AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 11, 2002
________________________________________________________________________________

                                 UNITED STATES
                       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

FOR THE TRANSITION PERIOD FROM             TO

                        COMMISSION FILE NUMBER 001-16397

                              -------------------

                               AGERE SYSTEMS INC.


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


               555 UNION BOULEVARD, ALLENTOWN, PENNSYLVANIA 18109

                      Telephone -- Area Code 610-712-4323

                              -------------------

    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 January 31, 2002, 727,431,519 shares of Class A common stock and
908,100,000 shares of Class B common stock were outstanding.

________________________________________________________________________________







                               AGERE SYSTEMS INC.
                                   FORM 10-Q
                FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2001

                               TABLE OF CONTENTS



                                                              PAGE
                                                              ----
                                                           
PART I -- FINANCIAL INFORMATION

    Item 1. Financial Statements (Unaudited)
        Condensed Consolidated and Combined Statements of
        Operations for the three months ended December 31,
        2001 and 2000.......................................    2
        Condensed Consolidated Balance Sheets at
        December 31, 2001 and September 30, 2001............    3
        Condensed Consolidated and Combined Statements of
        Changes in Stockholders' Equity/Invested Equity and
        Total Comprehensive Income (Loss) for the three
        months ended December 31, 2001 and 2000.............    4
        Condensed Consolidated and Combined Statements of
        Cash Flows for the three months ended December 31,
        2001 and 2000.......................................    5
        Notes to Condensed Consolidated and Combined
        Financial Statements................................    6

    Item 2. Management's Discussion and Analysis of
            Financial Condition and Results of Operations...   21
    Item 3. Quantitative and Qualitative Disclosures about
     Market Risk............................................   36

PART II -- OTHER INFORMATION

    Item 1. Legal Proceedings...............................   37
    Item 2. Changes in Securities and Use of Proceeds.......   37
    Item 6. Exhibits and Reports on Form 8-K................   37


                                       1







                        PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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



                                                               THREE MONTHS
                                                                   ENDED
                                                               DECEMBER 31,
                                                              ---------------
                                                               2001     2000
                                                               ----     ----
                                                                 
Revenue (includes $78 and $231 for the three months ended
  December 31, 2001 and 2000, respectively, from Lucent
  Technologies Inc.)........................................  $  537   $1,362
Costs.......................................................     521      782
                                                              ------   ------
Gross profit................................................      16      580
                                                              ------   ------
Operating expenses
    Selling, general and administrative.....................     109      157
    Research and development................................     194      276
    Amortization of goodwill and other acquired
      intangibles...........................................      21      111
    Restructuring and separation............................      72       11
                                                              ------   ------
        Total operating expenses............................     396      555
                                                              ------   ------
Operating income (loss).....................................    (380)      25
Other income -- net.........................................      75       21
Interest expense............................................      50       24
                                                              ------   ------
Income (loss) before provision for income taxes.............    (355)      22
Provision for income taxes..................................      20       22
                                                              ------   ------
Loss before cumulative effect of accounting change..........    (375)    --
Cumulative effect of accounting change (net of benefit for
  income taxes
  of $2 for the three months ended December 31, 2000).......    --         (4)
                                                              ------   ------
Net loss....................................................  $ (375)  $   (4)
                                                              ------   ------
                                                              ------   ------
Basic and diluted loss per share:
Loss before cumulative effect of accounting change..........  $(0.23)  $ --
Cumulative effect of accounting change......................    --       --
                                                              ------   ------
Net loss....................................................  $(0.23)  $ --
                                                              ------   ------
                                                              ------   ------
Weighted average shares outstanding -- basic and diluted (in
  millions).................................................   1,635    1,035
                                                              ------   ------
                                                              ------   ------


     See Notes to Condensed Consolidated and Combined Financial Statements.

                                       2







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



                                                              DECEMBER 31,   SEPTEMBER 30,
                                                                  2001           2001
                                                                  ----           ----
                                                                       
ASSETS
Current Assets
Cash and cash equivalents...................................     $1,781         $ 3,152
Trade receivables, less allowances of $26 at December 31,
  2001 and $33 at September 30, 2001........................        255             347
Receivables due from Lucent Technologies Inc................         44              42
Inventories.................................................        270             304
Prepaid expense.............................................         74              61
Other current assets........................................        146             154
                                                                 ------         -------
    Total current assets....................................      2,570           4,060
Property, plant and equipment -- net of accumulated
  depreciation and amortization of $2,456 at December 31,
  2001 and $2,419 at September 30, 2001.....................      1,666           1,851
Goodwill and other acquired intangibles -- net of
  accumulated amortization of $89 at December 31, 2001 and
  $93 at September 30, 2001.................................        330             343
Deferred income taxes -- net................................          3               4
Other assets................................................        278             304
                                                                 ------         -------
    Total assets............................................     $4,847         $ 6,562
                                                                 ------         -------
                                                                 ------         -------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable............................................     $  327         $   514
Payroll and benefit-related liabilities.....................        153             138
Short-term debt.............................................      1,393           2,516
Income taxes payable........................................        342             336
Restructuring reserve.......................................        105             171
Other current liabilities...................................        229             229
                                                                 ------         -------
    Total current liabilities...............................      2,549           3,904
Post-employment benefit liabilities.........................         93              92
Long-term debt..............................................         33              33
Other liabilities...........................................         65              72
                                                                 ------         -------
    Total liabilities.......................................      2,740           4,101
                                                                 ------         -------
Commitments and contingencies

STOCKHOLDERS' EQUITY
Preferred stock, par value $1.00 per share, 250,000,000
  shares authorized and no shares issued and outstanding....     --              --
Class A common stock, par value $0.01 per share,
  5,000,000,000 shares authorized and 727,429,667 and
  727,000,107 shares issued and outstanding at December 31,
  2001 and September 30, 2001, respectively.................          7               7
Class B common stock, par value $0.01 per share,
  5,000,000,000 shares authorized and 908,100,000 shares
  issued and outstanding at December 31, 2001 and
  September 30, 2001........................................          9               9
Additional paid-in capital..................................      7,012           6,996
Accumulated deficit.........................................     (4,917)         (4,542)
Accumulated other comprehensive loss........................         (4)             (9)
                                                                 ------         -------
    Total stockholders' equity..............................      2,107           2,461
                                                                 ------         -------
    Total liabilities and stockholders' equity..............     $4,847         $ 6,562
                                                                 ------         -------
                                                                 ------         -------


     See Notes to Condensed Consolidated and Combined Financial Statements.

                                       3







                      AGERE SYSTEMS INC. AND SUBSIDIARIES
           CONDENSED CONSOLIDATED AND COMBINED STATEMENTS OF CHANGES
                  IN STOCKHOLDERS' EQUITY/INVESTED EQUITY AND
                       TOTAL COMPREHENSIVE INCOME (LOSS)
                             (DOLLARS IN MILLIONS)
                                  (UNAUDITED)



                                                                THREE MONTHS
                                                                    ENDED
                                                                DECEMBER 31,
                                                              -----------------
                                                               2001      2000
                                                               ----      ----
                                                                  
Class A Common Stock -- beginning and ending balance........  $     7   $    --
                                                              -------   -------
Class B Common Stock -- beginning and ending balance........        9        10
                                                              -------   -------
Owner's net investment
Beginning balance...........................................    --        5,823
Net loss prior to February 1, 2001..........................    --           (4)
Transfers to Lucent Technologies Inc. ......................    --       (1,405)
Transfers from Lucent Technologies Inc. ....................    --        1,501
                                                              -------   -------
Ending balance..............................................    --        5,915
                                                              -------   -------
Additional paid in capital
Beginning balance...........................................    6,996     --
Transfers from Lucent Technologies Inc. ....................       15     --
Compensation on equity-based awards.........................        1     --
                                                              -------   -------
Ending balance..............................................    7,012     --
                                                              -------   -------
Accumulated deficit
Beginning balance...........................................   (4,542)    --
Net loss from February 1, 2001..............................     (375)    --
                                                              -------   -------
Ending balance..............................................   (4,917)    --
                                                              -------   -------
Accumulated other comprehensive income (loss)
Beginning balance...........................................       (9)      (52)
Foreign currency translations...............................       (2)       19
Unrealized gain on cash flow hedges.........................        2     --
Reclassification adjustments to net loss....................        5     --
                                                              -------   -------
Ending balance..............................................       (4)      (33)
                                                              -------   -------
    Total stockholders' equity/invested equity..............  $ 2,107   $ 5,892
                                                              -------   -------
                                                              -------   -------
Total comprehensive income (loss)
Net loss....................................................  $  (375)  $    (4)
Other comprehensive income..................................        5        19
                                                              -------   -------
    Total comprehensive income (loss).......................  $  (370)  $    15
                                                              -------   -------
                                                              -------   -------


     See Notes to Condensed Consolidated and Combined Financial Statements.

                                       4







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



                                                               THREE MONTHS
                                                                   ENDED
                                                               DECEMBER 31,
                                                              ---------------
                                                               2001     2000
                                                               ----     ----
                                                                  
OPERATING ACTIVITIES
    Net loss................................................  $  (375)  $  (4)
    Adjustments to reconcile net loss to net cash provided
      (used) by operating activities:
        Cumulative effect of accounting change..............    --          4
        Restructuring expense (reversal) -- net of cash
          payments..........................................      (10)   --
        Provision for inventory write-downs.................       55      40
        Depreciation and amortization.......................      126     216
        Provision for uncollectibles........................        5    --
        Provision for deferred income taxes.................        2      (6)
        Impairment of investments...........................        5       5
        Equity earnings from investments....................      (21)    (20)
        Gain on sales of investments........................      (40)   --
        Amortization of debt issuance costs.................       19    --
        Decrease in receivables.............................       85      42
        Increase in inventories.............................      (21)   (156)
        Increase (decrease) in accounts payable.............     (171)     60
        Increase (decrease) in payroll and benefit
          liabilities.......................................       15     (58)
        Changes in other operating assets and liabilities...      (23)    (21)
        Other adjustments for non-cash items -- net.........        5    --
                                                              -------   -----
    Net cash provided (used) by operating activities........     (344)    102
                                                              -------   -----
INVESTING ACTIVITIES
    Capital expenditures....................................      (43)   (201)
    Proceeds from the sale or disposal of property, plant
      and equipment.........................................      107    --
    Proceeds from sales of investments......................       53    --
    Other investing activities -- net.......................    --          4
                                                              -------   -----
    Net cash provided (used) by investing activities........      117    (197)
                                                              -------   -----
FINANCING ACTIVITIES
    Transfers from Lucent Technologies Inc..................    --         95
    Payment of credit facility fees.........................      (21)   --
    Principal repayments on short-term debt.................   (1,123)   --
                                                              -------   -----
    Net cash provided (used) by financing activities........   (1,144)     95
                                                              -------   -----

    Effect of exchange rate changes on cash.................    --       --

    Net decrease in cash and cash equivalents...............   (1,371)   --

    Cash and cash equivalents at beginning of period........    3,152    --
                                                              -------   -----

    Cash and cash equivalents at end of period..............  $ 1,781   $--
                                                              -------   -----
                                                              -------   -----


     See Notes to Condensed Consolidated and Combined Financial Statements.

                                       5







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

1. BACKGROUND AND BASIS OF PRESENTATION

BACKGROUND

    On July 20, 2000, Lucent Technologies Inc. ('Lucent') announced its
intention to spin off its integrated circuits and optoelectronic components
businesses (collectively, the 'Company's Businesses') as a separate company,
which is now Agere Systems Inc. (the 'Company' or 'Agere'). At that time, Lucent
announced it intended to distribute all shares of the Company's common stock it
then owned to its stockholders in a tax free distribution by the end of Lucent's
then current fiscal year, September 30, 2001, following the initial public
offering ('IPO') of the Company's Class A common stock, which was completed in
April 2001.

