we had to maintain such ratio for the previous four consecutive fiscal quarters. The covenant permitted us to exclude up to $950 million of business restructuring and related charges and $300 million of start-up expenses from the calculation of consolidated EBIT to be taken no later than September 30, 2001. In September 2001, the covenant was amended to permit us to exclude up to an additional $450 million of non-cash business restructuring and related charges from the calculation of EBIT during such period to be taken no later than the fourth quarter of fiscal 2001. The Company was in compliance with this covenant as of December 31, 2001, although based on our current estimates, we believe we may not be able to comply with this covenant for the quarter ended March 31, 2002. We are in discussions with the financial institution participating in the sale-leaseback transaction to restructure the agreements to address any potential conflict between our credit facilities and the lien covenant included in the sale-leaseback agreements and our ability to meet the financial covenant described above. If we are unable to reach an agreement with the financial institution on restructuring 38 these agreements, we may not be able to comply with these covenants and may be required to purchase the aircraft from the financial institution for a purchase price equal to the unamortized lease balance, which was approximately $33 million as of January 31, 2002. We may need to incur additional debt to the extent we are required to satisfy this obligation prior to the lease term. CROSS ACCELERATION/CROSS DEFAULT PROVISIONS The agreements governing the sale-leaseback transaction, the receivables purchase agreement governing the securitization of accounts receivable and the indenture governing the LYONs provide generally that an event of default under such agreements would result (i) if we fail to pay any obligation in respect of debt in excess of $100 million in the aggregate when such obligation becomes due and payable or (ii) if any such debt is declared to be due and payable prior to its stated maturity. The amended credit facilities provide generally that an event of default under such agreements would result (i) if we fail to pay any obligation in respect of any debt in excess of $100 million in the aggregate when such obligation becomes due and payable or (ii) if any event occurs or condition exists that would result in the acceleration, or permit the acceleration, of the maturity of such debt prior to the stated term. CONDITIONAL REPURCHASE OBLIGATIONS We sell products to various distributors that may obtain financing from unaffiliated third party lending institutions. In the event the lending institution repossesses the distributor's inventory of our products, we are obligated to repurchase such inventory from the lending institution. The repurchase amount is equal to the price originally paid to us by the lending institution for our inventory. Our obligation to repurchase inventory from the lending institution terminates 180 days from our date of invoicing to the distributor. During the three months ended December 31, 2001, there were no repurchases made by us under such agreements. There can be no assurance that we will not be obligated to repurchase inventory under these arrangements in the future. FUTURE CASH NEEDS Our primary future cash needs on a recurring basis will be to fund working capital, capital expenditures and debt service. We believe that our cash flows from operations will be sufficient to meet these needs. In addition, funding our business restructuring and related expenses has required, and is expected to continue to require, significant amounts of cash. We expect to fund our business restructuring and related charges through a combination of debt and internally generated funds. If we do not generate sufficient cash from operations, we may need to incur additional debt. We currently anticipate making additional cash payments of approximately $159 million in the remaining portion of fiscal 2002 related to our business restructuring. These cash payments are planned to be composed of $84 million for employee separation costs, $36 million for lease obligations, $4 million for other exit costs and $35 million for incremental period costs, including computer transition expenditures, relocation and consolidation costs. In order to meet our cash needs, we may from time to time, borrow under our revolving credit facilities or issue other long or short-term debt, if the market permits such borrowings. We cannot assure you that any such financings will be available to us on acceptable terms or at all. Our ability to make payments on and to refinance our indebtedness, and to fund working capital, capital expenditures, strategic acquisitions, and our business restructuring will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our credit facilities and the indenture governing the LYONs impose and any future indebtedness may impose, various restrictions and covenants which could limit our ability to respond to market conditions, to provide for unanticipated capital investments or to take advantage of business opportunities. As a result of the recent downgrades of our long-term debt ratings, borrowings under credit facilities, and other short-term or long-term debt we may issue to repay our remaining commercial paper obligations will likely be made available to us at a higher interest rate than our commercial paper and cause a decrease in our profitability. 39 ENVIRONMENTAL, HEALTH AND SAFETY MATTERS We are subject to a wide range of governmental requirements relating to employee safety and health and to the handling and emission into the environment of various substances used in our operations. We are subject to certain provisions of environmental laws, particularly in the U.S., governing the cleanup of soil and groundwater contamination. Such provisions impose liability for the costs of investigating and remediating releases of hazardous materials at currently or formerly owned or operated sites. In certain circumstances, this liability may also include the cost of cleaning up historical contamination, whether or not caused by us. We are currently conducting investigation and/or cleanup of known contamination at approximately five of our facilities either voluntarily or pursuant to government directives. It is often difficult to estimate the future impact of environmental matters, including potential liabilities. We have established financial reserves to cover environmental liabilities where they are probable and reasonably estimable. Reserves for estimated losses from environmental matters are, depending on the site, based primarily upon internal or third party environmental studies and the extent of contamination and the type of required cleanup. Although we believe that our reserves are adequate to cover known environmental liabilities, there can be no assurance that the actual amount of environmental liabilities will not exceed the amount of reserves for such matters or will not have a material adverse effect on our financial position, results