Form 10-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K


(Mark One)

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

For the fiscal year ended: December 31, 2003

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

For the transition period from:              to             

1-4471 (Commission File Number)


XEROX CORPORATION

(Exact name of registrant as specified in its charter)


New York   16-0468020
(State of incorporation)   (I.R.S. Employer Identification No.)

P.O. Box 1600, Stamford, Connecticut

(Address of principal executive offices)

06904

(Zip Code)

Registrant’s telephone number, including area code: (203) 968-3000

Securities registered pursuant to Section 12(b) of the Act:

Title of each Class


 

Name of Each Exchange on Which Registered


Common Stock, $1 par value  

New York Stock Exchange

Chicago Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None


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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by a check mark whether the registrant is an accelerated filer (as defined in Exchange Act

Rule 12b-2)    Yes:  x    No:  ¨

The aggregate market value of the voting stock of the registrant held by non-affiliates as of June 30, 2003 was: $8,362,554,892.

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

Class


 

Outstanding at January 31, 2004


Common Stock, $1 par value   797,707,422 Shares

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the following documents are incorporated herein by reference:

Document


   Part of Form 10-K in Which
Incorporated


Xerox Corporation 2003 Annual Report to Shareholders    I & II
Xerox Corporation Notice of 2004 Annual Meeting of Shareholders and Proxy Statement (to be filed not later than 120 days after the close of the fiscal year covered by this report on Form 10-K)    III


Forward Looking Statements

 

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

 

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

 

We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors which could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Annual Report on Form 10-K 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 and services and periodically enhance our existing offerings. If we are unable to compete successfully, we could lose market share and important customers to our competitors and that could materially adversely affect our results of operations and financial condition.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Debt—We have and will continue to have a substantial amount of debt and other obligations. As of December 31, 2003, we had $11.2 billion of total debt ($4.4 billion of which is secured by finance receivables) and $1.8 billion of liabilities to trusts issuing preferred securities. Cash and cash equivalents were $2.5 billion at December 31, 2003. Our substantial debt and other obligations could have important consequences. For example, it could (i) increase our vulnerability to general adverse economic and industry conditions; (ii) limit our ability to obtain additional financing for future working capital, capital expenditures, acquisitions and other general corporate requirements; (iii) increase our vulnerability to interest rate fluctuations because a portion of our debt has variable interest rates; (iv) require us to dedicate a substantial portion of our cash flows from operations to service debt and other obligations thereby reducing the availability of our cash flows from operations for other purposes; (v) limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; (vi) place us at a competitive disadvantage compared to our competitors that have less debt; and (vii) become due and payable upon a change in control. If new debt is added to our current debt levels, these related risks could increase.

 

Liquidity—The adequacy of our liquidity depends on our ability to successfully generate positive cash flow from an appropriate combination of efficient operations and improvements therein, financing from third parties, access to capital markets and securitizations of our finance receivables portfolios. With $2.5 billion of cash and cash equivalents on hand at December 31, 2003 and borrowing capacity under our 2003 Credit Facility of $700 million, less $51 million utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, our ability to maintain positive liquidity going forward depends on our ability to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

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

 

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maximum capital expenditures limits and minimum consolidated net worth, as defined. The indentures governing our outstanding senior notes contain similar covenants. They do not, however, contain any financial maintenance covenants, except the fixed charge coverage ratio applicable to certain types of payments. Our U.S. Loan Agreement with GECC (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of December 31, 2003, $2.6 billion was outstanding under this Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At December 31, 2003, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity, results of operations and financial condition. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us, and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

Litigation—We have various contingent liabilities that are not reflected on our balance sheet, including those arising as a result of being a defendant in numerous litigation and regulatory matters involving securities law, patent law, environmental law, employment law and the Employee Retirement Income Security Act (ERISA), as discussed in Note 15 to the Consolidated Financial Statements incorporated by reference in this Annual Report on Form 10-K. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of our legal matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

 

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PART I

 

Item 1. Business

 

Overview

 

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

 

Xerox is a technology and services enterprise and a leader in the global document market. We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions and services. We operate in over 130 countries worldwide, and distribute our products in the Western Hemisphere through divisions, wholly-owned subsidiaries and third-party distributors. In Europe, Africa, the Middle East, India and parts of Asia, we distribute our products through Xerox Limited and related companies (collectively “Xerox Limited”). We had approximately 61,100 employees at December 31, 2003.

 

The document industry is undergoing a fundamental transformation that includes the continuing transition from older light lens devices to digital technology, transition from black and white to color, management of publishing and printing jobs over the internet, use of variable data to create customized documents and an increase in mobile workers utilizing hand-held devices. Documents are increasingly created and stored in digital electronic form and the internet is increasing the amount of information that can be accessed in the form of electronic documents. We believe these trends play to the strengths of our product and service offerings and represent opportunities for future growth. Important areas for growth include color systems in both Office and Production environments, the replacement of multiple single-function office devices with multifunction systems, and the transition of low-end offset printing to digital technology.

 

We develop document technologies, systems, solutions and services intended to improve our customers’ work processes and business results. Our success rests on our ability to understand our customers’ needs and provide innovative document management solutions and services that deliver value to them. We deliver value to customers by leveraging our core competencies in technology, document knowledge, global sales and service, brand reputation and value added solutions across our three core markets, high-end production environments, small to large networked offices, and services led offerings for large enterprises.

 

We compete in both monochrome (i.e. black and white) and color segments by providing the industry’s broadest range of document products, solutions and services. Our products include printing and publishing systems, digital multifunction devices (which can print, copy, scan and fax), digital copiers, laser and solid ink printers, fax machines, document-management software, and supplies such as toner, paper and ink. We provide software and solutions that can help businesses easily print books or create personalized documents for their customers. In addition, we provide a range of comprehensive document management services, such as operating in-house production centers, developing online document repositories and analyzing how customers can most efficiently create and share documents in the office.

 

Our business model is based on increasing equipment sales in order to build the population of machines in the field (“MIF”) that will produce pages and therefore generate post sale and financing revenue streams. The majority of Xerox’s equipment is sold through sales type leases that are recorded as equipment sale revenue. Equipment sales represent approximately 25 percent of the Company’s total revenue. The post sale and financing revenue, which includes service and consumable supplies, is expected to approximate three times the equipment sale revenue over the life of the lease. Accordingly, equipment sale revenue is a key leading indicator of post sale and financing revenue trends as increased MIF should lead to increased pages and ultimately increased post sale revenue. The increasing mix of color pages is also of significant importance to post sale revenue as color pages currently generate five times the revenue and profit per page as compared to black and white.

 

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Segment Information

 

Our reportable segments are Production, Office, Developing Markets Operations (“DMO”) and Other. Operating segment financial information is presented in Note 8 to the Consolidated Financial Statements, which is incorporated herein by reference. We have a very broad and diverse base of customers, both geographically and demographically, ranging from small and middle market businesses to graphic arts shops, governmental entities, educational institutions and large (Fortune 1000) corporate accounts. None of our business segments depends upon a single customer, or a few customers, the loss of which would have a material adverse effect on our business.

 

Production

 

We provide monochrome and color systems for three main customer environments: production publishing, transaction printing and enterprise-wide printing. We are the only manufacturer in the market that offers a complete family of monochrome production publishing systems from 65 to 180 impressions per minute. In addition, we continue to support analog devices currently installed at customer locations. We offer total document solutions and services that can scan, view, manage and produce documents, as well as a variety of pre-press and post-press options to fully meet customer demands.

 

Our goals in the Production segment in 2003 were to defend our monochrome population, be the leader in color, and build on the power of solutions and services. To reach our goals, we increased our presence in the digital light production market and implemented a strategy that we call the “New Business of Printing.” The “New Business of Printing” includes introducing innovative production systems and solutions to expand our leadership position and focus on the higher growth digital color opportunities. This “New Business of Printing” responds to increasing customer requirements for fast turnaround times, precise quantities, personalization and customization and is built on the solid foundation of the digital production print on demand market, which we created in 1990 with the introduction of our first DocuTech Production Publisher. We provide content creation and management, production and fulfillment solutions and services to improve our customers’ work processes and business results. Our digital technology enables personalization and printing on demand that can eliminate inventory and warehousing costs.

 

Our results in 2003 included expanded digital light production offerings with the introduction of the 2101 Digital Copier / Printer, an increased presence in the commercial print market space with increased services and solutions that add value for our customers and the full commercial launch of our DocuColor iGen3 Digital Production Press. We launched the DocuColor iGen3 in October 2002, installed more than 125 systems and now provide the product in 34 markets around the world. The DocuColor iGen3 utilizes next generation color technology which we expect will expand the digital color print on demand market, as its speed, image quality, personalization and cost advantages enable the device to capture valuable pages from the color offset printing market. Utilizing patented imaging technology which produces photographic quality output indistinguishable from offset print, this breakthrough technology can produce over 100 pages per minute at an operating cost of about 5 cents per page. This product is the result of a multi- year research and development (“R&D”) investment of approximately $1 billion. We expect 400-500 installations in 2004 and we further expect to realize significant revenue contributions from this product in 2004, 2005 and beyond. We also introduced the following products in 2003:

 

  In April, we unveiled the Xerox FreeFlow Digital Workflow Collection, our umbrella workflow strategy which provides simple access to a comprehensive collection of Xerox and partner offerings that span all aspects of workflow from design to delivery. The strategy addresses the critical areas of digital workflow, the process by which print jobs make their way from submission through final production and invoicing, with a simplified set of workflow offerings. In addition to our current workflow offerings, Xerox is working with more than 100 industry leading companies, including Adobe, Creo, and EFI, on various workflow related initiatives.

 

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  In April, we also introduced the DocuPrint 850 and DocuPrint 425 continuous-feed digital printers that broaden our line of continuous-feed printers and print at speeds of 195 feet per minute. The DocuPrint 850, which is configured by pairing two DocuPrint 425s, enables duplex printing of as many as 850 duplex impressions per minute.

 

  In August, we introduced the 2101 Digital Copier/Printer that delivers high reliability and advanced features. This light production copier/printer targets the fastest growing segment of the black-and-white print-on-demand market and offers more capabilities at no extra cost. The system prints or copies as many as 101 pages per minute and addresses the growing need for advanced finishing, printing, copying and network scanning.

 

  In September, we launched the DocuColor 5252 Digital Production Press to strengthen the successful DocuColor 2000 family. The DocuColor 5252 replaces the DocuColor 2045, and, at 52 pages per minute, is 18 percent faster than its predecessor but offered at the same price.

 

In January 2004, we announced our next generation black-and-white production platform with the introduction of the DocuTech 100 and DocuTech 120 Copier/Printers. These systems define an entirely new “mid-production” product category as they offer more advanced and robust capabilities than light-production equipment while at a lower cost than full-production equipment. The DocuTech100 copies or prints at 100 pages per minute. The DocuTech 120 operates at 120 pages per minute, establishing a new speed benchmark for digital copiers.

 

Office

 

Our Office segment serves global, national and small to medium sized commercial customers as well as government, education and other public sector customers. Office systems and services, which encompass monochrome devices at speeds up to 90 pages per minute and color devices up to 40 pages per minute, include our family of CopyCentre, WorkCentre, and WorkCentre Pro digital multifunction systems; DocuColor printer/copiers, color laser, LED (light emitting diode), solid ink and monochrome laser desktop printers; digital copiers; light-lens copiers and facsimile products.

 

Our goals in the Office segment in 2003 were to continue to improve the competitiveness of our cost structure, increase our market coverage through indirect channel expansion, broaden our product offerings and capture growth opportunities in this market. Our strategy to capture growth remains centered around three key areas: color, digital multifunction devices and solutions. We plan to drive the market to color printing and copying by making color as easy, fast and affordable as traditional black and white. We continue to lead the transition from single-function machines to multifunction systems by ensuring that multifunction devices continue to be more cost-effective.

 

We provide further value to our customers by offering a range of solutions including the Office Document Assessment (“ODA”) in which we analyze a business’ workflow, document needs and then identify the most efficient, productive mix of office equipment and software for that business, thereby helping to reduce the customer’s document related costs.

 

Our 2003 results include a refreshed office product line with new and enhanced lower cost products offered with aggressive value pricing designed to reach both small and large customers. Additionally, we continued to expand our distribution channels by moving more of our sales from direct to lower cost indirect channels, such as Teleweb and resellers, thus improving efficiency and reducing costs. Our new products and product platforms announced in 2003 included the following:

 

  In February, we announced the DocuColor 3535 Printer / Copier which prints and copies color or monochrome at speeds up to 35 ppm. This multifunction device utilizes Xerox-exclusive Emulsion Aggregate (EA) toner, a super smooth form of dry ink that is chemically grown into uniform particles. It results in exceptional image quality, high reliability and lower operating costs.

 

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  In April we announced a suite of 21 new and enhanced office products, including nine new digital copiers, basic multifunction products (MFPs) that print and copy, and advanced MFPs that print, copy, fax, scan, and e-mail. The new line includes black and white and color-enabled devices with speeds ranging from 16-90 pages per minute that are produced at significantly lower cost and offered at aggressive price levels. All Xerox digital copiers and office multifunction systems now belong to one of three families—CopyCentre, WorkCentre or WorkCentre Pro.

 

CopyCentre products are affordable choices for customers who want fast, reliable digital copiers. They are available in speeds ranging from 16 ppm to 90 ppm and can be upgraded to a multifunction system as customers’ needs change and grow.

 

WorkCentre products are cost effective basic multifunction devices providing copying and network printing options for scanning, faxing, and e-mailing. Speeds range from 16 ppm to 55 ppm. These products enable companies to consolidate equipment, save space and energy, and increase office productivity.

 

WorkCentre Pro MFPs copy and print at speeds from 16 ppm to 90 ppm in color and monochrome. They offer open architecture, advanced networking, and easy integration with solutions from third party providers.

 

The new WorkCentre Pro C32 and C40 color-capable systems provide the most cost effective color printing in the industry. Users pay only for color on pages produced in color; the rest are charged at standard black and white costs eliminating the penalty typically associated with using color products to make black and white pages.

 

Additionally, Xerox has worked with third-party partners to develop network scanning, faxing and accounting solutions. More than a dozen updated and new document management solutions were announced in April.

 

  In September, we introduced the WorkCentre M24, a color-capable device that offers printing, copying, scanning, and faxing capabilities at a new low price for mid-range color.

 

  In September, we enhanced our Phaser printer product line by bringing to market the Phaser 6250, a 26 ppm letter / A4 size color laser printer that is the world’s fastest desktop letter size printer. At the same time, we introduced the Phaser 3450, a 25ppm black and white printer and the WorkCentre PE16, our lowest priced color multifunction device.

 

In January 2004, we launched the Phaser 8400 Color Printer which delivers unmatched value and quality at a starting price of $999. The Phaser 8400 is based on a new solid ink technology platform and delivers 24 color and black-and-white pages per minute.

 

DMO

 

DMO includes marketing, direct sales, distributors and service operations for Xerox products, supplies and services in Latin America, the Middle East, India, Eurasia, Russia and Africa. Over 120 countries are included in DMO, with Brazil representing approximately 40 percent of total DMO revenues in 2003. In countries with developing economies, DMO manages the Xerox business through operating companies, subsidiaries, joint ventures, product distributors, affiliates, concessionaires, resellers and dealers. DMO operations are managed separately as a segment due to the political and economic volatility and unique nature of its markets. Our 2003 DMO goals included revenue stabilization and improvement, a continued focus on cost structure to improve margins, and increased profitability for growth.

 

Other

 

The Other segment primarily includes revenue from paper and other substrates, wide format systems, consulting services, and Small Office / Home Office (“SOHO”).

 

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We sell cut-sheet paper to our customers for use in their document processing products. The market for cut-sheet paper is highly competitive and revenues are significantly affected by pricing. Our strategy is to charge a premium over mill wholesale prices, which is adequate to cover our costs and the value we add as a distributor. We also offer other document processing products, including devices designed to reproduce large engineering and architectural drawings up to three feet by four feet in size.

 

In line with our strategy to focus on our core business, we announced the disengagement from SOHO, our former consumer/personal inkjet printer business, in June 2001. We continue to sell consumables for the inkjet printers and personal copiers previously sold through indirect channels in North America and Europe. We expect that sales of these supplies will decline as the existing population of equipment is replaced.

 

Research and Development

 

Investment in R&D is critical to drive future growth, and we have directed our investments to the fastest growing segments of the market. Our goal is to continue to create innovative technologies that will expand current and future markets. Our R&D investments employ three key themes: 1) continue to reinvent our machines to deliver better quality, more functionality and improved productivity, 2) rethink how people work, including the use of variable information printing to customize documents and 3) redefine the document through new inventions such as SmartPaper a “paper-like” display media which enables signage to be instantly updated. Our research scientists regularly meet with customers and have dialogues with our business groups to ensure they understand customer requirements and develop products and solutions that can be commercialized.

 

In 2003, R&D expense was $868 million, compared with $917 million in 2002 and $997 million in 2001. 2003 R&D spending focused primarily on the development of high-end business applications to drive the “New Business of Printing,” on extending our color capabilities, and on lower cost platforms and customer productivity enablers to drive digitization of the office. The DocuColor iGen3, an advanced next-generation digital printing press launched in October 2002 that uses our patented imaging technology to produce photographic quality prints indistinguishable from offset, is an example of the type of breakthrough technologies we developed that we expect will drive future growth.

 

Our R&D is strategically coordinated with that of Fuji Xerox, which invested $724 million in R&D in 2003. To maximize the synergies of our relationship, Xerox R&D expenditures are focused primarily on the Production segment, while Fuji Xerox R&D expenditures are principally focused on the Office segment.

 

Patents, Trademarks and Licenses

 

We are a technology company. We were awarded over 625 U.S. patents in 2003, ranking us 27th on the list of companies that had been awarded the most U.S. patents during the year. With our research partner, Fuji Xerox, we were awarded close to 800 U.S. patents in 2003. Our patent portfolio evolves as new patents are awarded to us and as older patents expire. As of December 31, 2003, we held approximately 8,200 U.S. patents. These patents expire at various dates up to 20 years or more from their original filing dates. While we believe that our portfolio of patents and applications has value, in general no single patent is essential to our business or any individual segment. In addition, any of our proprietary rights could be challenged, invalidated or circumvented, or may not provide significant competitive advantages.

 

In the U.S., we own approximately 500 trademarks (registered or applied for). These trademarks have a perpetual life, subject to renewal every ten years. We vigorously enforce and protect our trademarks. We hold a perpetual trademark license for “DocuColor.”

 

In the U.S., we are party to approximately 220 agreements which involve U.S. patent licenses. We are the licensor in approximately 175 of those agreements. Most of the patent licenses expire concurrently with the expiration of the last patent identified in the license.

 

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Competition

 

We encounter aggressive competition in all areas of our business. Our competitors range from large international companies to relatively small firms. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, distribution and customer service and support. To remain competitive we must develop new products and services and periodically enhance our existing offerings.

 

We are the leader, or among the leaders, in each of our principal business segments. Our key competitors include Canon, Ricoh, IKON, Hewlett Packard and in certain areas of the business, Pitney Bowes, Heidelberger Druckmaschinen Aktiengesellschaft, Nexpress, Oce, Konica-Minolta and Lexmark.

 

We believe that our brand recognition, reputation for quality, innovative technology, breadth of product offerings, customer relationships and large customer base are important competitive advantages. We, and our competitors, continue to develop and market new and innovative products at competitive prices and, at any given time, we may set new market standards for quality, speed and function.

 

Marketing and Distribution

 

We manage our business and report our financial results based on the principal business segments described above. The marketing and selling of our products and solutions, however, are organized according to geography and channel types. Our products and solutions are principally sold directly to customers by our worldwide sales force totaling approximately 9,000 employees and through a network of independent agents, dealers, value-added resellers and systems integrators. Increasingly, we are utilizing our direct sales force to address our customers’ more advanced technology, solutions and services requirements, while expanding our use of cost-effective indirect distribution channels (such as “Teleweb,” a combination of telephone and internet selling) for basic product offerings. In addition, new initiatives were implemented in 2003 to add channel capacity through direct-to-customer e-commerce and direct-to-customer selling using our direct sales force in select large accounts.

 

We market our Phaser line of color and monochrome laser-class and solid ink printers through office information technology industry resellers, who typically access our products through distributors. In 2003 we increased the product offerings available through a two-tiered distribution model, particularly in Europe. Through a multi-phased roll-out, we will continue to increase offerings through this lower cost distribution channel for our office portfolio.

 

We are increasing our use of partners to improve our market coverage. Through alliances with Premier Partners, Creo, and Fuji Ennovation, we expanded coverage to market our DocuColor 2000 series to commercial printers. Our strategic alliance with Electronic Data Systems (“EDS”) is designed to integrate EDS’ information technology (“IT”) services with our document management systems and services to provide customers with full IT infrastructure support.

 

Our brand is a valuable resource and continues to be recognized in the top ten percent of all brands worldwide.

 

Backlog

 

We believe that backlog, or the value of unfilled orders, is not a meaningful indicator of future business prospects due to the significant proportion of our revenue that follows equipment installation, the large volume of products delivered from shelf inventories and the shortening of product life cycles.

 

Seasonality

 

Our revenues are affected by such factors as the introduction of new products, the length of the sales cycles and the seasonality of technology purchases. As a result, our operating results are difficult to predict. These factors have historically resulted in lower revenue in the first quarter than in the immediately preceding fourth quarter.

 

11


Fuji Xerox

 

Fuji Xerox Co., Limited is an unconsolidated entity in which Xerox Limited currently owns 25 percent and which Fuji Photo Film Co., Ltd. (“FujiFilm”) owns 75 percent. These ownership interests reflect the March 2001 sale of half our original ownership interest in Fuji Xerox to FujiFilm for $1.3 billion in cash. Fuji Xerox develops, manufactures and distributes document processing products in Japan, China, Hong Kong and other areas of the Pacific Rim, Australia and New Zealand. We retain significant rights as a minority shareholder. Our technology licensing agreements with Fuji Xerox ensure that the two companies retain uninterrupted access to each other’s portfolio of patents, technology and products.

 

Service

 

As of December 31, 2003, we had a worldwide service force of approximately 16,000 employees and a network of independent service agents. We are expanding our use of cost-effective remote service technology for basic product offerings while utilizing our direct service force to address customers’ more advanced technology requirements. We believe that our service force represents a significant competitive advantage in that the service force is continually trained on our products and their diagnostic equipment is state-of-the-art. Twenty-four-hours-a-day, seven-days-a-week service is available in major metropolitan areas around the world. As a result, we are able to provide a consistent and superior level of service worldwide.

 

Manufacturing Outsourcing

 

In the fourth quarter of 2001, we entered into purchase and supply agreements with Flextronics, a global electronics manufacturing services company, for the Office segment of our business. This represents approximately 50 percent of our overall worldwide manufacturing operations. Under these agreements, Flextronics purchased related inventory, property and equipment. Pursuant to the purchase agreement, we sold our operations in Toronto, Canada; Aguascalientes, Mexico; Penang, Malaysia, Venray; The Netherlands and Resende, Brazil to Flextronics in a series of transactions, which were completed in 2002. Approximately 4,100 Xerox employees in certain of these operations transferred to Flextronics.

 

The initial term of the Flextronics supply agreement is five years subject to our right to extend for two years. Thereafter, it will automatically be renewed for one-year periods, unless either party elects to terminate the agreement. We have agreed to purchase from Flextronics most of our requirements for certain products in specified product families. We also must purchase certain electronic components from Flextronics, so long as Flextronics meets certain pricing requirements. Flextronics must acquire inventory in anticipation of meeting our forecasted requirements and must maintain sufficient manufacturing capacity to satisfy such forecasted requirements. Under certain circumstances, we may become obligated to repurchase inventory that remains unused for more than 180 days, becomes obsolete or upon termination of the supply agreement. Our remaining manufacturing operations are primarily located in Rochester, New York for our high-end production products and consumables and Wilsonville, Oregon for consumable supplies and components for our Office printing products.

 

The foregoing summary of the supply agreement is not complete and is in all respects subject to the actual provisions of the supply agreement, which has been filed with the Securities and Exchange Commission.

 

International Operations

 

Our international operations represented approximately 45 percent of total revenues in 2003. Our largest interest outside the United States is Xerox Limited which operates predominately in Europe. Latin American operations are conducted through subsidiaries or distributors in over 38 countries. Fuji Xerox, an unconsolidated entity of which we own 25 percent, develops, manufactures and distributes document processing products in Japan, China, Hong Kong and other areas of the Pacific Rim, Australia and New Zealand.

 

12


Certain financial measures by geographical area for 2003, 2002 and 2001, included in Note 8 to the Consolidated Financial Statements in our 2003 Annual Report, are hereby incorporated by reference.

 

Other Information

 

Xerox is a New York corporation and our principal executive offices are located at 800 Long Ridge Road, P. O. Box 1600, Stamford, Connecticut 06904-1600. Our telephone number is (203) 968-3000.

 

Through the Investor Relations section of our Internet website, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all related amendments are available, free of charge, as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Our Internet address is http://www.xerox.com.