    On August 1, 2000, the Company was incorporated in Delaware as a wholly
owned subsidiary of Lucent. On this date, 1,000 shares of the Company's common
stock, par value $0.01 per share, were issued, authorized and outstanding.
Effective February 1, 2001, Lucent transferred to the Company substantially all
of the assets and liabilities of the Company's Businesses (the 'Separation')
except for short-term debt and related fees which were transferred at the IPO
closing date, and pension and postretirement plan assets and liabilities which
will be transferred at a later date.

    On March 14, 2001, the Company amended its certificate of incorporation to
authorize shares of Class A and Class B common stock and changed and
reclassified its 1,000 outstanding shares of common stock into 1,035,100,000
shares of Class B common stock (the 'Recapitalization'). The ownership rights of
Class A and Class B common stockholders are the same except that each share of
Class B common stock has four votes for the election and removal of directors
while each share of Class A common stock has one vote for such matters. All
Company share and per share data has been retroactively adjusted to reflect the
Recapitalization as if it had occurred at the beginning of the earliest period
presented. On April 2, 2001, the Company issued 600,000,000 shares of Class A
common stock in the IPO for $6 per share less underwriting discounts and
commissions of $.23 per share. On April 4, 2001, Lucent converted 90,000,000
shares of Class B common stock into Class A common stock and exchanged those
shares for outstanding Lucent debt with Morgan Stanley pursuant to the
overallotment option granted in connection with the IPO. After completion of the
IPO, inclusive of the overallotment option, Lucent owned approximately 58% of
the aggregate number of outstanding shares of Class A and B common stock. Also,
on April 2, 2001, the Company assumed from Lucent $2,500 of short-term debt. On
May 1, 2001, Lucent elected to convert 37,000,000 of its shares in the Company
from Class B common stock to Class A common stock.

    Agere is currently a majority-owned subsidiary of Lucent. On August 16,
2001, Lucent announced that it had entered into amendments with the lenders
under its credit facilities that impose a number of conditions that Lucent must
satisfy in order to spin off Agere. Lucent has stated that it remains committed
to completing the process of separating Agere from Lucent, and that it intends
to move forward with the distribution of the Agere stock it holds in a tax-free
distribution (the 'Distribution'). Because Lucent must meet a number of
conditions before it can complete the spin off and because Lucent alone will
make the decision about whether to complete the spin off, even if the conditions
were met, Agere can not assure you that Lucent will complete the spin off by a
particular date or at all.

BASIS OF PRESENTATION

    The condensed consolidated and combined financial statements include amounts
prior to February 1, 2001 that have been derived from the consolidated financial
statements and accounting records of Lucent using the historical results of
operations and historical basis of the assets and liabilities of the Company's
Businesses. Management believes the assumptions underlying the

                                       6







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

consolidated and combined financial statements are reasonable. However, the
consolidated and combined financial statements that were derived from Lucent's
financial records may not necessarily reflect the Company's results of
operations, financial position and cash flows in the future or what its results
of operations, financial position and cash flows would have been had the Company
been a stand-alone company. Because a direct ownership relationship did not
exist among all the various units comprising the Company, Lucent's net
investment in the Company is shown in lieu of stockholders' equity in the
combined financial statements prior to the Separation. The Company began
accumulating retained earnings (losses) on February 1, 2001, the date on which
Lucent transferred substantially all of the assets and liabilities of the
Company's Businesses to the Company. The formation of the Company and the
transfers of assets and liabilities from Lucent have been accounted for as a
reorganization of entities under common control, in a manner similar to a
pooling of interests.

    Beginning February 1, 2001, the Company's consolidated financial statements
include certain majority owned subsidiaries and assets and liabilities of the
Company. Investments in which the Company exercises significant influence, but
which it does not control are accounted for under the equity method of
accounting. Investments in which the Company does not exercise significant
influence are recorded at cost. All material intercompany transactions and
balances between and among the Company's Businesses, subsidiaries and investees
accounted for under the equity method have been eliminated. In addition, certain
amounts in the prior year's condensed consolidated and combined financial
statements have been reclassified to conform to the fiscal 2002 presentation.

GENERAL CORPORATE EXPENSES

    Prior to February 1, 2001, general corporate expenses were allocated from
Lucent based on revenue. These allocations were reflected in the selling,
general and administrative, costs and research and development line items in the
consolidated and combined statements of operations. The general corporate
expense allocations were primarily for cash management, legal, accounting, tax,
insurance, public relations, advertising, human resources and data services.
These allocations amounted to $45 for the three months ended December 31, 2000.
Management believes the costs of these services charged to the Company are a
reasonable representation of the costs that would have been incurred if the
Company had performed these functions as a stand-alone company. Since the
Separation, the Company has performed these functions using its own resources or
through purchased services. The Company and Lucent entered into agreements for
Lucent to provide certain general corporate services on a transition basis. See
Note 11 'Transactions with Lucent.'

BASIC RESEARCH

    Prior to February 1, 2001, research and development expenses included an
allocation from Lucent to fund a portion of the costs of basic research
conducted by Lucent's Bell Laboratories. This allocation was based on the number
of individuals conducting basic research who were transferred from Lucent's Bell
Laboratories to the Company as part of the Separation. The allocation amounted
to $17 for the three months ended December 31, 2000. Management believes the
costs of this research charged to the Company are a reasonable representation of
the costs that would have been incurred if the Company had performed this
research as a stand-alone company. Since the Separation, expenses for basic
research conducted by the Company are included with all other research and
development expenses in the consolidated statements of operations.

                                       7







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

INTEREST EXPENSE

    Prior to February 1, 2001, interest expense was allocated from Lucent as
Lucent provided financing to the Company and incurred debt at the parent level.
This allocation was based on the ratio of the Company's net assets, excluding
debt, to Lucent's total net assets, excluding debt. The allocation amounted to
$23 for the three months ended December 31, 2000. The Company's interest expense
as a stand-alone company is higher than that reflected in the combined
statements of operations for the three months ended December 31, 2000, primarily
due to the $2,500 credit facility assumed from Lucent at the completion of the
IPO. Interest expense for all periods presented includes interest expense
related to the Company's capitalized lease obligation.

PENSION AND POSTRETIREMENT COSTS

    The documents relating to the Separation provide that, until the
Distribution, the Company's United States ('U.S.') employees will be
participants in Lucent's pension plans. At the Distribution, the Company will
become responsible for pension benefits for the active U.S. employees of the
Company, as well as U.S. employees who retire or terminate after the IPO. Lucent
will transfer to the Company the pension and postretirement assets and
liabilities related to these employees at the Distribution. Obligations related
to retired and terminated vested U.S. employees prior to the IPO will remain the
responsibility of Lucent. Lucent has managed its U.S. pension and postretirement
benefit plans on a consolidated basis and separate Company information is not
readily available. The consolidated and combined statements of operations
include, however, an allocation of the costs of the U.S. employee pension and
postretirement plans. These costs were allocated based on the Company's U.S.
active employee population for each of the periods presented. In relation to the
Lucent plans, the Company recorded pension expense of $0 and $2 for the three
months ended December 31, 2001 and 2000, respectively, and postretirement
expense of $2 and $3 for the three months ended December 31, 2001 and 2000,
respectively. The Company is responsible for the pension and postretirement
benefits of its non-U.S. employees. The liabilities of the various
country-specific plans for these employees are reflected in the consolidated and
combined financial statements and were not material for the periods presented.
There are estimated prepaid pension assets of $121 and postretirement
liabilities of $102 as of December 31, 2001 associated with various existing
Lucent pension and other employee benefit plans related to the Company
employees. The amounts transferred to the Company for prepaid pension assets and
postretirement liabilities at the Distribution and the pension and
postretirement expenses recognized in future periods could be materially
different than these amounts.

INCOME TAXES

    The Company's income taxes were calculated on a separate tax return basis
prior to the IPO. This reflects Lucent's tax strategies and is not necessarily
reflective of the tax strategies that the Company would have followed or will
follow as a stand-alone company. For the three months ended December 31, 2001,
the Company recorded a provision for income taxes of $20 on a pre-tax loss of
$355, yielding an effective tax rate of negative 5.6%, due to the provision for
taxes in foreign jurisdictions and the recording of a full valuation allowance
of approximately $124 against U.S. net deferred tax assets. For the three months
ended December 31, 2000, the Company recorded a provision for income taxes of
$22 on pre-tax income of $22, yielding an effective tax rate of 100.0%, due to
the impact of non-tax deductible goodwill amortization and separation costs.

                                       8







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

CASH AND CASH EQUIVALENTS

    The Company considers all liquid investments with original maturities of
ninety days or less to be cash equivalents. Cash is reflected net of outstanding
checks.

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 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, 2001. The condensed financial information as of
December 31, 2001 and for the three months ended December 31, 2001 and 2000 is
unaudited, but includes all adjustments that management considers necessary for
a fair presentation of the Company's consolidated and combined results of
operations, financial position and cash flows. Results for the three months
ended December 31, 2001 are not necessarily indicative of results to be expected
for the full fiscal year 2002 or any other future periods.

2. RECENT PRONOUNCEMENTS

SFAS 142

    In July 2001, the Financial Accounting Standards Board ('FASB') issued
Statement of Financial Accounting Standards ('SFAS') No. 142, 'Goodwill and
Other Intangible Assets' ('SFAS 142'). SFAS 142 provides guidance on the
financial accounting and reporting for acquired goodwill and other intangible
assets. Under SFAS 142, goodwill and indefinite lived intangible assets will no
longer be amortized but will be reviewed for impairment at least annually and
subject to new impairment tests. Intangible assets with finite lives will
continue to be amortized over their useful lives but will no longer be limited
to a maximum life of forty years. SFAS 142 is effective for Agere in fiscal
2003, although earlier application is permitted. The Company plans to adopt
SFAS 142 effective October 1, 2002 and is currently evaluating the potential
effects of implementing this standard on its financial condition and results of
operations.

SFAS 143

    Also in July 2001, the FASB issued SFAS No. 143, 'Accounting for Asset
Retirement Obligations' ('SFAS 143'). SFAS 143 addresses financial accounting
and reporting for legal obligations associated with the retirement of tangible
long-lived assets and their associated retirement costs. In accordance with
SFAS 143, retirement obligations will be recorded at fair value in the period
they are incurred. When the liability is initially recorded, the cost is
capitalized by increasing the asset's carrying value, which is subsequently
depreciated over its useful life. SFAS 143 is effective for Agere in fiscal
2003, with earlier application encouraged. The Company is currently evaluating
the potential effects on its financial condition and results of operations of
adopting SFAS 143, as well as the timing of its adoption.

SFAS 144

    In October 2001, the FASB issued SFAS No. 144, 'Accounting for the
Impairment or Disposal of Long-Lived Assets' ('SFAS 144'). SFAS 144 primarily
addresses financial accounting and reporting for the impairment or disposal of
long-lived assets and also affects certain aspects of accounting for
discontinued operations. SFAS 144 is effective for Agere in fiscal 2003, with
earlier

                                       9







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

application encouraged. The Company is currently evaluating the potential
effects on its financial condition and results of operations of adopting
SFAS 144, as well as the timing of its adoption.

3. ACCOUNTING CHANGE

    Effective October 1, 2000, the Company adopted SFAS No. 133, 'Accounting for
Derivative Instruments and Hedging Activities' ('SFAS 133'), and its
corresponding amendments under SFAS No. 138. SFAS 133 requires the Company to
measure all derivatives, including certain derivatives embedded in other
contracts, at fair value and to recognize them in the balance sheet as an asset
or liability, depending on the Company's rights or obligations under the
applicable derivative contract. For derivatives designated as fair value hedges,
the changes in the fair value of both the derivative instrument and the hedged
item are recorded in earnings. For derivatives designated as cash flow hedges,
the effective portions of changes in fair value of the derivative are reported
in other comprehensive income and are subsequently reclassified into earnings
when the hedged item affects earnings. Changes in fair value of derivative
instruments not designated as hedging instruments and ineffective portions of
hedges are recognized in earnings in the current period. The adoption of SFAS
133 as of October 1, 2000, resulted in a cumulative after-tax increase in net
loss of $4 (net of a tax benefit of $2). The increase in net loss is primarily
due to derivatives not designated as hedging instruments. For both the three
months ended December 31, 2001 and 2000 the change in fair market value of
derivative instruments was recorded in other income-net and was not material.

