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    Annual Report 2003


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    Since 2000, we have relentlessly focused on effective execution and have consistently delivered on our commitments. In 2003, our progress continued. Our focus now is on growth. Financial Highlights ($ millions, except EPS) 2003 2002 Equipment Sales $ 4,250 $ 3,970 Post Sale, Finance and Other Revenue 11,451 11,879 Total Revenue 15,701 15,849 Total Cost and Expense 15,265 15,745 Net Income 360 91 Diluted EPS 0.36 0.02 Operating Cash Flows 1,879 1,980 Cash and Cash Equivalents 2,477 2,887 Debt 11,166 14,171 On the cover: The stylized chart on the front cover represents the extraordinary Xerox turnaround over the past four years – from a net loss of $273 million in 2000 to net income of $360 million in 2003.


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    Anne M. Mulcahy, Chairman and Chief Executive Officer Fellow Shareholders: It is with enormous pride in our people that I am able to report to you that 2003 was another year of good progress, excellent execution and Letter to Shareholders accelerating marketplace 01 momentum for Xerox. Strategies and Opportunities Everywhere you look the signs are positive. Take a look at 08 the charts accompanying this letter. We generated near record amounts of cash from operations, significantly reduced both 2003 debt and cost, maintained gross margins and recapitalized the Report Card company. Even more importantly, we brought to market an expansive armada of innovative technology and services, gained 16 market share in key segments of our business, grew equipment sales by 7 percent and won scores of large customer contracts – Financial Review many of them in direct face-offs with our best competitors. Across the board and around the world, we did what we said 17 we would do in 2003 – and then some.


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    In many ways, the curtain has closed on the Xerox turnaround. But we are keenly aware that most great plays have two acts. As pleased as we are with our performance the past few years, we know that it has merely set the stage for what is to come next – a period of growth and greatness for Xerox and for Xerox shareholders. We are already busy creating that future. Fortunately, we do not want for opportunity. I spend a lot of time with our customers – every chance I get. And every time I do, I come away bullish on our prospects for growth. Chief Executive Officers and Chief Information Officers have some very common and critical problems: the need to reduce costs and boost productivity, the desire to get closer to their existing customers and attract new ones, the need to make sense of a dizzying array of new technologies, and an almost desperate desire to optimize their investments in technology Declining Debt as of December 31 and make sure that technology is working for them and not ($ billions) against them. 18.6 And whenever I hear those customer needs, I know that Xerox 16.7 is part of the solution. Let me give you three examples of how we are helping our customers deal with their most pressing 14.2 business problems: 11.2 • In more than 200 blue-chip companies, Xerox has done rigorous Office Document Assessments to understand docu- ment workflows. We are saving these customers an average of 30 percent of their document costs and streamlining their processes as well. • In a growing list of marketing companies, our digital printing solutions are enabling our customers to communicate with their customers more effectively. We are helping hundreds of 2000 2001 2002 2003 our customers find what up to now has been the elusive Holy Grail of marketing – the ability to communicate with large customer bases with one-to-one precision at just the right time with just the right information, while eliminating the need to maintain inventories of marketing materials that quickly become obsolete. 2


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    • In global enterprises around the world, we are helping our customers maximize their investments in information technology and helping them make document-intensive Equipment Sales work processes more efficient, more impactful and more ($ millions) user friendly. Companies like Microsoft, Lloyd’s, Sun Microsystems and Siemens have turned to Xerox for help. 5,264 I could go on, but you get the point. The “copier giant” has transformed itself into a leading technology and services 4,403 4,250 company – with an important twist. Too many organizations 3,970 focus on the wrong side of information technology – putting too much emphasis on the “technology” and not enough on the “information.” With smart document management services, we’re helping our customers focus more on the information and ideas captured in documents than on the technology needed to produce them. A case in point is the the work work we we areare doing doingwith withaamajor majorairline. airline. 2000 2001 2002 2003 We are helping them manage manage their their documents documentsso sothat thatthey they structure their own content, content, automate automatetheir theirown owndistribution distributionandand approvals, track sign-off sign-off byby the the right rightperson, person,retire retiredocuments documentsto to a central repository, repository, and and provide provide reporting reportingstatistics statisticsto tomanage- manage- ment. That’s what we meanmean by by smart smart document documentmanagement. management. It’s also smart business. business. TheThe process processreduces reducesthetherisk riskofofdelayed delayed flight flight departures departuresand andarrivals, arrivals,practically practicallyeliminates eliminatesthe thelikelihood likelihood of a bad compliance of a bad compliance report by the report FAA,byand theisFAA, projected and saves to save them three-quarters three-quarters of of aa million million dollars dollarsaayear. year. We have continued to invest heavily in research and development and to focus that investment on helping our customers find better ways to do great work. Even in our darkest days, we never considered mortgaging our future. What a hollow victory it would have been to save the company from financial failure only to suffer the consequences of a technological drought. 3


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    Over the last two years, we have brought to market some Stabilized Gross Margins (Percent) 38 new products as well as a rich portfolio of smart document- related services. These investments are already paying off. In fact, more than half of our equipment sale revenue last 42.4 42.0 year – and 60 percent in the fourth quarter – came from offer- 37.4 38.2 ings that were introduced in the past two years. That pace will only quicken in the years ahead. We not only continue to invest heavily, but we’ve also become very smart in focusing that investment on solving real problems that real people have in the real world. Last year we were awarded 628 patents to place us among a handful of leaders worldwide. These are not patents for the sake of numbers. One of the hallmarks of the new Xerox is a deep desire to be connected to the realities of our customers. And we work at it with 2000 2001 2002 2003 a passion and pervasiveness that no other company in our industry can match: • More than 12,000 Xerox managed services employees currently work on-site in hundreds of customer locations around the world. • Our cadre of 350 senior executives have each accepted personal responsibility for at least one of our major accounts. • Our research labs regularly host customers for two-way communication exchanges. • Our product developers and engineers, as they are quick to tell you, spend more time in the field with our customers than at any time in our history. • And, of course, our unsurpassed field sales and service force of some 25,000 people worldwide are intimately involved with their clients on a daily basis. From top to bottom, Xerox people are tightly connected to our customers and their businesses. For us, it’s very personal. Our customers are not faceless names, but real people with aspirations and needs and dreams that we want to help them realize. As a result, we are focused on three areas where we can help them be more successful. 4


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    There is, of course, the $9 billion production market, which we lead. A strong array of systems and solutions – led by the Xerox DocuColor® iGen3® Digital Production Press – promises to dramatically expand the market opportunity for Xerox. As you will see elsewhere in this report, our new generation of digital technology and services expands our market oppor- tunity three-fold. We are driving the New Business of Printing™ in areas such as one-to-one marketing and print-on-demand. Early customer response to our new generation of color production technology has been very encouraging. By year’s end, we had installed more than 125 DocuColor iGen3 presses. Many customers are buying more than one. In fact, our leading DocuColor iGen3 partner already has a half-dozen. Improving Selling, Our second opportunity is in the office, a market that is Administrative and huge. Xerox is well established in this market and focused on General Expenses segments that are growing the fastest – color, digital multi- ($ millions) function, and office services and solutions. Last year, we brought 5,518 15 new offerings to the office market – color and black-and- white, printers and copiers, multifunction and services – at price 4,728 4,437 4,249 points that are highly competitive. Our customers approved. We participated in more buying decisions than ever before – and we’re winning. Our third opportunity is in the services market, in which we are making significant inroads. Our customers – particularly our larger ones – are turning to us for help in designing and improving work processes that are document intensive. These include mining customer databases for one-to-one marketing 2000 2001 2002 2003 applications, content management and retrieval, seamless integration of paper and digital documents and a host of other applications. Our successful document outsourcing business gives us a strong base on which to build. Three years ago we made a critical strategic decision – to place our investment bets on market segments that were growing the fastest, where our customers needed help and where we could add value. That meant putting our technology and innovation muscle and brainpower behind digital production, the digital office, color and value-added services. Last year, 70 percent of our revenue came from these areas and revenue from these segments grew 8 percent. 5


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    At the same time, we made another strategic bet. We substan- tially deepened and widened our distribution channels with an eye to reaching more customers in the way they want while reducing unnecessary costs to Xerox. Although our direct sales force is still one of our crown jewels, it is augmented by an equally effective network of agents, concessionaires, value- added resellers, retailers and a worldclass TeleWeb operation. Xerox now claims the broadest and deepest set of offerings in our industry and the broadest and deepest network of distribution Return to Profitability channels. It’s a winning combination. Net Income (Loss) ($ millions) If I sound bullish, it’s because I am. We are in the right markets with the technology to expand those markets over 360 time. We have the right offerings that help our customers find better ways to do great work. And we have the right business model which delivers both operational excellence and consistently improving performance. 91 When I wrote to you last year, I said that one of our key priorities was to continue to establish credibility with you and to earn your trust. That is very important to all of us at Xerox. (94) We now have a three-year track record of delivering on some very specific commitments. We have an attractive and (273) predictable business model with a large recurring revenue 2000 2001 2002 2003 stream. And we have strengthened and streamlined business processes that enable us to better manage our business with improved efficiencies. Just as importantly, we have a premium brand in the attractive and expanding $100 billion document market, a vast distribution network led by a global sales and service force that the rest of our industry only dreams about, worldclass technology and innovation fueled by leading labs and scientists around the world, a knowledge and savviness about our customers’ docu- ment needs that builds on a rich heritage and our passionate engagement with our customers, a focused strategy of investing for growth in markets where we can add value – and the enormous talent of 60,000 people in more than a hundred countries who are committed to success. 6


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    As you might expect, the size of our opportunities and the soundness of our strategies has attracted some very tough com- petitors. We do not shrink from that challenge. It energizes us. All of us at Xerox believe our best days are ahead of us. And we believe just as firmly that the caliber of our competitors and the demands of our customers will only strengthen our resolve to execute tomorrow even better than we do today. Our 2004 plan is for flat revenue with margin and earnings expansion followed by a return to revenue growth, operating margin expansion, and continued earnings growth in 2005 and beyond. As the curtain goes up on our second act, all the pieces are in place to return Xerox to growth and greatness. We are confident but not arrogant, assured but not complacent. We constantly remind ourselves that the enemy of great is good. None of us at Xerox wants to be just good enough. We are on a road whose destination is nothing short of greatness. You should expect no less; we aim to deliver no less. We are keenly aware that you put a lot of faith in us. Earning your trust energizes us. We believe we have demonstrated consistency and credibility over the past three years. And we are determined to keep earning your trust in 2004 and beyond. Anne M. Mulcahy Chairman and Chief Executive Officer March 2004 7


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    X Strategies and Opportunities is a $15.7 billion technology and services enterprise that helps businesses deploy smart document management strategies and find better ways to work. Our intent is to constantly lead with innovative technologies, products, solutions and services that customers can depend upon to improve business results. The company’s operations are guided by customer-focused and employee- centered core values – such as social responsibility, diversity and quality – erox Corporation augmented by a passion for innovation, speed and adaptability. Color Everywhere: Remember black-and-white television, 2003 color revenue grew 17 percent, largely due to black-and-white computer monitors, black- the success of our DocuColor ® series. Color revenue and-white cell phone screens? The now represents more than 20 percent of total view certainly wasn’t as vibrant as it revenue. Yet color pages represent less than is in today’s much more colorful 4 percent of the total pages printed on Xerox digital world. With Xerox’s industry- technology. The opportunity for color remains huge leading color technology for produc- – in equipment sales, page volume growth and tion and office markets, those vibrant the subsequent flow through to post sale revenue. images on screens can be printed From desktop solid ink and laser color printers in affordable, high-quality color. Xerox’s to color multifunction systems and 100 page-per- comprehensive portfolio of color minute digital color presses, with Xerox color systems is driving the rapid acceleration technology what you see is really what you get. of color printing in the workplace. 8


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    Think about all the ways documents affect the way we We call it work and the way businesses smart document operate. Marketing brochures. Financial reports. Purchase orders. Employment management. applications. Insurance policies. Health forms. Through the industry’s broadest portfolio of Report cards. The list goes on and on. In today’s systems and services, we’re helping our world, some of these documents exist on paper customers find more efficient ways to manage but more often they are digital, found on work processes, ensure a seamless flow computer screens, on PDAs, and on Web pages. between paper and digital environments, share That’s where information lives today. That’s knowledge, personalize communication and where ideas are born. At Xerox, we offer create documents – whether they’re marks unparalleled expertise and technology that free on paper or data in a server – that are smart people to spend more time on creating content sources of invaluable information. and less time dealing with technology issues. Xerox’s business imperatives are centered on It’s not just about finding better delivering smart document strategies through ways to print and copy, it’s the production, office and services markets. about better ways to work. Here’s how… 9


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    Product on: i t’s a $9 billion market that has the potential to expand into a $27 billion opportunity as more high-volume print jobs are produced using dynamic digital technology rather than static and more time- and labor-intensive offset presses. It’s a market that Xerox created and continues to lead through breakthrough technology and value-added solutions. It’s all about driving the New Business of Printing™ – digital, personal, colorful, fast and effective. Through our production business, Xerox is In 2003, Xerox strengthened its delivering smart document management to large market share leadership position in: corporations, graphic arts customers, quick • Production publishing print centers, and commercial print enterprises. • Production printing Our high-volume digital production printers and presses, integrated with solutions, enable • Production color on-demand printing, short-run book publishing, And grew share in: one-to-one marketing applications and more. • Light production • Continuous feed Color Everywhere: Students at Parsons School of Design in New York City created and produced a colorful, 52-page campus-life magazine working with Roger Gimble, owner of Global Document Solutions, a Xerox commercial printing customer who is grow- ing his business through digital workflow tools integrated with his Xerox DocuColor® iGen3® Digital Production Press. Many iGen3 customers expect that this powerful system will help increase their overall revenue by at least 15 percent. 10


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    Xerox has shown a keen ability to identify and address emerging opportunities in the commercial print market. It has led with advanced digital color and monochrome printers and presses that help print providers profitably address a range of customer requirements, including book publishing, on-demand printing and one-to-one variable data solutions. Charles Pesko, Managing Director, CAP Ventures Smart Smart technology: business: • Digital presses that run at speeds from • Impressions produced on digital color 52 to 850 pages per minute. production printers are expected to grow from 14 billion in 2002 to more than 58 billion in • DocuColor production printers including the 2007, according to CAP Ventures. DocuColor iGen3, the only digital color press in the industry that prints 100 full-color 8 1⁄2 x 11- • For Xerox, revenue per color page is more inch impressions per minute at quality that than five times greater than revenue per rivals traditional offset printing. More than 200 black-and-white page. million pages have been printed to date on • According to industry analysts, color and person- iGen3 presses. alization significantly increase the response rate • DocuTech® black-and-white high-speed of direct mail. When an individual’s name is digital presses, including a recently launched added to a printed page, response rates go up new DocuTech platform that creates a new 44 percent. When a name and color are added, mid-production market segment and sets response rates increase 135 percent. But when image-quality, productivity, ease-of-use direct mail includes the customer’s name and and reliability benchmarks. customized content that addresses the customer’s interest and is printed in color, the • Xerox 2101 and 1010 digital light production response rates increase more than 500 percent. printer/copiers, our first entries in this growing market. • Digital production printing enables faster turn- around of large print jobs and the advantages • Continuous feed printing systems. of customized, one-to-one printing. According • FreeFlow™ software that improves workflow to independent third-party research, by 2005, processes from creation to delivery. 33 percent of all commercial print jobs will be produced in 24 hours or less. And the market for customized print applications will grow from $2.5 billion in 2001 to $6 billion in 2004. Siemens has shifted the production of its cell phone user guides in the global markets to an on-demand model that relies on a smart document management solution from Xerox. Through a combination of digital and offset production systems combined with variable information software and services, Xerox helps Siemens eliminate costly inventory expenses, achieve global quality standards and optimize processes. Real-time delivery is achieved with significant total cost savings. 11