of operations or cash flows. LEGAL PROCEEDINGS From time to time we are involved in legal proceedings arising in the ordinary course of business. Other than as described below, we believe there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on our financial position, results of operations or cash flows. YEAR 2000 ACTIONS Three separate purported class action lawsuits are pending against Lucent, one in state court in West Virginia, one in federal court in the Southern District of New York and another in federal court in the Southern District of California. The case in New York was filed in January 1999 and, after being dismissed, was refiled in September 2000. The case in West Virginia was filed in April 1999 and the case in California was filed in June 1999, and amended in 2000 to include Avaya as a defendant. We may also be named a party to the other actions and, in any event, have assumed the obligations of Lucent for all of these cases under the Contribution and Distribution Agreement. All three actions are based upon claims that Lucent sold products that were not Year 2000 compliant, meaning that the products were designed and developed without considering the possible impact of the change in the calendar from December 31, 1999 to January 1, 2000. The complaints allege that the sale of these products violated statutory consumer protection laws and constituted breaches of implied warranties. A class has not been certified in any of the three cases and, to the extent a class is certified in any of the cases, we expect that class to constitute those enterprises that purchased the products in question. The complaints seek, among other remedies, compensatory damages, punitive damages and counsel fees in amounts that have not yet been specified. Although we believe that the outcome of these actions will not adversely affect our financial position, results of operations or cash flows, if these cases are not resolved in a timely manner, they will require expenditure of significant legal costs related to their defense. COUPON PROGRAM CLASS ACTION In April 1998, a class action was filed against Lucent in state court in New Jersey, alleging that Lucent improperly administered a coupon program resulting from the settlement of a prior class action. The plaintiffs allege that Lucent improperly limited the redemption of the coupons from dealers by not 40 allowing them to be combined with other volume discount offers, thus limiting the market for the coupons. We have assumed the obligations of Lucent for these cases under the Contribution and Distribution Agreement. The complaint alleges breach of contract, fraud and other claims and the plaintiffs seek compensatory and consequential damages, interest and attorneys' fees. The parties have entered into a proposed settlement agreement, pending final approval by the court. LUCENT SECURITIES LITIGATION In November 2000, three purported class actions were filed against Lucent in the Federal District Court for the District of New Jersey alleging violations of the federal securities laws as a result of the facts disclosed in Lucent's announcement on November 21, 2000 that it had identified a revenue recognition issue affecting its financial results for the fourth quarter of fiscal 2000. The actions purport to be filed on behalf of purchasers of Lucent common stock during the period from October 10, 2000 (the date Lucent originally reported these financial results) through November 21, 2000. The above actions have been consolidated with other purported class actions filed against Lucent on behalf of its stockholders in January 2000 and are pending in the Federal District Court for the District of New Jersey. We understand that Lucent has filed a motion to dismiss the Fifth Consolidated Amended and Supplemental Class Action Complaint in the consolidated action. The plaintiffs allege that they were injured by reason of certain alleged false and misleading statements made by Lucent in violation of the federal securities laws. The consolidated cases were initially filed on behalf of stockholders of Lucent who bought Lucent common stock between October 26, 1999 and January 6, 2000, but the consolidated complaint was amended to include purported class members who purchased Lucent common stock up to November 21, 2000. A class has not yet been certified in the consolidated actions. The plaintiffs in all these stockholder class actions seek compensatory damages plus interest and attorneys' fees. Any liability incurred by Lucent in connection with these stockholder class action lawsuits may be deemed a shared contingent liability under the Contribution and Distribution Agreement and, as a result, we would be responsible for 10% of any such liability. All of these actions are in the early stages of litigation and an outcome cannot be predicted and, as a result, we cannot assure you that these cases will not have a material adverse effect on our financial position, results of operations or cash flows. LICENSING MEDIATION In March 2001, a third party licensor made formal demand for alleged royalty payments which it claims we owe as a result of a contract between the licensor and our predecessors, initially entered into in 1995, and renewed in 1997. The contract provides for mediation of disputes followed by binding arbitration if the mediation does not resolve the dispute. The licensor claims that we owe royalty payments for software integrated into certain of our products. The licensor also alleges that we have breached the governing contract by not honoring a right of first refusal related to development of fax software for next generation products. The licensor has demanded arbitration of this matter, which we expect to occur within the next several months. At this point, an outcome in the arbitration proceeding cannot be predicted and, as a result, there can be no assurance that this case will not have a material adverse effect on our financial position, results of operations or cash flows. REVERSE/FORWARD STOCK SPLIT COMPLAINTS In January 2002, a complaint was filed in the Court of Chancery of the State of Delaware against us seeking to enjoin us from effectuating a reverse stock split followed by a forward stock split described in our proxy statement for our 2002 Annual Meeting of Shareholders to be held on 41 February 26, 2002. At the annual meeting, we are seeking the approval of our shareholders of each of three alternative transactions: - a reverse 1-for-30 stock split followed immediately by a forward 30-for-1 stock split of our common stock; - a reverse 1-for-40 stock split followed immediately by a forward 40-for-1 stock split of our common stock; - a reverse 1-for-50 stock split followed immediately by a forward 50-for-1 stock split of our common stock. The complaint alleges, among other things, that the manner in which we plan to implement the transactions, as described in our proxy statement, violates certain aspects of Delaware law with regard to the treatment of fractional shares and that the description of the proposed transactions in the proxy statement is misleading to the extent it reflects such