4. RESTRUCTURING AND SEPARATION EXPENSES

RESTRUCTURING EXPENSES

    In the first quarter of fiscal 2002, the Company recorded a net
restructuring charge of $70 classified within restructuring and separation
expenses. This net restructuring charge is comprised of a charge of $121, offset
by a reversal of $51. This net charge is related to a series of initiatives that
were announced in fiscal 2001 and in the first quarter of fiscal 2002 to align
the Company's cost structure with market conditions. These initiatives were
focused on improving gross profit, reducing expenses and streamlining
operations, and include a worldwide workforce reduction, rationalization of
manufacturing capacity and other activities. There were no restructuring charges
recorded in the first quarter of fiscal 2001.

  Worldwide Workforce Reduction

    During the first quarter of fiscal 2002, workforce reductions resulted in a
restructuring charge of $40. This charge includes $23 for approximately 500
remaining employees associated with the workforce reduction of 6,000 positions
announced in fiscal 2001. It also includes $17 for approximately 500 employees
impacted by the December 5, 2001 announcement of an additional workforce
reduction of 950 positions. This new initiative affects primarily management
positions within the Company's product groups, sales organizations and corporate
support functions located in New Jersey and Pennsylvania. Of the total charge,
$13 represents a non-cash charge for termination benefits to certain U.S.
management employees that will be funded through Lucent's pension assets.

    The Company also recorded a $20 reversal of the restructuring reserve
associated with the worldwide workforce reductions due to the revision of an
estimate reflecting lower severance and benefit costs. Severance costs and other
exit costs were determined in accordance with Emerging Issues Task Force
('EITF') No. 94-3, 'Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity.'

                                       10







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

    The Company has substantially completed the workforce reductions announced
in fiscal 2001 with approximately 5,600 employees taken off-roll as of
December 31, 2001. The remaining 400 employees associated with this action are
expected to be off-roll by the end of the second quarter of fiscal 2002. The
Company expects to complete the workforce reduction announced on December 5,
2001 by September 30, 2002.

  Rationalization of Manufacturing Capacity and Other Charges

    During the first quarter of fiscal 2002, the Company recognized a
restructuring charge of $81 for rationalization of manufacturing capacity and
other charges. This charge includes $40 relating to facility closings, $33 for
asset impairments and $8 primarily for contract terminations.

    The facility closing charge consists principally of 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 the Madrid, Spain manufacturing operations. This charge was
recognized in accordance with EITF No. 01-5, Issue Summary No. 1, 'Application
of SFAS No. 52, and Foreign Currency Translation, to an Investment Being
Evaluated for Impairment That Will Be Disposed Of.' The $5 balance of the charge
related to the facility closings is primarily for lease terminations and
non-cancelable leases and related costs.

    The $33 of asset impairment charges was recognized for property, plant, and
equipment associated with the consolidation of manufacturing and other corporate
facilities. This non-cash charge was recognized in accordance with the guidance
on impairment of assets in SFAS No. 121, 'Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of.'

    The Company also recorded a restructuring charge reversal of $31 during the
first quarter of fiscal 2002 associated with the rationalization of
manufacturing capacity and other charges. The majority of this reversal occurred
because the Company received $25 more from the sale of the assets associated
with the Company's Madrid, Spain manufacturing operations than originally
estimated. It also includes a $6 reversal of a restructuring reserve deemed no
longer necessary.

    The following table sets forth the Company's restructuring reserve as of
September 30, 2001 and reflects the activity regarding the worldwide workforce
reductions and the rationalization of manufacturing capacity and other charges
affecting the reserve for the three months ended December 31, 2001:



                               SEPTEMBER 30,                   THREE MONTHS ENDED                    DECEMBER 31,
                                   2001                         DECEMBER 31, 2001                        2001
                               -------------   ---------------------------------------------------   -------------
                               RESTRUCTURING   RESTRUCTURING   RESTRUCTURING   NON-CASH     CASH     RESTRUCTURING
                                  RESERVE         CHARGE         REVERSAL       ITEMS     PAYMENTS      RESERVE
                                  -------         ------         --------       -----     --------      -------
                                                                                   
Workforce reduction..........      $ 92            $ 40            $(20)         $(13)      $(61)        $ 38
Rationalization of
  manufacturing capacity and
  other charges..............        79              81             (31)          (43)       (19)          67
                                   ----            ----            ----          ----       ----         ----
    Total....................      $171            $121            $(51)         $(56)      $(80)        $105
                                   ----            ----            ----          ----       ----         ----
                                   ----            ----            ----          ----       ----         ----


    The Company anticipates that substantially all the remaining cash
expenditures relating to the workforce reduction will be paid by the end of
fiscal 2002. The majority of the contract terminations will be paid by the end
of the third quarter of fiscal 2002. Amounts related to non-cancelable lease
obligations due to the consolidation of facilities will be paid over the
respective lease terms through fiscal 2005.

                                       11







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

SEPARATION EXPENSES

    The Company incurred costs, fees and expenses relating to the Separation.
These fees and expenses were primarily related to legal separation matters,
designing and constructing the Company's computer infrastructure, information
and data storage systems, marketing expenses relating to building a company
brand identity and implementing treasury, real estate, pension and records
retention management services. For the three months ended December 31, 2001 and
2000, the Company incurred separation expenses of $2 and $11, respectively.

5. DEBT

    On April 2, 2001, in connection with the IPO, the Company assumed $2,500 of
short-term borrowings from Lucent under a credit facility. The Company did not
receive any of the proceeds of this short-term debt.

    On October 4, 2001, the Company amended this credit facility. In connection
with the amendment, the Company repaid $1,000 of the $2,500 then outstanding,
reducing the facility to $1,500. The Company also paid $21 of fees associated
with the amendment, which will be amortized over the life of the facility. The
facility is comprised of term loans and revolving credit loans and is secured by
the Company's principal domestic assets other than the proceeds of the IPO and,
while Lucent remains a majority stockholder, real estate. The maturity date of
the facility was extended from February 22, 2002 to September 30, 2002. In
addition, if the Company raises at least $500 in equity or debt capital markets
transactions before September 30, 2002, the maturity date of the facility will
be extended to September 30, 2004, with the facility required to be reduced to
$750 on September 30, 2002 and $500 on September 30, 2003. The debt is not
convertible into any other securities of the Company. The amended credit
facility contains financial covenants, including restrictions on the Company's
ability to pay cash dividends.

    The only periodic debt service obligation under the credit facility is to
make quarterly interest payments. The interest rates on borrowings under the
facility are based on a scale indexed to the Company's credit rating. At
December 31, 2001, the interest rate under the facility was the applicable LIBOR
rate plus 475 basis points, based upon the current ratings of BB- from Standard
& Poor's and Ba3 from Moody's. In addition, the agreement provided that until
the Company permanently reduced the size of the facility to $1,000 or less, the
applicable interest rate would increase by an additional 25 basis points every
ninety days. If the Company permanently reduces the size of the facility to
$1,000 or less, the interest rate for borrowings under the facility, assuming
the Company's credit ratings remain the same, would drop to the applicable LIBOR
rate plus 400 basis points. The weighted average interest rate at December 31,
2001 was 6.7%.

    Under the agreement, Agere must use proceeds of certain liquidity raising
transactions, asset sales outside the ordinary course of business and capital
markets transactions to reduce the size of the facility. If Agere completes the
liquidity raising transactions or sells assets outside the ordinary course of
business, it must apply 100% (50% if the size of the facility is $500 or less)
of the net cash proceeds it receives from the transaction to reduce the size of
the facility. The agreement also provides that 50% of the net cash proceeds of
the first $500 and 75% (50% if the size of the facility is $500 or less) of the
net cash proceeds greater than $500 from equity and debt capital markets
transactions be applied to reduce the credit facility. Notwithstanding the
foregoing, the Company must apply 100% of net cash proceeds over $1,000 from the
issuance of debt securities that are secured equally with the credit facility to
reduce the size of the credit facility. As required, the Company used the
proceeds of certain liquidity raising transactions to reduce the size of the
facility to $1,377 at December 31, 2001. Subsequent to December 31, 2001, the
Company reduced the outstanding balance under the facility to less than $1,000.
See Note 14 'Subsequent Events.'

                                       12







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

6. SUPPLEMENTARY FINANCIAL INFORMATION

BALANCE SHEET INFORMATION



                                                     DECEMBER 31,    SEPTEMBER 30,
                                                         2001            2001
                                                         ----            ----
                                                               
INVENTORIES
Completed goods....................................      $ 62            $ 87
Work in process and raw materials..................       208             217
                                                         ----            ----
    Inventories....................................      $270            $304
                                                         ----            ----
                                                         ----            ----


INCOME STATEMENT INFORMATION

    The Company recorded inventory provisions classified within costs of $55 and
$40 for the three months ended December 31, 2001 and 2000, respectively. These
amounts are calculated in accordance with the Company's inventory valuation
policy, which is based on a review of forecasted demand compared with existing
inventory levels.

7. COMPREHENSIVE INCOME (LOSS)

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



                                                          THREE MONTHS ENDED
                                                             DECEMBER 31,
                                                         ---------------------
                                                           2001        2000
                                                           ----        ----
                                                               
Net loss...............................................    $(375)       $(4)
Other comprehensive income (loss):
    Foreign currency translation adjustments...........       (2)        19
    Unrealized gain on cash flow hedges................        2         --
    Reclassification adjustment to net loss............        5         --
                                                           -----        ---
        Total comprehensive income (loss)..............    $(370)       $15
                                                           -----        ---
                                                           -----        ---


    The foreign currency translation adjustments are not currently adjusted for
income taxes because they relate to indefinite investments in non-U.S.
subsidiaries. The unrealized gain on cash flow hedges was related to hedging
activities by Silicon Manufacturing Partners ('SMP'), a joint venture accounted
for under the equity method with Chartered Semiconductor in Singapore, and there
were no income taxes provided for the unrealized gain. The reclassification
adjustment is comprised of a reversal of a $30 unrealized gain due to the
realization of this 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 the
Madrid, Spain manufacturing operations.

8. LOSS PER COMMON SHARE

    Basic and diluted 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 months ended December 31,
2001, 239,270 potential common shares have been excluded from the calculation of
diluted loss per share because their effect would be anti-dilutive.

                                       13







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

    In addition, at December 31, 2001, Agere employees held stock-based awards
covering approximately 43 million shares of Lucent common stock that will be
converted to Agere stock-based awards at the time of the Distribution, if the
Distribution occurs. The number of shares of Agere common stock subject to
substituted awards, if this conversion occurs, cannot be determined at this time
since the conversion ratio will be determined at the Distribution based on the
per share value of the Company's common stock in relation to that of Lucent's
common stock.

9. OPERATING SEGMENTS

    Effective October 1, 2001, the Company realigned its business operations
into two market-focused groups, Infrastructure Systems and Client Systems, that
target the network equipment and consumer communications markets respectively.
These two groups comprise the Company's only reportable operating segments. The
segments each include revenue from the licensing of intellectual property
related to that segment. There were no intersegment sales.

    The Infrastructure Systems segment is comprised of the former
Optoelectronics segment and portions of the former Integrated Circuits segment
and facilitates the convergence of products from both businesses as the Company
addresses markets in high-speed communications systems. The Company has
consolidated research and development, as well as marketing, for both
optoelectronic and integrated circuit devices aimed at communications systems.
This allows the more efficient design, development and delivery of complete,
interoperable solutions to equipment manufacturers for advanced enterprise,
access, metropolitan, long-haul and undersea applications.

    The Client Systems segment consists of the remainder of the former
Integrated Circuits segment and includes wireless data, computer communications,
storage and wireless terminal solutions products. This segment delivers
semiconductor solutions for a variety of end-user applications such as modems,
Internet-enabled cellular terminals and hard-disk drives for computers as well
as software, systems and wireless local area network solutions through the
ORiNOCO'TM' product family.

    Each segment is managed separately. Disclosure of segment information is on
the same basis as is used internally for evaluating segment performance and for
deciding how to allocate 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, the impairment of goodwill and other acquired
intangibles, and restructuring and separation expenses.

