For the quarterly period ended September 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: September 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  ¨

 

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

 

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 September 30, 2005
Common Stock, $1 par value   960,402,454 shares

 



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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

 

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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”), Merrill Lynch, and De Lage Landen Bank, 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 2005, we became subject to the European Union Directive on Waste Electrical and Electronic Equipment (“WEEE”) as enacted by individual European Union countries (“WEEE Legislation”), which makes producers of electrical goods, including computers and printers, responsible for collection, recycling, treatment and disposal of recovered products. We continue to evaluate the impact of the WEEE Legislation. If we are unable to collect, recycle, treat and dispose of our products in a cost-effective manner and in accordance with applicable country WEEE Legislation, it could materially adversely affect our results of operations and financial condition.

 

Sourcing of Products and Services—We have outsourced a significant portion of our overall worldwide manufacturing operations to third parties and various service providers. To the extent that we

 

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rely on 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 September 30, 2005, we had $7.5 billion of total debt ($3.1 billion of which is secured by finance receivables) and $728 million of liabilities to trusts issuing preferred securities. The total cash, cash equivalents and short-term investments balance was $1.6 billion at September 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,

 

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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 flows from a 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 $1.6 billion of total cash, cash equivalents and short-term investments as of September 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 secured loans up to $5 billion outstanding at any time. As of September 30, 2005, $1.8 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 September 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 Retirement Income Security Act (“ERISA”), as discussed in Note 14 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

 

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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.

 

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XEROX CORPORATION

Form 10-Q

September 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

   42

Capital Resources and Liquidity

   52

Financial Risk Management

   56

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   56

Item 4. Controls and Procedures

   56

Part II—Other Information

    

Item 1. Legal Proceedings

   58

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

   58

Item 5. Other Information

   58

Item 6. Exhibits

   58

Signatures

   60

Exhibit Index

   61

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.

    

Amendment to 2004 Restatement of Unfunded Supplemental Executive Retirement Plan.

    

Amendment to 2004 Restatement of Unfunded Retirement Income Guaranty 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.

 

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PART I—FINANCIAL INFORMATION

 

Item 1

 

XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

    

Three Months
Ended

September 30,


   

Nine Months

Ended

September 30,


 
     2005

    2004

    2005

    2004

 
     (in millions, except per-share data)  

Revenues

                                

Sales

   $ 1,721     $ 1,652     $ 5,242     $ 5,092  

Service, outsourcing and rentals

     1,822       1,834       5,545       5,602  

Finance income

     216       230       664       702  
    


 


 


 


Total Revenues

     3,759       3,716       11,451       11,396  
    


 


 


 


Costs and Expenses

                                

Cost of sales

     1,108       1,003       3,325       3,168  

Cost of service, outsourcing and rentals

     1,017       1,049       3,162       3,203  

Equipment financing interest

     81       85       250       260  

Research, development and engineering expenses

     242       234       709       684  

Selling, administrative and general expenses

     1,011       1,036       3,066       3,122  

Restructuring and asset impairment charges

     17       23       296       62  

Other expenses, net

     206       123       160       260  
    


 


 


 


Total Cost and Expenses

     3,682       3,553       10,968       10,759  
    


 


 


 


Income from Continuing Operations before Income Taxes, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle

     77       163       483       637  

Income tax expenses (benefits)

     29       62       (88 )     220  

Equity in net income of unconsolidated affiliates

     23       62       80       119  
    


 


 


 


Income from Continuing Operations before Discontinued Operations and Cumulative Effect of Change in Accounting Principle

     71       163       651       536  

Income from Discontinued Operations, net of tax

     —         —         53       83  

Cumulative Effect of Change in Accounting Principle, net of tax

     (8 )     —         (8 )     —    
    


 


 


 


Net Income

   $ 63     $ 163     $ 696     $ 619  

Less: Preferred stock dividends, net

     (14 )     (14 )     (43 )     (59 )
    


 


 


 


Income Available to Common Shareholders

   $ 49     $ 149     $ 653     $ 560  
    


 


 


 


Basic Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.06     $ 0.18     $ 0.63     $ 0.58  

Earnings from Discontinued Operations

     —         —         0.06       0.10  

Loss from Cumulative Effect of Change in Accounting Principle

     (0.01 )     —         (0.01 )     —    
    


 


 


 


Basic Earnings per Share

   $ 0.05     $ 0.18     $ 0.68     $ 0.68  
    


 


 


 


Diluted Earnings per Share

                                

Earnings from Continuing Operations

   $ 0.06     $ 0.17     $ 0.62     $ 0.55  

Earnings from Discontinued Operations

     —         —         0.05       0.08  

Loss from Cumulative Effect of Change in Accounting Principle

     (0.01 )     —         (0.01 )     —    
    


 


 


 


Diluted Earnings per Share

   $ 0.05     $ 0.17     $ 0.66     $ 0.63  
    


 


 


 


 

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

 

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XEROX CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

     September 30,
2005


    December 31,
2004


 
    

(in millions, except share

data in thousands)

 

Assets

                

Cash and cash equivalents

   $ 1,345     $ 3,218  

Short-term investments

     235       —    
    


 


Total cash, cash equivalents and short-term investments

     1,580       3,218  

Accounts receivable, net

     2,088       2,076  

Billed portion of finance receivables, net

     325       377  

Finance receivables, net

     2,590       2,932  

Inventories

     1,430       1,143  

Other current assets

     1,088       1,182  
    


 


Total current assets

     9,101       10,928  

Finance receivables due after one year, net

     4,860       5,188  

Equipment on operating leases, net

     414       398  

Land, buildings and equipment, net

     1,652       1,759  

Investments in affiliates, at equity

     797       845  

Intangible assets, net

     301       297  

Goodwill

     1,697       1,848  

Deferred tax assets, long-term

     1,518       1,521  

Other long-term assets

     1,930       2,100  
    


 


Total Assets

   $ 22,270     $ 24,884  
    


 


Liabilities and Equity

                

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

   $ 1,253     $ 3,074  

Accounts payable

     1,131       1,037  

Accrued compensation and benefits costs

     556       637  

Unearned income

     192       243  

Other current liabilities

     1,171       1,309  
    


 


Total current liabilities

     4,303       6,300  

Long-term debt

     6,198       7,050  

Liabilities to subsidiary trusts issuing preferred securities

     728       717  

Pension and other benefit liabilities

     1,078       1,189  

Post-retirement medical benefits

     1,187       1,180  

Other long-term liabilities

     1,320       1,315  
    


 


