XEROX CORP (XRX)
Item 2. Management’s Discussion and Analysis of Results of Operations and
Total third quarter 2002 revenues of $3.8 billion declined 6 percent from $4.1 billion in the 2001 third quarter, representing a reduced rate of decline from prior periods, as equipment sale declines moderated reflecting the success of our new product launches in several of our target markets. Approximately half the total revenue decline was due to our second half 2001 exit from the Small Office/Home Office (“SOHO”) business and declines in our Developing Markets Operations (“DMO”) as we continue to prioritize profitable revenue. The rest of the decline reflects continued economic weakness and marketplace competition as production monochrome and office light-lens declines were only partially offset by growth in the key areas of office monochrome digital multifunction, as well as production and office color. Cost and expense actions, consistent with improving our business model, enabled further progress in gross margins and reduced selling, administrative and general (“SAG”) expenses.
Total revenues of $11.6 billion declined 8 percent from $12.6 billion in the nine months ended September 30, 2002. Approximately one third of the year-to-date decline was due to declines in SOHO and DMO. The remaining decline occurred in all operating segments reflecting the effects of lower equipment population in most geographies, competitive pressures, a weak economic environment and our focus on more profitable revenue. Growth in digital multifunction and production and office color were more than offset by declines in production and office monochrome, particularly in light-lens.
Net Income (Loss):
Third quarter 2002 net income of $99 million or four cents per diluted share included after-tax restructuring charges of $49 million ($63 million pre-tax). The third quarter 2001 net loss of $69 million, or ten cents per diluted share, included after-tax restructuring charges of $47 million ($63 million pre-tax), net after-tax losses from foreign unhedged currency exposures of $38 million ($59 million pre-tax) and after-tax goodwill amortization of $15 million ($16 million pre-tax) that was amortized prior to our adoption of SFAS No.142.
Net income for the nine months ended September 30, 2002 was $72 million, or one cent per diluted share compared with $46 million or five cents per diluted share for the same period in the prior year. Net income for the nine months ended September 30, 2002 included a goodwill impairment of $63 associated with the adoption of SFAS No. 142, after-tax restructuring charges of $191 million ($262 million pre-tax) and an after-tax charge of $44 million ($72 million pre-tax) for permanently impaired capitalized software and net after tax losses from currency exposures of $53 million ($69 million pre-tax). Net income for the nine months ended September 30, 2001 included the following items: a $300 million after-tax gain ($769 million pre-tax) on the sale of half our interest in Fuji Xerox, after-tax restructuring charges of $350 million ($487 million pre-tax), after-tax goodwill amortization of $46 million ($49 million pre-tax), an after-tax gain of $34 million ($57 million pre-tax) reflecting the early extinguishment of debt and net after-tax losses from unhedged foreign currency exposures of $4 million ($8 million pre-tax).
As previously disclosed in our 2001 Annual Report, beginning in the second quarter of 2001, the Board of Directors suspended the dividend on the Company’s Preferred Stock held by its Employee Stock Ownership plan (“ESOP”). The ESOP is required to be funded by a combination of dividends and compensation payments over the term of the plan for pre-determined amounts each period. The dividends do not affect our income statement, while compensation is recorded as expense in our income statement. In order to meet ESOP debt service requirements since dividends were suspended, we incurred additional ESOP-related compensation expense for each period that the dividends were not declared. On September 9, 2002, the Board of Directors declared preferred dividends totaling $67 million (net dividends of $63 after tax benefits of unallocated shares. This resulted in a reversal of the previously recorded compensation expense through the third quarter 2002 and a corresponding increase to net income of $63 million. There is no corresponding earnings per share (“EPS”) improvement since the EPS calculation requires deduction of dividends declared from reported net income in arriving at net income available to common shareholders.
Operations Review
Pre-Currency Growth
To understand the trends in the business, we believe that it is helpful to adjust revenue and expense growth (except for ratios) to exclude the impact of changes in the translation of European and Canadian currencies into U.S. dollars. We refer to this adjusted growth as “pre-currency growth.” Latin American results are shown at actual exchange rates for both pre-currency and post-currency reporting, since these countries generally have volatile currency and inflationary environments.
A substantial portion of our consolidated revenues is derived from operations outside of the United States where the U.S. dollar is not the functional currency. When compared with the average of the major European and Canadian currencies on a revenue-weighted basis, the U.S. dollar was approximately 7 percent weaker in the 2002 third quarter than in the 2001 third quarter and 2 percent weaker on a year-to-date basis than in the comparable period of the prior year. As a result, foreign currency translation favorably impacted revenue growth by approximately 2 percentage points in the third quarter 2002 and one percentage point for the first nine months of 2002.
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Revenues by Type
Year-over-year post currency percent increases (decreases) by type of revenue on a quarterly basis were as follows:
2001 2002
------------------------------------------------------------ -----------------------------------
First Second
First Second Third Fourth Full Quarter Quarter Third
Quarter Quarter Quarter Quarter Year (2) (2) Quarter
------- ------- ------- ------- ---- ------- ------- -------
Equipment sales (1) (10 )% (20 )% (19 )% (21 )% (18 )% (17 )% (12 )% (9 )%
Post sale and other revenue (1) (5 )% (7 )% (6 )% (8 )% (6 )% (8 )% (6 )% (5 )%
Finance Income 1 % (1 )% (7 )% (5 )% (3 )% (10 )% (13 )% (10 )%
Total Revenue (6 )% (10 )% (9 )% (12 )% (9 )% (10 )% (8 )% (6 )%
(1) Total sales revenue in the Condensed Consolidated Statements of Income includes equipment sales noted above, as well as supplies, paper and other revenue that is included in “Post
Sale and Other Revenue” in the above table.