    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. 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. The accounting
policies of the reportable operating segments are the same as those described in
Note 1 'Background and Basis of Presentation.'

    The Company generates revenues from the sale of two products, integrated
circuits and optoelectronic components. These products are consistent with the
segments reported by the Company prior to October 1, 2001. Integrated circuits,
or chips, are made using semiconductor wafers imprinted with a network of
electronic components. They are designed to perform various functions such as
processing electronic signals, controlling electronic system functions and
processing and storing data. Optoelectronic components, including both active
and passive components, transmit, process, change, amplify and receive light
that carries data and voice traffic over optical networks.

                                       14







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

REPORTABLE SEGMENTS



                                                          THREE MONTHS ENDED
                                                             DECEMBER 31,
                                                         ---------------------
                                                           2001        2000
                                                           ----        ----
                                                               
REVENUE
Infrastructure Systems.................................    $ 263      $  929
Client Systems.........................................      274         433
                                                           -----      ------
    Total..............................................    $ 537      $1,362
                                                           -----      ------
                                                           -----      ------
OPERATING INCOME (LOSS) (excluding amortization of
  goodwill and other acquired intangibles and
  restructuring and separation expenses)
Infrastructure Systems.................................    $(201)     $  140
Client Systems.........................................      (86)          7
                                                           -----      ------
    Total..............................................    $(287)     $  147
                                                           -----      ------
                                                           -----      ------


RECONCILING ITEMS

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



                                                          THREE MONTHS ENDED
                                                             DECEMBER 31,
                                                         ---------------------
                                                           2001        2000
                                                           ----        ----
                                                               
Reportable segment operating income (loss).............    $(287)      $ 147
Amortization of goodwill and other acquired
  intangibles..........................................      (21)       (111)
Restructuring and separation expenses..................      (72)        (11)
                                                           -----       -----
    Total operating income (loss)......................    $(380)      $  25
                                                           -----       -----
                                                           -----       -----


10. STOCK COMPENSATION PLANS

    Agere maintains an Employee Stock Purchase Plan (the 'ESPP') with
consecutive offering periods, each consisting of four purchase periods of
approximately six months in length. The first offering period commenced on
March 27, 2001 and ends April 30, 2003. Subsequent offering periods will run
generally for 24 months beginning May 1 of every other year. Under the terms of
the ESPP, participating employees may have up to 10% of eligible compensation
(subject to certain limitations) deducted from their pay to purchase the
Company's common stock. The per share purchase price is equal to 85% of the
lower of either the market price on the employee's entry date for the current
offering period, or the last trading day of each purchase period. The amount
that may be offered pursuant to this plan is 85 million shares. Through
December 31, 2001, 2,214,003 shares had been purchased under the ESPP.

11. TRANSACTIONS WITH LUCENT

    Revenue from products sold to Lucent was $78 and $231 for the three months
ended December 31, 2001 and 2000, respectively. Products purchased from Lucent
were $9 for the three months ended December 31, 2000. There were no products
purchased from Lucent for the three months ended December 31, 2001.

    In connection with the Separation, the Company and Lucent entered into an
Interim Service and Systems Replication Agreement to provide each other, on an
interim, transitional basis, with

                                       15







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

various data processing services, telecommunications services and corporate
support services, including: accounting, financial management, information
systems management, tax, payroll, legal, human resources administration,
procurement and other general support. The costs associated with this agreement
amounted to $1 for the three months ended December 31, 2001.

    In connection with the Separation, the Company and Lucent entered into the
Microelectronics Product Purchase Agreement. Under the agreement, Lucent
committed to purchase at least $2,800 of products from the Company over a
three-year period beginning February 1, 2001. In limited circumstances, Lucent's
purchase commitment may be reduced or the term may be extended. For the period
February 1, 2001 through December 31, 2001, Lucent's purchases under this
agreement were $402. In light of Lucent's purchases to date and adverse market
conditions, the Company is discussing with Lucent ways to restructure Lucent's
obligations under the agreement.

12. 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. 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 at December 31, 2001 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 at
December 31, 2001, would not be material to the annual consolidated financial
statements.

    In December 1997, the Company entered into a joint venture, called SMP, with
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 has an agreement with SMP under which it has agreed to purchase 51% of
the production output from this facility and Chartered Semiconductor agreed to
purchase the remaining 49% of the production output. If the Company fails to
purchase its required commitments, it will be required to pay SMP for the fixed
costs associated with the unpurchased wafers. Chartered Semiconductor is
similarly obligated with respect to the wafers allotted to it. The agreement
also provides that Chartered Semiconductor will have the right of first refusal
to purchase integrated circuits produced in excess of the Company's
requirements. The agreement may be terminated by either party upon two years
written notice, but may not be terminated prior to February 2008. The agreement
may also be terminated for material breach, bankruptcy or insolvency.

    In July 2000, the Company and Chartered Semiconductor entered into an
agreement committing the Company and Chartered Semiconductor to jointly develop
manufacturing technologies for future generations of integrated circuits
targeted at high-growth communications markets. The Company has agreed to invest
up to $350 over a five-year period. As part of the joint development activities,
the two companies are staffing a new research and development team at Chartered
Semiconductor's Woodlands campus in Singapore. These scientists and engineers
are working with Company teams currently located in the U.S., as well as with
Chartered Semiconductor's technology development organization. The agreement may
be terminated for breach of material terms upon 30 days notice or for
convenience upon six months notice prior to

                                       16







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

the planned successful completion of a development project, in which case the
agreement will terminate upon the actual successful completion of that project.

    The Company has also entered into an agreement with Chartered Semiconductor
whereby Chartered Semiconductor will provide integrated circuit wafer
manufacturing services. Under the agreement, the Company provides a demand
forecast to Chartered Semiconductor for future periods and Chartered
Semiconductor commits to have manufacturing capacity available for the Company's
use. If the Company uses less than a certain percent of the forecasted
manufacturing capacity, the Company may be obligated to pay penalties to
Chartered Semiconductor. The Company does not expect any penalties under this
agreement to have a material impact on its results of operations or financial
condition.

RISKS AND UNCERTAINTIES

    The Company has a limited history operating as a stand-alone company, and it
may be unable to make the changes necessary to operate as a stand-alone company,
or it may incur greater costs as a stand-alone company. Until early 2001, the
Company's businesses were operated by Lucent as a segment of its broader
corporate organization rather than as a separate stand-alone company. Lucent
assisted the Company by performing various corporate functions, including public
relations, employee relations, investor relations, finance, legal and tax
functions.

    The Company's primary source of liquidity is its cash and cash equivalents.
The Company believes its cash and cash equivalents, together with additional
amounts that may be borrowed under the receivables securitization facility
described in Note 14, are sufficient to meet cash requirements at least through
the end of calendar year 2002, including repayment of borrowings under the
credit facility if its maturity is not extended, the cash requirements of the
facilities consolidation and the other announced restructuring activities. If
the Company's revenues are lower than what plans contemplate and as a result
less cash is generated, or if the Company no longer has access to the
receivables securitization facility, the Company would consider further cash
conserving actions to enable it to meet its cash requirements through the end of
calendar year 2002. These actions would include the elimination of employee
bonuses, the acceleration of already planned expense reductions, further limits
on capital spending and the retiming of certain restructuring initiatives. The
Company cannot assure you that these actions will be feasible at the time or
prove adequate. Currently, the Company is attempting to obtain additional
financing in a debt capital markets transaction. The Company cannot assure you
when it might complete this transaction, if at all, or how much it might be able
to raise from this transaction. The Company also intends to pursue other
financing transactions and will consider asset sales, although no committed
transactions exist at this time. Also, in connection with the spin-off from
Lucent, the Company is significantly restricted in its ability to issue stock in
order to raise capital. The Company's plan does not take into account any funds
that it may receive as a result of selling the Orlando, Florida or Reading and
Breinigsville, Pennsylvania facilities.

LEGAL PROCEEDINGS

    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. The Company
also may be subject to intellectual property litigation and infringement claims,
which could cause it to incur significant expenses or prevent it from selling
its products.

    On October 3, 2000, a patent infringement lawsuit was filed against Lucent,
among other optoelectronic components manufacturers, by Litton Systems, Inc. and
The Board of Trustees of

                                       17







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

the Leland Stanford Junior University in the United States District Court for
the Central District of California (Western Division). The Company anticipates
that it may be named a defendant in the suit. The complaint alleges that each of
the defendants is infringing a patent related to the manufacture of erbium-doped
optical amplifiers. The patent is owned by Stanford University and is
exclusively licensed to Litton. The complaint seeks, among other remedies,
unspecified monetary damages, counsel fees and injunctive relief. This matter is
in its early stages.

    An investigation was commenced on April 4, 2001, by the U.S. International
Trade Commission based on a request of Proxim, Inc. alleging patent infringement
by 14 companies, including some of the Company's customers for wireless local
area networking products. Proxim alleges infringement of three patents related
to spread-spectrum coding techniques. Spread-spectrum coding techniques refers
to a way of transmitting a signal for wireless communications by spreading the
signal over a wide frequency band. The Company believes that it has valid
defenses to Proxim's claims and has intervened in the investigation in order to
defend its customers. Proxim seeks relief in the form of an exclusion order
preventing the importation of specified wireless local area networking products,
including some of the Company's products, into the United States. One of the
Company's subsidiaries, Agere Systems Guardian Corp., filed a lawsuit on
May 23, 2001, in the U.S. District Court in Delaware against Proxim alleging
infringement of three patents used in Proxim's wireless local area networking
products.

    If the Company is unsuccessful in resolving these proceedings, as they
relate to the Company, its operations may be disrupted or it may incur
additional costs. Other than as described above, the Company does not believe
there is any litigation pending that should have, individually or in the
aggregate, a material adverse effect on its financial position, results of
operations or cash flows.

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. Lucent is a potentially
responsible party at numerous Superfund sites and sites otherwise requiring
cleanup action. With some limited exceptions, under the Separation and
Distribution Agreement with Lucent, the Company has assumed all environmental
liabilities resulting from the Company's Businesses, which include liabilities
for the costs associated with eight of these sites -- five Superfund sites, two
of the Company's former facilities and one of the Company's current
manufacturing facilities.

    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 will be
adjusted as further information develops or circumstances change. The amounts
provided for in the consolidated and combined financial statements for
environmental reserves are the gross undiscounted amount of

                                       18







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

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 effect on the
Company's financial condition, results of operations or cash flows.

13. INVESTMENT IN SILICON MANUFACTURING PARTNERS PTE LTD.

    The Company owns a 51% interest in SMP, a joint venture with Chartered
Semiconductor, which operates a 54,000 square foot integrated circuit
manufacturing facility in Singapore. The investment 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. For the three months ended December 31, 2001 and 2000
the Company recognized equity income of $21 and $20 from SMP, respectively. SMP
reported net income of $30 and $28 for the three months ended December 31, 2001
and 2000, respectively. As of December 31, 2001, SMP reported total assets of
$679 and total liabilities of $442 compared to total assets of $670 and total
liabilities of $467 as of September 30, 2001.

14. SUBSEQUENT EVENTS

SALE OF FPGA BUSINESS

    On January 18, 2002, the Company completed the sale of certain assets and
liabilities related to the field-programmable gate array ('FPGA') business of
the Infrastructure Systems segment to Lattice Semiconductor Corporation
('Lattice') for $250 in cash. The transaction included the Company's
general-purpose ORCA'r' FPGA product portfolio, field-programmable system chip
product portfolio and related software design tools. As part of the transaction,
approximately 100 product development, marketing and technical sales employees
transferred to Lattice. The net cash proceeds from the sale were used to
permanently reduce the credit facility in accordance with the terms of the
credit agreement.

FACILITIES CONSOLIDATION

    On January 23, 2002, the Company announced plans to further improve its
operating efficiency. The Company plans to seek a buyer for its wafer
fabrication operation in Orlando, Florida. This site has approximately 1,100
employees. Additionally, over the next twelve to eighteen months, the Company
will consolidate nine existing manufacturing, research and development, business
management and administrative facilities in Pennsylvania and New Jersey into its
Allentown, Pennsylvania campus and one new research and development facility in
central New Jersey.