violations. The action purports to be a class action on behalf of all holders of less than 50 shares of our common stock. The plaintiff is seeking, among other things, damages as well as injunctive relief enjoining us from effecting the transactions and requiring us to make corrective, supplemental disclosure. Although the transactions will be submitted to our shareholders for approval at the annual meeting, this matter is in the early stages and we cannot provide assurance that this lawsuit will not impair our ability to implement any of the transactions upon obtaining such approval. EUROPEAN MONETARY UNIT ("EURO") In 1999, most member countries of the European Union established fixed conversion rates between their existing sovereign currencies and the European Union's new currency, the euro. This conversion permitted transactions to be conducted in either the euro or the participating countries' national currencies through December 31, 2001. In January 2002, the new currency was issued, and legacy currencies are currently being withdrawn from circulation. By February 28, 2002, all member countries are expected to have permanently withdrawn their national currencies as legal tender and replaced their currencies with euro notes and coins. As of December 31, 2001, all of the member countries of the European Union in which we conduct business have converted to the euro. The conversion has not had, and we do not expect it to have, a material adverse effect on our consolidated financial position, results of operations or cash flows. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. See Avaya's Annual Report filed on Form 10-K for the fiscal year ended September 30, 2001 (Item 7A). At December 31, 2001, there has been no material change in this information. 42 PART II ITEM 1. LEGAL PROCEEDINGS. See Note 12--"Commitments and Contingencies" to the unaudited interim consolidated financial statements. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits: EXHIBIT PAGE NUMBER DESCRIPTION NUMBER ---- ---------------------------------------- --- 10.1 Severance Agreement, dated as of September 1, 2001, between the Company and Donald K. Peterson. 10.2 Amendment No. 1, dated as of February 8, 2002, to the 364-Day Competitive Advance and Revolving Credit Agreement, dated as of August 28, 2001 among the Company, the lenders party to the Credit Agreement and Citibank, N.A., as Agent for such lenders.* 10.3 Amendment No. 2, dated as of February 8, 2002, to the Five-Year Competitive Advance and Revolving Credit Agreement, dated as of September 25, 2000 among the Company, the lenders party to the Credit Agreement and Citibank, N.A., as Agent for such lenders.* - ------------------------ * Incorporated by reference to the Current Report on Form 8-K filed by the Company on February 13, 2002. (b) Reports on Form 8-K: The following Current Report on Form 8-K was filed by us during the fiscal quarter ended December 31, 2001: 1. October 24, 2001--Item 5. Other Events--Avaya furnished (i) its computation of the Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Accretion for the nine month period ended June 30, 2001 and 2000, the fiscal years ended September 30, 2000, 1999, 1998 and 1997 and the nine month period ended September 30, 1996, and (ii) a press release disclosing the financial results for the quarter and fiscal year ended September 30, 2001. 43 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AVAYA INC. By: /s/ CHARLES D. PEIFFER ----------------------------------------- Charles D. Peiffer CONTROLLER (PRINCIPAL ACCOUNTING OFFICER)
February 14, 2002 44 EXHIBIT INDEX EXHIBIT PAGE NUMBER DESCRIPTION NUMBER ---- ---------------------------------------- --- 10.1 Severance Agreement, dated as of September 1, 2001, between the Company and Donald K. Peterson. 10.2 Amendment No. 1, dated as of February 8, 2002, to the 364-Day Competitive Advance and Revolving Credit Agreement, dated as of August 28, 2001 among the Company, the lenders party to the Credit Agreement and Citibank, N.A., as Agent for such lenders.* 10.3 Amendment No. 2, dated as of February 8, 2002, to the Five-Year Competitive Advance and Revolving Credit Agreement, dated as of September 25, 2000 among the Company, the lenders party to the Credit Agreement and Citibank, N.A., as Agent for such lenders.* - ------------------------ * Incorporated by reference to the Current Report on Form 8-K filed by the Company on February 13, 2002. EX-10.1 3 a2070662zex-10_1.txt EXHIBIT 10.1 Exhibit 10.1 SEVERANCE AGREEMENT THIS AGREEMENT is entered into as of the 1st day of September 2001 (the "Effective Date") by and between Avaya Inc., a Delaware corporation, and Donald K. Peterson (the "Executive"). W I T N E S S E T H WHEREAS, the Executive currently serves as a key employee of the Company (as defined in Section 1) and the Executive's services and knowledge are valuable to the Company in connection with the management of one or more of the Company's principal operating facilities, divisions, departments or subsidiaries; and WHEREAS, the Board (as defined in Section 1) has determined that it is in the best interests of the Company and its stockholders to secure the Executive's continued services and to ensure the Executive's continued dedication and objectivity in the event of any threat or occurrence of, or negotiation or other action that could lead to, or create the possibility of, a Change in Control (as defined in Section 1) of the Company, without concern as to whether the Executive might be hindered or distracted by personal uncertainties and risks created by any such possible Change in Control, and to encourage the Executive's full attention and dedication to the Company, the Board has authorized the Company to enter into this Agreement. NOW, THEREFORE, for and in consideration of the premises and the mutual covenants and agreements herein contained, the Company and the Executive hereby agree as follows: 1. DEFINITIONS. As used in this Agreement, the following terms shall have the respective meanings set forth below: (a) "Board" means the Board of Directors of the Company. (b) "Cause" means: (1) a material breach by the Executive of those duties and responsibilities of the Executive which do not differ in any material respect from the duties and responsibilities of the Executive during the 90-day period immediately prior to a Change in Control (other than as a result of incapacity due to physical or mental illness) which is demonstrably willful and deliberate on the Executive's part, which is committed in bad faith or without reasonable belief that such breach is in the best interests of the Company and which is not remedied in a reasonable period of time after receipt of written notice from the Company specifying such breach; (2) the commission by the Executive of a felony involving moral turpitude; -1- (3) the commission by the Executive of theft, fraud, breach of trust or any act of dishonesty involving the Company or its subsidiaries; or (4) the significant violation by the Executive of the Company's code of conduct or any statutory or common law duty of loyalty to the Company or its