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    F Smart O fice: technology: In the $57 billion office market, Xerox has nearly doubled its portfolio of office systems in the last year. We now boast the industry’s most complete product line of cost-competitive offerings in rom businesses run by all segments – full color and black-and-white, networked printers, multifunction systems, one person to global enterprises that and digital copiers at speeds that range from 16 to 90 pages per minute. rely on contributions from thousands, • WorkCentre® Pro, WorkCentre®, and Xerox systems and services meet CopyCentre® products are scalable systems that offer customers what they need, when they the needs of offices of any size. need it at prices that are the most competitive in Xerox’s history. With Xerox’s award-winning Our integrated approach to smart multifunction devices, customers manage their document management in the office multiple document needs with a single device that prints, copies, scans, faxes and emails. environment responds to our • Color systems including the WorkCentre Pro customers’ critical priorities: improving 32/40 and DocuColor® 3535 printer-copier, which use chemically grown emulsion aggre- productivity, reducing costs and gation toner – a Xerox science breakthrough that improves image quality and operating costs turning complex work processes into while using less toner and producing less waste. simple, efficient solutions. • Phaser® black-and-white and color network printers that rely on single-pass laser and solid ink color technology, making color printing easy and more affordable for the office. • CentreWare® Web software solution that helps customers manage all network printing devices, regardless of brand, through a Web browser. • FlowPort® software, which bridges the paper and digital worlds by using a unique encoded cover sheet to send scanned documents directly to email or other digital destinations. Xerox has three big things going for them right now: The widest array of hardware products in the marketplace, solutions and services both of their own design and partner companies, and distribution channels at all levels of the marketplace. Bring them all together and Xerox can win the office. Richard Norton, President, DocuTrends 12


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    Smart ConAgra Foods, Inc., one of North America’s largest packaged food companies, markets many of America’s favorite brands including Banquet, Butterball business: and Chef Boyardee. To keep its internal operations running as smoothly as its diverse marketing initiatives, ConAgra Foods turned to Xerox for help in streamlining its document management infrastructure. Through an • In 2002, about 64 billion pages were printed in Office Document Assessment, Xerox identified cost savings color. Xerox expects that by 2007, office envi- opportunities to consolidate certain printing and copying ronments will print about 159 billion pages functions, encourage use of scanning capabilities, and in color. Like the production business, color more effectively manage document management assets including equipment, supplies and service contracts. pages can deliver five times the revenue of ConAgra Foods is now replacing dozens of standalone black-and-white. copiers and printers with Xerox networked multifunction devices that print, copy, • Xerox’s expanded distribution strategy scan, and fax. It’s a recipe for productivity brings the Xerox brand to businesses small with Xerox as the key ingredient. to large. In addition to the industry’s strongest direct sales force and thousands of global concessionaires, resellers and Xerox sales agents, our more than 600 global TeleWeb representatives expand Xerox’s reach, reduce selling costs, and touch one-third of all office- related purchasing decisions. • Xerox is playing in more office purchasing decisions – and winning. We are a leader in the office color multifunction market. And last year, we gained share in the black-and-white digital multifunction market despite the tough competitive landscape. • Solid ink produces 90 percent less waste than laser printing. It is also up to three times faster. Xerox recently introduced a new solid ink platform that sets an industry standard for performance in the sub-$1,000 color printer market. Color Everywhere: Flip through a stack of mail and notice the affordability, reliability and ease of use pieces that catch your eye. The shimmering of the Xerox Phaser 8200 solid ink color silver dress on the catalog cover, the burning printer to produce full-color direct mail orange of the sun on a postcard, the bold advertising. With our expanding network red offer on a promotional flyer. It’s simple: of resellers, concessionaires, and sales color cuts through clutter. And more small agents, Xerox is reaching more and more companies today are using color – Xerox color small- and medium-size businesses, – to make their business stand out in a crowd. helping them see green through the allure It’s working for Tricia Hendricks and Roy Hall of Xerox color. of Regency Financial Services, a mortgage brokerage in Bronx, N.Y. They depend on the 13


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    Servi es: C McGraw-Hill Construction “It’s not easy to take millions of documents, scan them, keep them all together, index them for keyword searches then transmit them to different locations ompetitors come and different databases at the same time for and go. At Xerox, we never take competition for granted. repurposing onto different But, we also know what gives us the competitive edge media. Xerox showed us that they had really and what differentiates Xerox from the other players in mastered this technology.” the industry. Quite simply: it’s our people and our know-how. Combined, it’s a powerful, unrivalled force of deep knowledge on how to simplify and streamline docu- ment-intensive business processes. No one knows the nuances of document management better than Xerox. No one knows how to make document devices perform more intuitively, more efficiently than Xerox. Xerox Global Services is all about savvy people These words from Mark Kent, vice president of content for McGraw-Hill Construction, sum sharing their knowledge to help our customers up the challenge McGraw-Hill faced and the effectiveness of our deliver better business results. solution. Xerox worked with McGraw-Hill to consolidate its five regional scanning centers, which hosted more than 30 million pages of information for 60,000 active construction sites, into Xerox’s centralized imaging center in Hot Springs, Ark. The outsourcing partnership delivers savings of 20 percent to McGraw- Hill, shortens turnaround time for accessing documentation and increases customer service levels. Massive amounts of information available at a moment’s notice. Smart documents at work. 14


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    Smart Smart offerings: business: Based on our leadership position with large enter- • People in offices produce 7.5 billion documents prises and a solid $3 billion Managed Document a year. Industry analyst IDC estimates that exec- Service business, we provide consulting, imaging, utives spend 45 percent of their time working content management and outsourcing services with documents. And research indicates that that help our customers reduce costs through typical organizations spend between 5 and 15 processes that deliver the right information, in the percent of their revenue on documents. Xerox right form, at the right time. is embracing this massive opportunity to re- engineer often ignored work processes that are Personalized Communication Services: costing companies time and money. To cut through the clutter of information overload, more businesses are relying on Xerox systems • In the $16 billion document services market, and services to create personalized documents Xerox holds the No. 1 worldwide market (like brochures, enrollment kits, catalogs) that are position with large enterprises. printed on demand, when our customer needs • Experts estimate that most corporations spend it with the individualized information that piques between $5,000-$10,000 per employee per their customers’ interest. year to support IT infrastructure. Xerox’s Office Product Lifecycle Services: Document Assessments identify, on average, Products and services are more complex than savings of about 30 percent for clients’ docu- ever. And so are the documents that support ment costs. Office Document Assessments – them. Xerox creates seamless workflow a Six Sigma-based consulting tool – evaluate processes that reduce the need to produce and a company’s entire document environment store large volumes, enhance the effectiveness to identify areas where operating costs can of documentation and drive faster product be reduced, processes simplified and produc- delivery times. tivity improved. Document, Content and Imaging Services: People are more productive when the documents they need are easy to find and easy to share. Xerox helps streamline operations by converting traditional, document-intensive business process- es into searchable digital files. Xerox’s imaging services include scanning, retrieving, archiving, and hosting massive digital repositories – every- thing from insurance forms and employment applications to historical photos and blueprints. The Xerox relationship has allowed us to launch Office and Production Services: an even more powerful series of connected databases Xerox helps customers simplify work and improve productivity by eliminating hidden costs in tech- and get even more connected to our customers – nology-laden infrastructures. We assess our cus- the architects, engineers, contractors, and building tomers’ current operations from small businesses product manufacturers who rely on our information to large commercial print shops, design new work around the clock to do their jobs more effectively. processes using existing equipment, and even provide day-to-day management of document Norbert Young, President, McGraw-Hill Construction systems, supplies and service. 15


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    We Deliver on Commitments 2003 Report Card Commitments Results Maintain minimum $2.5 billion cash balance of $1 billion Year-end debt below $12 billion $11.2 billion Low single-digit equipment 7% growth sales growth Modest total revenue declines 1% decline Gross margin remains in 42% the 40% – 41% range SAG as a % of revenue improves 0.9 point improvement about 2 percentage points Expect earnings of Reported $0.36 $0.50 – $0.55 Pro-Forma* $0.58 * In an effort to provide investors with additional and more some cases, large factors or events, such as those that occurred useful information regarding Xerox’s results as determined by in 2003, distort operational long-term trends. For this reason, generally accepted accounting principles (GAAP), the company we believe that investors would find a pro-forma earnings is disclosing this non-GAAP earnings measure. The pro-forma measure, which excludes the effects of the Berger litigation and measure excludes the effects of the charges recorded for the write-off of debt issue costs, more useful. Reconciliation to the Berger litigation and the write-off of the unamortized 2002 debt related GAAP measure is included below. issue costs in order to provide consistency in display with the 2003 full year earnings guidance provided to investors in Reconciliation of Non-GAAP measure Per/Share November 2002. These 2003 unanticipated charges were not Earnings $ 0.36 contemplated when the guidance was provided. In addition, the Berger Litigation Provision $ 0.17 ($146 million after-tax) pro-forma measure provides a consistent basis in evaluating Write-off of debt issue costs $ 0.05 ($45 million after-tax) Xerox’s 2004 earnings projections. We believe that meaningful Pro-forma earnings $ 0.58 analysis of our financial performance requires an understanding of the underlying factors and trends in that performance. In 16


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    Financial Review 18 Management’s Discussion and Analysis of Results of Operations and Financial Condition 38 Audited Consolidated Financial Statements 38 Consolidated Statements of Income 39 Consolidated Balance Sheets 40 Consolidated Statements of Cash Flows 41 Consolidated Statements of Common Shareholders’ Equity 42 Notes to the Consolidated Financial Statements 91 Report of Management 91 Report of Independent Auditors 92 Quarterly Results of Operations 93 Five Years in Review 94 Officers 95 Directors 96 Social Responsibility 17


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    Management’s Discussion and Analysis of Results of Operations and Financial Condition Throughout this document, references to “we,” Financial Overview: “our” or “us” refer to Xerox Corporation and its sub- sidiaries. References to “Xerox Corporation” refer to In 2003, we continued to build on our 2002 momentum the stand-alone parent company and do not include as evidenced by product installation and equipment its subsidiaries. sales growth, earnings growth and an improvement in our overall financial condition and liquidity. In a relatively weak economic environment, we continued Executive Overview: our transition toward revenue growth and further We are a technology and services enterprise and a improved our business model. Our focused invest- leader in the global document market, developing, ment in the growing areas of digital production and manufacturing, marketing, servicing and financing the office systems yielded 21 new products. The success industry’s broadest portfolio of document equipment, of these products, combined with the 17 products solutions and services. Our industry is undergoing a introduced in 2002, enabled us to gain market share in fundamental transformation from older technology key segments and deliver year-over-year equipment light lens devices to digital systems, the transition sales growth in each quarter. These improved trends, from black and white to color, as well as an increased combined with favorable currency translation, helped reliance on electronic documents. While in the near moderate the decline in total revenue. term we are experiencing certain revenue declines We maintained our focus on cost management related to the proportion of our total revenues attribut- throughout 2003. Gross margins remained strong as able to light lens products, we believe that, as a whole, we continued to offset price investments with produc- these trends play to our strengths and represent tivity improvements. We further reduced selling, admin- opportunities for future growth since our research istrative and general (SAG) expenses and continued to and development investments have been focused on invest in research and development, prioritizing our digital and color offerings. investments in the faster growing areas of the market. We operate in competitive markets and our cus- Our 2003 balance sheet strategy focused on reduc- tomers demand improved solutions, such as the abili- ing total debt, extending debt maturities, improving ty to print offset quality color documents on demand; operating cash flows, maintaining long-term financing improved product functionality, such as the ability to agreements supporting our secured borrowing strate- print, copy, fax and scan from a single device; and gy and maintaining a cash balance of at least $1 bil- lower prices for the same functionality. We deliver lion. In 2003, we significantly improved our liquidity advanced technology through focused investment in by completing a $3.6 billion Recapitalization, which research and development and offset lower prices included public offerings of common stock, 3-year through continuous improvement of our cost base. mandatory convertible preferred stock and 7-year Our revenue is heavily dependent on the amount of and 10-year senior unsecured notes, as well as our equipment installed at customer locations and the uti- new $1 billion 2003 Credit Facility. In 2003, we also lization of those devices. As such, our critical success improved our liquidity by expanding our secured bor- factors include hardware installation and equipment rowing programs beyond our primary $5 billion U.S. sales growth to stabilize and grow our installed base agreement with General Electric Capital Corporation of equipment at customer locations. In addition to our to also include long-term arrangements in Canada, the installed base, the key factors in delivering growth in U.K. and France. Proceeds from the Recapitalization, our recurring revenue streams (supplies, service, secured borrowing programs, and $1.9 billion of cash paper, outsourcing and rental, which we collectively generated from operations enabled us to reduce total refer to as post sale revenue) are page volume growth debt by $3 billion in 2003, extend $1.6 billion of debt and higher revenue per page. Connected multifunc- maturities and end the year with a cash balance of tion devices and new services and solutions are key $2.5 billion. We continue to focus on strengthening drivers to increase equipment usage. The transition to our balance sheet to further enhance our operating color is the primary driver to improve revenue per and financial flexibility. page, as color documents typically require significantly Revenues for the three-year period ended more toner coverage per page than traditional black December 31, 2003 were as follows: and white printing. Revenue per color page is approxi- mately five times higher than revenue per black and white page. 18


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    Year Ended December 31, Percent Change ($ in millions) 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 rev- by growth in our digital revenues, driven by increased enues to the revenue classifications included in our usage of color products and monochrome multifunc- Consolidated Statements of Income is as follows: tion systems. 2002 Finance income declined 11 per- cent from 2001, resulting from lower equipment Year Ended December 31, installations and our exit from the financing business ($ in millions) 2003 2002 2001 in certain European countries. Sales $ 6,970 $ 6,752 $ 7,443 Net income (loss) and diluted earnings (loss) per Less: Supplies, paper and share for the three years ended December 31, 2003 other sales (2,720) (2,782) (3,040) were as follows: Equipment Sales $ 4,250 $ 3,970 $ 4,403 Year Ended December 31, Service, outsourcing and rentals $ 7,734 $ 8,097 $ 8,436 ($ in millions, except share amounts) 2003 2002 2001 Add: Supplies, paper and Net income (loss) $ 360 $ 91 $ (94) other sales 2,720 2,782 3,040 Preferred stock dividends (71) (73) (12) Post sale and other revenue $10,454 $10,879 $11,476 Income (loss) available to common shareholders $ 289 $ 18 $ (106) Total 2003 revenues of $15.7 billion declined one Diluted earnings (loss) per share $0.36 $0.02 $(0.15) percent from 2002, reflecting moderating year-over- year revenue declines, as well as a 5-percentage point 2003 Net income of $360 million, or 36 cents per benefit from currency. Equipment sales increased diluted share, included after-tax impairment and 7 percent in 2003, reflecting a 6-percentage point ben- restructuring charges of $111 million ($176 million efit from currency, as well as the success of our pre-tax), an after-tax charge of $146 million ($239 mil- numerous color multifunction and production color lion pre-tax) related to the court approved settlement products and growth in our Developing Markets of the Berger v. RIGP litigation, a $45 million after-tax Operations (DMO) segment. 2003 Post sale and other ($73 million pre-tax) loss on early extinguishment of revenue declined 4 percent from 2002, primarily due debt and income tax benefits of $35 million from the to declines in older technology light lens revenues, reversal of deferred tax asset valuation allowances. DMO and the Small Office/Home Office (SOHO) busi- 2002 Net income of $91 million, or 2 cents per ness which we exited in the second half of 2001. These diluted share, included after-tax asset impairment and declines were partially offset by growth in our digital restructuring charges of $471 million ($670 million revenues and a 5-percentage point benefit from cur- pre-tax), a pre-tax and after-tax charge of $63 million rency. Post sale and other revenue declines reflect the for impaired goodwill and an after-tax charge of reduction in our equipment at customer locations and $72 million ($106 million pre-tax) for permanently related page volume declines. As our equipment sales impaired internal-use capitalized software, partially continue to increase, we expect that the effects of offset by $105 million of tax benefits arising from the post-sale declines will moderate and ultimately favorable resolution of a foreign tax audit and tax law reverse over time. 2003 Finance income, which was changes, as well as a favorable adjustment to com- primarily impacted by the volume of equipment lease pensation expense of $31 million ($33 million pre-tax), originations, approximated that of 2002, including a that was previously accrued in 2001, associated with 5-percentage point benefit from currency. the reinstatement of dividends for our Employee Stock Total 2002 revenues of $15.8 billion declined Ownership Plan (“ESOP”). 7 percent from 2001, including a one-percentage point The 2001 net loss of $94 million, or 15 cents per benefit from currency. Economic weakness and com- diluted share, included $507 million of after-tax petitive pressures were only partially offset by the charges ($715 million pre-tax) for restructuring and success of several new color and monochrome multi- asset impairments associated with our Turnaround function products, most of which were launched in the Program including our disengagement from our second half of the year. As a result, equipment sales worldwide SOHO business. 2001 results also included declined 10 percent from 2001. 2002 Post sale and a $304 million after-tax gain ($773 million pre-tax) other revenue declined 5 percent from 2001 primarily from the sale of half of our interest in Fuji Xerox, a due to declines in older technology light lens, DMO $38 million after-tax gain ($63 million pre-tax) related and SOHO. These declines were only partially offset 19