(2) Equipment sales and Post sale and other revenue for the first
and second quarter of 2002 have been revised from previously
reported percentages to conform certain sale revenue
classifications to the current quarter presentation.
Year-over-year post currency percent decreases by type of revenue on a year-to-date basis were as follows:
Nine Months Ended September 30,
-------------------------------------
2002 2001
----------- -----------
Equipment sales (1) (13 )% (17 )%
Post sale and other revenue (1) (6 )% (6 )%
Finance Income (11 )% (2 )%
Total Revenue (8 )% (8 )%
(1) Same as (1) in table above.
Equipment sales typically represent approximately 20-25 percent of total revenue. Equipment sales in the third quarter 2002 declined 9 percent (11 percent pre-currency) from the third quarter 2001 with approximately 40 percent of the decline due to our exit from the SOHO business. In addition, continued competitive pressures and economic weakness impacted equipment sales particularly in production monochrome. In November, we will launch our new 101 pages per minute (ppm) monochrome system, the Xerox 1010, our latest digital entry in the “light production” market and the least expensive and most advanced system in its class. In the third quarter, new products delivered growth in production color, monochrome digital multi-function and office color printing. Demand for the new Document Centre 500 Series exceeded our expectations and contributed to a backlog, which we expect to install in the fourth quarter.
Equipment sales in the nine months ended September 30, 2002 declined 13 percent (13 percent pre-currency) from the comparable period in the prior year reflecting competitive pressures, continued weakness in the economy and our focus on profitable revenue. However, the trend has been improving throughout the year, as new products are launched. Approximately 25 percent of the year-to-date decline was due to our previously discussed exit from SOHO.
Post sale and other revenues include service, document outsourcing, rentals, supplies and paper, which represent the revenue streams that follow equipment placement, as well as revenue not associated with equipment placement, such as royalties. Third quarter 2002 post sale and other revenues declined 5 percent (7 percent pre-currency) from the 2001 third quarter, as declines in North America and the DMO were only partially offset by growth in Europe. The declines reflect lower equipment populations due to reduced placements in earlier periods, lower page print volumes, and lower rental revenue in Latin America. Growth in Europe reflected the profile of the installed base, which has a higher proportion of digital products than North America, as well as longer average lease duration. Third quarter 2002 document outsourcing revenue declined from the third quarter 2001 as declines in North America outpaced revenue growth in Europe. We expect document outsourcing revenue will continue to decline as we continue to focus on more profitable contracts.
Year-to-date Post sale and other revenues declined by 6 percent (7 percent pre-currency). Revenue continues to grow in key areas of production color, office digital multifunction and color due to growth in the installed base. This growth only partially offsets declines in light-lens office and monochrome production, particularly in North America. Our ability to increase post sale revenue is largely dependent on our ability to increase equipment placements. Equipment placements typically occur through leases with original terms of three to five years. Our leases generate contractual and contingent post sale revenue during the terms. Once equipment placements start to increase, there will be a lag before post sale revenues also start to increase.
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Finance Incomedeclined 10 percent (12 percent pre-currency) in the third quarter 2002 from the third quarter 2001 and 11 percent (11 percent pre-currency) on a year-to-date basis reflecting continued equipment sale declines, primarily in North America, and the effects of the sale of our financing businesses in the Nordic countries and Italy.
Key Ratios and Expenses
The key ratios for 2002 and 2001 were as follows:
2001 2002
-------------------------------------------------------- ---------------------------------
First Second Third Fourth Full First Second Third
Quarter Quarter Quarter Quarter Year Quarter Quarter Quarter
------- ------- ------- ------- ---- ------- ------- -------
Gross Margin 34.8 % 39.1 % 37.6 % 41.4 % 38.2 % 41.0 % 42.5 % 42.0 %
Research and development expenses
(1) 5.8 % 6.0 % 6.3 % 5.3 % 5.9 % 6.0 % 6.1 % 6.0 %
Selling, administrative and
general expenses (1) 26.8 % 28.5 % 29.0 % 27.0 % 27.8 % 30.3 % 28.1 % 27.0 %
(1) As a percentage of Total Revenue
Year-to-date key ratios for 2002 and 2001 were as follows:
Nine Months Ended September 30,
--------------------------------
2002 2001
----------- -----------
Gross Margin 41.9 % 37.1 %
Research and development expenses (1) 6.0 % 6.1 %
Selling, administrative and general expenses (1) 28.5 % 28.0 %
(1) As a percentage of Total Revenue
Third quarter 2002 gross margin of 42.0 percent improved 4.4 percentage points from 37.6 percent in the third quarter 2001. Approximately two percentage points of the improvement reflect the prior liquidation of equipment inventory associated with our SOHO exit. In addition, the improvement reflects improved manufacturing and service productivity partially offset by the impact of competitive price pressures. The applicable portion of the previously discussed ESOP expense adjustment benefited the third quarter 2002 gross margin by $28 million or 0.7 percentage points. Year-to-date gross margin of 41.9 percent improved 4.8 percentage points from 37.1 percent in the comparable period of the prior year. Improved manufacturing and service productivity, favorable product mix, our SOHO exit and lower cost of borrowings for our finance businesses more than offset the adverse impact of competitive price pressures.
