AGERE SYSTEMS INC - 10-Q Quarterly Report

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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON AUGUST 7, 2003
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 001-16397

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AGERE SYSTEMS INC.

A DELAWARE I.R.S. EMPLOYER
CORPORATION NO. 22-3746606

1110 AMERICAN PARKWAY NE, ALLENTOWN, PA 18109

Telephone number: 610-712-1000

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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

As of July 31, 2003, 773,837,747 shares of Class A common stock and
907,994,888 shares of Class B common stock were outstanding.

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AGERE SYSTEMS INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
TABLE OF CONTENTS

1

PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

2

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

3

AGERE SYSTEMS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)

See Notes to Condensed Consolidated Financial Statements.

4

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

1. BACKGROUND AND BASIS OF PRESENTATION

BACKGROUND

Agere Systems Inc. (the 'Company' or 'Agere') was incorporated in Delaware
as a wholly owned subsidiary of Lucent Technologies Inc. ('Lucent') on
August 1, 2000. On February 1, 2001, Lucent transferred to Agere substantially
all of the assets and liabilities related to the Company's business (the
'Separation'). On April 2, 2001, the Company completed the initial public
offering of its Class A common stock, while Lucent retained all of the Company's
outstanding Class B common stock. On June 1, 2002, Lucent distributed all of the
Agere common stock it then owned to its stockholders (the 'Distribution'). Prior
to the Distribution, Agere was a majority-owned subsidiary and a related party
of Lucent. Revenue from products sold to Lucent prior to the Distribution was
$19 and $162 for the three and nine months ended June 30, 2002, respectively, of
which $6 and $43, respectively, is recorded within income (loss) from operations
of discontinued business.

Effective with the first quarter of fiscal 2003, the Company refined its
methodology for allocating shared information technology expenses to its
operating segments and between costs, selling, general and administrative
expenses, and research and development expenses. The Company believes that this
methodology provides a better assignment of these expenses based on additional
information about the components and underlying drivers which has been developed
since the Separation. Historical amounts for all periods presented have been
conformed to the current presentation. As a result of this change, approximately
$16 and $54 of expenses previously reflected in costs were reclassified to
operating expenses for the three and nine months ended June 30, 2002,
respectively.

INTERIM FINANCIAL INFORMATION

These condensed financial statements have been prepared in accordance with
the rules of the Securities and Exchange Commission for interim financial
statements and do not include all annual disclosures required by accounting
principles generally accepted in the United States ('U.S.'). These financial
statements should be read in conjunction with the audited consolidated and
combined financial statements and notes thereto included in the Company's
Form 10-K for the fiscal year ended September 30, 2002. The condensed financial
information as of June 30, 2003 and for the three and nine months ended
June 30, 2003 and 2002 is unaudited, but includes all adjustments that
management considers necessary for a fair presentation of the Company's
consolidated results of operations, financial position and cash flows. Results
for the three and nine months ended June 30, 2003 are not necessarily indicative
of results to be expected for the full fiscal year 2003 or any other future
periods.

2. DISCONTINUED OPERATIONS

On August 14, 2002, the Company announced plans to exit its optoelectronic
components business. The Company had historically reported this business as part
of its Infrastructure Systems segment. The condensed consolidated financial
statements have been reclassified for all periods presented to reflect this
business as discontinued operations. The Company first reflected this business
as discontinued operations in the first quarter of fiscal 2003 when the Company
entered into an agreement to sell a substantial portion of the business and
determined it could sell the remainder of the business. The revenues, costs and
expenses directly associated with this business have been reclassified as
discontinued operations on the condensed consolidated statements of operations.
Corporate expenses such as general corporate overhead and interest have not been
allocated to discontinued operations. Revenue recorded within income (loss) from
operations of discontinued business was $62 for the three months ended June 30,
2002, and $61 and $216 for the nine months ended June 30, 2003 and 2002,
respectively. There was no revenue recorded within income (loss) from operations
of discontinued business for the three months ended June 30, 2003. Income (loss)
from operations of discontinued business before income taxes was $(142) for the
three months ended June 30, 2002, and $19 and $(479) for the nine months

5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

ended June 30, 2003 and 2002, respectively. There was no income (loss) from
operations of discontinued business before income taxes for the three months
ended June 30, 2003.

During the second quarter of fiscal 2003, the Company sold a substantial
portion of its optoelectronic components business to TriQuint Semiconductor,
Inc. ('TriQuint') for $40 in cash. This transaction included the products,
product warranty liabilities, technology and certain facilities related to this
business; and included lasers, detectors, modulators, passive components,
arrayed waveguide-based components, amplifiers, transmitters, receivers,
transceivers, transponders, and micro electro-mechanical systems. As part of the
sale, the Company's facilities in Breinigsville, Pennsylvania and Matamoros,
Mexico were transferred and approximately 340 of the Company's employees joined
TriQuint. During the three months ended June 30, 2003, the Company recognized a
loss of $11 related to the sale of this business as the Company finalized
adjustments related to obligations it incurred as a result of the decision to
sell the business. For the nine months ended June 30, 2003, a net gain of $11 is
included in gain (loss) on disposal of discontinued business.

During the second quarter of fiscal 2003, the Company sold the remainder of
its optoelectronic components business, which provided cable television
transmission systems, telecom access and satellite communications components, to
EMCORE Corporation ('EMCORE') for $25 in cash. The transaction included the
assets, products, product warranty liabilities, technology and intellectual
property related to this business. As part of the sale, approximately 210 of the
Company's employees joined EMCORE. The Company recognized a net gain of $19 from
the sale which is included in gain (loss) on disposal of discontinued business
in the nine months ended June 30, 2003.

3. CUMULATIVE EFFECT OF ACCOUNTING CHANGE

Effective October 1, 2002, the Company adopted Statement of Financial
Accounting Standards ('SFAS') No. 143, 'Accounting for Asset Retirement
Obligations' ('SFAS 143'). This standard provides the financial accounting and
reporting requirements for the cost of legal obligations associated with the
retirement of tangible long-lived assets. SFAS 143 requires the Company to
record asset retirement obligations at fair value. The obligation is recorded as
a liability and the associated cost is capitalized as part of the related
long-lived asset and then depreciated over its remaining useful life. Changes in
the liability resulting from the passage of time are recognized as operating
expense. The adoption of SFAS 143 as of October 1, 2002 resulted in capitalizing
a net long-lived asset of $2, related to the restoration of leased facilities,
recording an associated liability of $7 and a cumulative loss of $5. The
cumulative loss represents the depreciation and other operating expenses that
would have been recorded previously if SFAS 143 had been in effect in prior
years. There were no income taxes provided due to the recording of a full
valuation allowance against U.S. net deferred tax assets. The pro forma effect
of retroactive application of SFAS 143 for the three and nine months ended June
30, 2002 would not change the net loss and loss per share, as reported.

