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    ANNUAL REPORT 2006


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    20 0 Documenting any communication used to mean committing it to paper, getting it down in black and white. Now communication is generally scanned, sent, searched, archived, merged, personalized – often in color. It can move back and forth, many times, from physical to digital. So when we say our mission is to help people be smarter about their documents, it really means giving them a range of tools and techniques to capture, organize, facilitate and enhance 01 Financial Overview 02 Chairman’s Letter 08 Citizenship 09 Customer Features 12 Board of Directors how they communicate. In any 15 form. To an audience of one Description of Business or many millions. 26 Management’s Discussion and Analysis of Results of Operations and Financial Condition Inside Back Cover Corporate Information and Officers


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    06 Financial Overview ($ millions, except EPS) Total Revenue Equipment Sales Post Sale, Finance Income and Other Revenue Net Income Diluted Earnings Per Share Net Cash Provided by Operating Activities 2006 $ 15,895 4,457 11,438 1,210 1.22 1,617 2005 $ 15,701 4,519 11,182 978 0.94 1,420 XEROX ANNUAL REPORT 2006 1


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    CHAIRMAN’S LETTER “I am pleased to report that 2006 was another year of good progress for Xerox. The strategic investments we made several years ago are paying off and we are confident in our continued ability to give you good returns on the trust you have placed in us.” Our progress in 2006 provided more evidence that we are on track and that we are building momentum. Our results In 2006, our financial results included: • Net income of $1.2 billion or earnings per share of $1.22, compared to EPS of 94 cents for full-year 2005. • Adjusted EPS of $1.05, an increase of 17 percent from full-year 2005 adjusted EPS of 90 cents.* • Total revenue of $15.9 billion, an increase of 1 percent or $194 million XEROX ANNUAL REPORT 2006 from full-year 2005. • Operating cash flow of $1.6 billion. • Year-end cash and short-term investments balance of $1.5 billion. 2


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    We met our full-year expectations on earnings growth and cash generation, increased post-sale revenue and strengthened our industry-leading portfolio of products and services. We purchased two well-performing companies – XMPie® and Amici – that are contributing revenue growth and helping us build value for our customers. We managed our operations efficiently, giving us the flexibility to compete effectively while generating strong bottom-line results. We returned to investment grade and bought back $1.1 billion of Xerox shares in 2006. We’ve committed $2.5 billion to share repurchase since the program launched in October 2005. Our healthy cash position allows us to deliver value for shareholders by buying back stock and investing in growth through acquisitions, innovation and a services-led approach to winning in the marketplace. In fact, Xerox stock appreciated 16 percent in 2006. It was a good year and we have every reason to believe we are on our way to a better one. Our growth strategy While we’re proud of our accomplishments, what gives me the greatest pride in our leadership team is that we’re not satisfied. Hubris is not a part of our vocabulary. Good enough is simply not good enough for Xerox. We’re keenly aware that the last frontier we need to tame is accelerating revenue growth. There are several reasons to believe this is within our reach. 2006 While we’re justifiably known for our technology, we’re running an annuity-based business that generates more than 70 percent of revenue from what we call “post sale.” This is the sale of supplies – like ink and toner – and technical services that are needed to support our products, as well as revenue from financing our customers’ purchases. It also includes consulting and outsourcing services such as document imaging and archiving, managing our customers’ print shops, simplifying their work processes and much more. Last year was a turning point in growing our post-sale revenue – up 2 percent for the year – as the annuity from our digital, color and services businesses helped to offset losses from our older light lens business. This positive trend is expected to continue; in fact, we expect it will accelerate as light lens becomes less and less of the total and the annuity from our strong growth markets kicks in. We have four planks in our growth strategy. Each builds on our core competencies. Each responds to customer need with customer value. Each is designed to fuel our annuity stream through long-term contracts. And each is yielding good results. Here’s a snapshot of how we’re doing in each of our four growth strategies. The first is to lead in color. We’ve been investing heavily in leading with the transition to color in the office and in expanding our leadership position in the production market. Last year we brought eight new color products to market, strengthening what was already the broadest and deepest set of technologies in our industry. We’ve already announced five more color products this year and we’re just getting started. The competition doesn’t stand still and neither do we. XEROX ANNUAL REPORT 2006 The power of color is in the pages. Color pages generate significantly more revenue and profit than black-and-white pages. We’re already seeing this benefit flow through to our annuity. Post-sale revenue from color was up 16 percent in 2006. Much of that is due to the 38 percent increase in color pages. More than 30 billion color pages were printed on Xerox color systems last year; that’s close to double what we were doing two years ago. Color now represents nine percent of total Xerox pages. As that percentage grows, so too will our all important post-sale revenue stream. It’s a great business model and it’s working. * See Page 7 for the reconciliation of the difference between this financial measure that is not in compliance with Generally Accepted Accounting Principles (GAAP) and the most directly comparable financial measure calculated in accordance with GAAP. 3