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    to the early retirement of debt, $21 million of after-tax Revenue Recognition Under Bundled Arrangements: gains ($29 million pre-tax) associated with unhedged As discussed more fully in Note 1 to the Consolidated foreign currency, partially offset by $31 million Financial Statements, we sell most of our products ($33 million pre-tax) of increased compensation and services under bundled contract arrangements, expense associated with the suspension of dividends which typically include equipment, service, supplies for our ESOP and after-tax goodwill amortization of and financing components for which the customer $59 million ($63 million pre-tax). pays a single negotiated price for all elements. These arrangements typically also include a variable compo- Application of Critical nent for page volumes in excess of contractual mini- mums, which are often expressed in terms of price per Accounting Policies: page, which we refer to as the “cost per copy.” In a In preparing our Consolidated Financial Statements typical bundled arrangement, our customer is quoted and accounting for the underlying transactions and a fixed minimum monthly payment for 1) the equip- balances, we apply accounting policies that are ment, 2) the associated services and other executory described in the Notes to the Consolidated Financial costs, 3) the financing element and 4) frequently sup- Statements. We consider the policies discussed below plies. When separate prices are listed in multiple ele- as critical to understanding our Consolidated Financial ment customer contracts, such prices may not be Statements, as their application places the most signif- representative of the fair values of those elements, icant demands on management’s judgment, since because the prices of the different components of the financial reporting results rely on estimates of the arrangement may be modified through customer effects of matters that are inherently uncertain. negotiations, although the aggregate consideration Specific risks associated with these critical accounting may remain the same. Revenues under these arrange- policies are described in the following paragraphs. ments are allocated based upon the estimated relative The impacts and significant risks associated with these fair values of each element. Our revenue allocation to policies on our business operations are discussed the lease deliverables begins by allocating revenues to throughout this MD&A where such policies affect our the maintenance and executory costs plus profit there- reported and expected financial results. For a detailed on. The remaining amounts are allocated to the equip- discussion of the application of these and other ment and financing elements. We perform extensive accounting policies, see Note 1 to the Consolidated analyses of available verifiable objective evidence of Financial Statements. equipment fair value based on cash selling prices dur- Senior management has discussed the develop- ing the applicable period. The cash selling prices are ment and selection of the critical accounting policies, compared to the range of values included in our lease estimates and related disclosures, included herein, accounting systems. The range of cash selling prices with the Audit Committee of the Board of Directors. must be reasonably consistent with the lease selling Preparation of this annual report requires us to make prices, taking into account residual values that accrue estimates and assumptions that affect the reported to our benefit, in order for us to determine that such amount of assets and liabilities, disclosure of contin- lease prices are indicative of fair value. Our pricing gent assets and liabilities as of the date of our financial interest rates, which are used in determining customer statements and the reported amounts of revenue and payments, are developed based upon a variety of fac- expenses during the reporting period. Although actual tors including local prevailing rates in the marketplace results may differ from those estimates, we believe and the customer’s credit history, industry and credit the estimates are reasonable and appropriate. In class. Effective January 1, 2004, the pricing rates will instances where different estimates could reasonably be reassessed quarterly based on changes in local pre- have been used in the current period, we have dis- vailing rates in the marketplace and will be adjusted to closed the impact on our operations of these different the extent such rates vary by twenty-five basis points estimates. In certain instances, for instance with or more, cumulatively, from the last rate in effect. The respect to revenue recognition for leases, because the pricing interest rates generally equal the implicit rates accounting rules are prescriptive, it would not have within the leases, as corroborated by our comparisons been possible to have reasonably used different esti- of cash to lease selling prices. mates in the current period and sensitivity information would therefore not be appropriate. Changes in Revenue Recognition for Leases: As more fully assumptions and estimates are reflected in the period discussed in Note 1 to the Consolidated Financial in which they occur. The impact of such changes could Statements, our accounting for leases involves specif- be material to our results of operations and financial ic determinations under applicable lease accounting condition in any quarterly or annual period. standards which often involve complex and prescrip- tive provisions. These provisions affect the timing of revenue recognition for our equipment. If the leases qualify as sales-type capital leases, equipment revenue 20


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    is recognized upon delivery or installation of the improved customer administration, collection practices equipment as sale revenue as opposed to ratably over and credit approval policies, as well as our revenue the lease term. The critical elements that we consider declines. with respect to our lease accounting are the determi- As discussed above, in preparing our Consolidated nation of the economic life and the fair value of equip- Financial Statements for the three years ended ment, including the residual value. Those elements December 31, 2003, we estimated our provision for are based upon historical experience with all our prod- doubtful accounts based on historical experience and ucts. For purposes of determining the economic life, customer-specific collection issues. We believe this we consider the most objective measure of historical methodology is appropriate. During the five year period experience to be the original contract term, since most ended December 31, 2003, our allowance for doubtful equipment is returned by lessees at or near the end of accounts ranged from approximately 3.4 to 5.5 percent the contracted term. The economic life of most of our of gross receivables. Holding all other assumptions products is five years since this represents the most constant, a one percentage point increase or decrease frequent contractual lease term for our principal prod- in the allowance from the December 31, 2003 rate ucts and only a small percentage of our leases are for of 4.6 percent would change the 2003 provision of original terms longer than five years and there is gen- $224 million by approximately $115 million. erally no significant after-market for our used equip- Historically, about half of the provision for doubtful ment. We believe five years is representative of the accounts relates to our finance receivables portfolio. period during which the equipment is expected to be This provision is inherently more difficult to estimate economically usable, with normal service, for the pur- than the provision for trade accounts receivable pose for which it is intended. Residual values are because the underlying lease portfolio has an average established at lease inception using estimates of fair maturity, at any time, of approximately two to three value at the end of the lease term and are established years and contains past due billed amounts, as well as with due consideration to forecasted supply and unbilled amounts. The estimated credit quality of any demand for our various products, product retirement given customer and class of customer or geographic and future product launch plans, end of lease cus- location can significantly change during the life of the tomer behavior, remanufacturing strategies, used portfolio. We consider all available information in our equipment markets, if any, competition and techno- quarterly assessments of the adequacy of the provi- logical changes. sion for doubtful accounts. Accounts and Finance Receivables Allowance for Provisions for Excess and Obsolete Inventory Losses: Doubtful Accounts and Credit Losses: We perform We value our inventories at the lower of average cost ongoing credit evaluations of our customers and or market. Inventories also include equipment that is adjust credit limits based upon customer payment his- returned at the end of the lease term. Returned equip- tory and current creditworthiness. We continuously ment is recorded at the lower of remaining net book monitor collections and payments from our customers value or salvage value. Salvage value consists of the and maintain a provision for estimated credit losses estimated market value (generally determined based based upon our historical experience and any specific on replacement cost) of the salvageable component customer collection issues that have been identified. parts, which are expected to be used in the remanu- While such credit losses have historically been within facturing process. We regularly review inventory our expectations and the provisions established, we quantities, including equipment to be leased to cus- cannot guarantee that we will continue to experience tomers, which is included as part of finished goods credit loss rates similar to those we have experienced inventory, and record a provision for excess and/or in the past. Measurement of such losses requires con- obsolete inventory based primarily on our estimated sideration of historical loss experience, including the forecast of product demand and production require- need to adjust for current conditions, and judgments ments. Several factors may influence the realizability about the probable effects of relevant observable data, of our inventories, including our decision to exit a including present economic conditions such as delin- product line, technological changes and new product quency rates and financial health of specific customers. development. These factors could result in an increase We recorded $224 million, $353 million, and $506 mil- in the amount of excess or obsolete inventory quan- lion in the Consolidated Statements of Income for pro- tities. Additionally, our estimates of future product visions for doubtful accounts for both our accounts demand may prove to be inaccurate, in which case we and finance receivables for the years ended December may have understated or overstated the provision 31, 2003, 2002 and 2001, respectively, of which $224 required for excess and obsolete inventories. million, $332 million, and $438 million were included Although we make every effort to ensure the accuracy in selling, administrative and general expenses for of our forecasts of future product demand, including such years, respectively. The declining trend in our the impact of future product launches and changes in provision for doubtful accounts is primarily due to remanufacturing strategies, significant unanticipated 21


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    changes in demand or technological developments Goodwill and Other Acquired Intangible Assets: We could materially impact the value of our inventory and have made acquisitions in the past that included the our reported operating results if our estimates prove recognition of a significant amount of goodwill and to be inaccurate. We recorded $78 million, $115 mil- other intangible assets. Commencing January 1, 2002, lion, and $242 million in inventory write-down charges goodwill is no longer amortized, but instead is for the years ended December 31, 2003, 2002 and 2001, assessed for impairment annually or more frequently respectively. The decline in inventory write-down as triggering events occur that indicate a decline in fair charges is due to the absence of business exiting activ- value below that of its carrying value. In making these ities, stabilization of our product lines, manufacturing assessments, we rely on a number of factors including outsourcing related improvements and a lower level operating results, business plans, economic projec- of inventories. tions, anticipated future cash flows and market compa- As discussed above, in preparing our financial rable data. There are inherent uncertainties related to statements for the three years ended December 31, these factors and our judgment, including the risk that 2003, we estimated our provision for excess and obso- the carrying value of our goodwill may be overstated lete inventories based primarily on forecasts of pro- or understated. In 2002, we recognized an impairment duction and service requirements. We believe this charge of $63 million related to the goodwill in our methodology is appropriate. During the three year DMO segment, which was recorded as a cumulative period ended December 31, 2003, inventory reserves effect of a change in accounting principle in the accom- for net realizable value adjustments as a percentage of panying Consolidated Statements of Income. gross inventory varied by approximately one percent- age point. Holding all other assumptions constant, a Pension and Post-retirement Benefit Plan 0.5 percentage point increase or decrease in our net Assumptions: We sponsor pension plans in various realizable value adjustments would change the 2003 forms in several countries covering substantially all provision of $78 million by approximately $7 million. employees who meet eligibility requirements. Post- retirement benefit plans cover primarily U.S. employ- Asset Valuations and Review for Potential ees for retirement medical costs. Several statistical Impairments: Our long-lived assets, excluding good- and other factors that attempt to anticipate future will, are assessed for impairment by comparison of events are used in calculating the expense, liability the total amount of undiscounted cash flows expected and asset values related to our pension and post- to be generated by such assets to their carrying value. retirement benefit plans. These factors include We periodically review our long-lived assets, whereby assumptions we make about the discount rate, expect- we make assumptions regarding the valuation and the ed return on plan assets, rate of increase in healthcare changes in circumstances that would affect the carry- costs, the rate of future compensation increases and ing value of these assets. If such analysis indicates mortality, among others. For purposes of determining that an impairment exists, we are then required to the expected return on plan assets, we utilize a calcu- estimate the fair value of the asset and, as appropriate, lated value approach in determining the value of the expense all or a portion of the asset, based on a com- pension plan assets, as opposed to a fair market value parison to the net book value of such asset or group of approach. The primary difference between the two assets. The determination of fair value includes inher- methods relates to a systematic recognition of ent uncertainties, such as the impact of competition changes in fair value over time (generally two years) on future value. Our primary methodology for deter- versus immediate recognition of changes in fair value. mining fair value is based on a discounted cash flow Our expected rate of return on plan assets is then model. We believe that we have made reasonable esti- applied to the calculated asset value to determine the mates and judgments in determining whether our amount of the expected return on plan assets to be long-lived assets have been impaired; however, if used in the determination of the net periodic pension there is a material change in the assumptions used in cost. The calculated value approach reduces the our determination of fair values or if there is a material volatility in net periodic pension cost that results from change in economic conditions or circumstances influ- using the fair market value approach. The difference encing fair value, we could be required to recognize between the actual return on plan assets and the certain impairment charges in the future. During 2002, expected return on plan assets is added to, or sub- due to our decision to abandon the use of certain soft- tracted from, any cumulative differences that arose in ware applications, we recorded an impairment charge prior years. This amount is a component of the unrec- of $106 million in Selling, administrative and general ognized net actuarial (gain) loss and is subject to expenses in the accompanying Consolidated amortization to net periodic pension cost over the Statement of Income. In addition, we recorded asset average remaining service lives of the employees par- impairment charges in connection with our restructur- ticipating in the pension plan. ing actions of $1 million, $55 million, and $205 million As a result of cumulative asset returns being lower in 2003, 2002, and 2001, respectively. than expected asset returns over the last several years 22


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    and declining interest rates, 2004 net periodic pension Balance Sheets, as well as operating loss and tax cred- cost will increase. The total unrecognized actuarial it carryforwards. We follow very specific and detailed loss as of December 31, 2003 was $1.87 billion, as guidelines in each tax jurisdiction regarding the recov- compared to $1.84 billion at December 31, 2002. The erability of any tax assets recorded in our change from December 31, 2002 relates to a decline in Consolidated Balance Sheets and provide necessary the discount rate, offset by improved asset returns as valuation allowances as required. We regularly review compared to expected returns. The total unrecognized our deferred tax assets for recoverability considering actuarial loss will be amortized in the future, subject to historical profitability, projected future taxable income, offsetting gains or losses that will change the future the expected timing of the reversals of existing tempo- amortization amount. We have recently utilized a rary differences and tax planning strategies. If we con- weighted average expected rate of return on plan tinue to operate at a loss in certain jurisdictions or are assets of 8.3 percent for 2003 expense, 8.8 percent for unable to generate sufficient future taxable income, or 2002 expense and 8.9 percent for 2001 expense, on a if there is a material change in the actual effective tax worldwide basis. In estimating this rate, we consid- rates or time period within which the underlying tem- ered the historical returns earned by the plan assets, porary differences become taxable or deductible, we the rates of return expected in the future and our could be required to increase the valuation allowance investment strategy and asset mix with respect to the against all or a significant portion of our deferred tax plans’ funds. The weighted average rate we will utilize assets, resulting in a substantial increase in our effec- to calculate our 2004 expense will be 8.1 percent. tive tax rate and a material adverse impact on our Another significant assumption affecting our pension operating results. Conversely, if and when our opera- and post-retirement benefit obligations and the net tions in some jurisdictions were to become sufficiently periodic pension and other post-retirement benefit profitable to recover previously reserved deferred tax cost is the rate that we use to discount our future assets, we would reduce all or a portion of the applica- anticipated benefit obligations. In estimating this rate, ble valuation allowance in the period when such deter- we consider rates of return on high quality fixed- mination is made. This would result in an increase to income investments over the period to expected pay- reported earnings in such period. Adjustments to our ment of the pension and other benefits. The weighted valuation allowance, through charges (credits) to average rate we will utilize to measure our pension expense, were $(16) million, $15 million, and $247 mil- obligation as of December 31, 2003 and calculate our lion for the years ended December 31, 2003, 2002 and 2004 expense will be 5.8 percent, which is a decrease 2001, respectively. from 6.2 percent used in the determination of our pen- We are subject to ongoing tax examinations and sion obligations in 2003. As a result of the reduction in assessments in various jurisdictions. Accordingly, we the discount rate, the lower cumulative actual return incur additional tax expense based upon the probable on plan assets during the prior three years and certain outcomes of such matters. In addition, when applica- other factors, our 2004 net periodic pension cost is ble, we adjust the previously recorded tax expense to expected to be $65 million higher than 2003. reflect examination results. Our ongoing assessments On a consolidated basis, we recognized net peri- of the probable outcomes of the examinations and odic pension cost of $364 million, $168 million, and related tax positions require judgment and can materi- $99 million for the years ended December 31, 2003, ally increase or decrease our effective tax rate as well 2002 and 2001, respectively. Pension cost is included as impact our operating results. in several income statement components based on the related underlying employee costs. Pension and Legal Contingencies: We are a defendant in numerous post-retirement benefit plan assumptions are included litigation and regulatory matters including those in Note 12 to the Consolidated Financial Statements. involving securities law, patent law, environmental Holding all other assumptions constant, a 0.25 percent law, employment law and ERISA, as discussed in Note increase or decrease in the discount rate from the 15 to the Consolidated Financial Statements. We 2004 projected rate of 5.8 percent would change the determine whether an estimated loss from a contin- 2004 projected net periodic pension cost by approxi- gency should be accrued by assessing whether a loss mately $23 million. Likewise, a 0.25 percent increase is deemed probable and can be reasonably estimated. or decrease in the expected return on plan assets from We assess potential liability by analyzing our litigation the 2004 projected rate of 8.1 percent would change and regulatory matters using available information. the 2004 projected net periodic pension cost by We develop our views on estimated losses in consul- approximately $9 million. tation with outside counsel handling our defense in these matters, which involves an analysis of potential Income Taxes and Tax Valuation Allowances: We results, assuming a combination of litigation and set- record the estimated future tax effects of temporary tlement strategies. Should developments in any of differences between the tax bases of assets and liabili- these matters cause a change in our determination as ties and amounts reported in our Consolidated to an unfavorable outcome and result in the need to 23


