By Jan Stoddard of Raine Consulting July 31, 2003 -- Xerox Corporation (NYSE: XRX) reported today second quarter earnings of $0.09 per share including a $0.05 previously announced charge for the remaining unamortized fees associated with its terminated 2002 credit facility. Equipment sale growth of 8 percent resulted in total revenue of $3.9 billion. Operating cash flow was reported at $682 million and following re-capitalization, a worldwide cash balance of $2.3 billion highlighted by a debt reduction of $2.5 billion Editor's Note: "The chapter is closed on our turnaround story." Of all the comments offered by Xerox Chairman and CEO Anne Mulcahy, this comment was perhaps the most prophetic. The results of the re-capitalization efforts demonstrate both easier access to capital and restored investor confidence. Xerox is not just surviving, but profitably succeeding in a quarter that produced dismal results for the graphic arts sector and other equipment companies. Mulcahy and her team have relentlessly pursued a color strategy that is seemingly effective against diminishing page counts and competitive pricing. Call Topics: * Chairman Comments * Financial Comments * Next Quarter Projections * Q&A Chairman Comments Ms. Anne M. Mulcahy, Xerox's Chairman and Chief Executive, opened today's quarterly analyst call stating, "Clearly this quarter was a breakthrough as we grew our equipment sales. This is particularly significant, as we know the economy and the competitive environment are challenging. But, as we have communicated, we are looking hard to build a business model that delivers sustained bottom-line results; and our technology and services have given us a competitive advantage in this tough marketplace." Citing install rates as an important indicator of future success and annuity growth, Mulcahy pointed to: * Equipment trends that grew 8% in second quarter, and * Post sale declines are moderating as the trend follows equipment sales. * There was a 7% increase in installs in the production color market led by increased demand for the Xerox DocuColor 6060 Digital Color Press. Mix was strong, driven by DocuColor 6060, which leverages the Xerox color page strategy that is particularly important to future growth. (Note: B&W installs declined in the low single digits, which is an improvement from recent trends.) Most notably, DocuTech installs increased in North America, characterized by Mulcahy as a "really encouraging sign." * In the office, color multifunction installs increased 64 percent and black-and-white multifunction grew the 8 percent announced last year. The company is also seeing the initial benefits from its new and enhanced office products launched in the second quarter. * Office color multi-functions increased 64% and B&W multi-functions by 8% primarily driven by sales of the Xerox Document Centre 500 Series. Mulcahy states that they are beginning to see the benefits of the new suite of products that were previously introduced (CopyCentre, WorkCentre, and WorkCentre Pro CopyCenter). Revenue Management: Xerox now has six quarters of consecutive improvement. Increasing equipment sales in key markets is an important part of the Xerox's growth strategy. More installs in the field mean more revenue flowing through post-sales and service. Post sales have declined (but are moderating) due to the business decisions made in 2000-2002, which resulted in fewer equipment placements but a stronger, more profitable bottom line. Equipment sales growth is expected to flow through post-sales growth by the second half of 2004. Mulcahy emphasizes, "We have a leaner, faster business model now poised for more profitable business growth." The strategy is also to reduce the proportion of revenue spent in declining markets like SoHo or light lens. Growth areas of Xerox's business (now representing 70% of revenue) grew 10% due to increasing customer demand for production digital and office digital markets. More frequently, integration with content and document management purposes adds customer value and gives Xerox a competitive edge. Mulcahy cited one example: Xerox recently signed a $50 million, 6-year contract with Well Choice, one of the country's largest healthcare insurers, for a solution integrating Xerox hardware, software and services that allows Xerox to manage the production and distribution of 3.5 million customized documents. Advanced Color Technology: Xerox is also continuing to invest and bring to market advanced color technology. In the second quarter, total color revenue was up 19%, largely due to the success of the DocuColor series. This is really an important indicator of future revenue growth. More placements means more pages printed in color - Xerox color. Developing markets (representing about 10% of revenue) were at 11%, a significant improvement from the past. Revenue declines in DMO are moderating and Xerox is expecting improvement in the second half of the year. Increasing Proportion of Revenues in Growth Areas: By 2005, approximately 90% of our revenue will be in growth business and DMO. Growth business is Digital Production, Digital Office and Value added Services, and this represents an increase from 59% in 2001 to an estimated 70% in 2003. Light Lens & SoHo will decrease from 19% in 2001 to an estimated 12% in 2003. Financial Comments Mr. Larry Zimmerman, Xerox's Senior Vice President and CFO, presented additional financial highlights: * Earnings expansion resulted in a significant expansion to $0.09 per share while absorbing $0.05 for credit facility fees. * Successful re-capitalization of the balance sheet resulted in a debt reduction of $2.5 billion (non-diluted), lowered interest rate, maturities extended, and non-securitized debt of $7.7 billion (reduced from a 2000 high of $18.6 billion). Two key accomplishments were the significant access to capital markets and investor confidence. * Strong cash performance was all related to earnings and capital improvements. Xerox currently has $2.3 billion cash on hand and have significant ($682 million) cash from operations driven by earnings and receivables. Currently, Xerox is working on all new originations in the U.S., Canada, UK and Germany. The expectation is that 50% of the business will be securitized, 25% will be self-financed, and 25% will be cash payments. * Gross margin is about the same as it was one year ago (42.4% in 2003 versus 42.5% Q2 2003). More significantly, Xerox has had six straight quarters all above 40%. Manufacturing and service productivity (2.2 points) more than offset price declines (1.1 points) and Xerox has also absorbed higher pension and employee benefits. * Selling, Administrative & General Expense is down as a percentage of revenue to 27.8%. Again, currency increases, and pension and other employee benefits offset by productivity improvements. R&D and S&G productivity include a 6% constant currency improvement. Next Quarter Projections Mulcahy presented third quarter projections that will include continued year-over-year improved equipment sales trends and increased revenue in targeted growth markets, as well as continued improvements in operation performance. For the third quarter, the expectation is to deliver earnings in the range of $0.08-$0.12 per share (tempered by seasonality and weakness in the economy). Q&A 1. Mulcahy clarified the third quarter estimated earnings (Note: the street expectation is around $0.12 for the third quarter), by stating that they do feel confident about operational improvements, however: 1) currency may not be as strong as in the first half of the year given June 30th spot rates, 2) there are potentially some changes related to tax rates, 3) the pace of restructuring and when it will hit, and 4) seasonality. Mulcahy noted that they been pleased with the progress in Europe (currency has been helpful); however, August is not an active time in Europe resulting in Europe being weaker in Q3 than other parts of the world. 