Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended: June 30, 2004

 

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 1-4471

 


 

XEROX CORPORATION

(Exact Name of Registrant as specified in its charter)

 


 

 

New York   16-0468020
(State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)

P.O. Box 1600

Stamford, Connecticut

  06904-1600
(Address of principal executive offices)   (Zip Code)

 

(203) 968-3000

(Registrant’s telephone number, including area code)

 

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

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class   Outstanding at June 30, 2004

Common Stock, $1 par value

 

839,106,777 shares

 



Table of Contents

Forward Looking Statements

 

From time to time we and our representatives, may provide information, whether orally or in writing, including certain statements in this Quarterly Report on Form 10-Q, which are forward-looking. These forward-looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.

 

The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. We do not intend to update these forward-looking statements.

 

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors which could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Quarterly Report on Form 10-Q and other public statements we make. Such factors include, but are not limited to, the following:

 

Competition—We operate in an environment of significant competition, driven by rapid technological advances and the demands of customers to become more efficient. Our competitors range from large international companies to relatively small firms. Some of the large international companies have significant financial resources and compete with us globally to provide document processing products and services in each of the markets we serve. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, distribution and customer service and support. Our success in future performance is largely dependent upon our ability to compete successfully in the markets we currently serve and to expand into additional market segments. To remain competitive, we must develop new products, services, and applications and periodically enhance our existing offerings. If we are unable to compete successfully, we could lose market share and important customers to our competitors and that could materially adversely affect our results of operations and financial condition.

 

Expansion of Color—Increasing the proportion of pages which are printed in color and transitioning color pages currently produced on offset devices to Xerox technology represent key growth opportunities. A significant part of our strategy and ultimate success in this changing market is our ability to develop and market technology that produces color prints and copies quickly, easily, with high quality and at reduced cost. Our continuing success in this strategy depends on our ability to make the investments and commit the necessary resources in this highly competitive market, as well as the pace of color adoption by our existing and prospective customers. If we are unable to develop and market advanced and competitive color technologies, we may be unable to capture these opportunities and it could materially adversely affect our results of operations and financial condition.

 

New Products/Research and Development—The process of developing new high technology products and solutions is inherently complex and uncertain. It requires accurate anticipation of customers’ changing needs and emerging technological trends. We must make long-term investments and commit significant resources before knowing whether these investments will eventually result in products that achieve customer acceptance and generate the revenues required to provide desired returns. If we fail to accurately anticipate and meet our customers’ needs through the development of new products or if our new products are not widely accepted, we could lose our customers and that could materially adversely affect our results of operations and financial condition.

 

Pricing—Our success depends on our ability to obtain adequate pricing for our products and services which provides a reasonable return to our shareholders. Depending on competitive market factors, future prices we obtain for our products and services may decline from previous levels. In addition, pricing actions to offset the effect of currency devaluations may not prove sufficient to offset further devaluations or may

 

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not hold in the face of customer resistance and/or competition. If we are unable to obtain adequate pricing for our products and services, it could materially adversely affect our results of operations and financial condition.

 

Customer Financing Activities—The long-term viability and profitability of our customer financing activities is dependent, in part, on our ability to borrow and the cost of borrowing in the credit markets. This ability and cost, in turn, is dependent on our credit ratings. Our access to the public debt markets is expected to be limited to the non-investment grade segment, which results in higher borrowing costs, until our credit ratings have been restored to investment grade. We are currently funding much of our customer financing activity through third-party financing arrangements, including several with General Electric in various geographies, cash generated from operations, cash on hand, capital markets offerings and securitizations. There is no assurance that we will be able to continue to fund our customer financing activity at present levels. We continue to negotiate and implement third-party financing programs and actively pursue alternative forms of financing including securitizations and secured borrowings. Our ability to continue to offer customer financing and be successful in the placement of equipment with customers is largely dependent upon maintaining our third party financing arrangements and, longer term, upon having our credit ratings restored to investment grade. If we are unable to continue to offer customer financing, it could materially adversely affect our results of operations and financial condition.

 

Productivity—Our ability to sustain and improve profit margins is largely dependent on our ability to continue to improve the cost efficiency of our operations through such programs as Lean Six Sigma and, to a lesser extent, our ability to successfully complete information technology initiatives. If we are unable to achieve productivity improvements through design efficiency, supplier and manufacturing cost improvements and information technology initiatives, our ability to offset labor cost inflation, potential materials cost increases and competitive price pressures would be impaired, all of which could materially adversely affect our results of operations and financial condition.

 

Outsourcing of Manufacturing Capacity—Since 2001, we have outsourced approximately 50 percent of our overall worldwide manufacturing operations to Flextronics, Inc. This includes the sale of some of our manufacturing facilities to Flextronics, which has significantly reduced our internal manufacturing capability. Flextronics manufactures and supplies equipment and components, including electronic components, for the Office segment of our business. We expect to increase our purchases from Flextronics commensurate with our future sales. To the extent that we rely on Flextronics and other third party manufacturing relationships, we face the risk that they may not be able to develop manufacturing methods appropriate for our products, they may not be able to quickly respond to changes in customer demand for our products, they may not be able to obtain supplies and materials necessary for the manufacturing process, they may experience labor shortages and/or disruptions, manufacturing costs could be higher than planned and the reliability of our products could decline. If any of these risks were to be realized, and assuming similar third-party manufacturing relationships could not be established, we could experience an interruption in supply or an increase in costs that might result in our being unable to meet customer demand for our products, damage to relationships with our customers, and a reduction in our market share, all of which could materially adversely affect our results of operations and financial condition.

 

International Operations—We derive approximately 45 percent of our revenue from operations outside the United States. In addition, we manufacture or acquire many of our products and/or their components from, and maintain significant operations, outside the United States. Our future revenues, costs and results from operations could be significantly affected by changes in foreign currency exchange rates, as well as by a number of other factors, including changes in economic conditions from country to country, changes in a country’s political conditions, trade protection measures, licensing requirements and local tax issues. We generally hedge foreign currency denominated assets, liabilities and anticipated transactions primarily through the use of currency derivative contracts. The use of these derivative contracts tends to mitigate volatility in our results of operations, but does not completely eliminate the volatility. We do not, however, hedge the translation effect of revenues denominated in currencies where the local currency is the functional currency.

 

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Revenue Trends—Our ability to return to and maintain a consistent trend of revenue growth over the intermediate to longer term is largely dependent upon expansion of our worldwide equipment placements, as well as sales of services and supplies occurring after the initial equipment placement (post sale revenue) in the key growth markets of color and multifunction systems. We expect that revenue growth can be further enhanced through our consulting services in the areas of personalized and product life cycle communications, office and production services and document content and imaging. The ability to achieve growth in our equipment placements is subject to the successful implementation of our initiatives to provide advanced systems, industry-oriented global solutions and services for major customers, improve direct sales productivity and expand our indirect distribution channels in the face of global competition and pricing pressures. Our ability to increase post sale revenue is largely dependent on our ability to increase equipment placements, equipment utilization and color adoption. Equipment placements typically occur through leases with original terms of three to five years. There will be a lag between the increase in equipment placement and an increase in post sale revenues. The ability to grow our customers’ usage of our products may continue to be adversely impacted by the movement toward distributed printing and electronic substitutes and the impact of lower equipment placements in prior periods. If we are unable to return to and maintain a consistent trend of revenue growth, it could materially adversely affect our results of operations and financial condition.

 

Restructuring Initiatives—Since early 2000, we have engaged in a series of restructuring programs related to downsizing our employee base, exiting certain businesses, outsourcing some internal functions and engaging in other actions designed to reduce our cost structure. If we are unable to continue to maintain our cost base at or below the current level and maintain process and systems changes resulting from the restructuring actions, it could materially adversely affect our results of operations and financial condition.

 

Debt—We have and will continue to have a substantial amount of debt and other obligations. As of June 30, 2004, we had $10.3 billion of total debt ($4.3 billion of which is secured by finance receivables) and $1.8 billion of liabilities to trusts issuing preferred securities. Cash and cash equivalents were $2.5 billion at June 30, 2004. Our substantial debt and other obligations could have important consequences. For example, it could (i) increase our vulnerability to general adverse economic and industry conditions; (ii) limit our ability to obtain additional financing for future working capital, capital expenditures, acquisitions and other general corporate requirements; (iii) increase our vulnerability to interest rate fluctuations because a portion of our debt has variable interest rates; (iv) require us to dedicate a substantial portion of our cash flows from operations to service debt and other obligations thereby reducing the availability of our cash flows from operations for other purposes; (v) limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; (vi) place us at a competitive disadvantage compared to our competitors that have less debt; and (vii) become due and payable upon a change in control. If new debt is added to our current debt levels, these related risks could increase.

 

Liquidity—Our liquidity is a function of our ability to successfully generate cash flow from an appropriate combination of efficient operations and improvements therein, financing from third parties, access to capital markets and securitizations of our finance receivables portfolios. With $2.5 billion of cash and cash equivalents on hand at June 30, 2004 and borrowing capacity under our 2003 Credit Facility of $700 million, less $15 million utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, our ability to maintain sufficient liquidity going forward depends on our ability to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

The 2003 Credit Facility contains affirmative and negative covenants including limitations on: issuance of debt and preferred stock; investments and acquisitions; mergers; certain transactions with affiliates; creation of liens; asset transfers; hedging transactions; payment of dividends and certain other payments and intercompany loans. The 2003 Credit Facility contains financial maintenance covenants, including minimum EBITDA, as defined, maximum leverage (total adjusted debt divided by EBITDA), annual

 

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maximum capital expenditures limits and minimum consolidated net worth, as defined. The indentures governing our outstanding senior notes contain similar covenants. They do not, however, contain any financial maintenance covenants, except the fixed charge coverage ratio applicable to certain types of payments. Our U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of June 30, 2004, $2.6 billion was outstanding under this Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At June 30, 2004, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity, results of operations and financial condition. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us, and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

Litigation—We have various contingent liabilities that are not reflected on our balance sheet, including those arising as a result of being involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act (ERISA), as discussed in Note 10 to the Condensed Consolidated Financial Statements. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of our legal matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

 

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XEROX CORPORATION

Form 10-Q

June 30, 2004

 

TABLE OF CONTENTS

 

     Page

Part I—Financial Information

    

Item 1. Financial Statements (Unaudited)

   7

Condensed Consolidated Statements of Income

   7

Condensed Consolidated Balance Sheets

   8

Condensed Consolidated Statements of Cash Flows

   9

Notes to Condensed Consolidated Financial Statements

   10

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   37

Results of Operations

   37

Capital Resources and Liquidity

   43

Financial Risk Management

   46

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   47

Item 4. Controls and Procedures

   47

Part II—Other Information

    

Item 1. Legal Proceedings

   48

Item 2. Changes in Securities

   48

Item 4. Submission of Matters to a Vote of Security Holders

   48

Item 6. Exhibits and Reports on Form 8-K

   49

Signatures

   51

Exhibit Index

   52

Xerox Corporation 2004 Performance Incentive Plan

    

Xerox Corporation 2004 Equity Compensation Plan for Non-Employee Directors

    

Computation of Ratio of Earnings to Fixed Charges and Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends

    

Certification of CEO pursuant to Rule 13a-14(a) or Rule 15d-14(a)

    

Certification of CFO pursuant to Rule 13a-14(a) or Rule 15d-14(a)

    

Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

    

 

For additional information about Xerox Corporation and access to our Annual Reports to Shareholders and SEC filings, free of charge, please visit our World-Wide Web site at www.xerox.com/investor. Any information on or linked from the website is not incorporated by reference into this Form 10-Q.