 

Item 2. Properties

 

We own several manufacturing, engineering and research facilities and lease additional facilities. The principal manufacturing and engineering facilities, located in California, New York, Oklahoma, Canada, UK, Ireland and The Netherlands, are used jointly by the Production and Office Segments, those in Oregon by the Office Segment, and those in Brazil and India by the DMO Segment. Our principal research facilities are located in California, New York, Canada, France and the U.K. The research activities in our principal research centers benefit all our operating segments.

 

As we implemented the Turnaround Program (discussed in Note 2 to the Consolidated Financial Statements in our Annual Report, incorporated by reference), several properties became surplus. The surplus properties have leases that we are obligated to maintain through required contractual periods. We have disposed or subleased certain of these properties and are aggressively pursuing the successful disposition and subleasing of all remaining surplus properties. At year-end 2003 there were approximately 40 surplus facilities.

 

In addition, we have numerous facilities, which encompass general offices, sales offices, service locations and distribution centers. The principal owned facilities are located in the United States, France, Ireland, Brazil, India and Mexico. The principal leased facilities are located in the United States, Brazil, Canada, UK, Mexico, France, Germany and Italy. In 2002, we entered into a joint venture (Xerox Capital Services) with General Electric to manage our administrative billing, credit and collection function. Xerox Capital Services licenses several of our owned and leased facilities for their use. The three principal Xerox Capital Services administrative facilities are located in Florida, Illinois and Texas. We also lease a portion of a training facility, located in Virginia. It is our opinion that our properties have been well maintained, are in sound operating condition and contain all the necessary equipment and facilities to perform our functions.

 

Item 3. Legal Proceedings

 

The information set forth under Note 15 to the Consolidated Financial Statements, “Litigation, Regulatory Matters and Other Contingencies,” of the Xerox Corporation 2003 Annual Report is hereby incorporated by reference.

 

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

 

None.

 

13


PART II

 

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

 

Market Information, Holders and Dividends

 

The information set forth under the following captions of the Xerox Corporation 2003 Annual Report to Shareholders is hereby incorporated by reference:

 

Caption


Stock Listed and Traded

Xerox Common Stock Prices and Dividends

Five Years in Review—Common Shareholders of Record at Year-End

Securities Authorized for Issuance Under Equity Compensation Plans

 

Recent Sales of Unregistered Securities

 

During the quarter ended December 31, 2003, Registrant issued the following securities in transactions that were not registered under the Securities Act of 1933, as amended (the Act):

 

Xerox Common Stock

 

(a) Securities Sold: On October 1, 2003, Registrant issued 6,354 shares of Common Stock, par value $1 per share.

 

(b) No underwriters participated. The shares were issued to each of the non-employee Directors of Registrant: A.A. Johnson, V.E. Jordan, Jr., Y. Kobayashi, H. Kopper, R.S. Larsen, N.J. Nicholas, Jr., J.E. Pepper and A. N. Reese.

 

(c) The shares were issued at a deemed purchase price of $10.26 per share (aggregate price $65,125), based upon the market value on the date of issuance, in payment of the quarterly Directors’ fees pursuant to Registrant’s Restricted Stock Plan for Directors.

 

(d) Exemption from registration under the Act was claimed based upon Section 4(2) as a sale by an issuer not involving a public offering.

 

Item 6. Selected Financial Data

 

The following selected financial data for the five years ended December 31, 2003, as set forth and included under the caption “Five Years in Review,” of the Xerox Corporation 2003 Annual Report to Shareholders, is incorporated by reference in this Form 10-K.

 

Revenues

Per-Share Data

Earnings (Loss)—Basic and Diluted

Common stock dividends

Total assets

Long-term debt

Liabilities to subsidiary trusts issuing preferred securities

Series B convertible preferred stock

Series C mandatory convertible preferred stock

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The information set forth under the caption “Management’s Discussion and Analysis of Results of Operations and Financial Condition,” of the Xerox Corporation 2003 Annual Report is hereby incorporated by reference.

 

14


Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

The information set forth under the caption “Financial Risk Management,” in the Xerox Corporation 2003 Annual Report is hereby incorporated by reference.

 

Item 8. Financial Statements and Supplementary Data

 

The consolidated financial statements, together with the reports thereon of PricewaterhouseCoopers LLP, included in the Xerox Corporation 2003 Annual Report, are incorporated by reference in this Form 10-K. With the exception of the aforementioned information and the information incorporated in Items 5, 6, 7, 7A and 8, the Xerox Corporation 2003 Annual Report is not to be deemed filed as part of this Form 10-K.

 

The quarterly financial data included under the caption “Quarterly Results of Operations (Unaudited)” of the Xerox Corporation 2003 Annual Report is incorporated by reference in this Annual Report on Form 10-K.

 

The financial statement schedule required herein is filed as referenced in Item 15 of this Form 10-K.

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None.

 

Item 9A. Controls and Procedures

 

(a) Evaluation of Disclosure Controls and Procedures

 

Under the supervision, and with the participation of our management, including our principal executive officer and principal financial officer, as of the end of the period covered by this report, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our Securities and Exchange Commission (“SEC”) reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms relating to Xerox Corporation, including our consolidated subsidiaries, and was made known to them by others within those entities, particularly during the period when this report was being prepared.

 

(b) Changes in Internal Controls

 

During our fourth fiscal quarter, there were no significant changes in our internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, such controls.

 

15


PART III

 

Item 10. Directors and Executive Officers of the Registrant

 

The information regarding directors is incorporated herein by reference from the section entitled “Proposal 1—Election of Directors” in our definitive Proxy Statement (“2004 Proxy Statement”) to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, for our Annual Meeting of Stockholders to be held on May 20, 2004. The Proxy Statement will be filed within 120 days after the end of our fiscal year ended December 31, 2003.

 

The information regarding compliance with Section 16(a) of the Securities and Exchange Act of 1934 is incorporated herein by reference from the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” of our 2004 Proxy Statement.

 

The information regarding audit committee financial experts is incorporated by reference herein from the subsection entitled “Committee Functions, Membership and Meetings” in the section entitled “Proposal 1—Election of Directors” in our 2004 Proxy Statement.

 

The information regarding the code of ethics applicable to our principal executive officer, principal financial officer and principal accounting officer is incorporated herein by reference from the subsection entitled —“Corporate Governance” in the section entitled “Proposal 1—Election of Directors” in our 2004 Proxy Statement.

 

Executive Officers of Xerox

 

The following is a list of the executive officers of Xerox, their current ages, their present positions and the year appointed to their present positions. Anne M. Mulcahy, Chairman of the Board and CEO and Thomas J. Dolan, Senior Vice President, are sister and brother. There are no other family relationships between any of the executive officers named.

 

Each officer is elected to hold office until the meeting of the Board of Directors held on the day of the next annual meeting of shareholders, subject to the provisions of the By-Laws.

 

Name


  Age

    

Present Position


  Year
Appointed
to Present
Position


  Officer
Since


Anne M. Mulcahy*

  51      Chairman of the Board and
Chief Executive Officer
  2002   1992

Lawrence A. Zimmerman

  61     

Senior Vice President and

Chief Financial Officer

  2002   2002

Ursula M. Burns

  45      Senior Vice President
President, Business Group Operations
  2002   1997

Thomas J. Dolan

  59      Senior Vice President
President, Xerox Global Services
  2001   1997

James A. Firestone

  49      Senior Vice President
President, Corporate Operations Group
  2001   1998

Hervé J. Gallaire

  59      Senior Vice President
President, Xerox Innovation Group and Chief Technology Officer
  2001   1997

Gilbert J. Hatch

  54      Senior Vice President
President, Production Systems Group
  2002   1997

 

16


Executive Officers of Xerox, Continued

 

Name


   Age

    

Present Position


   Year
Appointed
to Present
Position


   Officer
Since


Michael C. MacDonald

   50      Senior Vice President
President, North American Solutions Group
   2000    1997

Hector J. Motroni

   60      Senior Vice President and
Chief Staff Officer and
Chief Ethics Officer
   2003    1994

Jean-Noel Machon

   51      Senior Vice President
President, Developing Market Operations
   2004    2000

Harry R. Beeth

   58      Vice President and Controller    2002    2002

Christina E. Clayton

   56      Vice President and General Counsel    2000    2000

J. Michael Farren

   51      Vice President, External and Legal Affairs    2003    1994

Gary R. Kabureck

   50      Vice President and Chief Accounting Officer    2003    2000

Rhonda L. Seegal

   53      Vice President and Treasurer    2003    2003

Leslie F. Varon

   47      Vice President Investor Relations and Corporate Secretary    2001    2001

Armando Zagalo de Lima

   45      Vice President, President Xerox Europe    2004    2000

* Member of Xerox Board of Directors

 

Each officer named above, with the exception of Lawrence A. Zimmerman, Harry R. Beeth and Rhonda L. Seegal, has been an officer or an executive of Xerox or its subsidiaries for at least the past five years.

 

Prior to joining Xerox in 2002, Mr. Zimmerman had been with System Software Associates, Inc. where he was Executive Vice President and Chief Financial Officer from 1998–1999. Prior to that, he retired from International Business Machines Corporation (IBM), where he was Senior Finance Executive for IBM’s Server Division from 1996–1998, Vice President of Finance for Europe, Middle East and Africa Operations from 1994–1996 and IBM Corporate Controller from 1991–1994. He held various other positions at IBM from 1967–1991.

 

Prior to joining Xerox in 2002, Mr. Beeth had retired from IBM where he was Vice President, Finance for the Server division from 1998 until his retirement in 2000; Vice President, Finance, Microelectronics division from 1996-1998; Assistant Controller from 1994–1996; Group Director of Finance and Planning Operations for the North American sales organization from 1991–1994; and Vice President, Finance and Planning for the National Services organization from 1988–1990. He held various positions at IBM from 1967–1988.

 

Prior to joining Xerox in 2003, Ms. Seegal had been with Avaya Inc., where she was Vice President and Treasurer from 2000–2003. Prior to that, she was Deputy Treasurer at General Electric Company from 1996–2000.

 

Item 11. Executive Compensation

 

Information regarding executive compensation is incorporated herein by reference from the section entitled “Executive Officer Compensation” in our 2004 Proxy Statement.

 

17


Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Information regarding security ownership of certain beneficial owners and management and securities authorized for issuance under equity compensation plans is incorporated herein by reference from the sections entitled “Ownership of Company Securities” and “Equity Compensation Plan Information” in our 2004 Proxy Statement.

 

Item 13. Certain Relationships and Related Transactions

 

Information regarding certain relationships and related transactions is incorporated herein by reference from the section entitled “Certain Transactions” in our 2004 Proxy Statement.

 

Item 14. Principal Auditor Fees and Services

 

The information regarding principal auditor fees and services is incorporated herein by reference from the section entitled “Proposal 2—Ratification of Election of Independent Auditors” in our 2004 Proxy Statement.

 

18


PART IV

 

Item 15. Exhibits, Financial Statement Schedule and Reports on Form 8-K

 

(a)

   (1 )   Index to Financial Statements and Financial Statement Schedule, incorporated by reference or filed as part of this report:
          

Report of Independent Auditors

          

Consolidated Statements of Income for each of the years in the three-year period ended December 31, 2003

          

Consolidated Balance Sheets as of December 31, 2003 and 2002

          

Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2003

          

Consolidated Statements of Common Shareholders’ Equity for each of the years in the three-year period ended December 31, 2003

          

Notes to Consolidated Financial Statements

          

Financial Statement Schedule:

          

II—Valuation and qualifying accounts

          

All other schedules are omitted as they are not applicable, or the information required is included in the financial statements or notes thereto.

     (2 )  

Supplementary Data:

          

Quarterly Results of Operations (unaudited)

          

Five Years in Review

          

Financial statements of Fuji Xerox Co., Limited to be filed by June 30, 2004 (financial statements required by Regulation S-X which are excluded from the annual report to shareholders by Rule 14a-3(b))

     (3 )  

The exhibits filed herewith or incorporated herein by reference are set forth in the Index of Exhibits included herein.

(b)

   Current Reports on Form 8-K dated October 23, 2003 reporting Item 12 “Results of Operations and
Financial Condition” and November 14, 2003 reporting Item 5 “Other Events” were filed during the last
quarter of the period covered by this Report.

(c)

   The management contracts or compensatory plans or arrangements listed in the Index of Exhibits that are
applicable to the executive officers named in the Summary Compensation Table which appears in
Registrant’s 2004 Proxy Statement are preceded by an asterisk (*).

(d)

   Financial statements required by Regulation S-X which are excluded from the annual report to shareholders
by Rule 14a-3(b), including (1) separate financial statements of subsidiaries not consolidated and
fifty-percent-or-less-owned persons and (2) schedules, are filed under Item 15(a) of this Report which is
incorporated herein by reference.

 

19


Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

XEROX CORPORATION

By:

  /s/    ANNE M. MULCAHY        
   
    Anne M. Mulcahy
Chairman of the Board and Chief Executive Officer

February 27, 2004

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.

 

February 27, 2004

 

Signature


  

Title


Principal Executive Officer:

    

/s/    ANNE M. MULCAHY        


Anne M. Mulcahy

   Chairman of the Board, Chief Executive Officer and Director

Principal Financial Officer:

    

/s/    LAWRENCE A. ZIMMERMAN        


Lawrence A. Zimmerman

   Senior Vice President and Chief Financial Officer

Principal Accounting Officer:

    

/s/    GARY R. KABURECK        


Gary R. Kabureck

   Vice President and Chief Accounting Officer

/s/    ANTONIA AX:SON JOHNSON        


Antonia Ax:son Johnson

   Director

/s/    RICHARD J. HARRINGTON        


   Director
Richard J. Harrington     

/s/    WILLIAM CURT HUNTER        


   Director
William Curt Hunter     

/s/    VERNON E. JORDAN, JR.


Vernon E. Jordan, Jr.

   Director

/s/    YOTARO KOBAYASHI        


Yotaro Kobayashi

   Director

/s/    HILMAR KOPPER        


Hilmar Kopper

   Director

/s/    RALPH S. LARSEN        


Ralph S. Larsen

   Director

/s/    N. J. NICHOLAS, JR.        


N. J. Nicholas, Jr.

   Director

/s/    JOHN E. PEPPER        


John E. Pepper

   Director

/s/    ANN N. REESE        


Ann N. Reese

   Director

/s/    STEPHEN ROBERT        


Stephen Robert

   Director

 

20


Report of Independent Auditors on Financial Statement Schedule

 

To the Board of Directors of Xerox Corporation:

 

Our audits of the consolidated financial statements referred to in our report dated January 27, 2004, appearing in the 2003 Annual Report to Shareholders of Xerox Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 15(a)(1) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.

 

As discussed in Note 1, in 2003 the Company adopted the provisions of the Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities, an Interpretation of ARB 51,” which changed certain consolidation policies. Additionally, as discussed in Note 1, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002.

 

/s/ PRICEWATERHOUSECOOPERS LLP


PricewaterhouseCoopers LLP

Stamford, Connecticut

January 27, 2004

 

21


SCHEDULE II

 

Valuation and Qualifying Accounts

 

Year ended December 31, 2003, 2002 and 2001

 

(in millions)


   Balance
at Beginning
of period


   Additions
charged to
bad debt
provision (1)


   Additions
charged to
other income
statement
accounts(1)


    Deductions
and other, net
of recoveries (2)


    Balance
at end
of period


2003

                                    

Allowance for Losses on:

                                    

Accounts Receivable

   $ 282    $ 99    $ (27 )   $ (136 )   $ 218

Finance Receivables

     324      125      27       (161 )     315
    

  

  


 


 

     $ 606    $ 224    $ —       $ (297 )   $ 533
    

  

  


 


 

2002

                                    

Allowance for Losses on:

                                    

Accounts Receivable

   $ 306    $ 187    $ (3 )   $ (208 )   $ 282

Finance Receivables

     368      145      24       (213 )     324
    

  

  


 


 

     $ 674    $ 332    $ 21     $ (421 )   $ 606
    

  

  


 


 

2001

                                    

Allowance for Losses on:

                                    

Accounts Receivable

   $ 289    $ 154    $ 30     $ (167 )   $ 306

Finance Receivables

     345      284      38       (299 )     368
    

  

  


 


 

     $ 634    $ 438    $ 68     $ (466 )   $ 674
    

  

  


 


 


(1) Bad debt provisions relate to estimated losses due to credit and similar uncollectibility issues. Other provisions relate to reserves necessary to reflect events of non-payment such as customer accommodations and contract terminations.
(2) Deductions and other, net of recoveries primarily relates to receivable write-offs, but also includes the impact of foreign currency translation adjustments and recoveries of previously written off receivables.

 

22


INDEX OF EXHIBITS

 

Document and Location

 

(3)(a)   Restated Certificate of Incorporation of Registrant filed with the Department of State of New York on November 7, 2003.
    Incorporated by reference to Exhibit 4(a)(1) to Registrant’s Registration Statement No. 333-111623.
(b)   By-Laws of Registrant, as amended through December 10, 2003.
    Incorporated by reference to Exhibit 4(a)(2) to Registrant’s Registration Statement No. 333-111623.
(4)(a)(1)   Indenture dated as of December 1, 1991, between Registrant and Citibank, N.A., as trustee, relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by or pursuant to a resolution of Registrant’s Board of Directors (the “December 1991 Indenture”).
    Incorporated by reference to Exhibit 4(a) to Registrant’s Registration Statement Nos. 33-44597, 33-49177 and 33-54629.
(2)   Instrument of Resignation, Appointment and Acceptance dated as of February 1, 2001, among Registrant, Citibank, N.A., as resigning trustee, and Wilmington Trust Company, as successor trustee, relating to the December 1991 Indenture.
    Incorporated by reference to Exhibit 4(a)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
(b)(1)   Indenture dated as of September 20, 1996, between Registrant and Citibank, N.A., as trustee, relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by or pursuant to a resolution of Registrant’s Board of Directors (the “September 1996 Indenture”).
    Incorporated by reference to Exhibit 4(a) to Registration Statement No. 333-13179.
(2)   Instrument of Resignation, Appointment and Acceptance dated as of February 1, 2001, among Registrant, Citibank, N.A., as resigning trustee, and Wilmington Trust Company, as successor trustee, relating to the September 1996 Indenture.
    Incorporated by reference to Exhibit 4(b)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
(c)(1)   Indenture dated as of January 29, 1997, between Registrant and Bank One, National Association (as successor by merger with The First National Bank of Chicago) (“Bank One”), as trustee (the “January 1997 Indenture”), relating to Registrant’s Junior Subordinated Deferrable Interest Debentures (“Junior Subordinated Debentures”).
    Incorporated by reference to Exhibit 4.1 to Registration Statement No. 333-24193.
(2)   Form of Certificate of Exchange relating to Junior Subordinated Debentures.
    Incorporated by reference to Exhibit A to Exhibit 4.1 to Registration Statement No. 333-24193.
(3)   Certificate of Trust of Xerox Capital Trust I executed as of January 23, 1997.
    Incorporated by reference to Exhibit 4.3 to Registration Statement No. 333-24193.
(4)   Amended and Restated Declaration of Trust of Xerox Capital Trust I dated as of January 29, 1997.
    Incorporated by reference to Exhibit 4.4 to Registration Statement No. 333-24193.

 

23


(5)   Form of Exchange Capital Security Certificate for Xerox Capital Trust I.
    Incorporated by reference to Exhibit A-1 to Exhibit 4.4 to Registration Statement No. 333-24193.
(6)   Series A Capital Securities Guarantee Agreement of Registrant dated as of January 29, 1997, relating to Series A Capital Securities of Xerox Capital Trust I.
    Incorporated by reference to Exhibit 4.6 to Registration Statement No. 333-24193.
(7)   Registration Rights Agreement dated January 29, 1997, among Registrant, Xerox Capital Trust I and the initial purchasers named therein.
    Incorporated by reference to Exhibit 4.7 to Registration Statement No. 333-24193.
(8)   Instrument of Resignation, Appointment and Acceptance dated as of November 30, 2001, among Registrant, Bank One as resigning trustee, and Wells Fargo Bank Minnesota, National Association (“Wells Fargo”), as successor Trustee, relating to the January 1997 Indenture.
    Incorporated by reference to Exhibit (c)(8) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(d)(1)   Indenture dated as of October 1, 1997, among Registrant, Xerox Overseas Holding Limited (formerly Xerox Overseas Holding PLC), Xerox Capital (Europe) plc (formerly Rank Xerox Capital (Europe) plc) and Citibank, N.A., as trustee, relating to unlimited amounts of debt securities which may be issued from time to time by Registrant and unlimited amounts of guaranteed debt securities which may be issued from time to time by the other issuers when and as authorized by or pursuant to a resolution or resolutions of the Board of Directors of Registrant or the other issuers, as applicable (the “October 1997 Indenture”).
    Incorporated by reference to Exhibit 4(b) to Registrant’s Registration Statement No. 333-34333.
(2)   Instrument of Resignation, Appointment and Acceptance dated as of February 1, 2001, among Registrant, the other issuers under the October 1997 Indenture, Citibank, N.A., as resigning trustee, and Wilmington Trust Company, as successor trustee, relating to the October 1997 Indenture.
    Incorporated by reference to Exhibit 4(d)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
(e)(1)   Indenture dated as of April 21, 1998, between Registrant and Bank One, as trustee, relating to $1,012,198,000 principal amount at maturity of Registrant’s Convertible Subordinated Debentures due 2018 (the “April 1998 Indenture”).
    Incorporated by reference to Exhibit 4(b) to Registrant’s Registration Statement No. 333-59355.
(2)   Instrument of Resignation, Appointment and Acceptance dated as of July 26, 2001, among Registrant, Bank One as resigning trustee, and Wells Fargo, as successor Trustee, relating to the April 1998 Indenture (the “April 1998 Indenture Trustee Assignment”).
    Incorporated by reference to Exhibit 4(e)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(3)   Amendment to Instrument of Resignation, Appointment and Acceptance dated as of October 22, 2001, among Registrant, Bank One as resigning trustee, and Wells Fargo, as successor Trustee, relating to the April 1998 Indenture Trustee Assignment.
    Incorporated by reference to Exhibit 4(e)(3) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(f)   Indenture, dated as of July 1, 2001, between Xerox Equipment Lease Owner Trust 2001-1 (“Trust”) and U.S. Bank National Association, as trustee, relating to $513,000,000 Floating Rate Asset Backed Notes issued by the Trust.

 

24


    Incorporated by reference to Exhibit 4(f) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(g)(1)   Indenture, dated as of November 27, 2001, between Registrant and Wells Fargo, as trustee, relating to Registrant’s 7 1/2% Convertible Junior Subordinated Debentures Due 2021.
    Incorporated by reference to Exhibit 4(g)(1) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(2)   Indenture, dated as of November 27, 2001, between Xerox Funding LLC II and Wells Fargo, as trustee, relating to Xerox Funding LLC II’s 7 1/2% Convertible Junior Subordinated Debentures Due 2021.
    Incorporated by reference to Exhibit 4(g)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(3)   Amended and Restated Declaration of Trust of Xerox Capital Trust II, dated as of November 27, 2001, by Registrant, as sponsor, Wells Fargo, as property trustee, Wilmington Trust Company, as Delaware trustee, and the administrative trustees named therein, relating to Xerox Capital Trust II’s 7 1/2% Convertible Trust Preferred Securities and 7 1/2% Convertible Common Securities.
    Incorporated by reference to Exhibit 4(g)(3) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(4)   Pledge Agreement, made as of November 27, 2001, by Xerox Funding LLC II in favor of Wells Fargo, as trustee and for the holders of Xerox Funding LLC II’s 7 1/2% Convertible Junior Subordinated Debentures Due 2021.
    Incorporated by reference to Exhibit 4(g)(4) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(h)(1)   Indenture, dated as of January 17, 2002, between Registrant and Wells Fargo, as trustee, relating to Registrant’s 9 3/4% Senior Notes due 2009 (Denominated in U.S. Dollars) (the “January 17, 2002 U.S. Dollar Indenture”).
    Incorporated by reference to Exhibit 4(h)(1) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(2)   Indenture, dated as of January 17, 2002, between Registrant and Wells Fargo, as trustee, relating to Registrant’s 9 3/4% Senior Notes due 2009 (Denominated in Euros) (the “January 17, 2002 Euro Indenture”).
    Incorporated by reference to Exhibit 4(h)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(3)   Registration Rights Agreement, dated as of January 17, 2002, among Registrant and the initial purchasers named therein, relating to Registrant’s $600,000,000 9 3/4% Senior Notes due 2009.
    Incorporated by reference to Exhibit 4(h)(3) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(4)   Registration Rights Agreement, dated as of January 17, 2002, among Registrant and the initial purchasers named therein, relating to Registrant’s (euro) 225,000,000 9 3/4% Senior Notes due 2009.
    Incorporated by reference to Exhibit 4(h)(4) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
(5)   First Supplemental Indenture dated as of June 21, 2002 between Registrant and Wells Fargo, as trustee, to the January 17, 2002 U.S. Dollar Indenture.
    Incorporated by reference to Exhibit (4)(h)(5) to Registrant’s Current Report on Form 8-K dated June 21, 2002.