2. There is no conservatism in the next quarter forecast based on product transitions. Xerox is on schedule with all product time-lines. The availability of products launched late in the second quarter (April 30th announcement) will be a better indication of the success of those products in the marketplace. 3. If equipment installs continue at the current rate, post sales revenues are projected to turn positive in the second half of 2004. (This could be affected by color and rates of decline in light lens.) 4. Zimmerman commented that the trend of bad debts (slight increase in bad debt from previous quarter) is exactly the same at just under 2% and did not perceive any change in the coming quarters. 5. Two product areas, production printing and light lens, are declining not because of competition but due to market trends. Department digital (Product Group V- 480's and 490's) installs were up for the quarter. They are also pleased with 1010 progress although Q1 was slow, probably due to launching at the end of year, which is not usually done. DocuTech growing in North America was a very good signal to Xerox. Mulcahy summarized, "Overall, production trends got better and particularly in the areas that we care about." 6. Regarding the April 30th announcement in regards to channels, Mulcahy stated that they were really pleased with their progress in regards to tele-business. This channel is playing more to the office, touching 30% of Xerox revenues and Mulcahy believes that this will be increasing. Tele-business equipment sales are definitely playing a part in terms of improved productivity and distribution. Xerox has been more aggressive in Europe in regards to two-tier distribution. They have been particularly pleased in the multi-function products distributed through two-tier and plan to reflect some of these learnings back in the North American strategy. 7. When asked to comment on the economy, Mulcahy noted that they have not seen any real progress in any segment of the economy. They have seen more strength in the public sector reflective of the strength and competitiveness of the Xerox offerings in terms of getting state and federal contracts. She characterized Graphic Arts as better than one year ago, but certainly with slow progress. "We still seeing consolidation in the graphic arts market and one of the roles that we are trying to play is to help strengthen the graphics arts sector through creating new applications and growth opportunities with the iGen3 and some of the digital color capabilities." 8. Mulcahy says that they see the commercial sector as flat, and not seeing anything that would indicate an up-tick in capital spending. Xerox is actually doing better as it is focused on improving customer productivity through services such as office document assessment and getting customers a 'better bang for the buck that they are spending in the technology arena.' 9. Mulcahy stated (in reference from last quarter's call) that they are staying bullish on color. The leverage is still there at a rate of 5X per page. Overall, color grew 19% in the quarter, indicative of success both in production color and mid-range color area (both revenue and profit areas). 10. Pleased with the mix and growth in all segments, Mulcahy noted that they were particularly pleased with color. Production color mix is strong, and the most important part is the page leverage we get in the production color segment. They were also pleased to see the production growth of DocuTech in the production B&W segment which is the strongest contributor to pages and mix. Although not disclosing the number of iGen3 installs, Mulcahy did state that they were pleased in two aspects; 1) a lot of the initial installs have added second units already, and 2) almost all of installs have exceed the expectations on page volumes which is the key to making each and every install profitable. This creates a strong foundation in the graphic arts market to grow in 2003 and beyond. They have also initiated a command center (remote technical center) where all of the iGen3 installs are monitored from a diagnostic and a support perspective. 11. Regarding the staff reduction of 800 employees during the second quarter, Zimmerman noted that the attrition number is actually higher and there are hires offsetting some of the attrition. The intent is to balance investment in areas dependent on revenue growth or decrease (a "rifle shot where appropriate"). There may be some additional staff reductions depending on the business. 12. Regarding DocuTech market positioning, Mulcahy stated that it is based on basics: stable relationships with customers, stable coverage, competitive pricing, and beating the competition. "There is no question that the DocuTech (via Heidelberg) is winning." The iGen3 target is to have 100 graphic arts customers profitable in 2003 as the strongest profitable reference challenge. 13. Regarding the relationship with Flextronics, Xerox is pleased with the relationship and results where office products have moved and are working on some design aspects together. 14. Share is being taken from both high-end competitors (Heidelberg and HP/Indigo) and absolutely taking share in the production color part from Cannon, and also competing in the office market against all of the players (second stream players). Also, Xerox has not experienced any problematic backlogs for the quarter. 15. SAG did decline but offset by currency hedge and increasing costs in benefits and pensions. Overall, have improved the ratios. Some of the progress will be revenues as Xerox becomes more profitable. SAG in mid-20's still projected. 16. Mulcahy commented that gross margins are sustainable in the higher range (42% versus 40%) especially as invest more in SAG. 17. Overall, pages are declining but the mix of pages is changing substantially. All color segments are growing significantly while seeing more B&W segment declining but B&W multi-function growing. 18. Sales coverage is stable with 93-94% filled territories. The biggest impact will be on the tele-business.