For the quarterly period ended: June 30, 2005
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, 2005

 

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, 2005


Common Stock, $1 par value   959,476,802 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 deemed to be “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Litigation Reform Act”). 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.

 

In accordance with the provisions of the Litigation Reform Act, 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 that 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 or the pace of color adoption by our existing and prospective customers is less than anticipated, 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. We also must ensure that all of our products comply with existing and newly enacted applicable regulatory requirements in the countries in which they are sold, particularly European Union environmental directives. 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 or if our current or future products fail to meet applicable worldwide

 

2


Table of Contents

regulatory requirements, we could lose market share and customers to our competitors 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 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 our customer financing activity through third-party funding arrangements, including several with General Electric (“GE”) and Merrill Lynch, cash generated from operations, cash on hand, capital markets offerings, 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 on our ability to obtain funding at a reasonable cost, whether through third party funding arrangements (including securitizations and secured borrowings) or directly in the public debt markets. 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 dependent on a number of factors, including our ability to continue to improve the cost efficiency of our operations through such programs as Lean Six Sigma, pricing pressures on our products and services, the proportion of our equipment sales to high-end as opposed to low-end equipment, the trend in our post-sale revenue growth, and, our ability to successfully complete information technology initiatives. If any of these factors adversely materialize or 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.

 

Compliance with Environmental Regulations —Our operations are subject to environmental regulations in each of the jurisdictions in which we conduct our business. Some of our manufacturing operations use, and some of our products contain, substances that are regulated in various jurisdictions. The European Union Directive known as the Restriction on the Use of Hazardous Substances (RoHS), for example, requires the removal of lead, cadmium and certain other substances from product designs put on the market in the European Union beginning in July, 2006. We are currently evaluating the impact of the RoHS directive on our product line. If we do not comply with applicable rules and regulations in connection with the use of such substances and the sale of products containing such substances, then we could be subject to liability and could be prevented from selling our products, which could have a material adverse effect on our results of operations and financial condition. Further, we could also face substantial costs and liabilities in connection with product take-back legislation. Beginning in August 2005, we will be subject to the European Union Directive on Waste Electrical and Electronic Equipment (WEEE) as enacted by individual European Union countries (“WEEE Legislation”), which will make producers of electrical goods, including computers and printers, responsible for collection, recycling, treatment and disposal of recovered products. We are currently evaluating the impact of the WEEE Legislation. If we are unable to collect, recycle, treat and dispose of our products in a cost-effective manner, it could materially adversely affect our results of operations and financial condition.

 

Outsourcing of Manufacturing Capacity—Since 2001, we have outsourced a significant portion 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

 

3


Table of Contents

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 our relationships with our customers, and reduce our market share, all of which could materially adversely affect our results of operations and financial condition.

 

International Operations—Approximately half of our revenue is generated 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 of 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 international revenues and expenses which are denominated in currencies other than our U.S. parent functional currency.

 

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 digital printing, color and multifunction systems. We expect that revenue growth can be further enhanced through our document management and 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 our developing markets operations and other geographic areas in the face of global competition and pricing pressures. Our ability to increase post sale revenue is largely dependent on our ability to increase the volume of pages printed, the mix of color pages, 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, primarily to support our customer financing activities. As of June 30, 2005, we had $8.2 billion of total debt ($3.7 billion of which is secured by finance receivables) and $736 million of liabilities to trusts issuing preferred

 

4


Table of Contents

securities. Cash and cash equivalents and short-term investments balances were $2.1 billion at June 30, 2005. 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, funding from third parties, access to capital markets, securitizations and secured borrowings for our finance receivables portfolios. With $2.1 billion of cash and cash equivalents, including short-term investments, as of June 30, 2005, borrowing capacity under our 2003 Credit Facility of $700 million (less $15 million utilized for letters of credit) and funding available through our customer financing arrangements, 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 capital 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 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 customer 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, 2005, $2.1 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, 2005, 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 and that we were unable to obtain replacement financing in the public debt markets, it could 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

 

5


Table of Contents

Retirement Income Security Act (“ERISA”), as discussed in Note 13 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 legal 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.

 

6


Table of Contents

XEROX CORPORATION

Form 10-Q

June 30, 2005

 

TABLE OF CONTENTS

 

     Page

Part I—Financial Information

    

Item 1. Financial Statements (Unaudited)

   8

Condensed Consolidated Statements of Income

   8

Condensed Consolidated Balance Sheets

   9

Condensed Consolidated Statements of Cash Flows

   10

Notes to Condensed Consolidated Financial Statements

   11

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

   40

Capital Resources and Liquidity

   48

Financial Risk Management

   51

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   51

Item 4. Controls and Procedures

   51

Part II—Other Information

    

Item 1. Legal Proceedings

   53

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

   53

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

   53

Item 6. Exhibits

   54

Signatures

   55

Exhibit Index

   56

Restated Certificate of Incorporation of Registrant filed with the Department of State of the State of New York on November 7, 2003 as amended by Certificate of Amendment to Certificate of Incorporation filed with the Department of State of New York on August 19, 2004.

    

By-Laws of Registrant, as amended through December 10, 2003.

    

Form of Amendment to Agreements under 1991 Long-Term Incentive Plan.

    

Form of Amendment to Agreements under 2004 Performance Incentive Plan.

    

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 Web site is not incorporated by reference into this Form 10-Q.

 

7


Table of Contents

PART I—FINANCIAL INFORMATION

 

Item 1

 

XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

     Three Months Ended
June 30,


    Six Months Ended
June 30,


 
     2005

    2004

    2005

    2004

 
     (in millions, except per-share data)  

Revenues

                                

Sales

   $ 1,827     $ 1,759     $ 3,521     $ 3,440  

Service, outsourcing and rentals

     1,874       1,860       3,723       3,768  

Finance income

     220       234       448       472  
    


 


 


 


Total Revenues

     3,921       3,853       7,692       7,680  
    


 


 


 


Costs and Expenses

                                

Cost of sales

     1,221       1,123       2,307       2,235  

Cost of service, outsourcing and rentals

     1,086       1,052       2,151       2,154  

Equipment financing interest

     83       86       169       175  

Research and development expenses

     188       187       371       380  

Selling, administrative and general expenses

     1,046       1,050       2,055       2,086  

Restructuring and asset impairment charges

     194       33       279       39  

Other (income) expenses, net

     (14 )     50       (46 )     137  
    


 


 


 


Total Costs and Expenses

     3,804       3,581       7,286       7,206  
    


 


 


 


Income from Continuing Operations before Income Taxes, Equity Income and Discontinued Operations

     117       272       406       474  

Income tax (benefits) expenses

     (233 )     91       (117 )     158  

Equity in net income of unconsolidated affiliates

     20       27       57       57  
    


 


 


 


Income from Continuing Operations, before Discontinued Operations

     370       208       580       373  

Income from Discontinued Operations, net of tax

     53       —         53       83  
    


 


 


 


Net Income

   $ 423     $ 208     $ 633     $ 456  

Less: Preferred stock dividends, net

     (15 )     (21 )     (29 )     (45 )
    


 


 


 


Income Available to Common Shareholders

   $ 408     $ 187     $ 604     $ 411  
    


 


 


 


Basic Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.37     $ 0.23     $ 0.57     $ 0.41  

Earnings from Discontinued Operations

     0.06       —         0.06       0.10  
    


 


 


 


Basic Earnings per Share

   $ 0.43     $ 0.23     $ 0.63     $ 0.51  
    


 


 


 


Diluted Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.35     $ 0.21     $ 0.55     $ 0.38  

Earnings from Discontinued Operations

     0.05       —         0.05       0.08  
    


 


 


 


Diluted Earnings per Share

   $ 0.40     $ 0.21     $ 0.60     $ 0.46  
    


 


 


 


 

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

 

8


Table of Contents

XEROX CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

     June 30,
2005


    December 31,
2004


 
     (in millions, except share
data in thousands)
 

Assets

                

Cash and cash equivalents

   $ 1,912     $ 3,218  

Short-term investments

     190       —    

Accounts receivable, net

     2,070       2,076  

Billed portion of finance receivables, net

     314       377  

Finance receivables, net

     2,688       2,932  

Inventories

     1,217       1,143  

Other current assets

     1,081       1,182  
    


 