Total liabilities

     14,814       17,751  

Series C mandatory convertible preferred stock

     889       889  

Common stock, including additional paid-in-capital

     4,948       4,881  

Retained earnings

     2,754       2,101  

Accumulated other comprehensive loss

     (1,135 )     (738 )
    


 


Total Liabilities and Equity

   $ 22,270     $ 24,884  
    


 


Shares of common stock issued and outstanding

     960,402       955,997  

 

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

 

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XEROX CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

    

Three Months

Ended
September 30,


   

Nine Months

Ended

September 30,


 
     2005

    2004

    2005

    2004

 
     (in millions)  

Cash Flows from Operating Activities:

                                

Net income

   $ 63     $ 163     $ 696     $ 619  

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

                                

Depreciation and amortization

     156       168       480       511  

Provisions for receivables and inventory

     30       36       75       134  

Net loss (gain) on sales of businesses and assets

     2       3       (100 )     (51 )

Undistributed equity in net income of unconsolidated affiliates

     (22 )     (59 )     (55 )     (93 )

Income from discontinued operations

     —         —         (53 )     (83 )

Restructuring and asset impairment charges

     17       23       296       62  

Cash payments for restructurings

     (60 )     (38 )     (123 )     (142 )

Contributions to pension benefit plans

     (84 )     (127 )     (363 )     (376 )

Increase in inventories

     (221 )     (154 )     (358 )     (285 )

Increase in equipment on operating leases

     (63 )     (73 )     (176 )     (175 )

Decrease in finance receivables

     127       144       401       442  

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

     (38 )     58       (87 )     121  

Increase in accounts payable and accrued compensation

     121       160       278       147  

Net change in income tax assets and liabilities

     27       5       (246 )     27  

Net change in derivative assets and liabilities

     4       31       55       69  

Increase (decrease) in other current and long-term liabilities

     77       (8 )     (30 )     (95 )

Other, net

     26       103       99       102  
    


 


 


 


Net cash provided by operating activities

     162       435       789       934  
    


 


 


 


Cash Flows from Investing Activities:

                                

Proceeds from sales of short-term investments

     83       —         89       —    

Purchases of short-term investments

     (129 )     —         (325 )     —    

Cost of additions to land, buildings and equipment

     (48 )     (36 )     (124 )     (131 )

Proceeds from sales of land, buildings and equipment

     —         7       2       46  

Cost of additions to internal use software

     (15 )     (15 )     (41 )     (35 )

Proceeds from divestitures and investments, net

     —         1       105       187  

Net change in escrow and other restricted investments

     39       25       81       216  

Other

     —         —         (1 )     —    
    


 


 


 


Net cash (used in) provided by investing activities

     (70 )     (18 )     (214 )     283  
    


 


 


 


Cash Flows from Financing Activities:

                                

Cash proceeds from new secured financings

     36       402       321       1,599  

Debt payments on secured financings

     (560 )     (494 )     (1,512 )     (1,471 )

Net cash (payments) proceeds on other debt

     (129 )     529       (1,199 )     (380 )

Preferred stock dividends

     (14 )     (14 )     (43 )     (69 )

Proceeds from issuances of common stock

     8       6       32       53  

Other

     (1 )     (13 )     7       (14 )
    


 


 


 


Net cash (used in) provided by financing activities

     (660 )     416       (2,394 )     (282 )
    


 


 


 


Effect of exchange rate changes on cash and cash equivalents

     1       20       (54 )     (17 )
    


 


 


 


(Decrease) increase in cash and cash equivalents

     (567 )     853       (1,873 )     918  

Cash and cash equivalents at beginning of period

     1,912       2,542       3,218       2,477  
    


 


 


 


Cash and cash equivalents at end of period

   $ 1,345     $ 3,395     $ 1,345     $ 3,395  
    


 


 


 


 

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

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

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

 

1-Basis of Presentation

 

References herein to “we,” “us,” “our,” the “Company” and “Xerox” 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. These condensed consolidated financial statements should be read in conjunction with 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, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle” as “pre-tax income.”

 

Certain reclassifications have been made to prior year financial information to conform to the current year presentation. Effective July 1, 2005, we reclassified sustaining engineering costs from cost of sales and cost of service, outsourcing and rentals to a new line item in our Condensed Consolidated Statements of Income entitled Research, Development and Engineering (“R,D&E”). This presentation aligns our external reporting presentation to our internal management of these costs. The components of R,D&E are disclosed in Note 9 – Research, Development and Engineering to the Condensed Consolidated Financial Statements.

 

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 European Union (“EU”) Directive on Waste Electrical and Electronic Equipment (the “WEEE Directive”). 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 EU member country. As of the end of the third quarter 2005, the WEEE Directive has been adopted into law by the EU member countries in which we have significant operations, with the exception of the United Kingdom. Accordingly, we recorded an after-tax charge of $18 ($26 pre-tax) in Other expenses, net in the accompanying Condensed Consolidated Statement of Income. The charge reflects the disposal obligation primarily related to our leased equipment population in service as of the date the EU member countries adopted the WEEE Directive. The adoption of the WEEE Directive by an EU member country created a legal disposal obligation and accordingly we are now required to accrue the cost of that obligation at the time the equipment is placed in service. We will be required to record a similar charge for the United Kingdom when it adopts the WEEE Directive, which is expected to be less than $10. We believe that the on-going quarterly expense resulting from compliance with the WEEE Directive will not have a material effect on our financial condition or results of operations.

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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.

 

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 elected to early adopt FIN 47 during the third quarter of 2005 and accordingly recorded an after-tax charge of $8 ($12 pre-tax) as a cumulative effect of change in accounting principle in the accompanying Condensed Consolidated Statement of Income. This charge represents conditional asset retirement obligations associated with leased facilities where we are required to remove certain leasehold improvements and restore the facility to its original condition at lease termination. Previously we recorded costs associated with this obligation upon lease termination when the costs were known. On a prospective basis, this accounting change requires recognition of these costs ratably over the lease term. The pro-forma effect of applying this guidance in all prior periods presented was determined not to be material. The FIN 47 charge resulted in a non-cash addition to Land, buildings and equipment of $10 in the third quarter of 2005 with a corresponding increase in Other current and long-term liabilities. In future periods, when cash is paid upon the settlement of the asset retirement obligation, the payments will be classified as a component of operating cash flow in the Condensed Consolidated Statements of Cash Flows.