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    recognize a material accrual, or should any of these CopyCentre, WorkCentre, and WorkCentre Pro digital matters result in a final adverse judgment or be settled multifunction systems, DocuColor multifunction prod- for significant amounts, they could have a material ucts, color laser, solid ink and monochrome laser desk- adverse effect on our results of operations, cash flows top printers, digital and light-lens copiers and facsimile and financial position in the period or periods in which products. The DMO segment includes our operations in such change in determination, judgment or settlement Latin America, the Middle East, India, Eurasia, Russia occurs. In 2003, we recorded a charge of $239 million and Africa. This segment includes sales of products that reflecting the court approved settlement of the Berger are typical to the Production and Office segments; how- pension related litigation. ever, management serves and evaluates these markets on an aggregate geographic basis, rather than on a Summary of Results: product basis. The segment classified as Other, includes several units, none of which met the thresholds for sep- Our reportable segments are consistent with how we arate segment reporting. This group includes Xerox manage the business and view the markets we serve. Supplies Group (predominantly paper), SOHO, Xerox Our reportable segments are Production, Office, DMO Engineering Systems (“XES”), Xerox Technology and Other. Our offerings include hardware, services, Enterprises and consulting services, royalty and license solutions and consumable supplies. The Production revenues. Other segment profit (loss) includes the oper- segment includes black and white products which oper- ating results from these entities, other less significant ate at speeds over 90 pages per minute and color prod- businesses, our equity income from Fuji Xerox, and ucts over 40 pages per minute. Products include the certain costs which have not been allocated to the DocuTech, DocuPrint, Xerox 1010 and Xerox 2101 and Production, Office and DMO segments including non- DocuColor families, as well as older technology light- financing interest and other corporate costs. 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 Revenues: up to 40 pages per minute. Products include our family Revenues by segment for the years ended 2003, 2002 of Document Centre digital multifunction products and 2001 were as follows: which were expanded to include our new suite of (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: percentage point benefit from currency, as continued economic weakness and competitive pressures more 2003 Equipment sales of $4.3 billion increased 7 per- than offset the successful impact of new products, most cent from 2002, reflecting significant growth in DMO, of which were launched in the second half of 2002. the success of numerous new product introductions and a 6-percentage point benefit from currency. In Production: 2003 equipment sales grew 9 percent from 2003, approximately 50 percent of equipment sales 2002, as improved product mix, installation growth and were generated from products launched in the previ- favorable currency of 7 percent more than offset price ous two years. Color equipment sales represented declines of approximately 5 percent. Strong 2003 28 percent of total equipment sales compared with production color equipment sales growth reflected 24 percent in 2002. 2002 equipment sales of $4.0 bil- increased installations and stronger product mix driven lion declined 10 percent from 2001, including a one by the DocuColor 6060 and DocuColor iGen3 products. 24


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    The DocuColor iGen3 utilizes next generation color 2003 service, outsourcing and rental revenue of technology which we expect will expand the digital $7.7 billion declined 4 percent from 2002, reflecting color print on demand market. 2003 production declines in rental and facilities management revenues. monochrome equipment sales grew modestly as light- Declines in rental revenues primarily reflect reduced production installations, driven by the success of the equipment populations within DMO and declines in new Xerox 2101 copier/printer, and favorable currency facilities management revenues reflect consolidations more than offset declines in production publishing, by our customers as well as our prioritization of prof- printing and older technology light lens. 2002 equip- itable contracts. 2002 post sale and other revenues of ment sales declined 8 percent from 2001 reflecting $10.9 billion declined 5 percent from 2001. 2002 sup- price declines of approximately 5 percent, weaker plies, paper and other sales of $2.8 billion declined product mix and installation declines driven largely 8 percent from 2001, primarily reflecting declines in by older technology light lens equipment. supplies. 2002 service, outsourcing and rental revenue of $8.1 billion declined 4 percent from 2001 driven Office: 2003 equipment sales grew 5 percent from primarily by lower rental revenues in DMO. 2002, as favorable currency of 7 percent and installa- tion increases more than offset price declines of Production: 2003 post sale and other revenue declined approximately 10 percent and the impact of weaker 2 percent from 2002, as favorable currency and product mix. Equipment installation growth of approx- improved mix, driven largely by an increased volume imately 20 percent reflects growth in all monochrome of color pages, were more than offset by the impact of digital and color businesses, particularly office color monochrome page volume declines, primarily in older printing and our line of monochrome multifunction/ technology light lens products. 2002 post sale and copier systems. The CopyCentre, WorkCentre and other revenue declined 2 percent from 2001, as WorkCentre Pro systems, which were launched in the declines in monochrome page volumes more than second quarter 2003, are intended to expand our mar- offset the impact of improved mix due to significant ket reach and include new entry-level configurations growth in color page volumes. at more competitive prices. 2002 equipment sales declined 5 percent from 2001, with approximately two- Office: 2003 post sale and other revenue grew 1 percent thirds of the decline driven by older technology light from 2002, as favorable currency and strong digital lens products. The remainder of the decline was due page growth more than offset declines in older tech- to price declines of approximately 10 percent and nology light lens products. 2002 post sale and other weaker product mix, which more than offset installa- revenue declined 6 percent from 2001, as declines in tion growth in our digital products. older technology light lens products more than offset strong digital page growth. DMO: 2003 equipment sales grew 27 percent from 2002, reflecting volume growth of over 40 percent, DMO: 2003 post sale and other revenue declined partially offset by price declines of approximately 10 16 percent from 2002, due largely to a lower rental percent and unfavorable mix. equipment population at customer locations and relat- ed page volume declines. 2002 post sale and other rev- Other: 2003 equipment sales declined 14 percent from enue declined 16 percent from 2001, due to a reduction 2002 due to general sales declines, none of which in the amount of equipment installations at certain were individually significant. 2002 equipment sales DMO customer locations as a result of reduced place- declined 53 percent from 2001, primarily reflecting our ments in prior periods. exit from the SOHO business in 2001. Other: 2003 post sale and other revenue declined Post Sale and Other Revenue: 10 percent from 2002, reflecting supply sale declines in SOHO of $82 million as well as the absence of 2003 post sale and other revenues of $10.5 billion $50 million of third-party licensing revenue recognized declined 4 percent from 2002, including a 5-percent- in 2002. See Note 3 to the Consolidated Financial age point benefit from currency. These declines reflect Statements for further discussion. lower equipment populations, as post sale revenue is largely a function of the equipment placed at customer We expect 2004 equipment sales will continue to locations and the volume of prints and copies that our grow, as we anticipate that new products launched in customers make on that equipment as well as associ- 2002, 2003 and those planned in 2004 will enable us to ated services. 2003 supplies, paper and other sales of further strengthen our market position. Our ability to $2.7 billion (included within post sale and other rev- increase post sale revenue is dependent on our suc- enue) declined 2 percent from 2002 primarily due to cess at increasing the amount of our equipment at declines in supplies. Supplies sales declined due to customer locations and the volume of pages generat- reduced usage in the lower installed base of equip- ed on that equipment. In 2004, we expect post sale ment and our exit from the SOHO business in 2001. and other revenue declines will continue to moderate 25


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    as equipment sales increase and our services and Segment Operating Profit: solutions increase utilization of the equipment. Accordingly, we expect 2004 total revenues to be in Segment operating profit and operating margin for line with 2003 levels. 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 lion related to the ESOP expense adjustment and $50 from 2002, reflecting lower gross margins related to million of profit related to a licensing agreement. These initial installations of DocuColor iGen3 and Xerox amounts were partially offset by the write-off of internal 2101. The decrease in gross margins was only partially use software of $106 million in 2002. offset by lower R&D and SAG expenses. 2002 operat- 2002 Other segment loss of $329 million ing profit improved $78 million from 2001, reflecting decreased by $69 million from 2001, principally due to gross margin improvements and lower SAG expense, our exit from SOHO in the second half of 2001, which including reduced bad debt levels. improved results by $272 million on a year over year basis. Operating results were also favorably impacted Office: 2003 operating profit improved $132 million by lower non-financing interest expense of $49 mil- from 2002, reflecting improved gross margins driven lion, the $33 million beneficial year over year impact primarily by improved manufacturing and service pro- of the ESOP expense adjustment and the $50 million ductivity, as well as lower R&D and SAG expenses. profit from the licensing agreement. These amounts 2002 operating profit improved by $194 million from were offset by several items, including the write-off of 2001 as we focused on more profitable revenue, internal use software of $106 million, higher pension improved our manufacturing and service productivity and benefit expense of $93 million and higher adver- and reduced SAG expenses. tising expenses of $62 million. DMO: 2003 operating profit improved $60 million from Employee Stock Ownership Plan (ESOP): In 2002, 2002 due to significantly lower SAG spending resulting our Board of Directors reinstated the dividend on our from our cost saving initiatives, lower bad debts and ESOP, which resulted in a reversal of previously gains on currency exposures compared to currency recorded compensation expense. The reversal of exposure losses in 2002. These improvements were compensation expense corresponded to the line item partially offset by lower gross margins as a result of in the Consolidated Statement of Income for 2002 declining post sale revenue. 2002 operating profit where the charge was originally recorded and includ- improved by $188 million from the 2001 operating loss ed $28 million in both Cost of Sales and Selling, due to reduced SAG spending resulting from our cost administrative and general expenses and $11 million base restructuring actions and lower bad debt levels, in Research and Development expenses. Of the total as well as significant gross margin improvement driv- compensation expense originally recorded, $34 mil- en by our focus on profitability. DMO refined its busi- lion and $33 million was recognized in 2002 and 2001, ness model in 2002 by transitioning equipment respectively. As such, 2002 benefited by the reversal of financing to third parties, improving credit policies $33 million of excess compensation expense that was and implementing additional cost reduction actions. originally recorded in 2001. There is no corresponding earnings per share improvement in 2002 since the EPS Other: 2003 Other segment operating loss of $411 mil- calculation requires deduction of dividends declared lion increased by $82 million from 2002, principally from reported net income in arriving at net income due to the loss on early extinguishment of debt of available to common shareholders. See Note 12 to $73 million and lower SOHO profit of $39 million as our the Consolidated Financial Statements for a more supplies sales declined following our exit from this complete discussion of the ESOP, including current business. In addition, 2002 included benefits of $33 mil- funding status. 26


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    Gross Margin: Gross margins by revenue classification increases in DMO, 0.6 percentage points was due to were as follows: lower inventory charges associated with restructuring actions and the balance was largely due to manufac- Year Ended December 31, turing productivity, which more than offset competi- 2003 2002 2001 tive price pressures. 2002 Service, outsourcing and Total gross margin 42.0% 42.4% 38.2% rentals margins improved by 2.3 percentage points Sales 36.4% 37.3% 30.5% from 2001 reflecting the benefits of expense produc- Service, outsourcing and rentals 44.3% 44.5% 42.2% tivity actions and more profitable document outsourc- Finance income 63.7% 59.9% 59.5% ing contracts. 2003 Finance income gross margins increased The 2003 gross margin of 42.0 percent remained 3.8 percentage points from 2002 and similarly by strong and in line with our expectations, despite 0.4 percentage points from 2001, in line with declining declining 0.4 percentage points from 2002. During interest costs specific to equipment financing. 2003, we completed the R&D phase of the DocuColor Equipment financing interest expense is determined iGen3 development and, therefore, beginning in July based on a combination of actual interest expense 2003, ongoing engineering costs associated with initial incurred on financing debt, as well as our estimated commercial production are included in cost of sales. cost of funds, applied against the estimated level of DocuColor iGen3 ongoing engineering costs of $30 mil- debt required to support our finance receivables. The lion, the absence of the $28 million prior year favorable estimate is based on an assumed ratio which ranges ESOP adjustment and the absence of $50 million in from 80-90% of our average finance receivables. This prior year licensing revenue each contributed 0.2 per- methodology has been consistently applied for all centage points to the 2003 gross margin decline. periods presented. During 2003, manufacturing and service productivity improvements more than offset the impact of lower Research and Development: 2003 R&D spending of prices, higher pension and other employee benefit $868 million was $49 million lower than 2002, primarily costs and product mix. due to a $30 million reduction associated with the 2003 sales gross margin declined 0.9 percentage commercial launch of the DocuColor iGen3 and points from 2002, with over half of the decline due to improved R&D productivity, partially offset by higher DocuColor iGen3 ongoing engineering costs and the pension and other employee benefit expenses. We remainder due to product mix as we increased our expect 2004 R&D expense to range from 5-6 percent of penetration of the digital light production market. In total revenues. We continue to invest in technological 2003, manufacturing productivity more than offset development, particularly in color, and believe that the impact of planned lower prices. 2003 service, out- our R&D spending is at an adequate level to remain sourcing and rentals margin declined 0.2 percentage technologically competitive. Our R&D is strategically points from 2002. Improved productivity and product coordinated with that of Fuji Xerox, which invested mix more than offset lower prices and higher pension $724 million in R&D in 2003. To maximize the syner- and other employee expenses. 2002 also included a gies of our relationship, our R&D expenditures are 0.4 percentage point benefit from a $50 million licens- focused on the Production segment while Fuji Xerox ing agreement and a 0.3 percentage point benefit R&D expenditures are focused on the Office segment. due to favorable ESOP adjustments. 2002 research and development spending of $917 mil- The 2002 gross margin of 42.4 percent improved lion was $80 million lower than 2001. Approximately 4.2 percentage points from 2001. 1.4 percentage 40 percent of the decline was due to our SOHO exit, points of the increase reflects our second half 2001 another 40 percent of the decline reflects both benefits SOHO exit. Improved manufacturing and service from cost restructuring actions and the receipt of productivity, which more than offsetlower prices, external funding and the balance reflects the previous- accounted for approximately one percentage point of ly discussed favorable ESOP compensation expense improvement and higher margins in our DMO operat- adjustment. ing segment accounted for approximately 0.5 percent- age points of the improvement. The balance of the Selling, Administrative and General Expenses: SAG increase includes the favorable ESOP compensation expense information was as follows ($ in millions): expense adjustment, favorable transaction currency, lower inventory charges associated with restructuring Year Ended December 31, actions and improved document outsourcing margins 2003 2002 2001 associated with our focus on profitable revenue. Total Selling, administrative 2002 sales gross margin improved 6.8 percentage and general expenses $4,249 $4,437 $4,728 points from 2001. Approximately 2.6 percentage SAG as a percentage of points of the improvement was due to our SOHO exit, revenue 27.1% 28.0% 27.8% approximately 1.3 percentage points was due to 27