Total Current Assets

     9,472       10,928  

Finance receivables due after one year, net

     4,883       5,188  

Equipment on operating leases, net

     397       398  

Land, buildings and equipment, net

     1,658       1,759  

Investments in affiliates, at equity

     800       845  

Intangible assets, net

     304       297  

Goodwill

     1,726       1,848  

Deferred tax assets, long-term

     1,524       1,521  

Other long-term assets

     1,941       2,100  
    


 


Total Assets

   $ 22,705     $ 24,884  
    


 


Liabilities and Equity

                

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

   $ 1,529     $ 3,074  

Accounts payable

     1,111       1,037  

Accrued compensation and benefits costs

     511       637  

Unearned income

     191       243  

Other current liabilities

     1,164       1,309  
    


 


Total Current Liabilities

     4,506       6,300  

Long-term debt

     6,624       7,050  

Liabilities to subsidiary trusts issuing preferred securities

     736       717  

Pension and other benefit liabilities

     1,039       1,189  

Post-retirement medical benefits

     1,181       1,180  

Other long-term liabilities

     1,205       1,315  
    


 


Total Liabilities

     15,291       17,751  

Series C mandatory convertible preferred stock

     889       889  

Common stock, including additional paid in capital

     4,930       4,881  

Retained earnings

     2,705       2,101  

Accumulated other comprehensive loss

     (1,110 )     (738 )
    


 


Total Liabilities and Equity

   $ 22,705     $ 24,884  
    


 


Shares of common stock issued and outstanding

     959,477       955,997  

 

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

 

9


Table of Contents

XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

    

Three Months

Ended June 30,


    Six Months
Ended June 30,


 
     2005

    2004

    2005

    2004

 
     (in millions)  

Cash Flows from Operating Activities:

                                

Net income

   $ 423     $ 208     $ 633     $ 456  

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

                                

Depreciation and amortization

     165       168       324       343  

Provisions for receivables and inventory

     18       47       45       98  

Net gain on sales of businesses and assets

     (4 )     (40 )     (102 )     (54 )

Distributed (undistributed) equity in net income of unconsolidated affiliates

     2       (11 )     (33 )     (34 )

Income from discontinued operations

     (53 )     —         (53 )     (83 )

Restructuring and asset impairment charges

     194       33       279       39  

Cash payments for restructurings

     (27 )     (44 )     (63 )     (104 )

Contributions to pension benefit plans

     (255 )     (232 )     (279 )     (249 )

Increase in inventories

     (21 )     (58 )     (137 )     (131 )

Increase in on-lease equipment

     (61 )     (62 )     (113 )     (102 )

Decrease in finance receivables

     95       120       274       298  

(Increase) decrease in accounts receivable and billed portion of finance receivables

     (41 )     24       (49 )     63  

Increase (decrease) in accounts payable and accrued compensation

     158       70       157       (13 )

Net change in income tax assets and liabilities

     (346 )     2       (273 )     22  

Net change in derivative assets and liabilities

     (24 )     2       51       38  

Decrease in other current and long-term liabilities

     (9 )     (2 )     (107 )     (87 )

Other, net

     76       31       73       (1 )
    


 


 


 


Net cash provided by operating activities

     290       256       627       499  
    


 


 


 


Cash Flows from Investing Activities:

                                

Proceeds from sales of short-term investments

     6       —         6       —    

Purchases of short-term investments

     (196 )     —         (196 )     —    

Cost of additions to land, buildings and equipment

     (43 )     (47 )     (76 )     (95 )

Proceeds from sales of land, buildings and equipment

     —         7       2       39  

Cost of additions to internal use software

     (14 )     (12 )     (26 )     (20 )

Proceeds from divestitures and investments, net

     —         119       105       186  

Net change in escrow and other restricted investments

     11       158       42       191  

Other

     (1 )     —         (1 )     —    
    


 


 


 


Net cash (used in) provided by investing activities

     (237 )     225       (144 )     301  
    


 


 


 


Cash Flows from Financing Activities:

                                

Cash proceeds from new secured financings

     38       693       285       1,197  

Debt payments on secured financings

     (484 )     (404 )     (952 )     (977 )

Net cash payments on debt

     (958 )     (500 )     (1,070 )     (909 )

Preferred stock dividends

     (15 )     (30 )     (29 )     (55 )

Proceeds from issuances of common stock

     10       18       24       47  

Other

     (1 )     (1 )     8       (1 )
    


 


 


 


Net cash used in financing activities

     (1,410 )     (224 )     (1,734 )     (698 )
    


 


 


 


Effect of exchange rate changes on cash and cash equivalents

     (29 )     (13 )     (55 )     (37 )
    


 


 


 


(Decrease) increase in cash and cash equivalents

     (1,386 )     244       (1,306 )     65  

Cash and cash equivalents at beginning of period

     3,298       2,298       3,218       2,477  
    


 


 


 


Cash and cash equivalents at end of period

   $ 1,912     $ 2,542     $ 1,912     $ 2,542  
    


 


 


 


 

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

 

10


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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 2004 Annual Report to Shareholders, which is incorporated by reference in our 2004 Annual Report on Form 10-K (“2004 Annual Report”), 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 2004 Annual Report.

 

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 from Continuing Operations before Income Taxes and Equity Income as “pre-tax income.”

 

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

 

2-Recent Accounting Pronouncements

 

In June 2005, the FASB issued Staff Position No. FAS 143-1 “Accounting for Electronic Equipment Waste Obligations” (“FSP 143-1”), which provides guidance on the accounting for obligations associated with the Directive on Waste Electrical and Electronic Equipment (the “WEEE Directive”), which was adopted by the European Union. FSP 143-1 provides guidance on how to account for the effects of the WEEE Directive with respect to historical waste and waste associated with products on the market on or before August 13, 2005. FSP 143-1 is required to be applied to the later of the first reporting period ending after June 8, 2005 or the date of the adoption of the WEEE Directive into law by the applicable European Union member country. At this point, the Directive has not yet been adopted into law by the European Union member countries in which we have significant operations. Accordingly, we do not expect to fully apply this guidance until the third quarter of 2005, the expected period of implementation of the WEEE Directive by European Union member countries. We are currently evaluating the effect that the adoption of FSP 143-1 will have on our results of operations and financial condition.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“FAS 154”), which replaces Accounting Principles Board Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements – An Amendment of APB Opinion No. 28.” FAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We believe that the adoption of this statement will not have a material effect on our financial condition or results of operations.

 

11


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations – an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 states that a conditional asset retirement obligation is a legal obligation to perform an asset retirement activity in which the timing or method of settlement are conditional upon a future event that may or may not be within control of the entity. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. We are currently evaluating the effect and have not quantified the impact of adopting FIN 47.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 153, “Exchanges of Nonmonetary Assets” (“FAS 153”). This statement is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. FAS 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We believe that the adoption of this statement will not have a material effect on our financial condition or results of operations.

 

3-Stock-Based Compensation

 

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”), an amendment of FAS No. 123, “Accounting for Stock-Based Compensation.” FAS 123R eliminates the ability to account for share-based payments using Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and instead requires companies to recognize compensation expense using a fair-value based method for costs related to share-based payments, including stock options. The expense will be measured as the fair value of the award at its grant date based on the estimated number of awards that are expected to vest, and recorded over the applicable service period. In the absence of an observable market price for a share-based award, the fair value would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the award, the expected term of the award, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The requirements of FAS 123R are effective for our fiscal year beginning January 1, 2006, as a result of the SEC’s recent decision to delay the effective date of FAS 123R by six months in order to provide companies more time to implement the standard. FAS 123R will be applicable to all awards granted, modified or cancelled after that date. Prior to the SEC decision, we had previously disclosed in our 2004 Annual Report that we planned to adopt the standard prospectively as of July 1, 2005.

 

The standard also provides for different transition methods for past award grants, including the restatement of prior period results. We have elected to apply the modified prospective transition method to all past awards outstanding and unvested as of the effective date of January 1, 2006 and will recognize the associated expense over the remaining vesting period based on the fair values previously determined and disclosed as part of our pro-forma disclosures. We will not restate the results of prior periods.