4. RESTRUCTURING AND OTHER CHARGES -- NET

The Company has implemented restructuring and consolidation actions to
improve gross profit, reduce expenses and streamline operations. These actions
include workforce reductions, rationalization and consolidation of manufacturing
capacity, and the exit of the optoelectronic components business. Charges and
credits related to continuing operations are included in restructuring and other
charges -- net, while charges and credits related to discontinued operations are
included in income (loss) from operations of discontinued business. The
restructuring actions associated with discontinued operations remain an
obligation of the Company and are reflected in the restructuring reserve.

The Company also incurred expenses of $2 and $7 for the three and nine
months ended June 30, 2002, respectively, relating to its separation from Lucent
that are classified within restructuring and other charges -- net. There were no
expenses related to the separation from Lucent in the three and nine months
ended June 30, 2003.

6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

THREE AND NINE MONTHS ENDED JUNE 30, 2003

The following tables set forth the Company's restructuring reserves as of
June 30, 2003 and reflect the activity affecting the reserve for the three and
nine months ended June 30, 2003:

Workforce Reductions

The Company recorded restructuring charges of $13 and $60 relating to
workforce reductions for the three and nine months ended June 30, 2003,
respectively. The charges for the three months ended June 30, 2003 are non-cash
charges and consist of $10 for curtailment charges relating to the Company's
qualified management pension plan, as management employees became eligible to
receive retiree benefits sooner than actuarially anticipated, and $3 for
additional special pension benefits due to wage increases as a result of a new
collective bargaining agreement for the Company's U.S. represented employees.
The charges for the nine months ended June 30, 2003 also include $22 of cash
charges, principally related to a workforce reduction of approximately 330
management employees, and $25 of non-cash charges. The non-cash charges include
$12 for special pension benefits to certain U.S. employees, as well as $6 and $7
for curtailment charges relating to the Company's qualified occupational pension
plan and postretirement medical liability, respectively, as represented
employees at the Company's Orlando, Florida manufacturing facility became
eligible to receive retiree benefits sooner than actuarially anticipated. The
special pension benefits will be paid from the pension plan assets.

The Company recorded restructuring credits relating to workforce reductions
of $10 and $24 for the three and nine months ended June 30, 2003, respectively.
The credits for the three months ended

7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

June 30, 2003 are non-cash postemployment benefit adjustments principally
associated with the closing of international facilities. The credits for the
nine months ended June 30, 2003 also include $14, principally due to the
reversal of charges associated with the employees that joined TriQuint and
EMCORE, of which $7 are non-cash credits due to a decrease in special pension
benefits.

As previously announced on August 14, 2002, the Company expects to reduce
its active workforce by a total of approximately 4,000 employees by the end of
December 2003 as part of its plan to exit the optoelectronic components business
and consolidate U.S. manufacturing operations into its Orlando facility. As of
June 30, 2003, all severance and special pension benefit costs associated with
completing this workforce reduction have been recognized and approximately 200
employees remain to be taken off-roll.

Rationalization of Manufacturing Capacity and Other Charges

The Company recorded restructuring and related charges of $3 and $94 for the
three and nine months ended June 30, 2003, respectively, relating to the
rationalization of under-utilized manufacturing facilities, the exit of the
optoelectronic components business and other restructuring-related activities.
The charges for the three months ended June 30, 2003 include $1 for increased
depreciation and $2 for other related costs. The charges for the nine months
ended June 30, 2003 also include $40 for asset impairments, including $11
associated with the resizing of Orlando's research and development and
manufacturing operations; $17 for facility lease terminations, including
non-cancelable facility leases; $14 for increased depreciation; $7 for contract
terminations; and $13 for other related costs. Increased depreciation was
recognized due to a change in accounting estimate as a result of shortening the
estimated useful lives of certain assets in connection with the planned closing
of certain administrative facilities. The other related costs were incurred
primarily to implement the restructuring initiatives and include costs for the
relocation and training of employees and for the relocation of equipment.

The Company recorded restructuring and related credits of $41 for the nine
months ended June 30, 2003, which consist of $17 for a reversal of reserves
associated with the resizing of the research and development and manufacturing
operations in Orlando, including $13 for operating lease terminations and $4
related to asset decommissioning; $12 for asset impairment adjustments due to
realizing more proceeds than expected from asset dispositions; $4 for the
reversal of a facility lease termination reserve associated with a facility in
Mexico that was transferred to TriQuint; and $8 principally for the reversal of
reserves associated with actions deemed no longer necessary.

Restructuring Reserve Balances as of June 30, 2003

The Company anticipates that substantially all of the $9 restructuring
reserve as of June 30, 2003 relating to workforce reductions will be paid by
December 31, 2003. The Company also anticipates that the restructuring reserve
of $53 relating to the rationalization of manufacturing capacity and other
charges as of June 30, 2003 will be paid as follows: slightly more than
one-third of the contract terminations of $13 will be paid by September 30,
2003, with the remainder being paid $1 per quarter thereafter; facility lease
terminations of $25 will be paid over the respective lease terms through 2010;
and the majority of the facility restoration costs and other costs of $15 will
be paid by September 30, 2003. The Company expects to fund these cash payments
with cash on hand.

8

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

THREE AND NINE MONTHS ENDED JUNE 30, 2002

The following tables set forth the Company's restructuring reserves as of
June 30, 2002 and reflect the activity affecting the reserve for the three and
nine months ended June 30, 2002:

Workforce Reductions

The Company recorded restructuring charges of $88 and $144 relating to a
workforce reduction of approximately 790 and 1,990 employees for the three and
nine months ended June 30, 2002, respectively. These charges affected both
management and represented employees and spanned various business functions,
operating units and geographic regions. For the three and nine months ended
June 30, 2002, $9 and $42, respectively, represent cash charges, while $79 and
$102, respectively, represent non-cash charges for special pension benefits to
certain U. S. employees.

The Company recorded restructuring credits of $20 for the nine months ended
June 30, 2002 relating to workforce reductions, which resulted from severance
and benefit cost termination estimates that exceeded amounts paid during the
second half of calendar year 2001. The original reserve included an estimate for
represented employees that was based on the average rate of pay and years of
service of the represented employee pool at risk. The Company's collective
bargaining agreements allowed for a period when employees at risk could opt for
positions filled by employees with less seniority. When that period ended, a
series of personnel moves followed that ultimately resulted in lower payments
than originally expected. This was due principally to the termination of
represented employees with fewer years of service and fewer weeks of severance
entitlement. These personnel moves were substantially finished at the end of
calendar 2001.

9

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

Rationalization of Manufacturing Capacity and Other Charges

The Company recorded restructuring and related charges of $48 and $169 for
the three and nine months ended June 30, 2002, respectively, relating to the
rationalization of under-utilized manufacturing facilities and other
restructuring-related activities. The charges recorded for the three months
ended June 30, 2002 include $12 for asset impairments; $20 for facility
closings; $2 for increased depreciation; and $14 for other related costs. The
charges recognized for the nine months ended June 30, 2002 include $81 for asset
impairments; $60 for facility closings; $9 for contract terminations; $3 for
increased depreciation; and $16 for other related costs.