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    2003 SAG expense of $4.2 billion declined $188 Worldwide employment was approximately 67,800 and million from 2002 including adverse currency impacts 78,900 at December 31, 2002 and 2001, respectively. of $172 million and $70 million of higher pension and other employee benefit costs. 2003 SAG reductions Gain on Affiliate’s Sale of Stock: In 2003, we recorded reflect improved productivity and employment reduc- cumulative gains on an affiliate’s sale of stock of tions associated with our cost base restructuring, $13 million reflecting our proportionate share of the lower bad debt expenses of $109 million and the increase in equity of ScanSoft Inc., an equity invest- absence of 2002 expenses discussed below. ment. The gain resulted from ScanSoft’s issuance of 2002 SAG expense of $4.4 billion declined stock in connection with its acquisition of Speechworks, $291 million from 2001. The reduction includes lower Inc. ScanSoft is a developer of digital imaging soft- bad debt expenses of $106 million, lower SOHO ware that enables users to leverage the power of their spending of $84 million and a $34 million favorable scanners, digital cameras and other electronic devices. property tax adjustment in North America. These In 2001, the gain on affiliate’s sale of stock of $4 mil- decreases were partially offset by $106 million of inter- lion reflected our proportionate share of the increase nal-use software impairment charges, $65 million of in equity of ScanSoft Inc., resulting from issuance of higher advertising and marketing communications their stock in connection with an acquisition. spending, $18 million of increased professional fees and $26 million of losses associated with the exit from Provision for Litigation: In 2003, we recorded a certain leased facilities. The balance of the reduction $239 million provision for litigation relating to the primarily reflects employment reductions associated court approved settlement of the Berger v. Retirement with our cost base restructuring actions. Income Guarantee Plan (RIGP) litigation which is dis- Bad debt expense included in SAG was $224 mil- cussed in more detail in Note 15 to the Consolidated lion, $332 million and $438 million in 2003, 2002 and Financial Statements. 2001, respectively. The 2003 reduction reflects improved collections performance, receivables aging Other Expenses, Net: Other expenses, net for the three and write-off trends. Lower expense in 2002 is due to years ended December 31, 2003 consisted of the fol- improved customer administration, collection prac- lowing: tices and credit approval policies, as well as our rev- enue declines. Bad debt expense as a percent of total Year Ended December 31, revenue was 1.4 percent, 2.1 percent and 2.6 percent ($ in millions) 2003 2002 2001 for 2003, 2002 and 2001, respectively. Non-financing interest expense $522 $495 $544 Interest income (65) (77) (101) Restructuring Programs: For the three years ended Net currency losses (gains) 11 77 (29) December 31, 2003, we have engaged in a series of Legal and regulatory matters 3 37 – restructuring programs, resulting in approximately Amortization of goodwill (2001 only) and intangible assets 36 36 94 $1.6 billion in charges related to downsizing our Loss (gain) on early employee base, exiting certain businesses, outsourcing extinguishment of debt 73 (1) (63) some internal functions and engaging in other actions Business divestiture and asset designed to reduce our cost structure. In 2003, we sale losses (gains) 13 (1) 10 recorded restructuring and asset impairment charges of Minorities’ interests in earnings $176 million, primarily consisting of new severance of subsidiaries 6 3 2 actions and pension settlements related to previous All other, net 38 24 53 employee restructuring actions. We expect prospective $637 $593 $510 annual savings associated with 2003 actions to be approximately $170 million, as compared to 2003 levels. Non-financing interest expense: 2003 non-financing Restructuring and asset impairment charges of $670 interest expense was $27 million higher than 2002, million and $715 million in 2002 and 2001, respectively, primarily reflecting 2003 net losses of $13 million primarily relate to severance and employee benefits from the mark-to-market valuation of our interest rate related to worldwide terminations as well as certain swaps compared to gains of $12 million in 2002. Due costs related to the consolidation of excess facilities. The to the inherent volatility in the interest rate markets, remaining restructuring reserve balance at December we are unable to predict the amount of the above 31, 2003 for all programs was $221 million. Charges noted mark-to-market gains or losses in future peri- related to previous employee restructuring actions of ods. 2003 non-financing interest expense included approximately $20 million are expected to be recorded higher interest rates and borrowing costs in the first in 2004, primarily related to pension settlements. half of the year associated with the terms of the 2002 Worldwide employment declined by approximately Credit Facility. These increased expenses were offset 6,700 in 2003, to approximately 61,100, primarily reflect- by lower borrowing costs in the second half of 2003 ing reductions as part of our restructuring programs. following the June 2003 Recapitalization. 28


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    2002 non-financing interest expense was $49 mil- anticipated transactions not qualifying for hedge lion lower than 2001 reflecting lower debt levels accounting treatment. In 2001, exchange gains on yen throughout 2002 and lower borrowing costs in the first debt of $107 million more than offset losses on Euro half of the year, partially offset by higher interest rates loans of $36 million, a $17 million exchange loss result- and borrowing costs in the second half of the year ing from the peso devaluation in Argentina and other associated with the terms of the 2002 Credit Facility. currency exchange losses of $25 million. The 2001 cur- Lower borrowing costs reflected the continued decline rency gains were the result of net unhedged positions in interest rates throughout 2002, coupled with our largely caused by our restricted access to the deriva- higher proportion of variable rate debt in 2002 as tives markets beginning in the fourth quarter 2000. compared to 2001. Our 2002 credit ratings were below investment grade and effectively constrained our abili- Legal and regulatory matters: Legal and regulatory ty to fully use derivative contracts to manage interest matters for 2002 includes $27 million of expenses rate risk. Accordingly, although we benefited from related to certain litigation, indemnifications and asso- lower interest rates in 2002, we had greater exposure ciated claims, as well as the $10 million penalty to volatility in our results of operations. 2002 non- incurred in connection with our settlement with the financing interest expense included net gains of SEC. See Note 15 to the Consolidated Financial $12 million from the mark-to-market valuation of our Statements for additional information. interest rate swaps. Amortization of goodwill and intangible assets: Prior to Interest income: Interest income is derived primarily 2002, goodwill and other intangible asset amortization from our invested cash balances and interest resulting related primarily to our acquisitions of the remaining from periodic tax settlements. 2003 interest income minority interest in Xerox Limited in 1995 and 1997, was $12 million lower than 2002 reflecting declining XL Connect in 1998 and the Color Printing and Imaging interest rates and lower average cash balances, par- Division of Tektronix, Inc. in 2000. Effective January 1, tially offset by $13 million of interest income related to 2002 and in connection with the adoption of SFAS No. Brazilian tax credits that became realizable in 2003. 142, we no longer record amortization of goodwill. 2002 interest income was lower than 2001 due to Intangible assets continue to be amortized over their lower invested cash balances in the second half of useful lives. Further discussion is provided in Note 1 to 2002, resulting from the payment of significant out- the Consolidated Financial Statements. standing debt as well as lower interest rates. Loss (gain) on early extinguishment of debt: In 2003, Net currency losses (gains): Net currency losses we recorded a $73 million loss on early extinguish- (gains) result from the re-measurement of unhedged ment of debt reflecting the write-off of the remaining foreign currency-denominated assets and liabilities, unamortized fees associated with the 2002 Credit the spot/forward premiums on foreign exchange for- Facility. The 2002 Credit Facility was repaid upon com- ward contracts in those markets where we have been pletion of the June 2003 Recapitalization. In 2002, we able to restore economic hedging capability and eco- retired $52 million of long-term debt through the nomic hedges of anticipated transactions for which we exchange of 6.4 million shares of common stock val- do not qualify for cash flow hedge accounting treat- ued at $51 million. In 2001, we retired $374 million of ment under SFAS No. 133. Beginning with the second long-term debt through the exchange of 41 million half 2002 and throughout 2003, we restored currency shares of common stock valued at $311 million. hedging capabilities, subject to limited exceptions in These transactions resulted in gains of $1 million certain closed markets. This should limit remeasure- and $63 million in 2002 and 2001, respectively. ment gains or losses in future periods. In 2003, exchange losses of $11 million were due largely to Business divestiture and asset sale losses (gains): spot/forward premiums on foreign exchange forward Business divestitures and asset sales in all years contracts and unfavorable currency movements on included miscellaneous land, buildings and equipment economic hedges of anticipated transactions not qual- sales. In addition, the 2003 amount primarily included ifying for hedge accounting treatment. losses related to the sale of XES subsidiaries in France In the first half of 2002, we incurred $57 million of and Germany, which was partially offset by a gain on exchange losses, primarily in Brazil and Argentina due the sale of our investment in Xerox South Africa. The to the devaluation of the underlying currencies. In the 2002 amount included the sales of our leasing busi- latter half of 2002, we were able to restore hedging ness in Italy, our investment in Prudential Insurance capability in the majority of our key markets. Therefore, company common stock and our equity investment in the $20 million of currency losses in the second half Katun Corporation. The 2001 amount included the sale of 2002 primarily represented the spot/forward premi- of our Nordic leasing business. Further discussion is ums on foreign exchange forward contracts and unfa- included in Note 3 to the Consolidated Financial vorable currency movements on economic hedges of Statements. 29


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    Income Taxes: The following table summarizes our graphical mix of income before taxes and the related consolidated income taxes and the related effective tax rates in those jurisdictions. We anticipate that our tax rate for each respective period: 2004 annual consolidated effective tax rate will approximate 40 percent. Year Ended December 31, ($ in millions) 2003 2002 2001 Equity in Net Income of Unconsolidated Affiliates: Pre-tax income $436 $104 $328 Equity in net income of unconsolidated affiliates is Income taxes 134 4 473 principally related to our 25 percent share of Fuji Xerox Effective tax rate (1) 30.7% 3.8% 144.2% income. Our 2003 equity in net income of $58 million (1) A detailed reconciliation of the consolidated effective tax rate to the U.S. was comparable with 2002 and 2001 results of $54 mil- federal statutory income tax rate is included in Note 13. lion and $53 million, respectively. The difference between the 2003 consolidated Recent Accounting Pronouncements: See Note 1 of effective tax rate of 30.7 percent and the U.S. federal the Consolidated Financial Statements for a full statutory income tax rate of 35 percent relates primarily description of recent accounting pronouncements to $35 million of tax benefits arising from the reversal including the respective dates of adoption and effects of valuation allowances on deferred tax assets follow- on results of operations and financial condition. ing a re-evaluation of their future realization due to improved financial performance, other foreign adjust- Capital Resources and Liquidity: ments, including earnings taxed at different rates, the impact of Series B Convertible Preferred Stock divi- Cash Flow Analysis: The following summarizes our dends and state tax benefits. Such benefits were par- cash flows for the each of the three years ended tially offset by tax expense for audit and other tax December 31, 2003, as reported in our Consolidated return adjustments, as well as $19 million of unrecog- Statements of Cash Flows in the accompanying nized tax benefits primarily related to recurring losses Consolidated Financial Statements: in certain jurisdictions where we continue to maintain deferred tax asset valuation allowances. ($ in millions) 2003 2002 2001 The difference between the 2002 consolidated Net cash provided by effective tax rate of 3.8 percent and the U.S. federal operating activities $1,879 $1,980 $1,754 statutory income tax rate of 35 percent relates primari- Net cash provided by ly to the recognition of tax benefits resulting from the investing activities 49 93 685 favorable resolution of a foreign tax audit of approxi- Net cash used in mately $79 million, tax law changes of approximately financing activities (2,470) (3,292) (189) Effect of exchange rate $26 million and the impact of Series B Convertible changes on cash 132 116 (10) Preferred Stock dividends. Such benefits were offset, in part, by tax expense recorded for the on-going (Decrease) increase in cash and cash equivalents (410) (1,103) 2,240 examination in India, the sale of our interest in Katun Cash and cash equivalents Corporation, as well as recurring losses in certain at beginning of year 2,887 3,990 1,750 jurisdictions where we are not providing tax benefits Cash and cash equivalents and continue to maintain deferred tax asset valuation at end of year $2,477 $2,887 $3,990 allowances. The difference between the 2001 consolidated effective tax rate of 144.2 percent and the U.S. federal Operating: For the year ended December 31, 2003, statutory income tax rate of 35 percent relates primari- operating cash flows of $1.9 billion reflect pre-tax ly to the recognition of deferred tax asset valuation income of $436 million and the following non-cash allowances of $247 million from our recoverability items: depreciation and amortization of $748 million, assessments, the taxes incurred in connection with the provisions for receivables and inventory of $302 mil- sale of our partial interest in Fuji Xerox and recurring lion, the provision for the Berger litigation of $239 mil- losses in low tax jurisdictions. The gain for tax purpos- lion and a loss on early extinguishment of debt of es on the sale of Fuji Xerox was disproportionate to $73 million. In addition, operating cash flows were the gain for book purposes as a result of a lower tax enhanced by finance receivable reductions of $496 basis in the investment. Other items favorably impact- million, cash generated from the early termination of ing the tax rate included a tax audit resolution of interest rate swaps of $136 million, accounts receiv- approximately $140 million and additional tax benefits able reductions of $164 million, driven by improved arising from prior period restructuring provisions. collection efforts and other working capital improve- Our consolidated effective income tax rate will ments of over $600 million. The Finance receivable change based on discrete events (such as audit settle- reduction results from collections of finance receiv- ments) as well as other factors including the geo- ables associated with prior year sales that exceed receivables generated from recent equipment sales. 30


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    This trend is expected to moderate as our equipment occurred at a much slower rate than in 2001 as inven- sales continue to increase. These cash flows were par- tory reductions were offset by increased requirements tially offset by pension plan contributions of $672 mil- for new product launches. lion related to our decision to accelerate and increase We expect operating cash flows to approximate the 2003 funding level of our U.S. plans and increase $1.5 billion in 2004, as compared to $1.9 billion in the 2003 funding level of our U.K. plans, restructuring 2003. The reduction contemplates finance receivables related cash payments of $345 million, income tax growth as a result of continued expected equipment payments of $207 million and $166 million of cash out- sales expansion as well as the absence of early deriva- flow supporting our on-lease equipment investment. tive contract termination cash flow, partially offset by The $101 million decline in operating cash flow reduced restructuring payments and lower pension versus 2002 primarily reflects increased pension plan contributions. contributions of $534 million, lower finance receivable reductions of $258 million reflecting the increase in Investing: Investing cash flows for the year ended equipment sale revenue in 2003, and increased on-lease December 31, 2003 consisted primarily of $235 million equipment investment of $39 million. These items released from restricted cash related to former rein- were partially offset by increased pre-tax income of surance obligations associated with our discontinued $332 million, lower tax payments of $235 million and operations, $35 million of aggregate cash proceeds increased cash proceeds from the early termination from the divestiture of our investment in Xerox South of interest rate swaps of $80 million. The lower tax Africa, XES France and Germany and other minor payments reflect the absence of the $346 million tax investments, partially offset by capital and internal use payment associated with the 2001 sale of a portion of software spending of $250 million. We expect 2004 our ownership interest in Fuji Xerox. capital expenditures to approximate $250 million. For the year ended December 31, 2002, operating Investing cash flows for the year ended December cash flows of $2.0 billion reflect pre-tax income of 31, 2002 consisted primarily of proceeds of $200 mil- $104 million and the following non-cash items: depre- lion from the sale of our Italian leasing business, $53 ciation and amortization of $1,035 million, provisions million related to the sale of certain manufacturing for receivables and inventory of $468 million and locations to Flextronics, $67 million related to the sale impairment of goodwill of $63 million. Cash flows of our interest in Katun and $19 million from the sale were also enhanced by finance receivable reductions of our investment in Prudential common stock. These of $754 million due to collection of receivables from inflows were partially offset by capital and internal use prior year’s sales without an offsetting receivables software spending of $196 million and increased increase due to lower equipment sales in 2002, togeth- requirements of $63 million for restricted cash sup- er with a transition to third-party vendor financing porting our vendor financing activities. arrangements in the Nordic countries, Italy, Brazil and Investing cash flows in 2001 largely consisted of Mexico. In addition, a restructuring charge of $670 mil- the $1,768 million of cash received from sales of busi- lion was recorded during the period. These items were nesses, including one half of our interest in Fuji Xerox, partially offset by $442 million of tax payments, our leasing businesses in the Nordic countries and including $346 million related to the 2001 sale of half certain manufacturing assets to Flextronics. These of our interest in Fuji Xerox, $392 million of restructur- cash proceeds were offset by capital and internal use ing payments, $127 million of on-lease equipment software spending of $343 million, a $255 million pay- expenditures and a $138 million cash contribution to ment related to our funding of trusts to replace letters our pension plans. of credit within our insurance discontinued operations, The $226 million improvement in operating cash $115 million of payments for the funding of escrow flow as compared to 2001 reflects increased finance requirements related to lease contracts transferred to receivable collections of $666 million, an improvement GE, $229 million of payments for the funding of in cash flows from the early termination of derivative escrow requirements related to pre-funded interest contracts of $204 million, lower on-lease equipment payments required to support our liabilities to trusts spending of $144 million and lower restructuring pay- issuing preferred securities and $217 million of pay- ments of $92 million. The decline in 2002 on-lease ments for other contractual requirements. equipment spending reflected declining rental place- ment activity and populations, particularly in our Financing: Financing activities for the year ended older-generation light-lens products. These items were December 31, 2003 consisted of net proceeds from partially offset by higher cash taxes of $385 million, secured borrowing activity with GE and other vendor higher pension contributions of $96 million and financing partners of $269 million, net proceeds from increased working capital uses of over $400 million, the June 2003 convertible preferred stock offering of much of which was caused by the termination of an $889 million, net proceeds from the June 2003 com- accounts receivable sales facility. In addition, cash mon stock offering of $451 million, offset by preferred flow generated by reducing inventory during 2002 stock dividends of $57 million and other net cash out- 31