 

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PART I—FINANCIAL INFORMATION

 

Item 1

 

XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

     Three Months
Ended June 30,


   

Six Months

Ended June 30,


 
     2004

    2003

    2004

    2003

 
     (In millions, except per-share data)  

Revenues

                                

Sales

   $ 1,759     $ 1,696     $ 3,440     $ 3,285  

Service, outsourcing and rentals

     1,860       1,970       3,768       3,887  

Finance income

     234       254       472       505  
    


 


 


 


Total Revenues

     3,853       3,920       7,680       7,677  
    


 


 


 


Costs and Expenses

                                

Cost of sales

     1,123       1,069       2,235       2,070  

Cost of service, outsourcing and rentals

     1,052       1,096       2,154       2,185  

Equipment financing interest

     86       93       175       185  

Research and development expenses

     187       225       380       461  

Selling, administrative and general expenses

     1,050       1,089       2,086       2,109  

Restructuring charges

     33       37       39       45  

Provision for litigation

     —         —         —         300  

Other expenses, net

     50       201       137       358  
    


 


 


 


Total Costs and Expenses

     3,581       3,810       7,206       7,713  
    


 


 


 


Income (Loss) from Continuing Operations before Income Taxes and Equity Income

     272       110       474       (36 )

Income taxes (benefits)

     91       40       158       (27 )

Equity in net income of unconsolidated affiliates

     27       16       57       30  
    


 


 


 


Income from Continuing Operations

     208       86       373       21  

Gain on sale of ContentGuard, net of income taxes of $26

     —         —         83       —    
    


 


 


 


Net Income

   $ 208     $ 86     $ 456     $ 21  

Less: Preferred stock dividends, net

     (21 )     (11 )     (45 )     (21 )
    


 


 


 


Income Available to Common Shareholders

   $ 187     $ 75     $ 411     $ —    
    


 


 


 


Basic Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.23     $ 0.10     $ 0.41     $ —    

Net Earnings per Share

   $ 0.23     $ 0.10     $ 0.51     $ —    

Diluted Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.21     $ 0.09     $ 0.38     $ —    

Net Earnings per Share

   $ 0.21     $ 0.09     $ 0.46     $ —    

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

    

June 30,

2004


   

December 31,

2003


 
     (In millions, except share
data in thousands)
 

Assets

                

Cash and cash equivalents

   $ 2,542     $ 2,477  

Accounts receivable, net

     2,037       2,159  

Billed portion of finance receivables, net

     454       461  

Finance receivables, net

     2,850       2,981  

Inventories

     1,225       1,152  

Other current assets

     1,150       1,105  
    


 


Total Current Assets

     10,258       10,335  

Finance receivables due after one year, net

     4,961       5,371  

Equipment on operating leases, net

     350       364  

Land, buildings and equipment, net

     1,731       1,827  

Investments in affiliates, at equity

     702       644  

Intangible assets, net

     307       325  

Goodwill

     1,746       1,722  

Deferred tax assets, long-term

     1,468       1,526  

Other long-term assets

     1,974       2,477  
    


 


Total Assets

   $ 23,497     $ 24,591  
    


 


Liabilities and Equity

                

Short-term debt and current portion of long-term debt

   $ 4,219     $ 4,236  

Accounts payable

     901       1,010  

Accrued compensation and benefits costs

     422       532  

Unearned income

     223       251  

Other current liabilities

     1,356       1,540  
    


 


Total Current Liabilities

     7,121       7,569  

Long-term debt

     6,051       6,930  

Pension and other benefit liabilities

     1,079       1,058  

Post-retirement medical benefits

     1,268       1,268  

Liabilities to subsidiary trusts issuing preferred securities

     1,751       1,809  

Other long-term liabilities

     1,147       1,278  
    


 


Total Liabilities

     18,417       19,912  

Series B convertible preferred stock

     —         499  

Series C mandatory convertible preferred stock

     889       889  

Common stock and additional paid in capital

     3,801       3,239  

Retained earnings

     1,726       1,315  

Accumulated other comprehensive loss

     (1,336 )     (1,263 )
    


 


Total Liabilities and Equity

   $ 23,497     $ 24,591  
    


 


Shares of common stock issued and outstanding

     839,107       793,884  

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

     Three Months
Ended June 30,


   

Six Months

Ended June 30,


 
     2004

    2003

    2004

    2003

 
     (In millions)  

Cash Flows from Operating Activities:

                                

Net income

   $ 208     $ 86     $ 456     $ 21  

Adjustments required to reconcile net income to cash flows from operating activities:

                                

Gain on sale of ContentGuard, net of tax

     —         —         (83 )     —    

Provision for litigation

     —         —         —         300  

Depreciation and amortization

     168       189       343       388  

Provisions for receivables and inventory

     47       98       98       173  

Net (gain) loss on sales of businesses and assets

     (40 )     6       (50 )     8  

Undistributed equity in net income of unconsolidated affiliates

     (11 )     (7 )     (34 )     (20 )

Loss on early extinguishment of debt

     —         73       —         73  

Restructuring charges

     33       37       39       45  

Cash payments for restructurings

     (44 )     (73 )     (104 )     (253 )

Contributions to pension benefit plans

     (232 )     (32 )     (249 )     (52 )

Early termination of derivative contracts

     —         —         60       —    

(Increase) decrease in inventories

     (58 )     17       (131 )     17  

Increase in on-lease equipment

     (62 )     (36 )     (102 )     (72 )

Decrease in finance receivables

     120       162       298       345  

Decrease in accounts receivable and billed portion of finance receivables

     24       100       63       75  

Increase (decrease) in accounts payable and accrued compensation

     70       136       (13 )     (21 )

Net change in income tax assets and liabilities

     2       (48 )     22       (139 )

Decrease in other current and long-term liabilities

     (2 )     (47 )     (87 )     (51 )

Other, net

     33       21       (27 )     4  
    


 


 


 


Net cash provided by operating activities

     256       682       499       841  
    


 


 


 


Cash Flows from Investing Activities:

                                

Cost of additions to land, buildings and equipment

     (47 )     (44 )     (95 )     (79 )

Proceeds from sales of land, buildings and equipment

     7       3       39       4  

Cost of additions to internal use software

     (12 )     (14 )     (20 )     (24 )

Proceeds from divestitures and investments, net

     119       26       186       29  

Net change in escrow and other restricted investments

     158       19       191       (34 )
    


 


 


 


Net cash provided by (used in) investing activities

     225       (10 )     301       (104 )
    


 


 


 


Cash Flows from Financing Activities:

                                

Cash proceeds from new secured financings

     693       329       1,197       1,142  

Debt payments on secured financings

     (404 )     (516 )     (977 )     (975 )

Net cash payments on debt

     (500 )     (2,598 )     (909 )     (2,856 )

Net proceeds from issuance of mandatory convertible preferred stock

     —         889       —         889  

Proceeds from issuances of common stock

     18       457       47       460  

Dividends on preferred stock

     (30 )     (11 )     (55 )     (22 )

Dividends to minority shareholders

     (1 )     (1 )     (1 )     (1 )
    


 


 


 


Net cash used in financing activities

     (224 )     (1,451 )     (698 )     (1,363 )
    


 


 


 


Effect of exchange rate changes on cash and cash equivalents

     (13 )     23       (37 )     18  
    


 


 


 


Increase (decrease) in cash and cash equivalents

     244       (756 )     65       (608 )

Cash and cash equivalents at beginning of period

     2,298       3,035       2,477       2,887  
    


 


 


 


Cash and cash equivalents at end of period

   $ 2,542     $ 2,279     $ 2,542     $ 2,279  
    


 


 


 


 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

($ in millions except per share data and where otherwise noted)

 

1. Basis of Presentation:

 

References herein to “we,” “us” or “our” refer to Xerox Corporation and its consolidated subsidiaries unless the context specifically requires otherwise.

 

We have prepared the accompanying unaudited condensed consolidated interim financial statements in accordance with the accounting policies described in our 2003 Annual Report to Shareholders, which is incorporated by reference in our 2003 Annual Report on Form 10-K (“2003 Form 10-K”), and the interim reporting requirements of Form 10-Q. Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted. You should read these condensed consolidated financial statements in conjunction with the consolidated financial statements included in the 2003 Form 10-K.

 

In our opinion, all adjustments which are necessary for a fair statement of financial position, operating results and cash flows for the interim periods presented have been made. Interim results of operations are not necessarily indicative of the results of the full year.

 

For convenience and ease of reference, we refer to the financial statement caption “Income (Loss) from Continuing Operations before Income Taxes and Equity Income as “pre-tax income (loss).”

 

Certain reclassifications have been made to prior year financial information to conform to the current year presentation.

 

Liquidity: We manage our worldwide liquidity using internal cash management practices which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are parties and (3) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services.

 

With $2.5 billion of cash and cash equivalents on hand at June 30, 2004 and borrowing capacity under our 2003 Credit Facility of $700, less $15 utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Our ability to maintain sufficient liquidity going forward depends on our ability to continue to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

The 2003 Credit Facility contains affirmative and negative covenants, financial maintenance covenants and other limitations. The indentures governing our outstanding senior notes contain several affirmative and negative covenants. The senior notes do not, however, contain any financial maintenance covenants. Our U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of June 30, 2004, $2.6 billion was outstanding under the Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At June 30, 2004, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and we expect to remain in full compliance for at least the next

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

2. Stock-Based Compensation:

 

We do not recognize compensation expense relating to employee stock options because the exercise price is equal to the market price at the date of grant. If we had elected to recognize compensation expense using a fair value approach, and therefore determined the compensation based on the value as determined by the modified Black-Scholes option pricing model, our pro forma income (loss) and income (loss) per share for the three and six months ended June 30, 2004 and 2003 would have been as follows:

 

     Three Months
Ended June 30,


   Six Months
Ended June 30,


 
     2004

   2003

   2004

   2003

 

Net income—as reported

   $ 208    $ 86    $ 456    $ 21  

Deduct: Total stock-based employee compensation expense

determined under fair value based method for all awards, net of tax

     13      20      27      38  
    

  

  

  


Net income (loss)—pro forma

   $ 195    $ 66    $ 429    $ (17 )
    

  

  

  


Basic EPS—as reported

   $ 0.23    $ 0.10    $ 0.51    $ —    

Basic EPS—pro forma

     0.21      0.07      0.48      (0.05 )

Diluted EPS—as reported

   $ 0.21    $ 0.09    $ 0.46    $ —    

Diluted EPS—pro forma

     0.20      0.07      0.44      (0.05 )

 

The pro forma periodic compensation expense amounts may not be representative of future amounts since the estimated fair value of stock options is amortized to expense ratably over the vesting period, and additional options may be granted in future years.

 

3. Divestitures and Other:

 

In April 2004, we completed the sale of our ownership interest in ScanSoft, Inc. (“Scansoft”) to affiliates of Warburg Pincus for approximately $79 in cash, net of transaction costs. Prior to the sale, we beneficially owned approximately 15% of ScanSoft’s outstanding equity interests. The sale resulted in an after-tax gain of approximately $30 ($38 pre-tax). Prior to this transaction, our investment in Scansoft was accounted for as an investment “available for sale” in accordance with SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities.” The gain is classified within Other expenses, net in the condensed consolidated statements of income.

 

In the first quarter 2004, we sold all but 2 percent of our 75 percent ownership interest in ContentGuard Inc, (“ContentGuard”) to Microsoft Corporation and Time Warner Inc. for $66 cash. The sale resulted in an after-tax gain of approximately $83 ($109 pre-tax) and reflects our recognition of cumulative operating losses. The gain on the sale has been presented within the statement of income considering the reporting requirements related to

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

discontinued operations pursuant to SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The revenues, operating results and net assets of ContentGuard were immaterial for all periods presented. ContentGuard, which was originally created out of research developed at the Xerox Palo Alto Research Center (PARC), licenses intellectual property and technologies related to digital rights management.

 

In May 2002, we transferred part of our financing operations in Germany to a GE entity in order to finance certain prospective leasing business. In conjunction with this transaction, we received loans from GE secured by existing finance receivables that were transferred to this GE entity. At December 31, 2003, we consolidated this entity pursuant to the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46”) because we retained substantive rights related to the transferred finance receivables and were therefore deemed to be the primary beneficiary. During the first quarter 2004, the entity was deconsolidated because we were no longer deemed to be the primary beneficiary as the transferred finance receivables had been reduced to a level whereby we no longer retained significant risks relative to the total assets of the entity. Further, we are not providing loss protection on the new leasing business entered into by the entity. The deconsolidation of the entity reduced our assets by $114 and our debt and related securities by $84 as compared to December 31, 2003.

 

4. Restructuring Programs:

 

The restructuring charges in the Condensed Consolidated Statements of Income totaled $39 and $45 for the six months ended June 30, 2004 and 2003, respectively. Detailed information related to restructuring program activity during the six months ended June 30, 2004 is outlined below.

 

Restructuring Activity


  

Ongoing

Programs


   

Turnaround

Program


    Total

 

Ending Balance December 31, 2003

   $ 179     $ 42     $ 221  

Provision

     46       1       47  

Reversals of prior accruals

     (7 )     (1 )     (8 )

Charges against reserve and currency

     (104 )     (10 )     (114 )
    


 


 


Ending Balance June 30, 2004

   $ 114     $ 32     $ 146  
    


 


 


 

Reconciliation to Statements of Income

 

     Three Months
Ended June 30,


    Six Months
Ended June 30,


 
       2004  

      2003  

      2004  

      2003  

 

Restructuring provision

   $ 36     $ 40     $ 47     $ 60  

Restructuring reversal

     (3 )     (3 )     (8 )     (15 )
    


 


 


 


Restructuring charges

   $ 33     $ 37     $ 39     $ 45  
    


 


 


 


 

Reconciliation to Statements of Cash Flows

 

     Three Months
Ended June 30,


    Six Months
Ended June 30,


 
       2004  

      2003  

      2004  

      2003  

 

Charges to reserve, all programs

   $ (47 )   $ (78 )   $ (114 )   $ (280 )

Pension curtailment, special termination benefits and settlements

     1       12       7       25  

Effects of foreign currency and other non-cash

     2       (7 )     3       2  
    


 


 


 


Cash payments for restructurings

   $ (44 )   $ (73 )   $ (104 )   $ (253 )
    


 


 


 


 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Beginning in the fourth quarter of 2002, after effectively completing initiatives under our Turnaround program, we initiated a series of ongoing restructuring initiatives designed to continue to achieve the cost savings resulting from realized productivity improvements. These ongoing initiatives included downsizing our employee base and the outsourcing of certain internal functions. The initiatives are not individually significant and primarily include severance actions and impact all geographies and segments. During 2004, we provided an additional $39 for ongoing restructuring programs, including net reversals of $7, related to changes in estimates in severance costs from previously recorded actions. The additional provision consisted of $37, primarily related to the elimination of over 900 positions primarily in North America and Latin America, $7 for pension settlements and $2 for lease terminations. The following tables summarize the total amount of costs incurred in connection with these on-going restructuring programs and the cumulative amount incurred as of June 30, 2004 as well as the total costs expected to be incurred for initiatives identified to date:

 

Segment Reporting:

 

     Cumulative
amount
incurred as of
December 31, 2003


  

Net amount

incurred for the

six months

ended

June 30, 2004


   Cumulative
amount
incurred as of
June 30, 2004


  

Total expected

to be incurred *


Production

   $ 228    $ 8    $ 236    $ 243

Office

     168      17      185      191

DMO

     67      13      80      80

Other

     116      1      117      122
    

  

  

  

Total Provisions

   $ 579    $ 39    $ 618    $ 636
    

  

  

  


* The total amount of $636 represents the cumulative amount incurred through June 30, 2004 plus additional expected restructuring charges of $18 related to initiatives identified to date but not yet recognized in the Condensed Consolidated Financial Statements.