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    CHAIRMAN’S LETTER Our second strategic platform for growth is what we call the New Business of Printing.® It’s a market where Xerox is competitively advantaged. Our customers in this space are typically commercial printers, marketing and graphic arts companies and large enterprises. They depend on digital printing to print on demand, produce short runs of books, personalize documents as they come off the press and leverage the power of our digital technology in a myriad of other ways. Our digital presses, sophisticated workflow capabilities and expanding set of solutions and applications help our customers grow their businesses. New products helped drive a 74 percent increase in installs of Xerox’s production color publishing systems and printers – that’s actual placements in a customer’s workplace. We closely track install data as an indicator of what’s to come in post-sale revenue. The more color products we sell, the more pages printed on Xerox systems. More pages mean more profitable annuity, all adding up to sustainable growth. One especially satisfying trend: the acceptance of the Xerox iGen3® Digital Production Press, our flagship and unparalleled product that creates up to 110 full-color impressions per minute with the ability to personalize each and every one. The iGen3 is a winner with our customers. In fact, some 180 customers now own more than one. And, about 70 of our customers’ iGens produce more than 1 million images per month. Last year we acquired XMPie for $54 million. XMPie provides software that enables multimedia campaigns with personalized e-mail, Web sites, catalogs, brochures and other documents. When applied to direct marketing campaigns, these capabilities significantly increase standard response rates and open up new ways for marketing professionals to communicate with their customers. Net Income Post-Sale and Color Revenue Net Cash from ($ millions) Financing Revenue (Included in Total Revenue – Operating Activities (Included in Total Revenue – $ millions) ($ millions) $ millions) 1,210 5,578 11,879 1,980 11,451 11,438 11,242 1,879 11,182 1,750 4,928 1,617 978 4,188 1,420 859 3,267 2,781 360 91 ’02 ’03 ’04 ’05 ’06 ’02 ’03 ’04 ’05 ’06 ’02 ’03 ’04 ’05 ’06 ’02 ’03 ’04 ’05 ’06 You’ve probably received marketing materials in the mail that are targeted to your personal buying needs – like postcards from car dealers with an image of the new version of your car including a license plate with your initials or a travel itinerary from a cruise line featuring activities that appeal to your individual interests. These marketing campaigns cut through the clutter. They’re personalized, colorful and XEROX ANNUAL REPORT 2006 most likely printed on Xerox color systems using XMPie software. The market for variable data jobs that capture individual information such as name, address, account information and photographs is projected to grow from 49 billion pages in 2004 to 138 billion pages in 2009. That’s an annual compounded growth rate of 23 percent. Xerox is in the forefront of driving that market opportunity. Our third strategy for growth is to lead in services in our major accounts – and here, too, we’re making good progress. Our services signings last year were up over 15 percent from the previous year. Customers who are entrusting us to manage large enterprise systems include the likes of Medco and Honeywell, the University of Calgary and Microsoft, OfficeMax and United Technologies and more. 4


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    And we believe it’s the tip of the iceberg. More and more large customers are turning to us for help in simplifying their document-intensive work processes; bridging the divide between paper and digital documents; managing their infrastructure; and creating digital systems that allow them to easily store, search and retrieve their digital files. We call this Smarter Document Management™. It’s a market where Xerox is uniquely advantaged – drawing upon our heritage in understanding how people work with documents and adding our rich portfolio of digital applications and technology. During 2006, we acquired Amici LLC for $175 million. Amici is the market leader in e-discovery technology, which involves the identification, filtering, production and storage of relevant data from paper or electronic documents, such as e-mail, text files, memos, databases, presentations and spreadsheets. Projected to grow at an annual compounded rate of close to 40 percent, e-discovery services could be a nearly $2.5 billion market in the United States alone by 2009. Now a part of Xerox Litigation Services, Amici helps position us to go after this burgeoning market. The fourth plank in our growth strategy is to aggressively attack the small and medium business (SMB) market. It’s a $44 billion opportunity where our presence has been modest. Segments of the market, however, are growing – especially in developing countries, in color and in multifunction devices. 2006 Here, too, we are making excellent progress. Last year we introduced four products targeted to this segment and earlier this year we launched seven more. At the same time, we continue to expand our distribution channels. We recently announced our most significant investment in resellers and inde- pendent agents since launching Gross Margins Selling, Administrative (Percent) and General Expenses these sales channels several years ($ millions) ago. That means there will be more “feet on the street” selling Xerox systems and services and greater Xerox brand visibility in the SMB 4,437 42.8 42.6 41.6 41.2 4,249 4,203 40.6 market. Our strategy is straight-for- 4,110 4,008 ward: more technology plus more distribution equals more growth. We’re attacking a $117 billion market opportunity through our focus on these growth strategies. ’02 ’03 ’04 ’05 ’06 ’02 ’03 ’04 ’05 ’06 We can compete for every dollar of it – and we are. Our people Our success is dependent on contributions from Xerox’s 54,000 worldwide employees who impress me every day with their passion for creating great experiences for our customers. They’re led by a deeply committed executive team with a fierce will to win. We have a wealth XEROX ANNUAL REPORT 2006 of talent across our enterprise and spend significant time developing this talent – spreading that wealth throughout our operations and preparing our next generation of leadership. Our recent appointment of Ursula Burns to president of Xerox and a member of the Board of Directors reflects this commitment. Ursula joined Xerox in 1980 as an engineering intern and earned her stripes through product development and business division management roles to her most recent position as head of Business Group Operations with full responsibility for Xerox’s research and product groups through to manufacturing and distribution. She’s been instrumental in fine tuning Xerox’s business model so we’re more cost competitive, and accelerating our time to market with the launch of more than 100 products in the last three years. Ursula now brings her deep knowledge of our business to the president role, where she’ll work closely with me and our leadership team to aggressively drive our well-defined 5