The asset impairment charges of $12 for the three months ended June 30, 2002
resulted from the abandonment of certain research and development assets. The
asset impairment charges of $81 for the nine months ended June 30, 2002 also
include $33 for the impairment of assets under construction that had not been
placed into service and $36 for the impairment of property, plant and equipment
associated with the consolidation of manufacturing and other corporate
facilities. These non-cash impairment charges represent the write-down to fair
value less costs to sell of property, plant and equipment that were disposed of,
held for sale, or removed from operations.

The facility closing charges of $20 for the three months ended June 30, 2002
consist of $10 for facility lease terminations and facility restoration costs
primarily associated with the consolidation of the Company's California
operations and $10 for facility restoration costs associated with the
consolidation of the Company's Pennsylvania and New Jersey facilities. The
facility closing charges of $60 for the nine months ended June 30, 2002 also
include a non-cash charge of $35 for the realization of the cumulative
translation adjustment resulting from the Company's decision to substantially
liquidate its investment in the legal entity associated with its Madrid, Spain
manufacturing operations and $5 primarily for lease terminations, non-cancelable
leases and related costs.

The Company recorded restructuring and related credits of $11 and $77 for
the three and nine months ended June 30, 2002, respectively. The $11 credit
during the three months ended June 30, 2002 resulted from adjustments to
estimates of $7 for asset impairments and $4 for facility lease terminations and
facility restoration. The asset impairment adjustments were due principally to
realizing more proceeds than expected from asset dispositions. The facility
lease and restoration credits resulted from favorable lease termination
negotiations and lower facility restoration costs than previously reserved. The
restructuring credits for the nine months ended June 30, 2002 also include
adjustments to estimates of $52 for asset impairments, of which $17 is due to
the redeployment of assets and $35 is due to receiving more proceeds than
originally anticipated from the sale of assets, including $25 from the sale of
assets associated with the Madrid, Spain facility. The $14 balance of the
credits for the nine months ended June 30, 2002 consists of $8 for contract
terminations and $6 for a reserve deemed no longer necessary.

5. DEBT

ACCOUNTS RECEIVABLE SECURITIZATION

Agere Systems Inc. and certain of its subsidiaries amended the accounts
receivable securitization agreement on November 12, 2002. Agere Systems Inc. and
certain of its subsidiaries irrevocably transfer accounts receivable on a daily
basis to a wholly-owned, fully consolidated, bankruptcy-remote subsidiary, Agere
Systems Receivables Funding LLC ('ASRF'). ASRF has entered into a loan agreement
with certain financial institutions, pursuant to which the financial
institutions agreed to make loans to ASRF secured by the accounts receivable.
The financial institutions have commitments under the loan agreement of up to
$200; however the amount the Company can actually borrow at any time depends on
the amount and nature of the accounts receivable that the Company has
transferred to ASRF. The loan agreement expires on November 11, 2003.

10

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

As of June 30, 2003, ASRF had borrowings of $146 outstanding under this
agreement. The majority of the Company's accounts receivable are required to be
pledged as security for the outstanding loans even though some of those
receivables may not qualify for borrowings. As of June 30, 2003, $224 of gross
receivables was pledged as security for the outstanding loans. The Company pays
interest on amounts borrowed under the agreement based on one-month LIBOR. The
weighted average annual interest rate on amounts borrowed as of June 30, 2003
was 1.3%. In addition, the Company pays an annual commitment fee, which varies
depending on its credit rating, on the $200 total loan commitment. As of June
30, 2003, the commitment fee was 1.5% per annum. If the Company's credit rating
were to decline one or two levels, the commitment fee would increase to 2% or 3%
per annum, respectively.

ASRF is a separate legal entity with its own separate creditors. Upon
liquidation of ASRF, its assets will be applied to satisfy the claims of its
creditors prior to any value in ASRF becoming available to the Company. The
business of ASRF is limited to the acquisition of receivables from Agere Systems
Inc. and certain of its subsidiaries and related activities.

COLLATERAL INSTALLMENT LOAN

On March 28, 2003, the Company borrowed $20 under an installment note with a
fixed interest rate of 9.45% that is secured by certain Company equipment. On
May 1, 2003, the Company began paying 24 monthly installments, with a $7 balloon
payment due at the end of this period. Assuming certain conditions are met, the
Company has the ability to refinance the balloon payment for an additional
twelve month period. As of June 30, 2003, $19 is outstanding under this
installment loan, of which the current portion is $7.

6. SUPPLEMENTARY FINANCIAL INFORMATION

STATEMENT OF OPERATIONS INFORMATION

The Company has recognized increased depreciation due to a change in
accounting estimate as a result of shortening the estimated useful lives of
certain assets in connection with the Company's restructuring activities. The
Company recorded increased depreciation of $23 and $78 for the three and nine
months ended June 30, 2003, respectively. Of these amounts $22 and $63 were
recorded in costs and $1 and $15 were recorded in restructuring and other
charges -- net for the three and nine months ended June 30, 2003, respectively.
The Company also recorded increased depreciation of $24 and $40 for the three
and nine months ended June 30, 2002, respectively. Of these amounts $11 and $19
were recorded in costs, $2 and $3 were recorded in restructuring and other
charges -- net, and $11 and $18 were recorded in discontinued operations for the
three and nine months ended June 30, 2002, respectively. This increased
depreciation is reflected in net loss and resulted in a $0.01 and $0.05 per
share increase in the net loss for the three and nine months ended June 30,
2003, respectively, and a $0.01 and $0.02 per share increase in the net loss for
the three and nine months ended June 30, 2002, respectively.

During the three months ended June 30, 2003, the Company recognized a $16
gain on the sale of certain assets and liabilities of the analog line card
business. This business was sold to Legerity, Inc. ('Legerity') on September 30,
2002 for $70 in cash. At the time of the sale, the Company was obligated to
supply integrated circuits to Legerity into fiscal 2003 and the gain on the sale
was deferred. During the three months ended June 30, 2003, the Company
substantially satisfied its obligations to Legerity and recognized a gain on the
sale of $16, which is reflected in (gain) loss on sale of operating assets --
net. In addition, during the nine months ended June 30, 2002, the Company
realized a $243 gain on the sale of its field-programmable gate array business,
which is reflected in (gain) loss on sale of operating assets -- net.

For the three months ended June 30, 2003, the Company recorded a provision
for income taxes of $8 on a pre-tax loss from continuing operations of $59,
yielding an effective tax rate of (12.5)% due

11

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

primarily to the provision for taxes in foreign jurisdictions. No benefit was
recognized for U.S. tax purposes as a full valuation allowance of $7 was
recorded against U.S. net deferred tax assets for the three months ended June
30, 2003. For the three months ended June 30, 2002, the Company recorded a
provision for income taxes of $16 on a pre-tax loss from continuing operations
of $174, yielding an effective tax rate of (8.9)% due primarily to the provision
for taxes in foreign jurisdictions. No benefit was recognized for U.S. tax
purposes as a full valuation allowance of $68 was recorded against U.S. net
deferred tax assets for the three months ended June 30, 2002.