 

Major Cost Reporting:

 

    

Cumulative

amount

incurred as of

December 31, 2003


  

Amount

incurred for the

six months

ended

June 30, 2004


  

Cumulative

amount

incurred as of

June 30, 2004


  

Total expected

to be incurred *


Severance and related costs

   $ 483    $ 37    $ 520    $ 534

Lease cancellation and other costs

     51      2      53      57

Asset impairments

     45      —        45      45
    

  

  

  

Total provisions

   $ 579    $ 39    $ 618    $ 636
    

  

  

  

 

5. Inventories:

 

Inventories consist of the following:

 

    

June 30,

2004


  

December 31,

2003


Finished goods

   $ 928    $ 911

Work in process

     93      74

Raw materials

     204      167
    

  

Total inventories

   $ 1,225    $ 1,152
    

  

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

6. Common Shareholders’ Equity:

 

Common shareholders’ equity consisted of:

 

     June 30,
2004


    December 31,
2003


 

Common stock

   $ 840     $ 794  

Additional paid in capital

     2,961       2,445  

Retained earnings

     1,726       1,315  

Accumulated other comprehensive loss (1)

     (1,336 )     (1,263 )
    


 


Total

   $ 4,191     $ 3,291  
    


 



(1) Accumulated other comprehensive loss at June 30, 2004 was comprised of cumulative translation adjustments of $(1,073), a minimum pension liability of $(273) and unrealized cash flow hedging gains of $10.

 

Comprehensive income for the three and six months ended June 30, 2004 and 2003 was as follows:

 

     Three Months
Ended June 30,


    Six Months
Ended June 30,


 
     2004

    2003

    2004

    2003

 

Net income

   $ 208     $ 86     $ 456     $ 21  

Translation adjustments

     (80 )     194       (96 )     213  

Unrealized gains on marketable securities

     —         —         1       —    

Realized gain on marketable securities

     (18 )     —         (18 )     —    

Adjustment for minimum pension liability (1)

     —         (6 )     31       (91 )

Cash flow hedge adjustments

     10       —         9       1  
    


 


 


 


Comprehensive income

   $ 120     $ 274     $ 383     $ 144  
    


 


 


 



(1) The change of $31 in the minimum pension liability since December 31, 2003 relates to our portion of a minimum pension liability reduction recorded by Fuji Xerox during the period.

 

On May 27, 2004, all 6.2 million of our Employee Stock Ownership Plan (ESOP) Series B convertible preferred shares, which carried a $6.25 annual dividend per share, were redeemed for 37 million common shares in accordance with the original conversion provisions of the preferred shares. The redemption was accounted for through a transfer of $483 from preferred stock to common stock and additional paid-in-capital. Dividends were paid through the redemption date of May 27, 2004. The redemption had no impact on net income or diluted earnings per share (“EPS”) as such shares were previously included in our EPS computation in accordance with the “if converted” methodology.

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

7. Interest Expense and Income:

 

Interest expense and interest income for the three and six months ended June 30, 2004 and 2003 were as follows:

 

     Three Months Ended
June 30,


   Six Months Ended
June 30,


     2004

   2003

   2004

   2003

Interest expense (1)

   $ 170    $ 241    $ 354    $ 479

Interest income (2)

     263      266      516      527

(1) Includes Equipment financing interest, as well as non-financing interest expense that is included in Other expenses, net in the Condensed Consolidated Statements of Income.
(2) Includes Finance income, as well as other interest income that is included in Other expenses, net in the Condensed Consolidated Statements of Income.

 

Equipment financing interest is determined based on a combination of actual interest expense incurred on financing debt, as well as our estimated cost of funds, applied against the estimated level of debt required to support our financed receivables. The estimate is based on an assumed ratio of debt as compared to our finance receivables. This ratio ranges from 80-90% of our average finance receivables. This methodology has been consistently applied for all periods presented.

 

8. Segment Reporting:

 

Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Office, Developing Markets Operations (“DMO”) and Other. In 2004, we reclassified the operations of our Central and Eastern European entities to DMO to align our segment reporting with how we manage our business. Operating profit was reclassified for this change, as well as for certain other expense allocations. The following tables illustrate the impact of these changes on segment revenue and operating profit for 2003 and our 2004 Annual Report on Form 10-K will reflect these changes for all periods presented:

 

     Three Months Ended

 

Revenue


   Mar. 31

    June 30

    Sept. 30

    Dec. 31

    Total

 

Production

   $ (8 )   $ (9 )   $ (10 )   $ (13 )   $ (40 )

Office

     (14 )     (15 )     (14 )     (18 )     (61 )

DMO

     32       35       34       46       147  

Other

     (10 )     (11 )     (10 )     (15 )     (46 )
    


 


 


 


 


Total

   $ —       $ —       $ —       $ —       $ —    
    


 


 


 


 


Operating Profit


                              

Production

   $ (2 )   $ (1 )   $ (15 )   $ (3 )   $ (21 )

Office

     1       (2 )     (5 )     (5 )     (11 )

DMO

     4       4       4       9       21  

Other

     (3 )     (1 )     16       (1 )     11  
    


 


 


 


 


Total

   $ —       $ —       $ —       $ —       $ —    
    


 


 


 


 


 

15


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

The Production segment includes black and white products which operate at speeds over 90 pages per minute and color products which operate at speeds over 40 pages per minute. Products include the Xerox iGen3 digital color production press, Nuvera, DocuTech, DocuPrint, Xerox 2101 and DocuColor families, as well as older technology light-lens products. These products are sold, predominantly through direct sales channels in North America and Europe, to Fortune 1000, graphic arts, government, education and other public sector customers.

 

The Office segment includes black and white products which operate at speeds up to 90 pages per minute and color devices up to 40 pages per minute. Products include the suite of CopyCentre, WorkCentre, and WorkCentre Pro digital multifunction systems, DocuColor color multifunction products, color laser, solid ink and monochrome laser desktop printers, digital and light-lens copiers and facsimile products. These products are sold through direct and indirect sales channels in North America and Europe to global, national and mid-size commercial customers as well as government, education and other public sector customers.

 

The DMO segment includes our operations in Latin America, Central and Eastern Europe, the Middle East, India, Eurasia, Russia and Africa. This segment includes sales of products that are typical to the aforementioned segments, however, management serves and evaluates these markets on an aggregate geographic basis, rather than on a product basis.

 

The segment classified as Other, includes several units, none of which met the thresholds for separate segment reporting. This group primarily includes Xerox Supplies Group (predominantly paper), Small Office/Home Office (“SOHO”), Wide Format Systems, Xerox Technology Enterprises and consulting services, royalty and license revenues. Other segment profit (loss) includes the operating results from these entities, other less significant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the Production, Office and DMO segments including non-financing interest and other corporate costs.

 

Operating segment revenues and profitability for the three months ended June 30, 2004 and 2003 were as follows:

 

     Production

   Office

   DMO

   Other (1)

    Total

2004

                                   

Total segment revenues

   $ 1,122    $ 1,869    $ 417    $ 445     $ 3,853
    

  

  

  


 

Segment profit

   $ 90    $ 199    $ 8    $ 35     $ 332
    

  

  

  


 

2003

Total segment revenues

   $ 1,107    $ 1,923    $ 445    $ 445     $ 3,920
    

  

  

  


 

Segment profit (loss)

   $ 112    $ 158    $ 52    $ (86 )   $ 236
    

  

  

  


 

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Operating segment revenues and profitability for the six months ended June 30, 2004 and 2003 were as follows:

 

     Production

   Office

   DMO

   Other (1)

    Total

2004

                                   

Total segment revenues

   $ 2,216    $ 3,726    $ 837    $ 901     $ 7,680
    

  

  

  


 

Segment profit

   $ 168    $ 360    $ 30    $ 12     $ 570
    

  

  

  


 

2003

                                   

Total segment revenues

   $ 2,163    $ 3,743    $ 840    $ 931     $ 7,677
    

  

  

  


 

Segment profit (loss)

   $ 202    $ 315    $ 85    $ (190 )   $ 412
    

  

  

  


 


(1) The $73 loss associated with extinguishment of debt on the 2002 Credit Facility, previously reflected in Other segment profit (loss) for the three and six months ended June 30, 2003, has been reclassified and is reflected in the reconciliation to pre-tax income (loss) below.

 

The following is a reconciliation to pre-tax income (loss):

 

     Three Months
ended June 30,


    Six Months
ended June 30,


 
     2004

    2003

    2004

    2003

 

Total segment profit

   $ 332     $ 236     $ 570     $ 412  

Reconciling items:

                                

Restructuring and asset impairment charges

     (33 )     (37 )     (39 )     (45 )

2002 credit facility fee write-off

     —         (73 )     —         (73 )

Provision for litigation

     —         —         —         (300 )

Allocated item:

                                

Equity in net income of unconsolidated affiliates

     (27 )     (16 )     (57 )     (30 )
    


 


 


 


Pre-tax income (loss)

   $ 272     $ 110     $ 474     $ (36 )
    


 


 


 


 

9. Investment in Fuji Xerox:

 

Our equity in net income of our unconsolidated affiliates for the three and six months ended June 30, 2004 and 2003, was as follows:

 

     Three Months
ended June 30,


  

Six Months

ended June 30,


     2004

   2003

   2004

   2003

Fuji Xerox

   $ 22    $ 12    $ 48    $ 19

Other investments

     5      4      9      11
    

  

  

  

Total

   $ 27    $ 16    $ 57    $ 30
    

  

  

  

 

17


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed financial data of Fuji Xerox for the three and six months ended June 30, 2004 and 2003 was as follows:

 

     Three Months
ended June 30,


  

Six Months

ended June 30,


     2004

   2003

   2004

   2003

Summary of Operations

                           

Revenues

   $ 2,195    $ 1,986    $ 4,778    $ 4,103

Cost and Expenses

     2,072      1,861      4,475      3,893

Income before income taxes

     123      125      303      210

Income taxes

     45      51      120      112

Minorities’ interests

     4      9      9      19

Cumulative effect of change in accounting principle

     —        14      —        14
    

  

  

  

Net income

   $ 74    $ 51    $ 174    $ 65
    

  

  

  

 

Equity in net income of Fuji Xerox is affected by certain adjustments to reflect the deferral of profit associated with intercompany sales. These adjustments may result in recorded equity income that is different from that implied by our 25% ownership interest.

 

10. Contingencies:

 

Guarantees, Indemnifications and Warranty Liabilities:

 

Indemnification of Officers and Directors—Our corporate by-laws require that, except to the extent expressly prohibited by law, we must indemnify Xerox Corporation’s officers and directors against judgments, fines, penalties and amounts paid in settlement, including legal fees and all appeals, incurred in connection with civil or criminal action or proceedings, as it relates to their services to Xerox Corporation and our subsidiaries. The by-laws provide no limit on the amount of indemnification. The litigation matters and regulatory actions described below involve certain of our current and former directors and officers, all of whom are covered by the aforementioned indemnity and if applicable, the current and prior period insurance policies. However, certain indemnification payments may not be covered under our directors’ and officers’ insurance coverage. In addition, we indemnify certain fiduciaries of our employee benefit plans for liabilities incurred in their service as fiduciary whether or not they are officers of the Company.

 

Product Warranty Liabilities:

 

In connection with our normal sales of equipment, including those under sales-type leases, we generally do not issue product warranties. Our arrangements typically involve a separate full service maintenance agreement with the customer. The agreements generally extend over a period equivalent to the lease term or the expected useful life under a cash sale. The service agreements involve the payment of fees in return for our performance of repairs and maintenance. As a consequence, we do not have any significant product warranty obligations including any obligations under customer satisfaction programs. In a few circumstances, particularly in certain cash sales, we may issue a limited product warranty if negotiated by the customer. We also issue warranties for certain of our lower-end products in the Office segment, where full service maintenance agreements are not

 

18


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

available. In these instances, we record warranty obligations at the time of the sale. The following table summarizes product warranty activity for the six months ended June 30, 2004 and 2003:

 

     2004

    2003

 

Balance as of January 1

   $ 19     $ 25  

Provisions and adjustments

     24       28  

Payments

     (21 )     (27 )
    


 


Balance as of June 30

   $ 22     $ 26  
    


 


 

Tax related contingencies:

At June 30, 2004, our Brazilian operations had received assessments levied against it for indirect and other taxes which, inclusive of interest, were approximately $455. The change since the December 31, 2003 disclosed amount of $449 is primarily due to indexation and interest, additional assessments and currency. The assessments principally relate to the internal transfer of inventory. We are disputing these assessments and intend to vigorously defend our position. Based on the opinion of legal counsel, we do not believe that the ultimate resolution of these assessments will materially impact our results of operations, financial position or cash flows. In connection with these proceedings, we may be required to make cash deposits of up to half of the total amount in dispute. Generally, any such amounts would be refundable to the extent the matter is resolved in our favor.