 

During May 2005, the Company approved the accelerated vesting of approximately 3.6 million unvested stock options granted in 2004 to its employees that would have been scheduled to vest on December 31, 2006 or January 1, 2007, to December 31, 2005. These accelerated options had a weighted average exercise price of $13.71. The primary purpose of this accelerated vesting was to eliminate compensation expense we would recognize in our results of operations upon the adoption of FAS 123R, which is effective for our fiscal year beginning January 1, 2006. The acceleration is expected to reduce our pre-tax stock option compensation expense

 

12


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

in 2006 by approximately $31 or $0.02 per diluted share and accordingly, increase our 2005 pro-forma expense disclosed below. After the effects of the aforementioned action, the implementation of FAS 123R is expected to be immaterial. In addition, as disclosed in our 2004 Annual Report, in 2005 in lieu of stock options, we began granting time and performance-based restricted stock awards, which are already reflected as compensation expense in our results of operations. Therefore, the acceleration of vesting for substantially all previously awarded stock options effectively completes the transition to the new stock-based award program.

 

Pending the effective date of FAS 123R, 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 and income per share for the three and six months ended June 30, 2005 and 2004 would have been as follows:

 

     Three Months Ended
June 30,


    Six Months Ended
June 30,


 
     2005

     2004

    2005

    2004

 

Net income—as reported

   $ 423      $ 208     $ 633     $ 456  

Add: Stock-based employee compensation expense included in reported net income, net of tax

     6        3       12       6  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax

     (18 )      (16 )     (33 )     (33 )
    


  


 


 


Net income—pro forma

   $ 411      $ 195     $ 612     $ 429  
    


  


 


 


Basic EPS—as reported

   $ 0.43      $ 0.23     $ 0.63     $ 0.51  

Basic EPS—pro forma

     0.41        0.21       0.61       0.48  

Diluted EPS—as reported

   $ 0.40      $ 0.21     $ 0.60     $ 0.46  

Diluted EPS—pro forma

     0.39        0.20       0.58       0.44  

 

As disclosed in our 2004 Annual Report, the pro forma periodic compensation expense amounts are not representative of future amounts, as we began granting employees restricted stock awards with time- and performance-based restrictions in lieu of stock options in 2005.

 

4-Divestitures and Other

 

During March 2005, we completed the sale of our entire equity interest in Integic Corporation (“Integic”) for $96 in cash, net of transaction costs. The sale resulted in a pre-tax gain of $93 ($58 after-tax). Prior to this transaction, our investment in Integic was accounted for using the equity method and was included in Investments in affiliates, at equity within our Condensed Consolidated Balance Sheets. The pre-tax gain is classified within Other (income) expenses, net in the accompanying Condensed Consolidated Statements of Income.

 

13


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

5-Restructuring Programs

 

The restructuring and asset impairment charges in the Condensed Consolidated Statements of Income totaled $279 and $39 for the six months ended June 30, 2005 and 2004, respectively. Detailed information related to restructuring program activity during the six months ended June 30, 2005 is outlined below.

 

Restructuring Activity


   Ongoing
Programs


    Legacy
Programs (1)


    Total

 

Ending Balance December 31, 2004

   $ 93     $ 24     $ 117  

Provision

     282       —         282  

Reversals of prior accruals

     (3 )     (4 )     (7 )

Charges against reserve and currency

     (64 )     (6 )     (70 )
    


 


 


Ending Balance June 30, 2005

   $ 308     $ 14     $ 322  
    


 


 



(1) Legacy Programs include the Turnaround, SOHO and 1998/2000 Programs, which are fully described in our 2004 Annual Report.

 

Reconciliation to Statements of Income

 

     Three Months Ended
June 30,


     Six Months Ended
June 30,


 
     2005

    2004

     2005

     2004

 

Restructuring provision

   $ 197     $ 36      $ 282      $ 47  

Restructuring reversal

     (5 )     (3 )      (7 )      (8 )

Asset impairment charges

     2       —          4        —    
    


 


  


  


Restructuring and asset impairment charges

   $ 194     $ 33      $ 279      $ 39  
    


 


  


  


 

Reconciliation to Statements of Cash Flows

 

     Three Months Ended
June 30,


     Six Months Ended
June 30,


 
     2005

    2004

     2005

    2004

 

Charges to reserve, all programs

   $ (33 )   $ (47 )    $ (70 )   $ (114 )

Pension curtailment, special termination benefits and settlements

     —         1        —         7  

Effects of foreign currency and other non-cash

     6       2        7       3  
    


 


  


 


Cash payments for restructurings

   $ (27 )   $ (44 )    $ (63 )   $ (104 )
    


 


  


 


 

Beginning in the fourth quarter of 2002, we began a series of restructuring initiatives designed to continue to achieve the cost savings resulting from realized productivity improvements. These initiatives included downsizing our employee base and the outsourcing of certain internal functions. The initiatives primarily include severance actions and impact all geographies and segments. As disclosed in our 2004 Annual Report, in those geographies where we have either a formal severance plan or a history of consistently providing severance benefits representing a substantive plan, we recognize severance costs when they are determined to be both probable and reasonably estimable. Otherwise, we accrue severance costs when incurred. During 2005, we provided an additional $283 for ongoing restructuring programs, including net reversals of $3 related to changes

 

14


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

in estimates in severance costs from previously recorded actions. The additional provision consisted of $269 in severance and related costs, primarily related to initiatives that are expected to result in the elimination of approximately 2,800 positions in North America, Latin America and Europe, $10 for lease terminations and $4 for asset impairments. These initiatives are focused on cost reductions in service, manufacturing and back office support operations primarily within the Office and Production segments.

 

The following tables summarize the total amount of costs expected to be incurred in connection with our ongoing restructuring programs and the cumulative amount incurred as of June 30, 2005:

 

Segment Reporting:

 

     Cumulative
amount
incurred as of
December 31, 2004


  

Net amount
incurred for the
six months
ended

June 30, 2005


   Cumulative
amount
incurred as of
June 30, 2005


   Total expected
to be incurred *


Production

   $ 255    $ 124    $ 379    $ 381

Office

     198      135      333      336

DMO

     97      12      109      109

Other

     122      12      134      137
    

  

  

  

Total Provisions

   $ 672    $ 283    $ 955    $ 963
    

  

  

  

Major Cost Reporting:                            
     Cumulative
amount
incurred as of
December 31, 2004


  

Amount
incurred for the
six months
ended

June 30, 2005


   Cumulative
amount
incurred as of
June 30, 2005


   Total expected
to be incurred *


Severance and related costs

   $ 567    $ 269    $ 836    $ 843

Lease cancellation and other costs

     59      10      69      70

Asset impairments

     46      4      50      50
    

  

  

  

Total provisions

   $ 672    $ 283    $ 955    $ 963
    

  

  

  


* The total amount of $963 represents the cumulative amount incurred through June 30, 2005 plus additional expected restructuring charges of $8 related to initiatives identified to date and expected interest accretion on the reserve, that have not yet been recognized in the Condensed Consolidated Financial Statements. In addition, restructuring charges of approximately $100 are expected to be recognized in the second half of the year for initiatives that at this stage have not yet been finalized by management.

 

6-Short-term investments

 

As of June 30, 2005, we held $190 in marketable securities that are classified within Short-term investments in our Condensed Consolidated Balance Sheets. These securities are considered available-for-sale and are carried at estimated fair value based on quoted market prices. Unrealized gains and losses, net of taxes, are recorded within Accumulated other comprehensive loss, a component of Common shareholders’ equity (See Note 8). The cost of securities sold is based on the specific identification method. Proceeds from sales of Short-term investments during the three and six month periods ended June 30, 2005 were $6. No gains or losses were realized on these sales.

 

15


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

The following table summarizes the amortized costs and estimated fair market values of our Short-term investments as of June 30, 2005:

 

     Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


   Estimated Fair
Value


Corporate bonds

   $ 84    $ —      $ —      $ 84

Auction rate municipal bonds

     58      —        —        58

US government agency securities

     13      —        —        13

Auction rate preferred securities

     35      —        —        35
    

  

  

  

Total

   $ 190    $ —      $ —      $ 190
    

  

  

  

 

The contractual maturities of the available-for-sale debt securities at June 30, 2005 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay and creditors may have the right to call obligations. These securities are classified within current assets because they are highly liquid, traded in active markets and are available for use, if needed, for current operations.