 

25


(6)   First Supplemental Indenture dated as of June 21, 2002 between Registrant and Wells Fargo, as trustee, to the January 17, 2002 Euro Indenture.
    Incorporated by reference to Exhibit (4)(h)(6) to Registrant’s Current Report on Form 8-K dated June 21, 2002.
(7)   Second Supplemental Indenture dated as of July 30, 2002 between Registrant, the guarantors named therein and Wells Fargo, as trustee, to the January 17, 2002 U.S. Dollar Indenture.
    Incorporated by reference to Exhibit 4 (h)(7) to Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.
(8)   Second Supplemental Indenture dated as of July 30, 2002 between Registrant, the guarantors named therein and Wells Fargo, as trustee, to the January 17, 2002 Euro Indenture.
    Incorporated by reference to Exhibit 4 (h)(8) to Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.
(9)   Third Supplemental Indenture, dated June 25, 2003 among Registrant, the guarantors named therein and Wells Fargo, as trustee, to the January 17, 2002 U.S. Dollar Indenture.
    Incorporated by reference to Exhibit 4.11 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(10)   Third Supplemental Indenture, dated June 25, 2003 among Registrant, the guarantors named therein and Wells Fargo, as trustee, to the January 17, 2002 U.S. Euro Indenture.
    Incorporated by reference to Exhibit 4.12 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(i)   Indenture dated as of October 2, 1995, between Xerox Credit Corporation (“XCC”) and State Street Bank and Trust Company (“State Street”), as trustee, relating to unlimited amounts of debt securities which may be issued from time to time by XCC when and as authorized by XCC’s Board of Directors or Executive Committee of the Board of Directors.
    Incorporated by reference to Exhibit 4(a) to XCC’s Registration Statement Nos. 33-61481 and 333-29677.
(j)   Rights Agreement dated as of April 7, 1997 between Registrant and The First National Bank of Boston, as Rights Agent.
    Incorporated by reference to Exhibit 4.10 to Registrant’s Current Report on Form 8-K dated April 7, 1997.
(k)(1)   Indenture, dated as of June 25, 2003, between Registrant and Wells Fargo, as trustee, relating to unlimited amounts of debt securities which may be issued from time to time by Registrant when and as authorized by or pursuant to a resolution of Registrant’s Board of Directors (the “June 25, 2003 Indenture”).
    Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(2)   First Supplemental Indenture, dated June 25, 2003 among Registrant, the guarantors named therein and Wells Fargo, as trustee, to the June 25, 2003 Indenture.
    Incorporated by reference to Exhibit 4.2 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(l)(1)   Credit Agreement, dated as of June 19, 2003, among Registrant and Overseas Borrowers, as Borrowers, various Lenders, JPMorgan Chase Bank, as Administrative Agent, Collateral Agent and LC Issuing Bank, Deutsche Bank Securities Inc., as Syndication Agent, and Citicorp North America, Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated and UBS Securities LLC, as Co-Documentation Agents (the “Credit Agreement”).

 

26


    Incorporated by reference to Exhibit 4.6 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(2)   Guarantee and Security Agreement dated as of June 25, 2003 among Registrant, the Subsidiary Guarantors and JPMorgan Chase Bank., as Collateral Agent, relating to the Credit Agreement.
    Incorporated by reference to Exhibit 4.7 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(3)   Mortgage, Assignment of Leases and Rents, Security Agreement, Financing Statement and Fixture Filing dated as of June 25, 2003 between Xerox Corporation and JPMorgan Chase Bank, as Collateral Agent, encumbering one property located in the State of Oklahoma and relating to the Credit Agreement.
    Incorporated by reference to Exhibit 4.8 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(4)   Mortgage, Assignment of Leases and Rents, Security Agreement, Financing Statement and Fixture Filing dated as of June 25, 2003 between Xerox Corporation and JPMorgan Chase Bank, as Collateral Agent, encumbering three properties located in the State of New York and relating to the Credit Agreement.
    Incorporated by reference to Exhibit 4.9 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(5)   Line of Credit Deed of Trust, Assignment of Leases and Rents, Security Agreement, Financing Statement and Fixture Filing dated as of June 25, 2003 between Xerox Corporation and JPMorgan Chase Bank, as Collateral Agent, encumbering one property located in the State of Oregon and relating to the Credit Agreement.
    Incorporated by reference to Exhibit 4.10 to Registrant’s Current Report on Form 8-K dated June 25, 2003.
(m)   Master Demand Note dated December 10, 2003 between Registrant and Xerox Credit Corporation.
(n)   Instruments with respect to long-term debt where the total amount of securities authorized thereunder does not exceed 10 percent of the total assets of Registrant and its subsidiaries on a consolidated basis have not been filed. Registrant agrees to furnish to the Commission a copy of each such instrument upon request.
(10)   The management contracts or compensatory plans or arrangements listed below that are applicable to the executive officers named in the Summary Compensation Table which appears in Registrant’s 2004 Proxy Statement are preceded by an asterisk (*).
*(a)   Registrant’s Form of Salary Continuance Agreement.
    Incorporated by reference to Exhibit 10(a) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001, as amended.
*(b)   Registrant’s 1991 Long-Term Incentive Plan, as amended through October 9, 2000.
(c)   Registrant’s 1996 Non-Employee Director Stock Option Plan, as amended through May 20, 1999.
    Incorporated by reference to Registrant’s Notice of the 1999 Annual Meeting of Shareholders and Proxy Statement pursuant to Regulation 14A.
*(d)   Description of Registrant’s Annual Performance Incentive Plan.
*(e)   1997 Restatement of Registrant’s Unfunded Retirement Income Guarantee Plan, as amended through October 9, 2000.
    Incorporated by reference to Exhibit 10(e) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
*(f)   1997 Restatement of Registrant’s Unfunded Supplemental Retirement Plan, as amended through October 9, 2000.
    Incorporated by reference to Exhibit 10(f) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.

 

27


*(g)   Executive Performance Incentive Plan.
    Incorporated by reference to Exhibit 10(g) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001, as amended.
(h)   1996 Amendment and Restatement of Registrant’s Restricted Stock Plan for Directors.
    Incorporated by reference to Exhibit 10(h) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001, as amended.
*(i)   Form of severance agreement entered into with various executive officers, effective October 15, 2000.
    Incorporated by reference to Exhibit 10(i)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
*(j)   Registrant’s Contributory Life Insurance Program, as amended as of January 1, 1999.
    Incorporated by reference to Exhibit 10(j) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1999.
(k)   Registrant’s Deferred Compensation Plan for Directors, 1997 Amendment and Restatement, as amended through October 9, 2000.
    Incorporated by reference to Exhibit 10(k) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
*(l)   Registrant’s Deferred Compensation Plan for Executives, 1997 Amendment and Restatement, as amended through October 9, 2000.
    Incorporated by reference to Exhibit 10(l) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
*(m)   Letter Agreement dated June 4, 1997 between Registrant and G. Richard Thoman, former President and Chief Executive Officer of Registrant.
    Incorporated by reference to Exhibit 10(n) to Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1997.
*(n)   Registrant’s 1998 Employee Stock Option Plan, as amended through October 9, 2000.
    Incorporated by reference to Exhibit 10(n) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
*(o)   Registrant’s CEO Challenge Bonus Program.
    Incorporated by reference to Exhibit 10(o) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
(p)   Separation Agreement dated May 11, 2000 between Registrant and G. Richard Thoman, former President and Chief Executive Officer of Registrant.
    Incorporated by reference to Exhibit 10(p) to Registrant’s Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2000.
(q)   Letter Agreement dated December 4, 2000 between Registrant and William F. Buehler, Vice Chairman of Registrant.
    Incorporated by reference to Exhibit 10(p) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000 filed on June 7, 2001.
(r)(1)   Separation Agreement dated October 3, 2001 between Registrant and Barry D. Romeril, Vice Chairman and Chief Financial Officer of Registrant.
    Incorporated by reference to Exhibit 10(r)(1) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.

 

28


(2)   Form of Release between Registrant and Barry D. Romeril, Vice Chairman and Chief Financial Officer of Registrant.
    Incorporated by reference to Exhibit 10(r)(2) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
*(s)   Letter Agreement dated July 23, 2002 between Registrant and Carlos Pascual, Executive Vice President of Registrant.
    Incorporated by reference to Exhibit 10(s) to Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002.
(t)(1)   Master Supply Agreement, dated as of November 30, 2001, between Registrant and Flextronics International Ltd. **
    Incorporated by reference to Exhibit 10(t)(1) to Registrant’s Current Report on Form 8-K dated June 2, 2003.
(2)   Amended and Restated Letter Agreement dated as of November 30, 2001 between Registrant and Flextronics International Ltd. regarding collateral matters relating to the relationship between Registrant and Flextronics.**
    Incorporated by reference to Exhibit 10(t)(2) to Registrant’s Current Report on Form 8-K dated June 2, 2003.
*(u)   Letter Agreement dated May 20, 2002 between Registrant and Lawrence A. Zimmerman, Senior Vice President and Chief Financial Officer of Registrant.
    Incorporated by reference to Exhibit 10(u) to Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.
(v)   Amended and Restated Loan Agreement dated as of October 21, 2002 between Xerox Lease Funding LLC and General Electric Capital Corporation.
    Incorporated by reference to Exhibit 10(v) to Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002.
*(w)   Form of Cash Retention Agreement entered into with various executive officers during 2003.
(12)   Computation of Ratio of Earnings to Fixed charges and the Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends.
(13)   Registrant’s 2003 Annual Report to Shareholders.
(21)   Subsidiaries of Registrant.
(23)   Consent of PricewaterhouseCoopers LLP.
(31) (a)   Certification of CEO pursuant to Rule 13a-14(a) or Rule 15d-14(a).
(b)   Certification of CFO pursuant to Rule 13a-14(a) or Rule 15d-14(a).
(32)   Certification of CEO and CFO pursuant to 18 U.S.C. §1350 as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002.
(99.1)   Order under Section 36 of the Securities Exchange Act of 1934 Granting Exemptions from Certain Provisions of the Act and Rules Thereunder, dated April 11, 2002 (Release No. 45730).
    Incorporated by reference to Exhibit 99.2 to Registrant’s Current Report on Form 8-K dated April 11, 2002.

** Pursuant to the Freedom of Information Act, the confidential portion of this material has been omitted and filed separately with the Securities and Exchange Commission.

 

29

Master Demand Note dated December 10, 2003

Exhibit 4(m)

 

MASTER NOTE

 

U.S. $2,750,000,000

   December 10, 2003

 

FOR VALUE RECEIVED, Xerox Corporation, a New York corporation (“Xerox”), hereby promises to pay to the order of Xerox Credit Corporation, a Delaware corporation (“XCC”), ON DEMAND, in lawful money of the United States of America, at such place as XCC may from time to time designate to Xerox, the lesser of (i) the principal sum of U.S. $2,750,000,000 or (ii) the aggregate unpaid principal balance of all indebtedness of Xerox to XCC on account of loans from time to time made by XCC to Xerox under this Master Note (each a “Loan” and collectively the “Loans”).

 

Xerox promises to pay interest on the unpaid principal amount of each Loan, from the date of such Loan until the principal amount thereof is paid in full, at an annual interest rate equal to the result of: adding the H.15 Two-Year Swap Rate and H.15 Three-Year Swap Rate and dividing by two (2) and then adding 2.00% (200 basis points). Interest on outstanding principal of each Loan will be calculated monthly (an “Interest Period”) and payable quarterly on March 31, June 30, September 30 and December 31 of each year (each an “Interest Payment Date”) and at the date of repayment, if not an Interest Payment Date. Interest will be calculated on the basis of the actual number of days elapsed in a year of 360 days.

 

“H.15 Two-Year Swap Rate” means, with respect to an Interest Period for a Loan, the rate which appears in the relevant H.15 Release under the heading “Interest Rate Swaps”, “H15I2Y 2-Year” and “Week Ending” immediately prior to publication of such H.15 Release. “H.15 Three-Year Swap Rate” means, with respect to an Interest Period for a Loan, the rate which appears in the relevant H.15 Release under the heading “Interest Rate Swaps”, “H15I3Y 3-Year” and “Week Ending” immediately prior to publication of such H.15 Release. “H.15 Release” means the weekly statistical release designated as such, or any successor publication, published by the Federal Reserve System Board of Governors. The “relevant H.15 Release” for an Interest Period shall be the H.15 Release published on the second to the last Monday of such Interest Period and the interest rate calculated using such H.15 Release shall be applicable to the entire such Interest Period. If the relevant H.15 Release for an Interest Period is not published for any reason, then the interest rate applicable for such Interest Period shall be the interest rate in effect for the immediately preceding Interest Period. The interest rate in effect from time to time hereunder shall be determined by XCC, whose determination of such rate shall be conclusive absent manifest error.

 

If any Interest Payment Date or repayment date falls on a date which is not a Business Day, then the payment(s) due on such date shall be due on the preceding Business Day, with no adjustment to interest periods. For purposes of this Master Note, a Business Day shall be any day other than a Saturday, Sunday or other day on which commercial banks are required or authorized to close in New York, New York.

 

Xerox may, at any time and from time to time, repay the outstanding principal amount of the Loans, in whole or in part, together with accrued interest to the date of such repayment on the principal amount prepaid. Amounts repaid under this Master Note may be reborrowed, with the consent of XCC.

 

XCC is hereby authorized by Xerox to endorse on the schedule forming a part of this Master Note appropriate notations evidencing the date and amount of each Loan, the monthly interest rate, the date and amount of each payment of principal made by Xerox with respect to such Loan and the unpaid aggregate principal amount of all the Loans. XCC is hereby authorized by Xerox to attach to and make a part hereof a continuation of such schedule as and when required pursuant to the terms of this Master Note. The information endorsed by XCC on the schedule forming a part of this Master Note shall be prima facie evidence of the matters covered thereby in the absence of manifest error; provided, however, that the failure to endorse, or any error in endorsing, any such information on such schedule shall not affect the obligation of Xerox hereunder to repay the principal amount of each Loan made by XCC to Xerox and to pay accrued interest thereon.


Any amount due to XCC under this Master Note that is not paid when due shall bear interest at a rate per annum equal to the sum of the interest rate then in effect with respect to such amount plus 2.00%. Such interest shall be computed on the basis of the actual number of days elapsed in a year of 360 days and shall be payable on demand.

 

This Master Note and the rights of XCC hereunder may not be assigned or otherwise transferred without the prior written consent of Xerox.

 

The obligations of Xerox hereunder shall be governed by the laws of the State of New York without regard to the principles of conflict of laws thereof (other than General Obligations Law §5-1401).

 

This Master Note supersedes and replaces the U.S.$2,250,000,000 Master Note dated November 20, 2001 from Xerox to XCC.

 

IN WITNESS WHEREOF, the undersigned has executed this Master Note as of the date first written above.

 

XEROX CORPORATION

By:

 

/s/    RHONDA L. SEEGAL        


Name:   Rhonda L. Seegal
Title:   Vice President and Treasurer

 

SCHEDULE

 

Date


 

Amount


 

Aggregate
Outstanding

Principal Amount


   Interest Rate

  

Amount of

Principal
Repaid


   Notation Made
By


                        
                        
                        
Registrants 1991 Long-Term Incentive Plan

Exhibit 10(b)

 

As amended through 10/09/00

 

XEROX CORPORATION

 

1991 LONG-TERM INCENTIVE PLAN

 

1. Purpose

 

The purpose of the Xerox Corporation 1991 Long-Term Incentive Plan (the “Plan”) is to advance the interests of Xerox Corporation (the “Company”) and to increase shareholder value by providing officers and employees with a proprietary interest in the growth and performance of the Company and with incentives for continued service with the Company, its subsidiaries and affiliates.

 

2. Term

 

The Plan shall be effective as of May 16, 1991 and shall remain in effect until May 20, 2004 unless sooner terminated by the Company’s Board of Directors (the “Board”). After termination of the Plan, no future awards may be granted but previously made awards shall remain outstanding in accordance with their applicable terms and conditions and the terms and conditions of the Plan.

 

3. Plan Administration

 

The Executive Compensation and Benefits Committee of the Board, or such other committee as the Board shall determine, comprised of not less than three members shall be responsible for administering the Plan (the “Compensation Committee”). To the extent specified by the Compensation Committee it may delegate its administrative responsibilities to a subcommittee of the Compensation Committee comprised of not less than three members (the Compensation Committee and such subcommittee being hereinafter referred to as the “Committee”). The Compensation Committee or such subcommittee members, as appropriate, shall be qualified to administer this Plan as contemplated by (a) Rule 16b-3 under the Securities and Exchange Act of 1934 (the “1934 Act”) or any successor rule and (b) Section 162(m) of the Internal Revenue Code of 1986, as amended, and the regulations thereunder (“Section 162(m)”). The Committee, and such subcommittee to the extent provided by the Committee, shall have full and exclusive power to interpret, construe and implement the Plan and any rules, regulations, guidelines or agreements adopted hereunder and to adopt such rules, regulations and guidelines for carrying out the Plan as it may deem necessary or proper. These powers shall include, but not be limited to, (i) determination of the type or types of awards to be granted under the Plan; (ii) determination of the terms and conditions of any awards under the Plan; (iii) determination of whether, to what extent and under what circumstances awards may be settled, paid or exercised in cash, shares, other securities, or other awards, or other property, or canceled, forfeited or suspended; (iv) adoption of such modifications, amendments, procedures, subplans and the like as are necessary to comply with provisions of the laws of other countries in which the Company may operate in order to assure the viability of awards granted under the Plan and to enable participants employed in such other countries to receive advantages and benefits under the Plan and such laws; (v) subject to the rights of participants, modification, change, amendment or cancellation of any award to correct an administrative error and (vi) taking any other action the Committee deems necessary or desirable for the administration of the Plan. All determinations, interpretations, and other decisions under or with respect to the Plan or any award by the Committee shall be final, conclusive and binding upon the Company, any participant, any holder or beneficiary of any award under the Plan and any employee of the Company. Except for the power to amend this Plan as provided in Section 13 and except for determinations regarding employees who are subject to Section 16 of the 1934 Act or certain key employees who are or may become, as determined by the Committee, subject to the Section 162(m) compensation deductibility limit (the “Covered Employees”), the Committee may delegate any or all of its duties, powers and authority under the Plan pursuant to such conditions or limitations as the Committee may establish to any officer or officers of the Company.

 

1


4. Eligibility

 

Any employee of the Company shall be eligible to receive an award under the Plan. “Employee” shall also include any former employee of the Company eligible to receive a replacement award as contemplated in Sections 5 and 7, and “Company” shall include any entity that is directly or indirectly controlled by the Company or any entity in which the Company has a significant equity interest, as determined by the Committee.

 

5. Shares of Stock Subject to the Plan

 

For each calendar year from and including 1991 to but excluding 1999, a number of shares of Common Stock, par value $1.00 per share, of the Company (“Common Stock”) equal in an amount of up to one percent (1%) of the adjusted average shares of Common Stock outstanding used to calculate diluted earnings per share (previously known as fully diluted earnings per share) as reported in the annual report to shareholders for the preceding year shall become available for issuance under the Plan; and for the calendar year 1999, and for each calendar year thereafter, a number of shares of Common Stock equal in an amount to two percent (2%) of the adjusted average shares of Common Stock outstanding used to calculate diluted earnings per share (previously known as fully diluted earnings per share) as reported in the annual report to shareholders for the preceding year shall become available for issuance under the Plan.

 

For purposes of the preceding paragraph, the following shall not be counted against shares available for issuance under the Plan: (i) settlement of stock appreciation rights (“SAR”) in cash or any form other than shares and (ii) payment in shares of dividends and dividend equivalents in conjunction with outstanding awards. Any shares that are issued by the Company, and any awards that are granted by, or become obligations of, the Company, through the assumption by the Company or an affiliate of, or in substitution for, outstanding awards previously granted by an acquired company shall not be counted against the shares available for issuance under the Plan.

 

In no event, however, except as subject to adjustment as provided in Section 6 shall more than (a) thirty million (30,000,000) shares of Common Stock be available for issuance pursuant to the exercise of incentive stock options (“ISOs”) awarded under the Plan(1); (b) twenty-three million five hundred thirty-two thousand three hundred two (23,532,302) shares of Common Stock shall be available for issuance pursuant to stock awards granted under Section 7(c) of the Plan(1) ;and (c) ten million (10,000,000) shares of Common Stock shall be made the subject of awards under any combination of awards under Sections 7(a), 7(b) or 7(c) of the Plan to any single individual(1). SARs whether settled in cash or shares of Common Stock shall be counted against the limit set forth in (c).

 

Any shares issued under the Plan may consist in whole or in part, of authorized and unissued shares or of treasury shares, and no fractional shares shall be issued under the Plan. Cash may be paid in lieu of any fractional shares in settlements of awards under the Plan.

 

6. Adjustments and Reorganizations

 

The Committee may make such adjustments as it deems appropriate to meet the intent of the Plan in the event of changes that impact the Company’s share price or share status, provided that any such actions are consistently and equitably applicable to all affected participants.

 

In the event of any stock dividend, stock split, combination or exchange of shares, merger, consolidation, spin-off or other distribution (other than normal cash dividends) of Company assets to shareholders, or any other change affecting shares, such adjustments, if any, as the Committee in its discretion may deem appropriate to reflect such change shall be made with respect to (i) the aggregate number of shares that may be issued under the Plan; (ii) the number of shares subject to awards of a specified type or to any individual under the Plan; and/or (iii) the price per share for any outstanding stock options, SARs and other awards under the Plan.


(1) Effective February 1, 1999

 

2


7. Awards

 

The Committee shall determine the type or types of award(s) to be made to each participant under the Plan and shall approve the terms and conditions governing such awards in accordance with Section 12. Awards may include but are not limited to those listed in this Section 7. Awards may be granted singly, in combination or in tandem so that the settlement or payment of one automatically reduces or cancels the other. Awards may also be made in combination or in tandem with, in replacement of, as alternatives to, or as the payment form for, grants or rights under any other employee or compensation plan of the Company, including the plan of any acquired entity. However, under no circumstances may stock option awards be made which provide by their terms for the automatic award of additional stock options upon the exercise of such awards.

 

(a) Stock Option—is a grant of a right to purchase a specified number of shares of Common Stock during a specified period. The purchase price of each option shall be not less than 100% of Fair Market Value (as defined in Section 10) on the effective date of grant, except that, in the case of a stock option granted retroactively in tandem with or as a substitution for another award, the exercise or designated price may be no lower than the Fair Market Value of a share on the date such other award was granted. A stock option may be exercised in whole or in installments, which may be cumulative. A stock option may be in the form of an ISO which complies with Section 422 of the Internal Revenue Code of 1986, as amended, and the regulations thereunder at the time of grant. The price at which shares of Common Stock may be purchased under a stock option shall be paid in full at the time of the exercise in cash or such other method as provided by the Committee at the time of grant or as provided in the form of agreement approved in accordance herewith, including tendering (either actually or by attestation) Common Stock, surrendering a stock award valued at Fair Market Value on the date of surrender, surrendering a cash award, or any combination thereof.

 

(b) Stock Appreciation Right—is a right to receive a payment, in cash and/or Common Stock, as determined by the Committee, equal to the excess of the Fair Market Value of a specified number of shares of Common Stock on the date the SAR is exercised over the Fair Market Value on the date of grant of the SAR as set forth in the applicable award agreement, except that, in the case of a SAR granted retroactively in tandem with or as a substitution for another award, the exercise or designated price may be no lower than the Fair Market Value of a share on the date such other award was granted

 

(c) Stock Award—is an award made in stock or denominated in units of stock. All or part of any stock award may be subject to conditions established by the Committee, and set forth in the award agreement, which may include, but are not limited to, continuous service with the Company, achievement of specific business objectives, and other measurements of individual, business unit or Company performance.

 

(d) Cash Award—is an award denominated in cash with the eventual payment amount subject to future service and such other restrictions and conditions as may be established by the Committee, and as set forth in the award agreement, including, but not limited to, continuous service with the Company, achievement of specific business objectives, and other measurement of individual, business unit or Company performance. Cash Awards to any single Covered Employee, including dividend equivalents in cash or shares of Common Stock payable based upon attainment of specific performance goals, may not exceed in the aggregate $5,000,000 for each performance period established by the Committee under Section 23 of the Plan.

 

8. Dividends and Dividend Equivalents

 

The Committee may provide that awards denominated in stock earn dividends or dividend equivalents. Such dividend equivalents may be paid currently in cash or shares of Common Stock or may be credited to an account established by the Committee under the Plan in the name of the participant. In addition, dividends or dividend equivalents paid on outstanding awards or issued shares may be credited to such account rather than paid currently. Any crediting of dividends or dividend equivalents may be subject to such restrictions and conditions as the Committee may establish, including reinvestment in additional shares or share equivalents.

 

3


9. Deferrals and Settlements

 

Payment of awards may be in the form of cash, stock, other awards, or in such combinations thereof as the Committee shall determine at the time of grant, and with such restrictions as it may impose. The Committee may also require or permit participants to elect to defer the issuance of shares or the settlement of awards in cash under such rules and procedures as it may establish under the Plan. It may also provide that deferred settlements include the payment or crediting of interest on the deferral amounts or the payment or crediting of dividend equivalents on deferred settlements denominated in shares.

 

10. Fair Market Value

 

Fair Market Value for all purposes under the Plan shall mean the average of the high and low prices of Common Stock as reported in The Wall Street Journal in the New York Stock Exchange composite transactions or similar successor consolidated transactions reports for the relevant date, or if no sales of Common Stock were made on said exchange on that date, the average of the high and low prices of Common Stock as reported in said composite transaction report for the preceding day on which sales of Common Stock were made on said Exchange. Under no circumstances shall Fair Market Value be less than the par value of the Common Stock.