 

We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may record incremental tax expense based upon the probable outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results. Our ongoing assessments of the probable outcomes of the examinations and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results.

 

Legal Matters:

As more fully discussed below, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act (“ERISA”). We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

 

Litigation Against the Company:

 

In re Xerox Corporation Securities Litigation: A consolidated securities law action (consisting of 17 cases) is pending in the United States District Court for the District of Connecticut. Defendants are the Company, Barry Romeril, Paul Allaire and G. Richard Thoman. The consolidated action purports to be a class action on behalf of the named plaintiffs and all other purchasers of common stock of the Company during the period between

 

19


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

October 22, 1998 through October 7, 1999 (“Class Period”). The amended consolidated complaint in the action alleges that in violation of Section 10(b) and/or 20(a) of the Securities Exchange Act of 1934, as amended (“1934 Act”), and SEC Rule 10b-5 thereunder, each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of the Company’s common stock during the Class Period by disseminating materially false and misleading statements and/or concealing material facts relating to the defendants’ alleged failure to disclose the material negative impact that the April 1998 restructuring had on the Company’s operations and revenues. The amended complaint further alleges that the alleged scheme: (i) deceived the investing public regarding the economic capabilities, sales proficiencies, growth, operations and the intrinsic value of the Company’s common stock; (ii) allowed several corporate insiders, such as the named individual defendants, to sell shares of privately held common stock of the Company while in possession of materially adverse, non-public information; and (iii) caused the individual plaintiffs and the other members of the purported class to purchase common stock of the Company at inflated prices. The amended consolidated complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all defendants, jointly and severally, for all damages sustained as a result of defendants’ alleged wrongdoing, including interest thereon, together with reasonable costs and expenses incurred in the action, including counsel fees and expert fees. On September 28, 2001, the court denied the defendants’ motion for dismissal of the complaint. On November 5, 2001, the defendants answered the complaint. On or about January 7, 2003, the plaintiffs filed a motion for class certification. That motion has not yet been fully briefed or argued before the court. The parties are currently engaged in discovery. The individual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Christine Abarca, et al. v. City of Pomona, et al. (Pomona Water Cases): On June 24, 1999, the Company was served with a summons and complaint filed in the Superior Court of the State of California for the County of Los Angeles. The complaint was filed on behalf of 681 individual plaintiffs claiming damages as a result of our alleged disposal and/or release of hazardous substances into the soil and groundwater. Subsequently, six additional complaints were filed in the same court on behalf of another 459 plaintiffs, with the same claims for damages as the June 1999 action. All seven cases have been served on the Company. Currently there are approximately 540 plaintiffs remaining in the case, as many plaintiffs have been dismissed from the litigation. Plaintiffs in all seven cases allege that hazardous substances from the Company’s operations entered the municipal drinking water supplied by the City of Pomona and the Southern California Water Company, and as a result they were exposed to the substances by inhalation, ingestion and dermal contact. Plaintiffs’ claims against the Company include personal injury, wrongful death, property damage, negligence, trespass, nuisance, and violation of the California Unfair Trade Practices Act. Damages are unspecified. The seven cases against the Company (“Abarca Group”) have been coordinated with approximately 13 unrelated cases against other defendants which involve alleged contaminated groundwater and drinking water in the San Gabriel Valley area of Los Angeles County. In all of those cases, plaintiffs have sued both the providers of drinking water and the industrial defendants who they contend contaminated the water. The body of groundwater involved in the Abarca cases, and allegedly contaminated by the Company, is separate and distinct from the body of groundwater that is involved in the San Gabriel Valley cases, and there is no allegation that the Company is involved in the San Gabriel Valley cases. Nonetheless, the court ordered both groups of cases to be coordinated because both groups concern allegations of groundwater and drinking water contamination, have similar theories of liability alleged against the defendants, and involve a number of similar legal issues, thus apparently making it more efficient, in the view of the court, for all of them to be handled by one judge. Discovery has begun and no trial date has been set. The Company denies any wrongdoing and is vigorously defending the actions. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment of this matter.

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Carlson v. Xerox Corporation, et al.: A consolidated securities law action (consisting of 21 cases) is pending in the United States District Court for the District of Connecticut against the Company, KPMG and Paul A. Allaire, G. Richard Thoman, Anne M. Mulcahy, Barry D. Romeril, Gregory Tayler and Philip Fishbach. On September 11, 2002, the court entered an endorsement order granting plaintiffs’ motion to file a third consolidated amended complaint. The defendants’ motion to dismiss the second consolidated amended complaint was denied, as moot. According to the third consolidated amended complaint, plaintiffs purport to bring this case as a class action on behalf of an expanded class consisting of all persons and/or entities who purchased Xerox common stock and/or bonds during the period between February 17, 1998 through June 28, 2002 and who were purportedly damaged thereby (“Class”). The third consolidated amended complaint sets forth two claims: one alleging that each of the Company, KPMG, and the individual defendants violated Section 10(b) of the 1934 Act and SEC Rule 10b-5 thereunder; the other alleging that the individual defendants are also allegedly liable as “controlling persons” of the Company pursuant to Section 20(a) of the 1934 Act. Plaintiffs claim that the defendants participated in a fraudulent scheme that operated as a fraud and deceit on purchasers of the Company’s common stock and bonds by disseminating materially false and misleading statements and/or concealing material adverse facts relating to various of the Company’s accounting and reporting practices and financial condition. The plaintiffs further allege that this scheme deceived the investing public regarding the true state of the Company’s financial condition and caused the plaintiffs and other members of the alleged Class to purchase the Company’s common stock and bonds at artificially inflated prices, and prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a $10 penalty and restate its financials for the years 1997-2000 (including restatement of financials previously corrected in an earlier restatement which plaintiffs contend was improper). The third consolidated amended complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other Class members against all defendants, jointly and severally, including interest thereon, together with reasonable costs and expenses, including counsel fees and expert fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss the complaint. That motion has been fully briefed, but has not been argued before the court. The individual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Florida State Board of Administration, et al. v. Xerox Corporation, et al.: A securities law action brought by four institutional investors, namely the Florida State Board of Administration, the Teachers’ Retirement System of Louisiana, Franklin Mutual Advisers and PPM America, Inc., is pending in the United States District Court for the District of Connecticut against the Company, Paul Allaire, G. Richard Thoman, Barry Romeril, Anne Mulcahy, Philip Fishbach, Gregory Tayler and KPMG. The plaintiffs bring this action individually on their own behalves. In an amended complaint filed on October 3, 2002, one or more of the plaintiffs allege that each of the Company, the individual defendants and KPMG violated Sections 10(b) and 18 of the 1934 Act, SEC Rule 10b-5 thereunder, the Florida Securities Investors Protection Act, Fl. Stat. ss. 517.301, and the Louisiana Securities Act, R.S. 51:712(A). The plaintiffs further claim that the individual defendants are each liable as “controlling persons” of the Company pursuant to Section 20 of the 1934 Act and that each of the defendants is liable for common law fraud and negligent misrepresentation. The complaint generally alleges that the defendants participated in a scheme and course of conduct that deceived the investing public by disseminating materially false and misleading statements and/or concealing material adverse facts relating to the Company’s financial condition and accounting and reporting practices. The plaintiffs contend that in relying on false and misleading statements allegedly made by the defendants, at various times from 1997 through 2000 they bought shares of the Company’s common stock at artificially inflated prices. As a result, they allegedly suffered aggregated cash losses in excess of $200. The plaintiffs further contend that the alleged fraudulent scheme prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

$10 penalty and restate its financials for the years 1997-2000 including restatement of financials previously corrected in an earlier restatement which plaintiffs contend was false and misleading. The plaintiffs seek, among other things, unspecified compensatory damages against the Company, the individual defendants and KPMG, jointly and severally, including prejudgment interest thereon, together with the costs and disbursements of the action, including their actual attorneys’ and experts’ fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss all claims in the complaint that are in common with the claims in the Carlson action. That motion has been fully briefed, but has not been argued before the court. The individual defendants and we deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

In Re Xerox Corp. ERISA Litigation: On July 1, 2002, a class action complaint captioned Patti v. Xerox Corp. et al. was filed in the United States District Court for the District of Connecticut (Hartford) alleging violations of the ERISA. Three additional class actions (Hopkins, Uebele and Saba) were subsequently filed in the same court making substantially similar claims. On October 16, 2002, the four actions were consolidated as In Re Xerox Corporation ERISA Litigation. On November 15, 2002, a consolidated amended complaint was filed. A fifth class action (Wright) was filed in the District of Columbia. It has been transferred to Connecticut and consolidated with the other actions. The purported class includes all persons who invested or maintained investments in the Xerox Stock Fund in the Xerox 401(k) Plans (either salaried or union) during the proposed class period, May 12, 1997 through November 15, 2002, and allegedly exceeds 50,000 persons. The defendants include Xerox Corporation and the following individuals or groups of individuals during the proposed class period: the Plan Administrator, the Board of Directors, the Fiduciary Investment Review Committee, the Joint Administrative Board, the Finance Committee of the Board of Directors, and the Treasurer. The complaint claims that all the foregoing defendants were fiduciaries of the Plan under ERISA and, as such, were obligated to protect the Plan’s assets and act in the interest of Plan participants. The complaint alleges that the defendants failed to do so and thereby breached their fiduciary duties. Specifically, plaintiffs claim that the defendants failed to provide accurate and complete material information to participants concerning Xerox stock, including accounting practices which allegedly artificially inflated the value of the stock, and misled participants regarding the soundness of the stock and the prudence of investing their retirement assets in Xerox stock. Plaintiffs also claim that defendants failed to invest Plan assets prudently, to monitor the other fiduciaries and to disregard Plan directives they knew or should have known were imprudent, and failed to avoid conflicts of interest. The complaint does not specify the amount of damages sought. However, it asks that the losses to the Plan be restored, which it describes as “millions of dollars.” It also seeks other legal and equitable relief, as appropriate, to remedy the alleged breaches of fiduciary duty, as well as interest, costs and attorneys’ fees. We filed a motion to dismiss the complaint. The plaintiffs subsequently filed a motion for class certification and a motion to commence discovery. Defendants have opposed both motions, contending that both are premature before there is a decision on their motion to dismiss. We and the other defendants deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Digwamaje et al. v. IBM et al: A purported class action was filed in the United States District Court for the Southern District of New York on September 27, 2002. Service of the First Amended Complaint on the Company was deemed effective as of December 6, 2002. On March 19, 2003, Plaintiffs filed a Second Amended Complaint that eliminated a number of corporate defendants but was otherwise identical in all material respects to the First Amended Complaint. The defendants include Xerox and a number of other corporate defendants who are accused of providing material assistance to the apartheid government in South Africa from 1948 to 1994, by engaging in commerce in South Africa and with the South African government and by employing forced labor, thereby

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

violating both international and common law. Specifically, plaintiffs claim violations of the Alien Tort Claims Act, the Torture Victims Protection Act and RICO. They also assert human rights violations and crimes against humanity. Plaintiffs seek compensatory damages in excess of $200 billion and punitive damages in excess of $200 billion. The foregoing damages are being sought from all defendants, jointly and severally. Xerox has filed a motion to dismiss the Second Amended Complaint. Oral argument of the motion was heard on November 6, 2003 and we are awaiting the court’s decision. Xerox denies any wrongdoing and is vigorously defending the action. Based upon the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Arbitration between MPI Technologies, Inc. and Xerox Canada Ltd. and Xerox Corporation: A dispute between MPI Technologies, Inc. (“MPI”) and the Company and Xerox Canada Ltd. (“XCL”) is being arbitrated in Ontario, Canada. The dispute arose under a license agreement (“Agreement”) made as of March 15, 1994 between MPI and XCL. Subsequently, the Company became MPI’s primary interface for the Agreement and the activities thereunder. MPI has alleged damages of $69 for royalties owed under the Agreement, $35 for breach of fiduciary duty, $35 in punitive damages and unspecified damages and injunctive relief with respect to a claim of copyright infringement and unspecified damages with respect to a claim of breach of confidence. The Company and XCL deny that any damages are owed and have asserted a counterclaim against MPI for overpayment of royalties, breach of contract and copyright infringement. The Company and XCL deny any wrongdoing and are vigorously defending the action. The hearing of the arbitration is scheduled to commence on January 17, 2005. Based on the stage of the arbitration, it is not possible to estimate the amount of loss or the range of possible loss that might result from an adverse ruling or a settlement of this matter.