    The Company will move the majority of its integrated circuits and
optoelectronics operations from the Company's sites in Reading and
Breinigsville, Pa., into the Allentown, Pa. campus. In addition, the majority of
its assembly and test operations located in these three sites will move to the
Company's assembly and test facilities in Bangkok, Thailand; Matamoras, Mexico;
and Singapore. Subsequently, the Company will discontinue operations at the
Reading and Breinigsville facilities and will seek buyers for those properties.
The Company expects that its plans to combine

                                       19







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

operations from these facilities into Allentown will result in a net headcount
reduction of approximately 300 positions.

    The Company will also transfer approximately 350 corporate support and
product development positions from multiple locations in New Jersey to
Allentown. The remaining research and development positions in New Jersey will
move to a new research and development facility in central New Jersey.

    The Company expects to incur cash expenditures associated with moving
manufacturing operations and consolidating facilities of approximately $250 to
$350. The Company does not anticipate any significant charges until the latter
half of fiscal 2002. There will also be additional non-cash impacts associated
with accelerated depreciation and asset impairments that the Company is still
evaluating, and such impacts could be material.

ACCOUNTS RECEIVABLE SECURITIZATION

    On January 24, 2002, the Company and certain of its subsidiaries entered
into a securitization transaction relating to certain accounts receivable. As
part of the transaction, the Company 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 January 21, 2003. On February 1, 2002, the Company borrowed $104
under this agreement. The proceeds were used to repay amounts outstanding under
the credit facility in accordance with the terms of the credit facility
agreement.

    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 Agere. The business
of ASRF is limited to the acquisition of receivables from the Company and
certain of its subsidiaries and related activities.

REDUCTION OF THE CREDIT FACILITY

    On February 4, 2002, the outstanding balance under the Company's credit
facility was reduced to $999. This is $378 lower than the balance outstanding on
December 31, 2001. The amounts used to make the repayments resulted from the
following transactions: $24 from sale and leaseback transactions, $250 from the
FPGA sale and $104 from the accounts receivable securitization. Reducing the
facility below $1,000 resulted in a reduction in the interest rate for
borrowings under the facility to the applicable LIBOR rate plus 400 basis
points. Assuming the Company's credit ratings remain the same, this rate will
remain in effect for the life of the facility. Following these repayments, $500
of the facility is now a revolving credit facility with the remainder considered
a term loan.

                                       20







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

    The following discussion of our financial condition and results of
operations should be read in conjunction with our condensed consolidated and
combined financial statements 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 are the world's leading provider of components for communications
applications, delivering integrated solutions that form the building blocks for
advanced wired, wireless, and optical communications networks. We also design
and manufacture a wide range of semiconductor solutions for computer- and
communications-related devices used by consumers such as cellular phones,
modems, and hard disk drives for personal computers and workstations. In
addition, the company supplies complete wireless computer networking solutions
through the ORiNOCO'TM' product line.

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

    The Infrastructure Systems segment is comprised of our former
Optoelectronics segment and portions of our former Integrated Circuits segment
and facilitates the convergence of products from both businesses as we address
markets in high-speed communications systems. We have consolidated research and
development, as well as marketing, for both optoelectronic and integrated
circuit devices aimed at communications systems. This allows us to more
efficiently design, develop and deliver complete, interoperable solutions to
equipment manufacturers for advanced enterprise, access, metropolitan, long-haul
and undersea applications.

    The Client Systems segment consists of the remainder of our former
Integrated Circuits segment and includes our wireless data, computer
communications, storage and wireless terminal solutions products. This segment
delivers semiconductor solutions for a variety of end-user applications such as
modems, Internet-enabled cellular terminals and hard-disk drives for computers
as well as software, systems and wireless local area network solutions through
the ORiNOCO'TM' product family.

    We reported a net loss of $375 million for the three months ended
December 31, 2001, compared to a net loss of $4 million for the three months
ended December 31, 2000.

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 Technologies Inc. We had no
material assets or activities as a separate corporate entity until the
contribution to us by Lucent of its integrated circuits and optoelectronic
components businesses. Lucent had previously conducted these businesses through
various divisions and subsidiaries. On February 1, 2001, Lucent began the
separation of our company by transferring to us the assets and liabilities
related to these businesses. The separation was substantially completed,
including the transfer of all assets and liabilities other than pension and
postretirement plan assets and liabilities, which have yet to be transferred,
when we completed our initial public offering in April 2001. As of December 31,
2001, Lucent owned 100% of our outstanding Class B common stock and 37 million
shares of our outstanding Class A common stock, which represented approximately
58% of the total outstanding common stock and approximately 84% of the combined
voting power of both classes of our voting stock with respect to the election
and removal of directors.

                                       21







    Lucent originally announced its intention to distribute all shares of our
common stock it then owned to its shareholders in a tax-free distribution by
September 30, 2001. On August 16, 2001, Lucent amended its credit facilities.
The amended credit facilities modified the conditions that must be met before
Lucent can distribute its Agere stock to its stockholders. The distribution of
Agere stock can occur at Lucent's discretion if the following conditions are met
by Lucent:

     no event of default exists under the credit facilities;

     generated positive earnings before interest, taxes, depreciation and
     amortization for the fiscal quarter immediately preceding the distribution;

     meet a minimum current asset ratio;

     receipt of $5 billion in cash from certain non-operating sources; and

     its 364-day $2 billion credit facility has been terminated and the $2
     billion credit facility expiring in February 2003 has been reduced to $1.75
     billion or less.

    Lucent has announced that it has terminated its 364-day facility. On
January 22, 2002, Lucent stated it remained fully committed to completing the
process of separating Agere from Lucent in a tax-free spin-off and that it
intended to use the results for the quarter ending March 31, 2002 to meet the
conditions for the spin-off; although market conditions did introduce a degree
of uncertainty about the timing. Because Lucent must meet these conditions
before it can complete the spin-off and because Lucent alone will make the
decision about whether to complete the spin-off, even if the conditions were
met, we can not assure you that Lucent will complete the spin-off by a
particular date or at all.

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

    In connection with our separation from Lucent, we entered into several
agreements with Lucent including a product purchase agreement under which we
sell products to Lucent. For more information, see Note 11 to the condensed
consolidated and combined financial statements.

OPERATING TRENDS

    Order levels and revenues have declined significantly since the beginning of
fiscal 2001 and are expected to remain at these lower levels in the near-term.
We believe the decreases are due to weakness in our customers' markets and
excess inventory held by our customers. We have experienced a higher than normal
level of order cancellations and reschedules since the beginning of fiscal 2001.
Although the level of customer order changes has decreased in recent months, our
order backlog is lower than we have experienced in the past. Because of this
reduced backlog and the potential for additional order changes by customers our
ability to forecast future results is limited.

    During the first quarter of fiscal 2002, we observed that the personal
computer market is beginning to show signs of stabilization. Our storage-related
integrated circuits benefited from this strengthening in the personal computer
market and experienced sequential quarter growth, as we

                                       22







provided new read-channel products and preamplifier solutions to our hard-disk
drive customers. However, the optical networking market continues to experience
deterioration, as we saw a sequential quarter decline in those product areas.

RESTRUCTURING EXPENSES

    In the first quarter of fiscal 2002, we recorded a net restructuring charge
of $70 million classified within restructuring and separation expenses. This net
restructuring charge is comprised of a charge of $121 million, offset by a
reversal of $51 million. This net charge is related to a series of initiatives
that were announced in fiscal 2001 and in the first quarter of fiscal 2002 to
align our cost structure with market conditions. These initiatives were focused
on improving gross profit, reducing expenses and streamlining operations, and
include a worldwide workforce reduction, rationalization of manufacturing
capacity and other activities. There were no restructuring charges recorded in
the first quarter of fiscal 2001.

WORLDWIDE WORKFORCE REDUCTION

    During the first quarter of fiscal 2002, workforce reductions resulted in a
restructuring charge of $40 million. This charge includes $23 million for
approximately 500 remaining employees associated with the workforce reduction of
6,000 positions announced in fiscal 2001. It also includes $17 million for
approximately 500 employees impacted by the December 5, 2001 announcement of an
additional workforce reduction of 950 positions. This new initiative affects
primarily management positions within our product groups, sales organizations
and corporate support functions located in New Jersey and Pennsylvania. Of the
total charge, $13 million represents a non-cash charge for termination benefits
to certain U.S. management employees that will be funded through Lucent's
pension assets.

    We also recorded a $20 million reversal of the restructuring reserve
associated with the worldwide workforce reductions due to the revision of an
estimate reflecting lower severance and benefit costs. Severance costs and other
exit costs were determined in accordance with Emerging Issues Task Force
No. 94-3, 'Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity.'

    We substantially completed the workforce reductions announced in fiscal 2001
with approximately 5,600 employees taken off-roll as of December 31, 2001. The
remaining 400 employees associated with this action are expected to be off-roll
by the end of the second quarter of fiscal 2002. We expect to complete the
workforce reduction announced on December 5, 2001 by September 30, 2002.

RATIONALIZATION OF MANUFACTURING CAPACITY AND OTHER CHARGES

    During the first quarter of fiscal 2002, we recognized a restructuring
charge of $81 million for rationalization of manufacturing capacity and other
charges. This charge includes $40 million relating to facility closings, $33
million for asset impairments and $8 million primarily for contract
terminations.

    The facility closing charge consists principally of a non-cash charge of $35
million for the realization of the cumulative translation adjustment resulting
from management's decision to substantially liquidate our investment in the
legal entity associated with the Madrid, Spain manufacturing operations. This
charge was recognized in accordance with Emerging Issues Task Force No. 01-5,
Issue Summary No. 1, 'Application of SFAS No. 52, and Foreign Currency
Translation, to an Investment Being Evaluated for Impairment That Will Be
Disposed Of.' The $5 million balance of the charge related to the facility
closing is primarily for lease terminations and non-cancelable leases and
related costs.

    The $33 million of asset impairment charges was recognized for property,
plant, and equipment associated with the consolidation of manufacturing and
other corporate facilities. This non-cash charge was recognized in accordance
with the guidance on impairment of assets in

                                       23







Statement of Financial Accounting Standards No. 121, 'Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.'

    We also recorded a restructuring charge reversal of $31 million during the
first quarter of fiscal 2002 associated with the rationalization of
manufacturing capacity and other charges. The majority of this reversal occurred
because we received $25 million more from the sale of the assets associated with
our Madrid, Spain manufacturing operations than originally estimated. It also
includes a $6 million reversal of a restructuring reserve deemed no longer
necessary.

    The following table sets forth our restructuring reserve as of
September 30, 2001 and reflects the activity regarding the worldwide workforce
reductions and the rationalization of manufacturing capacity and other charges
affecting the reserve for the three months ended December 31, 2001:



                             SEPTEMBER 30,                     THREE MONTHS ENDED                    DECEMBER 31,
                                  2001                         DECEMBER 31, 2001                         2001
                             --------------   ----------------------------------------------------   -------------
                             RESTRUCTURING    RESTRUCTURING   RESTRUCTURING   NON-CASH      CASH     RESTRUCTURING
                                RESERVE          CHARGE         REVERSAL        ITEMS     PAYMENTS      RESERVE
                                -------          ------         --------        -----     --------      -------
                                                             (DOLLARS IN MILLIONS)
                                                                                   
Workforce reduction........       $ 92            $ 40            $(20)         $(13)       $(61)        $ 38
Rationalization of
  manufacturing capacity
  and other charges........         79              81             (31)          (43)        (19)          67
                                  ----            ----            ----          ----        ----         ----
    Total..................       $171            $121            $(51)         $(56)       $(80)        $105
                                  ----            ----            ----          ----        ----         ----
                                  ----            ----            ----          ----        ----         ----


    We anticipate that substantially all the remaining cash expenditures
relating to the workforce reductions announced as of December 31, 2001 will be
paid by the end of fiscal 2002. The majority of the contract terminations will
be paid by the end of the third quarter of fiscal 2002. Amounts related to
non-cancelable lease obligations due to the consolidation of facilities will be
paid over the respective lease terms through fiscal 2005. We currently estimate
future annualized pre-tax savings to be approximately $600 million, of which
$480 million are cash savings. The full benefit of these savings will begin to
be recognized in the third quarter of fiscal 2002.