Research and development (R&D) expenses of $229 million were $28 million lower in the 2002 third quarter than the third quarter 2001. Year-to-date 2002 R&D spending of $699 million was $66 million lower than in the first nine months of 2001. The R&D expense reduction reflects benefits from restructuring actions, the $11 million applicable portion of the ESOP expense adjustment and our SOHO exit. R&D spending in the 2002 third quarter and year-to-date represented 6 percent of revenue as we continue to invest in technological development, particularly color, in order to maintain our position in the rapidly changing document processing market. We expect 2002 R&D spending will represent approximately 6 percent of revenue, a level that we believe is adequate to remain technologically competitive. Xerox’s R&D remains strategically coordinated with Fuji Xerox.
Selling, administrative and general (SAG) expenses declined by $152 million in the 2002 third quarter to $1,023 million primarily reflecting business model improvements from our cost reductions, the $28 million applicable portion of the ESOP expense adjustment, a $34 million favorable property tax adjustment, lower bad debt provisions and a $26 million loss associated with leased facilities. The $34 million property tax adjustment resulted from a change in the estimated amounts payable to the numerous domestic state and local property tax jurisdictions where we place our equipment through sale or lease. Such change was due to our reviews of property tax rates, experience in property tax audits and amounts of leased equipment at customer sites. The $26 million loss associated with leased facilities represents a change in the estimated loss we expect to incur related to our decision not to utilize existing lease facilities, as well as changes in our estimates of certain sublease rentals at a lower rate than our lease costs. The third quarter 2002 bad debt provision of $87 million was $64 million lower than 2001 primarily due to improved aging and historical write-off trends for accounts and finance receivables as well as lower provisions in North America due to improved customer administration and tighter credit control policies. The third quarter 2001 was negatively impacted by provisions required for many high-risk small customers.
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Year-to-date 2002 SAG expense of $3,302 million declined $242 million or 7 percent from the comparable period in the prior year. The reduction reflects benefits from our restructurings, the applicable portion of the ESOP expense adjustment, the $34 million favorable property tax adjustment and lower bad debt provisions partially offset by a write-off of $72 million for permanently impaired capitalized software. Year-to-date bad debt expense of $258 million was $70 million lower than the comparable period in the prior year, due to improved aging and historical write-off trends for accounts and finance receivables as well as lower provisions in North America resulting from improvements in customer administration and tighter credit control policies, partially offset by higher provisions in Europe and DMO.
We have been initiating restructuring actions in order to cut costs and prioritize resources in strategic areas of our business. We recorded a restructuring charge in the three and nine months ended September 30, 2002 of $63 million and $262 million to reflect these actions. The third quarter charge primarily consisted of severance and employee benefits related to the termination of approximately 1,100 employees worldwide, as well as certain costs related to the consolidation of excess facilities. The third quarter and year-to-date actions are expected to reduce annualized costs by approximately $75 million and $250 million, respectively. We expect additional provisions will be required in the fourth quarter 2002 as additional plans are finalized and are committed to. The fourth quarter provision is expected to be higher than the average of the first 3 quarters of 2002 but cannot be estimated until the plans are finalized. The reserve balance for all restructuring actions at September 30, 2002 was $191 million.
Worldwide employmentwas 69,900 at the end of the 2002 third quarter primarily reflecting reductions due to our restructuring programs.
Other expenses, net for the three and nine months ended September 30, 2002 and 2001 were as follows:
($ in millions)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- --------------------------
2002 2001 2002 2001
---------- ------- ---------- ------
Non-financing interest expense $ 92 $ 56 $ 250 $ 369
Currency losses, net 12 59 69 8
Amortization of goodwill (2001 only) and intangible assets 9 21 28 66
Interest income (21 ) (24 ) (64 ) (71 )
Gain on early extinguishment of debt — (1 ) — (57 )
SEC civil penalty — — 10 —
Gains (losses) on sales of businesses and assets (14 ) — (21 ) 6
All other, net 25 22 45 33
-- ------- -- -- ---- - -- ------- -- - ---- -
Total $ 103 $ 133 $ 317 $ 354
-- ------- -- -- ---- - -- ------- -- - ---- -
Other expenses, net were $103 million in the third quarter 2002 and $133 million in the third quarter 2001. Higher non-financing interest expense primarily reflects higher borrowing costs associated with the terms of the New Credit Facility. Non-financing interest expense also includes net gains from the mark-to-market of interest rate swaps, including “received fixed/pay variable” type swaps. These gains are the result of a declining interest rate environment and totaled $29 million and $46 million in the third quarter of 2002 and 2001, respectively. The decline in gains is the result of a smaller swap portfolio and a lower relative interest rate decline in 2002 as compared to 2001.