 

11. Transferability and Exercisability

 

All awards under the Plan will be nontransferable and shall not be assignable, alienable, saleable or otherwise transferable by the participant other than by will or the laws of descent and distribution except pursuant to a domestic relations order entered by a court of competent jurisdiction or as otherwise determined by the Committee. In the event that a participant terminates employment with the Company to assume a position with a governmental, charitable, educational or similar non-profit institution, the Committee may authorize a third party, including but not limited to a “blind” trust, to act on behalf of and for the benefit of the respective participant with respect to any outstanding awards. Except as otherwise provided in this Section 11, during the life of the participant, awards under the Plan shall be exercisable only by him or her except as otherwise determined by the Committee. In addition, if so permitted by the Committee, a participant may designate a beneficiary or beneficiaries to exercise the rights of the participant and receive any distributions under this Plan upon the death of the participant.

 

12. Award Agreements

 

Awards under the Plan shall be evidenced by one or more agreements approved by the Committee that set forth the terms and conditions of and limitations on an award, except that in no event shall the term of any ISO exceed a period of ten years from the date of its grant. The Committee need not require the execution of any such agreement by a participant in which case acceptance of the award by the respective participant will constitute agreement to the terms of the award.

 

13. Plan Amendment

 

The Compensation Committee may amend the Plan as it deems necessary or appropriate, except that no such amendment which would cause the Plan not to comply with the requirements of (i) Section 162(m) with respect to performance-based compensation, (ii) the Code with respect to ISOs or (iii) the New York Business Corporation Law as in effect at the time of such amendment shall be made without the approval of the Company’s shareholders. No such amendment shall adversely affect any outstanding awards under the Plan without the consent of all of the holders thereof.

 

14. Tax Withholding

 

The Company shall have the right to deduct from any settlement of an award made under the Plan, including the delivery or vesting of shares, an amount sufficient to cover withholding required by law for any federal, state

 

4


or local taxes or to take such other action as may be necessary to satisfy any such withholding obligations. The Committee may permit shares to be used to satisfy required tax withholding and such shares shall be valued at the Fair Market Value as of the settlement date of the applicable award.

 

15. Other Company Benefit and Compensation Programs

 

Unless otherwise determined by the Committee, settlements of awards received by participants under the Plan shall not be deemed a part of a participant’s regular, recurring compensation for purposes of calculating payments or benefits from any Company benefit plan, severance program or severance pay law of any country.

 

16. Unfunded Plan

 

Unless otherwise determined by the Committee, the Plan shall be unfunded and shall not create (or be construed to create) a trust or a separate fund or funds. The Plan shall not establish any fiduciary relationship between the Company and any participant or other person. To the extent any person holds any rights by virtue of a grant awarded under the Plan, such right (unless otherwise determined by the Committee) shall be no greater than the right of an unsecured general creditor of the Company.

 

17. Future Rights

 

No person shall have any claim or right to be granted an award under the Plan, and no participant shall have any right by reason of the grant of any award under the Plan to continued employment by the Company or any subsidiary of the Company.

 

18. General Restriction

 

Each award shall be subject to the requirement that, if at any time the Committee shall determine, in its sole discretion, that the listing, registration or qualification of any award under the Plan upon any securities exchange or under any state or federal law, or the consent or approval of any government regulatory body, is necessary or desirable as a condition of, or in connection with, the granting of such award or the exercise settlement thereof, such award may not be granted, exercised or settled in whole or in part unless such listing, registration, qualification, consent or approval shall have been effected or obtained free of any conditions not acceptable to the Committee.

 

19. Governing Law

 

The validity, construction and effect of the Plan and any actions taken or relating to the Plan shall be determined in accordance with the laws of the state of New York and applicable Federal law.

 

20. Successors and Assigns

 

The Plan shall be binding on all successors and permitted assigns of a participant, including, without limitation, the estate of such participant and the executor, administrator or trustee of such estate, or any receiver or trustee in bankruptcy or representative of such participant’s creditors.

 

21. Rights as a Shareholder

 

A participant shall have no rights as a shareholder until he or she becomes the holder of record of Common Stock.

 

5


22. Change in Control

 

Notwithstanding anything to the contrary in the Plan, the following shall apply to all awards granted and outstanding under the Plan:

 

(a) Definitions. The following definitions shall apply to this Section 22:

 

A “Change in Control,” unless otherwise defined by the Compensation Committee, shall be deemed to have occurred if (a) any “person,” as such term in used in Section 13(d) and 14(d) of the 1934 Act, other than (1) the Company, (2) any trustee or other fiduciary holding securities under an employee benefit plan of the Company, (3) any company owned, directly or indirectly, by the shareholders of the Company in substantially the same proportions as their ownership of stock of the Company, or (4) any person who becomes a “beneficial owner” (as defined below) in connection with a transaction described in clause (1) of subparagraph (c) below, is or becomes the “beneficial owner” (as defined in Rule 13d-3 under the 1934 Act), directly or indirectly, of securities of the Company (not including in the securities beneficially owned by such person any securities acquired directly from the Company or its affiliates) representing 20 percent or more of the combined voting power of the Company’s then outstanding voting securities; (b) the following individuals cease for any reason to constitute a majority of the directors then serving; individuals who, on October 9, 2000 constitute the Board and any new director (other than a director whose initial assumption of office is in connection with an actual or threatened election contest, including but not limited to a consent solicitation, relating to the election of directors of the Company) whose appointment or election by the Board or nomination for election by the Company’s shareholders was approved or recommended by a vote of at least two-thirds of the directors then still in office who were directors on October 9, 2000 or whose appointment, election or nomination for election was previously so approved or recommended; (c) there is consummated a merger or consolidation of the Company or any direct or indirect subsidiary of the Company with any other corporation, other than (1) a merger or consolidation which results in the directors of the Company immediately prior to such merger or consolidation continuing to constitute at least a majority of the board of directors of the Company, the surviving entity or any parent thereof or (2) a merger or consolidation effected to implement a recapitalization of the Company (or similar transaction) in which no person is or becomes the beneficial owner, directly or indirectly, of securities of the Company (not including in the securities beneficially owned by such person any securities acquired directly from the Company or its affiliates) representing 20% or more of the combined voting power of the Company’s then outstanding securities; or (d) the shareholders of the Company approve a plan of complete liquidation or dissolution of the Company or there is consummated an agreement for the sale or disposition by the Company of all or substantially all of the Company’s assets, other than a sale or disposition by the Company of all or substantially all of the Company’s assets to an entity, at least 50% of the combined voting power of the voting securities of which are owned by stockholders of the Company in substantially the same proportions as their ownership of the Company immediately prior to such sale.

 

“CIC Price” shall mean the higher of (a) the highest price paid for a share of the Company’s Common Stock in the transaction or series of transactions pursuant to which a Change in Control of the Company shall have occurred, or (b) the highest price paid for a share of the Company’s Common Stock during the 60 day period immediately preceding the date upon which the event constituting a Change in Control shall have occurred as reported in The Wall Street Journal in the New York Stock Exchange Composite Transactions or similar successor consolidated transactions reports.

 

(b) Acceleration of Vesting and Payment of SARs, Stock Awards, Cash Awards, and Dividends and Dividend Equivalents.

 

(1) Upon the occurrence of an event constituting a Change in Control, all SARs, stock awards, cash awards, dividends and dividend equivalents outstanding on such date shall become 100% vested and shall be paid in cash as soon as may be practicable. Upon such payment, such awards and any related stock options shall be cancelled.

 

6


(2) The amount of cash to be paid shall be determined by multiplying the number of such awards, as the case may be, by: (i) in the case of stock awards, the CIC Price; (ii) in the case of SARs, the difference between the exercise price of the related option per share and the CIC Price; (iii) in the case of cash awards where the award period, if any, has not been completed upon the occurrence of a Change in Control, the maximum value of such awards as determined by the Committee at the time of grant, without regard to the performance criteria, if any, applicable to such award; and (iv) in the case of cash awards where the award period, if any, has been completed on or prior to the occurrence of a Change in Control: (aa) where the cash award is payable in cash, the value of such award as determined in accordance with the award agreement, and (bb) where the cash award is payable in shares of Common Stock, the CIC Price.

 

(c) Option Surrender Rights.

 

(1) All stock options granted under the Plan shall be accompanied by option surrender rights (“OSRs”). OSRs shall be evidenced by OSR agreements in such form and not inconsistent with the Plan as the Committee shall approve from time to time. Upon the occurrence of an event constituting a Change in Control, all OSRs, to the extent that the CIC Price exceeds the exercise price of the related stock options, shall be paid in cash as soon as may be practicable. Upon such payment, such rights and any related stock options shall be cancelled.

 

(2) The amount of cash payable in respect of an OSR shall be determined by multiplying the number of unexercised shares as to which the right then relates by the difference between the option price of such shares and the CIC Price.

 

(3) Upon the grant of SARs, with respect to the same shares covered by then outstanding OSRs the OSRs relating to such shares shall be automatically cancelled.

 

(d) Notwithstanding the foregoing subsections (a), (b) and (c), SARs, OSRs and any stock-based award held by an officer or director subject to Section 16 of the 1934 Act which have been outstanding less than six months (or such other period as may be required by the 1934 Act) upon the occurrence of an event constituting a Change in Control shall not be paid in cash until the expiration of such period, if any, as shall be required pursuant to such Section, and the amount to be paid shall be determined by multiplying the number of SARs, OSRs or stock awards by the CIC Price determined as though the event constituting the Change in Control had occurred on the first day following the end of such period.

 

23. Certain Provisions Applicable to Awards to Covered Employees

 

Performance-based awards made to Covered Employees shall be made by the Committee within the time period required under Section 162(m) for the establishment of performance goals and shall specify, among other things, the performance period(s) for such award (which shall be not less than one year), the performance criteria and the performance targets. The performance criteria shall be any one or more of the following as determined by the Committee and may differ as to type of award and from one performance period to another: earnings per share, total shareholder return, return on shareholders’ equity, economic value added measures, return on assets, revenue, profit before tax, profit after tax, stock price and return on sales. Payment or vesting of awards to Covered Employees shall be contingent upon satisfaction of the performance criteria and targets as certified by the Committee by resolution of the Committee. To the extent provided at the time of an award, the Committee may in its sole discretion reduce any award to any Covered Employee to any amount, including zero.

 

7

Description of Registrants Annual Performance Incentive Plan

Exhibit 10(d)

 

Annual Performance Incentive Plan (APIP)

 

Under APIP, executive officers of the Company are eligible to receive performance-related cash payments. Payments are, in general, only made if annual performance objectives established by the Compensation Committee (“Committee”) are met.

 

The Committee approved an annual incentive target and maximum opportunity for 2003, expressed as a percentage of base salary, for each participating officer.

 

The Committee also established overall threshold, target and maximum measures of performance for the 2003 APIP. The performance measures and weightings for 2003 were revenue (30%), earnings per share (40%), cash flow from operations (15%) and accounts receivable (15%). Additional goals were also established for each officer that included business-unit specific and/or individual performance goals and objectives, including new product launches and executing business turnarounds. The weightings associated with these business-unit specific or individual performance goals and objectives vary. In addition, the Committee approved a supplemental award opportunity equal to 100% of the APIP target bonus amount for select officers and other senior managers who have direct revenue generating responsibilities. The supplemental award was to be paid only if stretch revenue goals were exceeded and operating profit margin targets were maintained. One officer received a supplemental award as described above because of the stellar revenue growth delivered by his unit.

 

For 2003, the performance against the APIP goals was as follows: Revenue performance was below threshold, earnings per share performance was above target, cash flow from operations significantly exceeded target and accounts receivable performance exceeded target. Accordingly, the Committee approved APIP awards for 2003 to participating officers that on average were approximately 132% of target levels. Some individuals received higher or lower bonuses based on their individual and unit performance.

Form of Cash Retention Agreement

Exhibit 10(w)

 

Cash Retention Agreement

June #, 2003

 

RETENTION AGREEMENT dated as of December 9, 2002 between Xerox Corporation, a New York corporation (the “Company”), and # an employee of the Company (“Executive”).

 

WHEREAS, on December 9, 2002 the Compensation Committee of the Board of Directors (“Committee”) authorized the payment of a cash retention award to the Executive in the amount of $xxx,xxx (“Retention Award”), payable as to 50% in June, 2003 (“Initial Payment”) and 50% by December 31, 2004 (“Final Payment”); and

 

WHEREAS, that under the terms of the Retention Award authorized by the Committee the Executive is required to repay the Initial Payment to the Company if the Executive’s Employment terminates prior to December 31, 2004 except as otherwise provided herein; and

 

WHEREAS, the Final Payment is conditioned upon the Executive’s employment not terminating prior to December 31, 2004 except as otherwise provided herein.

 

NOW, THEREFORE, in consideration of the premises and of other good and valuable consideration the sufficiency and receipt of which are hereby acknowledged by the parties hereto the parties hereby agree as follows:

 

1. Initial Payment. The Initial Payment to Executive, net of any applicable withholding required under federal, state or local law, will be made as part of the regular salary payment on June 30, 2003.

 

2. Final Payment. Subject to Executive’s continued employment with the Company the Company hereby promises to pay to Executive the Final Payment on December 31, 2004 net of any applicable withholding required under federal, state or local law.

 

3. Effect of Termination Upon Retention Award. (a) In the event of termination of employment by the Executive for any reason prior to December 31, 2004 , other than as a result of death, Disability (as hereinafter defined) or by the Executive with Good Reason (as hereinafter defined), or (b) in the event of termination by the Company for Cause (as hereinafter defined), the Initial Payment shall be repaid to the Company net of any applicable withholding required under federal, state or local law withheld by the Company at the time of payment as soon as may be practicable and the Final Payment shall be cancelled and shall not be payable.

 

4. Effect of Death or Disability. In the event of the death or Disability of Executive prior to December 31, 2004, the total Retention Award will be prorated based upon a fraction, the numerator of which shall be the number of full weeks of employment commencing on December 9, 2002 and ending on the date of Death or commencement of Disability and the denominator shall be 107. To the extent that such pro-ration results in Executive being entitled to less than the Initial Payment, Executive or his estate shall be liable to repay to the Company, as soon as may be practicable, the difference between the Initial Payment and such lesser amount net of any applicable withholding required under federal, state or local law withheld by the Company at the time of payment. To the extent that such pro-ration results in Executive being entitled to more than the Initial Payment, the Company shall pay to Executive or his estate as promptly as practicable following death or Disability, the amount by which such pro-rated amount exceeds the Initial Payment, net of any applicable withholding required under federal, state or local law.

 

5. Definitions. The following terms shall have the following meanings:

 

(a) “Cause”—termination upon (A) the [willful and] continued failure by Executive to substantially perform his duties with the Company (other than any such failure resulting from Executive’s incapacity due to physical or mental illness) after a written demand for substantial performance is delivered to Executive by the Company which specifically identifies the manner in

 

1


which the Company believes that Executive has not substantially performed his duties, (B) the [willful] engaging by Executive in conduct which is demonstrably and materially injurious to the Company, monetarily or otherwise, (C) the conviction of any crime (whether or not involving the Company) which constitutes a felony or (D) the [willful] violation of any policy of the Company.

 

(b) “Disability”—physical or mental incapacity which would allow the Executive to receive benefits under the Company’s Long-Term Disability Income Plan (or any substitute plans).

 

(c) “Good Reason”—“Good Reason” shall mean, without Executive’s express written consent, the occurrence of any of the following circumstances:

 

A. (i) a reduction in Executive’s annual base salary and/or annual target bonus as in effect on the date hereof or as the same may be increased from time to time, (ii) a failure by the Company to increase Executive’s annual base salary at such periodic intervals consistent with the Company’s practice on the date hereof, except that this subparagraph (A) shall not apply to across-the-board salary reductions similarly affecting all executives of the Company;

 

B. the failure by the Company to continue to provide Executive with benefits substantially similar to those enjoyed by Executive under any of the Company’s pension, retirement, life insurance, medical, health and accident, or disability plans in which Executive is participating on the date hereof, the taking of any action by the Company which would directly or indirectly materially reduce any of such benefits or deprive Executive of any material fringe benefit enjoyed by Executive on the date hereof, or the failure by the Company to provide Executive with the number of paid vacation days to which Executive is entitled on the basis of years of service with the Company in accordance with the Company’s normal vacation policy in effect on the date hereof, provided, however, the foregoing shall not constitute Good Reason if the failure to act or action is consistent with failures to act or actions applicable to all similarly situated executives.

 

Executive’s right to terminate his employment for Good Reason shall not be affected by Executive’s incapacity due to physical or mental illness.

 

6. Notice. For the purposes of this Agreement, notices and all other communications provided in connection with this Agreement shall be in writing and shall be deemed to have been duly given when delivered or mailed by United States certified mail, return receipt requested, postage prepaid, addressed as follows:

 

If to the Company:

 

Xerox Corporation

P.O. Box 1600

800 Long Ridge Road

Stamford, CT. 06904

Attention: Executive Compensation

 

If to Executive:

 

[TO BE SUPPLIED]

 

or to such other address as either party may have furnished to the other in writing in accordance herewith, except that notice of change of address shall be effective only upon receipt.

 

7. Miscellaneous. No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing and signed by Executive and a duly authorized officer of the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect to the subject matter hereof have been made by either party which are not expressly set forth in this Agreement. The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the State of New York without regard to its conflicts of law principles. This Agreement shall

 

2


not be construed as creating an express or implied contract of employment and, except as otherwise agreed in writing between Executive and the Company, Executive shall not have any right to be retained in the employ of the Company.

 

8. Validity. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect.

 

9. Counterparts. This Agreement may be executed in several counterparts, each of which shall be deemed to be an original but all of which together will constitute one and the same instrument.

 

10. Entire Agreement. This Agreement sets forth the entire agreement of the parties hereto in respect of the subject matter contained herein and during the term of the Agreement supersedes the provisions of all prior agreements, promises, covenants, arrangements, communications, representations or warranties, whether oral or written, by any officer, employee or representative of any party hereto with respect to the subject matter hereof.

 

11. Effective Date. This Agreement shall become effective as of the date set forth above.

 

XEROX CORPORATION

By:

 

 


    Anne M. Mulcahy, Chairman of Board and
    Chief Executive Officer

 

 


Executive

 

3

Computation of Ratio of Earnings to Fixed Charges

Exhibit 12

 

Xerox Corporation

 

Computation of Ratio of Earnings to Fixed Charges

 

The ratio of earnings to fixed charges, the ratio of earnings to combined fixed charges and preferred stock dividends, as well as any deficiency of earnings are determined using the following applicable factors:

 

Earnings available for fixed charges are calculated first, by determining the sum of: (a) income (loss) before income taxes, (b) distributed equity income, (c) fixed charges, as defined below and (d) amortization of capitalized interest, if any. From this total, we subtract capitalized interest, if any.

 

Fixed charges are calculated as the sum of (a) interest costs (both expensed and capitalized), (b) amortization of debt expense and discount or premium relating to any indebtedness and (c) that portion of rental expense that is representative of the interest factor.

 

As of July 1, 2003, we adopted both Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“SFAS No. 150”) and FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB revised FIN 46, in part, to clarify certain of its provisions. The revision to FIN 46 addressed ownership provisions related to consolidation. This guidance resulted in the holders of the preferred securities being considered the primary beneficiaries of these trusts. As such, we are no longer permitted to consolidate these entities. As a result, we were required to deconsolidate all three of our subsidiary trusts (Capital Trust I, Capital Trust II and Capital LLC), two of which issued the securities previously reclassified in accordance with the adoption of SFAS No. 150.

 

We have deconsolidated the three trusts and reflected our obligations to them within the balance sheet liability caption “Liability to subsidiary trusts issuing preferred securities.” In addition to deconsolidating these subsidiary trusts, the interest expense on the loans has been included within “Other expenses, net” with the tax effects presented within “Income taxes (benefits).” Accordingly, $145 million, $145 million, $64 million, $56 million and $55 million is included in non-financing interest expense for each of the five years ended December 31, 2003, respectively.

 

Preferred stock dividends used in the ratio of earnings to combined fixed charges and preferred stock dividends consist of the amount of pre-tax earnings required to cover dividends paid on our Series B convertible preferred stock and our Series C mandatory convertible preferred stock. The Series B dividends are tax deductible and, as such, are equivalent to the pre-tax earnings required to cover such dividends.

 

     Year Ended December 31,

 
(In millions)    2003

    2002

    2001

    2000

    1999

 

Fixed charges:

                                        

Interest expense

   $ 884     $ 896     $ 1,001     $ 1,146     $ 897  

Portion of rental expense which represents interest factor

     77       82       111       115       132  
    


 


 


 


 


Total fixed charges before capitalized interest

     961       978       1,112       1,261       1,029  

Capitalized interest

     —         —         —         3       8  
    


 


 


 


 


Total fixed charges

   $ 961     $ 978     $ 1,112     $ 1,264     $ 1,037  
    


 


 


 


 


Earnings available for fixed charges:

                                        

Earnings

   $ 494     $ 158     $ 381     $ (365 )   $ 1,268  

Less: Undistributed equity in income of affiliated companies

     (37 )     (23 )     (20 )     (25 )     (10 )

Add: fixed charges before capitalized interest and preferred stock dividends

     961       978       1,112       1,261       1,029  
    


 


 


 


 


Total earnings available for fixed charges

   $ 1,418     $ 1,113     $ 1,473     $ 871     $ 2,287  
    


 


 


 


 


Ratio of earnings to fixed charges

     1.48       1.14       1.32       *       2.21  
    


 


 


 


 



* Earnings for the year ended December 31, 2000 were inadequate to cover fixed charges by $393 million.


Xerox Corporation

 

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

 

     Year Ended December 31,

 
(In millions)    2003

    2002

    2001

    2000

    1999

 

Fixed charges:

                                        

Interest expense

   $ 884     $ 896     $ 1,001     $ 1,146     $ 897  

Portion of rental expense which represents interest factor

     77       82       111       115       132  
    


 


 


 


 


Total fixed charges before capitalized interest and preferred stock dividends pre-tax income requirement

     961       978       1,112       1,261       1,029  

Capitalized interest

     —         —         —         3       8  

Preferred stock dividends pre-tax income requirement

     90       78       13       53       54  
    


 


 


 


 


Total combined fixed charges and preferred stock dividends

   $ 1,051     $ 1,056     $ 1,125     $ 1,317     $ 1,091  

Earnings available for fixed charges:

                                        

Earnings

   $ 494     $ 158     $ 381     $ (365 )   $ 1,268  

Less: Undistributed equity in income of affiliated companies

     (37 )     (23 )     (20 )     (25 )     (10 )

Add: fixed charges before capitalized interest and preferred stock dividends

     961       978       1,112       1,261       1,029  
    


 


 


 


 


Total earnings available for fixed charges

   $ 1,418     $ 1,113     $ 1,473     $ 871     $ 2,287  
    


 


 


 


 


Ratio of earnings to combined fixed charges and preferred stock dividends

     1.35       1.05       1.31       *       2.10  
    


 


 


 


 



* Earnings for the year ended December 31, 2000 were inadequate to cover combined fixed charges and preferred stock dividends by $446 million.
Registrants 2003 Annual Report to Shareholders

EXHIBIT 13

 

INDEX TO ANNUAL REPORT

 

Report of Management

   3

Management’s Discussion and Analysis of Results of Operations and Financial Condition

   4

Executive Overview

   4

Financial Overview

   4

Application of Critical Accounting Policies

   6

Summary of Results

   11

Revenues

   12

Segment Operating Profit

   14

Employee Stock Ownership Plan

   14

Gross Margin

   15

Research and Development

   16

Selling, Administrative and General Expenses

   16

Restructuring Programs

   16

Gain on Affiliate’s Sale of Stock

   17

Provision for Litigation

   17

Other Expenses, Net

   17

Income Taxes

   19

Equity in Net Income of Unconsolidated Affiliates

   19

Recent Accounting Pronouncements

   19

Capital Resources and Liquidity

   20

Cash Flow Analysis

   20

Capital Structure and Liquidity

   22

Liquidity, Financial Flexibility and Funding Plans

   23

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

   26

Off-Balance Sheet Arrangements

   27

Financial Risk Management

   28

Forward-Looking Cautionary Statements

   29

Audited Consolidated Financial Statements

    

Report of Independent Auditors

   30

Consolidated Statements of Income

   31

Consolidated Balance Sheets

   32

Consolidated Statements of Cash Flows

   33

Consolidated Statements of Common Shareholders’ Equity

   34

 

1


Notes to Consolidated Financial Statements

 

1.    Summary of Significant Accounting Policies    35
2.    Restructuring Programs    44
3.    Divestitures and Other Sales    47
4.    Receivables, Net    49
5.    Inventories and Equipment on Operating Leases, Net    52
6.    Land, Buildings and Equipment, Net    53
7.    Investments in Affiliates, at Equity    54
8.    Segment Reporting    55
9.    Supplementary Financial Information    58
10.    Debt    60
11.    Financial Instruments    65
12.    Employee Benefit Plans    69
13.    Income and Other Taxes    75
14.    Liability to Subsidiary Trusts Issuing Preferred Securities    78
15.    Litigation, Regulatory Matters and Other Contingencies    80
16.    Preferred Securities    91
17.    Common Stock    92
18.    Earnings Per Share    93
19.    Financial Statements of Subsidiary Guarantors    95

 

Other Data

    

Quarterly Results of Operations

   104

Five Years in Review

   105

Certifications Pursuant to Rule 13a - 14 under the Securities Exchange Act of 1934, as amended

    

 

2


REPORT OF MANAGEMENT

 

Our management is responsible for the integrity and objectivity of all information presented in this annual report. The Consolidated Financial Statements were prepared in conformity with accounting principles generally accepted in the United States of America and include amounts based on management’s best estimates and judgments.