 

     Estimated Fair
Value


Debt Securities:

      

Due in 1 year or less

   $ 41

Due after 1 year through 5 years

     56

Due after 5 years through 10 years

     —  

Due after 10 years

     58
    

Total debt securities

   $ 155
    

Auction rate preferred securities

     35

Total Short-term investments

   $ 190
    

 

On an ongoing basis, we evaluate our investments to determine if a decline in fair value is other-than-temporary. In this determination, we consider the duration that, and extent to which, market value is below original cost, our intent and ability to hold to recovery and the financial health of the issuer. During the second quarter of 2005, there were no other-than-temporary declines in the market values of our Short-term investments. In the event a decline in fair value is determined to be other than temporary, an impairment charge would be recorded within Other (income) expenses, net and a new cost basis in the investment would be established.

 

7-Inventories

 

Inventories consist of the following:

 

     June 30,
2005


   December 31,
2004


Finished goods

   $ 949    $ 895

Work-in-process

     73      65

Raw materials

     195      183
    

  

Total Inventories

   $ 1,217    $ 1,143
    

  

 

16


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

8-Common Shareholders’ Equity

 

Common shareholders’ equity consisted of:

 

     June 30,
2005


    December 31,
2004


 

Common stock

   $ 959     $ 956  

Additional paid-in-capital

     3,971       3,925  

Retained earnings

     2,705       2,101  

Accumulated other comprehensive loss (1)

     (1,110 )     (738 )
    


 


Total Common shareholders’ equity

   $ 6,525     $ 6,244  
    


 



(1) Accumulated other comprehensive loss at June 30, 2005 is composed of cumulative translation adjustments of $(910), a minimum pension liability of $(199) and unrealized losses on securities of $(1).

 

Comprehensive income for the three and six months ended June 30, 2005 and 2004 was as follows:

 

     Three Months Ended
June 30,


    Six Months Ended
June 30,


 
     2005

    2004

    2005

    2004

 

Net income

   $ 423     $ 208     $ 633     $ 456  

Translation adjustments

     (196 )     (80 )     (386 )     (96 )

Unrealized (losses) gains on securities, net of tax

     —         —         (2 )     1  

Realized losses on securities, net of tax

     —         (18 )     —         (18 )

Adjustment for minimum pension liability, net of tax (1)

     7       —         19       31  

Cash flow hedge adjustments, net of tax

     (5 )     10       (3 )     9  
    


 


 


 


Comprehensive income

   $ 229     $ 120     $ 261     $ 383  
    


 


 


 



(1) The change of $19 in the minimum pension liability since December 31, 2004 includes $5 relating to our portion of a minimum pension liability reduction that was recorded by Fuji Xerox during the period and a $14 benefit from currency.

 

9-Interest Expense and Income

 

Interest expense and interest income for the three and six months ended June 30, 2005 and 2004 was as follows:

 

     Three Months Ended
June 30,


   Six Months Ended
June 30,


     2005

   2004

   2005

   2004

Interest expense (1)

   $ 145    $ 170    $ 292    $ 354

Interest income (2)

     308      263      554      516

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

 

17


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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.

 

10-Income from Discontinued Operations

 

Income from discontinued operations, net of tax, for the three and six months ended June 30, 2005 and 2004 was as follows:

 

     Three Months Ended
June 30,


   Six Months Ended
June 30,


     2005

   2004

   2005

   2004

Insurance Group Operations tax benefits

   $ 53    $  —      $ 53    $  —  

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

     —        —        —        83
    

  

  

  

Total

   $ 53    $ —      $ 53    $ 83
    

  

  

  

 

As disclosed in Note 13 – Contingencies, in June 2005 we received notice that our 1996-1998 Internal Revenue Service (“IRS”) audit has been finalized. As a result, during the second quarter of 2005 we recorded an income tax benefit of $53 for the favorable resolution of certain tax matters from that audit associated with our discontinued operations.

 

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 revenues, operating results and net assets of ContentGuard were immaterial for all relevant 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.

 

18


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

11-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. The Production and Office segments are centered around strategic product groups which share common technology, manufacturing and product platforms, as well as classes of customers. During the 2005 first quarter, we implemented a new financial reporting system which has enabled greater efficiencies in financial reporting and provides enhanced analytical capabilities including activity-based cost analysis on shared services and internal cost allocations. As a result of the implementation, changes in the allocation of certain segment costs and expenses were made. These changes included a reallocation of costs associated with corporate and certain shared service functions. These changes did not involve a change in the composition of our reportable segments and did not impact segment revenue in 2004. We have reclassified prior-period amounts to conform to the current period’s presentation. The following table illustrates the impact of these changes on quarterly segment operating profit for 2004:

 

     Three Months Ended

 

Operating Profit


   Mar. 31

    June 30

    Sept. 30

    Dec. 31

    Total

 

Production

   $ 4     $ 32     $ 47     $ 40     $ 123  

Office

     8       (12 )     —         (15 )     (19 )

DMO

     (3 )     (2 )     (2 )     (1 )     (8 )

Other

     (9 )     (18 )     (45 )     (24 )     (96 )
    


 


 


 


 


Total

   $ —       $ —       $ —       $ —       $ —    
    


 


 


 


 


 

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 Business Group (predominantly paper), Small Office/Home Office (“SOHO”), Wide Format Systems, Xerox Technology Enterprises and value-added 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 as well as other items included in Other (income) expenses, net.

 

19


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Operating segment revenues and profitability for the three months ended June 30, 2005 and 2004 was as follows:

 

     Production

   Office

   DMO

   Other

    Total

2005

                                   

Total segment revenues

   $ 1,125    $ 1,914    $ 440    $ 442     $ 3,921
    

  

  

  


 

Segment profit

   $ 79    $ 173    $ 19    $ 66     $ 337
    

  

  

  


 

2004

                                   

Total segment revenues

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

  

  

  


 

Segment profit

   $ 122    $ 187    $ 6    $ 17     $ 332
    

  

  

  


 

Operating segment revenues and profitability for the six months ended June 30, 2005 and 2004 was as follows:
     Production

   Office

   DMO

   Other

    Total

2005

                                   

Total segment revenues

   $ 2,197    $ 3,743    $ 852    $ 900     $ 7,692
    

  

  

  


 

Segment profit

   $ 180    $ 365    $ 29    $ 175     $ 749
    

  

  

  


 

2004

                                   

Total segment revenues

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

  

  

  


 

Segment profit

   $ 204    $ 356    $ 25    $ (15 )   $ 570
    

  

  

  


 

 

The following is a reconciliation to pre-tax income:

 

     Three Months Ended
June 30,


    Six Months Ended
June 30,


 
     2005

    2004

    2005

    2004

 

Total segment profit

   $ 337     $ 332     $ 749     $ 570  

Reconciling items:

                                

Restructuring and asset impairment charges

     (194 )     (33 )     (279 )     (39 )

Other expenses

     (6 )     —         (7 )     —    

Equity in net income of unconsolidated affiliates

     (20 )     (27 )     (57 )     (57 )
    


 


 


 


Pre-tax income

   $ 117     $ 272     $ 406     $ 474  
    


 


 


 


 

20


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

12-Investment in Fuji Xerox

 

Our equity in net income of our unconsolidated affiliates for the three and six months ended June 30, 2005 and 2004 was as follows:

 

     Three Months Ended
June 30,


   Six Months Ended
June 30,


     2005

   2004

   2005

   2004

Fuji Xerox

   $ 18    $ 22    $ 53    $ 48

Other investments

     2      5      4      9
    

  

  

  

Total

   $ 20    $ 27    $ 57    $ 57
    

  

  

  

 

Unaudited condensed financial data of Fuji Xerox for the three and six months ended June 30, 2005 and 2004 was as follows:

 

     Three Months Ended
June 30,


   Six Months Ended
June 30,


     2005

   2004

   2005

   2004

Summary of Operations

                           

Revenues

   $ 2,462    $ 2,195    $ 5,193    $ 4,778

Cost and Expenses

     2,305      2,072      4,842      4,475

Income before income taxes

     157      123      351      303

Income taxes

     66      45      123      120

Minorities’ interests

     4      4      7      9
    

  

  

  

Net income

   $ 87    $ 74    $ 221    $ 174
    

  

  

  

 

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 percent ownership interest.