subsidiaries. (c) "Change in Control" means: (1) an acquisition by any individual, entity or group (within the meaning of Section 13 (d)(3) or 14 (d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), (an "Entity") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of either (A) the then outstanding shares of common stock of the Company (the "Outstanding Company Common Stock") or (B) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); excluding, however, the following: (1) any acquisition directly from the Company, other than an acquisition by virtue of the exercise of a conversion privilege unless the security so being converted was itself acquired directly from the Company, (2) any acquisition by the Company, (3) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company, or (4) any acquisition by any corporation pursuant to a transaction which complies with clauses (A), (B) and (C) of subsection (3) of this Section 1(c); or (2) a change in the composition of the Board such that the individuals who, as of the Effective Date, constitute the Board (such Board shall be hereinafter referred to as the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; PROVIDED, HOWEVER, that for purposes of this definition, that any individual who becomes a member of the Board subsequent to the Effective Date, whose election, or nomination for election by the Company's stockholders, was approved by a vote of at least a majority of those individuals who are members of the Board and who were also members of the Incumbent Board (or deemed to be such pursuant to this proviso) shall be considered as though such individual were a member of the Incumbent Board; and PROVIDED, FURTHER HOWEVER, that any such individual whose initial assumption of office occurs as a result of or in connection with either an actual or threatened solicitation by an Entity other than the Board for the purpose of opposing a solicitation by any other Entity with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of an Entity other than the Board shall not be so considered as a member of the Incumbent Board; or (3) the approval by the stockholders of the Company of a merger, reorganization or consolidation or sale or other disposition of all or substantially all of the assets of the Company (each, a "Corporate Transaction") or, if consummation of such Corporate Transaction is subject, at the time of such approval by stockholders, to the consent of any government or governmental agency, the obtaining of such consent (either explicitly or implicitly by consummation); excluding however, such a Corporate -2- Transaction pursuant to which (A) all or substantially all of the individuals and entities who are beneficial owners, respectively, of the Outstanding Company Stock and Outstanding Company Voting Securities immediately prior to such Corporate Transaction will beneficially own, directly or indirectly, more than 60% of, respectively, the outstanding shares of common stock, and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Corporate Transaction (including, without limitation, a corporation or other individual, partnership, association, joint-stock company, trust, unincorporated organization, limited liability company, other entity or government or political subdivision which as a result of such transaction owns the Company or all or substantially all of the Company's assets either directly or through one or more subsidiaries (a "Parent Company")) in substantially the same proportions as their ownership, immediately prior to such Corporate Transaction, of the Outstanding Company Common Stock and Outstanding Company Voting Securities, as the case may be, (B) no Entity (other than the Company, any employee benefit plan (or related trust) of the Company, such corporation resulting from such Corporate Transaction or, if reference was made to equity ownership of any Parent Company for purposes of determining whether clause (A) above is satisfied in connection with the applicable Corporate Transaction, such Parent Company) will beneficially own, directly or indirectly, 20% or more of, respectively, the outstanding shares of common stock of the corporation resulting from such Corporate Transaction or the combined voting power of the outstanding voting securities of such corporation entitled to vote generally in the election of the directors unless such ownership resulted solely from ownership of securities of the Company prior to the Corporate Transaction, and (C) individuals who were members of the Incumbent Board will immediately after the consummation of the Corporate Transaction constitute at least a majority of the members of the board of directors of the corporation resulting from such Corporate Transaction (or, if reference was made to equity ownership of any Parent Company for purposes of determining whether clause (A) above is satisfied in connection with the applicable Corporate Transaction, of the Parent Company); or (4) the approval by the stockholders of the Company of a complete liquidation or dissolution of the Company. (d) "Company" means Avaya Inc., a Delaware corporation. (e) "Date of Termination" means: (1) the effective date on which the Executive's employment by the Company terminates as specified in a prior written notice by the Company or the Executive, as the case may be, to the other, delivered pursuant to Section 11 or (2) if the Executive's employment by the Company terminates by reason of death, the date of death of the Executive. (f) "Entity" has the meaning set forth in Section 1(c)(1). -3- (g) "Good Reason" means, without the Executive's express written consent, the occurrence of any of the following events after a Change in Control: (1) any of (i) the assignment to the Executive of any duties inconsistent in any material respect with the Executive's duties or responsibilities with the Company immediately prior to such Change in Control, (ii) any material reduction in the Executive's duties or responsibilities with the Company immediately prior to such Change in Control; (iii) a change in the Executive's titles or offices with the Company as in effect immediately prior to such Change in Control which is adverse to the Executive or (iv) any removal or involuntary termination of the Executive from the Company otherwise than as expressly permitted by this Agreement; (2) a reduction by the Company in the Executive's rate of annual base salary or Target Percentage as in effect immediately prior to such Change in Control (or if a different short-term incentive compensation opportunity is then in effect, a reduction in the amount of such different short-term incentive compensation opportunity below the short-term incentive compensation opportunity which had been afforded by the Target Percentage as in effect immediately prior to such Change in Control) or as the same may be increased from time to time thereafter; (3) any requirement of the Company that the Executive be based more than 30 miles from the facility where the Executive is located at the time of the Change in Control; (4) the failure of the Company to continue in effect any incentive compensation plan or