 

Accuscan, Inc. v. Xerox Corporation: On April 11, 1996, an action was commenced by Accuscan, Inc. (“Accuscan”), in the United States District Court for the Southern District of New York (“DCSD”), against the Company seeking unspecified damages for infringement of a patent of Accuscan which expired in 1993. The suit, as amended, was directed to facsimile and certain other products containing scanning functions and sought damages for sales between 1990 and 1993. On April 1, 1998, a verdict was entered in favor of Accuscan for $40. However, on September 14, 1998, the court granted our motion for a new trial on damages. The trial ended on October 25, 1999 with a verdict of $10. We appealed to the Court of Appeals for the Federal Circuit (“CAFC”) which found the patent was not infringed, thereby terminating the lawsuit subject to an appeal which was filed by Accuscan to the U.S. Supreme Court. The decision of the U.S. Supreme Court was to remand the case back to the CAFC to consider its previous decision based on the U.S. Supreme Court’s May 28, 2002 ruling in the Festo case. On September 17, 2003, the CAFC reconsidered the case and again held that the patent was not infringed. On December 15, 2003, Accuscan filed a petition to the U.S. Supreme Court to appeal the CAFC’s September 17, 2003 decision. This petition was denied on February 23, 2004. The period during which Accuscan could obtain reconsideration of the Supreme Court’s denial of the petition for writ of certiorari has expired. We expect that judgment for Xerox will be entered by the DCSC in the ordinary course consistent with the mandate issued by the CAFC.

 

Arbitration between Paul Lahmi and Xerox Corporation: A former employee of Xerox-The Document Company SAS (“Xerox France”), our French subsidiary, has filed a petition in arbitration against Xerox France claiming that he was owed €100 million in royalties for alleged use of a patent that he transferred to Xerox France under an Agreement dated December 3, 2000. After negotiations, in July 2004, the parties entered into a confidential settlement agreement, the terms of which are not material to the Company.

 

National Union Fire Insurance Company v. Xerox Corporation, et al.: On October 24, 2003, a declaratory judgment action was filed in the Supreme Court of the State of New York, County of New York against the

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Company and several current and former officers and/or members of the Board of Directors. Plaintiff claims that it issued an Excess Directors & Officers Liability and Corporate Reimbursement Policy to the Company in reliance on information from the Company that allegedly misrepresented the Company’s financial condition and outlook. The policy at issue provides for $25 of coverage as a component of the company reimbursement portion of an insurance program that provides for up to $135 coverage (after deductibles and coinsurance and subject to other policy limitations and requirements) over a three-year period. However, $10 of the entire amount may be unavailable due to the liquidation of one of the other insurers. Plaintiff seeks judgment (i) that it is entitled to rescind the policy as void from the outset; (ii) in the alternative, limiting coverage under the policy and awarding plaintiff damages in an unspecified amount representing that portion of any required payment under the policy that is attributable to the Company’s and the individual defendants’ own misconduct; and (iii) for the costs and disbursement of the action and such other relief as the court deems just and proper. On December 19, 2003, the Company and individual defendants moved to dismiss the complaint. The Court heard oral argument on the motions to dismiss on March 15, 2004, however no decision has been issued. The individual defendants and the Company deny any wrongdoing and are vigorously defending the action.

 

ePaperSign, LLC v. Xerox Corporation: On June 24, 2003 ePaperSign, LLC (“ePS”) commenced an action in the United States District Court for the District of Massachusetts against the Company, seeking unspecified damages. An amended complaint was filed on August 29, 2003. The amended complaint generally alleged that the Company fraudulently induced ePS into entering an agreement to form entities intended to commercialize and market electronic paper that had been invented at the Company’s Palo Alto Research Center, and intentionally misrepresented to ePS the technological state of electronic paper. In July 2004, the parties entered into a confidential settlement agreement, the terms of which are not material to the Company.

 

Warren, et al. v. Xerox Corporation: On March 11, 2004, the United States District Court for the Eastern District of New York entered an order certifying a nationwide class of all black salespersons employed by Xerox from February 1, 1997 to the present under Title VII of the Civil Rights Act of 1964, as amended, and the Civil Rights Act of 1871. The suit was commenced on May 9, 2001 by six black sales representatives. The plaintiffs allege that Xerox has engaged in a pattern or practice of race discrimination against them and other black sales representatives by assigning them to less desirable sales territories, denying them promotional opportunities, and paying them less than their white counterparts. Although the complaint does not specify the amount of damages sought, plaintiffs do seek, on behalf of themselves and the classes they seek to represent, front and back pay, compensatory and punitive damages, and attorneys’ fees. We deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Compression Labs, Inc. v. Xerox Corporation: In April 2004, Compression Labs, Incorporated (CLI) commenced an action in the United States District Court for the Eastern District of Texas, Marshall Division against Xerox, along with 27 other companies, seeking unspecified damages for patent infringement, injunction and other ancillary relief. According to CLI, the patent covers an aspect of a standard for compressing full-color or gray-scale still images (JPEG). We deny any wrongdoing and are vigorously defending this action. In July 2004, along with several of the other defendants in the above named action, we filed a complaint against CLI in Federal Court in Delaware, requesting a declaratory judgment of non-infringement and invalidity; a finding of an implied license to use the patent; a finding that CLI is estopped from enforcing the patent; damages and relief under state law for deceptive trade practices, unfair competition, fraud, negligent misrepresentation, equitable estoppel and patent misuse; and relief under federal anti-trust laws for CLI’s violation of Section 2 of the Sherman Act. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Derivative Litigation Brought on Behalf of the Company:

 

In re Xerox Derivative Actions: A consolidated putative shareholder derivative action is pending in the Supreme Court of the State of New York, County of New York against several current and former members of the Board of Directors including William F. Buehler, B.R. Inman, Antonia Ax:son Johnson, Vernon E. Jordan, Jr., Yotaro Kobayashi, Hilmar Kopper, Ralph Larsen, George J. Mitchell, N.J. Nicholas, Jr., John E. Pepper, Patricia Russo, Martha Seger, Thomas C. Theobald, Paul Allaire, G. Richard Thoman, Anne Mulcahy and Barry Romeril, and KPMG. The plaintiffs purportedly brought this action in the name of and for the benefit of the Company, which is named as a nominal defendant, and its public shareholders. The second consolidated amended complaint alleged that each of the director defendants breached their fiduciary duties to the Company and its shareholders by, among other things, ignoring indications of a lack of oversight at the Company and the existence of flawed business and accounting practices within the Company’s Mexican and other operations; failing to have in place sufficient controls and procedures to monitor the Company’s accounting practices; knowingly and recklessly disseminating and permitting to be disseminated, misleading information to shareholders and the investing public; and permitting the Company to engage in improper accounting practices. The plaintiffs further alleged that each of the director defendants breached his/her duties of due care and diligence in the management and administration of the Company’s affairs and grossly mismanaged or aided and abetted the gross mismanagement of the Company and its assets. The second amended complaint also asserted claims of negligence, negligent misrepresentation, breach of contract and breach of fiduciary duty against KPMG. Additionally, plaintiffs claimed that KPMG is liable to Xerox for contribution, based on KPMG’s share of the responsibility for any injuries or damages for which Xerox is held liable to plaintiffs in related pending securities class action litigation. On behalf of the Company, the plaintiffs seek a judgment declaring that the director defendants violated and/or aided and abetted the breach of their fiduciary duties to the Company and its shareholders; awarding the Company unspecified compensatory damages against the director defendants, individually and severally, together with pre-judgment and post-judgment interest at the maximum rate allowable by law; awarding the Company punitive damages against the director defendants; awarding the Company compensatory damages against KPMG; and awarding plaintiffs the costs and disbursements of this action, including reasonable attorneys’ and experts’ fees. On December 16, 2002, the Company and the individual defendants answered the complaint. The plaintiffs filed a third consolidated and amended derivative action complaint on July 23, 2003 adding factual allegations relating to subsequent acts and transactions, namely indemnification of six former officers for disgorgements imposed pursuant to their respective settlements with the SEC and related legal fees, and adding a demand for injunctive relief with respect to that indemnification. On September 12, 2003, Xerox and the individuals filed an answer to the third consolidated and amended derivative action complaint. Discovery in this case has been stayed, to the extent it is duplicative of discovery in Carlson, as discussed herein, pending determination of the motion to dismiss in Carlson. The individual defendants deny any wrongdoing and are vigorously defending the action.

 

Pall v. KPMG, et al.: On May 13, 2003, a shareholder commenced a derivative action in the United States District Court for the District of Connecticut against KPMG and four of its current or former partners. The Company was named as a nominal defendant. The plaintiff had filed an earlier derivative action against certain current and former members of the Xerox Board of Directors and KPMG. That action, captioned Pall v. Buehler, et al., was dismissed for lack of jurisdiction. Plaintiff purports to bring this current action derivatively on behalf and for the benefit of the Company seeking damages allegedly caused to the Company by KPMG and the named individual defendants. The plaintiff asserts claims for contribution under the securities laws, negligence, negligent misrepresentation, breach of contract, breach of fiduciary duty and indemnification. The plaintiff seeks unspecified compensatory damages (together with pre-judgment and post-judgment interest), a declaratory judgment that defendants violated and/or aided and abetted the breach of fiduciary and professional duties to the

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Company, an award of punitive damages for the Company against the defendants, plus the costs and disbursements of the action. On November 7, 2003, the Company filed a limited motion to dismiss the complaint on jurisdictional grounds and reserved its right to seek dismissal on other grounds, if the court denies the initial motion. KPMG and the individual defendants also filed limited motions to dismiss on the same grounds. The motions have not been fully briefed or argued before the court.

 

Other Matters:

 

Xerox Corporation v. 3Com Corporation, et al.: On April 28, 1997, we commenced an action in U.S. District Court for the Western District of New York against Palm, formerly owned by 3Com Corporation, for infringement of the Xerox “Unistrokes” handwriting recognition patent by the Palm Pilot using “Graffiti.” Upon reexamination, the U.S. Patent and Trademark Office confirmed the validity of all 16 claims of the original Unistrokes patent. On June 6, 2000, the District Court found the Palm Pilot with Graffiti did not infringe the Unistrokes patent claims, and on October 5, 2000 the Court of Appeals for the Federal Circuit reversed the finding of no infringement and sent the case back to the lower court to continue toward trial on the infringement claims. On December 20, 2001, the District Court granted our motions on infringement and for a finding of validity, thus establishing liability. In January 2003, Palm announced that it would stop including Graffiti in its future operating systems. On February 20, 2003, the Court of Appeals for the Federal Circuit affirmed the infringement of the Unistrokes patent by Palm’s handheld devices and remanded the validity issues to the District Court for further analysis. On December 5, 2003 Palm moved for sanctions, alleging that Xerox withheld production of material information. Xerox has since responded to the motion denying the basis of claims. On December 10, 2003 the District Court heard oral arguments on summary judgment motions from both parties directed solely to the issue of validity. A decision denying Xerox’s motions and granting Palm’s motion of summary judgment for invalidity was granted in May 2004. In June 2004, Palm filed a motion requesting clarification of the grant of summary judgment, and Xerox has responded to that motion. Xerox plans to appeal the grant of summary judgment of invalidity in due course.

 

U.S. Attorney’s Office Investigation: The U.S. attorney’s office in Bridgeport, Connecticut, is conducting an investigation into matters relating to Xerox. Xerox is a subject of this grand jury investigation. We believe that the U.S. Attorney’s office is focusing on accounting and disclosure issues during the period 1998 to 2000, particularly relating to the Company’s operations in Latin America. The accounting matters upon which the U.S. Attorney’s office appears to be focusing are ones that were investigated by the SEC and addressed in the Company’s restatements. It is not possible at this time to reasonably assess the final outcome of this investigation or its future impact on the Company. We are cooperating with the investigation and providing documents as requested.

 

Securities and Exchange Commission Investigation and Review: On April 1, 2002, we announced that we had reached a settlement with the SEC on the previously disclosed proposed allegations related to matters that had been under investigation since June 2000. As a result, on April 11, 2002, the SEC filed a complaint, which we simultaneously settled by consenting to the entry of an Order enjoining us from future violations of Section 17(a) of the Securities Act of 1933, Sections 10(b), 13(a) and 13(b) of the 1934 Act and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder, requiring payment of a civil penalty of $10, and imposing other ancillary relief. We neither admitted nor denied the allegations of the complaint. Under the terms of the settlement, in 2001 we restated our financial statements for the years 1997 through 2000.

 

As part of the settlement, a special committee of our Board of Directors retained Michael H. Sutton, former Chief Accountant of the SEC, as an independent consultant to review our material accounting controls and

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

policies. Mr. Sutton commenced his review in July 2002. On February 21, 2003, Mr. Sutton delivered his final report, together with observations and recommendations, to members of the special committee. On April 18, 2003, a copy of Mr. Sutton’s report was delivered to the Board of Directors and the SEC. On June 17, 2003, the Board of Directors reported to the SEC the decisions taken as a result of the report. We have a comprehensive ongoing program addressing continued progress in enterprise risk management as well as our process and systems management. We are devoting significant additional resources to this end.

 

Other Matters: It is our policy to promptly and carefully investigate, often with the assistance of outside advisers, allegations of impropriety that may come to our attention. If the allegations are substantiated, appropriate prompt remedial action is taken. When and where appropriate, we report such matters to the U.S. Department of Justice and to the SEC, and/or make public disclosure.

 

India. In recent years we have become aware of a number of issues at our Indian subsidiary that occurred over a period of several years much of which occurred before we obtained majority ownership of these operations in mid 1999. These issues include misappropriations of funds and payments to other companies that may have been inaccurately recorded on the subsidiary’s books and certain improper payments in connection with sales to government customers. These transactions were not material to the Company’s financial statements. We have reported these transactions to the Indian authorities, the U.S. Department of Justice and to the SEC.