SEPARATION EXPENSES

    We incurred costs, fees and expenses relating to the Separation. These fees
and expenses were primarily related to legal separation matters, designing and
constructing our computer infrastructure, information and data storage systems,
marketing expenses relating to building a company brand identity and
implementing treasury, real estate, pension and records retention management
services. For the three months ended December 31, 2001 and 2000, we incurred
separation expenses of $2 million and $11 million, respectively.

FACILITIES CONSOLIDATION

    On January 23, 2002, we announced plans to further improve our operating
efficiency. We plan to seek a buyer for our wafer fabrication operation in
Orlando, Florida. This site has approximately 1,100 employees. Additionally,
over the next twelve to eighteen months, we will consolidate nine existing
manufacturing, research and development, business management and administrative
facilities in Pennsylvania and New Jersey into our Allentown, Pennsylvania
campus and one new research and development facility in central New Jersey.

    We will move the majority of our integrated circuits and optoelectronics
operations from our sites in Reading and Breinigsville, Pa., into the Allentown,
Pa. campus. In addition, the majority of our assembly and test operations
located in these three sites will move to our assembly and test facilities in
Bangkok, Thailand; Matamoras, Mexico; and Singapore. Subsequently, we will
discontinue operations at the Reading and Breinigsville facilities and will seek
buyers for those properties. We expect that our plan to combine operations from
these facilities into Allentown will result in a net headcount reduction of
approximately 300 positions.

    We will also transfer approximately 350 corporate support and product
development positions from multiple locations in New Jersey to Allentown. The
remaining research and development

                                       24







positions in New Jersey will move to a new research and development facility in
central New Jersey.

    We expect to incur cash expenditures associated with moving manufacturing
operations and consolidating facilities of approximately $250 million to $350
million. We do not anticipate any significant charges until the latter half of
fiscal 2002. There will also be additional non-cash impacts associated with
accelerated depreciation and asset impairments that we are still evaluating, and
such impacts could be material.

    Through the consolidation of operations from nine sites to Allentown and one
New Jersey location, we will reduce our square footage in the two states by
about two million square feet, or approximately 50 percent, significantly
lowering costs. We expect to realize approximately $100 million annually in cash
savings from these actions, driven primarily by a reduction in rent and building
infrastructure costs.

RESULTS OF OPERATIONS
THREE MONTHS ENDED DECEMBER 31, 2001 COMPARED TO THE 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)
                                                               
Operating Segment:
    Infrastructure Systems.......................  $263   $  929   $(666)  (72)%
    Client Systems...............................   274      433    (159)  (37)%
                                                   ----   ------   -----
        Total....................................  $537   $1,362   $(825)  (61)%
                                                   ----   ------   -----
                                                   ----   ------   -----


REVENUE

    Revenue decreased 61% or $825 million, for the three months ended
December 31, 2001 as compared to the same period in 2000, due primarily to
volume decreases. The decrease of $666 million within the Infrastructure Systems
segment was due to depressed market conditions and reduced expenditures by
service providers, which drove volume decreases across the entire segment. The
decrease of $159 million within the Client Systems segment was also primarily
the result of depressed market conditions, which drove volume decreases across
the entire segment.

COSTS AND GROSS MARGIN

    Costs decreased 33% or $261 million, from $782 million for the three months
ended December 31, 2000 to $521 million for the three months ended December 31,
2001. Gross margin decreased from 42.6% in the prior year quarter to 3.0% in the
current quarter, a decrease of 39.6 percentage points. Gross margin for the
Infrastructure Systems segment decreased to a negative 6.5% in the current
quarter from 46.3% in the prior year quarter, largely as a result of lower
manufacturing capacity utilization and the impact of inventory provisions in the
current quarter. Gross margin for the Client Systems segment declined to 12.0%
in the current quarter from 34.6% in the prior year quarter. This decline was
primarily due to lower manufacturing capacity utilization. The negative effect
of the excess manufacturing capacity in both segments was lessened by savings
realized from the restructuring and cost saving initiatives announced in fiscal
2001.

SELLING, GENERAL AND ADMINISTRATIVE

    Selling, general and administrative expenses decreased 31% or $48 million,
from $157 million in the three months ended December 31, 2000 to $109 million in
the three months ended December 31, 2001. The decrease was principally due to
savings realized from the restructuring and cost saving initiatives announced in
fiscal 2001.

                                       25







RESEARCH AND DEVELOPMENT

    Research and development expenses decreased 30% or $82 million, from $276
million in the prior year quarter to $194 million in the current quarter. The
decrease was primarily due to savings realized from the restructuring and cost
saving initiatives announced in fiscal 2001.

AMORTIZATION OF GOODWILL AND OTHER ACQUIRED INTANGIBLES

    Amortization expense decreased 81% or $90 million from $111 million for the
three months ended December 31, 2000 to $21 million for the three months ended
December 31, 2001. The decrease is due to the impairment of goodwill and other
acquired intangibles of $2,762 million that was recognized in the second half of
fiscal 2001. This impairment significantly reduced our goodwill and other
acquired intangibles and therefore, our current period amortization.

RESTRUCTURING AND SEPARATION EXPENSES

    Restructuring and separation expenses increased $61 million from $11 million
for the three months ended December 31, 2000 to $72 million for the three months
ended December 31, 2001. Net restructuring expenses of $70 million were incurred
in the first quarter of fiscal 2002 as we continued to implement our announced
restructuring initiatives. No restructuring expenses were recognized in the
prior year quarter. Separation expenses decreased $9 million or 81% from $11
million in the first quarter of fiscal 2001 to $2 million in the first quarter
of fiscal 2002. As we incurred the majority of the necessary expenses related to
our separation from Lucent in fiscal 2001 we would expect these expenses to be
substantially lower in fiscal 2002.

OPERATING INCOME (LOSS)

    We reported an operating loss of $380 million for the three months ended
December 31, 2001, a decline of $405 million from operating income of $25
million reported for the three months ended December 31, 2000. This change
reflects primarily a decline in gross profit, as well as an increase in
restructuring and separation expenses, partially offset by expense reductions
resulting from restructuring and cost saving initiatives announced in fiscal
2001 and a decrease in the amortization of goodwill and other acquired
intangibles. 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, the impairment of goodwill and other
acquired intangibles, and restructuring and separation expenses, which is shown
in the following table.



                                                   THREE MONTHS
                                                      ENDED
                                                   DECEMBER 31,      CHANGE
                                                  --------------   -----------
                                                   2001    2000      $      %
                                                   ----    ----      -      -
                                                     (DOLLARS IN MILLIONS)
                                                               
Operating Segment:
    Infrastructure Systems......................  $(201)   $140    $(341)  N/M
    Client Systems..............................    (86)      7      (93)  N/M
                                                  -----    ----    -----
        Total...................................  $(287)   $147    $(434)  N/M
                                                  -----    ----    -----
                                                  -----    ----    -----


---------

N/M = Not meaningful

OTHER INCOME -- NET

    Other income -- net increased $54 million, from $21 million for the three
months ended December 31, 2000 to $75 million for the same period in 2001. The
increase was primarily due to the sale of an available-for-sale investment, as
well as interest income from our investment of the initial public offering
proceeds.

                                       26







INTEREST EXPENSE

    Interest expense increased $26 million to $50 million for the three months
ended December 31, 2001 from $24 million in prior year period. This increase is
due to the interest expense associated with our credit facility being greater
than what Lucent allocated to us in the prior year quarter.

PROVISION FOR INCOME TAXES

    For the first quarter of fiscal 2002, we recorded a provision for income
taxes of $20 million on a pre-tax loss of $355 million, yielding an effective
tax rate of negative 5.6%. This rate is higher than the U.S. statutory rate
primarily due to the provision for taxes in foreign jurisdictions and the
recording of a full valuation allowance of approximately $124 against U.S. net
deferred tax assets. For the first quarter of fiscal 2001, we recorded a
provision for income taxes of $22 million on pre-tax income of $22 million,
yielding an effective tax rate of negative 100.0%. This rate is higher than the
U.S. statutory rate primarily due to non-tax deductible goodwill amortization
and separation costs.

LIQUIDITY AND CAPITAL RESOURCES

    As of December 31, 2001, our net cash position was $388 million, which
reflects $1,781 million in cash and cash equivalents less $1,377 million of
short-term debt under our credit facility and $16 million from the current
portion of our capitalized lease obligation.

    Net cash used in operations was $344 million for the three months ended
December 31, 2001, compared with $102 million of net cash provided by operations
for the three months ended December 31, 2000. The decline in the cash flow from
operations for the three months ended December 31, 2001, compared with the same
period last year, was driven primarily by the increase in our net loss, as a
result of depressed market conditions and a reduction in accounts payable.

    Cash provided by investing activities was $117 million for the three months
ended December 31, 2001 compared with cash used by investing activities of $197
million for the three months ended December 31, 2000. The increase in cash flow
from investing activities is primarily due to proceeds of $107 million from the
sale of property, plant and equipment, proceeds of $53 million from the sale of
investments and a reduction of capital expenditures. Capital expenditures
decreased $158 million to $43 million for the three months ended December 31,
2001, from $201 million for the three months ended December 31, 2000. We are
seeking to limit our capital expenditures principally to projects critical to
winning new business, keeping customer commitments and the completion of a new
office facility adjacent to our current headquarters.

    Net cash used in financing activities was $1,144 million for the three
months ended December 31, 2001, compared with cash provided by financing
activities of $95 million for the three months ended December 31, 2000. The
decrease was primarily the result of our repayment of $1 billion of our credit
facility in connection with the amendment of the facility on October 4, 2001.
Subsequent to the amendment of our facility, we further reduced the amount
outstanding under the facility by $123 million to $1,377 million at
December 31, 2001.The amounts used to make these repayments resulted from the
following transactions: $50 million from the sale of an available-for-sale
investment, $67 million from the sale of our manufacturing facility and related
equipment located in Spain and $6 million from various sale and leaseback
transactions.

    The $2.5 billion credit facility that we assumed from Lucent at the time of
our initial public offering was a 364-day facility that was to mature on
February 21, 2002. On October 4, 2001, this credit facility was amended. In
connection with the amendment, we repaid $1 billion, thereby reducing the
facility to $1.5 billion. The Company also paid $21 million of fees in
connection with the amendment, which we will amortize over the life of the
facility. The facility is comprised of term loans and revolving credit loans and
is secured by our principal domestic assets other than the proceeds of our
initial public offering and, while Lucent remains a majority stockholder, real
estate. The maturity date of the facility was extended from February 22, 2002 to
September 30, 2002. In addition, if we raise at least $500 million in equity or
debt capital markets transactions

                                       27







before September 30, 2002, the maturity date of the facility will be extended to
September 30, 2004, with the facility required to be reduced to $750 million on
September 30, 2002 and $500 million on September 30, 2003. The debt is not
convertible into any other securities of the company.

    The interest rates applicable to borrowings under the facility are based on
a scale indexed to our credit rating. Based upon our credit ratings as of
December 31, 2001 of BB- from Standard & Poor's and Ba3 from Moody's, the
interest rate under the facility was the applicable LIBOR rate plus 475 basis
points. As discussed below, subsequent to December 31, 2001, we reduced the size
of the facility to less than $1 billion and therefore reduced the interest rate
for borrowings under the facility to the applicable LIBOR rate plus 400 basis
points. Unless our credit ratings change, this rate will remain in effect for
the life of the facility. Following these repayments, $500 million of the
facility is now a revolving credit facility with the remainder considered a term
loan. The only periodic debt service obligation under the amended credit
facility is to make quarterly interest payments.