 

13-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. Although the by-laws provide no limit on the amount of indemnification, we may have recourse against our insurance carriers for certain payments made by us. 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, 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.

 

21


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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 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, 2005 and 2004:

 

     2005

    2004

 

Balance as of January 1

   $ 23     $ 19  

Provisions

     24       24  

Payments and adjustments

     (23 )     (21 )
    


 


Balance as of June 30

   $ 24     $ 22  
    


 


 

Tax related contingencies:

 

Brazil Tax Contingencies: At June 30, 2005, our Brazilian operations had received assessments levied against it for indirect and other taxes which, inclusive of interest, were approximately $689. The change since the December 31, 2004 disclosed amount of $559 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 escrow 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.

 

IRS Audit Resolution: During June 2005, we received notice that our 1996-1998 IRS audit had been finalized. As a result, we recorded an aggregate second quarter 2005 net income benefit of $343. $260 of this benefit, which includes an after-tax benefit of $33 for interest ($54 pre-tax benefit), is the result of a previously disclosed 2002 change in tax law that allowed us to recognize a benefit for capital losses associated with the disposition of our insurance group operations. As disclosed in our 2004 Annual Report, the capital losses from the sale of our insurance group operations were disallowed under the tax law existing at the time of those dispositions. As a result of IRS regulations issued in 2002, some portion of the losses could be claimed, subject to certain limitations. We filed amended tax returns for the period 1995 through 1998, reporting $1.2 billion of additional capital losses. The claim of additional losses and related tax benefits required review by the U.S. Joint Committee on Taxation, which was completed on June 27, 2005. We had not previously recognized any tax benefit associated with these losses pending the finalization of the 1996 – 1998 IRS audit. The benefit will not result in a significant cash refund, but will increase tax credit carryforwards and reduce taxes otherwise potentially due. While these benefits originated from our discontinued operations, tax accounting rules require the classification of benefits resulting from a change in tax law to be classified within the continuing operations tax provision.

 

 

22


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

The $343 benefit also includes after-tax benefits of $83 related to the favorable resolution of certain other tax matters. Of this amount, $53 is related to our discontinued operations and is reported within Income from discontinued operations in the Condensed Consolidated Statements of Income (See Note 10-Income from discontinued operations).

 

The following is a summary of the aggregate benefit recorded and where classified in the Condensed Consolidated Statements of Income for the three months ended June 30, 2005:

 

     Tax Law Change

    Resolution of Tax Matters

    Aggregate Benefits

 

Other (income) expenses, net

   $ (54 )   $ (3 )   $ (57 )

Income tax (benefits) expenses

     (206 )     (27 )     (233 )

Income from discontinued operations, net of tax

     —         (53 )     (53 )
    


 


 


Net income

   $ (260 )   $ (83 )   $ (343 )
    


 


 


 

General Tax Contingencies: 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 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

 

23


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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. Xerox and the individual defendants filed their opposition to that motion on June 28, 2005. The motion has not yet been fully briefed or argued before the court. On or about November 8, 2004, the International Brotherhood of Electrical Workers Welfare Fund of Local Union No. 164 (“IBEW”) filed a motion to intervene as a named plaintiff and class representative. That motion has been fully briefed, but has not been argued before the court. The court has not issued a ruling. Separately, on June 8, 2005, IBEW and Robert W. Roten moved to substitute as lead plaintiffs and proposed class representatives. That motion has been fully briefed, but has not been 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.

 

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

 

24


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

expenses, including counsel fees and expert fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss the complaint. On July 13, 2005, the court denied the motion. 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 $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. On July 13, 2005, the court denied the motion. 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

 

25


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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. In the fall of 2004, the Court requested an updated briefing on our motion to dismiss and update briefs were filed in December. 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 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 filed a motion to dismiss the Second Amended Complaint. Oral argument of the motion was heard on November 6, 2003. By Memorandum Opinion and Order filed November 29, 2004, the court granted the motion to dismiss. A clerk’s judgment of dismissal was filed on November 30, 2004. On December 27, 2004, the Company received a notice of appeal dated December 24, 2004. On February 16, 2005, the parties filed a stipulation withdrawing the December 24, 2004 appeal on the ground that the November 30, 2004 judgment of dismissal was not appealable. On March 28, 2005, Plaintiffs submitted a letter requesting permission to file a motion for leave to file an amended and consolidated complaint. By Summary Order filed April 6, 2005, the Court denied the request. In a second Summary Order filed the same day, the Court amended its November 29, 2004, Opinion and Order, which dismissed the action, so as to render the Opinion and Order appealable and plaintiffs filed a new appeal on May 3, 2005. 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

 

26


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

activities thereunder. Following amended pleadings and MPI’s release of certain claims previously asserted, MPI seeks in its pleadings damages of $58 for royalties owed under the Agreement, $36 for equitable royalties, $35 for breach of fiduciary duty or breach of confidence, $35 in punitive damages and $4 in damages plus disgorgement of profits and injunctive relief with respect to a claim of copyright infringement. The Company and XCL have asserted a counterclaim against MPI for overpayment of royalties and breach of contract. In November 2004, MPI’s motion to amend its claim to add its parent, MPI Tech S.A., as a claimant was granted and the motion of the Company and XCL to dismiss MPI’s copyright claim was denied. The hearing of the arbitration commenced on January 18, 2005. Closing submissions concluded on April 28, 2005. While the arbitration agreement provided for a decision of the arbitration panel within 90 days following completion of the hearing, the parties have agreed that the arbitration panel may have additional time if necessary. The Company and XCL deny any wrongdoing, deny that any damages are owed and have vigorously defended the action. 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.

 

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 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. On November 10, 2004, the Court issued an opinion partially granting and partially denying the motions. Among other things, the Court granted the motions to dismiss all of the claims for rescission and denied plaintiff’s request to replead. The Court denied the Company’s and some of the individual defendants’ motions to dismiss certain claims that seek to limit coverage based on particular provisions in the policy and that at least in part related to settlement with the SEC. Plaintiff filed notices of appeal on January 10, 2005 and February 11, 2005. The appeal is fully briefed. Oral argument before the Appellate Division has not been scheduled. Separately, on February 22, 2005, the defendants filed a motion seeking dismissal of any remaining claims in light of Xerox’s representation that it will not seek coverage from plaintiff for settlement payments to the SEC. By order dated July 12, 2005, the court denied the motion. The Company and the individual defendants deny any wrongdoing and are vigorously defending the action.

 

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

 

27


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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. Agfa et al. (including 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). 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. On February 16, 2005, the U.S. Multi-District Litigation Panel ordered the subject lawsuit (along with all related lawsuits) be transferred from the District Court of the Eastern District of Texas to the District Court for the Northern District of California. All pre-trial proceedings will occur in the Northern District of California and the lawsuit will, if necessary, be transferred back to the Eastern District of Texas for trial. Discovery for all related cases will continue in the Northern District of California. On May 19, 2005 the judge recused herself from the litigation and the parties are awaiting reassignment of the litigation to another judge. It is expected that the litigation will remain in the Northern District of California. We deny any wrongdoing and are vigorously defending this 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.

 

Tesseron, Ltd. v. Xerox Corporation: On October 28, 2004, an action was commenced by Tesseron, Ltd., in the United States District Court for the Northern District of Ohio against Xerox seeking unspecified damages for alleged infringement of seven U.S. patents. Tesseron asserts that its patents cover Xerox’s variable imaging software sold with Xerox’s production printing systems. Xerox filed an answer on January 28, 2005. We deny any wrongdoing and intend to vigorously defend 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.

 

Derivative Litigation Brought on Behalf of the Company:

 

In re Xerox Derivative Actions: A consolidated putative shareholder derivative action was filed 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

 

28


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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. On July 8, 2005, the court entered a stipulated order pursuant to which: (i) the plaintiffs dismissed the action without prejudice and with the right to re-file their claim within the earlier of one year after the date of the stipulation or sixty days after the United States District Court’s decision on the motions to dismiss in the action captioned Carlson v. Xerox Corporation, et al., (ii) the statute of limitations is tolled during that period, and (iii) certain rights and defenses of the parties existing as of the date of dismissal are preserved. The individual defendants deny any wrongdoing.

 

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 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.