 

We maintain an internal control structure designed to provide reasonable assurance that assets are safeguarded against loss or unauthorized use and that financial records are adequate and can be relied upon to produce accurate and complete financial statements. This structure includes the hiring and training of qualified people, written accounting and control policies and procedures, clearly drawn lines of accountability and delegations of authority. In a business ethics policy that is continuously communicated to all employees, we have established our intent to adhere to the highest standards of ethical conduct in all of our business activities.

 

We monitor our internal control structure with direct management reviews and a comprehensive program of internal audits. In addition, PricewaterhouseCoopers LLP, our independent auditors, have audited the 2003, 2002 and 2001 Consolidated Financial Statements in accordance with auditing standards generally accepted in the United States of America and considered the internal controls over financial reporting to determine their audit procedures for the purpose of expressing an opinion on our Consolidated Financial Statements.

 

The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets regularly with the independent auditors, the internal auditors and representatives of management to review audits, financial reporting and internal control matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors and internal auditors have free access to the Audit Committee.

 

/s/    ANNE M. MULCAHY        


Anne M. Mulcahy

Chairman and Chief Executive

Officer

 

/s/    LAWRENCE A. ZIMMERMAN


Lawrence A. Zimmerman

Senior Vice President

and Chief Financial

Officer

 

/s/    GARY R. KABURECK        


Gary R. Kabureck

Vice President

and Chief Accounting

Officer

 

3


Management’s Discussion and Analysis of Results of Operations and Financial Condition

 

Throughout this document, references to “we,” “our” or “us” refer to Xerox Corporation and its subsidiaries. References to “Xerox Corporation” refer to the stand-along parent company and do not include its subsidiaries.

 

Executive Overview:

 

We are a technology and services enterprise and a leader in the global document market, developing, manufacturing, marketing, servicing and financing the industry’s broadest portfolio of document equipment, solutions and services. Our industry is undergoing a fundamental transformation from older technology light lens devices to digital systems, the transition from black and white to color, as well as an increased reliance on electronic documents. While in the near term we are experiencing certain revenue declines related to the proportion of our total revenues attributable to light lens products, we believe that, as a whole, these trends play to our strengths and represent opportunities for future growth since our research and development investments have been focused on digital and color offerings.

 

We operate in competitive markets and our customers demand improved solutions, such as the ability to print offset quality color documents on demand; improved product functionality, such as the ability to print, copy, fax and scan from a single device; and lower prices for the same functionality. We deliver advanced technology through focused investment in research and development and offset lower prices through continuous improvement of our cost base. Our revenue is heavily dependent on the amount of equipment installed at customer locations and the utilization of those devices. As such, our critical success factors include hardware installation and equipment sales growth to stabilize and grow our installed base of equipment at customer locations. In addition to our installed base, the key factors in delivering growth in our recurring revenue streams (supplies, service, paper, outsourcing and rental, which we collectively refer to as post sale revenue) are page volume growth and higher revenue per page. Connected multifunction devices and new services and solutions are key drivers to increase equipment usage. The transition to color is the primary driver to improve revenue per page, as color documents typically require significantly more toner coverage per page than traditional black and white printing. Revenue per color page is approximately five times higher than revenue per black and white page.

 

Financial Overview:

 

In 2003, we continued to build on our 2002 momentum as evidenced by product installation and equipment sales growth, earnings growth and an improvement in our overall financial condition and liquidity. In a relatively weak economic environment, we continued our transition toward revenue growth and further improved our business model. Our focused investment in the growing areas of digital production and office systems yielded 21 new products. The success of these products, combined with the 17 products introduced in 2002, enabled us to gain market share in key segments and deliver year-over-year equipment sales growth in each quarter. These improved trends, combined with favorable currency translation, helped moderate the decline in total revenue.

 

We maintained our focus on cost management throughout 2003. Gross margins remained strong as we continued to offset price investments with productivity improvements. We further reduced selling, administrative and general (SAG) expenses and continued to invest in research and development, prioritizing our investments in the faster growing areas of the market.

 

Our 2003 balance sheet strategy focused on reducing total debt, extending debt maturities, improving operating cash flows, maintaining long-term financing agreements supporting our secured borrowing strategy and maintaining a cash balance of at least $1 billion. In 2003, we significantly improved our liquidity by completing a $3.6 billion Recapitalization, which included public offerings of common stock, 3-year mandatory convertible preferred stock and 7-year and 10-year senior unsecured notes, as well as our new $1 billion 2003 Credit Facility. In 2003, we also improved our liquidity by expanding our secured borrowing programs beyond our primary $5 billion U.S. agreement with General Electric Capital Corporation to also include long-term

 

4


arrangements in Canada, the U.K. and France. Proceeds from the Recapitalization, secured borrowing programs, and $1.9 billion of cash generated from operations enabled us to reduce total debt by $3 billion in 2003, extend $1.6 billion of debt maturities and end the year with a cash balance of $2.5 billion. We continue to focus on strengthening our balance sheet to further enhance our operating and financial flexibility.

 

Revenues for the three-year period ended December 31, 2003 were as follows:

 

($ in millions)    Year Ended December 31,

   Percent Change

 
     2003

   2002

   2001

   2003

    2002

 

Equipment sales

   $ 4,250    $ 3,970    $ 4,403    7 %   (10 )%

Post sale and other revenue

     10,454      10,879      11,476    (4 )%   (5 )%

Finance income

     997      1,000      1,129    —       (11 )%
    

  

  

            

Total revenues

   $ 15,701    $ 15,849    $ 17,008    (1 )%   (7 )%
    

  

  

            

Total color revenue included in total revenues

   $ 3,267    $ 2,781    $ 2,759    17 %   1 %

 

A reconciliation of the above presentation of revenues to the revenue classifications included in our Consolidated Statements of Income is as follows:

 

($ in millions)    Year Ended December 31,

 
     2003

    2002

    2001

 

Sales

   $ 6,970     $ 6,752     $ 7,443  

Less: Supplies, paper and other sales

     (2,720 )     (2,782 )     (3,040 )
    


 


 


Equipment Sales

   $ 4,250     $ 3,970     $ 4,403  

Service, outsourcing and rentals

   $ 7,734     $ 8,097     $ 8,436  

Add: Supplies, paper and other sales

     2,720       2,782       3,040  
    


 


 


Post sale and other revenue

   $ 10,454     $ 10,879     $ 11,476  
    


 


 


 

Total 2003 revenues of $15.7 billion declined one percent from 2002, reflecting moderating year-over-year revenue declines, as well as a 5-percentage point benefit from currency. Equipment sales increased 7 percent in 2003, reflecting a 6-percentage point benefit from currency, as well as the success of our numerous color multifunction and production color products and growth in our Developing Markets Operations (DMO) segment. 2003 Post sale and other revenue declined 4 percent from 2002, primarily due to declines in older technology light lens revenues, DMO and the Small Office / Home Office (SOHO) business which we exited in the second half of 2001. These declines were partially offset by growth in our digital revenues and a 5-percentage point benefit from currency. Post sale and other revenue declines reflect the reduction in our equipment at customer locations and related page volume declines. As our equipment sales continue to increase, we expect that the effects of post-sale declines will moderate and ultimately reverse over time. 2003 Finance income, which was primarily impacted by the volume of equipment lease originations, approximated that of 2002, including a 5-percentage point benefit from currency.

 

Total 2002 revenues of $15.8 billion declined 7 percent from 2001, including a one-percentage point benefit from currency. Economic weakness and competitive pressures were only partially offset by the success of several new color and monochrome multifunction products, most of which were launched in the second half of the year. As a result, equipment sales declined 10 percent from 2001. 2002 Post sale and other revenue declined 5 percent from 2001 primarily due to declines in older technology light lens, DMO and SOHO. These declines were only partially offset by growth in our digital revenues, driven by increased usage of color products and monochrome multifunction systems. 2002 Finance income declined 11 percent from 2001, resulting from lower equipment installations and our exit from the financing business in certain European countries.

 

5


Net income (loss) and diluted earnings (loss) per share for the three years ended December 31, 2003 were as follows:

 

($ in millions, except share amounts)    Year Ended December 31,

 
     2003

    2002

    2001

 

Net income (loss)

   $ 360     $ 91     $ (94 )

Preferred stock dividends

     (71 )     (73 )     (12 )
    


 


 


Income (loss) available to common shareholders

   $ 289     $ 18     $ (106 )
    


 


 


Diluted earnings (loss) per share

   $ 0.36     $ 0.02     $ (0.15 )
    


 


 


 

2003 Net income of $360 million, or 36 cents per diluted share, included after-tax impairment and restructuring charges of $111 million ($176 million pre-tax), an after-tax charge of $146 million ($239 million pre-tax) related to the court approved settlement of the Berger v. RIGP litigation, a $45 million after-tax ($73 million pre-tax) loss on early extinguishment of debt and income tax benefits of $35 million from the reversal of deferred tax asset valuation allowances.

 

2002 Net income of $91 million, or 2 cents per diluted share, included after-tax asset impairment and restructuring charges of $471 million ($670 million pre-tax), a pre-tax and after-tax charge of $63 million for impaired goodwill and an after-tax charge of $72 million ($106 million pre-tax) for permanently impaired internal-use capitalized software, partially offset by $105 million of tax benefits arising from the favorable resolution of a foreign tax audit and tax law changes, as well as a favorable adjustment to compensation expense of $31 million ($33 million pre-tax), that was previously accrued in 2001, associated with the reinstatement of dividends for our Employee Stock Ownership Plan (“ESOP”).

 

The 2001 net loss of $94 million, or 15 cents per diluted share, included $507 million of after-tax charges ($715 million pre-tax) for restructuring and asset impairments associated with our Turnaround Program including our disengagement from our worldwide SOHO business. 2001 results also included a $304 million after-tax gain ($773 million pre-tax) from the sale of half of our interest in Fuji Xerox, a $38 million after-tax gain ($63 million pre-tax) related to the early retirement of debt, $21 million of after-tax gains ($29 million pre-tax) associated with unhedged foreign currency, partially offset by $31 million ($33 million pre-tax) of increased compensation expense associated with the suspension of dividends for our ESOP and after-tax goodwill amortization of $59 million ($63 million pre-tax).

 

Application of Critical Accounting Policies:

 

In preparing our Consolidated Financial Statements and accounting for the underlying transactions and balances, we apply accounting policies that are described in the Notes to the Consolidated Financial Statements. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management’s judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. Specific risks associated with these critical accounting policies are described in the following paragraphs. The impacts and significant risks associated with these policies on our business operations are discussed throughout this MD&A where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements.

 

Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures, included herein, with the Audit Committee of the Board of Directors. Preparation of this annual report requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities as of the date of our financial statements and the reported amounts of revenue and expenses during the reporting period. Although actual results may differ from those estimates, we believe the estimates are reasonable and appropriate. In instances where different

 

6


estimates could reasonably have been used in the current period, we have disclosed the impact on our operations of these different estimates. In certain instances, for instance with respect to revenue recognition for leases, because the accounting rules are prescriptive, it would not have been possible to have reasonably used different estimates in the current period and sensitivity information would therefore not be appropriate. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period.

 

Revenue Recognition Under Bundled Arrangements: As discussed more fully in Note 1 to the Consolidated Financial Statements, we sell most of our products and services under bundled contract arrangements, which typically include equipment, service, supplies and financing components for which the customer pays a single negotiated price for all elements. These arrangements typically also include a variable component for page volumes in excess of contractual minimums, which are often expressed in terms of price per page, which we refer to as the “cost per copy.” In a typical bundled arrangement, our customer is quoted a fixed minimum monthly payment for 1) the equipment, 2) the associated services and other executory costs, 3) the financing element and 4) frequently supplies. When separate prices are listed in multiple element customer contracts, such prices may not be representative of the fair values of those elements, because the prices of the different components of the arrangement may be modified through customer negotiations, although the aggregate consideration may remain the same. Revenues under these arrangements are allocated based upon the estimated relative fair values of each element. Our revenue allocation to the lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon. The remaining amounts are allocated to the equipment and financing elements. We perform extensive analyses of available verifiable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must be reasonably consistent with the lease selling prices, taking into account residual values that accrue to our benefit, in order for us to determine that such lease prices are indicative of fair value. Our pricing interest rates, which are used in determining customer payments, are developed based upon a variety of factors including local prevailing rates in the marketplace and the customer’s credit history, industry and credit class. Effective January 1, 2004, the pricing rates will be reassessed quarterly based on changes in local prevailing rates in the marketplace and will be adjusted to the extent such rates vary by twenty-five basis points or more, cumulatively, from the last rate in effect. The pricing interest rates generally equal the implicit rates within the leases, as corroborated by our comparisons of cash to lease selling prices.

 

Revenue Recognition for Leases: As more fully discussed in Note 1 to the Consolidated Financial Statements, our accounting for leases involves specific determinations under applicable lease accounting standards which often involve complex and prescriptive provisions. These provisions affect the timing of revenue recognition for our equipment. If the leases qualify as sales-type capital leases, equipment revenue is recognized upon delivery or installation of the equipment as sale revenue as opposed to ratably over the lease term. The critical elements that we consider with respect to our lease accounting are the determination of the economic life and the fair value of equipment, including the residual value. Those elements are based upon historical experience with all our products. For purposes of determining the economic life, we consider the most objective measure of historical experience to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is five years since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases are for original terms longer than five years and there is generally no significant after-market for our used equipment. We believe five years is representative of the period during which the equipment is expected to be economically usable, with normal service, for the purpose for which it is intended. Residual values are established at lease inception using estimates of fair value at the end of the lease term and are established with due consideration to forecasted supply and demand for our various products, product retirement and future product launch plans, end of lease customer behavior, remanufacturing strategies, used equipment markets, if any, competition and technological changes.

 

7


Accounts and Finance Receivables Allowance for Doubtful Accounts and Credit Losses: We perform ongoing credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that have been identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and financial health of specific customers. We recorded $224 million, $353 million, and $506 million in the Consolidated Statements of Income for provisions for doubtful accounts for both our accounts and finance receivables for the years ended December 31, 2003, 2002 and 2001, respectively, of which $224 million, $332 million, and $438 million were included in selling, administrative and general expenses for such years, respectively. The declining trend in our provision for doubtful accounts is primarily due to improved customer administration, collection practices and credit approval policies, as well as our revenue declines.

 

As discussed above, in preparing our Consolidated Financial Statements for the three years ended December 31, 2003, we estimated our provision for doubtful accounts based on historical experience and customer-specific collection issues. We believe this methodology is appropriate. During the five year period ended December 31, 2003, our allowance for doubtful accounts ranged from approximately 3.4 to 5.5 percent of gross receivables. Holding all other assumptions constant, a one percentage point increase or decrease in the allowance from the December 31, 2003 rate of 4.6 percent would change the 2003 provision of $224 million by approximately $115 million.

 

Historically, about half of the provision for doubtful accounts relates to our finance receivables portfolio. This provision is inherently more difficult to estimate than the provision for trade accounts receivable because the underlying lease portfolio has an average maturity, at any time, of approximately two to three years and contains past due billed amounts, as well as unbilled amounts. The estimated credit quality of any given customer and class of customer or geographic location can significantly change during the life of the portfolio. We consider all available information in our quarterly assessments of the adequacy of the provision for doubtful accounts.

 

Provisions for Excess and Obsolete Inventory Losses: We value our inventories at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equipment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvageable component parts, which are expected to be used in the remanufacturing process. We regularly review inventory quantities, including equipment to be leased to customers, which is included as part of finished goods inventory, and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand and production requirements. Several factors may influence the realizability of our inventories, including our decision to exit a product line, technological changes and new product development. These factors could result in an increase in the amount of excess or obsolete inventory quantities. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventories. Although we make every effort to ensure the accuracy of our forecasts of future product demand, including the impact of future product launches and changes in remanufacturing strategies, significant unanticipated changes in demand or technological developments could materially impact the value of our inventory and our reported operating results if our estimates prove to be inaccurate. We recorded $78 million, $115 million, and $242 million in inventory write-down charges for the years ended December 31, 2003, 2002 and 2001, respectively. The decline in inventory write-down charges is due to the absence of business exiting activities, stabilization of our product lines, manufacturing outsourcing related improvements and a lower level of inventories.

 

8


As discussed above, in preparing our financial statements for the three years ended December 31, 2003, we estimated our provision for excess and obsolete inventories based primarily on forecasts of production and service requirements. We believe this methodology is appropriate. During the three year period ended December 31, 2003, inventory reserves for net realizable value adjustments as a percentage of gross inventory varied by approximately one percentage point. Holding all other assumptions constant, a 0.5 percentage point increase or decrease in our net realizable value adjustments would change the 2003 provision of $78 million by approximately $7 million.

 

Asset Valuations and Review for Potential Impairments: Our long-lived assets, excluding goodwill, are assessed for impairment by comparison of the total amount of undiscounted cash flows expected to be generated by such assets to their carrying value. We periodically review our long-lived assets, whereby we make assumptions regarding the valuation and the changes in circumstances that would affect the carrying value of these assets. If such analysis indicates that an impairment exists, we are then required to estimate the fair value of the asset and, as appropriate, expense all or a portion of the asset, based on a comparison to the net book value of such asset or group of assets. The determination of fair value includes inherent uncertainties, such as the impact of competition on future value. Our primary methodology for determining fair value is based on a discounted cash flow model. We believe that we have made reasonable estimates and judgments in determining whether our long-lived assets have been impaired; however, if there is a material change in the assumptions used in our determination of fair values or if there is a material change in economic conditions or circumstances influencing fair value, we could be required to recognize certain impairment charges in the future. During 2002, due to our decision to abandon the use of certain software applications, we recorded an impairment charge of $106 million in Selling, administrative and general expenses in the accompanying Consolidated Statement of Income. In addition, we recorded asset impairment charges in connection with our restructuring actions of $1 million, $55 million, and $205 million in 2003, 2002, and 2001, respectively.

 

Goodwill and Other Acquired Intangible Assets: We have made acquisitions in the past that included the recognition of a significant amount of goodwill and other intangible assets. Commencing January 1, 2002, goodwill is no longer amortized, but instead is assessed for impairment annually or more frequently as triggering events occur that indicate a decline in fair value below that of its carrying value. In making these assessments, we rely on a number of factors including operating results, business plans, economic projections, anticipated future cash flows and market comparable data. There are inherent uncertainties related to these factors and our judgment, including the risk that the carrying value of our goodwill may be overstated or understated. In 2002, we recognized an impairment charge of $63 million related to the goodwill in our DMO segment, which was recorded as a cumulative effect of a change in accounting principle in the accompanying Consolidated Statements of Income.

 

Pension and Post-retirement Benefit Plan Assumptions: We sponsor pension plans in various forms in several countries covering substantially all employees who meet eligibility requirements. Post-retirement benefit plans cover primarily U.S. employees for retirement medical costs. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and post-retirement benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases and mortality, among others. For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, as opposed to a fair market value approach. The primary difference between the two methods relates to a systematic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is then applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that results from using the fair market value approach. The difference between the actual return on plan assets and the expected return on plan assets is added to, or subtracted from, any cumulative differences that arose in prior years. This amount is a component of the unrecognized net actuarial (gain) loss and is subject to amortization to net periodic pension cost over the average remaining service lives of the employees participating in the pension plan.

 

9


As a result of cumulative asset returns being lower than expected asset returns over the last several years and declining interest rates, 2004 net periodic pension cost will increase. The total unrecognized actuarial loss as of December 31, 2003 was $1.87 billion, as compared to $1.84 billion at December 31, 2002. The change from December 31, 2002 relates to a decline in the discount rate, offset by improved asset returns as compared to expected returns. The total unrecognized actuarial loss will be amortized in the future, subject to offsetting gains or losses that will change the future amortization amount. We have recently utilized a weighted average expected rate of return on plan assets of 8.3 percent for 2003 expense, 8.8 percent for 2002 expense and 8.9 percent for 2001 expense, on a worldwide basis. In estimating this rate, we considered the historical returns earned by the plan assets, the rates of return expected in the future and our investment strategy and asset mix with respect to the plans’ funds. The weighted average rate we will utilize to calculate our 2004 expense will be 8.1 percent. Another significant assumption affecting our pension and post-retirement benefit obligations and the net periodic pension and other post-retirement benefit cost is the rate that we use to discount our future anticipated benefit obligations. In estimating this rate, we consider rates of return on high quality fixed-income investments over the period to expected payment of the pension and other benefits. The weighted average rate we will utilize to measure our pension obligation as of December 31, 2003 and calculate our 2004 expense will be 5.8 percent, which is a decrease from 6.2 percent used in the determination of our pension obligations in 2003. As a result of the reduction in the discount rate, the lower cumulative actual return on plan assets during the prior three years and certain other factors, our 2004 net periodic pension cost is expected to be $65 million higher than 2003.

 

On a consolidated basis, we recognized net periodic pension cost of $364 million, $168 million, and $99 million for the years ended December 31, 2003, 2002 and 2001, respectively. Pension cost is included in several income statement components based on the related underlying employee costs. Pension and post-retirement benefit plan assumptions are included in Note 12 to the Consolidated Financial Statements. Holding all other assumptions constant, a 0.25 percent increase or decrease in the discount rate from the 2004 projected rate of 5.8 percent would change the 2004 projected net periodic pension cost by approximately $23 million. Likewise, a 0.25 percent increase or decrease in the expected return on plan assets from the 2004 projected rate of 8.1 percent would change the 2004 projected net periodic pension cost by approximately $9 million.

 

Income Taxes and Tax Valuation Allowances: We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We follow very specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded in our Consolidated Balance Sheets and provide necessary valuation allowances as required. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. If we continue to operate at a loss in certain jurisdictions or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a significant portion of our deferred tax assets resulting in a substantial increase in our effective tax rate and a material adverse impact on our operating results. Conversely, if and when our operations in some jurisdictions were to become sufficiently profitable to recover previously reserved deferred tax assets, we would reduce all or a portion of the applicable valuation allowance in the period when such determination is made. This would result in an increase to reported earnings in such period. Adjustments to our valuation allowance, through charges (credits) to expense, were $(16) million, $15 million, and $247 million for the years ended December 31, 2003, 2002 and 2001, respectively.

 

We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we incur additional 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.

 

10


Legal Contingencies: We are a defendant in numerous litigation and regulatory matters including those involving securities law, patent law, environmental law, employment law and ERISA, as discussed in Note 15 to the Consolidated Financial Statements. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of 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. In 2003, we recorded a charge of $239 million reflecting the court approved settlement of the Berger pension related litigation.

 

Summary of Results:

 

Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Office, DMO and Other. Our offerings include hardware, services, solutions and consumable supplies. The Production segment includes black and white products which operate at speeds over 90 pages per minute and color products over 40 pages per minute. Products include the DocuTech, DocuPrint, Xerox 1010 and Xerox 2101 and DocuColor families, as well as older technology light-lens products. The Office segment includes black and white products which operate at speeds up to 90 pages per minute and color devices which operate at speeds up to 40 pages per minute. Products include our family of Document Centre digital multifunction products which were expanded to include our new suite of CopyCentre, WorkCentre, and WorkCentre Pro digital multifunction systems, DocuColor multifunction products, color laser, solid ink and monochrome laser desktop printers, digital and light-lens copiers and facsimile products. The DMO segment includes our operations in Latin America, the Middle East, India, Eurasia, Russia and Africa. This segment includes sales of products that are typical to the Production and Office 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 includes Xerox Supplies Group (predominantly paper), SOHO, Xerox Engineering Systems (“XES”), Xerox Technology Enterprises and consulting services, royalty and license revenues. Other segment profit (loss) includes the operating results from these entities, other less significant businesses, our equity income from Fuji Xerox, and certain costs which have not been allocated to the Production, Office and DMO segments including non-financing interest and other corporate costs.