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    CHAIRMAN’S LETTER growth strategy. With a lot of heavy lifting behind us, our operations are in good shape. We’re now well positioned – with the best people and best products and services – to build on our momentum in the marketplace both in the near term and for your long-term investment in Xerox. Our innovation Including our partner Fuji Xerox, we invested a combined $1.4 billion last year in research and development, with a similar amount planned for 2007. Our returns on that investment are excellent. Last year we launched 14 products that together earned 208 industry awards. We expect to more than double the number of product announcements this year. We measure the success of our R&D investments through a metric called “Time to Revenue” – how long it takes for new ideas to become new revenue. We believe our progress in this area is among the best in the industry. About two-thirds of Xerox’s equipment sales come from products launched in the past two years. Thanks to our scientists and engineers, the future is bright as well. Last year, the Xerox innovation community received nearly 560 U.S. utility patents. That’s up 24 percent over the previous year. With our research partner, Fuji Xerox, the total was over 800. We hold more than 8,000 active patents, many that are the foundation of breakthrough technology like: • Self-erasable paper that uses a combination of light and ink to automatically erase marks on a page about 16-24 hours after the page is printed. • E-Agent, a special chemical ingredient that reduces the amount of energy needed to make certain Xerox toners by up to 22 percent. • Advancements in natural language search technology which uses familiar phrases and sentences to simplify search results. Our customers One of the hallmarks of the new Xerox is deep relationships with our customers. Increasingly, we are strategic partners. One of them recently referred to Xerox as a combination painkiller and steroid. We’ve been called lots of things, but never that, so I asked him what he meant. His answer went something like this: “Before Xerox came along, document management was a huge headache. We had no idea what we were spending. We had lots of vendors but no partners. We kept investing in the promise that the next new thing would be the right thing. Xerox has made my life simpler. I talk to one person who saves me money and boosts my productivity. That’s the painkiller. The steroid part comes from leveraging documents to reach customers more effectively, to make it easier for customers to do business with us and to grow our business. That’s the steroid part. Xerox gives me both in ways no one else can.” That’s music to my ears. It’s also a novel way to express our value proposition – painkiller and steroid, streamlining document processes to reduce costs and leveraging documents to grow revenue. No one does that better than Xerox – no one. Our operations XEROX ANNUAL REPORT 2006 We also have a business model that works – in part because it’s flexible. We react quickly and decisively to marketplace challenges and opportunities. In today’s world, every quarter seems to present its own unique dynamics. Pricing pressures may put pressures on our margins. Economic slowdowns may slow our revenue pipeline. Competitive threats may cause us to bulk up our investments in marketing. Whatever the circumstances, we adjust. We do it quickly. And we do it in a way that keeps our business model aligned with our financial objectives. As a result, we are a company that is known for consistency. We know that’s important to you so it’s critical to us. 6


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    Our commitment to citizenship So, too, is our continued focus on being a good corporate citizen. It’s a cherished part of our heritage and an essential part of our future. I urge you to read the snapshot description of our activities in this report. We’re making progress in reducing greenhouse gas emissions. We supported more than 500 non-profit organizations; spent more than $370 million with minority-, women- and veteran-owned businesses; strengthened our efforts to protect our forests; sent thousands of volunteers into the communities in which we work and live; and much more. Last year, we published our first Report on Global Citizenship. It provides a comprehensive look at how we run our company – from serving our customers and taking care of the environment to conducting our business with integrity and giving back to our communities. The report is available in its entirety at www.xerox.com/citizenship. Our commitment to you We believe our track record is good, our strategy is sound and our business model is robust. We’re participating in a $117 billion market and we’re positioned to compete aggressively for every dollar of it. In 2007 you’ll see continued activity that strengthens our leadership in color, accelerates the New Business of Printing, expands our offerings in services, and broadens our offerings and distribution in the small and medium business 2006 market. All this fuels our profitable annuity stream, which accounts for more than 70 percent of our revenue. At the same time, you can expect us to remain diligent on reducing costs, generating cash and prioritizing profitability and earnings growth. We know that you have invested in Xerox because you have confidence in us. It’s an awesome responsibility that we embrace and take very seriously. The thing I love the most about this company is the people. They have what I like to call a “steely optimism.” They do whatever it takes to make Xerox successful, to help our customers be successful and to give you a good return on your investment. Because of them, I have every confidence that 2007 will be another good year for Xerox – and for you. Anne M. Mulcahy Chairman and Chief Executive Officer XEROX ANNUAL REPORT 2006 Non-GAAP Reconciliation Full-Year ’06 Full-Year ’05 (in $ millions, except per-share data) Net Income Diluted EPS Net Income Diluted EPS As Reported $1,210 $ 1.22 $ 978 $ 0.94 Adjustments Restructuring and Asset Impairment 254 0.25 247 0.24 Tax Audit Benefits (494) (0.50) (343) (0.34) Litigation Matters 68 0.07 84 0.08 Credit Facility Fee 9 0.01 Integic Gain (58) (0.06) EU Waste Directive 18 0.02 Hurricane Katrina Loss 9 0.01 Accounting Change 8 0.01 Adjusted $1,047 $ 1.05 $ 943 $ 0.90 7