Non-financing interest expense was $250 million year-to-date 2002 as compared to $369 million in the same period of the prior year due to lower 2002 debt levels and reduced borrowing costs in the first half of the year, partially offset by higher borrowing costs in the third quarter associated with the terms of the New Credit Facility and lower net gains from mark-to-market interest rate swaps. The proportion of our debt that is subject to variable rates has increased significantly from 2001 which, coupled with the significant reduction in market interest rates has resulted in a significant reduction in interest expense as compared to prior year periods. However, the increased variable rate debt leaves us exposed to higher interest expense if interest rates rise.
Net currency losses of $12 million in the 2002 third quarter primarily represent the cost of hedging our foreign currency denominated exposures in markets where we have been able to restore economic hedging capability, as well as lower foreign exchange volatility on unhedged currency exposures. Gains and losses on unhedged exposures were immaterial on a net basis in the quarter. The $59 million loss in the third quarter 2001 resulted from losses on unhedged exposures, largely due to our restricted access to the derivatives markets in 2001. Year-to-date 2002 currency losses were $69 million compared to $8 million
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
in the comparable period of the prior year primarily reflecting the Brazilian exchange losses incurred in the second quarter and the devaluation of the Argentine Peso. The 2001 year-to-date loss was primarily related to Yen denominated debt.
Effective January 1, 2002, we adopted the provisions of SFAS No. 142 “Goodwill and Other Intangible Assets.” Accordingly, the amortization of goodwill was discontinued in 2002. In December 2002, finalized our goodwill impairment testing and recorded an impairment charge of $63 million, that was recorded as a cumulative effect of change in accounting principle in accordance with the provisions of SFAS No. 142 as of January 1, 2002. Interest income is derived from our invested cash balances and income tax receivables. In the future, we expect interest income will decline, as cash balances are lower than prior years following a $3.2 billion net decrease in debt in 2002.
Effective April 1, 2002 we adopted the provisions of SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” Accordingly, we have reclassified the extraordinary gain on extinguishment of debt, which was previously reported in the Consolidated Statements of Income as an extraordinary item to Other expenses, net. The effect of this reclassification was a decrease in Other expenses, net of $1 million and $57 million and an increase in Income taxes (Benefits) of less than $1 million and $22 million for the three and nine months ended September 30, 2001.
In July 2002, we sold our 22 percent investment in Katun Corporation, a supplier of aftermarket copier/printer parts and supplies, for net proceeds of $67 million, which resulted in a pre-tax gain of $12 million. After-tax, the sale was essentially break-even, as the taxable basis of Katun was lower than our carrying value on the sale date resulting in a high rate of income tax.
In the second quarter 2002 we sold our Italian leasing subsidiary to a third party for $200 million cash plus the assumption of $20 million of debt. The loss on this transaction totaled $16 million, primarily related to recognition of cumulative translation adjustment losses and final sale contingency settlements. In addition, in the first half of 2002, the sale of Prudential Insurance Company common stock associated with that company’s demutualization generated a $19 million gain. The $10 million civil penalty is associated with our April 2002 settlement with the SEC.
All other, net for the 2002 third quarter includes $20 million of expenses related to certain litigation and associated claims. The 2001 third quarter included $10 million of property losses related to the September 11 attacks as well as numerous other individually insignificant items.
Income Taxes, Equity in Net Income of Unconsolidated Affiliates and Minorities’ Interests in Earnings of Subsidiaries
The following table summarizes our consolidated income taxes (benefits) and the related effective tax rate for each respective period:
($ in millions)
Three Months Ended September Nine Months Ended September
30, 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------- -------- ------------- --------
Pre-tax income (loss) $ 176 $ (105 ) $ 276 $ 308
Income taxes (benefits) 77 (45 ) 118 268
Effective tax rate 43.7 % 42.9 % 42.8 % 87.0 %
The difference between the 2002 third quarter and year-to-date effective tax rates and the U.S. statutory tax rate primarily related to additional tax expense recorded for the sale of our interest in Katun Corporation, the on-going examination in India, as well as losses in certain jurisdictions where we are not providing tax benefits. Such expense is offset, in part, by certain benefits arising from tax law changes and the retroactive declaration of ESOP dividends.
The 2001 third quarter effective tax rate was higher than the U.S. statutory tax rate primarily due to the favorable resolution of certain tax audit issues, partially offset by losses in low tax jurisdictions or jurisdictions where we are not providing tax benefits. On a year-to-date basis through September 30, 2001 the effective tax rate was higher than the U.S. statutory tax rate primarily due to the taxes incurred in connection with the sale of one-half of our ownership interest in Fuji Xerox as well as losses in low tax jurisdictions or jurisdictions where we are not providing tax benefits, partially offset by the favorable resolution of certain tax audit issues.
Our effective tax rate will change based on nonrecurring events (such as new restructuring initiatives) as well as recurring factors including the geographical mix of income before taxes and the related tax rates in those jurisdictions. We expect that our
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
consolidated 2002 effective tax rate will approximate 45 percent. Before restructuring charges, we expect that our 2002 effective tax rate will approximate 40 percent.