 

In December 2004, the FASB issued 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. The adoption of this statement did 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

 

12


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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, we approved the accelerated vesting of approximately 3.6 million unvested stock options granted in 2004 to our 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 as of the accelerated vesting date. 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 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 accelerated vesting, 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 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 nine months ended September 30, 2005 and 2004 would have been as follows:

 

     Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Net income—as reported

   $ 63     $ 163     $ 696     $ 619  

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

     7       3       19       10  

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

     (25 )     (17 )     (58 )     (51 )
    


 


 


 


Net income—pro forma

   $ 45     $ 149     $ 657     $ 578  
    


 


 


 


Basic EPS—as reported

   $ 0.05     $ 0.18     $ 0.68     $ 0.68  

Basic EPS—pro forma

     0.03       0.16       0.64       0.63  

Diluted EPS—as reported

   $ 0.05     $ 0.17     $ 0.66     $ 0.63  

Diluted EPS—pro forma

     0.03       0.15       0.63       0.59  

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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.

 

5-Restructuring Programs

 

The restructuring and asset impairment charges in the Condensed Consolidated Statements of Income totaled $296 and $62 for the nine months ended September 30, 2005 and 2004, respectively. Detailed information related to restructuring program activity during the nine months ended September 30, 2005 is outlined below.

 

Restructuring Activity


   Ongoing
Programs


   

Legacy

Programs (1)


    Total

 

Balance as of December 31, 2004

   $ 93     $ 24     $ 117  

Restructuring Provision

     300       1       301  

Reversals of prior accruals

     (6 )     (4 )     (10 )

Charges against reserve and currency

     (123 )     (8 )     (131 )
    


 


 


Balance as of September 30, 2005

   $ 264     $ 13     $ 277  
    


 


 



(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
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Restructuring provision

   $ 19     $ 24     $ 301     $ 71  

Reversals of prior accruals

     (3 )     (1 )     (10 )     (9 )

Asset impairment charges

     1       —         5       —    
    


 


 


 


Restructuring and asset impairment charges

   $ 17     $ 23     $ 296     $ 62  
    


 


 


 


 

14


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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

Reconciliation to Statements of Cash Flows

 

     Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Charges to reserve, all programs

   $ (61 )   $ (37 )   $ (131 )   $ (151 )

Pension curtailment, special termination benefits and settlements

     —         1       —         8  

Effects of foreign currency and other non-cash

     1       (2 )     8       1  
    


 


 


 


Cash payments for restructurings

   $ (60 )   $ (38 )   $ (123 )   $ (142 )
    


 


 


 


 

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 major 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 incurred $299 for ongoing restructuring programs, including net reversals of $6 related to changes in estimates in severance costs from previously recorded actions. The additional provision in 2005 consisted of $289 in severance and related costs, primarily related to initiatives that are expected to result in the elimination of approximately 3,000 positions in North America, Latin America and Europe, $11 for lease terminations and $5 for asset impairments. The initiatives in 2005 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 September 30, 2005:

 

Segment Reporting:

 

     Cumulative
amount
incurred as of
December 31, 2004


  

Net amount
incurred for the
nine months

ended
September 30, 2005


   Cumulative
amount
incurred as of
September 30, 2005


   Total expected
to be incurred *


Production

   $ 255    $ 126    $ 381    $ 410

Office

     198      145      343      388

DMO

     97      12      109      109

Other

     122      16      138      144
    

  

  

  

Total Provisions

   $ 672    $ 299    $ 971    $ 1,051
    

  

  

  

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

Major Cost Reporting:

 

     Cumulative
amount
incurred as of
December 31, 2004


  

Amount
incurred for the
nine months

ended
September 30, 2005


   Cumulative
amount
incurred as of
September 30, 2005


   Total expected
to be incurred *


Severance and related costs

   $ 567    $ 283    $ 850    $ 929

Lease cancellation and other costs

     59      11      70      71

Asset impairments

     46      5      51      51
    

  

  

  

Total provisions

   $ 672    $ 299    $ 971    $ 1,051
    

  

  

  


* The total amount of $1,051 represents the cumulative amount incurred through September 30, 2005 plus additional expected restructuring charges of approximately $80 related to initiatives identified to date that have not yet been recognized in the Condensed Consolidated Financial Statements as well as expected interest accretion on the reserve.

 

6-Short-term investments

 

As of September 30, 2005, we held $235 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 nine month periods ended September 30, 2005 were $83 and $89, respectively. No gains or losses were realized on these sales.

 

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

 

     Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


    Estimated
Fair Value


Corporate bonds

   $ 129    $ —      $ (1 )   $ 128

Auction rate municipal bonds

     44      —        —         44

US government agency securities

     32      —        —         32

Auction rate preferred securities

     31      —        —         31
    

  

  


 

Total

   $ 236    $ —      $ (1 )   $ 235
    

  

  


 

 

16


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

The contractual maturities of the available-for-sale debt securities at September 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

   $ 73

Due after 1 year through 5 years

     87

Due after 5 years through 10 years

     —  

Due after 10 years

     44
    

Total debt securities

   $ 204
    

Auction rate preferred securities

     31
    

Total Short-term investments

   $ 235
    

 

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 nine months ended 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 consisted of the following:

 

     September 30,
2005


   December 31,
2004


Finished goods

   $ 1,133    $ 895

Work-in-process

     107      65

Raw materials

     190      183
    

  

Total Inventories

   $ 1,430    $ 1,143
    

  

 

8-Common Shareholders’ Equity

 

Common shareholders’ equity consisted of:

 

     September 30,
2005


    December 31,
2004


 

Common stock

   $ 960     $ 956  

Additional paid-in-capital

     3,988       3,925  

Retained earnings

     2,754       2,101  

Accumulated other comprehensive loss (1)

     (1,135 )     (738 )
    


 


Total Common shareholders’ equity

   $ 6,567     $ 6,244  
    


 



(1) Accumulated other comprehensive loss at September 30, 2005 is composed of cumulative translation adjustments of $(936), a minimum pension liability of $(198) and unrealized losses on securities of $(1).

 

17


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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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

 

     Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Net income

   $ 63     $ 163     $ 696     $ 619  

Translation adjustments

     (26 )     93       (412 )     (3 )

Unrealized (gain) loss on securities, net of tax

     —         —         (2 )     1  

Realized gain on securities, net of tax

     —         —         —         (18 )

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

     1       70       20       101  

Cash flow hedge adjustments, net of tax

     —         (7 )     (3 )     2  
    


 


 


 


Comprehensive income

   $ 38     $ 319     $ 299     $ 702  
    


 


 


 



(1) The change of $20 in the minimum pension liability since December 31, 2004 includes $3 relating to our portion of a minimum pension liability reduction that was recorded during the period and a $17 benefit from currency.