 

11


Revenues:

 

Revenues by segment for the years ended 2003, 2002 and 2001 were as follows:

 

(in millions)


   Production

   Office

   DMO

   Other

    Total

2003

                                   

Equipment sales

   $ 1,201    $ 2,452    $ 425    $ 172     $ 4,250

Post sale and other revenue

     2,970      4,656      1,182      1,646       10,454

Finance income

     376      595      9      17       997
    

  

  

  


 

Total Revenue

   $ 4,547    $ 7,703    $ 1,616    $ 1,835     $ 15,701
    

  

  

  


 

2002

                                   

Equipment sales

   $ 1,100    $ 2,336    $ 334    $ 200     $ 3,970

Post sale and other revenue

     3,028      4,604      1,408      1,839       10,879

Finance income

     394      601      16      (11 )     1,000
    

  

  

  


 

Total Revenue

   $ 4,522    $ 7,541    $ 1,758    $ 2,028     $ 15,849
    

  

  

  


 

2001

                                   

Equipment sales

   $ 1,196    $ 2,458    $ 321    $ 428     $ 4,403

Post sale and other revenue

     3,092      4,898      1,679      1,807       11,476

Finance income

     439      661      26      3       1,129
    

  

  

  


 

Total Revenue

   $ 4,727    $ 8,017    $ 2,026    $ 2,238     $ 17,008
    

  

  

  


 

 

Equipment Sales:

 

2003 Equipment sales of $4.3 billion increased 7 percent from 2002, reflecting significant growth in DMO, the success of numerous new product introductions and a 6-percentage point benefit from currency. In 2003, approximately 50 percent of equipment sales were generated from products launched in the previous two years. Color equipment sales represented 28 percent of total equipment sales compared with 24 percent in 2002. 2002 equipment sales of $4.0 billion declined 10 percent from 2001, including a one percentage point benefit from currency, as continued economic weakness and competitive pressures more than offset the successful impact of new products, most of which were launched in the second half of 2002.

 

Production: 2003 equipment sales grew 9 percent from 2002, as improved product mix, installation growth and favorable currency of 7 percent more than offset price declines of approximately 5 percent. Strong 2003 production color equipment sales growth reflected increased installations and stronger product mix driven by the DocuColor 6060 and DocuColor iGen3 products. The DocuColor iGen3 utilizes next generation color technology which we expect will expand the digital color print on demand market. 2003 production monochrome equipment sales grew modestly as light-production installations, driven by the success of the new Xerox 2101 copier/printer, and favorable currency more than offset declines in production publishing, printing and older technology light lens. 2002 equipment sales declined 8 percent from 2001 reflecting price declines of approximately 5 percent, weaker product mix and installation declines driven largely by older technology light lens equipment.

 

Office: 2003 equipment sales grew 5 percent from 2002, as favorable currency of 7 percent and installation increases more than offset price declines of approximately 10 percent and the impact of weaker product mix. Equipment installation growth of approximately 20 percent reflects growth in all monochrome digital and color businesses, particularly office color printing and our line of monochrome multifunction/copier systems. The CopyCentre, WorkCentre and WorkCentre Pro systems, which were launched in the second quarter 2003, are intended to expand our market reach and include new entry-level configurations at more competitive prices. 2002 equipment sales declined 5 percent from 2001, with approximately two-thirds of the decline driven by older technology light lens products. The remainder of the decline was due to price declines of approximately 10 percent and weaker product mix, which more than offset installation growth in our digital products.

 

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DMO: 2003 equipment sales grew 27 percent from 2002, reflecting volume growth of over 40 percent, partially offset by price declines of approximately 10 percent and unfavorable mix.

 

Other: 2003 equipment sales declined 14 percent from 2002 due to general sales declines, none of which were individually significant. 2002 equipment sales declined 53 percent from 2001, primarily reflecting our exit from the SOHO business in 2001.

 

Post Sale and Other Revenue:

 

2003 post sale and other revenues of $10.5 billion declined 4 percent from 2002, including a 5-percentage point benefit from currency. These declines reflect lower equipment populations, as post sale revenue is largely a function of the equipment placed at customer locations and the volume of prints and copies that our customers make on that equipment as well as associated services. 2003 supplies, paper and other sales of $2.7 billion (included within post sale and other revenue) declined 2 percent from 2002 primarily due to declines in supplies. Supplies sales declined due to reduced usage in the lower installed base of equipment and our exit from the SOHO business in 2001. 2003 service, outsourcing and rental revenue of $7.7 billion declined 4 percent from 2002, reflecting declines in rental and facilities management revenues. Declines in rental revenues primarily reflect reduced equipment populations within DMO and declines in facilities management revenues reflect consolidations by our customers as well as our prioritization of profitable contracts. 2002 post sale and other revenues of $10.9 billion declined 5 percent from 2001. 2002 supplies, paper and other sales of $2.8 billion declined 8 percent from 2001, primarily reflecting declines in supplies. 2002 service, outsourcing and rental revenue of $8.1 billion declined 4 percent from 2001 driven primarily by lower rental revenues in DMO.

 

Production: 2003 post sale and other revenue declined 2 percent from 2002, as favorable currency and improved mix, driven largely by an increased volume of color pages, were more than offset by the impact of monochrome page volume declines, primarily in older technology light lens products. 2002 post sale and other revenue declined 2 percent from 2001, as declines in monochrome page volumes more than offset the impact of improved mix due to significant growth in color page volumes.

 

Office: 2003 post sale and other revenue grew 1 percent from 2002, as favorable currency and strong digital page growth more than offset declines in older technology light lens products. 2002 post sale and other revenue declined 6 percent from 2001, as declines in older technology light lens products more than offset strong digital page growth.

 

DMO: 2003 post sale and other revenue declined 16 percent from 2002, due largely to a lower rental equipment population at customer locations and related page volume declines. 2002 post sale and other revenue declined 16 percent from 2001, due to a reduction in the amount of equipment installations at certain DMO customer locations as a result of reduced placements in prior periods.

 

Other: 2003 post sale and other revenue declined 10 percent from 2002, reflecting supply sale declines in SOHO of $82 million as well as the absence of $50 million of third-party licensing revenue recognized in 2002. See Note 3 to the Consolidated Financial Statements for further discussion.

 

We expect 2004 equipment sales will continue to grow, as we anticipate that new products launched in 2002, 2003 and those planned in 2004 will enable us to further strengthen our market position. Our ability to increase post sale revenue is dependent on our success at increasing the amount of our equipment at customer locations and the volume of pages generated on that equipment. In 2004, we expect post sale and other revenue declines will continue to moderate as equipment sales increase and our services and solutions increase utilization of the equipment. Accordingly, we expect 2004 total revenues to be in line with 2003 levels.

 

13


Segment Operating Profit:

 

Segment operating profit and operating margin for each of the three years ended December 31, 2003 were as follows ($ in millions):

 

     Production

    Office

    DMO

    Other

    Total

 

2003

                                        

Operating Profit

   $ 422     $ 753     $ 151     $ (411 )   $ 915  

Operating Margin

     9.3 %     9.8 %     9.3 %     (22.4 %)     5.8 %

2002

                                        

Operating Profit

   $ 450     $ 621     $ 91     $ (329 )   $ 833  

Operating Margin

     10.0 %     8.2 %     5.2 %     (16.2 %)     5.3 %

2001

                                        

Operating Profit

   $ 372     $ 427     $ (97 )   $ (398 )   $ 304  

Operating Margin

     7.9 %     5.3 %     (4.8 %)     (17.8 %)     1.8 %

 

Production: 2003 operating profit declined $28 million from 2002, reflecting lower gross margins related to initial installations of DocuColor iGen3 and Xerox 2101. The decrease in gross margins was only partially offset by lower R&D and SAG expenses. 2002 operating profit improved $78 million from 2001, reflecting gross margin improvements and lower SAG expense, including reduced bad debt levels.

 

Office: 2003 operating profit improved $132 million from 2002, reflecting improved gross margins driven primarily by improved manufacturing and service productivity, as well as lower R&D and SAG expenses. 2002 operating profit improved by $194 million from 2001 as we focused on more profitable revenue, improved our manufacturing and service productivity and reduced SAG expenses.

 

DMO: 2003 operating profit improved $60 million from 2002 due to significantly lower SAG spending resulting from our cost saving initiatives, lower bad debts and gains on currency exposures compared to currency exposure losses in 2002. These improvements were partially offset by lower gross margins as a result of declining post sale revenue. 2002 operating profit improved by $188 million from the 2001 operating loss due to reduced SAG spending resulting from our cost base restructuring actions and lower bad debt levels, as well as significant gross margin improvement driven by our focus on profitability. DMO refined its business model in 2002 by transitioning equipment financing to third parties, improving credit policies and implementing additional cost reduction actions.

 

Other: 2003 Other segment operating loss of $411 million increased by $82 million from 2002, principally due to the loss on early extinguishment of debt of $73 million and lower SOHO profit of $39 million as our supplies sales declined following our exit from this business. In addition, 2002 included benefits of $33 million related to the ESOP expense adjustment and $50 million of profit related to a licensing agreement. These amounts were partially offset by the write-off of internal use software of $106 million in 2002.

 

2002 Other segment loss of $329 million decreased by $69 million from 2001, principally due to our exit from SOHO in the second half of 2001, which improved results by $272 million on a year over year basis. Operating results were also favorably impacted by lower non-financing interest expense of $49 million, the $33 million beneficial year over year impact of the ESOP expense adjustment and the $50 million profit from the licensing agreement. These amounts were offset by several items, including the write-off of internal use software of $106 million, higher pension and benefit expense of $93 million and higher advertising expenses of $62 million.

 

Employee Stock Ownership Plan (ESOP): In 2002, our Board of Directors reinstated the dividend on our ESOP, which resulted in a reversal of previously recorded compensation expense. The reversal of compensation expense corresponded to the line item in the Consolidated Statement of Income for 2002 where the charge was

 

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originally recorded and included $28 million in both Cost of Sales and Selling, administrative and general expenses and $11 million in Research and Development expenses. Of the total compensation expense originally recorded, $34 million and $33 million was recognized in 2002 and 2001, respectively. As such, 2002 benefited by the reversal of $33 million of excess compensation expense that was originally recorded in 2001. There is no corresponding earnings per share improvement in 2002 since the EPS calculation requires deduction of dividends declared from reported net income in arriving at net income available to common shareholders. See Note 12 to the Consolidated Financial Statements for a more complete discussion of the ESOP, including current funding status.

 

Gross Margin: Gross margins by revenue classification were as follows:

 

     Year Ended
December 31,


 
     2003

    2002

    2001

 

Total gross margin

   42.0 %   42.4 %   38.2 %

Sales

   36.4 %   37.3 %   30.5 %

Service, outsourcing and rentals

   44.3 %   44.5 %   42.2 %

Finance income

   63.7 %   59.9 %   59.5 %

 

The 2003 gross margin of 42.0 percent remained strong and in line with our expectations, despite declining 0.4 percentage points from 2002. During 2003 we completed the R&D phase of the DocuColor iGen3 development and, therefore, beginning in July 2003 ongoing engineering costs associated with initial commercial production are included in cost of sales. DocuColor iGen3 ongoing engineering costs of $30 million, the absence of the $28 million prior year favorable ESOP adjustment and the absence of $50 million in prior year licensing revenue each contributed 0.2 percentage points to the 2003 gross margin decline. During 2003, manufacturing and service productivity improvements more than offset the impact of lower prices, higher pension and other employee benefit costs and product mix.

 

2003 sales gross margin declined 0.9 percentage points from 2002, with over half of the decline due to DocuColor iGen3 ongoing engineering costs and the remainder due to product mix as we increased our penetration of the digital light production market. In 2003, manufacturing productivity more than offset the impact of planned lower prices. 2003 service, outsourcing and rentals margin declined 0.2 percentage points from 2002. Improved productivity and product mix more than offset lower prices and higher pension and other employee expenses. 2002 also included a 0.4 percentage point benefit from a $50 million licensing agreement and a 0.3 percentage point benefit due to favorable ESOP adjustments.

 

The 2002 gross margin of 42.4 percent improved 4.2 percentage points from 2001. 1.4 percentage points of the increase reflects our second half 2001 SOHO exit. Improved manufacturing and service productivity, which more than offsetlower prices, accounted for approximately one percentage point of improvement and higher margins in our DMO operating segment accounted for approximately 0.5 percentage points of the improvement. The balance of the increase includes the favorable ESOP compensation expense adjustment, favorable transaction currency, lower inventory charges associated with restructuring actions and improved document outsourcing margins associated with our focus on profitable revenue.

 

2002 Sales gross margin improved 6.8 percentage points from 2001. Approximately 2.6 percentage points of the improvement was due to our SOHO exit, approximately 1.3 percentage points was due to increases in DMO, 0.6 percentage points was due to lower inventory charges associated with restructuring actions and the balance was largely due to manufacturing productivity, which more than offset competitive price pressures. 2002 Service, outsourcing and rentals margins improved by 2.3 percentage points from 2001 reflecting the benefits of expense productivity actions and more profitable document outsourcing contracts.

 

2003 Finance income gross margins increased 3.8 percentage points from 2002 and similarly by 0.4 percentage points from 2001, in line with declining interest costs specific to equipment financing. Equipment

 

15


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

 

Research and Development: 2003 R&D spending of $868 million was $49 million lower than 2002, primarily due to a $30 million reduction associated with the commercial launch of the DocuColor iGen3 and improved R&D productivity, partially offset by higher pension and other employee benefit expenses. We expect 2004 R&D expense to range from 5-6 percent of total revenues. We continue to invest in technological development, particularly in color, and believe that our R&D spending is at an adequate level to remain technologically competitive. Our R&D is strategically coordinated with that of Fuji Xerox, which invested $724 million in R&D in 2003. To maximize the synergies of our relationship, our R&D expenditures are focused on the Production segment while Fuji Xerox R&D expenditures are focused on the Office segment. 2002 research and development spending of $917 million was $80 million lower than 2001. Approximately 40 percent of the decline was due to our SOHO exit, another 40 percent of the decline reflects both benefits from cost restructuring actions and the receipt of external funding and the balance reflects the previously discussed favorable ESOP compensation expense adjustment.

 

Selling, Administrative and General Expenses: SAG expense information was as follows ($ in millions):

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Total Selling, administrative and general expenses

   $ 4,249     $ 4,437     $ 4,728  

SAG as a percentage of revenue

     27.1 %     28.0 %     27.8 %

 

2003 SAG expense of $4.2 billion declined $188 million from 2002 including adverse currency impacts of $172 million and $70 million of higher pension and other employee benefit costs. 2003 SAG reductions reflect improved productivity and employment reductions associated with our cost base restructuring, lower bad debt expenses of $109 million and the absence of 2002 expenses discussed below.

 

2002 SAG expense of $4.4 billion declined $291 million from 2001. The reduction includes lower bad debt expenses of $106 million, lower SOHO spending of $84 million and a $34 million favorable property tax adjustment in North America. These decreases were partially offset by $106 million of internal-use software impairment charges, $65 million of higher advertising and marketing communications spending, $18 million of increased professional fees and $26 million of losses associated with the exit from certain leased facilities. The balance of the reduction primarily reflects employment reductions associated with our cost base restructuring actions.

 

Bad debt expense included in SAG was $224 million, $332 million and $438 million in 2003, 2002 and 2001, respectively. The 2003 reduction reflects improved collections performance, receivables aging and write-off trends. Lower expense in 2002 is due to improved customer administration, collection practices and credit approval policies, as well as our revenue declines. Bad debt expense as a percent of total revenue was 1.4 percent, 2.1 percent and 2.6 percent for 2003, 2002 and 2001, respectively.

 

Restructuring Programs: For the three years ended December 31, 2003, we have engaged in a series of restructuring programs, resulting in approximately $1.6 billion in charges related to downsizing our employee base, exiting certain businesses, outsourcing some internal functions and engaging in other actions designed to reduce our cost structure. In 2003, we recorded restructuring and asset impairment charges of $176 million, primarily consisting of new severance actions and pension settlements related to previous employee restructuring actions. We expect prospective annual savings associated with 2003 actions to be approximately $170 million, as compared to 2003 levels. Restructuring and asset impairment charges of $670 million and $715 million in 2002 and 2001, respectively, primarily relate to severance and employee benefits related to worldwide terminations as

 

16


well as certain costs related to the consolidation of excess facilities. The remaining restructuring reserve balance at December 31, 2003 for all programs was $221 million. Charges related to previous employee restructuring actions of approximately $20 million are expected to be recorded in 2004, primarily related to pension settlements.

 

Worldwide employment declined by approximately 6,700 in 2003, to approximately 61,100, primarily reflecting reductions as part of our restructuring programs. Worldwide employment was approximately 67,800 and 78,900 at December 31, 2002 and 2001, respectively.

 

Gain on Affiliate’s Sale of Stock: In 2003, we recorded cumulative gains on an affiliate’s sale of stock of $13 million reflecting our proportionate share of the increase in equity of ScanSoft Inc., an equity investment. The gain resulted from ScanSoft’s issuance of stock in connection with its acquisition of Speechworks, Inc. ScanSoft is a developer of digital imaging software that enables users to leverage the power of their scanners, digital cameras and other electronic devices. In 2001, the gain on affiliate’s sale of stock of $4 million reflected our proportionate share of the increase in equity of ScanSoft Inc., resulting from issuance of their stock in connection with an acquisition.

 

Provision for Litigation: In 2003, we recorded a $239 million provision for litigation relating to the court approved settlement of the Berger v. Retirement Income Guarantee Plan (RIGP) litigation which is discussed in more detail in Note 15 to the Consolidated Financial Statements.

 

Other Expenses, Net: Other expenses, net for the three years ended December 31, 2003 consisted of the following ($ in millions):

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Non-financing interest expense

   $ 522     $ 495     $ 544  

Interest income

     (65 )     (77 )     (101 )

Net currency losses (gains)

     11       77       (29 )

Legal and regulatory matters

     3       37       —    

Amortization of goodwill (2001 only) and intangible assets

     36       36       94  

Loss (gain) on early extinguishment of debt

     73       (1 )     (63 )

Business divestiture and asset sale losses (gains)

     13       (1 )     10  

Minorities’ interests in earnings of subsidiaries

     6       3       2  

All other, net

     38       24       53  
    


 


 


     $ 637     $ 593     $ 510  
    


 


 


 

Non-financing interest expense: 2003 non-financing interest expense was $27 million higher than 2002, primarily reflecting 2003 net losses of $13 million from the mark-to-market valuation of our interest rate swaps compared to gains of $12 million in 2002. Due to the inherent volatility in the interest rate markets, we are unable to predict the amount of the above noted mark-to-market gains or losses in future periods. 2003 non-financing interest expense included higher interest rates and borrowing costs in the first half of the year associated with the terms of the 2002 Credit Facility. These increased expenses were offset by lower borrowing costs in the second half of 2003 following the June 2003 Recapitalization.

 

2002 non-financing interest expense was $49 million lower than 2001 reflecting lower debt levels throughout 2002 and lower borrowing costs in the first half of the year, partially offset by higher interest rates and borrowing costs in the second half of the year associated with the terms of the 2002 Credit Facility. Lower borrowing costs reflected the continued decline in interest rates throughout 2002, coupled with our higher proportion of variable rate debt in 2002 as compared to 2001. Our 2002 credit ratings were below investment grade and effectively constrained our ability to fully use derivative contracts to manage interest rate risk.

 

17


Accordingly, although we benefited from lower interest rates in 2002, we had greater exposure to volatility in our results of operations. 2002 non-financing interest expense included net gains of $12 million from the mark-to-market valuation of our interest rate swaps.

 

Interest income: Interest income is derived primarily from our invested cash balances and interest resulting from periodic tax settlements. 2003 interest income was $12 million lower than 2002 reflecting declining interest rates and lower average cash balances, partially offset by $13 million of interest income related to Brazilian tax credits that became realizable in 2003. 2002 interest income was lower than 2001 due to lower invested cash balances in the second half of 2002, resulting from the payment of significant outstanding debt as well as lower interest rates.

 

Net currency losses (gains): Net currency losses (gains) result from the re-measurement of unhedged foreign currency-denominated assets and liabilities, the spot/forward premiums on foreign exchange forward contracts in those markets where we have been able to restore economic hedging capability and economic hedges of anticipated transactions for which we do not qualify for cash flow hedge accounting treatment under SFAS No. 133. Beginning with the second half 2002 and throughout 2003, we restored currency hedging capabilities, subject to limited exceptions in certain closed markets. This should limit remeasurement gains or losses in future periods. In 2003, exchange losses of $11 million were due largely to spot/forward premiums on foreign exchange forward contracts and unfavorable currency movements on economic hedges of anticipated transactions not qualifying for hedge accounting treatment.

 

In the first half of 2002, we incurred $57 million of exchange losses, primarily in Brazil and Argentina due to the devaluation of the underlying currencies. In the latter half of 2002, we were able to restore hedging capability in the majority of our key markets. Therefore, the $20 million of currency losses in the second half of 2002 primarily represented the spot/forward premiums on foreign exchange forward contracts and unfavorable currency movements on economic hedges of anticipated transactions not qualifying for hedge accounting treatment. In 2001, exchange gains on yen debt of $107 million more than offset losses on Euro loans of $36 million, a $17 million exchange loss resulting from the peso devaluation in Argentina and other currency exchange losses of $25 million. The 2001 currency gains were the result of net unhedged positions largely caused by our restricted access to the derivatives markets beginning in the fourth quarter 2000.

 

Legal and regulatory matters: Legal and regulatory matters for 2002 includes $27 million of expenses related to certain litigation, indemnifications and associated claims, as well as the $10 million penalty incurred in connection with our settlement with the SEC. See Note 15 to the Consolidated Financial Statements for additional information.

 

Amortization of goodwill and intangible assets: Prior to 2002, goodwill and other intangible asset amortization related primarily to our acquisitions of the remaining minority interest in Xerox Limited in 1995 and 1997, XL Connect in 1998 and the Color Printing and Imaging Division of Tektronix, Inc. in 2000. Effective January 1, 2002 and in connection with the adoption of SFAS No. 142, we no longer record amortization of goodwill. Intangible assets continue to be amortized over their useful lives. Further discussion is provided in Note 1 to the Consolidated Financial Statements.

 

Loss (gain) on early extinguishment of debt: In 2003, we recorded a $73 million loss on early extinguishment of debt reflecting the write-off of the remaining unamortized fees associated with the 2002 Credit Facility. The 2002 Credit Facility was repaid upon completion of the June 2003 Recapitalization. In 2002, we retired $52 million of long-term debt through the exchange of 6.4 million shares of common stock valued at $51 million. In 2001, we retired $374 million of long-term debt through the exchange of 41 million shares of common stock valued at $311 million. These transactions resulted in gains of $1 million and $63 million in 2002 and 2001, respectively.

 

Business divestiture and asset sale losses (gains): Business divestitures and asset sales in all years included miscellaneous land, buildings and equipment sales. In addition, the 2003 amount primarily included losses

 

18


related to the sale of XES subsidiaries in France and Germany, which was partially offset by a gain on the sale of our investment in Xerox South Africa. The 2002 amount included the sales of our leasing business in Italy, our investment in Prudential Insurance company common stock and our equity investment in Katun Corporation. The 2001 amount included the sale of our Nordic leasing business. Further discussion is included in Note 3 to the Consolidated Financial Statements.

 

Income Taxes: The following table summarizes our consolidated income taxes and the related effective tax rate for each respective period ($ in millions):

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Pre-tax income

   $ 436     $ 104     $ 328  

Income taxes

     134       4       473  

Effective tax rate (1)

     30.7 %     3.8 %     144.2 %

(1) A detailed reconciliation of the consolidated effective tax rate to the U.S. federal statutory income tax rate is included in Note 13.

 

The difference between the 2003 consolidated effective tax rate of 30.7 percent and the U.S. federal statutory income tax rate of 35 percent relates primarily to $35 million of tax benefits arising from the reversal of valuation allowances on deferred tax assets following a re-evaluation of their future realization due to improved financial performance, other foreign adjustments, including earnings taxed at different rates, the impact of Series B Convertible Preferred Stock dividends and state tax benefits. Such benefits were partially offset by tax expense for audit and other tax return adjustments, as well as $19 million of unrecognized tax benefits primarily related to recurring losses in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances.

 

The difference between the 2002 consolidated effective tax rate of 3.8 percent and the U.S. federal statutory income tax rate of 35 percent relates primarily to the recognition of tax benefits resulting from the favorable resolution of a foreign tax audit of approximately $79 million, tax law changes of approximately $26 million and the impact of Series B Convertible Preferred Stock dividends. Such benefits were offset, in part, by tax expense recorded for the on-going examination in India, the sale of our interest in Katun Corporation, as well as recurring losses in certain jurisdictions where we are not providing tax benefits and continue to maintain deferred tax asset valuation allowances.

 

The difference between the 2001 consolidated effective tax rate of 144.2 percent and the U.S. federal statutory income tax rate of 35 percent relates primarily to the recognition of deferred tax asset valuation allowances of $247 million from our recoverability assessments, the taxes incurred in connection with the sale of our partial interest in Fuji Xerox and recurring losses in low tax jurisdictions. The gain for tax purposes on the sale of Fuji Xerox was disproportionate to the gain for book purposes as a result of a lower tax basis in the investment. Other items favorably impacting the tax rate included a tax audit resolution of approximately $140 million and additional tax benefits arising from prior period restructuring provisions.

 

Our consolidated effective income tax rate will change based on discrete events (such as audit settlements) as well as other factors including the geographical mix of income before taxes and the related tax rates in those jurisdictions. We anticipate that our 2004 annual consolidated effective tax rate will approximate 40 percent.

 

Equity in Net Income of Unconsolidated Affiliates: Equity in net income of unconsolidated affiliates is principally related to our 25 percent share of Fuji Xerox income. Our 2003 equity in net income of $58 million was comparable with 2002 and 2001 results of $54 million and $53 million, respectively.