    Under the agreement, we must use proceeds of certain liquidity raising
transactions, asset sales outside the ordinary course of business and capital
markets transactions to reduce the size of the facility. If we complete the
liquidity raising transactions or sell assets outside the ordinary course of
business, we must apply 100% (50% if the size of the facility is $500 million or
less) of the net cash proceeds we receive from the transactions to reduce the
size of the facility. The agreement also provides that 50% of the net cash
proceeds of the first $500 million and 75% (50% if the size of the facility is
$500 million or less) of the net cash proceeds greater than $500 million from
equity and debt capital markets transactions be applied to reduce the credit
facility. Notwithstanding the foregoing, we must apply 100% of net cash proceeds
over $1 billion from the issuance of debt securities that are secured equally
with the credit facility to reduce the size of the credit facility.

    On January 18, 2002, we completed the sale of certain assets and liabilities
related to our FPGA business to Lattice Semiconductor Corporation for $250
million in cash. The net cash proceeds from the sale were used to repay amounts
outstanding under our credit facility in accordance with the terms of the credit
agreement.

    On January 24, 2002, we and certain of our subsidiaries entered into a
securitization transaction relating to certain of our and their accounts
receivable. As part of the transaction, we and certain of our subsidiaries
irrevocably transfer accounts receivable on a daily basis to a wholly-owned,
fully consolidated, bankruptcy-remote subsidiary. The subsidiary has entered
into a loan agreement with certain financial institutions, pursuant to which the
financial institutions agreed to make loans to the special purpose subsidiary
secured by the accounts receivable. The financial institutions have commitments
under the loan agreement of up to $200 million; however the amount that we can
actually borrow at any time depends on the amount and nature of the accounts
receivable that we have transferred to the subsidiary. The loan agreement
expires on January 21, 2003. On February 1, 2002, we borrowed $104 million under
this agreement. On February 4, 2002, these proceeds were used to repay amounts
outstanding under our credit facility in accordance with the terms of the credit
agreement. Following this repayment and the repayment of the $250 from the sale
of our FPGA business and $24 million from additional sale and leaseback
transactions, our credit facility was reduced to $999 million.

    The credit facility contains financial covenants that require us to: (i)
maintain a minimum level of liquidity, (ii) achieve a minimum level of earnings
before interest, taxes, depreciation and amortization computed in accordance
with the agreement each quarter, (iii) maintain a minimum level of net worth,
and (iv) limit capital expenditures. Other covenants restrict our ability to pay
cash dividends, incur indebtedness and invest cash in our subsidiaries and other
businesses. The receivables securitization has the same four financial covenants
and covenant levels as the credit facility, however, a violation of these
covenants will not accelerate payment or require an immediate cash outlay to
cover amounts previously loaned under the facility, but will end our ability to
obtain further loans under the agreement.

                                       28







    On January 23, 2002, we announced plans to consolidate nine existing
manufacturing, research and development, business management and administrative
facilities in Pennsylvania and New Jersey into our Allentown, Pennsylvania
campus and one new research and development facility in central New Jersey. The
consolidation is expected to be completed in twelve to eighteen months. We
anticipate the cash required for this consolidation to be between $250 million
and $350 million. We plan to discontinue operations and seek buyers for our
Reading and Breinigsville facilities. Through this consolidation we will reduce
our square footage in the two states by about two million square feet, or
approximately 50 percent, significantly lowering cost. We expect to realize
approximately $100 million annually in cash savings from these actions, driven
primarily by a reduction in rent and building infrastructure costs. In addition,
we plan to seek a buyer for our wafer fabrication operation in Orlando, Florida.

    Our primary source of liquidity is our cash and cash equivalents. We believe
our cash and cash equivalents, together with additional amounts that may be
borrowed under the receivables securitization facility, are sufficient to meet
our cash requirements at least through the end of calendar year 2002, including
repayment of borrowings under the credit facility if its maturity is not
extended, the cash requirements of the facilities consolidation described above
and the other announced restructuring activities. If our revenues are lower than
what our plans contemplate and as a result less cash is generated, or if we no
longer have access to the receivables securitization facility, we would consider
further cash conserving actions to enable us to meet our cash requirements
through the end of calendar year 2002. These actions would include the
elimination of employee bonuses, the acceleration of already planned expense
reductions, further limits on capital spending and the retiming of certain
restructuring initiatives. We cannot assure you that these actions will be
feasible at the time or prove adequate. Currently, we are attempting to obtain
additional financing in a debt capital markets transaction. We cannot assure you
when we might complete this transaction, if at all, or how much we might be able
to raise from this transaction. We also intend to pursue other financing
transactions and will consider asset sales, although we have no committed
transactions at this time. Also, in connection with our spin-off from Lucent, we
are significantly restricted in our ability to issue stock in order to raise
capital. Our planning does not take into account any funds that we may receive
as a result of selling our Orlando, Florida or Reading and Breinigsville,
Pennsylvania facilities.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS

    Our contractual obligations and commitments include leases entered into in
the normal course of business and the credit facility described above, as well
as the following commitments.

    In December 1997, we entered into a joint venture, called Silicon
Manufacturing Partners Pte Ltd, or SMP, with Chartered Semiconductor, a leading
manufacturing foundry for integrated circuits, to operate a 54,000 square foot
integrated circuit manufacturing facility in Singapore. We own a 51% equity
interest in this joint venture, and Chartered Semiconductor owns the remaining
49% equity interest. We have an agreement with SMP under which we have agreed to
purchase 51% of the production output from this facility and Chartered
Semiconductor has agreed to purchase the remaining 49% of the production output.
If we fail to purchase the required commitments, we will be required to pay SMP
for the fixed costs associated with the unpurchased wafers. Chartered
Semiconductor is similarly obligated with respect to the wafers allotted to it.
The agreement may be terminated by either party upon two years' written notice,
but may not be terminated prior to February 2008. The agreement may also be
terminated for material breach, bankruptcy or insolvency. Based on forecasted
demand, we believe it is unlikely that we would have to pay any significant
amounts for underutilization in the near future. However, if our purchases under
this agreement are less than anticipated, our cash obligation to SMP may be
significant.

    In July 2000, we and Chartered Semiconductor entered into an agreement
committing both parties to jointly develop manufacturing technologies for future
generations of integrated circuits targeted at high-growth communications
markets. We have agreed to invest up to $350 million over a five-year period. As
part of the joint development activities, the two companies are staffing

                                       29







a new research and development team at Chartered Semiconductor's Woodlands
campus in Singapore. The agreement may be terminated for breach of material
terms upon 30 days notice or for convenience upon six months notice prior to the
planned successful completion of a development project, in which case the
agreement will terminate upon the actual successful completion of that project.

    We have also entered into an agreement with Chartered Semiconductor whereby
Chartered Semiconductor will provide integrated circuit wafer manufacturing
services to us. Under the agreement, we provide a demand forecast to Chartered
Semiconductor for future periods and Chartered Semiconductor commits to have
manufacturing capacity available for our use. If we use less than a certain
percent of the forecasted manufacturing capacity, we may be obligated to pay
penalties to Chartered Semiconductor. We do not expect any penalties under this
agreement to have a material impact on our results of operations or financial
condition.

ACCOUNTING POLICIES INVOLVING SIGNIFICANT ESTIMATES

    The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements and revenue and expenses
during the period reported. The following accounting policies require management
to make estimates and assumptions. These estimates and assumptions are reviewed
periodically and the effects of revisions are reflected in the period that they
are determined to be necessary. If actual results differ significantly from
management's estimates, our financial statements could be materially impacted.

    Inventories are stated at the lower of cost, determined on a first-in,
first-out basis, or market. Our inventory valuation policy is based on a review
of forecasted demand compared with existing inventory levels. If our estimate of
forecasted demand is significantly different than our actual demand, our
inventory may be over- or under-valued.

    Long-lived assets, such as goodwill and other acquired intangibles and
property, plant and equipment, are reviewed for impairment whenever events such
as a significant industry downturn, product discontinuance, plant closures,
product dispositions, technological obsolescence or other changes in
circumstances indicate that the carrying amount may not be recoverable. When
such events occur, we compare the carrying amount of the assets to undiscounted
expected future cash flows. If this comparison indicates that there is an
impairment, the amount of the impairment is typically calculated using
discounted expected future cash flows. If our estimate of an asset's future cash
flows is significantly different from the asset's actual cash flows, we may
over- or under-estimate the value of an asset's impairment. A long-lived asset's
value is also dependent upon its estimated useful life. A change in the useful
life of a long-lived asset could result in higher or lower depreciation and
amortization expenses. If the asset's actual life is different than its
estimated life, the asset could be over- or under-valued.

    Restructuring reserves are recorded in connection with the restructuring
initiatives we have announced. These reserves include estimates pertaining to
employee separation costs, the settlement of contractual obligations and other
matters. Although we do not anticipate significant changes, the actual costs may
differ from these estimates, resulting in further charges or reversals of
previously recorded charges.

    We are subject to proceedings, lawsuits and other claims related to
environmental, labor, product and other matters. We are required to assess the
likelihood of adverse outcomes to these matters as well as potential ranges of
probable losses. A determination of the amount of reserves required, if any, for
these contingencies is made after careful analysis of each individual issue. The
required reserves may change in the future due to new developments in each
matter or changes in the approach, such as a change in settlement strategy.

    Historically, certain of our operations have been included in Lucent's
consolidated income tax returns. Income tax expense in our consolidated and
combined statements of operations has been calculated on a separate tax return
basis prior to our initial public offering. The asset and liability

                                       30







approach is used to recognize deferred tax assets and liabilities for the
expected future tax consequences of temporary differences between the carrying
amounts and the tax bases of assets and liabilities. A valuation allowance is
established, as needed, to reduce net deferred tax assets to the amount for
which recovery is probable. If estimates of our future profitability are
different than that actually attained, our deferred tax assets could be under-
or over-valued.

RECENT ACCOUNTING PRONOUNCEMENTS

    In July 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 142, 'Goodwill and Other Intangible Assets.'
Statement 142 provides guidance on the financial accounting and reporting for
acquired goodwill and other intangible assets. Under Statement 142, goodwill and
indefinite lived intangible assets will no longer be amortized but will be
reviewed for impairment at least annually and subject to new impairment tests.
Intangible assets with finite lives will continue to be amortized over their
useful lives but will no longer be limited to a maximum life of forty years.
Statement 142 is effective for us in fiscal 2003, although earlier application
is permitted. We plan to adopt Statement 142 effective October 1, 2002 and are
currently evaluating the potential effects of implementing this standard on our
financial condition and results of operations.

    Also in July 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 143, 'Accounting for Asset Retirement
Obligations.' Statement 143 addresses financial accounting and reporting for
legal obligations associated with the retirement of tangible long-lived assets
and their associated retirement costs. In accordance with Statement 143,
retirement obligations will be recorded at fair value in the period they are
incurred. When the liability is initially recorded, the cost is capitalized by
increasing the asset's carrying value, which is subsequently depreciated over
its useful life. Statement 143 is effective for us in fiscal 2003, with earlier
application encouraged. We are currently evaluating the potential effects on our
financial condition and results of operations of adopting Statement 143, as well
as the timing of its adoption.

    In October 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 144, 'Accounting for the Impairment or
Disposal of Long-Lived Assets.' Statement 144 primarily addresses financial
accounting and reporting for the impairment or disposal of long-lived assets and
also affects certain aspects of accounting for discontinued operations.
Statement 144 is effective for us in fiscal 2003, with earlier application
encouraged. We are currently evaluating the potential effects on our financial
condition and results of operations of adopting Statement 144, as well as the
timing of its adoption.

ENVIRONMENTAL, HEALTH AND SAFETY MATTERS

    We are subject to a wide range of laws and regulations relating to
protection of the environment and employee safety and health. We are currently
involved in investigations and/or cleanup of known contamination at eight sites
either voluntarily or pursuant to government directives. There are established
reserves for environmental liabilities where they are probable and reasonably
estimable. Reserves for estimated losses from environmental remediation are,
depending on the site, based primarily upon internal or third party
environmental studies, estimates as to the number, participation level and
financial viability of all potential responsible parties, the extent of
contamination and the nature of required remedial actions. Although we believe
that the reserves are adequate to cover known environmental liabilities, it is
often difficult to estimate with certainty the future cost of such matters.
Therefore, there is no assurance that expenditures that will be required
relating to remedial actions and compliance with applicable environmental laws
will not exceed the amount reflected in the reserves for such matters or will
not have a material adverse effect on our consolidated financial condition,
results of operations or cash flows.