supplemental retirement plan, including the Supplemental Pension Plan, in which the Executive is participating immediately prior to such Change in Control, unless the Executive is permitted to participate in other plans providing the Executive with substantially comparable compensation opportunity and benefits, or the taking of any action by the Company which would adversely affect the Executive's participation in or materially reduce the Executive's compensation opportunity and benefits under any such plan; or (5) the failure of the Company to obtain the assumption agreement from any successor as contemplated in Section 10(b). For purposes of this Agreement, any good faith determination of Good Reason made by the Executive shall be conclusive; PROVIDED, HOWEVER, that an isolated, insubstantial and inadvertent action taken in good faith and which is remedied by the Company promptly after receipt of written notice thereof given by the Executive shall not constitute Good Reason. (h) "Nonqualifying Termination" means a termination of the Executive's employment: (1) by the Company for Cause, (2) by the Executive for any reason other than Good Reason, -4- (3) by the Executive for Good Reason more than six (6) months after the event constituting Good Reason, (4) as a result of the Executive's death or (5) by the Company under circumstances where the Executive qualifies for benefits under a long-term disability pay plan. (i) "Potential Change in Control," for purposes of this Plan, shall mean the happening of any of the following events: (1) the commencement of a tender or exchange offer by any third person which, if consummated, would result in a Change in Control; (2) the execution of an agreement by the Company, the consummation of which would result in the occurrence of a Change in Control; (3) the public announcement by any person (including the Company) of an intention to take or to consider taking actions which if consummated would constitute a Change in Control other than through a contested election for directors of the Company; or (4) the adoption by the Board, as a result of other circumstances, including, without limitation, circumstances similar or related to the foregoing, of a resolution to the effect that a Potential Change in Control has occurred. A Potential Change in Control shall be deemed to be pending until the earliest of (i) the first anniversary thereof, (ii) the occurrence of a Change in Control and (iii) the occurrence of a subsequent Potential Change in Control. (j) "Supplemental Pension Plan" means the Avaya Inc. Supplemental Pension Plan or any successor plan. (k) "Target Percentage" means the annualized percentage applied to an Executive's annual base salary in order to calculate the target award for such Executive under the Company's short-term incentive compensation program, prior to the application of Company or individual performance factors. (l) "Termination Period" means the period of time beginning with a Change in Control and ending on the earlier to occur of: (1) two years following such Change in Control and (2) the Executive's death. 2. OBLIGATIONS OF THE EXECUTIVE. The Executive agrees that in the event of a Potential Change in Control, he shall not voluntarily leave the employ of the Company without Good Reason prior to the termination of such Potential Change in Control as follows: -5- (a) if the Potential Change in Control terminates by reason other than the occurrence of a Change in Control, until the earlier of (1) the first anniversary of such Potential Change in Control and (2) the occurrence of a subsequent Potential Change in Control; and (b) if the Potential Change in Control terminates by reason of the occurrence of a Change in Control, until 90 days following such Change in Control. For purposes of clause (a) of the preceding sentence, Good Reason shall be determined as if a Change in Control had occurred when such Potential Change in Control became known to the Board. 3. PAYMENTS UPON TERMINATION OF EMPLOYMENT. (a) If during the Termination Period the employment of the Executive shall terminate, other than by reason of a Nonqualifying Termination, then the Company shall pay to the Executive, within 30 days following the Date of Termination, as compensation for services rendered to the Company: (1) a cash amount equal to the sum of (i) the Executive's full annual base salary from the Company and its affiliated companies through the Date of Termination and any short-term incentive compensation earned by the Executive for any performance period ending prior to the Date of Termination, in each case to the extent not theretofore paid, (ii) an amount equal to the Executive's annual base salary multiplied by the Executive's Target Percentage applicable immediately prior to the Date of Termination (or, if greater, immediately prior to the Change in Control), multiplied by 50%, multiplied by a fraction, the numerator of which is the number of days elapsed in the applicable six-month performance period in which the Date of Termination occurs through the Date of Termination and the denominator of which is 180 (or if a different short-term incentive compensation opportunity is then in effect, an amount equal to the target short-term incentive compensation afforded by such different short-term incentive compensation opportunity for the applicable performance period in which the Date of Termination occurs (but not less than the amount that would have been afforded by the Target Percentage as in effect immediately prior to such Change in Control), multiplied by a fraction, the numerator of which is the number of days elapsed in the applicable performance period in which the Date of Termination occurs through the Date of Termination and the denominator of which is the total number of days in such applicable performance period) and (iii) any compensation previously deferred by the Executive (together with any interest and earnings thereon) and any accrued vacation pay, in each case to the extent not theretofore paid; plus (2) a lump-sum cash amount (subject to any applicable payroll or other taxes required to be withheld pursuant to Section 5) in an amount equal to (i) three (3) times the Executive's highest annual base salary from the Company and its affiliated companies in effect during the 12-month period prior to the Date of Termination, plus (ii) an amount equal to the product of three (3) times such annual base salary multiplied by the Executive's Target Percentage as applicable immediately prior to the Date of Termination (or, if greater, immediately prior to the Change in -6- Control) (or if a different short-term incentive compensation opportunity is then in effect, an amount equal to the product of [ ] ( )] times the annual target short-term incentive compensation afforded by such different short-term incentive compensation opportunity, but not less than [ ] ( )] times the amount that would have been afforded by the Target Percentage as in effect immediately prior to such Change in Control); PROVIDED, HOWEVER, that any amount paid pursuant to this Section 3(a)(2) shall be paid in lieu of any other