 

Eurasian Subsidiary. In the third quarter 2003, we became aware of a number of transactions in a Eurasian subsidiary that appear to have been improperly recorded in late 2002 and early 2003. Appropriate disciplinary actions have been taken and a charge of approximately $5 ($5 million) related to the periods prior to July 1, 2003 was made in our financial statements for the third quarter of 2003. This matter has been reported to the SEC.

 

11. Employee Benefit Plans

 

Components of Net Periodic Cost

 

     Pension Benefits

    Other Benefits

 
    

Three months
Ended

June 30,


   

Six months
Ended

June 30,


   

Three months
Ended

June 30,


   

Six months
Ended

June 30,


 
     2004

    2003

    2004

    2003

    2004

    2003

    2004

    2003

 

Service cost

   $ 56     $ 52     $ 108     $ 101     $ 3     $ 7     $ 11     $ 13  

Interest cost

     126       110       240       221       22       22       45       45  

Expected return on plan assets

     (131 )     (112 )     (246 )     (223 )     —         —         —         —    

Recognized net actuarial loss

     25       14       49       27       6       4       12       7  

Amortization of prior service cost

     (1 )     —         (1 )     —         (7 )     (5 )     (12 )     (9 )

Recognized net transition obligation

     2       —         3       —         —         —         —         —    

Recognized settlement loss (1)

     13       34       28       78       —         —         —         —    
    


 


 


 


 


 


 


 


Net periodic benefit cost

   $ 90     $ 98     $ 181     $ 204     $ 24     $ 28     $ 56     $ 56  
    


 


 


 


 


 


 


 



(1) Approximately $1 and $12 of the settlement losses incurred during the three months ended June 30, 2004 and 2003, respectively, were incurred as a direct result of restructuring actions. Approximately $7 and $25 of the settlement losses incurred during the six months ended June 30, 2004 and 2003, respectively, were incurred as a direct result of restructuring actions. These amounts are included as restructuring charges in our condensed consolidated statements of income.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Employer Contributions

 

We previously disclosed in our financial statements for the year ended December 31, 2003 that we expected to contribute $63 to our worldwide defined benefit pension plans and $114 to our other post-retirement benefit plans in 2004. As of June 30, 2004, contributions of $249 and $56 were made to our defined benefit pension plans and our other post-retirement benefit plans, respectively. We presently anticipate contributing an additional $30 to our defined benefit pension plans and $55 to our other post-retirement benefit plans in 2004 for a total of $279 for defined benefit plans and $111 for other post-retirement benefit plans. The increase in expected 2004 defined benefit pension plan contributions is primarily due to our election to contribute $210 to our U.S. plans in April 2004 for the purpose of making those plans 100 percent funded on a current liability basis under government funding rules. This $210 contribution was made following a review of the 2004 actuarial valuation results and giving consideration to our liquidity position.

 

Medicare Prescription Drug, Improvement and Modernization Act of 2003

 

In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Act”) was signed into law. The Act will provide prescription drug coverage to retirees beginning in 2006 and will provide subsidies to sponsors of post-retirement medical plans that provide actuarially equivalent prescription drug coverage. In May 2004, FASB Staff Position No. FAS 106-2 (“FSP”) was issued by the FASB to provide guidance relating to the prescription drug subsidy provided by the Act. We currently provide post-retirement benefits to a group of retirees under two plans whereby retirees have little or no cost sharing for the prescription benefits. For these retirees, the prescription drug benefit provided by us would be considered to be actuarially equivalent to the benefit provided under the Act. Therefore, we have retroactively applied the FSP as of our measurement date of December 31, 2003. The Company has reduced its Accumulated Projected Benefit Obligation (APBO) by $64 for the subsidy related to benefits attributed to past service under these plans. This reduction will be reflected through the reduction of the amortization of actuarial losses over an effective amortization period of 12 years which reflects the average remaining service period of the employees in the plan. The effect of the subsidy on the measurement of net periodic post-retirement cost for the full year 2004 was not material. We also provide postretirement benefits to another group of retirees with cost sharing. At present, due to the lack of clarifying regulations related to the Act, we cannot determine if the benefit provided by us would be considered actuarially equivalent to the benefit provided under the Act. The issuance of final guidance could cause us to change the other post-retirement benefits financial information as it relates to this plan.

 

Berger Litigation

 

The Company’s Retirement Income Guarantee Plan (“RIGP”) represents the primary U.S. pension plan for salaried employees. In 2003, we recorded a $239 provision for litigation relating to the court approved settlement of the Berger v. RIGP litigation. Although the total amount ultimately paid under the final settlement could change, the Company does not believe that any change would be material to its results of operations or financial condition in any period. The settlement will be paid from RIGP assets and has been reflected in our 2004 actuarial valuation.

 

28


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

12. Earnings per Share:

 

The following tables summarize basic and diluted income per share for the three and six months ended June 30, 2004 and 2003 (shares in thousands):

 

    

Three months ended

June 30,


   

Six months ended

June 30,


 
     2004

    2003

    2004

    2003

 

Basic Earnings per Common Share:

                                

Income from continuing operations

   $ 208     $ 86     $ 373     $ 21  

Accrued dividends on Series B convertible preferred stock, net

     (6 )     (10 )     (16 )     (20 )

Accrued dividends on Series C mandatory convertible preferred stock

     (15 )     (1 )     (29 )     (1 )
    


 


 


 


Adjusted income from continuing operations

   $ 187     $ 75     $ 328     $ —    

Gain on sale of ContentGuard, net of tax

     —         —         83       —    
    


 


 


 


Net income available to common shareholders

   $ 187     $ 75     $ 411     $ —    
    


 


 


 


Weighted average common shares outstanding

     816,947       747,275       808,034       744,372  

Basic earnings per share

                                

Earnings from continuing operations

   $ 0.23     $ 0.10     $ 0.41     $ —    

Gain on sale of ContentGuard, net of tax

     —         —         0.10       —    
    


 


 


 


Net earnings per share

   $ 0.23     $ 0.10     $ 0.51     $ —    
    


 


 


 


Diluted Earnings per Common Share:

                                

Income from continuing operations

   $ 208     $ 86     $ 373     $ 21  

Accrued dividends on Series C mandatory convertible preferred stock

     —         (1 )     (29 )     (1 )

ESOP expense adjustment, net

     (2 )     (10 )     (6 )     (20 )

Interest on convertible securities (1), net of tax

     13       —         27       —    
    


 


 


 


Adjusted income from continuing operations

   $ 219     $ 75     $ 365     $ —    

Gain on sale of ContentGuard, net of tax

     —         —         83       —    
    


 


 


 


Adjusted net income available to common shareholders

   $ 219     $ 75     $ 448     $ —    
    


 


 


 


Weighted average common shares outstanding

     816,947       747,275       808,034       744,372  

Common shares issuable with respect to:

                                

Stock options

     15,064       8,968       15,162       —    

Convertible securities (1)

     115,417       —         115,417       —    

Series B convertible preferred stock

     23,338       51,705       26,947       —    

Series C mandatory convertible preferred stock

     74,797       —         —         —    
    


 


 


 


Adjusted weighted average shares outstanding

     1,045,563       807,948       965,560       744,372  
    


 


 


 


Diluted earnings per share

                                

Earnings from continuing operations

   $ 0.21     $ 0.09     $ 0.38     $ —    

Gain on sale of ContentGuard, net of tax

     —         —         0.08       —    
    


 


 


 


Net earnings per share

   $ 0.21     $ 0.09     $ 0.46     $ —    
    


 


 


 



(1) The convertible securities primarily consist of the convertible liability to Xerox Capital Trust II which is described in Note 14 to our 2003 financial statements included in the 2003 Form 10-K.

 

29


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

13. Financial Statements of Subsidiary Guarantors

 

The Senior Notes due 2009, 2010 and 2013 are jointly and severally guaranteed by Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc. (the “Guarantor Subsidiaries”), each of which is wholly-owned by Xerox Corporation (the “Parent Company”). The following supplemental financial information sets forth, on a condensed consolidating basis, the balance sheets, statements of income and statements of cash flows for the Parent Company, the Guarantor Subsidiaries, the non-guarantor subsidiaries and total consolidated Xerox Corporation and subsidiaries as of June 30, 2004 and December 31, 2003 and for the three and six months ended June 30, 2004 and 2003.

 

Condensed Consolidating Statements of Income for the Three Months Ended June 30, 2004

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


   Eliminations

    Total
Company


Revenues

                                     

Sales

   $ 860     $ —       $ 974    $ (75 )   $ 1,759

Service, outsourcing and rentals

     1,011       —         902      (53 )     1,860

Finance income

     83       —         151      —         234

Intercompany revenues

     184       —         97      (281 )     —  
    


 


 

  


 

Total Revenues

     2,138       —         2,124      (409 )     3,853
    


 


 

  


 

Cost and Expenses

                                     

Cost of sales

     596       —         645      (118 )     1,123

Cost of service, outsourcing and rentals

     563       —         493      (4 )     1,052

Equipment financing interest

     28       —         58      —         86

Intercompany cost of sales

     162       —         84      (246 )     —  

Research and development expenses

     166       —         29      (8 )     187

Selling, administrative and general expenses

     580       —         521      (51 )     1,050

Restructuring charges

     19       —         14      —         33

Other expenses (income), net

     (26 )     (6 )     83      (1 )     50
    


 


 

  


 

Total Cost and Expenses

     2,088       (6 )     1,927      (428 )     3,581
    


 


 

  


 

Income before Continuing Operations, Income Taxes and Equity Income

     50       6       197      19       272

Income taxes

     8       2       60      21       91

Equity in net income of unconsolidated affiliates

     4       —         20      3       27

Equity in net income of consolidated affiliates

     162       (8 )     —        (154 )     —  
    


 


 

  


 

Income (Loss) from Continuing Operations

     208       (4 )     157      (153 )     208

Gain on sale of ContentGuard, net of income taxes of $26

     —         —         —        —         —  

Net Income (Loss)

   $ 208     $ (4 )   $ 157    $ (153 )   $ 208
    


 


 

  


 

 

30


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Income for the Six Months Ended June 30, 2004

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


   Eliminations

    Total
Company


Revenues

                                     

Sales

   $ 1,687     $ —       $ 1,901    $ (148 )   $ 3,440

Service, outsourcing and rentals

     2,031       —         1,842      (105 )     3,768

Finance income

     165       —         307      —         472

Intercompany revenues

     333       —         183      (516 )     —  
    


 


 

  


 

Total Revenues

     4,216       —         4,233      (769 )     7,680
    


 


 

  


 

Cost and Expenses

                                     

Cost of sales

     1,173       —         1,283      (221 )     2,235

Cost of service, outsourcing and rentals

     1,137       —         1,027      (10 )     2,154

Equipment financing interest

     51       —         124      —         175

Intercompany cost of sales

     286       —         146      (432 )     —  

Research and development expenses

     339       —         59      (18 )     380

Selling, administrative and general expenses

     1,146       —         1,039      (99 )     2,086

Restructuring charges

     23       —         16      —         39

Other expenses (income), net

     (39 )     (11 )     188      (1 )     137
    


 


 

  


 

Total Cost and Expenses

     4,116       (11 )     3,882      (781 )     7,206
    


 


 

  


 

Income before Continuing Operations, Income Taxes and Equity Income

     100       11       351      12       474

Income taxes

     17       4       118      19       158

Equity in net income of unconsolidated affiliates

     8       —         45      4       57

Equity in net income of consolidated affiliates

     282       (14 )     —        (268 )     —  
    


 


 

  


 

Income (Loss) from Continuing Operations

     373       (7 )     278      (271 )     373

Gain on sale of ContentGuard, net of income taxes of $26

     83       —         —        —         83
    


 


 

  


 

Net Income (Loss)

   $ 456     $ (7 )   $ 278    $ (271 )   $ 456
    


 


 

  


 

 

31


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Balance Sheets as of June 30, 2004

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


    Eliminations

    Total
Company


 

Assets

                                        

Cash and cash equivalents

   $ 1,487     $ —       $ 1,055     $ —       $ 2,542  

Accounts receivable, net

     387       —         1,650       —         2,037  

Billed portion of finance receivables, net

     274       —         180       —         454  

Finance receivables, net

     488       —         2,362       —         2,850  

Inventories

     721       —         544       (40 )     1,225  

Other current assets

     510       —         647       (7 )     1,150  
    


 


 


 


 


Total Current Assets

     3,867       —         6,438       (47 )     10,258  
    


 


 


 


 


Finance receivables due after one year, net

     905       —         4,056       —         4,961  

Equipment on operating leases, net

     221       —         150       (21 )     350  

Land, buildings and equipment, net

     990       —         741       —         1,731  

Investments in affiliates, at equity

     82       —         636       (16 )     702  

Investments in and advances to consolidated subsidiaries

     8,385       (84 )     104       (8,405 )     —    

Intangible assets, net

     307       —         —         —         307  

Goodwill

     490       296       960       —         1,746  

Other long-term assets

     930       —         2,512       —         3,442  
    


 


 


 


 


Total Assets

   $ 16,177     $ 212     $ 15,597     $ (8,489 )   $ 23,497  
    


 


 


 


 


Liabilities and Equity

                                        

Short-term debt and current portion of long-term debt

   $ 202     $ —       $ 4,017     $ —       $ 4,219  

Accounts payable

     494       —         407       —         901  

Other current liabilities

     1,294       5       698       4       2,001  
    


 


 


 


 