We are subject to ongoing tax examinations in various jurisdictions. Accordingly, we provide for additional tax expense based upon the probable outcomes of such tax examinations. In addition, when applicable, we adjust the previously recorded tax expense to reflect favorable examination results.
As a result of the investigations in India, as discussed in Note 12 to our Condensed Consolidated Financial Statements, and an expansion of those investigations to other years, we have recorded a tax liability based upon our best estimate of the probable loss resulting from the disallowable deductions.
Equity in Net income of unconsolidated affiliates consists of our 25 percent share of Fuji Xerox income as well as income from other smaller equity investments. Higher equity in net income for the third quarter and nine months ended 2002 primarily reflects improved Fuji Xerox performance including strong revenue growth and improved gross margins.
Minorities interest in earnings of subsidiaries increased by $8 million to $17 million in the third quarter 2002 and by $40 million to $66 million year-to-date primarily due to the quarterly distributions on the November 2001 Convertible Trust Preferred Securities.
Business Performance by Operating Segment
Our operating segments are as follows: Production, Office, DMO, SOHO, and Other. The following table summarizes our business performance by segment. Revenue and year-over-year revenue percentage changes by segment are as follows ($ in millions, as restated):
($ in millions)
---------------------------------------------------------------------------
Nine Months Ended
Three Months Ended September 30, September 30,
-------------------------------------- ------------------------------
2002 2001 Change 2002 2001 Change
----------- ----------- ------ -------- -------- ------
Production $ 1,324 $ 1,391 (5 )% $ 4,012 $ 4,324 (7 )%
Office 1,616 1,641 (2 )% 4,909 5,114 (4 )%
DMO 412 487 (15 )% 1,322 1,503 (12 )%
SOHO 63 111 (43 )% 189 330 (43 )%
Other 378 422 (10 )% 1,171 1,355 (14 )%
-- -------- -- -------- ------ -- - ------ - ------ ------ --
Total $ 3,793 $ 4,052 (6 )% $ 11,603 $ 12,626 (8 )%
-- -------- -- -------- ------ -- - ------ - ------ ------ --
Color $ 673 $ 650 4 % $ 1,985 $ 2,014 (1 )%
-- -------- -- -------- ------ -- - ------ - ------ ------ --
Operating segment profit (loss) and margins were as follows (in millions, as restated):
($ in millions)
Operating Segment Profit (Loss) ---------------------
---------------------------------------------------------------------------------------------------------------
2001 2002 Segment Margin
------------------------------------------------------------------ --------------------------------------- ---------------------
Third Third
First Second Third Fourth Full First Second Third Quarter Quarter
Quarter Quarter Quarter Quarter Year Quarter Quarter Quarter 2002 2001
--------- --------- --------- --------- ------ --------- --------- --------- ------- -------
Production $ 112 $ 101 $ 73 $ 180 $ 466 $ 105 $ 125 $ 142 10.7 % 5.2 %
Office 47 98 63 157 365 91 138 115 7.1 % 3.8 %
DMO (70 ) 5 (12 ) (48 ) (125 ) (5 ) 7 21 5.1 % (2.5 %)
SOHO (79 ) (84 ) (54 ) 22 (195 ) 27 15 23 36.5 % (49.1 %)
Other (10 ) (50 ) (109 ) 26 (143 ) (120 ) (56 ) (45 ) (11.9 %) (25.8 %)
-- ------ - -- ------ - -- ------ - -- ------ - - ---- - -- ------ - -- ------ - -- ------ - ------- -- ------- --
Total $ — $ 70 $ (39 ) $ 337 $ 368 $ 98 $ 229 $ 256 6.7 % (0.9 %)
-- ------ - -- ------ - -- ------ - -- ------ - - ---- - -- ------ - -- ------ - -- ------ - ------- -- ------- --
Note: For purposes of comparability, 2001 segment information has been adjusted to reflect a change in measurement of segment profit or loss that was implemented in 2002. The nature of the changes related primarily to corporate expense and other allocations associated with internal reorganizations made in 2002, as well as decisions concerning direct applicability of certain overhead expenses to the segments. The adjustments increased (decreased) full year 2001 revenues as follows: Production ($16), Office ($16), DMO ($1), SOHO $3 and Other $30. The full year 2001 segment profit was increased (decreased) as follows: Production $12, Office $24, DMO $32, SOHO $2 and Other ($70).
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Refer to Note 9 to the Condensed Consolidated Financial Statements for a reconciliation of operating segment profit (loss) to consolidated pre-tax income (loss).
Production revenues include production publishing, production printing, color products for the production and graphic arts markets and light lens copiers over 90 ppm sold predominantly through direct sales channels in North America and Europe. Revenues in the third quarter 2002 declined 5 percent (8 percent pre-currency) from the 2001 third quarter and declined 7 percent (8 percent pre-currency) year-to-date from the comparable period in the prior year. Production monochrome declines reflect customer transition from light lens to digital offerings, continued market weakness, particularly in the Graphic Arts market and the trend towards distributed printing and electronic substitutes. We have just announced the November launch of the Xerox 1010, our latest digital entry for the growing “light production” market. Production color revenues grew during both periods reflecting the recently launched DocuColor 1632 and DocuColor 2240 printer/copiers as well as continued success in the DocuColor 2000 family. Production revenues represented approximately 35 percent of total revenue in the third quarter and year-to-date 2002 and 34 percent of revenue in the third quarter and year-to-date 2001.