For the nine months ended June 30, 2003, the Company recorded a provision
for income taxes of $62 on a pre-tax loss from continuing operations of $331,
yielding an effective tax rate of (18.7)% due primarily to the provision for
taxes in foreign jurisdictions. No benefit was recognized for U.S. tax purposes
as a full valuation allowance of $133 was recorded against U.S. net deferred tax
assets for the nine months ended June 30, 2003. For the nine months ended June
30, 2002, the Company recorded a provision for income taxes of $56 on a pre-tax
loss from continuing operations of $391, yielding an effective tax rate of
(14.3)% due primarily to the provision for taxes in foreign jurisdictions. No
benefit was recognized for U.S. tax purposes as a full valuation allowance of
$145 was recorded against U.S. net deferred tax assets for the nine months ended
June 30, 2002.

BALANCE SHEET INFORMATION

During the three months ended June 30, 2003, the Company identified $14 of
machinery, electronic and other equipment that it intends to sell by the end of
fiscal 2003. These assets have been reflected as assets held for sale as of June
30, 2003. The equipment had previously been depreciated to its salvage value,
which approximates its fair value less cost to sell.

7. INVESTMENT IN SILICON MANUFACTURING PARTNERS

In December 1997, the Company entered into a joint venture, called Silicon
Manufacturing Partners Pte Ltd. ('SMP'), with Chartered Semiconductor
Manufacturing Ltd. ('Chartered Semiconductor'), a leading manufacturing foundry
for integrated circuits, to operate a 54,000 square foot integrated circuit
manufacturing facility in Singapore. The Company owns a 51% equity interest in
this joint venture, and Chartered Semiconductor owns the remaining 49% equity
interest. The Company's 51% interest in SMP is accounted for under the equity
method due to Chartered Semiconductor's participatory rights under the joint
venture agreement. Under the joint venture agreement, each partner is entitled
to the margins from sales to customers directed to SMP by that partner, after
deducting their respective share of the overhead costs of SMP. Accordingly,
SMP's net income (loss) is not expected to be shared in the same ratio as equity
ownership. The Company's investment in SMP was $196 and $179 as of June 30, 2003
and September 30, 2002, respectively, and is recorded in other assets.

For the three and nine months ended June 30, 2003 the Company recognized
equity earnings from SMP, which is recorded in other income -- net, of $2 and
$14, respectively, compared to $14 and $40, respectively, in the corresponding
prior year periods. SMP reported net income of $1 and $3 for the three and nine
months ended June 30, 2003, respectively, versus net income of $1 and $27,
respectively, in the corresponding prior year periods. As of June 30, 2003, SMP
reported total assets of $521 and total liabilities of $290 compared to total
assets of $589 and total liabilities of $367 as of September 30, 2002.

12

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

8. COMPREHENSIVE INCOME (LOSS)

Total comprehensive loss represents net loss plus the results of certain
equity changes not reflected in the condensed consolidated statements of
operations. The components of other comprehensive income (loss) are shown below.

The foreign currency translation adjustments are not adjusted for income
taxes because they relate to indefinite investments in non-U.S. subsidiaries.
The unrealized gain on cash flow hedges is related to hedging activities by SMP
and there are no income taxes provided as they relate to an equity method
investee. The minimum pension liability adjustment is related to the items
discussed in Note 14 and there are no income taxes provided due to the recording
of a full valuation allowance against U.S. net deferred tax assets. The
reclassification adjustment for the nine months ended June 30, 2002 is comprised
of a reversal of a $30 unrealized gain due to the realization of a gain from the
sale of an available-for-sale investment and a $35 unrealized foreign currency
translation loss due to the realization of the cumulative translation adjustment
resulting from the Company's decision to substantially liquidate its investment
in the legal entity associated with its Madrid, Spain manufacturing operations.

9. INTANGIBLE ASSETS

Effective October 1, 2002, the Company adopted SFAS No. 142, 'Goodwill and
Other Intangible Assets' ('SFAS 142'). SFAS 142 provides guidance on the
financial accounting and reporting for goodwill and other acquired intangible
assets. Under SFAS 142, goodwill and indefinite lived intangible assets are no
longer amortized. Intangible assets with finite lives will continue to be
amortized over their useful lives, which are no longer limited to a maximum of
forty years. SFAS 142 also requires that goodwill be tested for impairment at
least annually. The adoption of SFAS 142 did not result in the recording of an
impairment charge or any adjustments to previously recorded amounts. There were
also no changes to the classification and useful lives of previously acquired
goodwill and other intangible assets. The following table reflects intangible
assets by major class and the related accumulated amortization:

13

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

Intangible asset amortization expense for the three and nine months ended
June 30, 2003 was $2 and $7, respectively. Intangible asset amortization expense
for the remainder of fiscal 2003 is estimated to be $2. The amortization expense
for the succeeding two fiscal years is estimated to be $6 and $3, respectively.
The Company does not have any intangibles with indefinite lives.

The following table reflects the impact of SFAS 142 on net loss and net loss
per share had SFAS 142 become effective October 1, 2001.

10. STOCK COMPENSATION PLANS

In December 2002, the Financial Accounting Standards Board ('FASB') issued
SFAS No. 148 'Accounting for Stock-Based Compensation -- Transition and
Disclosure,' ('SFAS 148') which amends the transition and disclosure provisions
of SFAS No. 123 'Accounting for Stock-Based Compensation' ('SFAS 123').
SFAS 148 provides alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee compensation
and amends the disclosure requirements of SFAS 123 to require more prominent and
more frequent disclosures in financial statements about the effects of
stock-based compensation. The transition provisions are effective for fiscal
years ending after December 15, 2002. The disclosure provisions are effective
for interim periods beginning after December 15, 2002, with early application
encouraged. The Company adopted the interim period disclosure provisions of
SFAS 148 beginning with the first quarter of fiscal 2003 and these provisions
had no effect on the Company's financial condition or results of operations. The
Company applies Accounting Principles Board Opinion No. 25, 'Accounting for
Stock Issued to Employees' ('APB 25') and related interpretations in accounting
for its plans, as permitted under SFAS 123. There was no compensation expense
recorded under APB 25 for three months ended June 30, 2003 and 2002. For the
nine months ended June 30, 2003 and 2002, the Company recorded compensation
expense of $1 and $3, respectively.

The following table illustrates the effect on net loss and net loss per
share if Agere had applied the fair value recognition provisions of
SFAS No. 123 to its stock option plans and employee stock purchase plan (the
'ESPP'):

(footnote on next page)

14

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

(footnote from previous page)

(1) The pro forma amounts shown above include the fair values of
all Agere stock options including, for the three and nine
months ended June 30, 2002, Lucent options held by Agere
employees that were converted to Agere options at the
Distribution date. Also included is the fair value of the
option embedded in Agere shares under the ESPP. The pro
forma impact of applying SFAS No. 123 in the third quarter
of fiscal 2003 and 2002 does not necessarily represent the
expected pro forma impact in future quarters or years.

The Company granted options to purchase 66,241,050 shares of Class A common
stock under its stock option plans during the nine months ended June 30, 2003.
These option grants were primarily broad based grants that were part of the
Company's annual grant program. Options to purchase 198,563,211 shares of Class
A common stock were outstanding as of June 30, 2003.