 

9-Research, Development and Engineering (“R,D&E”)

 

R,D&E for the three and nine months ended September 30, 2005 was $242 and $709, respectively, as compared to $234 and $684 for comparable periods in 2004. Research and development (“R&D”) costs for the three and nine months ended September 30, 2005 totaled $196 and $567, respectively, as compared to $189 and $569 for comparable periods in 2004.

 

Sustaining engineering costs are incurred with respect to ongoing product improvements after initial product launch, as well as RoHS programs. Our sustaining engineering costs for the three and nine months ended September 30, 2005 was $46 and $142, respectively, as compared to $45 and $115 for comparable periods in 2004.

 

10-Interest Expense and Income

 

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

 

     Three Months
Ended
September 30,


   Nine Months
Ended
September 30,


     2005

   2004

   2005

   2004

Interest expense (1)

   $ 136    $ 176    $ 428    $ 530

Interest income (2)

     234      244      788      760

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

 

Equipment financing interest is determined based on a combination of actual interest expense incurred on financing debt, as well as our estimated cost of funds applied against the estimated level of debt required to

 

18


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

support our financed receivables. The estimated level of debt 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.

 

11-Income from Discontinued Operations

 

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

 

     Nine Months
Ended
September 30,


   2005

   2004

Insurance Group Operations tax benefits

   $ 53    $ —  

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

     —        83
    

  

Total

   $ 53    $ 83
    

  

 

As disclosed in Note 14 – Contingencies, in June 2005 we received notice that our 1996-1998 Internal Revenue Service (“IRS”) audit was 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 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.

 

12-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, we made changes to the allocation of certain segment costs and expenses. These changes included a reallocation of costs associated with corporate and certain shared service

 

19


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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

 
     Mar. 31

    June 30

    Sept. 30

    Dec. 31

    Total

 

Operating Profit

                                        

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, excluding 50 pages per minute products with an embedded controller. 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, as well as, 50 pages per minute color devices with an embedded controller. 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.

 

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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 September 30, 2005 and 2004 were as follows:

 

     Production

   Office

   DMO

   Other

    Total

2005

                                   

Total segment revenues

   $ 1,058    $ 1,848    $ 446    $ 407     $ 3,759
    

  

  

  


 

Segment profit (loss)

   $ 73    $ 189    $ 18    $ (14 )   $ 266
    

  

  

  


 

2004

                                   

Total segment revenues

   $ 1,067    $ 1,819    $ 406    $ 424     $ 3,716
    

  

  

  


 

Segment profit (loss)

   $ 105    $ 182    $ 4    $ (43 )   $ 248
    

  

  

  


 

 

Operating segment revenues and profitability for the nine months ended September 30, 2005 and 2004 were as follows:

 

     Production

   Office

   DMO

   Other

    Total

2005

                                   

Total segment revenues

   $ 3,255    $ 5,591    $ 1,298    $ 1,307     $ 11,451
    

  

  

  


 

Segment profit

   $ 253    $ 554    $ 47    $ 161     $ 1,015
    

  

  

  


 

2004

                                   

Total segment revenues

   $ 3,283    $ 5,545    $ 1,243    $ 1,325     $ 11,396
    

  

  

  


 

Segment profit (loss)

   $ 309    $ 538    $ 29    $ (58 )   $ 818
    

  

  

  


 

 

The following is a reconciliation to pre-tax income:

 

     Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Total segment profit

   $ 266     $ 248     $ 1,015     $ 818  

Reconciling items:

                                

Restructuring and asset impairment charges

     (17 )     (23 )     (296 )     (62 )

Provision for litigation matters

     (107 )     —         (107 )     —    

Initial provision for WEEE Directive

     (26 )     —         (26 )     —    

Hurricane Katrina losses

     (15 )     —         (15 )     —    

Other expenses

     (1 )     —         (8 )     —    

Equity in net income of unconsolidated affiliates

     (23 )     (62 )     (80 )     (119 )
    


 


 


 


Pre-tax income

   $ 77     $ 163     $ 483     $ 637  
    


 


 


 


 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

13-Investment in Affiliates, at Equity

 

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

 

     Three Months
Ended
September 30,


   Nine Months
Ended
September 30,


     2005

   2004

   2005

   2004

Fuji Xerox

   $ 22    $ 60    $ 75    $ 108

Other investments

     1      2      5      11
    

  

  

  

Total

   $ 23    $ 62    $ 80    $ 119
    

  

  

  

 

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

 

     Three Months
Ended
September 30,


   Nine Months
Ended
September 30,


     2005

   2004

   2005

   2004

Summary of Operations

                           

Revenues

   $ 2,527    $ 2,309    $ 7,720    $ 7,087

Cost and expenses

     2,392      1,926      7,234      6,401

Income before income taxes

     135      383      486      686

Income taxes

     47      142      170      262

Minorities’ interests

     1      6      8      15
    

  

  

  

Net income

   $ 87    $ 235    $ 308    $ 409
    

  

  

  

 

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.

 

14-Contingencies

 

Guarantees, Indemnifications and Warranty Liabilities

 

Patent Indemnifications: In most sales transactions to resellers of our products, we indemnify against possible claims of patent infringement caused by our products or solutions. These indemnifications usually do not include limits on claims, provided the claims are made pursuant to the procedures required in the sales contracts. Also, in conjunction with our internal use or external distribution of third-party software products, we may provide indemnification to these third-party software providers against possible claims of patent infringement related to our use and distribution of their products. For the indemnification agreements discussed above, it is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each agreement. Historically, payments we have made under these agreements did not have a material effect on our business, financial condition or results of operations.

 

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,

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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.

 

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 nine months ended September 30, 2005 and 2004:

 

     2005

    2004

 

Balance as of January 1

   $ 23     $ 19  

Provisions

     33       33  

Payments and adjustments

     (34 )     (31 )
    


 


Balance as of September 30

   $ 22     $ 21  
    


 


 

Tax related contingencies

 

Brazil Tax Contingencies: At September 30, 2005, our Brazilian operations had received assessments levied against it for indirect and other taxes which, inclusive of interest, were approximately $799. 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 second quarter 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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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.