 

Recent Accounting Pronouncements: See Note 1 of the Consolidated Financial Statements for a full description of recent accounting pronouncements including the respective dates of adoption and effects on results of operations and financial condition.

 

19


Capital Resources and Liquidity:

 

Cash Flow Analysis: The following summarizes our cash flows for the each of the three years ended December 31, 2003, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements ($ in millions):

 

     2003

    2002

    2001

 

Net cash provided by operating activities

   $ 1,879     $ 1,980     $ 1,754  

Net cash provided by investing activities

     49       93       685  

Net cash used in financing activities

     (2,470 )     (3,292 )     (189 )

Effect of exchange rate changes on cash

     132       116       (10 )
    


 


 


(Decrease) increase in cash and cash equivalents

     (410 )     (1,103 )     2,240  

Cash and cash equivalents at beginning of year

     2,887       3,990       1,750  
    


 


 


Cash and cash equivalents at end of year

   $ 2,477     $ 2,887     $ 3,990  
    


 


 


 

Operating: For the year ended December 31, 2003, operating cash flows of $1.9 billion reflect pre-tax income of $436 million and the following non-cash items: depreciation and amortization of $748 million, provisions for receivables and inventory of $302 million, the provision for the Berger litigation of $239 million and a loss on early extinguishment of debt of $73 million. In addition, operating cash flows were enhanced by finance receivable reductions of $496 million, cash generated from the early termination of interest rate swaps of $136 million, accounts receivable reductions of $164 million, driven by improved collection efforts and other working capital improvements of over $600 million. The Finance receivable reduction results from collections of finance receivables associated with prior year sales that exceed receivables generated from recent equipment sales. This trend is expected to moderate as our equipment sales continue to increase. These cash flows were partially offset by pension plan contributions of $672 million related to our decision to accelerate and increase the 2003 funding level of our U.S. plans and increase the 2003 funding level of our U.K. plans, restructuring related cash payments of $345 million, income tax payments of $207 million and $166 million of cash outflow supporting our on-lease equipment investment.

 

The $101 million decline in operating cash flow versus 2002 primarily reflects increased pension plan contributions of $534 million, lower finance receivable reductions of $258 million reflecting the increase in equipment sale revenue in 2003, and increased on-lease equipment investment of $39 million. These items were partially offset by increased pre-tax income of $332 million, lower tax payments of $235 million and increased cash proceeds from the early termination of interest rate swaps of $80 million. The lower tax payments reflect the absence of the $346 million tax payment associated with the 2001 sale of a portion of our ownership interest in Fuji Xerox.

 

For the year ended December 31, 2002, operating cash flows of $2.0 billion reflect pre-tax income of $104 million and the following non-cash items: depreciation and amortization of $1,035 million, provisions for receivables and inventory of $468 million and impairment of goodwill of $63 million. Cash flows were also enhanced by finance receivable reductions of $754 million due to collection of receivables from prior year’s sales without an offsetting receivables increase due to lower equipment sales in 2002, together with a transition to third-party vendor financing arrangements in the Nordic countries, Italy, Brazil and Mexico. In addition, a restructuring charge of $670 million was recorded during the period. These items were partially offset by $442 million of tax payments, including $346 million related to the 2001 sale of half of our interest in Fuji Xerox, $392 million of restructuring payments, $127 million of on-lease equipment expenditures and a $138 million cash contribution to our pension plans.

 

The $226 million improvement in operating cash flow as compared to 2001 reflects increased finance receivable collections of $666 million, an improvement in cash flows from the early termination of derivative contracts of $204 million, lower on-lease equipment spending of $144 million and lower restructuring payments

 

20


of $92 million. The decline in 2002 on-lease equipment spending reflected declining rental placement activity and populations, particularly in our older-generation light-lens products. These items were partially offset by higher cash taxes of $385 million, higher pension contributions of $96 million and increased working capital uses of over $400 million, much of which was caused by the termination of an accounts receivable sales facility. In addition, cash flow generated by reducing inventory during 2002 occurred at a much slower rate than in 2001 as inventory reductions were offset by increased requirements for new product launches.

 

We expect operating cash flows to approximate $1.5 billion in 2004, as compared to $1.9 billion in 2003. The reduction contemplates finance receivables growth as a result of continued expected equipment sales expansion as well as the absence of early derivative contract termination cash flow, partially offset by reduced restructuring payments and lower pension contributions.

 

Investing: Investing cash flows for the year ended December 31, 2003 consisted primarily of $235 million released from restricted cash related to former reinsurance obligations associated with our discontinued operations, $35 million of aggregate cash proceeds from the divestiture of our investment in Xerox South Africa, XES France and Germany and other minor investments, partially offset by capital and internal use software spending of $250 million. We expect 2004 capital expenditures to approximate $250 million.

 

Investing cash flows for the year ended December 31, 2002 consisted primarily of proceeds of $200 million from the sale of our Italian leasing business, $53 million related to the sale of certain manufacturing locations to Flextronics, $67 million related to the sale of our interest in Katun and $19 million from the sale of our investment in Prudential common stock. These inflows were partially offset by capital and internal use software spending of $196 million and increased requirements of $63 million for restricted cash supporting our vendor financing activities.

 

Investing cash flows in 2001 largely consisted of the $1,768 million of cash received from sales of businesses, including one half of our interest in Fuji Xerox, our leasing businesses in the Nordic countries and certain manufacturing assets to Flextronics. These cash proceeds were offset by capital and internal use software spending of $343 million, a $255 million payment related to our funding of trusts to replace letters of credit within our insurance discontinued operations, $115 million of payments for the funding of escrow requirements related to lease contracts transferred to GE, $229 million of payments for the funding of escrow requirements related to pre-funded interest payments required to support our liabilities to trusts issuing preferred securities and $217 million of payments for other contractual requirements.

 

Financing: Financing activities for the year ended December 31, 2003 consisted of net proceeds from secured borrowing activity with GE and other vendor financing partners of $269 million, net proceeds from the June 2003 convertible preferred stock offering of $889 million, net proceeds from the June 2003 common stock offering of $451 million, offset by preferred stock dividends of $57 million and other net cash outflows related to debt of $4.0 billion as detailed below:

 

     $ In Millions

 

Payments

        

2002 Credit Facility

   $ (3,490 )

Convertible Subordinated Debentures

     (560 )

Term debt and other

     (1,596 )
    


       (5,646 )
    


Borrowings, net of issuance costs

        

2010/2013 Senior Notes

     1,218  

2003 Credit Facility

     271  

All other

     113  
    


       1,602  
    


Net cash payments on debt

   $ (4,044 )
    


 

21


Further details on our June 2003 Recapitalization are included within the Liquidity, Financial Flexibility and Funding Plans section of this MD&A.

 

Financing activities for the year ended December 31, 2002 consisted of $2.8 billion of debt repayments on the terminated revolving credit facility, $710 million on the 2002 Credit Facility, $1.9 billion of other scheduled debt payments and preferred stock dividends of $67 million. These cash outflows were partially offset by proceeds of $746 million from our 9.75 percent Senior Notes offering and $1.4 billion of net proceeds from secured borrowing activity with GE and other vendor financing partners.

 

Financing activities for the comparable 2001 period consisted of scheduled debt repayments of $2.4 billion and dividends on our common and preferred stock of $93 million. These outflows were offset by net proceeds from secured borrowing activity of $1,350 million and proceeds from a loan from trust subsidiaries issuing preferred securities of $1.0 billion.

 

Capital Structure and Liquidity: We provide equipment financing to a significant majority of our customers. Because the finance leases allow our customers to pay for equipment over time rather than at the date of installation, we need to maintain significant levels of debt to support our investment in customer finance leases. Since 2001, we have funded a significant portion of our finance receivables through third-party vendor financing arrangements. Securing the financing debt with the receivables it supports, eliminates certain significant refinancing, pricing and duration risks associated with our debt. We are currently raising funds to support our finance leasing through third-party vendor financing arrangements, cash generated from operations and capital markets offerings. Over time, we intend to increase the proportion of our total debt that is associated with vendor financing programs.

 

During the years ended December 31, 2003 and 2002, we borrowed $2,450 million and $3,055 million, respectively, under secured third-party vendor financing arrangements. Approximately 60 percent of our total finance receivable portfolio has been pledged to secure vendor financing loan arrangements at December 31, 2003, compared with approximately 50 percent a year earlier. We expect the pledged portion of our finance receivable portfolio to range from 55-60 percent during 2004. The following table compares finance receivables to financing-related debt as of December 31, 2003 and 2002 ($ in millions):

 

    December 31, 2003

  December 31, 2002

   

Finance

Receivables,

Net


 

Secured

Debt


 

Finance

Receivables,

Net


 

Secured

Debt


GE secured loans:

                       

United States

  $ 2,939   $ 2,598   $ 2,430   $ 2,323

Canada

    528     440     347     319

United Kingdom

    719     570     691     529

Germany

    114     84     95     95
   

 

 

 

Total GE encumbered finance receivables, net

    4,300     3,692     3,563     3,266

Merrill Lynch Loan – France

    138     92     413     377

Asset-backed notes – France

    429     364     —       —  

DLL – Netherlands, Spain, and Belgium

    335     277     113     111

U.S. asset-backed notes

    —       —       247     139

Other U.S. securitizations

    —       —       101     7
   

 

 

 

Total encumbered finance receivables, net (1)

    5,202   $ 4,425     4,437   $ 3,900
         

       

Unencumbered finance receivables, net

    3,611           4,568      
   

       

     

Total finance receivables, net

  $ 8,813         $ 9,005      
   

       

     

(1) Encumbered finance receivables represent the book value of finance receivables that secure each of the indicated loans.

 

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As of December 31, 2003 and 2002, debt secured by finance receivables was approximately 40 percent and 28 percent of total debt, respectively. The following represents our aggregate debt maturity schedule as of December 31, 2003 ($ in millions):

 

    

Bonds/

Bank
Loans


  

Secured by

Finance

Receivables


   Total
Debt


 

2004

   $ 2,208    $ 2,028    $ 4,236 (1)

2005

     1,065      1,064      2,129  

2006

     25      461      486  

2007

     307      468      775  

2008

     378      404      782  

Thereafter

     2,758      —        2,758  
    

  

  


Total

   $ 6,741    $ 4,425    $ 11,166  
    

  

  



(1) Quarterly debt maturities for 2004 are $1,081, $1,087, $686 and $1,382 for the first, second, third and fourth quarters, respectively.

 

The following table summarizes our secured and unsecured debt as of December 31, 2003 and 2002:

 

    

December 31,

2003


  

December 31,

2002


Credit Facility

   $ 300    $ 925

Debt secured by finance receivables

     4,425      3,900

Capital leases

     29      40

Debt secured by other assets

     99      90
    

  

Total Secured Debt

   $ 4,853    $ 4,955
    

  

Credit Facility – unsecured

   $ —      $ 2,565

Senior Notes

     2,137      852

Subordinated debt

     19      575

Other Debt

     4,157      5,224
    

  

Total Unsecured Debt

     6,313      9,216
    

  

Total Debt

   $ 11,166    $ 14,171
    

  

 

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

 

Recapitalization: In June 2003, we successfully completed a $3.6 billion Recapitalization which reduced debt by $1.6 billion increased common and preferred equity by $1.3 billion and provided $0.7 billion of additional borrowing capacity. The Recapitalization included the offering and sale of 9.2 million shares of 6.25 percent Series C Mandatory Convertible Preferred Stock, 46 million shares of Common Stock, $700 million of 7.125 percent Senior Notes due 2010 and $550 million of 7.625 percent Senior Notes due 2013, and the closing of our $1 billion 2003 Credit Facility. Proceeds from the Recapitalization were used to fully repay our 2002 Credit Facility. The 2003 Credit Facility consists of a $300 million term loan and a $700 million revolving credit facility (which includes a $200 million sub-facility for letters of credit). Terms of the 2003 Credit Facility and the 2010 and 2013 Senior Notes are included in Note 10 to the Consolidated Financial Statements. The covenants under the 2003 Credit Facility reflect our improved financial position. For instance, there are no mandatory prepayments under the 2003 Credit Facility and the interest rate is approximately 2 percentage points lower than

 

23


the 2002 Credit Facility. We expect that the reduced interest expense in 2004 attributable to the Recapitalization will largely offset the dilutive impact of the additional common shares issued.

 

2003 Credit Facility: Xerox Corporation is the only borrower of the term loan. The revolving credit facility is available, without sub-limit, to Xerox Corporation and certain of its foreign subsidiaries, including Xerox Canada Capital Limited, Xerox Capital (Europe) plc and other qualified foreign subsidiaries (excluding Xerox Corporation, the “Overseas Borrowers”). The 2003 Credit Facility matures on September 30, 2008. Debt issuance costs of $29 million were deferred in conjunction with the 2003 Credit Facility.

 

Subject to certain limits described in the following paragraph, the obligations under the 2003 Credit Facility are secured by liens on substantially all the assets of Xerox and each of our U.S. subsidiaries that have a consolidated net worth from time to time of $100 million or more (the “Material Subsidiaries”), excluding Xerox Credit Corporation (“XCC”) and certain other finance subsidiaries, and are guaranteed by certain Material Subsidiaries. Xerox Corporation is required to guarantee the obligations of the Overseas Borrowers. As of December 31, 2003, there were no outstanding borrowings under the revolving credit facility. However, as of December 31, 2003, the $300 million term loan and $51 million of letters of credit were outstanding.

 

Under the terms of certain of our outstanding public bond indentures, the amount of obligations under the 2003 Credit Facility that can be secured, as described above, is limited to the excess of (x) 20 percent of our consolidated net worth (as defined in the public bond indentures) over (y) the outstanding amount of certain other debt that is secured by the Restricted Assets. Accordingly, the amount of 2003 Credit Facility debt secured by the Restricted Assets will vary from time to time with changes in our consolidated net worth. The amount of security provided under this formula is allocated ratably to the term loan and revolving loans outstanding at any time.

 

The term loan and the revolving loans each bear interest at LIBOR plus a spread that varies between 1.75 percent and 3 percent (or, at our election, at a base rate plus a spread that varies between 0.75 percent and 2 percent) depending on the then-current leverage ratio, as defined, in the 2003 Credit Facility. This rate was 3.42 percent at December 31, 2003.

 

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. These covenants are more fully discussed in Note 10.

 

The 2003 Credit Facility generally does not affect our ability to continue to securitize receivables under additional or existing third-party vendor financing arrangements. Subject to certain exceptions, we cannot pay cash dividends on our common stock during the term of the 2003 Credit Facility, although we can pay cash dividends on our preferred stock, provided there is then no event of default under the 2003 Credit Facility. Among defaults customary for facilities of this type, defaults on our other debt, bankruptcy of certain of our legal entities, or a change in control of Xerox Corporation, would all constitute events of default under the 2003 Credit Facility.

 

2010 and 2013 Senior Notes: We issued $700 million aggregate principal amount of Senior Notes due 2010 and $550 million aggregate principal amount of Senior Notes due 2013 in connection with the June 2003 Recapitalization. Interest on the Senior Notes due 2010 and 2013 accrues at the rate of 7.125 percent and 7.625 percent, respectively, per year and is payable semiannually on each June 15 and December 15. In conjunction with the issuance of the 2010 and 2013 Senior Notes, debt issuance costs of $32 million were deferred. These notes, along with our Senior Notes due 2009, are guaranteed by our wholly-owned subsidiaries Intelligent Electronics, Inc. and Xerox International Joint Marketing, Inc. Financial information of these guarantors is included in Note 19 to the Consolidated Financial Statements. The senior notes also contain negative covenants

 

24


(but no financial maintenance covenants) similar to those contained in the 2003 Credit Facility. However, they generally provide us with more flexibility than the 2003 Credit Facility covenants, except that payment of cash dividends on the 6.25 percent Series C Mandatory Convertible Preferred Stock is subject to certain conditions. See Note 10 to the Consolidated Financial Statements for a description of the covenants.

 

Financing Business: We implemented third-party vendor financing programs in the United States, Canada, the U.K., France, The Netherlands, the Nordic countries, Italy, Brazil and Mexico through major initiatives with GE, Merrill Lynch and other third-party vendors to fund our finance receivables in these countries. These initiatives include the completion of the U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (the “Loan Agreement”). See Note 4 to the Consolidated Financial Statements for a discussion of our vendor financing initiatives.

 

GECC U.S. Secured Borrowing Arrangement: In October 2002, we finalized an eight-year Loan Agreement with GECC. The Loan Agreement provides for a series of monthly secured loans up to $5 billion outstanding at any time ($2.6 billion outstanding at December 31, 2003). The $5 billion limit may be increased to $8 billion subject to agreement between the parties. Additionally, the agreement contains mutually agreed renewal options for successive two-year periods. 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.

 

Under the Loan Agreement, we expect GECC to fund a significant portion of new U.S. lease originations at over-collateralization rates, which vary over time, but are expected to approximate 10 percent at the inception of each funding. The securitizations are subject to interest rates calculated at each monthly loan occurrence at yield rates consistent with average rates for similar market based transactions. The funds received under this agreement are recorded as secured borrowings and the associated finance receivables are included in our Consolidated Balance Sheet. GECC’s commitment to fund under this agreement is not subject to our credit ratings.

 

Loan Covenants and Compliance: At December 31, 2003, 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 and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations. We have the right at any time to prepay any loans outstanding under or terminate the 2003 Credit Facility.

 

Credit Ratings: Our credit ratings as of February 27, 2004 were as follows:

 

     Senior Unsecured
Debt


   Outlook

  

Comments


Moody’s (1)

             B1    Stable    The Moody’s rating was upgraded from B1 (with a negative outlook) in December 2003.

S&P

             B+    Negative    The S&P rating on Senior Secured Debt is BB-.

Fitch

             BB    Stable    The Fitch rating was upgraded from BB- (with a negative outlook) in June 2003.

(1) In December 2003, Moody’s assigned to Xerox a first time SGL-1 rating.

 

Our ability to obtain financing and the related cost of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. Our current credit ratings are below investment grade

 

25


and we expect our access to the public debt markets to be limited to the non-investment grade segment until our ratings have been restored. Specifically, until our credit ratings improve, it is unlikely we will be able to access the low-interest commercial paper markets or to obtain unsecured bank lines of credit.

 

Summary - Financial Flexibility and Liquidity: With $2.5 billion of cash and cash equivalents on hand at December 31, 2003 and borrowing capacity under our 2003 Credit Facility of $700 million, less $51 million utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Our ability to maintain positive liquidity going forward depends on our ability to continue to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control. We currently have a $2.5 billion shelf registration that enables us to access the market on an opportunistic basis and offer both debt and equity securities.

 

Contractual Cash Obligations and Other Commercial Commitments and Contingencies: At December 31, 2003, we had the following contractual cash obligations and other commercial commitments and contingencies ($ in millions):

 

    Year 1

  Years 2-3

  Years 4-5

   
    2004

  2005

  2006

  2007

  2008

  Thereafter

Long-term debt, including capital lease obligations 1

  $ 4,194   $ 2,129   $ 486   $ 775   $ 782   $ 2,758

Minimum operating lease commitments 2

    235     190     148     118     96     383

Liabilities to subsidiary trusts issuing preferred securities 3

    1,067     —       77     —       —       665
   

 

 

 

 

 

Total contractual cash obligations

  $ 5,496   $ 2,319   $ 711   $ 893   $ 878   $ 3,806
   

 

 

 

 

 


1 Refer to Note 10 to our Consolidated Financial Statements for additional information related to long-term debt (amounts include principal portion only).
2 Refer to Notes 5 and 6 to our Consolidated Financial Statements for additional information related to minimum operating lease commitments.
3 Refer to Note 14 to our Consolidated Financial Statements for additional information related to liabilities to subsidiary trusts issuing preferred securities (amounts include principal portion only). The amounts shown above correspond to the year in which the preferred securities can first be put to us. We have the option to settle the 2004 amounts in stock if such loan is put to us.

 

Other Commercial Commitments and Contingencies:

 

Pension and Other Post-Retirement Benefit Plans: We sponsor pension and other post-retirement benefit plans that require periodic cash contributions. Our 2003 cash fundings for these plans were $672 million for pensions and $101 million for other post-retirement plans. Our anticipated cash fundings for 2004 are $63 million for pensions and $114 million for other post-retirement plans. Cash contribution requirements for our domestic tax qualified pension plans are governed by the Employment Retirement Income Security Act (ERISA) and the Internal Revenue Code. Cash contribution requirements for our international plans are subject to the applicable regulations in each country. The expected contributions for pensions for 2004 of $63 million include no expected contributions to the domestic tax qualified plans because these plans have already exceeded the ERISA minimum funding requirements for the plans’ 2003 plan year due to funding of approximately $450 million in 2003. Of this amount, $325 million was accelerated or in excess of required amounts. Our post-retirement plans are non-funded and are almost entirely related to domestic operations. Cash contributions are made each year to cover medical claims costs incurred in that year.

 

Flextronics: As previously discussed, in 2001 we outsourced certain manufacturing activities to Flextronics under a five-year agreement. During 2003, we purchased approximately $910 million of inventory from

 

26


Flextronics. We anticipate that we will purchase approximately $915 million of inventory from Flextronics during 2004 and expect to increase this level commensurate with our sales in the future.

 

Fuji Xerox: We had product purchases from Fuji Xerox totaling $871 million, $727 million, and $598 million in 2003, 2002 and 2001, respectively. Our purchase commitments with Fuji Xerox are in the normal course of business and typically have a lead time of three months. We anticipate that we will purchase approximately $1 billion of products from Fuji Xerox in 2004. Related party transactions with Fuji Xerox are disclosed in Note 7 to the Consolidated Financial Statements.

 

Other Purchase Commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts.

 

EDS Contract: We have an information management contract with Electronic Data Systems Corp. to provide services to us for global mainframe system processing, application maintenance and enhancements, desktop services and helpdesk support, voice and data network management, and server management. In 2001, we extended the original ten-year contract through June 30, 2009. Although there are no minimum payments required under the contract, we anticipate making the following payments to EDS over the next five years (in millions): 2004—$331; 2005—$332; 2006—$317; 2007—$307; 2008—$302. The estimated payments are the result of an EDS and Xerox Global Demand Case process that has been in place for eight years. Twice a year, using this estimating process based on historical activity, the parties agree on a projected volume of services to be provided under each major element of the contract. Pricing for the base services (which are comprised of global mainframe system processing, application maintenance and enhancements, desktop services and help desk support, voice and data management) were established when the contract was signed in 1994 based on our actual costs in preceding years. The pricing was modified through comparisons to industry benchmarks and through negotiations in subsequent amendments. Prices and services for the period July 1, 2004 through June 30, 2009 are currently being negotiated and, as such, are subject to change. Under the current contract, we can terminate the contract with six months notice, as defined in the contract, with no termination fee and with payment to EDS for incurred costs as of the termination date. We have an option to purchase the assets placed in service under the EDS contract, should we elect to terminate the contract and either operate those assets ourselves or enter a separate contract with a similar service provider.

 

Off-Balance Sheet Arrangements:

 

As discussed in Note 1 to the Consolidated Financial Statements, in December 2003, we adopted Financial Accounting Standards Board Interpretation No. 46R “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). As a result of our adoption of FIN 46R, we deconsolidated certain subsidiary trusts which were previously consolidated. All periods presented have been reclassified to reflect this change. As discussed further in Note 14 to the Consolidated Financial Statements, “Liability to Subsidiary Trusts Issuing Preferred Securities,” these trusts previously issued preferred securities. Although the preferred securities issued by these subsidiaries are not reflected on our consolidated balance sheets, we have reflected our obligations to them in the liability caption “Liability to Subsidiary Trusts Issuing Preferred Securities.” The nature of our obligations to these deconsolidated subsidiaries are discussed in Note 14.

 

Although we generally do not utilize off-balance sheet arrangements in our operations, we enter into operating leases in the normal course of business. The nature of these lease arrangements is discussed in Note 6 to the Consolidated Financial Statements. Additionally, we utilize special purpose entities (“SPEs”) in conjunction with certain vendor financing transactions. The SPEs utilized in conjunction with these transactions are consolidated in our financial statements in accordance with applicable accounting standards. These transactions, which are discussed further in Note 4 to the Consolidated Financial Statements, have been accounted for as secured borrowings with the debt and related assets remaining on our balance sheets. Although the obligations related to these transactions are included in our balance sheet, recourse is generally limited to the secured assets and no other assets of the Company.

 

27


Financial Risk Management:

 

As a multinational company, we are exposed to market risk from changes in foreign currency exchange rates and interest rates that could affect our results of operations and financial condition. As a result of our improved liquidity and financial position, our ability to utilize derivative contracts as part of our risk management strategy, described below, has substantially improved. Certain of these hedging arrangements do not qualify for hedge accounting treatment under SFAS 133. Accordingly, our results of operations are exposed to some volatility, which we attempt to minimize or eliminate whenever possible. The level of volatility will vary with the level of derivative hedges outstanding, as well as the currency and interest rate market movements in the period.

 

We enter into limited types of derivative contracts, including interest rate swap agreements, foreign currency swap agreements, cross currency interest rate swap agreements, forward exchange contracts, purchased foreign currency options and purchased interest rate collars, to manage interest rate and foreign currency exposures. The fair market values of all our derivative contracts change with fluctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Our derivative instruments are held solely to hedge economic exposures; we do not enter into derivative instrument transactions for trading or other speculative purposes and we employ long-standing policies prescribing that derivative instruments are only to be used to achieve a very limited set of objectives.