For the nine months ended June 30, 2003, 4,306,105 shares were purchased
under the ESPP. A new 24-month offering period for the ESPP began May 1, 2003.
As of June 30, 2003, 76,140,843 shares remained available for purchase under the
ESPP.

11. NET LOSS PER COMMON SHARE

Basic and diluted net loss per common share is calculated by dividing net
loss by the weighted average number of common shares outstanding during the
period. As a result of the net loss reported for the three and nine months ended
June 30, 2003, 198,563,211 outstanding stock options and 123,960,695 potential
common shares related to convertible notes have been excluded from the diluted
loss per share calculations because their effect would be anti-dilutive. As a
result of the net loss reported for the three months ended June 30, 2002,
187,201,009 outstanding stock options and 16,346,465 potential common shares
related to convertible notes have been excluded from the diluted loss per share
calculation because their effect would be anti-dilutive. As a result of the net
loss reported for the nine months ended June 30, 2002, 187,201,009 outstanding
stock options and 5,448,822 potential common shares related to convertible notes
have been excluded from the diluted loss per share calculation because their
effect would be anti-dilutive.

12. OPERATING SEGMENTS

The Company's business operations are divided into two market-focused
groups, Client Systems and Infrastructure Systems, that target the consumer
communications and network equipment markets respectively. These two groups
comprise the Company's reportable operating segments. The segments each include
revenue from the licensing of intellectual property assigned to that segment.
There were no intersegment sales.

The Client Systems segment provides integrated circuit solutions for a
variety of end-user applications such as hard disk drives and modems for
computers, Internet-enabled cellular terminals and wireless local area
networking.

The Infrastructure Systems segment provides integrated circuit solutions to
makers of high-speed communications systems. Prior to the reflection of the
Company's optoelectronic components business as discontinued operations, as
discussed in Note 2, the Infrastructure Systems segment also included the
results of operations from this business.

Each segment is managed separately. Disclosure of segment information is on
the same basis used internally for evaluating segment performance and allocating
resources. Performance measurement and resource allocation for the segments are
based on many factors. The primary financial measure used is operating income
(loss), exclusive of amortization of goodwill and other acquired intangibles,
net restructuring and other charges and net gain or loss on the sale of
operating assets.

The Company does not identify or allocate assets by operating segment. In
addition, the Company does not allocate interest income or expense, other income
or expense, or income taxes to the segments.

15

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

Management does not evaluate segments based on these criteria. The Company has
centralized corporate functions and uses shared service arrangements to realize
economies of scale and efficient use of resources. The costs of shared services,
and other corporate center operations managed on a common basis, are allocated
to the segments based on usage or other factors based on the nature of the
activity.

At the beginning of each fiscal year, the Company updates the allocation of
its shared integrated circuit fabrication costs based on the demand forecasts by
month for the fiscal year from the two operating segments. This essentially
creates a take-or-pay relationship between the Company's manufacturing
facilities and the operating segments. Effective October 1, 2002, with the
update of the demand forecast for fiscal 2003, the costs allocated to the Client
segment have increased by approximately $20 and $65 for the three and nine
months ended June 30, 2003, respectively, when compared to the corresponding
prior year period. Accordingly, the costs allocated to the Infrastructure
Systems segment decreased by the same amount. This change in allocation impacts
gross margin at the segment level, but has no effect on the overall gross margin
for the Company.

The Company generates revenues from the sale of one product, integrated
circuits. Integrated circuits are made using semiconductor wafers imprinted with
a network of electronic components. They are designed to perform various
functions such as processing electronic signals, controlling electronic system
functions and processing and storing data.

REPORTABLE SEGMENTS

RECONCILING ITEMS

A reconciliation of the totals reported for the operating segments to the
significant line items in the condensed consolidated statements of operations is
shown below.

16

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

13. FINANCIAL GUARANTEES

In November 2002, the FASB issued Interpretation No. 45 'Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others' ('FIN 45'). FIN 45 is principally a
clarification and elaboration of SFAS No. 5 'Accounting for Contingencies,'
under which companies were required to recognize a liability when it became
likely that the company would have to honor its guarantee. FIN 45 prescribes the
disclosures required by a guarantor about its obligations under certain
guarantees it has issued, including loan guarantees and standby letters of
credit. The disclosure requirements in FIN 45 are effective for annual and
interim periods ending after December 15, 2002. It also requires a guarantor to
recognize a liability, at the inception of a guarantee, for the fair value of
the obligations it has assumed, even if it is not probable that payments will be
required. The initial recognition and measurement provisions of FIN 45 are
required only on a prospective basis for guarantees issued or modified after
December 31, 2002. The Company adopted FIN 45 effective with the first quarter
of fiscal 2003 with no material impact on its financial condition or results of
operations. Set forth below is a discussion of the Company's guarantees as of
June 30, 2003.

A subsidiary of Agere Systems Inc. has guaranteed $9 of debt and interest
incurred by SMP. As of June 30, 2003, no liability is recorded since the Company
entered into the guarantee prior to December 31, 2002 and believes it is
unlikely that the subsidiary would be required to make any payments associated
with this guarantee.

Two real estate leases were assigned in connection with the sale of the
Company's wireless local area networking equipment business. The Company remains
secondarily liable for the remaining lease payments in the event of default. The
maximum potential amount of future payments that the Company could be liable for
is $6. As of June 30, 2003, no liability is recorded since the Company entered
into the guarantee prior to December 31, 2002 and believes it is unlikely that
payments related to these obligations would be required.

Agere Systems Inc. includes indemnification clauses in its standard terms
and conditions for product sales agreements, which indemnify its customers from
third party intellectual property infringement litigation. Also, the Company's
installment note contains an indemnification clause in which Agere provides
indemnification against any claims, liabilities, losses and costs associated
with the collateral named in the agreement. There are no liabilities recorded as
of June 30, 2003 for indemnification clauses since the fair vale of potential
obligations cannot be estimated.

The Company's policy is to record a liability, which is reflected within
other current liabilities, for known or potential warranty claims based on
historical experience. The tables below present a reconciliation of the changes
in the Company's aggregate product warranty liability for continuing operations
for the three and nine months ended June 30, 2003.

17

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

14. BENEFIT OBLIGATIONS

On March 14, 2003, the Company voluntarily contributed 18,750,000 shares of
its Class A common stock to the qualified occupational pension plan. The value
of the stock at the time of the contribution was $30. This contribution,
combined with the remeasurements of the pension plans as a result of the
curtailments discussed below, led to a $20 reduction of the minimum pension
liability from $170 as of September 30, 2002 to $150 as of June 30, 2003.

The Company recognized curtailment charges of $10 and $16 for the three and
nine months ended June 30, 2003, respectively, related to its pension plans and
$7 for the nine months ended June 30, 2003 related to its postretirement plans.
There were no curtailment charges for the three months ended June 30, 2003
related to postretirement plans. There were no curtailment charges for the three
and nine months ended June 30, 2002. The curtailment charges reflect an increase
in the liabilities of the plans, as employees became eligible to receive retiree
benefits sooner than actuarially anticipated due to the Company's restructuring
activities. See Note 4 for additional information regarding the curtailment
charges.