 

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 11-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 nine months ended September 30, 2005:

 

     Tax
Law
Change


    Resolution
of Tax
Matters


    Aggregate
Benefits


 

Other income, net

   $ (54 )   $ (3 )   $ (57 )

Income tax benefits

     (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.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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 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 been fully briefed, but has not been argued before the court. The court has not issued a ruling. 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 court has not issued a ruling. 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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

defendants participated in a fraudulent scheme that operated as a fraud and deceit on purchasers of the Company’s common stock and bonds by disseminating materially false and misleading statements and/or concealing material adverse facts relating to various of the Company’s accounting and reporting practices and financial condition. The plaintiffs further allege that this scheme deceived the investing public regarding the true state of the Company’s financial condition and caused the plaintiffs and other members of the alleged Class to purchase the Company’s common stock and bonds at artificially inflated prices, and prompted a SEC investigation that led to the April 11, 2002 settlement which, among other things, required the Company to pay a $10 penalty and restate its financials for the years 1997-2000 (including restatement of financials previously corrected in an earlier restatement which plaintiffs contend was improper). The third consolidated amended complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other Class members against all defendants, jointly and severally, including interest thereon, together with reasonable costs and expenses, including counsel fees and expert fees. On December 2, 2002, the Company and the individual defendants filed a motion to dismiss the complaint. 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.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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: In an arbitration proceeding the hearing of which commenced on January 18, 2005, MPI Technologies, Inc. (“MPI”) sought damages from Xerox Corporation and Xerox Canada Ltd. (“XCL”) for royalties owed under a license agreement made as of March 15, 1994 between MPI and XCL and breach of fiduciary duty, breach of confidence, equitable royalties and punitive damages and disgorgement of profits and injunctive relief with respect to a claim of copyright infringement. On September 9, 2005, the arbitration panel rendered its decision, awarding MPI approximately $89, plus interest thereon. The amount of interest has yet to be determined. We have accrued the amount of the $89 award, as well as our current estimate of the interest thereon. The parties have 90 days from September 9, 2005 in which to seek to set aside the award. We are reviewing the decision and expect to seek judicial review and intend to vigorously defend 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 and oral argument was heard on September 29, 2005. The appellate court has not rendered a decision. 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. On August 23, 2005, defendants moved for leave to reargue the February 22 motion and separately moved for leave to renew the December 19, 2003 motions. Those motions have been fully briefed, but have not yet been argued before the court. The court has not issued a ruling. 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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

Rights Act of 1871. The suit was commenced on May 9, 2001 by six black sales representatives. The plaintiffs allege that Xerox has engaged in a pattern or practice of race discrimination against them and other black sales representatives by assigning them to less desirable sales territories, denying them promotional opportunities, and paying them less than their white counterparts. Although the complaint does not specify the amount of damages sought, plaintiffs do seek, on behalf of themselves and the classes they seek to represent, front and back pay, compensatory and punitive damages, and attorneys’ fees. We deny any wrongdoing and are vigorously defending the action. Based on the stage of the litigation, it is not possible to estimate the amount of loss or range of possible loss that might result from an adverse judgment or a settlement of this matter.

 

Compression Labs, Inc. v. 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 a new judge was assigned in August 2005. 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. The parties are currently engaged in discovery. 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:

 

Miller, et al. v. Allaire, et al.: Following the voluntary dismissal without prejudice of In re Xerox Derivative Actions in the Supreme Court of the State of New York, County of New York, the plaintiffs purportedly brought a substantially similar putative shareholder derivative action in Connecticut Superior Court, Judicial District of Stamford-Norwalk at Stamford in the name of and for the benefit of the Company, which is named as a nominal defendant, and its public shareholders 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 LLP. This action is based on substantially the same allegations and seeks substantially the same relief as the

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

discontinued action. The complaint alleges 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 allege that each of the director defendants breached his/her duties of due care and diligence in the management and administration of the Company’s affairs and grossly mismanaged or aided and abetted the gross mismanagement of the Company and its assets. The complaint also asserts claims of negligence, negligent misrepresentation, breach of contract and breach of fiduciary duty against KPMG. Additionally, plaintiffs claim 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. Plaintiffs also demand injunctive relief from the indemnification of six former officers for disgorgements imposed pursuant to their respective settlements with the SEC and related legal fees. 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.

 

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

 

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Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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. Xerox is now preparing a reply brief to the Palm brief on the issue of invalidity. An oral hearing is scheduled for early March 2006.

 

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.

 

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-Employee Benefit Plans

 

Components of Net Periodic Cost

 

     Pension Benefits

    Other Benefits

 
     Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


    Three Months
Ended
September 30,


    Nine Months
Ended
September 30,


 
     2005

    2004

    2005

    2004

    2005

    2004

    2005

    2004

 

Service cost

   $ 57     $ 56     $ 173     $ 164     $ 6     $ 5     $ 17     $ 16  

Interest cost

     124       122       376       362       23       22       68       67  

Expected return on plan assets

     (134 )     (130 )     (401 )     (376 )     —         —         —         —    

Recognized net actuarial loss

     24       23       74       72       8       6       24       18  

Amortization of prior service cost

     —         1       (1 )     —         (6 )     (6 )     (18 )     (18 )

Recognized net transition obligation

     —         1       1       4       —         —         —         —    

Recognized settlement loss (1)

     10       10       45       38       —         —         —         —    
    


 


 


 


 


 


 


 


Net periodic benefit cost

   $ 81     $ 83     $ 267     $ 264     $ 31     $ 27     $ 91     $ 83  
    


 


 


 


 


 


 


 



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

 

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 September 30, 2005, contributions of $363 and $87 were made to our defined benefit pension plans and our other post-retirement benefit plans, respectively. We presently anticipate contributing an additional $32 to our defined benefit pension plans and $28 to our other post-retirement benefit plans in 2005 for a total of $395 for defined benefit plans and $115 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. In addition to the contribution to our U.S. plan, during September 2005, we contributed an additional $50 to our pension plan in the U.K. This contribution was also made for the purpose of improving the funded status of the plan and was not anticipated in our original funding estimate.

 

Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”)

 

As disclosed in our 2004 Annual Report, we provide post-retirement benefits to a group of retirees under a plan for which we had not treated the employer paid drug coverage under the plan as being 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.