Third quarter 2002 production segment profit increased by $69 million to $142 million and year-to-date by $86 million to $372 million. Third quarter 2002 segment margin improved by 5.5 percentage points to 10.7 percent and year-to-date 2002 segment margin improved by 2.7 percentage points to 9.3 percent reflecting gross margin improvement and expense benefits from our cost saving initiatives, partially offset by increased R&D spending.
Office revenues include our family of Document Centre digital multifunction products, color laser, solid ink and monochrome laser printers, digital and light lens copiers up to 90 ppm, and facsimile products sold through direct and indirect sales channels in North America and Europe. Third quarter 2002 revenues declined 2 percent (4 percent pre-currency) from the 2001 third quarter as light lens declines were only partially offset by strong monochrome digital and color revenue growth from recently launched products. In the third quarter 2002, we launched the Document Centre 500 Series digital multifunction systems at speeds of 35, 45 and 55 ppm. The new Phaser office color printers, launched in May, are designed to fuel the migration to color in the office by offering cost and print quality advantages that make it practical to replace black-and-white printers. Office revenues represented approximately 43 percent of total revenue in the third quarter 2002 and 40 percent in the third quarter 2001. Year-to-date 2002 Office revenues declined 4 percent (5 percent pre-currency) from the same period in the prior year. Office revenues represented 42 percent of total 2002 year-to-date revenue compared to 41 percent in the same period of the prior year.
Third quarter 2002 office segment profit increased by $52 million to $115 million and the segment margin improved by 3.3 percentage points to 7.1 percent reflecting expense benefits from our cost saving initiatives and improved gross margins driven primarily by improved manufacturing and service productivity. Year-to-date segment profit increased by $136 million to $344 million and the segment margin improved by 2.9 percentage points to 7.0 percent also reflecting expense benefits from our cost saving initiatives and improved gross margins driven primarily by improved manufacturing and service productivity.
DMOincludes operations in Latin America, the Middle East, India, Eurasia, Russia and Africa. DMO revenue declined 15 percent in the 2002 third quarter and 12 percent year-to-date, predominantly due to lower equipment populations, major economic disruptions in Argentina, Brazil and Venezula and the related currency devaluations.
Third quarter 2002 DMO segment profit increased by $33 million to $21 million and the segment margin improved by 7.6 percentage points to 5.1 percent. Year-to-date 2002 segment profit improved by $100 million to $23 million compared to the same period in the prior year. The improvements reflect significantly lower SAG spending resulting from our cost saving initiatives and the currency devaluation. Additionally, our improved liquidity has allowed us to better economically hedge currency exposures.
We announced our disengagement from our worldwide SOHO business in June 2001. SOHO revenues now consist primarily of consumables for the inkjet printers and personal copiers previously sold through indirect channels in North America and Europe. Third quarter and year-to-date 2002 SOHO revenues declined 43 percent from 2001, primarily due to the absence of Equipment sale revenue. Third quarter and year-to-date 2002 profitability reflects continued sales of high margin consumables for the existing equipment population. We expect sales of these supplies to continue over the next few years, and will decline over time as the existing population of equipment is replaced.
Other includes revenues and costs associated with paper sales, Xerox Engineering Systems (XES), Xerox Connect, our investment in Fuji Xerox, consulting and other services. Other also includes corporate items such as non-financing interest and
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XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
other non-allocated costs. Third quarter 2002 revenue declined 10 percent (14 percent pre-currency) principally due to lower XES and Xerox Connect revenues partially offset by higher paper revenue. The improvement in third quarter 2002 loss, as compared with the prior period, principally reflects the beneficial impact of the ESOP expense adjustment, partially offset by higher non-financing interest expense. Year-to-date 2002 revenue declined 14 percent due to lower paper revenue and lower Xerox Connect revenues. The increased year-to-date loss reflects a write-off of $72 million of impaired capitalized software in the first quarter of 2002, as well as higher advertising expense, unfavorable currency impacts, the loss associated with leased facilities and the SEC civil penalty, partially offset by lower non-financing interest expense, the favorable impact of the ESOP expense adjustment, the gain on the Prudential demutualization and the sale of Katun.
Third quarter and year-to-date 2002 Adjusted Average Shares Outstandingof 825 million and 803 million, respectively, for the diluted EPS calculation increased by approximately 107 million and 21 million shares from the third quarter and year-to-date 2001, respectively. The third quarter increase reflects the effect of our dilutive securities, which are included in the calculation when we are profitable. The increase primarily reflects share dilution resulting from the application of the “if converted” methodology in the calculation of our diluted EPS for the Preferred Shares held by the ESOP. The 2002 year-to-date increase from the comparable period of the prior year reflects the issuance of additional common shares resulting from our debt-to-equity exchanges.