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    CITIZENSHIP Citizenship at Xerox Over the past 40 years, Xerox has demonstrated leadership by supporting educational and community projects around the world, designing “waste-free” products built in “waste-free” plants, investing in innovation that delivers measurable benefits to the environment, and many other integrated initiatives that touch Xerox communities, employees and stakeholders. 2006 Through our Social Service Leave program, eight Xerox Some highlights from 2006 include: employees volunteered full • Launched the company’s first Report on Global Citizenship, which time and at full pay to support includes information on ethics and governance, customer privacy and community service agencies. Xerox marketing professional, satisfaction, employee diversity and development, waste-free initiatives, Katelyn Dyer, pictured here, philanthropy, community involvement and more. The full report is spent her Social Service Leave available at www.xerox.com/citizenship. with Junior Achievement of Rochester, N.Y., helping to • Adopted the Electronics Industry Code of Conduct, a standards-based increase its base of funding approach for monitoring suppliers’ compliance across several areas and volunteers to support more educational programs. of social responsibility. • Continued progress toward reducing Xerox’s global greenhouse gas emissions 10 percent by 2012 from a 2002 baseline. • Xerox’s Palo Alto Research Center partnered with SolFocus to develop technology that will break price barriers in the solar electricity market. • Contributed $1 million to The Nature Conservancy to develop science-based tools and systems that will help the paper industry better manage ecologically important forest land. The funding focuses on the Canadian Boreal Forest as well as the forests of the southern United States, Indonesia and Brazil’s Atlantic Forest. • Invested just over $12 million in the non-profit sector through the XEROX ANNUAL REPORT 2006 Xerox Foundation, supporting about 500 organizations last year. • More than 20,000 elementary students benefited from science lessons taught by Xerox employees who volunteer their time in classrooms to inspire the next generation of scientists and inventors. • Hispanic Business, National Association of Female Executives, Hispanic Magazine, Black Enterprise and Asian Enterprise were just some of the external endorsements Xerox received for its focus on diversity and nurturing an inclusive workplace environment. Xerox was also honored by the Families and Work Institute for our progressive work-life practices. 8


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    Understanding customers Xerox introduced a content management system that instantly refreshes informational copy across all better – serving them best. languages by identifying and translating key common words and phrases. If a phrase is repeated in context, it automatically updates all versions. If a phrase is out The leading European IT provider, Fujitsu Siemens of context, it applies logic to adapting it. The system Computers (FSC) has customers in more than 170 also refreshes and integrates diagrams and pictures countries. So, as you might expect, communicating to suit evolving content. effectively in its customers’ many languages is tantamount to fulfilling its corporate vision of To reduce time to market, Xerox also introduced “Understanding you better – serving you best.” local operations close to each FSC plant so that 100 percent of all printed material could be delivered When you multiply these many languages by FSC’s within hours of the times requested. extensive portfolio of products that includes PCs, notebooks, workstations, pen tablet PCs and The translation of manuals is one of many projects handhelds, you can begin to appreciate the enormity Xerox undertakes on behalf of FSC. As with other of the task of producing user manuals for these key global accounts, Xerox has appointed a Client many devices. Not only do the manuals need to be Managing Director for Siemens group of companies, technically precise, they also need to be engaging, who, as the one go-to point of ownership, leads all conversational and easy to understand. partnership endeavors. That’s why FSC chose Xerox for the lifecycle After a flawless conversion from the existing method, management of its user manuals, which includes the initiative immediately delivered cost savings of consulting on design and editorial content, translating 25-30 percent, with recent savings approaching 45 the manuals into as many as 29 languages and percent. Just as significant has been the nonexistent managing all print fulfillment. disruption to customer satisfaction. Those are results worth noting. In any language. XEROX ANNUAL REPORT 2006 9


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    Katrina and Rita are no match offsite University command centers and executive offices. Within days, the critical work of remediation for Xavier and Xerox. and reconstruction was underway. Once floodwaters had receded, a Xerox team toured Xavier University of Louisiana has been a top producer the stricken campus only to find that water and mold of the nation’s Black pharmacists for eight decades, had damaged virtually all of the equipment that it had and since 1993 it has placed more African Americans placed. The University print shop managed by Xerox into medical schools each year than any college was a total loss. in America. But like much of New Orleans in the late summer of 2005, its campus was under water. Again Xerox went to work. It conducted an inventory And most of its administrative offices – along with to assess the status of all equipment throughout the the equipment and technology to run them – were campus, ordered replacements, and by early January completely disabled. had installed all of it, at no cost to the University. Xerox also provided five of its associates to manage Fortunately, Dr. Norman Francis wasn’t about to let the 84 replaced Xerox systems. When Xavier reopened the weather get in the way of the mission he has been its doors on January 9, so did the print shop. fulfilling as Xavier’s president for nearly 40 years. He vowed that the University would reopen on January 9, Today, student enrollment is about 80 percent of what 2006, a scant four months after the storms’ ravages. it was before Katrina, Dr. Francis has been awarded the United States Medal of Freedom by President Bush Accepting Dr. Francis’s mandate that delay was not and Xavier University of Louisiana has reaffirmed its an option, Xerox sprung into action. It immediately academic, civic and humanitarian leadership. provided Xerox WorkCentre multifunction systems for XEROX ANNUAL REPORT 2006 10