 

Our primary foreign currency market exposures include the Japanese yen, Euro, British pound sterling, Brazilian real, and Canadian dollar. For each of our legal entities, we generally hedge foreign currency denominated assets and liabilities, primarily through the use of derivative contracts. In entities with significant assets and liabilities, we use derivative contracts to hedge the net exposure in each currency, rather than hedging each asset and liability separately. We typically enter into simple unleveraged derivative transactions. Our policy is to transact derivatives only with counterparties having an investment-grade or better rating and to monitor market risk and exposure for each counterparty. We also utilize arrangements with each counterparty that allow us to net gains and losses on separate contracts. This further mitigates the credit risk associated with our financial instruments. Based upon our ongoing evaluation of the replacement cost of our derivative transactions and counterparty credit worthiness, we consider the risk of a material default by any of our counterparties to be remote.

 

Some of our derivative contracts and several other material contracts at December 31, 2003 require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are reported in our Consolidated Balance Sheets within Other current assets or other long-term assets, depending on when the cash will be contractually released, as presented in Note 1 to the Consolidated Financial Statements.

 

Assuming a 10 percent appreciation or depreciation in foreign currency exchange rates from the quoted foreign currency exchange rates at December 31, 2003, the potential change in the fair value of foreign currency-denominated assets and liabilities in each entity would be insignificant because all material currency asset and liability exposures were hedged as of December 31, 2003. A 10 percent appreciation or depreciation of the U.S. Dollar against all currencies from the quoted foreign currency exchange rates at December 31, 2003 would have a $443 million impact on our Cumulative Translation Adjustment portion of equity. The amount permanently invested in foreign subsidiaries and affiliates, primarily Xerox Limited, Fuji Xerox and Xerox do Brasil, and translated into dollars using the year-end exchange rates, was $4.4 billion at December 31, 2003, net of foreign currency-denominated liabilities designated as a hedge of our net investment.

 

Interest Rate Risk Management: The consolidated weighted-average interest rates related to our debt and liabilities to subsidiary trusts issuing preferred securities for 2003, 2002 and 2001 approximated 6.0 percent, 5.0 percent, and 5.5 percent, respectively. Interest expense includes the impact of our interest rate derivatives.

 

Virtually all customer-financing assets earn fixed rates of interest. As discussed above, a significant portion of those assets has been pledged to secure vendor financing loan arrangements and the interest rates on a significant portion of those loans are fixed. As we implement additional third-party vendor financing

 

28


arrangements and continue to repay existing debt, the proportion of our financing assets which is match-funded against related secured debt will increase.

 

As of December 31, 2003, approximately $2.7 billion of our debt bears interest at variable rates, including the effect of pay-variable interest rate swaps we are utilizing to reduce the effective interest rate on our debt.

 

The fair market values of our fixed-rate financial instruments, including debt and interest-rate derivatives, are sensitive to changes in interest rates. At December 31, 2003, a 10 percent change in market interest rates would change the fair values of such financial instruments by $297 million.

 

Forward-Looking Cautionary Statements:

 

This Annual Report contains forward-looking statements and information relating to Xerox that are based on our beliefs, as well as assumptions made by and information currently available to us. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Actual results could differ materially from those projected in such forward-looking statements. Information concerning certain factors that could cause actual results to differ materially is included in our 2003 Annual Report on Form 10-K filed with the SEC. We do not intend to update these forward-looking statements.

 

29


REPORT OF INDEPENDENT AUDITORS

 

To the Board of Directors and Shareholders of Xerox Corporation:

 

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, cash flows and common shareholders’ equity present fairly, in all material respects, the financial position of Xerox Corporation and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

As discussed in Note 1, in 2003 the Company adopted the provisions of the Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities, an Interpretation of ARB 51,” which changed certain consolidation policies. Additionally, as discussed in Note 1, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002.

 

PricewaterhouseCoopers LLP

Stamford, Connecticut

January 27, 2004

 

30


CONSOLIDATED STATEMENTS OF INCOME

 

     Year ended December 31,

 
(in millions, except per-share data)    2003

    2002

    2001

 

Revenues

                        

Sales

   $ 6,970     $ 6,752     $ 7,443  

Service, outsourcing and rentals

     7,734       8,097       8,436  

Finance income

     997       1,000       1,129  
    


 


 


Total Revenues

     15,701       15,849       17,008  
    


 


 


Costs and Expenses

                        

Cost of sales

     4,436       4,233       5,170  

Cost of service, outsourcing and rentals

     4,311       4,494       4,880  

Equipment financing interest

     362       401       457  

Research and development expenses

     868       917       997  

Selling, administrative and general expenses

     4,249       4,437       4,728  

Restructuring and asset impairment charges

     176       670       715  

Gain on sale of half of interest in Fuji Xerox

     —         —         (773 )

Gain on affiliate’s sale of stock

     (13 )     —         (4 )

Provision for litigation

     239       —         —    

Other expenses, net

     637       593       510  
    


 


 


Total Costs and Expenses

     15,265       15,745       16,680  
    


 


 


Income before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle

     436       104       328  

Income taxes

     134       4       473  
    


 


 


Income (Loss) before Equity Income and Cumulative Effect of Change in Accounting Principle

     302       100       (145 )

Equity in net income of unconsolidated affiliates

     58       54       53  
    


 


 


Income (Loss) before Cumulative Effect of Change in Accounting Principle

     360       154       (92 )

Cumulative effect of change in accounting principle

     —         (63 )     (2 )
    


 


 


Net Income (Loss)

     360       91       (94 )

Less: Preferred stock dividends, net

     (71 )     (73 )     (12 )
    


 


 


Income (Loss) available to common shareholders

   $ 289     $ 18     $ (106 )
    


 


 


Basic Earnings (Loss) per Share

                        

Income (Loss) before Cumulative Effect of Change in Accounting Principle

   $ 0.38     $ 0.11     $ (0.15 )
    


 


 


Net Earnings (Loss) per Share

   $ 0.38     $ 0.02     $ (0.15 )
    


 


 


Diluted Earnings (Loss) per Share

                        

Income (Loss) before Cumulative Effect of Change in Accounting Principle

   $ 0.36     $ 0.10     $ (0.15 )
    


 


 


Net Earnings (Loss) per Share

   $ 0.36     $ 0.02     $ (0.15 )
    


 


 


 

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

 

31


CONSOLIDATED BALANCE SHEETS

 

     December 31,

 
(in millions)    2003

    2002

 

Assets

                

Cash and cash equivalents

   $ 2,477     $ 2,887  

Accounts receivable, net

     2,159       2,072  

Billed portion of finance receivables, net

     461       564  

Finance receivables, net

     2,981       3,088  

Inventories

     1,152       1,231  

Other current assets

     1,105       1,187  
    


 


Total Current Assets

     10,335       11,029  

Finance receivables due after one year, net

     5,371       5,353  

Equipment on operating leases, net

     364       450  

Land, buildings and equipment, net

     1,827       1,757  

Investments in affiliates, at equity

     644       695  

Intangible assets, net

     325       360  

Goodwill

     1,722       1,564  

Deferred tax assets, long-term

     1,526       1,592  

Other long-term assets

     2,477       2,750  
    


 


Total Assets

   $ 24,591     $ 25,550  
    


 


Liabilities and Equity

                

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

   $ 4,236     $ 4,377  

Accounts payable

     898       839  

Accrued compensation and benefits costs

     532       481  

Unearned income

     251       257  

Other current liabilities

     1,652       1,833  
    


 


Total Current Liabilities

     7,569       7,787  

Long-term debt

     6,930       9,794  

Pension and other benefit liabilities

     1,058       1,307  

Post-retirement medical benefits

     1,268       1,251  

Liabilities to subsidiary trusts issuing preferred securities

     1,809       1,793  

Other long-term liabilities

     1,278       1,217  
    


 


Total Liabilities

     19,912       23,149  

Series B convertible preferred stock

     499       508  

Series C mandatory convertible preferred stock

     889       —    

Common stock, including additional paid in capital

     3,239       2,739  

Retained earnings

     1,315       1,025  

Accumulated other comprehensive loss

     (1,263 )     (1,871 )
    


 


Total Liabilities and Equity

   $ 24,591     $ 25,550  
    


 


 

Shares of common stock issued and outstanding were (in thousands) 793,884 and 738,273 at December 31, 2003 and December 31, 2002, respectively.

 

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

 

32


CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year ended December 31,

 
(in millions)    2003

    2002

    2001

 

Cash Flows from Operating Activities:

                        

Net income (loss)

   $ 360     $ 91     $ (94 )

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

                        

Provision for litigation

     239       —         —    

Depreciation and amortization

     748       1,035       1,332  

Impairment of goodwill

     —         63       —    

Provisions for receivables and inventory

     302       468       748  

Restructuring and other charges

     176       670       715  

Deferred tax benefit

     (70 )     (178 )     (10 )

Loss (gain) on early extinguishment of debt

     73       (1 )     (63 )

Cash payments for restructurings

     (345 )     (392 )     (484 )

Contributions to pension benefit plans

     (672 )     (138 )     (42 )

Net gains on sales of businesses, assets and affiliate’s sale of stock

     (1 )     (1 )     (765 )

Undistributed equity in net income of unconsolidated affiliates

     (37 )     (23 )     (20 )

Decrease in inventories

     62       16       319  

Increase in on-lease equipment

     (166 )     (127 )     (271 )

Decrease in finance receivables

     496       754       88  

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

     164       (266 )     189  

Increase (decrease) in accounts payable and accrued compensation

     414       330       (228 )

Net change in income tax assets and liabilities

     (3 )     (260 )     428  

Decrease in other current and long-term liabilities

     (43 )     (109 )     (95 )

Early termination of derivative contracts

     136       56       (148 )

Other, net

     46       (8 )     155  
    


 


 


Net cash provided by operating activities

     1,879       1,980       1,754  
    


 


 


Cash Flows from Investing Activities:

                        

Cost of additions to land, buildings and equipment

     (197 )     (146 )     (219 )

Proceeds from sales of land, buildings and equipment

     10       19       69  

Cost of additions to internal use software

     (53 )     (50 )     (124 )

Proceeds from divestitures, net

     35       340       1,768  

Net change in escrow and other restricted investments

     254       (63 )     (816 )

Other, net

     —         (7 )     7  
    


 


 


Net cash provided by investing activities

     49       93       685  
    


 


 


Cash Flows from Financing Activities:

                        

Cash proceeds from new secured financings

     2,450       3,055       2,418  

Debt payments on secured financings

     (2,181 )     (1,662 )     (1,068 )

Net cash payments on debt

     (4,044 )     (4,619 )     (2,448 )

Proceeds from issuance of mandatorily redeemable preferred stock

     889       —         —    

Dividends on common and preferred stock

     (57 )     (67 )     (93 )

Proceeds from issuances of common stock

     477       4       28  

Proceeds from loans to trusts issuing preferred securities

     —         —         1,004  

Settlements of equity put options, net

     —         —         (28 )

Dividends to minority shareholders

     (4 )     (3 )     (2 )
    


 


 


Net cash used in financing activities

     (2,470 )     (3,292 )     (189 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     132       116       (10 )
    


 


 


(Decrease) increase in cash and cash equivalents

     (410 )     (1,103 )     2,240  

Cash and cash equivalents at beginning of year

     2,887       3,990       1,750  
    


 


 


Cash and cash equivalents at end of year

   $ 2,477     $ 2,887     $ 3,990  
    


 


 


 

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

 

33


CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS’ EQUITY

 

(In millions, except share data)

 

   Common
Stock
Shares


   Common
Stock
Amount


    Additional
Paid-In
Capital


    Retained
Earnings


    Accumulated
Other
Comprehensive
Loss(1)


    Total

 

Balance at December 31, 2000

   668,576    $ 670     $ 1,561     $ 1,150     $ (1,580 )   $ 1,801  
    
  


 


 


 


 


Net loss

                          (94 )             (94 )

Translation adjustments

                                  (210 )     (210 )

Minimum pension liability, net of tax

                                  (40 )     (40 )

Unrealized gain on securities, net of tax

                                  4       4  

FAS 133 transition adjustment

                                  (19 )     (19 )

Unrealized gains on cash flow hedges, net of tax

                                  12       12  
                                         


Comprehensive loss

                                        $ (347 )
                                         


Stock option and incentive plans, net

   546      1       5                       6  

Convertible securities

   5,865      6       36                       42  

Common stock dividends ($0.05 per share)

                          (34 )             (34 )

Series B convertible preferred stock dividends ($1.56 per share), net of tax

                          (12 )             (12 )

Equity for debt exchanges

   41,154      41       270                       311  

Issuance of unregistered shares

   5,861      6       22                       28  

Other

   312      —         4       (2 )     —         2  
    
  


 


 


 


 


Balance at December 31, 2001

   722,314    $ 724     $ 1,898     $ 1,008     $ (1,833 )   $ 1,797  
    
  


 


 


 


 


Net income

                          91               91  

Translation adjustments (2)

                                  234       234  

Minimum pension liability, net of tax

                                  (279 )     (279 )

Unrealized gain on securities, net of tax

                                  1       1  

Unrealized gains on cash flow hedges, net of tax

                                  6       6  
                                         


Comprehensive income

                                        $ 53  
                                         


Stock option and incentive plans, net

   2,385      2       10                       12  

Convertible securities

   7,118      7       48                       55  

Series B convertible preferred stock dividends ($10.94 per share), net of tax

                          (73 )             (73 )

Equity for debt exchanges

   6,412      6       45                       51  

Other

   44      (1 )     —         (1 )     —         (2 )
    
  


 


 


 


 


Balance at December 31, 2002

   738,273    $ 738     $ 2,001     $ 1,025     $ (1,871 )   $ 1,893  
    
  


 


 


 


 


Net income

                          360               360  

Translation Adjustments

                                  547       547  

Minimum pension liability, net of tax

                                  42       42  

Unrealized gain on securities, net of tax

                                  17       17  

Unrealized gains on cash flow hedges, net of tax

                                  2       2  
                                         


Comprehensive income

                                        $ 968  
                                         


Stock option and incentive plans, net

   9,530      9       41                       50  

Common stock offering

   46,000      46       405                       451  

Series B convertible preferred stock dividends ($6.25 per share), net of tax

                          (41 )             (41 )

Series C mandatory convertible preferred stock dividends ($3.23 per share)

                          (30 )             (30 )

Other

   81      1       (2 )     1       —         —    
    
  


 


 


 


 


Balance at December 31, 2003

   793,884    $ 794     $ 2,445     $ 1,315     $ (1,263 )   $ 3,291  
    
  


 


 


 


 



(1) As of December 31, 2003, Accumulated Other Comprehensive Loss is composed of cumulative translation adjustments of $(977), unrealized gain on securities of $17, minimum pension liabilities of $(304) and cash flow hedging gains of $1.
(2) Includes reclassification adjustments for foreign currency translation losses of $59, that were realized in 2002 due to the sale of businesses. These amounts were included in accumulated other comprehensive loss in prior periods as unrealized losses. Refer to Note 3 for further discussion.

 

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

 

34


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

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

 

Note 1—Summary of Significant Accounting Policies

 

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

 

Description of Business and Basis of Presentation: We are a technology and services enterprise, as well as a leader in the global document market, developing, manufacturing, marketing, servicing and financing a complete range of document equipment, software, solutions and services.

 

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

 

In June 2003, we completed a $3.6 billion recapitalization (the “Recapitalization”) that included the offering and sale of 9.2 million shares of 6.25 percent Series C Mandatory Convertible Preferred Stock, 46 million shares of Common Stock, $700 of 7.125 percent Senior Notes due 2010 and $550 of 7.625 percent Senior Notes due 2013 and the closing of our new $1.0 billion credit agreement which matures on September 30, 2008 (the “2003 Credit Facility”). The 2003 Credit Facility consists of a fully drawn $300 term loan and a $700 revolving credit facility (which includes a $200 sub-facility for letters of credit). The proceeds from the Recapitalization were used to repay the amounts outstanding under the Amended and Restated Credit Agreement we entered into in June 2002 (the “2002 Credit Facility”). Upon repayment of amounts outstanding, the 2002 Credit Facility was terminated and we incurred a $73 charge associated with unamortized debt issuance costs.

 

On December 31, 2003, we had $700 of borrowing capacity under the 2003 Credit Facility, less $51 utilized for letters of credit. The 2003 Credit Facility contains affirmative and negative covenants, financial maintenance covenants and other limitations. The indentures governing our outstanding senior notes contain several affirmative and negative covenants. The senior notes do not, however, contain any financial maintenance covenants. The covenants and other limitations contained in the 2003 Credit Facility and the senior notes are more fully discussed in Note 10. Our U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to our vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of December 31, 2003, $2.6 billion was outstanding under the Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada that are discussed further in Note 4, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At December 31, 2003, we were in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and we expect to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on our liquidity and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to us. If GECC were to make no further loans to us and assuming a similar facility was not established, it would materially adversely affect our liquidity and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations.

 

With $2.5 billion of cash and cash equivalents on hand at December 31, 2003 and borrowing capacity under our 2003 Credit Facility of $700, less $51 utilized for letters of credit, we believe our liquidity (including

 

35


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

operating and other cash flows that we expect to generate) will be sufficient to meet operating cash flow requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Our ability to maintain positive liquidity going forward depends on our ability to continue to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

Our ability to obtain financing and the related cost of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. Our current credit ratings are below investment grade and we expect our access to the public debt markets to be limited to the non-investment grade segment until our ratings have been restored. Specifically, until our credit ratings improve, it is unlikely we will be able to access the low-interest commercial paper markets or to obtain unsecured bank lines of credit.

 

We currently have a $2.5 billion shelf registration that enables us to access the market on an opportunistic basis and offer both debt and equity securities.

 

Basis of Consolidation: The Consolidated Financial Statements include the accounts of Xerox Corporation and all of our controlled subsidiary companies. All significant intercompany accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but we have the ability to exercise significant influence over operating and financial policies (generally 20 to 50 percent ownership), are accounted for using the equity method of accounting. Upon the sale of stock of a subsidiary, we recognize a gain or loss in our Consolidated Statements of Income equal to our proportionate share of the corresponding increase or decrease in that subsidiary’s equity. Operating results of acquired businesses are included in the Consolidated Statements of Income from the date of acquisition and, for variable interest entities in which we are determined to be the primary beneficiary, from the date such determination is made.

 

Certain reclassifications of prior year amounts have been made to conform to the current year presentation.

 

Income before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle: Throughout the Notes to the Consolidated Financial Statements, we refer to the effects of certain changes in estimates and other adjustments on Income before Income Taxes, Equity Income and Cumulative Effect of Change in Accounting Principle. For convenience and ease of reference, that caption in our Consolidated Statements of Income is hereafter referred to as “pre-tax income.”

 

Use of Estimates: The preparation of our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are used for, but not limited to: (i) allocation of revenues and fair values in leases and other multiple element arrangements; (ii) accounting for residual values; (iii) economic lives of leased assets; (iv) allowance for doubtful accounts; (v) inventory valuation; (vi) restructuring and related charges; (vii) asset impairments; (viii) depreciable lives of assets; (ix) useful lives of intangible assets; (x) pension and post-retirement benefit plans; (xi) income tax valuation allowances and (xii) contingency and litigation reserves. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Actual results could differ from those estimates.

 

36


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

The following table summarizes the more significant charges that require management estimates:

 

     Year ended
December 31,


     2003

    2002

   2001

Restructuring provisions and asset impairments

   $ 176     $ 670    $ 715

Amortization and impairment of goodwill and intangible assets

     35       99      94

Provisions for receivables

     224       353      506

Provisions for obsolete and excess inventory

     78       115      242

Depreciation and obsolescence of equipment on operating leases

     271       408      657

Depreciation of buildings and equipment

     299       341      402

Amortization of capitalized software

     143       249      179

Pension benefits - net periodic benefit cost

     364       168      99

Other post-retirement benefits - net periodic benefit cost

     108       120      130

Deferred tax asset valuation allowance provisions

     (16 )     15      247

 

Changes in Estimates: In the ordinary course of accounting for items discussed above, we make changes in estimates as appropriate, and as we become aware of circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to the Consolidated Financial Statements.

 

New Accounting Standards and Accounting Changes:

 

Variable Interest Entities: In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46”). The primary objectives of FIN 46 were to provide guidance on the identification of entities for which control is achieved through means other than through voting rights and how to determine when and which business enterprise should consolidate the variable interest entity (“VIE”). We adopted FIN 46 on July 1, 2003 and, as a result, we began consolidating our joint venture with De Lage Landen International BV (“DLL”), our vendor financing partnership in the Netherlands, effective July 1, 2003 as we were deemed to be the primary beneficiary of the joint venture’s financial results. Prior to the adoption of FIN 46, we accounted for our investment with DLL under the equity method of accounting.

 

In December 2003, the FASB published a revision to FIN 46 (“FIN 46R”), in part, to clarify certain of its provisions. FIN 46R addressed substantive ownership provisions related to consolidation. As a result of FIN 46R, we were required to deconsolidate three of our subsidiary trusts— Capital Trust I, Capital Trust II and Capital LLC. These trusts had previously issued mandatorily redeemable preferred securities and entered into loan agreements with the Company having similar terms as the preferred securities. Specifically, FIN 46R resulted in the holders of the preferred securities being considered the primary beneficiaries of the trusts. As such, we were no longer permitted to consolidate these entities. We have therefore deconsolidated the three trusts and reflected our obligations to them within the balance sheet liability caption “Liability to subsidiary trusts issuing preferred securities.” In addition to deconsolidating these subsidiary trusts, the interest on the loans, which was previously reported net of tax as a component of “Minorities’ interests in earnings of subsidiaries” in our Consolidated Statements of Income, are now accounted for as interest expense within “Other expenses, net”, with the tax effects presented within “Income taxes (benefits).” Accordingly, $145, $145 and $64 in interest expense on loans payable to the subsidiary trusts for the years ended December 31, 2003, 2002, and 2001, respectively, was reflected as non-financing interest expense. The related income tax effects were $56, $56 and $24, for the years ended December 31, 2003, 2002, and 2001, respectively. Financial statements for all periods presented have been

 

37


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

revised to reflect this change. The adoption of this interpretation had no impact on the net income or earnings per share. In connection with the adoption of FIN 46R, we also reclassified prior periods for the effects of the consolidation of DLL. The impact of consolidating DLL was immaterial for all periods presented.

 

Revenue Recognition: In November 2002, the Emerging Issues Task Force (the “EITF”) reached a consensus on Issue 00-21, “Revenue Arrangements with Multiple Deliverables.” The EITF requires that the deliverables must be divided into separate units of accounting when the individual deliverables have value to the customer on a stand-alone basis, when there is objective and reliable evidence of the fair value of the undelivered elements, and, if the arrangement includes a general right to return the delivered element, delivery or performance of the undelivered element is considered probable. The relative fair value of each unit should be determined and the total consideration of the arrangement should be allocated among the individual units based on their relative fair value. With respect to bundled lease arrangements, this guidance impacts the allocation of revenues to the aggregate lease and non-lease deliverables. Lease deliverables include executory costs, equipment and interest, while non-lease deliverables consist of the supplies and non-maintenance services component of the bundled lease arrangements. The lease deliverables must continue to be accounted for in accordance with SFAS No. 13, consistent with our revenue recognition policies. The guidance in this issue was effective for revenue arrangements entered into after June 30, 2003. EITF 00-21 did not, and is not expected to, have a material effect on our financial position or results of operations. A full description of our revenue recognition policy associated with bundled contractual lease arrangements appears below.

 

Guarantees: In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). This interpretation expanded the disclosure requirements of guarantee obligations and requires the guarantor to recognize a liability for the fair value of the obligation assumed under a guarantee. The disclosure requirements of FIN 45 were effective as of December 31, 2002. The recognition requirements of FIN 45 were required to be applied prospectively to guarantees issued or modified after December 31, 2002. Significant guarantees that we have entered are disclosed in Note 15. The requirements of FIN 45 did not have a material impact on our results of operations, financial position or liquidity.

 

Costs Associated with Exit or Disposal Activities: In 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”). This standard requires companies to recognize costs associated with exit or disposal activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, plant closing, or other exit or disposal activity. We adopted SFAS No. 146 in the fourth quarter of 2002. Refer to Note 2 for further discussion.

 

Goodwill and Other Intangible Assets: Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), whereby goodwill was no longer to be amortized, but instead is to be tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. In 2002, we recorded an impairment charge of $63 as a cumulative effect of change in accounting principle in the accompanying Consolidated Statements of Income. Upon adoption of SFAS No. 142, we reclassified $61 of intangible assets to goodwill. Prior to adoption, goodwill and identifiable intangible assets were amortized on a straight-line basis over periods ranging from 5 to 40 years. Pro forma net loss as adjusted for the exclusion of amortization expense of $59 for the year ended December 31, 2001 was $35 or $0.06 per share.

 

38


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

The following table presents the changes in the carrying amount of goodwill, by operating segment, for the years ended December 31, 2003 and 2002:

 

     Production

    Office

    DMO

    Other

   Total

 

Balance at January 1, 2002

   $ 605