 

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XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

16-Earnings per Share

 

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

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2005

    2004

    2005

    2004

 

Basic Earnings per Share:

                                

Income from continuing operations before discontinued operations and cumulative effect of change in accounting principle

   $ 71     $ 163     $ 651     $ 536  

Accrued dividends on:

                                

Series B Convertible Preferred Stock, net

     —         —         —         (16 )

Series C Mandatory Convertible Preferred Stock

     (14 )     (14 )     (43 )     (43 )
    


 


 


 


Adjusted income from continuing operations before discontinued operations and cumulative effect of change in accounting principle

   $ 57     $ 149     $ 608     $ 477  

Income from discontinued operations, net

     —         —         53       83  

Cumulative effect of change in accounting principle, net

     (8 )     —         (8 )     —    
    


 


 


 


Adjusted net income available to common shareholders

   $ 49     $ 149     $ 653     $ 560  
    


 


 


 


Weighted Average Common Shares Outstanding

     961,553       841,078       960,249       819,066  

Basic Earnings per Share

                                

Earnings from continuing operations

   $ 0.06     $ 0.18     $ 0.63     $ 0.58  

Earnings from discontinued operations

     —         —         0.06       0.10  

Loss from cumulative effect of change in accounting principle

     (0.01 )     —         (0.01 )     —    
    


 


 


 


Basic Earnings per Share

   $ 0.05     $ 0.18     $ 0.68     $ 0.68  
    


 


 


 


Diluted Earnings per Share:

                                

Income from continuing operations before discontinued operations and cumulative effect of change in accounting principle

   $ 71     $ 163     $ 651     $ 536  

ESOP expense adjustment, net

     —         —         —         (6 )

Accrued dividends on Series C Mandatory Convertible Preferred Stock

     (14 )     (14 )     —         (43 )

Interest on Convertible Securities, net (1)

     —         14       1       41  
    


 


 


 


Adjusted income from continuing operations before discontinued operations and cumulative effect of change in accounting principle

   $ 57     $ 163     $ 652     $ 528  

Income from discontinued operations, net

     —         —         53       83  

Cumulative effect of change in accounting principle, net

     (8 )     —         (8 )     —    
    


 


 


 


Adjusted net income available to common shareholders

   $ 49     $ 163     $ 697     $ 611  
    


 


 


 


Weighted Average Common Shares Outstanding

     961,553       841,078       960,249       819,066  

Common shares issuable with respect to:

                                

Stock options and restricted stock

     10,999       12,927       11,380       13,841  

Series B Convertible Preferred Stock

     —         —         —         22,567  

Series C Mandatory Convertible Preferred Stock

     —         —         74,797       —    

Convertible securities (1)

     —         115,417       1,992       115,417  
    


 


 


 


Adjusted Weighted Average Common Shares Outstanding

     972,552       969,422       1,048,418       970,891  
    


 


 


 


Diluted Earnings per Share

                                

Earnings from continuing operations

   $ 0.06     $ 0.17     $ 0.62     $ 0.55  

Earnings from discontinued operations

     —         —         0.05       0.08  

Loss from cumulative effect of change in accounting principle

     (0.01 )     —         (0.01 )     —    
    


 


 


 


Diluted Earnings per Share

   $ 0.05     $ 0.17     $ 0.66     $ 0.63  
    


 


 


 



(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.

 

33


Table of Contents

XEROX CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

17-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 September 30, 2005 and December 31, 2004 and for the three and nine months ended September 30, 2005 and 2004.

 

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

 

    Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


    Eliminations*

    Total
Company


 

Revenues

                                       

Sales

  $ 776     $ —       $ 945     $ —       $ 1,721  

Service, outsourcing and rentals

    974       —         900       (52 )     1,822  

Finance income

    81       —         168       (33 )     216  

Intercompany revenues

    303       —         82       (385 )     —    
   


 


 


 


 


Total Revenues

    2,134       —         2,095       (470 )     3,759  

Costs and Expenses

                                       

Cost of sales

    485       —         666       (43 )     1,108  

Cost of service, outsourcing and rentals

    528       —         489       —         1,017  

Equipment financing interest

    36       —         78       (33 )     81  

Intercompany cost of sales

    269       —         65       (334 )     —    

Research, development and engineering expenses

    227       —         24       (9 )     242  

Selling, administrative and general expenses

    561       —         503       (53 )     1,011  

Restructuring and asset impairment charges

    15       —         2       —         17  

Other (income) expenses, net

    100       (6 )     112       —         206  
   


 


 


 


 


Total Costs and Expenses

    2,221       (6 )     1,939       (472 )     3,682  
   


 


 


 


 


Income (Loss) from Continuing Operations before Income Taxes, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    (87 )     6       156       2       77  

Income tax (benefits) expenses

    (22 )     2       50       (1 )     29  

Equity in net income of unconsolidated affiliates

    1       —         22       —         23  

Equity in net income (loss) of consolidated affiliates

    130       (4 )     (2 )     (124 )     —    
   


 


 


 


 


Income from Continuing Operations before Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    66       —         126       (121 )     71  

Income from Discontinued Operations, net of tax

    —         —         —         —         —    

Cumulative Effect of Change in Accounting Principle, net of tax

    (3 )     —         (5 )     —         (8 )
   


 


 


 


 


Net Income

  $ 63     $ —       $ 121     $ (121 )   $ 63  
   


 


 


 


 



* 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 Statements of Income for the Nine Months Ended September 30, 2005

 

    Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


    Eliminations*

    Total
Company


 

Revenues

                                       

Sales

  $ 2,301     $ —       $ 2,941     $ —       $ 5,242  

Service, outsourcing and rentals

    2,928       —         2,768       (151 )     5,545  

Finance income

    229       —         527       (92 )     664  

Intercompany revenues

    866       —         228       (1,094 )     —    
   


 


 


 


 


Total Revenues

    6,324       —         6,464       (1,337 )     11,451  

Costs and Expenses

                                       

Cost of sales

    1,422       —         2,027       (124 )     3,325  

Cost of service, outsourcing and rentals

    1,648       —         1,515       (1 )     3,162  

Equipment financing interest

    111       —         231       (92 )     250  

Intercompany cost of sales

    768       —         181       (949 )     —    

Research, development and engineering expenses

    667       —         70       (28 )     709  

Selling, administrative and general expenses

    1,672       —         1,546       (152 )     3,066  

Restructuring and asset impairment charges

    111       —         185       —         296  

Other (income) expenses, net

    (91 )     (16 )     267       —         160  
   


 


 


 


 


Total Costs and Expenses

    6,308       (16 )     6,022       (1,346 )     10,968  
   


 


 


 


 


Income from Continuing Operations, before Income Taxes, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    16       16       442       9       483  