Total Current Liabilities

     1,990       5       5,122       4       7,121  
    


 


 


 


 


Long-term debt

     2,808       —         3,243       —         6,051  

Intercompany payables, net

     2,847       (193 )     (2,607 )     (47 )     —    

Liabilities to subsidiary trusts issuing preferred securities

     684       —         1,067       —         1,751  

Other long-term liabilities

     2,768       —         741       (15 )     3,494  
    


 


 


 


 


Total Liabilities

     11,097       (188 )     7,566       (58 )     18,417  
    


 


 


 


 


Series C mandatory convertible preferred stock

     889       —         —         —         889  

Common stock, including additional paid in capital

     3,801       395       7,615       (8,010 )     3,801  

Retained earnings

     1,726       5       1,419       (1,424 )     1,726  

Accumulated other comprehensive loss

     (1,336 )     —         (1,003 )     1,003       (1,336 )
    


 


 


 


 


Total Liabilities and Equity

   $ 16,177     $ 212     $ 15,597     $ (8,489 )   $ 23,497  
    


 


 


 


 


 

32


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Cash Flows for the Six Months Ended June 30, 2004

 

     Parent
Company


    Guarantor
Subsidiaries


   Non-
Guarantor
Subsidiaries


    Total
Company


 

Net cash provided by (used in) operating activities

   $ 651     $ —      $ (152 )   $ 499  

Net cash provided by investing activities

     135       —        166       301  

Net cash used in financing activities

     (398 )     —        (300 )     (698 )

Effect of exchange rate changes on cash and cash equivalents

     (2 )     —        (35 )     (37 )
    


 

  


 


(Decrease) increase in cash and cash equivalents

     386       —        (321 )     65  

Cash and cash equivalents at beginning of period

     1,101       —        1,376       2,477  
    


 

  


 


Cash and cash equivalents at end of period

   $ 1,487     $ —      $ 1,055     $ 2,542  
    


 

  


 


 

Condensed Consolidating Statements of Income for the Three Months Ended June 30, 2003

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


   Eliminations

    Total
Company


Revenues

                                     

Sales

   $ 798     $ —       $ 898    $ —       $ 1,696

Service, outsourcing and rentals

     1,071       —         899      —         1,970

Finance income

     87       —         190      (23 )     254

Intercompany revenues

     161       —         121      (282 )     —  
    


 


 

  


 

Total Revenues

     2,117       —         2,108      (305 )     3,920
    


 


 

  


 

Cost and Expenses

                                     

Cost of sales

     514       —         593      (38 )     1,069

Cost of service, outsourcing and rentals

     586       —         512      (2 )     1,096

Equipment financing interest

     27       —         89      (23 )     93

Intercompany cost of sales

     145       —         100      (245 )     —  

Research and development expenses

     191       —         38      (4 )     225

Selling, administrative and general expenses

     626       —         463      —         1,089

Restructuring charges

     20       —         17      —         37

Provision for litigation

     —         —         —        —         —  

Other expenses (income), net

     157       (6 )     50      —         201
    


 


 

  


 

Total Cost and Expenses

     2,266       (6 )     1,862      (312 )     3,810
    


 


 

  


 

Income (Loss) before Income Taxes (Benefits) and Equity Income

     (149 )     6       246      7       110

Income taxes (benefits)

     (57 )     3       92      2       40

Equity in net income of unconsolidated affiliates

     1       4       13      (2 )     16

Equity in net income of consolidated affiliates

     177       (6 )     —        (171 )     —  
    


 


 

  


 

Net Income (Loss)

   $ 86     $ 1     $ 167    $ (168 )   $ 86
    


 


 

  


 

 

33


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Income for the Six Months Ended June 30, 2003

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


   Eliminations

    Total
Company


 

Revenues

                                       

Sales

   $ 1,597     $ —       $ 1,688    $ —       $ 3,285  

Service, outsourcing and rentals

     2,166       —         1,721      —         3,887  

Finance income

     165       —         386      (46 )     505  

Intercompany revenues

     244       —         222      (466 )     —    
    


 


 

  


 


Total Revenues

     4,172       —         4,017      (512 )     7,677  
    


 


 

  


 


Cost and Expenses

                                       

Cost of sales

     1,015       —         1,136      (81 )     2,070  

Cost of service, outsourcing and rentals

     1,179       —         1,011      (5 )     2,185  

Equipment financing interest

     50       —         181      (46 )     185  

Intercompany cost of sales

     219       —         178      (397 )     —    

Research and development expenses

     408       —         59      (6 )     461  

Selling, administrative and general expenses

     1,244       —         865      —         2,109  

Restructuring and asset impairment charges

     31       —         14      —         45  

Provision for litigation

     300       —         —        —         300  

Other expenses (income), net

     275       (12 )     95      —         358  
    


 


 

  


 


Total Cost and Expenses

     4,721       (12 )     3,539      (535 )     7,713  
    


 


 

  


 


Income (Loss) before Income Taxes (Benefits) and Equity Income

     (549 )     12       478      23       (36 )

Income taxes (benefits)

     (220 )     5       180      8       (27 )

Equity in net income of unconsolidated affiliates

     3       4       20      3       30  

Equity in net income of consolidated affiliates

     347       (15 )     —        (332 )     —    
    


 


 

  


 


Net Income (Loss)

   $ 21     $ (4 )   $ 318    $ (314 )   $ 21  
    


 


 

  


 


 

34


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Balance Sheets as of December 31, 2003

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


    Eliminations

    Total
Company


 

Assets

                                        

Cash and cash equivalents

   $ 1,101     $ —       $ 1,376     $ —       $ 2,477  

Accounts receivable, net

     717       —         1,442       —         2,159  

Billed portion of finance receivables, net

     270       —         191       —         461  

Finance receivables, net

     454       —         2,527       —         2,981  

Inventories

     669       —         520       (37 )     1,152  

Other current assets

     466       —         639       —         1,105  
    


 


 


 


 


Total Current Assets

     3,677       —         6,695       (37 )     10,335  
    


 


 


 


 


Finance receivables due after one year, net

     834       —         4,537       —         5,371  

Equipment on operating leases, net

     212       —         176       (24 )     364  

Land, buildings and equipment, net

     1,024       —         803       —         1,827  

Investments in affiliates, at equity

     73       —         571       —         644  

Investments in and advances to consolidated subsidiaries

     7,849       (75 )     192       (7,966 )     —    

Intangible assets, net

     325       —         —         —         325  

Goodwill

     491       296       935       —         1,722  

Other long-term assets

     1,611       —         2,392       —         4,003  
    


 


 


 


 


Total Assets

   $ 16,096     $ 221     $ 16,301     $ (8,027 )   $ 24,591  
    


 


 


 


 


Liabilities and Equity

                                        

Short-term debt and current portion of long-term debt

   $ 588     $ —       $ 3,648     $ —       $ 4,236  

Accounts payable

     517       —         493       —         1,010  

Other current liabilities

     868       13       1,431       11       2,323  
    


 


 


 


 


Total Current Liabilities

     1,973       13       5,572       11       7,569  
    


 


 


 


 


Long-term debt

     2,840       —         4,090       —         6,930  

Intercompany payables, net

     3,042       (188 )     (2,869 )     15       —    

Liabilities to subsidiary trusts issuing preferred securities

     743       —         1,066       —         1,809  

Other long-term liabilities

     2,819       —         684       101       3,604  
    


 


 


 


 


Total Liabilities

     11,417       (175 )     8,543       127       19,912  
    


 


 


 


 


Series B convertible preferred stock

     499       —         —         —         499  

Series C mandatory convertible preferred stock

     889       —         —         —         889  

Common stock, including additional paid in capital

     3,239       396       7,107       (7,503 )     3,239  

Retained earnings

     1,315       —         1,827       (1,827 )     1,315  

Accumulated other comprehensive loss

     (1,263 )     —         (1,176 )     1,176       (1,263 )
    


 


 


 


 


Total Liabilities and Equity

   $ 16,096     $ 221     $ 16,301     $ (8,027 )   $ 24,591  
    


 


 


 


 


 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

($ in millions except per share data and where otherwise noted)

 

Condensed Consolidating Statements of Cash Flows for the Six Months Ended June 30, 2003

 

     Parent
Company


    Guarantors
Subsidiaries


   Non-Guarantor
Subsidiaries


    Total
Company


 

Net cash provided by (used in) operating activities

   $ 1,497     $ —      $ (656 )   $ 841  

Net cash (used in) provided by investing activities

     (265 )     —        161       (104 )

Net cash provided by financing activities

     (1,337 )     —        (26 )     (1,363 )

Effect of exchange rate changes on cash and cash equivalents

     —         —        18       18  
    


 

  


 


Increase (decrease) in cash and cash equivalents

     (105 )     —        (503 )     (608 )

Cash and cash equivalents at beginning of period

     1,672       —        1,215       2,887  
    


 

  


 


Cash and cash equivalents at end of period

   $ 1,567     $ —      $ 712     $ 2,279  
    


 

  


 


 

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Table of Contents

Item 2

 

XEROX CORPORATION

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

References to “Xerox Corporation” below refer to the standalone parent company and do not include subsidiaries. References to “we,” “our” or “us” refer to Xerox Corporation and its consolidated subsidiaries.

 

Summary

 

     Three Months
Ended June 30,


   

Six Months

Ended June 30,


 
($ In millions)    2004

    2003

    2004

    2003

 

Equipment sales

   $ 1,070     $ 1,023     $ 2,052     $ 1,921  

Post sale and other revenue

     2,549       2,643       5,156       5,251  

Finance income

     234       254       472       505  
    


 


 


 


Total Revenues

   $ 3,853     $ 3,920     $ 7,680     $ 7,677  
    


 


 


 


Reconciliation to Condensed Consolidated Statements of Income

                                

Sales

   $ 1,759     $ 1,696     $ 3,440     $ 3,285  

Less: Supplies, paper and other sales

     (689 )     (673 )     (1,388 )     (1,364 )
    


 


 


 


Equipment sales

   $ 1,070     $ 1,023     $ 2,052     $ 1,921  
    


 


 


 


Service, outsourcing & rentals

   $ 1,860     $ 1,970     $ 3,768     $ 3,887  

Add: Supplies, paper and other sales

     689       673       1,388       1,364  
    


 


 


 


Post sale and other revenue

   $ 2,549     $ 2,643     $ 5,156     $ 5,251  
    


 


 


 


 

Total second quarter 2004 revenues of $3.9 billion declined 2 percent from the 2003 second quarter including a 2-percentage point benefit from currency. Equipment sales grew 5 percent in the second quarter 2004 reflecting the success of our recent color and light production product launches, as well as a 2-percentage point benefit from currency. 2004 second quarter post sale and other revenue declined 4 percent from the 2003 second quarter as declines in Developing Market Operations (“DMO”), driven by Latin America, and older light lens technology products were partially offset by digital office and production color growth as well as a 2-percentage point currency benefit. The DMO and light lens declines reflect a reduction of equipment at customer locations and related page volume declines. Finance income declined 8 percent, including a 2-percentage point benefit from currency.

 

Total first half 2004 revenues of $7.7 billion were comparable to those for the six month period ended June 30, 2003 and included a 4-percentage point benefit from currency. Equipment sales increased 7 percent reflecting the success of our recent color and light production product launches and a 4-percentage point benefit from currency. Post sale and other revenues declined 2 percent as declines in older light lens technology products and DMO, driven by Latin America, were partially offset by digital office and production color growth as well as a 3-percentage point benefit from currency. The light lens and DMO declines reflect a reduction of equipment at customer locations and related page volume declines.

 

2004 second quarter net income of $208 million, or $0.21 per diluted share, included an after-tax gain of $30 million ($38 million pre-tax) from the previously announced sale of Xerox’s ownership interest in ScanSoft, Inc. (“ScanSoft”) and after-tax restructuring charges of $21 million ($33 million pre-tax). Second quarter 2003 net income of $86 million, or $0.09 per diluted share, included a $45 million after-tax loss ($73 million pre-tax)

 

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on the early extinguishment of debt related to the write-off of the remaining unamortized fees associated with our terminated 2002 credit facility, as well as after-tax restructuring charges of $23 million ($37 million pre-tax).

 

Net income for the six months ended June 30, 2004 was $456 million or $0.46 per diluted share compared with net income of $21 million or $0.00 per diluted share for the same period in the prior year. Net income for the first half of 2004 included an after-tax gain of $83 million ($109 million pre-tax) related to the sale of all but 2 percent of our 75 percent equity interest in ContentGuard Holdings, Inc. (“ContentGuard”), an after-tax gain of $30 million ($38 million pre-tax) from the ScanSoft sale and after-tax restructuring charges of $25 million ($39 million pre-tax). Net income for the first half of 2003 included a $183 million ($300 million pre-tax) charge related to the Berger v. Retirement Income Guarantee Plan Litigation, a $45 million after-tax loss ($73 million pre-tax) on the early extinguishment of debt related to the remaining unamortized fees associated with the terminated 2002 Credit Facility, and after-tax restructuring charges of $28 million ($45 million pre-tax).