When computing diluted EPS, the “if converted” methodology requires us to assume conversion of the ESOP preferred shares into common stock if we are profitable. The conversion guarantees that each ESOP preferred share be converted into shares worth a minimum value of $78.25. As long as our common stock price is above $13.04 per share, the conversion ratio is 6 to 1. As our share price falls below this amount, the conversion ratio increases. Approximately, 87 million and 68 million common shares were included in the adjusted average shares outstanding for the three and nine months ended September 30, 2002, resulting from the assumed conversion of the 7.2 million average outstanding ESOP Preferred Shares at the third quarter and year-to-date 2002 average share price of approximately $6.46 per share and $8.50, respectively.
In November 2001 Xerox Capital Trust II, a trust sponsored and wholly-owned by us, issued 20.7 million 7.5 percent convertible trust preferred securities. The securities are convertible at any time, at the option of the holders, into 5.4795 shares of our common stock per trust security or a total of 113.4 million shares. When computing diluted EPS, the “if converted” methodology requires us to assume conversion of these preferred securities into common stock, assuming they are dilutive. The securities are dilutive when our quarterly basic EPS is greater than $0.12 per share.
Recent Events
Pensions:
The market performance over the past two years has decreased the value of the assets held by our pension plans and has correspondingly increased the amount by which our worldwide pension plans are under-funded. As a result of the decline in the value of our pension plan assets and a decline in interest rates, which will increase the present value of our benefit obligations for our major worldwide pension plans, we expect to record, during the fourth quarter, a non-cash charge to shareholders’ equity which could total several hundred million dollars. The majority of this charge relates to our European pension plans and the total amount of this charge will vary depending on asset returns and interest rate changes during the fourth quarter. A recovery of equity market returns in future periods would reverse this charge.
We currently expect to reduce our discount rate assumption, for our major pension plans, in response to a decline in corporate bond yields. We are also contemplating reducing our 2003 expected return on plan assets assumption by approximately 1 percent as a result of current market conditions and our longer term outlook. The potentially lower discount rate and expected rate of return on plan asset assumptions, combined with negative asset returns in 2001 and 2002, is currently estimated to increase our pension expense in 2003 by approximately $150 million versus 2002. However this expected increase will fluctuate as interest rates and asset returns fluctuate during the remainder of the year. Restructuring actions may also lead to an increase in our pension expense in the fourth quarter of 2002 and in fiscal 2003.
It is also expected that our pension plan cash funding requirements will increase in the future provided market performance does not improve. The 2003 cash contributions for our significant worldwide pension plans are estimated to be $170 million, versus $120 million for 2002.
Table of Contents
XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Capital Resources and Liquidity
Cash Flow Analysis
The following summarizes our cash flows for the nine months ended September 30, 2002 and 2001 as reported in our Condensed Consolidated Statement of Cash Flows in the accompanying Condensed Consolidated Financial Statements:
(In millions) 2002 2001
-------------------------------------------------------- -------- --------
Operating Cash Flows $ 1,242 $ 967
Investing Cash Flows 221 1,180
Financing Cash Usage (3,236 ) (1,480 )
Effect of exchange rate changes on cash and cash
equivalents 64 8
- ------ - - ------ -
(Decrease) increase in cash and cash equivalents (1,709 ) 675
Cash and cash equivalents at beginning of period 3,990 1,750
- ------ - - ------ -
Cash and cash equivalents at end of period $ 2,281 $ 2,425
- ------ - - ------ -
For the nine months ended September 30, 2002, operating cash flows of $1,242 million reflected net income, as well as working capital and finance receivable reductions, partially offset by a $346 million tax payment related to the 2001 sale of one-half our interest in Fuji Xerox, a $90 million cash contribution to our pension plans and a general reduction in current and long-term liabilities. A significant portion of the 2002 year-to-date operating cash flow resulted from ongoing run-off of our finance receivables portfolios consistent with the continuing decline in our equipment sales, together with a transition to third party vendor financing arrangements in Italy, Brazil, Mexico and the Nordic countries. The portion of operating cash flows in the nine months ended September 30, 2001 that was generated by finance receivables run-off was approximately one-third of that for the September 30, 2002 period. A decline in 2002 year-to-date on-lease equipment spending reflected declining rental placement activity and populations, particularly in our older-generation light-lens products. We continued to reduce inventory levels during 2002, although at a slower pace than in 2001. Lower interest payments in the nine months ended September 30, 2002 reflected lower debt levels, partially offset by higher interest rates versus the prior year period.
Investing cash flows for the nine months ended September 30, 2002 consisted of proceeds of $200 million from the sale of our Italian leasing business, $53 million related to the sale of certain manufacturing locations to Flextronics and $67 million related to the sale of our interest in Katun, partially offset by our capital spending. Investing cash flows in the prior year period largely consisted of the $1,635 million of cash received from sales of businesses, including one half of our interest in Fuji Xerox and our leasing businesses in the Nordic countries. These cash proceeds were offset by our capital spending and a $255 million payment related to our funding of trusts to replace Ridge Reinsurance letters of credit.
Financing activities for the nine months ended September 30, 2002 consisted of $3.5 billion of debt repayments under the renegotiated New Credit Facility, as well as other scheduled payments of maturing debt, offset by proceeds from the 9.75 percent Senior Notes offering and secured borrowings from GE and other vendor financing partners. Financing activities for the comparable 2001 period consisted of scheduled debt repayments as well as dividends on our common and preferred stock, which were suspended in the third quarter of 2001 (see Note 7 to the Condensed Consolidated Financial Statements). In the third quarter of 2002, we reinstated the preferred dividend related to the shares of our Employee Stock Ownership Plan. The cash payment of that dividend will appear in our fourth quarter 2002 cash flow statement.