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    Magical photographic stories, Shutterfly was looking for a strategic partner who could help sustain their staggeringly high volumes told perfectly every time. with the highest quality and consistency. They wanted experts who could show their team how to minimize downtime and maximize throughput. They wanted In 1999, they started as an online resource to a business partner who shared their relentless pursuit help photography enthusiasts print the photos from of delighting customers. their new digital cameras. They have become the preeminent Internet-based service for social expression Shutterfly chose Xerox, and its iGen3® 110 and personal publishing. Digital Production Presses with recently introduced image-improving software. It captures the deepest They’re Shutterfly. And every year they help millions of blues in beach vacation photos to the palest people tell the stories of their lives by making it easy pinks in a newborn’s first close-up. And it makes and fun for them to upload, edit, enhance, organize, it easier for Shutterfly’s people to know when to find, share, print and preserve their digital photos. make adjustments to maintain these many hues. Shutterfly’s printed products include personalized photo books, children’s story books, greeting cards, “Tough customers” by their own admission, the calendars and other custom photo gifts. Shutterfly team is intently focused on preserving the smiles on the millions of family faces entrusted to Imagine an enormous room full of presses – the them. In Xerox they have found a kindred spirit – every largest all-digital lab in the world – operating around bit as demanding, and equally single-minded about the clock with periodic maintenance being attended to keeping the customer smiling. with the speed of racecar pit crews. That’s Shutterfly at the height of their busiest seasons. They’re not about to trust the timeliness and quality of all those cherished images to just anyone. XEROX ANNUAL REPORT 2006 11


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    BOARD OF DIRECTORS 10 2 9 11 3 4 1 8 5 7 6 1. Anne M. Mulcahy 8. Glenn A. Britt A, C Chairman and Chief Executive Officer President and Chief Executive Officer Xerox Corporation Time Warner Cable Stamford, CT Stamford, CT 2. Richard J. Harrington A 9. Hilmar Kopper B, D* President and Chief Executive Officer Former Chairman and Chief Executive Officer The Thomson Corporation Deutsche Bank AG Stamford, CT Frankfurt, Germany 3. Robert A. McDonald A 10. Vernon E. Jordan, Jr. B, C Vice Chairman-Global Operations Senior Managing Director The Procter & Gamble Company Lazard Frères & Co., LLC Cincinnati, OH New York, NY Of Counsel, Akin, Gump, Strauss, 4. Mary Agnes Wilderotter D Hauer & Feld, LLP Attorneys-at-Law Chairman and Chief Executive Officer Washington, DC Citizens Communications Stamford, CT 11. William Curt Hunter A, C Dean, Tippie College of Business 5. Ralph S. Larsen B, C University of Iowa Former Chairman and Chief Executive Officer Iowa City, IA Johnson & Johnson New Brunswick, NJ Ursula M. Burns** President 6. N. J. Nicholas, Jr.B, D Xerox Corporation Investor Stamford, CT New York, NY XEROX ANNUAL REPORT 2006 7. Ann N. Reese C, D Executive Director Center for Adoption Policy A: Member of the Audit Committee Rye, NY B: Member of the Compensation Committee C: Member of the Corporate Governance Committee D: Member of the Finance Committee * Mr. Kopper is not standing for reelection at the 2007 Annual Meeting of Shareholders. ** Ms. Burns (not pictured) was elected to the Xerox Board on April 2, 2007. 12


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    INDEX TO ANNUAL REPORT Description of Business 15 Management’s Discussion and Analysis of Results of Operations and Financial Condition 26 Executive Overview 26 Financial Overview 26 Currency Impacts 27 Summary Results 27 Application of Critical Accounting Policies 29 Results of Operations 32 Segment Revenue 32 Segment Operating Profit 36 Gross Margins 37 Research, Development and Engineering 37 Selling, Administrative and General Expenses 38 Restructuring and Asset Impairment Charges 38 Other Expenses, Net 39 Income Taxes 40 Equity in Net Income of Unconsolidated Affiliates 41 Income from Discontinued Operations 41 Recent Accounting Pronouncements 41 Capital Resources and Liquidity 41 Cash Flow Analysis 41 Customer Financing Activities and Secured Debt 43 Liquidity, Financial Flexibility and Other Financing Activity 45 Contractual Cash Obligations and Other Commercial Commitments and Contingencies 47 Off-Balance Sheet Arrangements 48 Financial Risk Management 49 Forward-Looking Statements 49 Audited Consolidated Financial Statements 50 Consolidated Statements of Income 50 Consolidated Balance Sheets 51 Consolidated Statements of Cash Flows 52 Consolidated Statements of Common Shareholders’ Equity 53 13


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    Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies 54 2. Segment Reporting 63 3. Short-Term Investments 65 4. Receivables, Net 66 5. Inventories and Equipment on Operating Leases, Net 69 6. Land, Buildings and Equipment, Net 69 7. Investments in Affiliates, at Equity 70 8. Goodwill and Intangible Assets, Net 72 9. Restructuring and Asset Impairment Charges 73 10. Supplementary Financial Information 75 11. Debt 76 12. Liability to Subsidiary Trusts Issuing Preferred Securities 80 13. Financial Instruments 80 14. Employee Benefit Plans 85 15. Income and Other Taxes 89 16. Contingencies 92 17. Preferred Stock 100 18. Common Stock 101 19. Earnings Per Share 104 20. Acquisitions 105 21. Divestitures and Other Sales 105 22. Subsequent Event 106 Reports of Management 107 Report of Independent Registered Public Accounting Firm 108 Quarterly Results of Operations 110 Five Years in Review 111 Certifications Pursuant to Rule 13a - 14 under the Securities Exchange Act of 1934, as amended 112 14