 

29


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Other Litigation:

 

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 (“SJ”) was granted on May 21, 2004. In June 2004, Palm filed a motion requesting clarification of the grant of SJ, Xerox has responded to that motion, and also filed a motion to reconsider the SJ. On February 16, 2005, the District Court denied Xerox’s motion to reconsider and granted Palm’s motion to clarify. Pursuant to granting Palm’s motion, the District Court supplemented its decision of May 21, 2004. On June 10, 2005, Xerox filed an appeal brief with the Court of Appeals for the Federal Circuit, seeking reversal of the District Court’s holding of invalidity.

 

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 matters at our Indian subsidiary, Xerox Modicorp Ltd., that occurred over a period of several years much of which occurred before we obtained majority ownership of these operations in mid 1999. These matters 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. The private Indian investigator engaged by the Indian Ministry of Company Affairs has completed an investigation of these matters. The Indian Ministry of Company Affairs has provided our Indian subsidiary with the investigator’s report which addresses the previously disclosed misappropriation of funds and improper payments and has requested comments, which the Indian subsidiary intends to provide in due course. The report includes allegations that Xerox Modicorp Ltd.’s senior officials and the Company were aware of such activities. The report also asserts the need for further investigation into potential criminal acts related to the improper activities addressed by the report. The matter is now pending in the Indian Ministry of Company Affairs. The Company has reported these developments and made a copy of the report received by Xerox Modicorp Ltd. available to the U.S. Department of Justice and the SEC. In March 2005, following the completion of a share buy-back program that increased our controlling ownership interest in our Indian subsidiary to approximately 89 percent from approximately 86 percent at year-end 2004, we changed the name of our Indian subsidiary to Xerox India Ltd.

 

30


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

14-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,


 
     2005

    2004

    2005

    2004

    2005

    2004

    2005

    2004

 

Service cost

   $ 58     $ 56     $ 116     $ 108     $ 5     $ 3     $ 11     $ 11  

Interest cost

     125       126       252       240       22       22       45       45  

Expected return on plan assets

     (134 )     (131 )     (267 )     (246 )     —         —         —         —    

Recognized net actuarial loss

     25       25       50       49       8       6       16       12  

Amortization of prior service cost

     (1 )     (1 )     (1 )     (1 )     (6 )     (7 )     (12 )     (12 )

Recognized net transition obligation

     —         2       1       3       —         —         —         —    

Recognized settlement loss (1)

     13       13       35       28       —         —         —         —    
    


 


 


 


 


 


 


 


Net periodic benefit cost

   $ 86     $ 90     $ 186     $ 181     $ 29     $ 24     $ 60     $ 56  
    


 


 


 


 


 


 


 



(1) Refer to Note 5 for that portion included in restructuring charges for the three and six month periods ended June 30, 2005 and 2004, respectively.

 

Employer Contributions

 

We previously disclosed in our 2004 Annual Report that we expected to contribute $114 to our worldwide defined benefit pension plans and $128 to our other post-retirement benefit plans in 2005. As of June 30, 2005, contributions of $279 and $59 were made to our defined benefit pension plans and our other post-retirement benefit plans, respectively. We presently anticipate contributing an additional $66 to our defined benefit pension plans and $54 to our other post-retirement benefit plans in 2005 for a total of $345 for defined benefit plans and $113 for other post-retirement benefit plans. The increase in expected 2005 defined benefit pension plan contributions is primarily due to our election to contribute $230 to our U.S. plans in April 2005 for the purpose of making those plans 100 percent funded on a current liability basis under ERISA funding rules. This $230 contribution was made following a review of the 2005 actuarial valuation results and giving consideration to our liquidity position.

 

Medicare Prescription Drug, Improvement and Modernization Act of 2003

 

As disclosed in our 2004 Annual Report, we provide postretirement benefits to a group of retirees for which we had not treated the employer paid drug coverage under this plan as actuarially equivalent to the benefits provided under the Act. This assessment was made prior to the recent issuance of final regulations regarding the Act. Upon completion of our review of these regulations, we determined that this plan will be actuarially equivalent for a period of time subject to actual trend rates of prescription drug costs and mortality of plan participants. However, this new determination did not materially change the other post-retirement benefits financial information presented above and in our 2004 Annual Report as it relates to this plan.

 

31


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

15-Earnings per Share:

 

The following tables summarize basic and diluted income per share for the three and six months ended June 30, 2005 and 2004 (shares in thousands):

 

    

Three Months Ended

June 30,


   

Six Months Ended

June 30,


 
     2005

    2004

    2005

    2004

 

Basic Earnings per Common Share:

                                

Income from continuing operations

   $ 370     $ 208     $ 580     $ 373  

Accrued dividends on:

                                

Series B Convertible Preferred Stock, net

     —         (6 )     —         (16 )

Series C Mandatory Convertible Preferred Stock

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


 


 


 


Adjusted income from continuing operations

   $ 355     $ 187     $ 551     $ 328  

Income from discontinued operations, net of tax

     53       —         53       83  
    


 


 


 


Adjusted net income available to common shareholders

   $ 408     $ 187     $ 604     $ 411  
    


 


 


 


Weighted Average Common Shares Outstanding

     960,450       816,947       959,631       808,034  

Basic earnings per share

                                

Earnings from continuing operations

   $ 0.37     $ 0.23     $ 0.57     $ 0.41  

Earnings from discontinued operations

     0.06       —         0.06       0.10  
    


 


 


 


Basic earnings per share

   $ 0.43     $ 0.23     $ 0.63     $ 0.51  
    


 


 


 


Diluted Earnings per Common Share:

                                

Income from continuing operations

   $ 370     $ 208     $ 580     $ 373  

ESOP expense adjustment, net

     —         (2 )     —         (6 )

Accrued dividends on Series C Mandatory Convertible Preferred Stock

     —         —         —         (29 )

Interest on Convertible Securities, net (1)

     —         13       1       27  
    


 


 


 


Adjusted income from continuing operations

   $ 370     $ 219     $ 581     $ 365  

Income from discontinuing operations, net of tax

     53       —         53       83  
    


 


 


 


Adjusted net income available to common shareholders

   $ 423     $ 219     $ 634     $ 448  
    


 


 


 


Weighted Average Common Shares Outstanding

     960,450       816,947       959,631       808,034  

Common shares issuable with respect to:

                                

Stock options and restricted stock

     11,194       15,064       11,687       15,162  

Series B Convertible Preferred Stock

     —         23,338       —         26,947  

Series C Mandatory Convertible Preferred Stock

     74,797       74,797       74,797       —    

Convertible securities (1)

     1,992       115,417       1,992       115,417  
    


 


 


 


Adjusted Weighted Average Shares Outstanding

     1,048,433       1,045,563       1,048,107       965,560  
    


 


 


 


Diluted earnings per share

                                

Earnings from continuing operations

   $ 0.35     $ 0.21     $ 0.55     $ 0.38  

Earnings from discontinued operations

     0.05       —         0.05       0.08  
    


 


 


 


Diluted earnings per share

   $ 0.40     $ 0.21     $ 0.60     $ 0.46  
    


 


 


 



(1) The 2004 convertible securities amount primarily consisted of the convertible liability to Xerox Capital Trust II which is described in Note 10 to our 2004 financial statements included in the 2004 Annual Report.

 

32


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

16-Financial Statements of Subsidiary Guarantors

 

The Senior Notes due 2009, 2010, 2011 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, statements of income, the balance sheets 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, 2005 and December 31, 2004 and for the three and six months ended June 30, 2005 and 2004.