The EBITDA-based cash flow presentation below portrays the way we analyze cash flows from a cash management perspective. We define EBITDA as earnings (excluding financing income) before interest expense, income taxes, depreciation, amortization, minorities’ interests, equity in net income of unconsolidated affiliates, and non-recurring and non-operating items. We believe that EBITDA provides investors and analysts with a useful measure of liquidity generated from recurring operations. EBITDA is not intended to represent an alternative to either operating income or cash flows from operating activities (as those terms are defined in GAAP). While EBITDA is frequently used to analyze companies, the definition of EBITDA that we employ, as presented herein, may be different than definitions of EBITDA used by other companies.
Table of Contents
XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
EBITDA and the related cash flows for the nine months ended September 30, 2002 and 2001were as follows:
For the Nine Months Ended
September 30,
------------------------------
2001
Restated
(In millions) 2002 Note 2
--------------------------------------------------- ----------- ---------
Non-financing revenues $ 10,842 $ 11,775
Non-financing cost of sales 6,447 7,575
-- -------- ---- -- ------ --
Non-financing gross profit 4,395 4,200
Research and development expenses (699 ) (765 )
Selling, administrative and general expenses (3,302 ) (3,544 )
Depreciation and amortization expense, excluding
goodwill and intangibles 744 931
-- -------- ---- -- ------ --
EBITDA 1,138 822
Working capital and other changes (53 ) 433
Increase in on-lease equipment (98 ) (231 )
Cost of additions to land, buildings and equipment (109 ) (159 )
Cash payments for restructurings (276 ) (365 )
Interest payments (523 ) (789 )
Equipment financing 1,520 1,136
Debt repayments, net (3,238 ) (1,414 )*
Dividends and other non-operating items (45 ) (393 )
Proceeds from divestitures (25 )** 1,635
-- -------- ---- -- ------ --
Net (decrease) increase in cash and cash
equivalents $ (1,709 ) $ 675
-- -------- ---- -- ------ --
* Amount includes $29 million of cash held in escrow, which is included in operating activities in our GAAP Condensed Consolidated
Statements of Cash Flows.
** Amount includes the tax payments associated with the Fuji Xerox
sale explained below. Such amount is included in operating
activities in our GAAP Condensed Consolidated Statements of Cash
Flows.
Table of Contents
XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
Capital Structure and Liquidity
Historically we have used leasing arrangements to provide equipment financing to a significant majority of our customers. The finance receivable portfolios and the related financing income they generate have been a significant source of liquidity for us. However, because the finance leases allow our customers to pay for equipment over time rather than at the date of purchase, we have also needed to maintain significant levels of debt to provide operating liquidity, as liquidity generated from receivable collections has generally been used to fund new equipment leases. A significant portion of our debt is directly related to the funding requirements of our financing business.
During the three and nine month periods ended September 30, 2002 we originated loans, secured by finance receivables, with cash proceeds of $846 million and $2,023 million, respectively. The following table compares finance receivables to financing-related debt as of September 30, 2002:
(In millions) Finance Receivables Debt (2)
------------------------------------------- --------------------- ----------
Finance Receivables Encumbered by Loans(1):
GE Loans—U.S. $ 2,079 $ 2,006
GE Loans—Canada 385 370
U.S. Asset-backed notes 304 200
XCC securitizations 129 38
---- ---------------- -- -------
Subtotal—SPEs 2,897 2,614
GE Loans—UK 693 509
Other 86 86
---- ---------------- -- -------
Total—Finance Receivable Securitizations 3,676 $ 3,209
-- -------
Unencumbered Finance Receivables 5,204
---- ----------------
Total Finance Receivables $ 8,880
---- ----------------
(1) Encumbered Finance receivables represent the book value of
finance receivables that secure each of the indicated
loans.
(2) Represents the debt secured by finance receivables, including transactions utilizing SPE’s, which are described
below.
The following represents our aggregate debt maturity schedules by quarter for the remainder of 2002 and all of 2003:
(In millions) 2002 2003
-------------- ------- -------
First Quarter $ 625
Second Quarter 1,223
Third Quarter 593
Fourth Quarter $ 1,073 1,493
- ----- - -----
Full Year $ 1,073 $ 3,934
- ----- - -----
Table of Contents
XEROX CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
The following table summarizes our secured and unsecured debt as of September 30, 2002:
(In millions) As of September 30, 2002
-------------------------------------------------------------------- -----------------------------------
New Credit Facility—debt secured within the 20% net worth limitation $ 900 (1)
New Credit Facility—debt secured outside the 20% net worth
limitation 600 (2)
Debt secured by finance receivables 3,209 (3)
Capital leases 24
Debt secured by other assets 97
----- ----------------------------- ---
Total Secured Debt 4,830
----- ----------------------------- ---
New Credit Facility—unsecured 2,000 (4)
Senior Notes 835
Subordinated debt 574
Other Debt 5,738
----- ----------------------------- ---
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