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    DESCRIPTION OF BUSINESS Global Overview Xerox is a $15.9 billion Revenues by Geography technology and services enterprise in millions U.S. and a leader in the global docu- $8,406 ment market. Europe $5,378 We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions, and services. Other Areas $2,111 We operate in over Globally, we have 53,700 direct employees. 160 We have over 6,500 Sales Professionals, over 12,500 countries Managed Service Employees at customer sites and worldwide 12,000 Technical Service Employees. In addition, we have over 7,000 Agents and Concessionaires and over 10,000 Resellers. Markets We serve a $117 billion market. This estimate, and the market estimates that follow, is calculated by leveraging third-party forecasts from firms such as International Data Corporation and InfoSource in conjunction with our assumptions about our markets. $21 $17 $8 $71 Services Eligible Offset Production Office Our value-added services deliver We are creating new market We are the only manufacturer in We are well placed to capture solutions, which not only optimize opportunities with digital printing the market that offers a complete growth by leading the transition enterprise output spend and as a complement to traditional family of monochrome production to color and by reaching new infrastructure, but also streamline, offset printing. (This is an estimate systems from 65 to 180 impressions customers with our broadened simplify and digitize our for this Eligible Offset market.) per minute and color production offerings and expanded customers’ document-intensive systems from 40 to 110 pages per distribution channels. business processes. minute (“ppm”). 15


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    Overview The document industry is transitioning to digital systems, to color, and to an increased reliance on References in this section to “we,” “us,” “our,” the electronic documents. More and more, businesses are “Company” and “Xerox” refer to Xerox Corporation and creating and storing documents digitally and using the its subsidiaries unless the context specifically states or Internet to exchange electronic documents. We believe implies otherwise. these trends play to the strengths of our product and service offerings and represent opportunities for future growth in the $117 billion market we serve. In our core markets of Production and Office, we are well-placed to grow by leading the transition to color and by reaching new customers with our broadened offerings and expanded distribution channels. Within these markets, the fastest growing segment is color, which we estimate is a $21 billion opportunity. At the same time, we continue to compete to capture growth opportunities within the black-and-white segment of our core markets, which we estimate is a $58 billion market. North America DMO Europe Fuji Xerox We are expanding our core markets with Document Management Services, which is the combination of Xerox markets and supports managed services and value-added services. We have document management systems, organized our Document Management Services around three offerings: 1. Xerox Office Services, where we help supplies, and services through a our customers reduce costs and improve productivity by variety of distribution channels optimizing their global print infrastructure through analyzing the most efficient ways to create and share around the world. documents in the office; 2. Document Outsourcing and Communication Services, which focuses on optimizing Xerox North America operates the production environment as well as operating in-house production centers; and 3. Business Process Services, across the United States and Canada. where we show our customers how to use digital workflow and develop online document repositories. Xerox Europe covers 17 countries Our products include high-end printing and publishing systems; digital multifunctional devices across Europe. (“MFDs”) which can print, copy, scan and fax; digital copiers; laser and solid ink printers; fax machines; Developing Markets Operations document-management software; and supplies such as supports more than 130 countries. toner, paper and ink. We provide software and workflow solutions with which businesses can easily and affordably print books, create personalized documents for their Fuji Xerox, an unconsolidated customers, and scan and route digital information. We entity of which we own 25%, are creating new market opportunities with digital printing as a complement to traditional offset printing, develops, manufactures, and which we refer to as the Eligible Offset market. Within distributes document management the Eligible Offset market we offer leading digital systems, supplies, and services. technology, led by our market-making Xerox iGen3® technology, which meets the increasing demand for short-run, customized and quick-turnaround offset quality printing. Our business model is an annuity model, based on increasing equipment installations and Document Management Services in order to increase the number of machines in the field (“MIF”) that will produce pages 16


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    and generate post sale and financing revenue. revenue over the life of a lease. Thus, the number of Seventy-two percent of our 2006 total revenue was post equipment installations is a key indicator of post sale and sale and financing revenue that includes equipment financing revenue trends. The mix of color pages is maintenance and consumable supplies, among other another significant indicator of post sale revenue trends elements. We sell the majority of our equipment through because color pages use more consumables per page than sales-type leases that we record as equipment sale black-and-white. In addition, market development, revenue. Equipment sales represented 28% of our 2006 particularly within the Eligible Offset market, is key to total revenue. increasing pages and we have leading tools and resources We expect this large, recurring post sale revenue to develop this large market opportunity. stream to be approximately three times the equipment sale Acquisitions To further our business goals, we made two We also purchased XMPie, Inc. (“XMPie”) to acquisitions in 2006. We completed the purchase of further strengthen our position in the growing market for Amici LLC, (“Amici”), a provider of electronic- personalized communications and cross-media marketing discovery (“e-discovery”) services, primarily supporting campaigns involving digital printing, e-mail and litigation and regulatory compliance. E-discovery is the customized websites. XMPie helps graphic designers, identification, filtering, production, and storage of marketing companies and print providers develop relevant data from paper or electronic documents, such as creative, customized marketing programs. XMPie e-mail, text files, memos, databases, presentations and provides software for variable data publishing ranging spreadsheets. Amici, now branded Xerox Litigation from the desktop to servers, from print to multi-channel Services, provides comprehensive litigation discovery campaigns, from personalized images to personalized management services, including the conversion, hosting booklets, and from out-of-the-box solutions to a platform and production of electronic and hard copy documents. for creating custom solutions that fit unique business, They also provide consulting and professional services to integration and workflow requirements. assist attorneys in the discovery process. Segment Information Our reportable segments are Production, Office, ranging from small and medium businesses to graphic Developing Markets Operations (“DMO”), and Other. We communications companies, governmental entities, present operating segment financial information in educational institutions and large (Fortune 1000) Note 2 – Segment Reporting to the Consolidated corporate accounts. None of our business segments Financial Statements, which we incorporate by reference depends upon a single customer, or a few customers, the here. We have a very broad and diverse base of loss of which would have a material adverse effect on our customers, both geographically and demographically, business. Reviews by Business Segment Office $7,625 million Our Office segment serves global, national and small to medium-size commercial customers as well as government, education, and other public sector customers. 28.81% Production $4,579 million We provide high-end digital monochrome and color systems designed for customers 47.97% in the graphic communications industry and for large enterprises. DMO $1,938 million DMO includes the marketing, sales, and servicing of Xerox products, supplies, and 12.19% services in Latin America, Brazil, the Middle East, India, Eurasia and Central-Eastern Europe, and Africa. 11.03% Other $1,753 million The Other segment primarily includes revenue from paper sales, wide-format systems, and value-added services. 17