Income tax (benefits) expenses

    (205 )     6       106       5       (88 )

Equity in net income of unconsolidated affiliates

    4       —         80       (4 )     80  

Equity in net income (loss) of consolidated affiliates

    421       (12 )     (2 )     (407 )     —    
   


 


 


 


 


Income (Loss) from Continuing Operations before Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    646       (2 )     414       (407 )     651  

Income from Discontinued Operations, net of tax

    53       —         —         —         53  

Cumulative Effect of Change in Accounting Principle, net of tax

    (3 )     —         (5 )     —         (8 )
   


 


 


 


 


Net Income (Loss)

  $ 696     $ (2 )   $ 409     $ (407 )   $ 696  
   


 


 


 


 



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

 

35


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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 September 30, 2005

 

     Parent
Company


   Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


    Eliminations*

    Total
Company


Assets

                                     

Cash and cash equivalents

   $ 838    $ —       $ 507     $ —       $ 1,345

Short-term investments

     235      —         —         —         235

Accounts receivable, net

     464      —         1,624       —         2,088

Billed portion of finance receivables, net

     181      —         144       —         325

Finance receivables, net

     849      —         1,741       —         2,590

Inventories

     824      —         641       (35 )     1,430

Other current assets

     479      —         581       28       1,088
    

  


 


 


 

Total Current Assets

     3,870      —         5,238       (7 )     9,101

Finance receivables due after one year, net

     1,568      —         3,292       —         4,860

Equipment on operating leases, net

     246      —         168       —         414

Land, buildings and equipment, net

     942      —         710       —         1,652

Investments in affiliates, at equity

     41      —         1,184       (428 )     797

Investments in and advances to consolidated subsidiaries

     8,582      142       (172 )     (8,552 )     —  

Intangible assets, net

     287      —         14       —         301

Goodwill

     89      —         1,600       8       1,697

Other long-term assets

     1,587      —         1,558       303       3,448
    

  


 


 


 

Total Assets

   $ 17,212    $ 142     $ 13,592     $ (8,676 )   $ 22,270
    

  


 


 


 

Liabilities and Equity

                                     

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

   $ 2    $ —       $ 1,251     $ —       $ 1,253

Accounts payable

     577      —         535       19       1,131

Other current liabilities

     755      16       1,153       (5 )     1,919
    

  


 


 


 

Total Current Liabilities

     1,334      16       2,939       14       4,303

Long-term debt

     3,535      —         2,663       —         6,198

Intercompany payables, net

     1,612      (256 )     (1,314 )     (42 )     —  

Liabilities to subsidiary trusts issuing preferred securities

     728      —         —         —         728

Other long-term liabilities

     2,547      (1 )     1,055       (16 )     3,585
    

  


 


 


 

Total Liabilities

     9,756      (241 )     5,343       (44 )     14,814

Series C mandatory convertible preferred stock

     889      —         —         —         889

Common shareholders’ equity

     6,567      383       8,249       (8,632 )     6,567
    

  


 


 


 

Total Liabilities and Equity

   $ 17,212    $ 142     $ 13,592     $ (8,676 )   $ 22,270
    

  


 


 


 


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

 

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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 Nine Months Ended September 30, 2005

 

     Parent
Company


    Guarantor
Subsidiaries


   Non-
Guarantor
Subsidiaries


   

Total

Company


 

Net cash (used in) provided by operating activities

   $ (1,328 )   $ —      $ 2,117     $ 789  

Net cash (used in) provided by investing activities

     (224 )     —        10       (214 )

Net cash used in financing activities

     (56 )     —        (2,338 )     (2,394 )

Effect of exchange rate changes on cash and cash equivalents

     —         —        (54 )     (54 )
    


 

  


 


Decrease in cash and cash equivalents

     (1,608 )     —        (265 )     (1,873 )

Cash and cash equivalents at beginning of period

     2,446       —        772       3,218  
    


 

  


 


Cash and cash equivalents at end of period

   $ 838     $ —      $ 507     $ 1,345  
    


 

  


 


 

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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 Three Months Ended September 30, 2004

 

    Parent
Company


  Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


  Eliminations*

    Total
Company


Revenues

                                 

Sales

  $ 772   $ —       $ 880   $ —       $ 1,652

Service, outsourcing and rentals

    1,006     —         883     (55 )     1,834

Finance income

    72     —         184     (26 )     230

Intercompany revenues

    244     —         92     (336 )     —  
   

 


 

 


 

Total Revenues

    2,094     —         2,039     (417 )     3,716

Costs and Expenses

                                 

Cost of sales

    474     —         559     (30 )     1,003

Cost of service, outsourcing and rentals

    551     —         502     (4 )     1,049

Equipment financing interest

    26     —         85     (26 )     85

Intercompany cost of sales

    219     —         75     (294 )     —  

Research, development and engineering expenses

    214     —         29     (9 )     234

Selling, administrative and general expenses

    574     —         515     (53 )     1,036

Restructuring and asset impairment charges

    7     —         16     —         23

Other expenses (income), net

    16     (5 )     112     —         123
   

 


 

 


 

Total Costs and Expenses

    2,081     (5 )     1,893     (416 )     3,553
   

 


 

 


 

Income from Continuing Operations before Income Taxes, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    13     5       146     (1 )     163

Income tax expenses

    8     2       40     12       62

Equity in net income of unconsolidated affiliates

    2     —         59     1       62

Equity in net income (loss) of consolidated affiliates

    156     (12 )     —       (144 )     —  
   

 


 

 


 

Income (Loss) from Continuing Operations before Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    163     (9 )     165     (156 )     163

Income from Discontinued Operations, net of tax

    —       —         —       —         —  

Cumulative Effect of Change in Accounting Principle, net of tax

    —       —         —       —         —  
   

 


 

 


 

Net Income (Loss)

  $ 163   $ (9 )   $ 165   $ (156 )   $ 163
   

 


 

 


 


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

 

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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 Nine Months Ended September 30, 2004

 

    Parent
Company


    Guarantor
Subsidiaries


    Non-
Guarantor
Subsidiaries


  Eliminations*

    Total
Company


Revenues

                                   

Sales

  $ 2,311     $ —       $ 2,781   $ —       $ 5,092

Service, outsourcing and rentals

    3,037       —         2,725     (160 )     5,602

Finance income

    237       —         532     (67 )     702

Intercompany revenues

    725       —         275     (1,000 )     —  
   


 


 

 


 

Total Revenues

    6,310       —         6,313     (1,227 )     11,396

Costs and Expenses

                                   