  • Page 34

    flows related to debt of $4.0 billion as detailed below: proceeds from secured borrowing activity of $1,350 million and proceeds from a loan from trust sub- $ In Millions sidiaries issuing preferred securities of $1.0 billion. Payments 2002 Credit Facility $(3,490) Capital Structure and Liquidity: We provide equipment Convertible Subordinated Debentures (560) financing to a significant majority of our customers. Term debt and other (1,596) Because the finance leases allow our customers to pay (5,646) for equipment over time rather than at the date of Borrowings, net of issuance costs installation, we need to maintain significant levels of 2010/2013 Senior Notes 1,218 debt to support our investment in customer finance 2003 Credit Facility 271 leases. Since 2001, we have funded a significant por- All other 113 tion of our finance receivables through third-party ven- 1,602 dor financing arrangements. Securing the financing Net cash payments on debt $(4,044) debt with the receivables it supports, eliminates certain significant refinancing, pricing and duration risks asso- ciated with our debt. We are currently raising funds to Further details on our June 2003 Recapitalization support our finance leasing through third-party vendor are included within the Liquidity, Financial Flexibility financing arrangements, cash generated from opera- and Funding Plans section of this MD&A. tions and capital markets offerings. Over time, we Financing activities for the year ended December intend to increase the proportion of our total debt that 31, 2002 consisted of $2.8 billion of debt repayments is associated with vendor financing programs. on the terminated revolving credit facility, $710 million During the years ended December 31, 2003 and on the 2002 Credit Facility, $1.9 billion of other sched- 2002, we borrowed $2,450 million and $3,055 million, uled debt payments and preferred stock dividends of respectively, under secured third-party vendor financ- $67 million. These cash outflows were partially offset ing arrangements. Approximately 60 percent of our by proceeds of $746 million from our 9.75 percent total finance receivable portfolio has been pledged to Senior Notes offering and $1.4 billion of net proceeds secure vendor financing loan arrangements at from secured borrowing activity with GE and other December 31, 2003, compared with approximately vendor financing partners. 50 percent a year earlier. We expect the pledged por- Financing activities for the comparable 2001 peri- tion of our finance receivable portfolio to range from od consisted of scheduled debt repayments of $2.4 bil- 55-60 percent during 2004. The following table com- lion and dividends on our common and preferred pares finance receivables to financing-related debt as stock of $93 million. These outflows were offset by net of December 31, 2003 and 2002: December 31, 2003 December 31, 2002 Finance Finance Receivables, Secured Receivables, Secured ($ in millions) Net Debt Net 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. 32


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    As of December 31, 2003 and 2002, debt secured Proceeds from the Recapitalization were used to fully by finance receivables was approximately 40 percent repay our 2002 Credit Facility. The 2003 Credit Facility and 28 percent of total debt, respectively. The follow- consists of a $300 million term loan and a $700 million ing represents our aggregate debt maturity schedule revolving credit facility (which includes a $200 million as of December 31, 2003: sub-facility for letters of credit). Terms of the 2003 Credit Facility and the 2010 and 2013 Senior Notes are Secured by included in Note 10 to the Consolidated Financial Bonds/ Finance Statements. The covenants under the 2003 Credit Bank Receiv- Total Facility reflect our improved financial position. For ($ in millions) Loans ables Debt instance, there are no mandatory prepayments under 2004 $2,208 $2,028 $ 4,236 (1) the 2003 Credit Facility and the interest rate is approxi- 2005 1,065 1,064 2,129 mately 2 percentage points lower than the 2002 Credit 2006 25 461 486 Facility. We expect that the reduced interest expense 2007 307 468 775 in 2004 attributable to the Recapitalization will largely 2008 378 404 782 Thereafter 2,758 – 2,758 offset the dilutive impact of the additional common shares issued. Total $6,741 $4,425 $11,166 (1) Quarterly debt maturities for 2004 are $1,081, $1,087, $686 and $1,382 for 2003 Credit Facility: Xerox Corporation is the only bor- the first, second, third and fourth quarters, respectively. rower of the term loan. The revolving credit facility is available, without sub-limit, to Xerox Corporation and The following table summarizes our secured and certain of its foreign subsidiaries, including Xerox unsecured debt as of December 31, 2003 and 2002: Canada Capital Limited, Xerox Capital (Europe) plc and other qualified foreign subsidiaries (excluding ($ in millions) 2003 2002 Xerox Corporation, the “Overseas Borrowers”). The Credit Facility $ 300 $ 925 2003 Credit Facility matures on September 30, 2008. Debt secured by finance Debt issuance costs of $29 million were deferred in receivables 4,425 3,900 conjunction with the 2003 Credit Facility. Capital leases 29 40 Subject to certain limits described in the following Debt secured by other assets 99 90 paragraph, the obligations under the 2003 Credit Total Secured Debt $ 4,853 $ 4,955 Facility are secured by liens on substantially all the Credit Facility – unsecured $ – $ 2,565 assets of Xerox and each of our U.S. subsidiaries that Senior Notes 2,137 852 have a consolidated net worth from time to time of Subordinated debt 19 575 $100 million or more (the “Material Subsidiaries”), Other Debt 4,157 5,224 excluding Xerox Credit Corporation (“XCC”) and cer- Total Unsecured Debt $ 6,313 $ 9,216 tain other finance subsidiaries, and are guaranteed by Total Debt $11,166 $14,171 certain Material Subsidiaries. Xerox Corporation is required to guarantee the obligations of the Overseas Liquidity, Financial Flexibility and Funding Plans: We Borrowers. As of December 31, 2003, there were no manage our worldwide liquidity using internal cash outstanding borrowings under the revolving credit management practices, which are subject to (1) the facility. However, as of December 31, 2003, the statutes, regulations and practices of each of the local $300 million term loan and $51 million of letters of jurisdictions in which we operate, (2) the legal require- credit were outstanding. ments of the agreements to which we are a party and Under the terms of certain of our outstanding (3) the policies and cooperation of the financial institu- public bond indentures, the amount of obligations tions we utilize to maintain and provide cash manage- under the 2003 Credit Facility that can be secured, as ment services. described above, is limited to the excess of (x) 20 per- cent of our consolidated net worth (as defined in the Recapitalization: In June 2003, we successfully com- public bond indentures) over (y) the outstanding pleted a $3.6 billion Recapitalization which reduced amount of certain other debt that is secured by the debt by $1.6 billion, increased common and preferred Restricted Assets. Accordingly, the amount of 2003 equity by $1.3 billion and provided $0.7 billion of Credit Facility debt secured by the Restricted Assets additional borrowing capacity. The Recapitalization will vary from time to time with changes in our consol- included the offering and sale of 9.2 million shares of idated net worth. The amount of security provided 6.25 percent Series C Mandatory Convertible Preferred under this formula is allocated ratably to the term loan Stock, 46 million shares of Common Stock, $700 mil- and revolving loans outstanding at any time. lion of 7.125 percent Senior Notes due 2010 and The term loan and the revolving loans each bear $550 million of 7.625 percent Senior Notes due 2013, interest at LIBOR plus a spread that varies between and the closing of our $1 billion 2003 Credit Facility. 1.75 percent and 3 percent (or, at our election, at a 33


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    base rate plus a spread that varies between 0.75 per- dor financing programs in the United States, Canada, cent and 2 percent) depending on the then-current the U.K., France, The Netherlands, the Nordic coun- leverage ratio, as defined, in the 2003 Credit Facility. tries, Italy, Brazil and Mexico through major initiatives This rate was 3.42 percent at December 31, 2003. with GE, Merrill Lynch and other third-party vendors The 2003 Credit Facility contains affirmative and to fund our finance receivables in these countries. negative covenants including limitations on: issuance These initiatives include the completion of the U.S. of debt and preferred stock; investments and acquisi- Loan Agreement with General Electric Capital tions; mergers; certain transactions with affiliates; cre- Corporation (“GECC”) (the “Loan Agreement”). See ation of liens; asset transfers; hedging transactions; Note 4 to the Consolidated Financial Statements for a payment of dividends and certain other payments and discussion of our vendor financing initiatives. intercompany loans. The 2003 Credit Facility contains financial maintenance covenants, including minimum GECC U.S. Secured Borrowing Arrangement: In EBITDA, as defined, maximum leverage (total adjusted October 2002, we finalized an eight-year Loan debt divided by EBITDA), annual maximum capital Agreement with GECC. The Loan Agreement provides expenditures limits and minimum consolidated net for a series of monthly secured loans up to $5 billion worth, as defined. These covenants are more fully dis- outstanding at any time ($2.6 billion outstanding at cussed in Note 10. December 31, 2003). The $5 billion limit may be The 2003 Credit Facility generally does not affect increased to $8 billion subject to agreement between our ability to continue to securitize receivables under the parties. Additionally, the agreement contains additional or existing third-party vendor financing mutually agreed renewal options for successive two- arrangements. Subject to certain exceptions, we can- year periods. The Loan Agreement, as well as similar not pay cash dividends on our common stock during loan agreements with GE in the U.K. and Canada, the term of the 2003 Credit Facility, although we can incorporates the financial maintenance covenants pay cash dividends on our preferred stock, provided contained in the 2003 Credit Facility and contains there is then no event of default under the 2003 Credit other affirmative and negative covenants. Facility. Among defaults customary for facilities of this Under the Loan Agreement, we expect GECC to type, defaults on our other debt, bankruptcy of certain fund a significant portion of new U.S. lease origina- of our legal entities, or a change in control of Xerox tions at over-collateralization rates, which vary over Corporation, would all constitute events of default time, but are expected to approximate 10 percent at under the 2003 Credit Facility. the inception of each funding. The securitizations are subject to interest rates calculated at each monthly 2010 and 2013 Senior Notes: We issued $700 million loan occurrence at yield rates consistent with average aggregate principal amount of Senior Notes due rates for similar market based transactions. The funds 2010 and $550 million aggregate principal amount of received under this agreement are recorded as Senior Notes due 2013 in connection with the June secured borrowings and the associated finance receiv- 2003 Recapitalization. Interest on the Senior Notes due ables are included in our Consolidated Balance Sheet. 2010 and 2013 accrues at the rate of 7.125 percent and GECC’s commitment to fund under this agreement is 7.625 percent, respectively, per year and is payable not subject to our credit ratings. semiannually on each June 15 and December 15. In conjunction with the issuance of the 2010 and 2013 Loan Covenants and Compliance: At December 31, Senior Notes, debt issuance costs of $32 million were 2003, we were in full compliance with the covenants deferred. These notes, along with our Senior Notes and other provisions of the 2003 Credit Facility, the due 2009, are guaranteed by our wholly-owned sub- senior notes and the Loan Agreement and expect to sidiaries Intelligent Electronics, Inc. and Xerox remain in full compliance for at least the next twelve International Joint Marketing, Inc. Financial informa- months. Any failure to be in compliance with any tion of these guarantors is included in Note 19 to the material provision or covenant of the 2003 Credit Consolidated Financial Statements. The senior notes Facility or the senior notes could have a material also contain negative covenants (but no financial adverse effect on our liquidity and operations. Failure maintenance covenants) similar to those contained in to be in compliance with the covenants in the Loan the 2003 Credit Facility. However, they generally Agreement, including the financial maintenance provide us with more flexibility than the 2003 Credit covenants incorporated from the 2003 Credit Facility, Facility covenants, except that payment of cash would result in an event of termination under the Loan dividends on the 6.25 percent Series C Mandatory Agreement and in such case GECC would not be Convertible Preferred Stock is subject to certain required to make further loans to us. If GECC were to conditions. See Note 10 to the Consolidated Financial make no further loans to us and assuming a similar Statements for a description of the covenants. facility was not established, it would materially adversely affect our liquidity and our ability to fund our Financing Business: We implemented third-party ven- customers’ purchases of our equipment and this could 34


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    materially adversely affect our results of operations. unlikely we will be able to access the low-interest We have the right at any time to prepay any loans out- commercial paper markets or to obtain unsecured standing under or terminate the 2003 Credit Facility. bank lines of credit. Credit Ratings: Our credit ratings as of February 27, Summary – Financial Flexibility and Liquidity: With 2004 were as follows: $2.5 billion of cash and cash equivalents on hand at December 31, 2003 and borrowing capacity under our Senior 2003 Credit Facility of $700 million, less $51 million uti- Unsecured lized for letters of credit, we believe our liquidity Debt Outlook Comments (including operating and other cash flows that we Moody’s (1) B1 Stable The Moody’s rating was expect to generate) will be sufficient to meet operating upgraded from B1 cash flow requirements as they occur and to satisfy all (with a negative outlook) scheduled debt maturities for at least the next twelve in December 2003. months. Our ability to maintain positive liquidity going S&P B+ Negative The S&P rating on Senior forward depends on our ability to continue to generate Secured Debt is BB-. cash from operations and access to the financial mar- Fitch BB Stable The Fitch rating was upgraded from BB- (with a negative kets, both of which are subject to general economic, outlook) in June 2003. financial, competitive, legislative, regulatory and other market factors that are beyond our control. We cur- (1) In December 2003, Moody’s assigned to Xerox a first time SGL-1 rating. rently have a $2.5 billion shelf registration that enables us to access the market on an opportunistic basis and Our ability to obtain financing and the related cost offer both debt and equity securities. of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agen- Contractual Cash Obligations and Other Commercial cies. Our current credit ratings are below investment Commitments and Contingencies: At December 31, grade and we expect our access to the public debt 2003, we had the following contractual cash obliga- markets to be limited to the non-investment grade tions and other commercial commitments and contin- segment until our ratings have been restored. gencies ($ in millions): Specifically, until our credit ratings improve, it is Year 1 Years 2-3 Years 4-5 There- 2004 2005 2006 2007 2008 after 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 $63 million include no expected contributions to the Contingencies: domestic tax qualified plans because these plans have already exceeded the ERISA minimum funding Pension and Other Post-Retirement Benefit Plans: We requirements for the plans’ 2003 plan year due to sponsor pension and other post-retirement benefit funding of approximately $450 million in 2003. Of this plans that require periodic cash contributions. Our amount, $325 million was accelerated or in excess of 2003 cash fundings for these plans were $672 million required amounts. Our post-retirement plans are non- for pensions and $101 million for other post-retire- funded and are almost entirely related to domestic ment plans. Our anticipated cash fundings for 2004 are operations. Cash contributions are made each year to $63 million for pensions and $114 million for other cover medical claims costs incurred in that year. post-retirement plans. Cash contribution requirements for our domestic tax qualified pension plans are gov- Flextronics: As previously discussed, in 2001 we out- erned by the Employment Retirement Income Security sourced certain manufacturing activities to Flextronics Act (ERISA) and the Internal Revenue Code. Cash con- under a five-year agreement. During 2003, we pur- tribution requirements for our international plans are chased approximately $910 million of inventory from subject to the applicable regulations in each country. Flextronics. We anticipate that we will purchase The expected contributions for pensions for 2004 of approximately $915 million of inventory from 35


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    Flextronics during 2004 and expect to increase this Off-Balance Sheet Arrangements: level commensurate with our sales in the future. As discussed in Note 1 to the Consolidated Financial Fuji Xerox: We had product purchases from Fuji Xerox Statements, in December 2003, we adopted Financial totaling $871 million, $727 million, and $598 million in Accounting Standards Board Interpretation No. 46R 2003, 2002 and 2001, respectively. Our purchase com- “Consolidation of Variable Interest Entities, an interpre- mitments with Fuji Xerox are in the normal course of tation of ARB 51” (“FIN 46R”). As a result of our adop- business and typically have a lead time of three tion of FIN 46R, we deconsolidated certain subsidiary months. We anticipate that we will purchase approxi- trusts which were previously consolidated. All periods mately $1 billion of products from Fuji Xerox in 2004. presented have been reclassified to reflect this change. Related party transactions with Fuji Xerox are disclosed As discussed further in Note 14 to the Consolidated in Note 7 to the Consolidated Financial Statements. Financial Statements, “Liability to Subsidiary Trusts Issuing Preferred Securities,” these trusts previously Other Purchase Commitments: We enter into other issued preferred securities. Although the preferred purchase commitments with vendors in the ordinary securities issued by these subsidiaries are not reflected course of business. Our policy with respect to all on our consolidated balance sheets, we have reflected purchase commitments is to record losses, if any, our obligations to them in the liability caption, “Liability when they are probable and reasonably estimable. to Subsidiary Trusts Issuing Preferred Securities.” The We currently do not have, nor do we anticipate, nature of our obligations to these deconsolidated sub- material loss contracts. sidiaries are discussed in Note 14. Although we generally do not utilize off-balance EDS Contract: We have an information management sheet arrangements in our operations, we enter into contract with Electronic Data Systems Corp. to pro- operating leases in the normal course of business. vide services to us for global mainframe system pro- The nature of these lease arrangements is discussed cessing, application maintenance and enhancements, in Note 6 to the Consolidated Financial Statements. desktop services and helpdesk support, voice and Additionally, we utilize special purpose entities data network management, and server management. (“SPEs”) in conjunction with certain vendor financing In 2001, we extended the original ten-year contract transactions. The SPEs utilized in conjunction with through June 30, 2009. Although there are no mini- these transactions are consolidated in our financial mum payments required under the contract, we antic- statements in accordance with applicable accounting ipate making the following payments to EDS over the standards. These transactions, which are discussed next five years (in millions): 2004—$331; 2005—$332; further in Note 4 to the Consolidated Financial 2006—$317; 2007—$307; 2008—$302. The estimated Statements, have been accounted for as secured bor- payments are the result of an EDS and Xerox Global rowings with the debt and related assets remaining Demand Case process that has been in place for eight on our balance sheets. Although the obligations relat- years. Twice a year, using this estimating process ed to these transactions are included in our balance based on historical activity, the parties agree on a pro- sheet, recourse is generally limited to the secured jected volume of services to be provided under each assets and no other assets of the Company. major element of the contract. Pricing for the base services (which are comprised of global mainframe Financial Risk Management: system processing, application maintenance and enhancements, desktop services and help desk sup- As a multinational company, we are exposed to mar- port, voice and data management) were established ket risk from changes in foreign currency exchange when the contract was signed in 1994 based on our rates and interest rates that could affect our results of actual costs in preceding years. The pricing was modi- operations and financial condition. As a result of our fied through comparisons to industry benchmarks improved liquidity and financial position, our ability to and through negotiations in subsequent amend- utilize derivative contracts as part of our risk manage- ments. Prices and services for the period July 1, 2004 ment strategy, described below, has substantially through June 30, 2009 are currently being negotiated improved. Certain of these hedging arrangements do and, as such, are subject to change. Under the current not qualify for hedge accounting treatment under contract, we can terminate the contract with six SFAS 133. Accordingly, our results of operations are months notice, as defined in the contract, with no ter- exposed to some volatility, which we attempt to mini- mination fee and with payment to EDS for incurred mize or eliminate whenever possible. The level of costs as of the termination date. We have an option to volatility will vary with the level of derivative hedges purchase the assets placed in service under the EDS outstanding, as well as the currency and interest rate contract, should we elect to terminate the contract market movements in the period. and either operate those assets ourselves or enter a We enter into limited types of derivative contracts, separate contract with a similar service provider. including interest rate swap agreements, foreign cur- 36