amount of severance relating to salary, short-term incentive compensation or other bonus continuation to be received by the Executive upon termination of employment of the Executive under any severance plan, policy or arrangement of the Company. Notwithstanding the foregoing, if the Company is obligated by law or contract to pay severance pay, notice pay or other similar benefits, or if the Company is obligated by law or by contract to provide advance notice of separation ("Notice Period"), then the payments made pursuant to this Section 3(a)(2) shall be reduced by the amount of any such severance, notice pay or other similar benefits, as applicable, and by the amount of any severance pay, notice pay or other similar benefits received during any Notice Period. (b) In addition to the payments to be made pursuant to Section 3(a), the Company shall pay to the Executive at the time the payments pursuant to Section 3(a) shall be made, a lump-sum cash amount equal to the actuarial equivalent of the excess of (i) the Executive's accrued benefits under any qualified defined benefit pension plan and any nonqualified supplemental defined benefit pension plan of the Company in which the Executive is a participant, calculated by increasing the Executive's age and service credit under such plans as of the Date of Termination by three (3) year(s) over (ii) the Executive's accrued benefits under such plans as of the Date of Termination. Such lump sum cash amount shall be computed using the same actuarial methods and assumptions then in use for purposes of computing benefits under such plans, provided that the interest rate used in making such computation shall not be greater than the interest rate permitted under Section 417(e) of the Internal Revenue Code of 1986, as amended (the "Code"), on the Date of Termination. (c) For a period of three (3) years commencing on the Date of Termination, the Company shall continue to keep in full force and effect all policies of medical and life insurance with respect to the Executive and his dependents with the same level of coverage, upon the same terms and otherwise to the same extent as such policies shall have been in effect immediately prior to the Date of Termination or as provided generally with respect to other peer executives of the Company and its affiliated companies, and the Company and the Executive shall share the costs of the continuation of such insurance coverage in the same proportion as such costs were shared immediately prior to the Date of Termination; PROVIDED, HOWEVER, that the medical and life insurance coverage provided pursuant to this Section 3(c) shall be in lieu of any other medical and life insurance coverage to which the Executive is entitled under any plan, policy or arrangement of the Company or any law obligating the Company to provide such insurance coverage upon termination of employment of the Executive. (d) If during the Termination Period the employment of the Executive shall terminate by reason of a Nonqualifying Termination, then the Company shall pay to the Executive, within 30 days following the Date of Termination, a cash amount equal to the sum of: -7- (1) the Executive's full annual base salary from the Company through the Date of Termination, to the extent not theretofore paid, and (2) any compensation previously deferred by the Executive (together with any interest and earnings thereon) and any accrued vacation pay, in each case to the extent not theretofore paid. 4. CERTAIN ADDITIONAL PAYMENTS BY THE COMPANY. (a) Anything in this Agreement to the contrary notwithstanding, in the event it shall be determined that any payment or distribution by the Company or its affiliated companies to or for the benefit of the Executive (whether paid or payable or distributed or distributable pursuant to the terms of this Agreement or otherwise, including, without limitation, as a result of the acceleration of the vesting of stock options, restricted stock units or other equity awards, but determined without regard to any additional payments required under this Section 4) (a "Payment") would be subject to the excise tax imposed by Section 4999 of the Code, or any interest or penalties are incurred by the Executive with respect to such excise tax (such excise tax, together with any such interest and penalties, are hereinafter collectively referred to as the "Excise Tax"), then the Executive shall be entitled to receive an additional payment (a "Gross-Up Payment") in an amount such that after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including, without limitation, any income and employment taxes (and any interest and penalties imposed with respect thereto) and the Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments; PROVIDED, HOWEVER, that the Executive shall be entitled to receive a Gross-Up Payment only if the amount of the "parachute payment" (as defined in Section 280G(b)(2) of the Code) exceeds the sum of (A) $50,000 plus (B) 2.99 times the Executive's "base amount" (as defined in Section 280G(b)(3) of the Code), and PROVIDED FURTHER, that if the Executive is not entitled to receive a Gross-Up Payment, the Executive shall be entitled to receive only such amounts under Sections 3(a)(2), 3(b) and 3(c) of this Agreement that would not include any "excess parachute payment" (as defined in Section 280G(b)(1) of the Code). The intent of the parties is that the Company shall be solely responsible for, and shall pay, any Excise Tax on any Payment and Gross-Up Payment and any income and employment taxes (including, without limitation, penalties and interest) imposed on any Gross-Up Payment, as well as bearing any loss of tax deduction caused by the Gross-Up Payment. (b) Subject to the provisions of Section 4(c), all determinations required to be made under this Section 4, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by the Company's public accounting firm (the "Accounting Firm") which shall provide detailed supporting calculations both to the Company and the Executive within 15 business days of the receipt of notice from the Executive that there has been a Payment, or such earlier time as is requested by the Company. All fees and expenses of the Accounting Firm shall be borne solely by the Company. Any Gross-Up Payment, as determined pursuant to this Section 4, shall be paid by the Company to the Executive within five (5) days of the receipt of the Accounting Firm's determination. If the Accounting Firm determines that no Excise Tax is payable by the Executive, it shall furnish the Executive with a written opinion that -8- failure to report the Excise Tax on the Executive's applicable federal income tax return would not result in the imposition of a negligence or similar penalty. The Accounting Firm shall make all determinations under the tax standard of "substantial authority" as such term is used in Section 6662 of the Code. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments which will not have been made by the Company should have been made ("Underpayment"), consistent with the calculations required to be made hereunder. In the event that the Company exhausts its remedies pursuant to Section 4(c) and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Company to or for the benefit of the Executive. (c) The Executive shall notify the Company in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Company of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than 10 business days after the Executive is informed in writing of such claim and shall apprise the Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which the Executive gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (1) give the Company any information reasonably requested by the Company relating to such claim, (2) take such action in connection with contesting such claim as the Company shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney reasonably selected by the Company, (3) cooperate with the Company in good faith in order effectively to contest such claim, and (4) permit the Company to participate in any proceedings relating to such claim; PROVIDED, HOWEVER, that the Company shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this Section 4(c), the Company shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or -9- contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine; PROVIDED FURTHER, that if the Company directs the Executive to pay such claim and sue for a refund, the Company shall advance the amount of such payment to the Executive on an interest-free basis and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax or income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance; and PROVIDED FURTHER, that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. (d) If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 4(c), the Executive becomes entitled to receive, and receives, any refund with respect to such claim, the Executive shall (subject to the Company's complying with the requirements of Section 4(c)) promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 4(c), a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 5. WITHHOLDING TAXES. The Company may withhold from all payments due to the Executive (or his beneficiary or estate) hereunder all taxes which, by applicable federal, state, local or other law, the Company is required to withhold therefrom. 6. REIMBURSEMENT OF EXPENSES. If any contest or dispute shall arise under this Agreement involving termination of the Executive's employment with the Company or involving the failure or refusal of the Company to perform fully in accordance with the terms hereof, the Company shall reimburse the Executive, on a current basis, for all reasonable legal fees and expenses, if any, incurred by the Executive in connection with such contest or dispute, together with interest thereon at a rate equal to the prime rate, as published under "Money Rates" in THE WALL STREET JOURNAL from time to time, but in no event higher than the maximum legal rate permissible under applicable law, such interest to accrue from the date the Company receives the Executive's statement for such fees and expenses through the date of payment thereof; PROVIDED, HOWEVER, that in the event the resolution of any such contest or dispute includes a finding denying, in total, the Executive's claims in such contest or dispute, the Executive shall be required to reimburse the Company, over a period of 12 months from the date of such resolution, for all sums advanced to the Executive pursuant to this Section 6. -10- 7. OPERATIVE EVENT. Notwithstanding any provision herein to the contrary, no amounts shall be payable hereunder unless and until there is a Change in Control at a time when the Executive is employed by the Company. 8. TERMINATION OF AGREEMENT. (a) This Agreement shall be effective on the Effective Date and shall expire on the second anniversary of the Effective Date, provided that the term of this Agreement shall be extended automatically for one additional year as of each annual anniversary of the Effective Date, commencing with the second anniversary of the Effective Date (each such date a "Renewal Date") unless this Agreement is terminated pursuant to Section 8(b) or, if earlier, upon the earlier to occur of (i) termination of the Executive's employment with the Company prior to a Change in Control and (ii) the Executive's death. Notwithstanding the foregoing, any expiration of this Agreement shall not retroactively impair or otherwise adversely affect the rights of the Executive which have arisen prior to the date of such expiration. (b) The Company shall have the right, in its sole discretion, pursuant to action by the Board, to approve the amendment or termination of this Agreement, which amendment or termination shall not become effective until the Renewal Date coincident with or next following the date of such action, or if later, the date fixed by the Board for such amendment or termination; provided, that an amendment which is not adverse to the interests of the Executive shall take effect immediately; and provided further, that in no event shall this Agreement be amended in a manner adverse to the interests of the Executive or be terminated during any period that a Potential Change in Control is pending or in the event of a Change in Control. 9. SCOPE OF AGREEMENT. Nothing in this Agreement shall be deemed to entitle the Executive to continued employment with the Company or its subsidiaries and, if the Executive's employment with the Company shall terminate prior to a Change in Control, then the Executive shall have no further rights under this Agreement; PROVIDED, HOWEVER, that any termination of the Executive's employment following a Change in Control shall be subject to all of the provisions of this Agreement. 10. SUCCESSORS; BINDING AGREEMENT. (a) This Agreement shall not be terminated by any merger or consolidation of the Company whereby the Company is or is not the surviving or resulting corporation or as a result of any transfer of all or substantially all of the assets of the Company. In the event of any such merger, consolidation or transfer of assets, the provisions of this Agreement shall be binding upon the surviving or resulting corporation or the person or entity to which such assets are transferred. (b) The Company agrees that concurrently with any merger, consolidation or transfer of assets referred to in Section 10(a), it will cause any successor or transferee unconditionally to assume, by written instrument delivered to the Executive (or the Executive's beneficiary or estate), all of the obligations of the Company hereunder. Failure of the Company to obtain such assumption prior to the effectiveness of any such merger, consolidation or transfer of assets shall be a breach of this Agreement and shall entitle the Executive to compensation and -11- other benefits from the Company in the same amount and on the same terms as the Executive would be entitled hereunder if the Executive's employment were terminated following a Change in Control other than by reason of a Nonqualifying Termination during the Termination Period. For purposes of implementing the foregoing, the date on which any such merger, consolidation or transfer becomes effective shall be deemed the Date of Termination. (c) This Agreement shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive shall die while any amounts would be payable to the Executive hereunder had the Executive continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to such person or persons appointed in writing by the Executive to receive such amounts or, if no person is so appointed, to the Executive's estate. 