Cost of sales

    1,427       —         1,841     (100 )     3,168

Cost of service, outsourcing and rentals

    1,688       —         1,529     (14 )     3,203

Equipment financing interest

    77       —         250     (67 )     260

Intercompany cost of sales

    656       —         221     (877 )     —  

Research, development and engineering expenses

    622       —         89     (27 )     684

Selling, administrative and general expenses

    1,720       —         1,554     (152 )     3,122

Restructuring and asset impairment charges

    30       —         32     —         62

Other (income) expenses, net

    (23 )     (16 )     300     (1 )     260
   


 


 

 


 

Total Costs and Expenses

    6,197       (16 )     5,816     (1,238 )     10,759
   


 


 

 


 

Income from Continuing Operations before Income Taxes, Equity Income, Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    113       16       497     11       637

Income tax expenses

    25       6       158     31       220

Equity in net income of unconsolidated affiliates

    10       —         104     5       119

Equity in net income (loss) of consolidated affiliates

    438       (26 )     —       (412 )     —  
   


 


 

 


 

Income (Loss) from Continuing Operations before Discontinued Operations and Cumulative Effect of Change in Accounting Principle

    536       (16 )     443     (427 )     536

Income from Discontinued Operations, net of tax

    83       —         —       —         83

Cumulative Effect of Change in Accounting Principle, net of tax

    —         —         —       —         —  
   


 


 

 


 

Net Income (Loss)

  $ 619     $ (16 )   $ 443   $ (427 )   $ 619
   


 


 

 


 


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

 

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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     154       (165 )     (9,039 )     —  

Intangible assets, net

    289     —         8       —         297

Goodwill ***

    490     —         1,350       8       1,848

Other long-term assets

    1,106     —         2,515       —         3,621
   

 


 


 


 

Total Assets

  $ 18,020   $ 154     $ 15,745     $ (9,035 )   $ 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       8,645       (9,031 )     6,244
   

 


 


 


 

Total Liabilities and Equity

  $ 18,020   $ 154     $ 15,745     $ (9,035 )   $ 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.
*** Reclassification to prior presentation made for a pushdown of goodwill from guarantor to non-guarantor subsidiaries. This pushdown did not effect total assets of the guarantor subsidiaries.

 

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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 Nine Months Ended September 30, 2004

 

     Parent
Company


    Guarantor
Subsidiaries


   Non-
Guarantor
Subsidiaries


   

Total

Company


 

Net cash provided by operating activities

   $ 872     $ —      $ 62     $ 934  

Net cash provided by investing activities

     127       —        156       283  

Net cash provided by (used in) financing activities

     149       —        (431 )     (282 )

Effect of exchange rate changes on cash and cash equivalents

     (2 )     —        (15 )     (17 )
    


 

  


 


Increase (decrease) in cash and cash equivalents

     1,146       —        (228 )     918  

Cash and cash equivalents at beginning of period

     1,101       —        1,376       2,477  
    


 

  


 


Cash and cash equivalents at end of period

   $ 2,247     $ —      $ 1,148     $ 3,395  
    


 

  


 


 

18-Subsequent Events

 

In October 2005, the board of directors authorized the repurchase of up to $500 million of the company’s common stock. The stock is expected to be repurchased over the next 12 months primarily through open-market purchases. Repurchases will be made in compliance with the Securities and Exchange Commission’s Rule 10b-18, and are subject to market conditions as well as applicable legal and other considerations.

 

In October 2005, we renegotiated our Loan Agreement with GECC resulting in a reduction in applicable interest rates and the elimination of the monthly borrowing requirement. The interest rate reduction is applicable to existing and new loans.

 

In October 2005, we finalized renegotiation of our Loan Agreement with Merrill Lynch in France resulting in an increase in the size of the facility from €350 million to €420 million ($421 to $505), lower applicable interest rates and an extension for an additional 2 years at our option from the current expiration date of July 2007.

 

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Table of Contents

Item 2

 

XEROX CORPORATION

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

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

 

Summary

 

     Three Months
Ended
September 30,


   

Nine Months
Ended

September 30,


 
(in millions)    2005

    2004

    2005

    2004

 

Equipment sales

   $ 1,018     $ 1,000     $ 3,113     $ 3,052  

Post sale and other revenue

     2,525       2,486       7,674       7,642  

Finance income

     216       230       664       702  
    


 


 


 


Total Revenues

   $ 3,759     $ 3,716     $ 11,451     $ 11,396  
    


 


 


 


Reconciliation to Condensed Consolidated Statements of Income

                                

Sales

   $ 1,721     $ 1,652     $ 5,242     $ 5,092  

Less: Supplies, paper and other sales

     (703 )     (652 )     (2,129 )     (2,040 )
    


 


 


 


Equipment sales

   $ 1,018     $ 1,000     $ 3,113     $ 3,052  
    


 


 


 


Service, outsourcing and rentals

   $ 1,822     $ 1,834     $ 5,545     $ 5,602  

Add: Supplies, paper and other sales

     703       652       2,129       2,040  
    


 


 


 


Post sale and other revenue

   $ 2,525     $ 2,486     $ 7,674     $ 7,642  
    


 


 


 


 

Third quarter 2005 total revenues increased by 1% compared to the third quarter 2004. Currency impact on total revenues was negligible in the quarter. Total revenues included the following:

 

    2% growth in equipment sales, including benefits from currency of 1-percentage points, primarily reflects revenue growth from color in Office and Production, low-end black and white office products as well as growth in DMO. These growth areas were partially offset by revenue declines in higher-end office black and white products, and black and white production products.

 

    2% growth in post sale and other revenue, including benefits from currency of 1-percentage points, primarily reflects growth in digital products and in DMO, which were partially offset by declines in light lens.

 

    Finance income declined 6% including benefits from currency of 1-percentage points.

 

Total revenues for the nine months ended September 30, 2005 were comparable to the prior year period including benefits from currency with 1-percentage points. Total revenues included the following:

 

    2% growth in equipment sales, including benefits from currency of 1-percentage points, primarily reflects revenue growth from color in Office and Production, low-end black and white office products as well as growth in DMO. These growth areas were partially offset by revenue declines in higher-end office black and white products, and black and white production products.

 

    Post sale and other revenue were essentially unchanged, including benefits from currency of 1-percentage points, primarily reflecting growth in digital products as well as in DMO, which were partially offset by declines in light lens.

 

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<
    Finance income declined 5% including benefits from currency of 2-percentage points.