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    rency swap agreements, cross currency interest rate Fuji Xerox and Xerox do Brasil, and translated into swap agreements, forward exchange contracts, pur- dollars using the year-end exchange rates, was chased foreign currency options and purchased inter- $4.4 billion at December 31, 2003, net of foreign est rate collars, to manage interest rate and foreign currency-denominated liabilities designated as a currency exposures. The fair market values of all our hedge of our net investment. derivative contracts change with fluctuations in inter- est rates and/or currency rates and are designed so Interest Rate Risk Management: The consolidated that any changes in their values are offset by changes weighted-average interest rates related to our debt in the values of the underlying exposures. Our deriva- and liabilities to subsidiary trusts issuing preferred tive instruments are held solely to hedge economic securities for 2003, 2002 and 2001 approximated exposures; we do not enter into derivative instrument 6.0 percent, 5.0 percent, and 5.5 percent, respectively. transactions for trading or other speculative purposes Interest expense includes the impact of our interest and we employ long-standing policies prescribing that rate derivatives. derivative instruments are only to be used to achieve a Virtually all customer-financing assets earn fixed very limited set of objectives. rates of interest. As discussed above, a significant por- Our primary foreign currency market exposures tion of those assets has been pledged to secure ven- include the Japanese yen, Euro, British pound sterling, dor financing loan arrangements and the interest rates Brazilian real, and Canadian dollar. For each of our on a significant portion of those loans are fixed. As we legal entities, we generally hedge foreign currency implement additional third-party vendor financing denominated assets and liabilities, primarily through arrangements and continue to repay existing debt, the the use of derivative contracts. In entities with signifi- proportion of our financing assets which is match- cant assets and liabilities, we use derivative contracts funded against related secured debt will increase. to hedge the net exposure in each currency, rather than As of December 31, 2003, approximately $2.7 bil- hedging each asset and liability separately. We typical- lion of our debt bears interest at variable rates, includ- ly enter into simple unleveraged derivative transac- ing the effect of pay-variable interest rate swaps we tions. Our policy is to transact derivatives only with are utilizing to reduce the effective interest rate on counterparties having an investment-grade or better our debt. rating and to monitor market risk and exposure for The fair market values of our fixed-rate financial each counterparty. We also utilize arrangements with instruments, including debt and interest-rate deriva- each counterparty that allow us to net gains and losses tives, are sensitive to changes in interest rates. At on separate contracts. This further mitigates the credit December 31, 2003, a 10 percent change in market risk associated with our financial instruments. Based interest rates would change the fair values of such upon our ongoing evaluation of the replacement cost financial instruments by $297 million. of our derivative transactions and counterparty credit worthiness, we consider the risk of a material default Forward-Looking Cautionary Statements: by any of our counterparties to be remote. Some of our derivative contracts and several other This Annual Report contains forward-looking statements material contracts at December 31, 2003 require us to and information relating to Xerox that are based on post cash collateral or maintain minimum cash bal- our beliefs, as well as assumptions made by and infor- ances in escrow. These cash amounts are reported in mation currently available to us. The words “antici- our Consolidated Balance Sheets within Other current pate,” “believe,” “estimate,” “expect,” “intend,” assets or other long-term assets, depending on when “will,” “should” and similar expressions, as they the cash will be contractually released, as presented in relate to us, are intended to identify forward-looking Note 1 to the Consolidated Financial Statements. statements. Actual results could differ materially from Assuming a 10 percent appreciation or deprecia- those projected in such forward-looking statements. tion in foreign currency exchange rates from the quot- Information concerning certain factors that could ed foreign currency exchange rates at December 31, cause actual results to differ materially is included in 2003, the potential change in the fair value of foreign our 2003 Annual Report on Form 10-K filed with the currency-denominated assets and liabilities in each SEC. We do not intend to update these forward-looking entity would be insignificant because all material cur- statements. rency 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, 37


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    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. 38


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    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. 39


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    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. 40


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    Consolidated Statement of Common Shareholders’ Equity Common Common Additional Accumulated Stock Stock Paid-In Retained Other Compre- (In millions, except share data) Shares Amount Capital Earnings hensive 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. 41


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    Notes to the Consolidated Financial Statements (Dollars in millions, except per-share data and unless otherwise indicated) Note 1 – Summary of Significant contained in the 2003 Credit Facility and the senior notes are more fully discussed in Note 10. Our U.S. Accounting Policies Loan Agreement with General Electric Capital References herein to “we,” “us” or “our” refer to Corporation (“GECC”) (effective through 2010) relating Xerox Corporation and its subsidiaries unless the con- to our vendor financing program (the “Loan text specifically requires otherwise. Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of Description of Business and Basis of Presentation: We December 31, 2003, $2.6 billion was outstanding are a technology and services enterprise, as well as a under the Loan Agreement. The Loan Agreement, as leader in the global document market, developing, well as similar loan agreements with GE in the U.K. manufacturing, marketing, servicing and financing a and Canada that are discussed further in Note 4, incor- complete range of document equipment, software, porates the financial maintenance covenants con- solutions and services. tained in the 2003 Credit Facility and contains other affirmative and negative covenants. Liquidity, Financial Flexibility and Funding Plans: We At December 31, 2003, we were in full compliance manage our worldwide liquidity using internal cash with the covenants and other provisions of the management practices which are subject to (1) the 2003 Credit Facility, the senior notes and the Loan statutes, regulations and practices of each of the local Agreement and we expect to remain in full compli- jurisdictions in which we operate, (2) the legal require- ance for at least the next twelve months. Any failure ments of the agreements to which we are parties and to be in compliance with any material provision or (3) the policies and cooperation of the financial institu- covenant of the 2003 Credit Facility or the senior notes tions we utilize to maintain and provide cash manage- could have a material adverse effect on our liquidity ment services. and operations. Failure to be in compliance with the In June 2003, we completed a $3.6 billion recapi- covenants in the Loan Agreement, including the finan- talization (the “Recapitalization”) that included the cial maintenance covenants incorporated from the offering and sale of 9.2 million shares of 6.25 percent 2003 Credit Facility, would result in an event of termi- Series C Mandatory Convertible Preferred Stock, nation under the Loan Agreement and in such case 46 million shares of Common Stock, $700 of 7.125 per- GECC would not be required to make further loans to cent Senior Notes due 2010 and $550 of 7.625 percent us. If GECC were to make no further loans to us and Senior Notes due 2013 and the closing of our new assuming a similar facility was not established, it $1.0 billion credit agreement which matures on would materially adversely affect our liquidity and our September 30, 2008 (the “2003 Credit Facility”). The ability to fund our customers’ purchases of our equip- 2003 Credit Facility consists of a fully drawn $300 term ment and this could materially adversely affect our loan and a $700 revolving credit facility (which includes results of operations. a $200 sub-facility for letters of credit). The proceeds With $2.5 billion of cash and cash equivalents on from the Recapitalization were used to repay the hand at December 31, 2003 and borrowing capacity amounts outstanding under the Amended and under our 2003 Credit Facility of $700, less $51 utilized Restated Credit Agreement we entered into in June for letters of credit, we believe our liquidity (including 2002 (the “2002 Credit Facility”). Upon repayment of operating and other cash flows that we expect to gen- amounts outstanding, the 2002 Credit Facility was ter- erate) will be sufficient to meet operating cash flow minated and we incurred a $73 charge associated with requirements as they occur and to satisfy all sched- unamortized debt issuance costs. uled debt maturities for at least the next twelve On December 31, 2003, we had $700 of borrowing months. Our ability to maintain positive liquidity going capacity under the 2003 Credit Facility, less $51 utilized forward depends on our ability to continue to generate for letters of credit. The 2003 Credit Facility contains cash from operations and access the financial mar- affirmative and negative covenants, financial mainte- kets, both of which are subject to general economic, nance covenants and other limitations. The indentures financial, competitive, legislative, regulatory and other governing our outstanding senior notes contain sever- market factors that are beyond our control. al affirmative and negative covenants. The senior Our ability to obtain financing and the related cost notes do not, however, contain any financial mainte- of borrowing is affected by our debt ratings, which are nance covenants. The covenants and other limitations periodically reviewed by the major credit rating agen- cies. Our current credit ratings are below investment 42


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    grade and we expect our access to the public debt leased assets; (iv) allowance for doubtful accounts; markets to be limited to the non-investment grade (v) inventory valuation; (vi) restructuring and related segment until our ratings have been restored. charges; (vii) asset impairments; (viii) depreciable lives Specifically, until our credit ratings improve, it is of assets; (ix) useful lives of intangible assets; (x) pen- unlikely we will be able to access the low-interest sion and post-retirement benefit plans; (xi) income tax commercial paper markets or to obtain unsecured valuation allowances and (xii) contingency and litiga- bank lines of credit. tion reserves. Future events and their effects cannot We currently have a $2.5 billion shelf registration be predicted with certainty; accordingly, our account- that enables us to access the market on an opportunis- ing estimates require the exercise of judgment. The tic basis and offer both debt and equity securities. accounting estimates used in the preparation of our Consolidated Financial Statements will change as new Basis of Consolidation: The Consolidated Financial events occur, as more experience is acquired, as addi- Statements include the accounts of Xerox Corporation tional information is obtained and as our operating and all of our controlled subsidiary companies. All sig- environment changes. Actual results could differ from nificant intercompany accounts and transactions have those estimates. been eliminated. Investments in business entities in The following table summarizes the more signifi- which we do not have control, but we have the ability cant charges that require management estimates: to exercise significant influence over operating and financial policies (generally 20 to 50 percent owner- Year ended December 31, ship), are accounted for using the equity method of 2003 2002 2001 accounting. Upon the sale of stock of a subsidiary, we Restructuring provisions recognize a gain or loss in our Consolidated and asset impairments $176 $670 $715 Statements of Income equal to our proportionate Amortization and impairment of share of the corresponding increase or decrease in goodwill and intangible assets 35 99 94 Provisions for receivables 224 353 506 that subsidiary’s equity. Operating results of acquired Provisions for obsolete and businesses are included in the Consolidated excess inventory 78 115 242 Statements of Income from the date of acquisition Depreciation and obsolescence of and, for variable interest entities in which we are equipment on operating leases 271 408 657 determined to be the primary beneficiary, from the Depreciation of buildings date such determination is made. and equipment 299 341 402 Certain reclassifications of prior year amounts Amortization of capitalized have been made to conform to the current year software 143 249 179 presentation. Pension benefits – net periodic benefit cost 364 168 99 Income before Income Taxes, Equity Income and Other post-retirement benefits – net periodic benefit cost 108 120 130 Cumulative Effect of Change in Accounting Principle: Deferred tax asset valuation Throughout the Notes to the Consolidated Financial allowance provisions (16) 15 247 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 Changes in Estimates: In the ordinary course of Change in Accounting Principle. For convenience and accounting for items discussed above, we make ease of reference, that caption in our Consolidated changes in estimates as appropriate, and as we Statements of Income is hereafter referred to as become aware of circumstances surrounding those “pre-tax income.” estimates. Such changes and refinements in estima- tion methodologies are reflected in reported results of Use of Estimates: The preparation of our Consolidated operations in the period in which the changes are Financial Statements in accordance with accounting made and, if material, their effects are disclosed in the principles generally accepted in the United States of Notes to the Consolidated Financial Statements. America requires that we make estimates and assumptions that affect the reported amounts of New Accounting Standards and assets and liabilities, as well as the disclosure of con- Accounting Changes: tingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues Variable Interest Entities: In January 2003, the FASB and expenses during the reporting period. Significant issued Interpretation No. 46, “Consolidation of estimates and assumptions are used for, but not limit- Variable Interest Entities, an interpretation of ARB 51” ed to: (i) allocation of revenues and fair values in leas- (“FIN 46”). The primary objectives of FIN 46 were to es and other multiple element arrangements; (ii) provide guidance on the identification of entities for accounting for residual values; (iii) economic lives of 43


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    which control is achieved through means other than there is objective and reliable evidence of the fair through voting rights and how to determine when and value of the undelivered elements, and, if the arrange- which business enterprise should consolidate the vari- ment includes a general right to return the delivered able interest entity (“VIE”). We adopted FIN 46 on July element, delivery or performance of the undelivered 1, 2003 and, as a result, we began consolidating our element is considered probable. The relative fair value joint venture with De Lage Landen International BV of each unit should be determined and the total con- (“DLL”), our vendor financing partnership in the sideration of the arrangement should be allocated Netherlands, effective July 1, 2003 as we were among the individual units based on their relative fair deemed to be the primary beneficiary of the joint ven- value. With respect to bundled lease arrangements, ture’s financial results. Prior to the adoption of FIN 46, this guidance impacts the allocation of revenues to the we accounted for our investment with DLL under the aggregate lease and non-lease deliverables. Lease equity method of accounting. deliverables include executory costs, equipment and In December 2003, the FASB published a revision interest, while non-lease deliverables consist of the to FIN 46 (“FIN 46R”), in part, to clarify certain of its supplies and non-maintenance services component of provisions. FIN 46R addressed substantive ownership the bundled lease arrangements. The lease deliver- provisions related to consolidation. As a result of FIN ables must continue to be accounted for in accordance 46R, we were required to deconsolidate three of our with SFAS No. 13, consistent with our revenue recog- subsidiary trusts— Capital Trust I, Capital Trust II and nition policies. The guidance in this issue was effective Capital LLC. These trusts had previously issued manda- for revenue arrangements entered into after June 30, torily redeemable preferred securities and entered into 2003. EITF 00-21 did not, and is not expected to, have a loan agreements with the Company having similar material effect on our financial position or results of terms as the preferred securities. Specifically, FIN 46R operations. A full description of our revenue recogni- resulted in the holders of the preferred securities being tion policy associated with bundled contractual lease considered the primary beneficiaries of the trusts. As arrangements appears below. such, we were no longer permitted to consolidate these entities. We have therefore deconsolidated the Guarantees: In November 2002, the FASB issued three trusts and reflected our obligations to them with- Interpretation No. 45, “Guarantor’s Accounting and in the balance sheet liability caption “Liability to sub- Disclosure Requirements for Guarantees, Including sidiary trusts issuing preferred securities.” In addition Indirect Guarantees of Indebtedness of Others” (“FIN to deconsolidating these subsidiary trusts, the interest 45”). This interpretation expanded the disclosure on the loans, which was previously reported net of tax requirements of guarantee obligations and requires as a component of “Minorities’ interests in earnings of the guarantor to recognize a liability for the fair value subsidiaries” in our Consolidated Statements of of the obligation assumed under a guarantee. The dis- Income, are now accounted for as interest expense closure requirements of FIN 45 were effective as of within “Other expenses, net”, with the tax effects pre- December 31, 2002. The recognition requirements of sented within “Income taxes (benefits).” Accordingly, FIN 45 were required to be applied prospectively to $145, $145 and $64 in interest expense on loans guarantees issued or modified after December 31, payable to the subsidiary trusts for the years ended 2002. Significant guarantees that we have entered are December 31, 2003, 2002, and 2001, respectively, was disclosed in Note 15. The requirements of FIN 45 did reflected as non-financing interest expense. The relat- not have a material impact on our results of opera- ed income tax effects were $56, $56 and $24, for the tions, financial position or liquidity. years ended December 31, 2003, 2002, and 2001, respectively. Financial statements for all periods pre- Costs Associated with Exit or Disposal Activities: In sented have been revised to reflect this change. The 2002, the FASB issued SFAS No. 146, “Accounting for adoption of this interpretation had no impact on the Costs Associated with Exit or Disposal Activities” net income or earnings per share. In connection with (“SFAS No. 146”). This standard requires companies the adoption of FIN 46R, we also reclassified prior to recognize costs associated with exit or disposal periods for the effects of the consolidation of DLL. activities when they are incurred, rather than at the The impact of consolidating DLL was immaterial for date of a commitment to an exit or disposal plan. all periods presented. Examples of costs covered by the standard include lease termination costs and certain employee sever- Revenue Recognition: In November 2002, the ance costs that are associated with a restructuring, Emerging Issues Task Force (the “EITF”) reached a plant closing, or other exit or disposal activity. We consensus on Issue 00-21, “Revenue Arrangements adopted SFAS No. 146 in the fourth quarter of 2002. with Multiple Deliverables.” The EITF requires that the Refer to Note 2 for further discussion. deliverables must be divided into separate units of accounting when the individual deliverables have value to the customer on a stand-alone basis, when 44