11. NOTICES. (a) For purposes of this Agreement, all notices and other communications required or permitted hereunder shall be in writing and shall be deemed to have been duly given when delivered or five (5) days after deposit in the United States mail, certified and return receipt requested, postage prepaid, addressed (1) if to the Executive, to the home address of the Executive on the most current Company records, and if to the Company, to Avaya Inc., attention Vice President, Human Resources with a copy to the Secretary of the Board, or (2) to such other address as either party may have furnished to the other in writing in accordance herewith, except that notices of change of address shall be effective only upon receipt. (b) A written notice of the Executive's Date of Termination by the Company or the Executive, as the case may be, to the other, shall (i) indicate the specific termination provision in this Agreement relied upon, (ii) to the extent applicable, set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive's employment under the provision so indicated and (iii) specify the termination date (which date shall be not less than fifteen (15) days after the giving of such notice). The failure by the Executive or the Company to set forth in such notice any fact or circumstance which contributes to a showing of Good Reason or Cause shall not waive any right of the Executive or the Company hereunder or preclude the Executive or the Company from asserting such fact or circumstance in enforcing the Executive's or the Company's rights hereunder. 12. FULL SETTLEMENT; RESOLUTION OF DISPUTES. (a) The Company's obligation to make any payments provided for in this Agreement and otherwise to perform its obligations hereunder shall not be affected by any set-off, counterclaim, recoupment, defense or other claim, right or action which the Company may have against the Executive or others. In no event shall the Executive be obligated to seek other employment or take any other action by way of mitigation of the amounts payable to the -12- Executive under any of the provisions of this Agreement and such amounts shall not be reduced whether or not the Executive obtains other employment. (b) If there shall be any dispute between the Company and the Executive in the event of any termination of the Executive's employment, then, unless and until there is a final, nonappealable judgment by a court of competent jurisdiction declaring that such termination was for Cause, that the determination by the Executive of the existence of Good Reason was not made in good faith, or that the Company is not otherwise obligated to pay any amount or provide any benefit to the Executive and his dependents or other beneficiaries, as the case may be, under Sections 3(a), 3(b) and 3(c), the Company shall pay all amounts, and provide all benefits, to the Executive and his dependents or other beneficiaries, as the case may be, that the Company would be required to pay or provide pursuant to Sections 3(a), 3(b) and 3(c) as though such termination were by the Company without Cause or by the Executive with Good Reason; PROVIDED, HOWEVER, that the Company shall not be required to pay any disputed amounts pursuant to this Section 12(b) except upon receipt of an undertaking by or on behalf of the Executive to repay all such amounts to which the Executive is ultimately adjudged by such court not to be entitled. 13. EMPLOYMENT WITH SUBSIDIARIES. Employment with the Company for purposes of this Agreement shall include employment with (i) any "subsidiary corporation" of the Company, as defined in Section 424(f) of the Code, (ii) an entity in which the Company directly or indirectly owns 50% or more of the voting interests or (iii) an entity in which the Company has a significant equity interest, as determined by the Board or by the Corporate Governance and Compensation Committee (or any successor committee) of the Board. 14. GOVERNING LAW; VALIDITY. The interpretation, construction and performance of this Agreement shall be governed by and construed and enforced in accordance with the internal laws of the State of Delaware without regard to the principle of conflicts of laws. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provisions of this Agreement, which other provisions shall remain in full force and effect. 15. COUNTERPARTS. This Agreement may be executed in two counterparts, each of which shall be deemed to be an original and both of which together shall constitute one and the same instrument. 16. MISCELLANEOUS. No provision of this Agreement may be modified or waived unless such modification or waiver is agreed to in writing and signed by the Executive and by a duly authorized officer of the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. Failure by the Executive or the Company to insist upon strict compliance with any provision of this Agreement or to assert any right the Executive or the Company may have hereunder, including, without limitation, the right of the Executive to terminate employment for Good Reason, shall not be deemed to be a waiver of such provision or right or any other provision or right of this Agreement. Except as otherwise expressly set forth in this Agreement, the rights of, and benefits -13- payable to, the Executive, his estate or his beneficiaries pursuant to this Agreement are in addition to any rights of, or benefits payable to, the Executive, his estate or his beneficiaries under any other employee benefit plan or compensation program of the Company. -14- IN WITNESS WHEREOF, the Company has caused this Agreement to be executed by a duly authorized officer of the Company and the Executive has executed this Agreement as of the day and year first above written. AVAYA INC. By: /s/ Michael J. Harrison ---------------------------- EXECUTIVE /s/ Donald K. Peterson ------------------------------ Donald K. Peterson -15- NOTE: The Company has also entered into Severance Agreements, each dated as of September 1, 2001, with each of the following executive officers: Garry K. McGuire, Sr. Chief Financial Officer and Senior Vice President, Operations Michael A. Dennis Group Vice President, Services David P. Johnson Senior Vice President, Sales and Marketing Karyn Mashima Senior Vice President, Strategy and Technology Such Severance Agreements are substantially identical to Mr. Peterson's in all material respects, except that the severance benefit for each above listed executive officer is two times the sum of their respective annual base salaries and target bonuses. In addition, these executive officers are entitled to continuation of medical and life insurance and a pension enhancement payment for a two-year period. -----END PRIVACY-ENHANCED MESSAGE-----