 

Condensed Consolidating Statements of Income for the Three Months Ended June 30, 2005

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


    Eliminations*

    Total
Company


 

Revenues

                                        

Sales

   $ 784     $ —       $ 1,043     $ —       $ 1,827  

Service, outsourcing and rentals

     984       —         941       (51 )     1,874  

Finance income

     76       —         174       (30 )     220  

Intercompany revenues

     305       —         73       (378 )     —    
    


 


 


 


 


Total Revenues

     2,149       —         2,231       (459 )     3,921  
    


 


 


 


 


Cost and Expenses

                                        

Cost of sales

     538       —         728       (45 )     1,221  

Cost of service, outsourcing and rentals

     570       —         517       (1 )     1,086  

Equipment financing interest

     39       —         74       (30 )     83  

Intercompany cost of sales

     267       —         57       (324 )     —    

Research and development expenses

     175       —         23       (10 )     188  

Selling, administrative and general expenses

     569       —         529       (52 )     1,046  

Restructuring and asset impairment charges

     35       —         159       —         194  

Other (income) expenses, net

     (77 )     (5 )     67       1       (14 )
    


 


 


 


 


Total Cost and Expenses

     2,116       (5 )     2,154       (461 )     3,804  
    


 


 


 


 


Income from Continuing Operations, before Income Taxes, Equity Income and Discontinued Operations

     33       5       77       2       117  

Income tax (benefits) expenses

     (227 )     2       (8 )     —         (233 )

Equity in net income (loss) of unconsolidated affiliates

     —         —         25       (5 )     20  

Equity in net income (loss) of consolidated affiliates

     110       (5 )     (2 )     (103 )     —    
    


 


 


 


 


Income from Continuing Operations, before Discontinued Operations

     370       (2 )     108       (106 )     370  

Income from Discontinued Operations, net of tax

     53       —         —         —         53  
    


 


 


 


 


Net Income (Loss)

   $ 423     $ (2 )   $ 108     $ (106 )   $ 423  
    


 


 


 


 



* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.

 

33


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Condensed Consolidating Statements of Income for the Six Months Ended June 30, 2005

 

     Parent
Company


    Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


   Eliminations*

    Total
Company


 

Revenues

                                       

Sales

   $ 1,525     $ —       $ 1,996    $ —       $ 3,521  

Service, outsourcing and rentals

     1,954       —         1,868      (99 )     3,723  

Finance income

     148       —         359      (59 )     448  

Intercompany revenues

     563       —         146      (709 )     —    
    


 


 

  


 


Total Revenues

     4,190       —         4,369      (867 )     7,692  
    


 


 

  


 


Cost and Expenses

                                       

Cost of sales

     1,027       —         1,361      (81 )     2,307  

Cost of service, outsourcing and rentals

     1,125       —         1,027      (1 )     2,151  

Equipment financing interest

     75       —         153      (59 )     169  

Intercompany cost of sales

     499       —         116      (615 )     —    

Research and development expenses

     345       —         45      (19 )     371  

Selling, administrative and general expenses

     1,111       —         1,043      (99 )     2,055  

Restructuring and asset impairment charges

     96       —         183      —         279  

Other (income) expenses, net

     (191 )     (10 )     155      —         (46 )
    


 


 

  


 


Total Cost and Expenses

     4,087       (10 )     4,083      (874 )     7,286  
    


 


 

  


 


Income from Continuing Operations, before Income Taxes, Equity Income and Discontinued Operations

     103       10       286      7       406  

Income tax (benefits) expenses

     (183 )     4       56      6       (117 )

Equity in net income (loss) of unconsolidated affiliates

     3       —         58      (4 )     57  

Equity in net income (loss) of consolidated affiliates

     291       (8 )     —        (283 )     —    
    


 


 

  


 


Income from Continuing Operations, before Discontinued Operations

     580       (2 )     288      (286 )     580  

Income from Discontinued Operations, net of tax

     53       —         —        —         53  
    


 


 

  


 


Net Income (Loss)

   $ 633     $ (2 )   $ 288    $ (286 )   $ 633  
    


 


 

  


 



* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.

 

34


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Condensed Consolidating Balance Sheets as of June 30, 2005

 

     Parent
Company


   Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


    Eliminations*

    Total
Company


Assets

                                     

Cash and cash equivalents

   $ 1,265    $ —       $ 647     $ —       $ 1,912

Short-term investments

     190      —         —         —         190

Accounts receivable, net

     435      —         1,635       —         2,070

Billed portion of finance receivables, net

     168      —         146       —         314

Finance receivables, net

     772      —         1,916       —         2,688

Inventories

     701      —         553       (37 )     1,217

Other current assets

     449      —         593       39       1,081
    

  


 


 


 

Total Current Assets

     3,980      —         5,490       2       9,472
    

  


 


 


 

Finance receivables due after one year, net

     1,390      —         3,493       —         4,883

Equipment on operating leases, net

     242      —         155       —         397

Land, buildings and equipment, net

     948      —         710       —         1,658

Investments in affiliates, at equity

     40      —         778       (18 )     800

Investments in and advances to consolidated subsidiaries

     8,837      (137 )     193       (8,893 )     —  

Intangible assets, net

     296      —         8       —         304

Goodwill

     89      290       1,339       8       1,726

Other long-term assets

     1,425      —         2,040       —         3,465
    

  


 


 


 

Total Assets

   $ 17,247    $ 153     $ 14,206     $ (8,901 )   $ 22,705
    

  


 


 


 

Liabilities and Equity

                                     

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

   $ 42    $ —       $ 1,487     $ —       $ 1,529

Accounts payable

     551      —         533       27       1,111

Other current liabilities

     653      6       1,203       4       1,866
    

  


 


 


 

Total Current Liabilities

     1,246      6       3,223       31       4,506
    

  


 


 


 

Long-term debt

     3,573      —         3,051       —         6,624

Intercompany payables, net

     1,726      (250 )     (1,454 )     (22 )     —  

Liabilities to subsidiary trusts issuing preferred securities

     736      —         —         —         736

Other long-term liabilities

     2,552      —         888       (15 )     3,425
    

  


 


 


 

Total Liabilities

     9,833      (244 )     5,708       (6 )     15,291
    

  


 


 


 

Series C mandatory convertible preferred stock

     889      —         —         —         889

Common shareholders’ equity

     6,525      397       8,498       (8,895 )     6,525
    

  


 


 


 

Total Liabilities and Equity

   $ 17,247    $ 153     $ 14,206     $ (8,901 )   $ 22,705
    

  


 


 


 


* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.

 

35


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Condensed Consolidating Statements of Cash Flows for the Six Months Ended June 30, 2005

 

     Parent
Company


    Guarantor
Subsidiaries


   Non-Guarantor
Subsidiaries


    Total
Company


 

Net cash (used in) provided by operating activities

   $ (1,028 )   $ —      $ 1,655     $ 627  

Net cash used in investing activities

     (144 )     —        —         (144 )

Net cash used in financing activities

     (9 )     —        (1,725 )     (1,734 )

Effect of exchange rate changes on cash and cash equivalents

     —         —        (55 )     (55 )
    


 

  


 


Decrease in cash and cash equivalents

     (1,181 )     —        (125 )     (1,306 )

Cash and cash equivalents at beginning of period

     2,446       —        772       3,218  
    


 

  


 


Cash and cash equivalents at end of period

   $ 1,265     $ —      $ 647     $ 1,912  
    


 

  


 


 

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

  $ 785     $ —       $ 974   $ —       $ 1,759

Service, outsourcing and rentals

    1,011       —         902     (53 )     1,860

Finance income

    83       —         175     (24 )     234

Intercompany revenues

    259       —         97     (356 )     —  
   


 


 

 


 

Total Revenues

    2,138       —         2,148     (433 )     3,853
   


 


 

 


 

Cost and Expenses

                                   

Cost of sales

    521       —         645     (43 )     1,123

Cost of service, outsourcing and rentals

    563       —         493     (4 )     1,052

Equipment financing interest

    28       —         82     (24 )     86

Intercompany cost of sales

    237       —         84     (321 )     —  

Research and development expenses

    166       —         29     (8 )     187

Selling, administrative and general expenses

    580       —         521     (51 )     1,050

Restructuring and asset impairment charges

    19       —         14     —         33

Other (income) expenses, net

    (26 )     (6 )     83     (1 )     50
   


 


 

 


 

Total Cost and Expenses

    2,088       (6 )     1,951     (452 )     3,581
   


 


 

 


 

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

    50       6       197     19       272

Income tax expenses

    8       2       60     21       91

Equity in net income of unconsolidated affiliates

    4       —         20     3       27

Equity in net income (loss) of consolidated affiliates

    162       (8 )     —       (154 )     —  
   


 


 

 


 

Income (Loss) from Continuing Operations, before Discontinued Operations

    208       (4 )     157     (153 )     208

Income from Discontinued Operations, net of tax

    —         —         —       —         —  
   


 


 

 


 

Net Income (Loss)

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


 


 

 


 


* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.