15. COMMITMENTS AND CONTINGENCIES

In the normal course of business, the Company is involved in proceedings,
lawsuits and other claims, including proceedings under laws and government
regulations related to environmental, tax and other matters. The semiconductor
industry is characterized by substantial litigation concerning patents and other
intellectual property rights. From time to time, the Company may be party to
various inquiries or claims in connection with these rights. In addition, from
time to time the Company is involved in legal proceedings arising in the
ordinary course of business, including unfair labor charges filed by its unions
with the National Labor Relations Board, claims before the U.S. Equal Employment
Opportunity Commission and other employee grievances. These matters are subject
to many uncertainties, and outcomes are not predictable with assurance.
Consequently, the ultimate aggregate amount of monetary liability or financial
impact with respect to these matters as of June 30, 2003 cannot be ascertained.
While these matters could affect the operating results of any one quarter when
resolved in future periods and while there can be no assurance with respect
thereto, management believes that after final disposition, any monetary
liability or financial impact to the Company beyond that provided for as of June
30, 2003, would not be material to the annual consolidated financial statements.

LEGAL PROCEEDINGS

On October 17, 2002, the Company filed a patent infringement lawsuit against
Intersil Corporation ('Intersil') in the United States District Court in
Delaware. The Company alleged that Intersil had infringed six of the Company's
patents related to integrated circuits for wireless networking using the IEEE
802.11 standard and is seeking monetary damages for Intersil's infringement of
these patents and an injunction prohibiting Intersil from using the patents in
the future. On November 6, 2002, Intersil filed a counterclaim in this matter,
alleging that ten patents of Intersil are infringed by unspecified Agere
products. Two of the patents relate to system-level circuits, and eight patents
relate to semiconductor processing. The complaint seeks an injunction and
damages. The Company believes that Intersil's claims are without merit.

On October 30, 2002, Choice-Intersil Microsystems, Inc. ('Choice-Intersil'),
filed a lawsuit against the Company in the United States District Court for the
Eastern District of Pennsylvania. The amended complaint alleges misappropriation
of trade secrets and copyrights that were jointly developed and jointly owned by
Digital Ocean, Inc. (which, following several acquisitions and corporate
reorganizations, is now Choice-Intersil) and Lucent. The trade secrets and
copyrights relate to media access controller technology for wireless local area
networks. The complaint seeks an injunction and damages. The Company believes
that Choice-Intersil's claims are without merit.

18

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

On November 19, 2002, the Company filed a lawsuit against Choice-Intersil,
Intersil and Intersil Americas Inc. in state court in Delaware. The Company
alleged, among other things, misappropriation of trade secrets and breach of
contract relating to the trade secrets that were jointly developed and
jointly-owned by Digital Ocean, Inc. and Lucent. The Company is seeking an
injunction against further use and disclosure of the trade secrets and damages
for past disclosure and misuse. This matter has been consolidated with the
Pennsylvania Choice-Intersil proceeding described above.

The Company intends to vigorously defend itself against the claims of the
Intersil parties.

ENVIRONMENTAL, HEALTH AND SAFETY

The Company is subject to a wide range of U.S. and non-U.S. 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 also is subject to environmental laws, including the Comprehensive
Environmental Response, Compensation and Liability Act, also known as Superfund,
that require the cleanup of soil and groundwater contamination at sites
currently or formerly owned or operated by the Company, or at sites where the
Company may have sent waste for disposal. These laws often require parties to
fund remedial action at sites regardless of fault. Agere has responsibility for
remediation costs associated with five Superfund sites, two facilities formerly
owned by Lucent and one facility currently owned by the Company.

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. This practice is followed whether the claims are asserted
or unasserted. Management expects that the amounts reserved will be paid out
over the period of remediation for the applicable site, which typically ranges
from five to thirty years. Reserves for estimated losses from environmental
remediation are, depending upon the site, based primarily upon internal or third
party environmental studies, estimates as to the number, participation level and
financial viability of all potentially responsible parties, the extent of the
contamination and the nature of required remedial actions. Accruals are adjusted
as further information develops or circumstances change. The amounts provided
for in the condensed consolidated financial statements for environmental
reserves are the gross undiscounted amount of such reserves, without deductions
for insurance or third party indemnity claims. Although the Company believes
that its reserves are adequate, including those covering the Company's potential
liabilities at Superfund sites, there can be no assurance that expenditures
which will be required relating to remedial actions and compliance with
applicable environmental laws will not exceed the amounts reflected in these
reserves or will not have a material adverse impact on the Company's financial
condition, results of operations or cash flows. Any possible loss or range of
loss that may be incurred in excess of that provided for as of June 30, 2003,
cannot be estimated.

19

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion of our financial condition and results of
operations should be read in conjunction with our unaudited financial statements
for the three and nine months ended June 30, 2003 and 2002 and the notes
thereto. This discussion contains forward-looking statements. Please see
'Forward-Looking Statements' and 'Factors Affecting Our Future Performance' for
a discussion of the uncertainties, risks and assumptions associated with these
statements.

OVERVIEW

We provide advanced integrated circuit solutions for wireless data,
high-density storage and multi-service networking applications. These solutions
form the building blocks for a broad range of communications and computing
applications. Integrated circuits are made using semiconductor wafers imprinted
with a network of electronic components. They are designed to perform various
functions such as processing electronic signals, controlling electronic system
functions and processing and storing data.

Our business operations are divided into two market-focused groups, Client
Systems and Infrastructure Systems, that target the consumer communications and
network equipment markets respectively. Each of these two groups is a reportable
operating segment. The segments each include revenue from the licensing of
intellectual property assigned to that segment. The Client Systems segment
provides integrated circuit solutions for a variety of end-user applications
such as hard disk drives and modems for computers, Internet-enabled cellular
terminals and wireless local area networking. The Infrastructure Systems segment
provides integrated circuit solutions to makers of high-speed communications
systems. In addition, the Infrastructure Systems segment formerly provided
optoelectronic components; however, we have sold these operations and have
reflected them as discontinued operations for all periods presented. See 'Sale
of Optoelectronic Components Business' for additional details.

Effective with the first quarter of fiscal 2003, we refined our methodology
for allocating shared information technology expenses to our operating segments
and between costs, selling, general and administrative expenses, and research
and development expenses. We believe that this methodology provides a better
assignment of these expenses based on additional information about the
components and underlying drivers which has been developed since our separation
from Lucent Technologies Inc. in fiscal 2001. Historical amounts for all periods
presented have been conformed to the current presentation. As a result of this
change, approximately $16 million and $54 million of expenses previously
reflected in costs were reclassified to operating expenses for the three and
nine months ended June 30, 2002, respectively.