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    Production We provide high-end digital monochrome and pre-press and post-press options and the industry’s color systems designed for customers in the graphic broadest set of workflow software. communications industry and for large enterprises. With our Freeflow™ digital workflow collection These high-end devices enable digital on-demand our customers can improve everything from content printing, digital full-color printing, and enterprise creation and management to production and printing. We are the only manufacturer in the market fulfillment. Our digital technology, combined with that offers a complete family of monochrome total document solutions and services that enable production systems from 65 to 180 pages per minute personalization and printing on demand, delivers value and color production systems from 40 to 110 pages per that improves our customers’ business results. minute (“ppm”). In addition, we offer a variety of Our 2006 Production Goals Our 2006 goals for our Production segment were to continue strengthening our leadership position in monochrome and color and to build on the power of digital printing in the Eligible Offset market. Our “New Business of Printing®” strategy complements the traditional offset market with digital printing and workflow capabilities, which include the introduction of innovative production systems and development of applications and solutions to expand our leadership position and focus on the higher growth applications and digital color opportunities. Here are the accomplishments that enabled us to reach our 2006 goals. Our 2006 Production Accomplishments We continued to build on our unmatched product breadth, world class market and business development tools and integrated end-to-end applications. – Xerox iGen3 90: We expanded our offerings within the color print on-demand market with the April launch of our iGen3 90 Digital Press, a 90 ppm full-color production system with improved productivity, image quality, personalization and running cost. – Xerox DocuColor® 5000: In June, we launched the DocuColor 5000 Digital Press, a 50 ppm full-color production system, which provides excellent print resolution, color reproduction, and reliability for a wide range of applications. – Xerox 4590 EPS and 4110® EPS: In April, we expanded our presence in light production with the launch of our 4590 and 4110 Enterprise Printing Systems, two robust digital production monochrome systems at 90 ppm and 110 ppm, respectively. – Xerox DocuTech® Highlight Color 180 Publishing System: In October, we launched our DocuTech Highlight Color 180 Publishing System for print on-demand applications. This system prints both black-and-white, as well as highlight color, at the rated speed of 180 ppm. – Highlight Custom Blended Color Program: In October, we announced additional standard colors for a total of eight. We also expanded the range of colors with Custom Colors, enabling customers to match their company logos for brand identity applications. – Applications: We continued to increase installations of our flagship Digital Color Production Presses. In addition to the launch of the iGen3 90, in June we launched Auto Image Enhancement Software, which intelligently adjusts images to improve photo submission problems. We followed this with an October announcement of another release that improves photo rendering, color profiling and color checking. In October, we also introduced a series of solutions that included workflow and marketing support to enable such applications as teacher edition books, photo memory books and greeting cards. In July, we launched FreeFlow Web Services 5.0, which makes it simpler for our customers to procure, print, access or order documents. We continued to build our marketplace 18


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    leading Profit Accelerator Program, which helps customers get the most from their digital technology investments. We offer over 50 tools for graphic communication and in-plant environments to help our customers increase and improve their digital business. – XMPie Acquisition: In November, we acquired XMPie, a leading provider of variable information software with which users can create cross media, personalized marketing programs. With this acquisition we can provide complete, measurable solutions for multi-media marketing campaigns. – Xerox Nuvera™ 288 Digital Perfecting System: In October at Graph Expo, we demonstrated a tandem engine architecture Xerox Nuvera 288 Digital Perfecting System. This high-end, cut sheet printer will be the fastest on the market at 288 ppm. The quality, productivity, and ability to run two engines in parallel, as well as run one engine while the other is idle, is the result of a unique tandem architecture developed by Xerox research and engineering. This product will be available in 2007. Office Our Office segment serves global, national, and products. We have transitioned to digital by joining our small to medium-size commercial customers as well as laser and solid ink MFDs to powerful scanning government, education and other public sector customers. technology, which enables our customers to maximize Office systems and services, which include monochrome their document workflow. We offer a range of solutions devices at speeds up to 90 ppm and color devices up to 50 including the Office Document Assessment, in which we ppm, include our family of CopyCentre®, WorkCentre® analyze a business’ workflow and document needs, and and WorkCentre® Pro digital multifunction systems; then we identify the most efficient, productive mix of DocuColor printer/copiers; color laser, LED (light office equipment and software for that business, helping emitting diode), solid ink and monochrome laser desktop to reduce the customer’s document-related costs. printers; digital copiers; light-lens copiers and facsimile Our 2006 Office Goals Our 2006 Office goals were to drive the transition to color in the office and to build on our 2005 product launches, to extend our reach in the market and increase our capture of pages. Our objective was to complement our broadened product line with expanded distribution capacity to increase our population of systems, building the foundation for future post sale revenue growth. Here are the accomplishments that enabled us to reach our 2006 goals. Our 2006 Office Accomplishments We continued to drive color by making it more affordable, easier to use, faster and more reliable. Our color- capable laser devices provide an attractive entry point into color. Our patented solid ink technology offers unmatched ease of use, vibrant color image quality and economic color run costs. – Phaser™ 7760: With the May introduction of the Phaser 7760, we further strengthened our position in the graphics art segment. A 35 ppm color printer, the Phaser 7760, delivers the color output and media handling and finishing options required by this market segment. – WorkCentre 7132: In May, we introduced the WorkCentre 7132, an eight ppm (32 ppm black-and-white) color- capable multi-function printer. – WorkCentre 7128/7135/7145: In May, we introduced the restriction on the use of hazardous substances (“ROHS”) compliant product family in Europe. Offering 28, 35 or 45 ppm, these color-capable MFDs expand our reach into a rapidly growing market segment. – WorkCentre 7655/7665: In May, we introduced the WorkCentre 7655 and 7665 color capable MFDs, offering color pages at 40 and 50 ppm, respectively, along with superior image quality, excellent productivity, extensive media handling and professional in-line finishing capabilities. 19