 

36


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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

   $ 1,539     $ —       $ 1,901    $ —       $ 3,440

Service, outsourcing and rentals

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

Finance income

     165       —         349      (42 )     472

Intercompany revenues

     481       —         183      (664 )     —  
    


 


 

  


 

Total Revenues

     4,216       —         4,275      (811 )     7,680
    


 


 

  


 

Cost and Expenses

                                     

Cost of sales

     1,025       —         1,283      (73 )     2,235

Cost of service, outsourcing and rentals

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

Equipment financing interest

     51       —         166      (42 )     175

Intercompany cost of sales

     434       —         146      (580 )     —  

Research and development expenses

     339       —         59      (18 )     380

Selling, administrative and general expenses

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

Restructuring and asset impairment charges

     23       —         16      —         39

Other (income) expenses, net

     (39 )     (11 )     188      (1 )     137
    


 


 

  


 

Total Cost and Expenses

     4,116       (11 )     3,924      (823 )     7,206
    


 


 

  


 

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

     100       11       351      12       474

Income tax expenses

     17       4       118      19       158

Equity in net income of unconsolidated affiliates

     8       —         45      4       57

Equity in net income (loss) of consolidated affiliates

     282       (14 )     —        (268 )     —  
    


 


 

  


 

Income (Loss) from Continuing Operations, before Discontinued Operations

     373       (7 )     278      (271 )     373

Income from Discontinued Operations, net of tax

     83       —         —        —         83
    


 


 

  


 

Net Income (Loss)

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


 


 

  


 


* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.

 

37


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

Condensed Consolidating Balance Sheets as of December 31, 2004

 

     Parent
Company


   Guarantor
Subsidiaries


    Non-Guarantor
Subsidiaries


    Eliminations*

    Total
Company


Assets

                                     

Cash and cash equivalents

   $ 2,446    $ —       $ 772     $ —       $ 3,218

Short-term investments

     —        —         —         —         —  

Accounts receivable, net

     358      —         1,718       —         2,076

Billed portion of finance receivables, net

     206      —         171       —         377

Finance receivables, net

     581      —         2,351       —         2,932

Inventories

     669      —         514       (40 )     1,143

Other current assets

     457      —         672       53       1,182
    

  


 


 


 

Total Current Assets

     4,717      —         6,198       13       10,928
    

  


 


 


 

Finance receivables due after one year, net

     1,099      —         4,089       —         5,188

Equipment on operating leases, net

     229      —         169       —         398

Land, buildings and equipment, net

     979      —         780       —         1,759

Investments in affiliates, at equity

     61      —         801       (17 )     845

Investments in and advances to consolidated subsidiaries

     9,050      (136 )     (165 )     (8,749 )     —  

Intangible assets, net

     289      —         8       —         297

Goodwill

     490      290       1,060       8       1,848

Other long-term assets

     1,106      —         2,515       —         3,621
    

  


 


 


 

Total Assets

   $ 18,020    $ 154     $ 15,455     $ (8,745 )   $ 24,884
    

  


 


 


 

Liabilities and Equity

                                     

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

   $ 5    $ —       $ 3,069     $ —       $ 3,074

Accounts payable

     476      —         522       39       1,037

Other current liabilities **

     858      7       1,330       (6 )     2,189
    

  


 


 


 

Total Current Liabilities

     1,339      7       4,921       33       6,300
    

  


 


 


 

Long-term debt

     3,632      —         3,418       —         7,050

Intercompany payables, net **

     2,461      (239 )     (2,200 )     (22 )     —  

Liabilities to subsidiary trusts issuing preferred securities

     717      —         —         —         717

Other long-term liabilities

     2,738      —         961       (15 )     3,684
    

  


 


 


 

Total Liabilities

     10,887      (232 )     7,100       (4 )     17,751
    

  


 


 


 

Series C mandatory convertible preferred stock

     889      —         —         —         889

Common shareholders’ equity

     6,244      386       8,355       (8,741 )     6,244
    

  


 


 


 

Total Liabilities and Equity

   $ 18,020    $ 154     $ 15,455     $ (8,745 )   $ 24,884
    

  


 


 


 


* The information primarily includes elimination entries necessary to consolidate Xerox Corporation, the parent, with the guarantor and non-guarantor subsidiaries.
** Reclassification to prior presentation made to properly reflect the elimination of an intercompany balance within these line items.

 

38


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(Dollars in millions, except per-share data and unless otherwise indicated)

 

 

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 )
    


 

  


 


Increase (decrease) 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  
    


 

  


 


 

 

39


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)    2005

    2004

     2005

    2004

 

Equipment sales

   $ 1,109     $ 1,070      $ 2,095     $ 2,052  

Post sale and other revenue

     2,592       2,549        5,149       5,156  

Finance income

     220       234        448       472  
    


 


  


 


Total Revenues

   $ 3,921     $ 3,853      $ 7,692     $ 7,680  
    


 


  


 


Reconciliation to Condensed Consolidated Statements of Income

                                 

Sales

   $ 1,827     $ 1,759      $ 3,521     $ 3,440  

Less: Supplies, paper and other sales

     (718 )     (689 )      (1,426 )     (1,388 )
    


 


  


 


Equipment sales

   $ 1,109     $ 1,070      $ 2,095     $ 2,052  
    


 


  


 


Service, outsourcing and rentals

   $ 1,874     $ 1,860      $ 3,723     $ 3,768  

Add: Supplies, paper and other sales

     718       689        1,426       1,388  
    


 


  


 


Post sale and other revenue

   $ 2,592     $ 2,549      $ 5,149     $ 5,156  
    


 


  


 


 

Total second quarter 2005 revenues of $3.9 billion grew 2 percent from the 2004 second quarter including a 2-percentage point benefit from currency. Equipment sales in the second quarter 2005 grew 4 percent from the 2004 second quarter, also including a 2-percentage point benefit from currency. Equipment sales growth reflects strong sales of lower-end office black and white devices, color printers, as well as office and production color systems, which more than offset declines in other monochrome office and production products. Second quarter 2005 post sale and other revenue grew 2 percent from the 2004 second quarter including a 2-percentage point currency benefit. Increased post sale revenues from digital office and production products offset the declines from older technology light lens products. Finance income declined 6 percent, including a 2-percentage point benefit from currency.

 

Total first half 2005 revenues of $7.7 billion were comparable to the prior year period ending June 30, 2004 and included a 2-percentage point benefit from currency. Equipment sales increased 2 percent reflecting strong sales of lower-end office black and white devices, color printers, as well as office and production color systems, which more than offset declines in other monochrome office and production products. Post sale and other revenues were comparable for the first half of 2005 versus first half of 2004 as increased post sale revenues from digital office and production products and a 2-percentage point benefit from currency offset the declines from older technology light lens products. Finance income declined 5 percent, including a 2-percentage point benefit from currency.

 

40


Table of Contents

Second quarter 2005 net income of $423 million or $0.40 per diluted share included a $343 million after-tax benefit related to finalization of the 1996-1998 IRS audit, as well as after-tax restructuring charges of $130 million ($194 million pre-tax). 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 sale of our ownership interest in ScanSoft, Inc. and after-tax restructuring charges of $21 million ($33 million pre-tax).

 

Net income for the six months ended June 30, 2005 was $633 million or $0.60 per diluted share compared with net income of $456 million or $0.46 per diluted share for the same period in the prior year. Net income for the first half of 2005 included an after-tax gain of $58 million ($93 million pre-tax) related to the sale of our equity interest in Integic Corporation (“Integic”), an after-tax benefit of $343 million related to the finalization of the 1996-1998 IRS audit, and after-tax restructuring charges of $185 million ($279 million pre-tax). 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).

 

Operations Review

 

Revenues for the three and six months ended June 30, 2005 and 2004 was as follows:

 

(in millions)    Production

   Office

   DMO

   Other

   Total

Three months ended June 30, 2005

                                  

Equipment sales

   $ 328    $ 610    $ 133    $ 38    $ 1,109

Post sale and other revenue

     712      1,175      304      401      2,592

Finance income

     85      129      3      3      220
    

  

  

  

  

Total Revenue

   $ 1,125    $ 1,914    $ 440    $ 442    $ 3,921
    

  

  

  

  

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
    

  

  

  

  

(in millions)    Production