                                       31







LEGAL PROCEEDINGS

    From time to time we are involved in legal proceedings arising in the
ordinary course of business, including unfair labor charges filed by our unions
with the National Labor Relations Board, claims before the U.S. Equal Employment
Opportunity Commission and other employee grievances. We also may be subject to
intellectual property litigation and infringement claims, which could cause us
to incur significant expenses or prevent us from selling our products.

    On October 3, 2000, a patent infringement lawsuit was filed against Lucent,
among other optoelectronic components manufacturers, by Litton Systems, Inc. and
The Board of Trustees of the Leland Stanford Junior University in the United
States District Court for the Central District of California (Western Division).
We anticipate we may be named a defendant in the suit. The complaint alleges
that each of the defendants is infringing a patent related to the manufacture of
erbium-doped optical amplifiers. The patent is owned by Stanford University and
is exclusively licensed to Litton. The complaint seeks, among other remedies,
unspecified monetary damages, counsel fees and injunctive relief. This matter is
in its early stages.

    An investigation was commenced on April 4, 2001, by the U.S. International
Trade Commission based on a request of Proxim, Inc. alleging patent infringement
by 14 companies, including some of our customers for wireless local area
networking products. Proxim alleges infringement of three patents related to
spread-spectrum coding techniques. Spread-spectrum coding techniques refers to a
way of transmitting a signal for wireless communications by spreading the signal
over a wide frequency band. We believe we have valid defenses to Proxim's claims
and have intervened in the investigation in order to defend our customers.
Proxim seeks relief in the form of an exclusion order preventing the importation
of specified wireless local area networking products, including some of our
products, into the United States. One of our subsidiaries, Agere Systems
Guardian Corp., filed a lawsuit on May 23, 2001, in the U.S. District Court in
Delaware against Proxim alleging infringement of three patents used in Proxim's
wireless local area networking products.

    If we are unsuccessful in resolving these proceedings, as they relate to us,
our operations may be disrupted or we may incur additional costs. Other than as
described above, we do not believe there is any litigation pending that should
have, individually or in the aggregate, a material adverse effect on our
consolidated financial position, results of operations or cash flows.

RISK MANAGEMENT

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

    We use foreign currency forward contracts, and may from time to time use
foreign currency options, to manage the volatility of non-functional currency
cash flows resulting from changes in exchange rates. Foreign currency exchange
contracts are designated for recorded, firmly committed or anticipated purchases
and sales. The use of these derivative financial instruments allows us to reduce
our overall exposure to exchange rate movements, since the gains and losses on
these contracts substantially offset losses and gains on the assets, liabilities
and transactions being hedged.

    Effective October 1, 2000, we adopted Statement 133 and its corresponding
amendments under Statement 138. The adoption of Statement 133 resulted in a
cumulative effect of an increase in our net loss of $4 million, net of a tax
benefit of $2 million for the three months ended December 31,

                                       32







2000. The increase in our net loss is primarily due to derivatives not
designated as hedging instruments. For both the three months ended December 31,
2001 and 2000, the change in fair market value of derivative instruments was
recorded in other income-net and was not material.

    While we hedge certain foreign currency transactions, a decline in value of
non-U.S. dollar currencies may adversely affect our ability to contract for
product sales in U.S. dollars because our products may become more expensive to
purchase in U.S. dollars for local customers doing business in the countries of
the affected currencies.

    As of December 31, 2001, we had $1,377 million of short-term variable rate
debt outstanding. To manage the cash flow risk associated with this debt, we
may, from time to time, enter into interest rate swap agreements. There were no
interest rate swap agreements in effect as of December 31, 2001.

EUROPEAN MONETARY UNION -- EURO

    Several member countries of the European Union have established fixed
conversion rates between their sovereign currencies and the Euro, and have
adopted the Euro as their new single legal currency. The legacy currencies
remained legal tender in the participating countries for a transition period
between January 1, 1999 and January 1, 2002. During the transition period,
cash-less payments were permitted to be made in the Euro. Beginning on
January 1, 2002, the participating countries introduced Euro notes and coins.
The participating countries must withdraw all legacy currencies by February 28,
2002 so that they will no longer be available. The Euro conversion may affect
cross-border competition by creating cross-border price transparency. We will
continue to evaluate issues involving introduction of the Euro as further
accounting, tax and governmental legal and regulatory guidance is available.
Based on current information and our current assessment, it is not expected that
the Euro conversion will have a material adverse effect on our business or
financial condition.

FORWARD-LOOKING STATEMENTS

    This Management's Discussion and Analysis of Results of Operations and
Financial Condition and other sections of this report contain forward-looking
statements that are based on current expectations, estimates, forecasts and
projections about the industry in which we operate, management's beliefs and
assumptions made by management. Words such as 'expects', 'anticipates',
'intends', 'plans', 'believes', 'seeks', 'estimates', variations of such words
and similar expressions are intended to identify such forward looking
statements. These statements are not guarantees of future performance and
involve risks, uncertainties and assumptions which are difficult to predict.
Therefore, actual outcomes and results may differ materially from what is
expressed or forecasted in such forward-looking statements. Except as required
under the federal securities laws and the rules and regulations of the
Securities and Exchange Commission, we do not have any intention or obligation
to update publicly any forward-looking statements whether as a result of new
information, future events or otherwise.

FACTORS AFFECTING OUR FUTURE PERFORMANCE

    The following factors, many of which are discussed in greater detail in our
Annual Report on Form 10-K for the fiscal year ended September 30, 2001 (File
no. 001-16397), could affect our future performance and the price of our stock.

RISKS RELATED TO OUR SEPARATION FROM LUCENT

     We will be controlled by Lucent as long as it owns a majority of our common
     stock, and our other stockholders will be unable to affect the outcome of
     stockholder voting during that time.

                                       33







     We do not control the timing and manner of our separation from Lucent and
     it may not occur, and even if it does occur we may not achieve many of the
     expected benefits of our separation, so we may lose many of our employees
     and our business may suffer.

     We may have potential business conflicts of interest with Lucent with
     respect to our past and ongoing relationships and, because of Lucent's
     controlling ownership, the resolution of these conflicts may not be on the
     most favorable terms to us.

     Our historical financial information prior to the February 1, 2001
     contribution to us of our business from Lucent may not be representative of
     our results as a stand-alone company and, therefore, may not be reliable as
     an indicator of our historical or future results.

     Because Lucent's Bell Laboratories' central research organization
     historically performed important research for us, we must continue to
     develop our own core research capability. We may not be successful, which
     could materially harm our prospects and adversely affect our results of
     operations.

     Many of our executive officers and some of our directors may have conflicts
     of interest because of their ownership of Lucent common stock and other
     ties to Lucent.

     We could incur significant tax liability if Lucent fails to pay the tax
     liabilities attributable to Lucent under our tax sharing agreement, which
     could require us to pay a substantial amount of money.

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

RISKS RELATED TO OUR BUSINESS

     The demand for products in our industry has recently declined, and we
     cannot predict the duration or extent of this trend. Sales of our
     integrated circuits and optoelectronic components are dependent on the
     growth of communications networks.

     If we are unable to extend or refinance our credit facility when it matures
     on September 30, 2002, we may not have sufficient cash available to repay
     that facility or to fund our operations.

     Because we expect to continue to derive a majority of our revenue from
     integrated circuits and the integrated circuits industry is highly
     cyclical, our revenue may fluctuate.

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

     Our quarterly revenue and operating results may vary significantly in
     future periods due to the nature of our business.

     If we fail to keep pace with technological advances in our industry or if
     we pursue technologies that do not become commercially accepted, customers
     may not buy our products and our revenue may decline.

     Because many of our current and planned products are highly complex, they
     may contain defects or errors that are detected only after deployment in
     commercial communications networks and if this occurs, then it could harm
     our reputation and result in increased expense.

     Our products and technologies typically have lengthy design and development
     cycles. A customer may decide to cancel or change its product plans, which
     could cause us to generate no revenue from a product and adversely affect
     our results of operations.

     Because our sales are concentrated on Lucent and a few other customers, our
     revenue may materially decline if one or more of our key customers do not
     continue to purchase our existing and new products in significant
     quantities.

                                       34







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

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

     We depend on some single sources of supply, particularly for our
     optoelectronic components, and interruptions affecting these and other
     suppliers could disrupt our production, compromise our product quality and
     cause our revenue to decline.

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

     We have relatively high gross margin on the revenue we derive from the
     licensing of our intellectual property, and a decline in this revenue would
     have a greater impact on our net income than a decline in revenue from our
     integrated circuits and optoelectronic products.

     We depend on joint ventures or other third-party strategic relationships
     for the manufacture of some of our products, especially integrated
     circuits. If these manufacturers are unable to fill our orders on a timely
     and reliable basis, our revenue may decline.

     If our customers do not qualify our manufacturing lines for volume
     shipments, our revenue may be delayed or reduced.

     Because integrated circuit and optoelectronic component average selling
     prices in particular product areas are declining and some of our older
     products are becoming obsolete, our results of operations may be adversely
     affected.

     We conduct a significant amount of our sales activity and manufacturing
     efforts outside the United States, which subjects us to additional business
     risks and may adversely affect our results of operations due to increased
     costs.

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

     The communications component industry is intensely competitive, and our
     failure to compete effectively could hurt our revenue.

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

     If we cannot maintain our strategic relationships or if our strategic
     relationships fail to meet their goals of developing technologies or
     processes, we will lose our investment and may fail to keep pace with the
     rapid technological developments in our industry.

     We may not have financing for future strategic initiatives, which may
     prevent us from addressing gaps in our product offerings, improving our
     technology or increasing our manufacturing capacity.

RISKS RELATED TO OUR STOCK

     Because our Class A common stock has a limited trading history and our
     stock may be considered a technology stock, the market price and trading
     volume of our Class A common stock may be volatile.

     Because our quarterly revenue and operating results are likely to vary
     significantly in future periods, our stock price may decline.

     Because of differences in voting power and liquidity between the Class A
     common stock and the Class B common stock, the market price of the Class A
     common stock may be less than the market price of the Class B common stock
     following Lucent's distribution of the Class B common stock if Lucent
     completes the Distribution.

                                       35







     A number of our shares are or will be eligible for future sale or
     distribution, including as a result of our spin-off from Lucent, which may
     cause our stock price to decline.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

    We have exposure to foreign exchange and interest rate risk. There have been
no material changes in market risk exposures from those disclosed in our Annual
Report on Form 10-K for the fiscal year ended September 30, 2001 (File no.
001-16397). See Item 2 -- 'Management's Discussion and Analysis of Results of
Operations and Financial Condition -- Risk Management' for additional details.

                                       36







                          PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

    See Part I -- 'Management's Discussion and Analysis of Results of Operations
and Financial Condition -- Legal Proceedings'.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

    On October 4, 2001, we repaid $1,000 million under our credit facility.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

    (b) Reports on Form 8-K

    Current Report on Form 8-K filed October 5, 2001 pursuant to Item 5 (Other
Events).

    (c) Exhibits


        
     10.1  Letter Agreement with Daniel A. DiLeo (Incorporated by
           reference to exhibit 10.25 to our registration statement on
           Form S-1, File No. 333-81632)
     10.2  Agere Systems Inc. Retention Plan (Incorporated by reference
           to exhibit 10.26 to our registration statement on Form S-1,
           File No. 333-81632)


                                       37







                                   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.

                                          AGERE SYSTEMS INC.


                                          
Date February 11, 2002                                        /S/ MARK T. GREENQUIST
                                             ........................................................
                                                                MARK T. GREENQUIST
                                                           EXECUTIVE VICE PRESIDENT AND
                                                             CHIEF FINANCIAL OFFICER


                                       38


                             STATEMENT OF DIFFERENCES
                             ------------------------

The trademark symbol shall be expressed as................................ 'TM'