 

Operations Review

 

Revenues for the three and six months ended June 30, 2004 and 2003 were as follows:

 

($ In millions)    Production

   Office

   DMO

   Other

   Total

Three months ended June 30, 2004

                                  

Equipment sales

   $ 320    $ 572    $ 121    $ 57    $ 1,070

Post sale and other revenue

     711      1,160      293      385      2,549

Finance income

     91      137      3      3      234
    

  

  

  

  

Total Revenue

   $ 1,122    $ 1,869    $ 417    $ 445    $ 3,853
    

  

  

  

  

Three months ended June 30, 2003

                                  

Equipment sales

   $ 286    $ 588    $ 109    $ 40    $ 1,023

Post sale and other revenue

     724      1,185      333      401      2,643

Finance income

     97      150      3      4      254
    

  

  

  

  

Total Revenue

   $ 1,107    $ 1,923    $ 445    $ 445    $ 3,920
    

  

  

  

  

($ In millions)    Production

   Office

   DMO

   Other

   Total

Six months ended June 30, 2004

                                  

Equipment sales

   $ 595    $ 1,123    $ 239    $ 95    $ 2,052

Post sale and other revenue

     1,440      2,329      592      795      5,156

Finance income

     181      274      6      11      472
    

  

  

  

  

Total Revenue

   $ 2,216    $ 3,726    $ 837    $ 901    $ 7,680
    

  

  

  

  

Six months ended June 30, 2003

                                  

Equipment sales

   $ 499    $ 1,139    $ 198    $ 85    $ 1,921

Post sale and other revenue

     1,473      2,306      636      836      5,251

Finance income

     191      298      6      10      505
    

  

  

  

  

Total Revenue

   $ 2,163    $ 3,743    $ 840    $ 931    $ 7,677
    

  

  

  

  

 

Equipment sales of $1,070 million in the second quarter 2004 increased 5 percent from $1,023 million in the second quarter 2003 including a 2-percentage point benefit from currency. Equipment sales of $2,052 million for the six-month period ended June 30, 2004 increased 7 percent from the comparable period including a 4-percentage point currency benefit. Both periods reflect significant color and light production sales growth. Continued equipment sales growth reflects the success of numerous products launched during the last two years as approximately two thirds of 2004 second quarter sales were generated from these products. Color equipment sales continued to grow rapidly in the second quarter 2004 and represented approximately one-third of total equipment sales.

 

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Production: 2004 second quarter equipment sales grew 12 percent from the second quarter 2003 as installation growth and favorable currency were only partially offset by the impact of monochrome product mix and very modest single-digit price declines. Strong color equipment sales growth reflected strong installation growth and product mix, partially offset by modest price declines. Production monochrome equipment sales declined slightly as installation growth was offset by modest price declines and mix. Production monochrome installation growth reflects the continued success of the Xerox 2101 and strong demand for the Nuvera 100 and 120 copier/printers. For the six months ended June 30, 2004, Production equipment sales increased 19 percent primarily due to installation growth and favorable currency, which were only partially offset by product mix and very modest single-digit price declines. Strong color equipment sales growth reflected strong installation growth and mix, partially offset by modest price declines. Production monochrome equipment sales growth reflects installation growth, partially offset by mix and modest price declines. Monochrome installation growth reflects the success of the Xerox 2101 and strong demand for Nuvera 100 and 120 copier/printers. These Nuvera products, which were announced in January 2004, began installations in March 2004.

 

Office: 2004 second quarter and first half equipment sales declined 3 percent and one percent, respectively, from the comparable periods as product mix and price declines of 5 to 10 percent were only partially offset by strong installation growth and favorable currency. Product mix reflected an increased proportion of low-end equipment sales due to very strong growth in monochrome desktop multifunction devices (“Segment 1”) and office monochrome and color printers driven by new product introductions. Office color printing growth primarily reflects the success of the Phaser 8400, which was launched in January 2004.

 

DMO: DMO equipment sales consist primarily of Segment 1 devices and office printers. Equipment sales for the three and six months ended June 30, 2004 increased 11 percent, or $12 million, and 21 percent, or $41 million, respectively, from the comparable periods. The increases were the result of growth in geographies where we successfully operate a two-tiered distribution model, such as Russia and Central and Eastern Europe.

 

Post sale and other revenues of $2,549 million declined 4 percent from the second quarter 2003 as a 2-percentage point benefit from currency only partially offset declines from lower equipment populations. Post sale revenue is largely a function of the equipment at customer locations and the volume of prints and copies that our customers make on that equipment as well as associated services. Second quarter 2004 supplies, paper and other sales of $689 million (included within post sale and other revenue) grew 2 percent from the 2003 second quarter, due primarily to favorable currency. Service, outsourcing and rental revenue of $1,860 million declined 6 percent from the 2003 second quarter as lower equipment populations and related page volumes more than offset benefits from currency. Post sale and other revenues for the six-month period ended June 30, 2004 of $5,156 million declined 2 percent from the comparable period as a 3-percentage point benefit from currency only partially offset declines from lower equipment populations. Supplies, paper and other sales for the six-month period ended June 30, 2004 of $1,388 million increased 2 percent from the comparable period due primarily to favorable currency. Service, outsourcing and rental revenue for the six-month period ended June 30, 2004 of $3,768 million declined 3 percent from the comparable period as lower equipment populations and related page volumes more than offset benefits from currency.

 

Production: Production post sale and other revenue for the three and six month periods ended June 30, 2004 declined 2 percent as monochrome declines, driven primarily by lower page volumes, more than offset color page growth and favorable currency.

 

Office: 2004 second quarter post sale and other revenue declined 2 percent as digital monochrome and color page growth as well as favorable currency only partially offset declines in older technology light lens products. Office post sale and other revenue for the six-month period ended June 30, 2004 increased one percent from the comparable period primarily reflecting color and digital monochrome page growth as well as favorable currency, partially offset by declines in older technology light lens products.

 

DMO: DMO post sale and other revenue for the three and six month periods ended June 30, 2004 declined 12 percent and 7 percent, respectively, from the comparable periods, primarily reflecting Latin America’s rental

 

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Table of Contents

equipment population declines. In response, we are in the process of implementing a two-tiered distribution model that is intended to increase sales of office devices as well as the associated supplies and service revenue. There may be additional short-term declines before the two-tiered model is fully implemented.

 

Other: 2004 second quarter post sale and other revenue for the three and six month periods ended June 30, 2004 declined 4 percent and 5 percent, respectively, from the comparable periods, primarily resulting from declines in SOHO supply sales following our 2001 exit from this business, and paper sales. These declines were only partially offset by the favorable impact of currency.

 

Segment Operating Profit

 

Total segment operating profit for the three and six months ended June 30, 2004 of $332 million and $570 million increased by $96 million and $158 million, respectively, from the comparable periods in 2003. 2004 segment operating margin for the three and six months ended June 30, 2004 of 8.6 percent and 7.4 percent increased by 2.6 percentage points and 2.0 percentage points, respectively, from the comparable periods in 2003. The increases primarily reflected non-financing interest expense reductions, the second quarter gain on the sale of ScanSoft and disciplined cost and expense management.

 

Production: Production operating profit for the three and six months ended June 30, 2004 of $90 million and $168 million decreased by $22 million and $34 million, respectively, from the comparable periods in 2003. 2004 Production operating margin for the three and six months ended June 30, 2004 of 8.0 percent and 7.6 percent decreased by 2.1 percentage points and 1.7 percentage points, respectively, from the comparable periods in 2003. The declines were primarily due to product mix, price investments that were only partially offset by service productivity actions, and selling and marketing investments. These items were partially offset by lower R&D spending, general and administrative productivity and lower bad debt expense.

 

Office: Office operating profit for the three and six months ended June 30, 2004 of $199 million and $360 million increased by $41 million and $45 million, respectively, from the comparable periods in 2003. Office operating margin of 10.6 percent and 9.7 percent improved by 2.4 percentage points and 1.3 percentage points, respectively, from the comparable periods in 2003. These improvements primarily reflected selling infrastructure and R&D efficiencies as well as bad debt expense reductions.

 

DMO: DMO operating profit for the three and six months ended June 30, 2004 of $8 million and $30 million decreased by $44 million and $55 million, respectively, from the comparable periods in 2003. The declines primarily reflected reductions in Latin America where revenue declines have not been matched with cost and expense reductions. Additional Latin American productivity actions are being considered for the 2004 second half. In addition, we realized $6 million and $12 million of currency exchange losses in the three and six month periods ended June 30, 2004, respectively, compared with $17 million and $19 million of currency exchange gains in the comparable periods.

 

Other: Other operating profit for the three and six months ended June 30, 2004 of $35 million and $12 million increased by $121 million and $202 million, respectively, from the comparable periods in 2003, primarily reflecting significantly lower non-financing interest expense, higher equity income related to Fuji Xerox and the $38 million gain on the sale of ScanSoft.

 

Key Ratios and Expenses

 

     Three months ended
June 30,


   Six months ended
June 30,


     2004

   2003

   2004

   2003

     %    %    %    %

Gross Margin

                   

Sales

   36.2    37.0    35.0    37.0

Service, outsourcing and rentals

   43.4    44.4    42.8    43.8

Finance income

   63.2    63.4    62.9    63.4

Total

   41.3    42.4    40.6    42.2

 

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Second quarter 2004 total gross margin of 41.3 percent reflected the anticipated sequential improvement from 39.8 percent in the 2004 first quarter, and declined 1.1 percentage points from 42.4 percent in the second quarter 2003. About one percentage point of the decline was due to an increased proportion of monochrome desktop multifunction, office printing, and digital light production sales. Approximately 0.3 percentage points of the decline reflects ongoing engineering costs resulting from completion of the R&D phase of the Xerox iGen3 development. Finally, productivity improvements and other variances more than offset price investments benefiting gross margin by 0.2 percentage points. Gross margin of 40.6 percent for the six months ended June 30, 2004 decreased by 1.6 percentage points from 42.2 percent in the comparable period of the prior year. Approximately one percentage point of the decline was due to product mix and approximately 0.3 percentage points reflected ongoing engineering costs resulting from completion of the R&D phase of the Xerox iGen3 development.

 

Second quarter 2004 sales gross margin declined 0.8 percentage points from the 2003 second quarter. About 1.2 percentage points of the decline was due to the previously discussed product mix and approximately 0.6 percentage points was due to the Xerox iGen3 ongoing engineering costs. Productivity improvements net of price investments and other variances benefited the sales gross margin by about one percentage point. Sales gross margin of 35.0 percent for the six months ended June 30, 2004 decreased 2 percentage points from 37.0 percent in the comparable period of the prior year. Approximately 1.7 percentage points of the decline was due to product mix and approximately 0.8 percentage points was due to the Xerox iGen3 ongoing engineering costs. Productivity improvements net of price investments and other variances benefited the first half 2004 sales gross margin by about 0.5 percentage points.

 

Service outsourcing and rentals margin declined one percentage point from the second quarter 2003 as price investments were only partially offset by North American service productivity actions that were completed late in the 2004 second quarter. Additional productivity actions are being considered for the 2004 second half to address Latin American cost and expense levels that have not kept pace with post sale revenue declines. Service outsourcing and rentals margin of 42.8 percent for the six months ended June 30, 2004 decreased one percentage point from 43.8 percent in the comparable period as price investments were only partially offset by improved service productivity.

 

Research and development (R&D) expense of $187 million and $380 million for the three and six months ended June 30, 2004, respectively, was $38 million and $81 million less than the comparable periods, respectively, primarily related to improved R&D productivity as we capture benefits from our platform development strategy, other cost efficiencies and the commercial launch of the Xerox iGen3. We continue to invest in technological development, particularly in color, and believe our R&D spending is at an adequate level to remain technologically competitive. Xerox R&D remains strategically coordinated with that of Fuji Xerox.

 

Selling, administrative and general (SAG) expenses of $1,050 million in the 2004 second quarter declined by $39 million from the 2003 second quarter as general and administrative expense productivity and bad debt expense reductions were partially offset by adverse currency impacts of $24 million and marketing investments of approximately $13 million for the drupa trade show. Second quarter 2004 bad debt expense of $35 million was $39 million lower than the second quarter 2003 reflecting continued improvements in collections performance, receivables aging and write-off trends. SAG expense of $2,086 million in the six-month period ended June 30, 2004 decreased $23 million, or 1 percent, compared to the comparable period as general and administrative expense productivity and bad debt expense reductions of $53 million offset adverse currency impacts and marketing investments for the drupa trade show.

 

For the three and six months ended June 30, 2004, we recorded restructuring charges of $33 million and $39 million, respectively, primarily consisting of severance actions in North America and Latin America as well as pension settlements related to previous employee restructuring actions. The remaining restructuring reserve balance at June 30, 2004 for all restructuring programs was $146 million, approximately half of which will be spent during the balance of 2004.

 

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Table of Contents

Worldwide employment of 60,000 declined by 1,100 from December 31, 2003, primarily reflecting reductions attributable to our restructuring programs and other attrition.

 

Other expenses, net for the three and six months ended June 30, 2004 and 2003 were as follows:

 

    

Three months ended

June 30,


   

Six months ended

June 30,


 
($ in millions)      2004  

      2003  

      2004  

      2003  

 

Non-financing interest expense

   $ 84     $ 148     $ 179     $ 294  

Interest income

     (29 )     (12 )     (44 )     (22 )

(Gain) loss on sales of businesses and assets

     (40 )     10       (54 )     12  

Legal Matters

     8       (3 )     8       (3 )

Loss on early extinguishment of debt

     —         73       —         73  

Currency losses (gains), net

     18       (21 )     26       (20