SEPARATION FROM LUCENT

We were incorporated under the laws of the State of Delaware on August 1,
2000, as a wholly owned subsidiary of Lucent. On February 1, 2001, Lucent
transferred to us the assets and liabilities related to our business, other than
pension and postretirement assets and liabilities. In April 2001, we completed
our initial public offering. On June 1, 2002, Lucent completed our spin-off by
distributing all of the Agere common stock it then owned to its stockholders.
Also in June 2002, Lucent transferred to us the pension and postretirement
assets and liabilities related to our employees based on then available census
data. In July 2003 the final transfer of the pension and postretirement assets
and liabilities occurred. We are currently in the process of reviewing the
pension calculations based upon the final census data. Prior to the completion
of the spin-off, we were a majority-owned subsidiary and a related party of
Lucent. Revenue from products sold to Lucent prior to the spin-off was $19
million and $162 million for the three and nine months ended June 30, 2002,
respectively, of which $6 million and $43 million, respectively, is recorded
within income (loss) from operations of discontinued business.

SALE OF OPTOELECTRONIC COMPONENTS BUSINESS

During the second quarter of fiscal 2003, we sold a substantial portion of
our optoelectronic components business to TriQuint Semiconductor, Inc. for $40
million in cash. The transaction included

20

the products, product warranty liabilities, technology and certain facilities
related to this business; and included lasers, detectors, modulators, passive
components, arrayed waveguide-based components, amplifiers, transmitters,
receivers, transceivers, transponders, and micro electro-mechanical systems.

During the second quarter of fiscal 2003, we also sold the remainder of our
optoelectronic components business, which provided cable television transmission
systems, telecom access and satellite communications components, to EMCORE
Corporation for $25 million in cash. The transaction included the assets,
products, product warranty liabilities, technology and intellectual property
related to this business.

Our exit from the optoelectronic components business was completed as a
result of these two sales. The condensed consolidated financial statements have
been reclassified for all periods presented to reflect the optoelectronic
components business as discontinued operations. See Note 2 to our financial
statements in Item 1 for additional details.

OPERATING ENVIRONMENT

In fiscal 2001 and 2002, we saw significant declines in our revenue,
particularly from our telecommunications equipment manufacturing customers. We
believe that these customers were themselves experiencing significant declines
in demand from their customers. As our revenue declined, we determined on
several occasions that we needed to reduce our cost structure. As a result, we
implemented programs to reduce our headcount, consolidate our operations into
fewer facilities and reduce our owned manufacturing capacity. We also exited our
optoelectronic components business, sold several non-core businesses and reduced
our capital spending.

We have now nearly completed our planned restructuring activities, including
headcount reductions and facility consolidations. We have also ceased operations
at our integrated circuit manufacturing facilities located in Allentown and
Reading, Pennsylvania. To complete our remaining restructuring activities,
primarily the decommissioning of these manufacturing facilities, will take
several more quarters.

Our revenue has increased in each of the last two quarters, after reaching a
low-point in the first quarter of fiscal 2003. As a result of our actions to
reduce costs and expenses and our stabilizing revenue, we are seeing
improvements in our gross profit, net loss and net cash used in operating
activities.

Our business depends in large part on demand for personal computers and
associated equipment, wireless communications equipment such as wireless
handsets and wireless local area networking equipment and telecommunications
infrastructure equipment, and our revenues can be affected by changes in demand
for any of these types of products.

RESTRUCTURING ACTIVITIES

As a result of our restructuring activities, we recorded net restructuring
and related charges for continuing operations of $6 million and $99 million for
the three and nine months ended June 30, 2003, respectively, and $73 million and
$135 million for the three and nine months ended June 30, 2002, respectively,
which are classified within restructuring and other charges -- net. For
additional details regarding our net restructuring and other charges, see
Note 4 to our financial statements in Item 1.

We also recorded restructuring related costs within gross profit of $32
million and $86 million for the three and nine months ended June 30, 2003,
respectively, of which $22 million and $63 million, respectively, resulted from
increased depreciation. For the three and nine months ended June 30, 2002
restructuring related costs within gross profit were $23 million and $33
million, respectively, of which $11 million and $19 million, respectively,
resulted from increased depreciation. The increased depreciation is due to the
shortening of estimated useful lives of certain manufacturing assets in
connection with our restructuring activities.

To complete our remaining restructuring and consolidation actions, we
estimate we will incur approximately $100 million in additional charges, of
which approximately $85 million will be cash-related and approximately $15
million will be non-cash related. The largest part of our existing

21

restructuring plan that remains to be completed is the decommissioning of our
integrated circuit manufacturing facilities located in Allentown and Reading.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO THE THREE MONTHS ENDED JUNE 30,
2002

The following table shows the change in revenue, both in dollars and in
percentage terms by segment:

Revenue. Revenue decreased 8% or $42 million, for the three months ended
June 30, 2003, as compared to the same quarter in 2002. The decrease of $6
million within the Client segment reflects the absence of $17 million in
revenues from our wireless local area network equipment business which was sold
in fiscal 2002, as well as a decline in revenues related to our wireless local
area networking solutions as we experienced price pressures and lower volumes,
and transition from a board-based to a chipset-based business model. These
decreases were partially offset by strength in the sales of General Packet Radio
Service, or GPRS, solutions used in mobile terminal devices and
systems-on-a-chip solutions used in hard disk drives, as well as an $11 million
increase in revenues derived from the licensing of intellectual property.

The decrease of $36 million within the Infrastructure segment reflects the
absence of $10 million in revenues from our analog line card business which was
sold in fiscal 2002. The remaining decrease resulted primarily from lower demand
from telecommunications equipment manufacturers for mature products used in
telephony applications.

Gross margin. Gross margin increased 4.1 percentage points to 29.6% for the
three months ended June 30, 2003 from 25.5% for the three months ended June 30,
2002. Gross margin for the Client segment decreased to 19.4% in the current
quarter from 30.0% in the prior year quarter. Gross margin for the
Infrastructure segment increased to 54.5% in the current quarter from 16.7% in
the prior year quarter. The changes in gross margin on a segment basis were
caused in part by a change in the allocation of certain shared manufacturing
costs. At the beginning of each fiscal year, we update the allocation of our
shared integrated circuit fabrication costs based on the demand forecasts by
month for the fiscal year from our two operating segments. This essentially
creates a take-or-pay relationship between our manufacturing facilities and the
operating segments. As a result, the dramatic decline in the telecommunications
markets in fiscal 2002 negatively impacted Infrastructure gross margin due to
un-recovered costs, as sales volumes were less than we had anticipated. With the
update of our demand forecast for fiscal 2003, effective October 1, 2002, the
costs allocated to our Client segment for the three months ended June 30, 2003
increased by approximately $20 million when compared to the prior year quarter
and the costs allocated to the Infrastructure segment decreased by the same
amount. This change in allocation is partly responsible for the decrease in
Client gross margin and the increase in Infrastructure gross margin, although it
has no effect on our total gross margin.