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    Goodwill and Other Intangible Assets: Effective Revenue Recognition: In the normal course of busi- January 1, 2002, we adopted Statement of Financial ness, we generate revenue through the sale and rental Accounting Standards No. 142, “Goodwill and Other of equipment, service and supplies and income asso- Intangible Assets” (“SFAS No. 142”), whereby good- ciated with the financing of our equipment sales. will was no longer to be amortized, but instead is to be Revenue is recognized when earned. More specifically, tested for impairment annually or more frequently if revenue related to sales of our products and services an event or circumstance indicates that an impairment is recognized as follows: loss may have been incurred. In 2002, we recorded an impairment charge of $63 as a cumulative effect of Equipment: Revenues from the sale of equipment, change in accounting principle in the accompanying including those from sales-type leases, are recognized Consolidated Statements of Income. Upon adoption of at the time of sale or at the inception of the lease, as SFAS No. 142, we reclassified $61 of intangible assets appropriate. For equipment sales that require us to to goodwill. Prior to adoption, goodwill and identifiable install the product at the customer location, revenue is intangible assets were amortized on a straight-line recognized when the equipment has been delivered to basis over periods ranging from 5 to 40 years. Pro and installed at the customer location. Sales of cus- forma net loss as adjusted for the exclusion of amorti- tomer installable products are recognized upon ship- zation expense of $59 for the year ended December ment or receipt by the customer according to the 31, 2001 was $35 or $0.06 per share. customer’s shipping terms. Revenues from equipment under other leases and similar arrangements are The following table presents the changes in the accounted for by the operating lease method and are carrying amount of goodwill, by operating segment, recognized as earned over the lease term, which is for the years ended December 31, 2003 and 2002: generally on a straight-line basis. Production Office DMO Other Total Service: Service revenues are derived primarily from Balance at maintenance contracts on our equipment sold to cus- January 1, 2002 $605 $710 $ 70 $121 $1,506 tomers and are recognized over the term of the con- Foreign currency tracts. A substantial portion of our products are sold translation with full service maintenance agreements for which adjustment 82 55 (3) – 134 the customer typically pays a base service fee plus a Impairment charge – – (63) – (63) variable amount based on usage. As a consequence, Divestitures (4) – (1) – (5) other than the product warranty obligations associat- Other – (5) (3) – (8) ed with certain of our low end products in the Office Balance at segment, we do not have any significant product December 31, 2002 $683 $760 $ – $121 $1,564 warranty obligations, including any obligations under Foreign currency customer satisfaction programs. translation adjustment 88 67 – 3 158 Supplies: Supplies revenue generally is recognized Balance at upon shipment or utilization by customer in accor- December 31, 2003 $771 $827 $ – $124 $1,722 dance with sales terms. All intangible assets relate to the Office operating Revenue Recognition Under Bundled Arrangements: segment and were comprised of the following as We sell most of our products and services under bun- of December 31, 2003: dled contract arrangements, which contain multiple deliverable elements. These contractual lease arrange- Accu- ments typically include equipment, service, supplies Amorti- Gross mulated and financing components for which the customer zation Carrying Amorti- Net Period Amount zation Amount pays a single negotiated price for all elements. These arrangements typically also include a variable compo- Installed customer base 17.5 years $209 $ 45 $164 nent for page volumes in excess of contractual mini- Distribution network 25 years 123 20 103 Existing technology 7 years 103 56 47 mums, which are often expressed in terms of price per Trademarks 7 years 23 12 11 page, which we refer to as the “cost per copy.” In a typical bundled arrangement, our customer is quoted $458 $133 $325 a fixed minimum monthly payment for 1) the equip- ment, 2) the associated services and other executory Amortization expense related to intangible assets costs, 3) the financing element and 4) frequently sup- was $35, $36, and $40 for the years ended December plies. The fixed minimum monthly payments are mul- 31, 2003, 2002 and 2001, respectively, and is expected tiplied by the number of months in the contract term to approximate $36 annually through 2008. to arrive at the total fixed minimum payments that the 45


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    customer is obligated to make (“fixed payments”) Revenue Recognition for Leases: Our accounting for over the lease term. The payments associated with leases involves specific determinations under page volumes in excess of the minimums are contin- Statement of Financial Accounting Standards No. 13 gent on whether or not such minimums are exceeded “Accounting for Leases” (“SFAS No. 13”) which often (“contingent payments”). The minimum contractual involve complex provisions and significant judgments. committed copy volumes are typically negotiated to The two primary criteria of SFAS No. 13 which we use equal the customer’s estimated copy volume at lease to classify transactions as sales-type or operating leas- inception. In applying our lease accounting methodol- es are (1) a review of the lease term to determine if it is ogy, we consider the fixed payments for purposes of equal to or greater than 75 percent of the economic allocating to the relative fair value elements of the life of the equipment and (2) a review of the present contract. We do not consider the contingent payments value of the minimum lease payments to determine if for purposes of allocating to the elements of the con- they are equal to or greater than 90 percent of the fair tract or recognizing revenue on the sale of the equip- market value of the equipment at the inception of the ment, given the inherent uncertainties as to whether lease. We assess important criteria related to lease such amounts will ever be received. Contingent pay- classification, including whether collectibility of the ments are recognized as revenue in the period when payments is reasonably predictable and whether there the customer exceeds the minimum copy volumes are important uncertainties related to costs that we specified in the contract. have yet to incur with respect to the lease. In our opin- When separate prices are listed in multiple ele- ion, our sales-type lease portfolios contain only nor- ment customer contracts, such prices may not be rep- mal credit and collection risks and have no important resentative of the fair values of those elements, uncertainties with respect to future costs. Our leases because the prices of the different components of the in our Latin America operations have historically been arrangement may be modified through customer recorded as operating leases because the recoverability negotiations, although the aggregate consideration of the lease investment is deemed not to be predictable may remain the same. Revenues under bundled at lease inception. arrangements are allocated based upon the estimated The critical elements that we consider with respect fair values of each element (and for transactions to our lease accounting are the determination of the entered into after July 1, 2003, revenues are allocated economic life and the fair value of equipment, includ- considering the relative fair values of the lease and ing the residual value. Those elements are based upon non-lease deliverables in accordance with EITF 00-21). historical experience with all our products. For purpos- Our revenue allocation to the lease deliverables es of determining the economic life, we consider the begins by allocating revenues to the maintenance and most objective measure of historical experience to be executory costs plus profit thereon. The remaining the original contract term, since most equipment is amounts are allocated to the equipment and financing returned by lessees at or near the end of the contract- elements. We perform extensive analyses of available ed term. The economic life of most of our products is verifiable objective evidence of equipment fair value five years since this represents the most frequent con- based on cash selling prices during the applicable tractual lease term for our principal products and only period. The cash selling prices are compared to the a small percentage of our leases have original terms range of values included in our lease accounting sys- longer than five years and there is generally no signifi- tems. The range of cash selling prices must be reason- cant after-market for our used equipment. We believe ably consistent with the lease selling prices, taking that this is representative of the period during which into account residual values that accrue to our benefit, the equipment is expected to be economically usable, in order for us to determine that such lease prices are with normal service, for the purpose for which it is indicative of fair value. Our pricing interest rates, intended. We continually evaluate the economic life of which are used to determine customer lease pay- both existing and newly introduced products for pur- ments, are developed based upon a variety of factors poses of this determination. Residual values are estab- including local prevailing rates in the marketplace and lished at lease inception using estimates of fair value the customer’s credit history, industry and credit class. at the end of the lease term. Our residual values are Effective January 1, 2004, the pricing rates will be established with due consideration to forecasted sup- reassessed quarterly based on changes in local pre- ply and demand for our various products, product vailing rates in the marketplace and will be adjusted to retirement and future product launch plans, end of the extent such rates vary by twenty-five basis points lease customer behavior, remanufacturing strategies, or more, cumulatively, from the last rate in effect. The used equipment markets, if any, competition and pricing interest rates generally equal the implicit rates technological changes. within the leases, as corroborated by our comparisons The vast majority of our leases that qualify as of cash to lease selling prices. sales-type are non-cancelable and include cancellation penalties approximately equal to the full value of the lease receivables. A portion of our business involves 46


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    sales to governmental units. Governmental units are December 31, those entities that have statutorily defined funding or 2003 2002 annual budgets that are determined by their legislative Escrow and cash collections bodies. Certain of our governmental contracts may related to secured borrowing have cancellation provisions or renewal clauses that arrangements $462 $349 are required by law, such as 1) those dependant on Escrow related to liability to trusts fiscal funding outside of a governmental unit’s control, issuing preferred securities 79 155 Collateral related to swaps and 2) those that can be cancelled if deemed in the taxpay- letters of credit 74 77 er’s best interest or 3) those that must be renewed each Other restricted cash 114 97 fiscal year, given limitations that may exist on entering Total $729 $678 multi-year contracts that are imposed by statute. In these circumstances and in accordance with the rele- vant accounting literature, we carefully evaluate these Of these amounts, $386 and $263 were included in contracts to assess whether cancellation is remote Other current assets and $343 and $415 were included because of the existence of substantive economic in Other long-term assets, as of December 31, 2003 penalties upon cancellation or whether the renewal is and 2002, respectively. The current amounts are reasonably assured due to the existence of a bargain expected to be available for our use within one year. renewal option. The evaluation of a lease agreement with a renewal option includes an assessment as to Provisions for Losses on Uncollectible Receivables: whether the renewal is reasonably assured based on The provisions for losses on uncollectible trade and the intent of such governmental unit and pricing terms finance receivables are determined principally on the as compared to those of short-term leases at lease basis of past collection experience applied to ongoing inception. We further ensure that the contract provi- evaluations of our receivables and evaluations of the sions described above are offered only in instances default risks of repayment. Allowances for doubtful where required by law. Where such contract terms are accounts on accounts receivable balances were $218 not legally required, we consider the arrangement to and $282, as of December 31, 2003 and 2002, respec- be cancelable and account for it as an operating lease. tively. Allowances for doubtful accounts on finance Aside from the initial lease of equipment to our receivables were $315 and $324 at December 31, 2003 customers, we may enter subsequent transactions and 2002, respectively. with the same customer whereby we extend the term. We evaluate the classification of lease extensions of Inventories: Inventories are carried at the lower of sales-type leases using the originally determined eco- average cost or market. Inventories also include equip- nomic life for each product. There may be instances ment that is returned at the end of the lease term. where we enter into lease extensions for periods that Returned equipment is recorded at the lower of are within the original economic life of the equipment. remaining net book value or salvage value. Salvage These are accounted for as sales-type leases only value consists of the estimated market value (general- when the extensions occur in the last three months of ly determined based on replacement cost) of the sal- the lease term and they otherwise meet the appropri- vageable component parts, which are expected to be ate criteria of SFAS 13. All other lease extensions of used in the remanufacturing process. We regularly this type are accounted for as direct financing leases review inventory quantities and record a provision for or operating leases, as appropriate. excess and/or obsolete inventory based primarily on our estimated forecast of product demand, production Cash and Cash Equivalents: Cash and cash equivalents requirements and servicing commitments. Several fac- consist of cash on hand, including money-market tors may influence the realizability of our inventories, funds, and investments with original maturities of including our decision to exit a product line, techno- three months or less. logical changes and new product development. The provision for excess and/or obsolete raw materials and Restricted Cash and Investments: Several of our equipment inventories is based primarily on near term borrowing and derivative contracts, as well as other forecasts of product demand and include considera- material contracts, require us to post cash collateral tion of new product introductions as well as changes or maintain minimum cash balances in escrow. These in remanufacturing strategies. The provision for cash amounts are reported in our Consolidated excess and/or obsolete service parts inventory is Balance Sheets within Other current assets or Other based primarily on projected servicing requirements long-term assets, depending on when the cash will over the life of the related equipment populations. be contractually released. At December 31, 2003 and 2002, such restricted cash amounts were as follows: 47


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    Land, Buildings and Equipment and Equipment on healthcare costs, the rate of future compensation Operating Leases: Land, buildings and equipment are increases, and mortality, among others. Actual returns recorded at cost. Buildings and equipment are depreci- on plan assets are not immediately recognized in our ated over their estimated useful lives. Leasehold income statement, due to the delayed recognition improvements are depreciated over the shorter of the requirement. In calculating the expected return on the lease term or the estimated useful life. Equipment on plan asset component of our net periodic pension operating leases is depreciated to estimated residual cost, we apply our estimate of the long term rate of value over the lease term. Depreciation is computed return to the plan assets that support our pension obli- using the straight-line method. Significant improve- gations, after deducting assets that are specifically ments are capitalized and maintenance and repairs are allocated to Transitional Retirement Accounts (which expensed. Refer to Notes 5 and 6 for further discussion. are accounted for based on specific plan terms). For purposes of determining the expected return Impairment of Long-Lived Assets: We review the on plan assets, we utilize a calculated value approach recoverability of our long-lived assets, including build- in determining the value of the pension plan assets, as ings, equipment, internal-use software and other opposed to a fair market value approach. The primary intangible assets, when events or changes in circum- difference between the two methods relates to system- stances occur that indicate that the carrying value of atic recognition of changes in fair value over time the asset may not be recoverable. The assessment of (generally two years) versus immediate recognition of possible impairment is based on our ability to recover changes in fair value. Our expected rate of return on the carrying value of the asset from the expected plan assets is then applied to the calculated asset value future pre-tax cash flows (undiscounted and without to determine the amount of the expected return on interest charges) of the related operations. If these plan assets to be used in the determination of the net cash flows are less than the carrying value of such periodic pension cost. The calculated value approach asset, an impairment loss is recognized for the differ- reduces the volatility in net periodic pension cost that ence between estimated fair value and carrying value. results from using the fair market value approach. Our primary measure of fair value is based on dis- The difference between the actual return on plan counted cash flows. The measurement of impairment assets and the expected return on plan assets is added requires management to make estimates of these cash to, or subtracted from, any cumulative differences that flows related to long-lived assets, as well as other fair arose in prior years. This amount is a component of value determinations. the unrecognized net actuarial (gain) loss and is sub- ject to amortization to net periodic pension cost over Research and Development Expenses: Research and the remaining service lives of the employees partici- development costs are expensed as incurred. pating in the pension plan. Another significant assumption affecting our pen- Pension and Post-Retirement Benefit Obligations: We sion and post-retirement benefit obligations and the sponsor pension plans in various forms in several net periodic pension and other post-retirement benefit countries covering substantially all employees who cost is the rate that we use to discount our future antic- meet eligibility requirements. Post-retirement benefit ipated benefit obligations. In estimating this rate, we plans cover primarily U.S. employees for retirement consider rates of return on high quality fixed-income medical costs. As required by existing accounting investments over the period to expected payment of rules, we employ a delayed recognition feature in the pension and other post-retirement benefits. measuring the costs and obligations of pension and post-retirement benefit plans. This requires changes in Stock-Based Compensation: We do not recognize the benefit obligations and changes in the value of compensation expense relating to employee stock assets set aside to meet those obligations, to be rec- options because the exercise price is equal to the mar- ognized, not as they occur, but systematically and ket price at the date of grant. If we had elected to rec- gradually over subsequent periods. All changes are ognize compensation expense using a fair value ultimately recognized, except to the extent they may approach, and therefore determined the compensa- be offset by subsequent changes. At any point, tion based on the value as determined by the modified changes that have been identified and quantified Black-Scholes option pricing model, our pro forma await subsequent accounting recognition as net cost income (loss) and income (loss) per share would have components and as liabilities or assets. been as follows: Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pen- sion and post-retirement benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in 48

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