In addition to the change in allocation described above, the Client segment
gross margin was negatively impacted by a $23 million increase in restructuring
related costs, as well as the absence of gross margin from our wireless local
area network equipment business which was sold in fiscal 2002. These decreases
to gross margin were partially offset by improved expense management related to
the actions taken under our restructuring and cost saving initiatives and a $9
million increase in gross margin derived from the licensing of intellectual
property. In addition to the change in allocation

22

described above, the Infrastructure segment gross margin was positively impacted
by improved expense management related to the actions taken under our
restructuring and cost saving initiatives, a $14 million decrease in
restructuring related costs and the sale of our analog line card business in
fiscal 2002, offset in part by lower sales volumes.

Selling, general and administrative. Selling, general and administrative
expenses increased 7% or $5 million from $71 million in the three months ended
June 30, 2002 to $76 million in the three months ended June 30, 2003. Expenses
for the prior year quarter were lower than the current year quarter primarily as
a result of a $15 million benefit that was recognized in the prior year quarter
for the recovery of a receivable that had been previously written-off. The
current year quarter is also impacted by reduced salary, benefit and other
expenditures as a result of our restructuring and cost saving initiatives and
the absence of expenditures related to our analog line card and wireless local
area network equipment businesses which were sold in fiscal 2002.

Research and development. Research and development expenses decreased 19% or
$28 million from $145 million in the three months ended June 30, 2002 to $117
million in the three months ended June 30, 2003. The majority of the decrease
was due to reduced expenditures as we focused our product development efforts
and realized savings from our restructuring and cost saving initiatives,
including the absence of expenses related to our analog line card and wireless
local area network equipment businesses which were sold in fiscal 2002.

Amortization of goodwill and other acquired intangibles. Amortization
expense decreased 71% or $5 million from $7 million for the three months ended
June 30, 2002 to $2 million for the three months ended June 30, 2003. The
decrease is due to the absence of amortization of goodwill in the three months
ended June 30, 2003. Effective October 1, 2002, we adopted Statement 142,
'Goodwill and Other Intangible Assets' and are no longer permitted to amortize
goodwill. Acquired intangible assets with finite lives are still amortized.

Restructuring and other charges -- net. Net restructuring and other charges
decreased 92% or $69 million to $6 million for the three months ended June 30,
2003 from $75 million for the three months ended June 30, 2002. See
'Restructuring Activities' for additional details.

Gain on sale of operating assets -- net. Gain on sale of operating
assets -- net was $15 million for the three months ended June 30, 2003, which
consists principally of a $16 million gain on the sale of the analog line card
business. See Note 6 to our financial statements in Item 1 for additional
information. There was no gain or loss for the three months ended June 30, 2002.

Operating loss. We reported an operating loss of $51 million for the three
months ended June 30, 2003, compared to an operating loss of $171 million for
the three months ended June 30, 2002. The improvement in operating loss is
primarily attributable to lower net restructuring and other charges, lower
research and development costs, increased gain on sale of operating assets and
higher gross margin in the current year quarter. Although performance
measurement and resource allocation for the reportable segments are based on
many factors, the primary financial measure used is operating income (loss) by
segment, exclusive of amortization of goodwill and other acquired intangibles,
net restructuring and other charges and net (gain) loss on sale of operating
assets, which is shown in the following table.

- ---------

N/M = Not meaningful

23

Other income -- net. Other income -- net decreased 85% or $17 million to $3
million for the three months ended June 30, 2003, compared with $20 million for
the three months ended June 30, 2002. This decrease was primarily due to a $12
million decrease in income from our equity investment in Silicon Manufacturing
Partners Pte, Ltd.

Interest expense. Interest expense decreased 52% or $12 million to $11
million for the three months ended June 30, 2003 from $23 million for the three
months ended June 30, 2002. This decrease is due to having significantly lower
debt in the three months ended June 30, 2003, primarily as a result of
repayments on our credit facility, which matured on September 30, 2002.

Provision for income taxes. For the three months ended June 30, 2003, we
recorded a provision for income taxes of $8 million on a pre-tax loss from
continuing operations of $59 million, yielding an effective tax rate of (12.5)%.
This rate differs from the U.S. statutory rate primarily due to the recording of
a full valuation allowance of $7 million against U.S. net deferred tax assets
and the provision for taxes in foreign jurisdictions. For the three months ended
June 30, 2002, we recorded a provision for income taxes of $16 million on
pre-tax loss from continuing operations of $174 million, yielding an effective
tax rate of (8.9)%. This rate differs from the U.S. statutory rate primarily due
to the impact of recording of a full valuation allowance of $68 million against
U.S. net deferred tax assets and the provision for taxes in foreign
jurisdictions.

Income (loss) from discontinued operations. For the three months ended
June 30, 2003, loss from discontinued operations was $11 million, or $0.01 per
share, as we finalized adjustments related to obligations incurred as a result
of the decision to sell the optoelectronic components business. For the three
months ended June 30, 2002, loss from discontinued operations was $142 million,
or $0.09 per share. See 'Sale of Optoelectronic Components Business' for
additional details.

NINE MONTHS ENDED JUNE 30, 2003 COMPARED TO THE NINE MONTHS ENDED JUNE 30, 2002

The following table shows the change in revenue, both in dollars and in
percentage terms by segment:

Revenue. Revenue decreased 7% or $97 million, for the nine months ended
June 30, 2003, as compared to the same period in 2002. The increase of $11
million within the Client segment reflects strength in the sales of GPRS
solutions used in mobile terminal devices and systems-on-a-chip solutions used
in hard disk drives, as well as a $28 million increase in revenues derived from
the licensing of intellectual property. These increases were partially offset by
the absence of $55 million in revenues from our wireless local area network
equipment business which was sold in fiscal 2002. Also offsetting the increase
was a decline in revenues related to our wireless local area networking
solutions as we experienced price pressures.

The decrease of $108 million within the Infrastructure segment reflects the
absence of $54 million in revenues from our analog line card and
field-programmable gate array businesses which were sold in fiscal 2002. The
remaining decrease was caused by decreased volume, which resulted from lower
demand from telecommunications equipment manufacturers as their customers,
communication service providers, reduced capital expenditures.

Gross margin. Gross margin increased 5.9 percentage points to 27.3% for the
nine months ended June 30, 2003 from 21.4% for the nine months ended June 30,
2002. Gross margin for the Client segment decreased to 15.6% in the current
period from 24.4% in the prior year period. Gross margin for the Infrastructure
segment increased to 55.2% in the current period from 15.9% in the prior year

24

period. The changes in gross margin on a segment basis were caused in part by
the change in the allocation of certain shared manufacturing costs described
above. The dramatic decline in the telecommunications markets in fiscal 2002
negatively impacted Infrastructure gross margin due to un-recovered costs, as
sales volumes were less than we had anticipated. With the update of our cost
allocation for fiscal 2003, effective October 1, 2002, the costs allocated to
our Client segment for the nine months ended June 30, 2003 increased by
approximately $65 million when compared to prior year period and the costs
allocated to the Infrastructure segment decreased by the same amount. This
change in allocation is partly responsible for the decrease in Client gross
margin and the increase in Infrastructure gross margin, although it has no
effect on our total gross margin.

In addition to the change in allocation described above, the Client segment
gross margin was negatively impacted by a $68 million increase in restructuring
related costs, as well as the absence of gross margi