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    We also extended our black-and-white MFD series, broadening our already extensive product line. – WorkCentre 4118: Introduced in June, the 4118 is designed for small workgroups and has the strongest set of features that we offer on a low-end, black-and-white desktop MFD. – WorkCentre 4150: With the introduction in September of this 50 ppm A4 monochrome MFD, we entered a new, rapidly growing market segment, offering an economical alternative to large enterprises interested in replacing their printer fleet. – WorkCentre 4590: Introduced in January, the 4590, which runs at 90 ppm, rounds out the high-end of our office monochrome fleet. – Extensible Interface Platform: In October, we introduced our Extensible Interface Platform (“EIP”) with a configurable user interface. With EIP, customers can access document-related software applications on a Xerox MFD user interface, improving workflow and productivity. DMO DMO includes the marketing, sales and servicing of geographies of Russia and Central-Eastern Europe, and in Xerox products, supplies, and services in Latin America, 2006 we completed implementing this business model Brazil, the Middle East, India, Eurasia and Central- throughout the remainder of DMO. We manage our DMO Eastern Europe and Africa. In countries with developing operations separately as a segment because of the political economies, DMO manages the Xerox business through and economic volatility, and the unique nature of its operating companies, subsidiaries, joint ventures, product markets. Our 2006 DMO goals included revenue growth, distributors, affiliates, concessionaires, value-added a continued focus on improving the entire cost base and resellers and dealers. Our two-tiered distribution model providing a foundation for profitable growth. has proven very successful in the high-growth Other Our Other segment primarily includes revenue from launching the Xerox Litigation Services line of electronic paper sales, value-added services and wide-format discovery (“e-discovery”) and records management systems. services. E-discovery is the identification, filtering, We sell cut-sheet paper to our customers for use in production and storage of relevant data from paper or their document processing products. The market for electronic documents, like e-mail, text files, memos, cut-sheet paper is highly competitive and revenues are databases, presentations and spreadsheets. Often our significantly affected by pricing. Our strategy is to charge value-added services solutions lead to larger managed a premium over mill wholesale prices, which is adequate services contracts, including our equipment, supplies, to cover our costs and the value we add as a distributor, as service, and labor. We report the revenue from managed well as to provide unique products that enhance the “New services contracts in the Production, Office, or DMO Business of Printing” and color output. segments. In 2006, the combined value-added services An increasingly important part of our offering is and managed services revenue, including equipment, value-added services, which uses our document industry totaled $3.5 billion. knowledge and experience. Our value-added services We offer document processing products and devices deliver solutions that optimize our customers’ document in our wide-format systems business designed to output and infrastructure costs while streamlining, reproduce large engineering and architectural drawings up simplifying, and digitizing their document-intensive to three feet by four feet in size. business processes. In July, we acquired Amici, officially 20


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    Revenue Research and Development Revenue Stream R, D&E Expenses (in millions) R&D Sustaining Engineering 1000 $922 $943 $914 28% 72% Approximately 28% of our The remaining 72% of our 800 $161 $188 $154 revenue comes from equipment revenue, “Post sale and sales, from either lease financing,” includes annuity- 600 arrangements that qualify as based revenue from maintenance, sales for accounting purposes, services, supplies, and financing, or outright cash sales. as well as revenue from rentals 400 $761 $755 $760 or operating lease arrangements. 200 We sell most of our products and services under bundled lease arrangements, in which our customers pay a 0 monthly amount for the equipment, maintenance, 2006 2005 2004 services, supplies and financing over the course of the lease agreement. These arrangements are beneficial to our customers and us since, in addition to customers receiving Investment in R&D is critical for competitiveness in a bundled offering, these arrangements allow us to Xerox’s fast paced markets where more than two-thirds of maintain the customer relationship for future sales of our equipment sales are from products launched during equipment and services. the past two years. We are required, for accounting purposes, to analyze Xerox’s R&D drives innovation and customer value these arrangements to determine whether the equipment by: component meets certain accounting requirements so that – Creating new differentiated products and services. the equipment should be recorded as a sale at lease – Enabling cost competitiveness through disruptive inception, that is, a sales-type lease. Under a sales-type products and services. lease we are required to allocate a portion of the monthly – Enabling new ways to serve customers. minimum payments attributable to the fair value of the – Creating new business opportunities to drive future equipment to equipment sales. We allocate the remaining growth by reaching out to new customers. portion of the monthly minimum payments to the various remaining elements based on fair value – service, To ensure our success, we have aligned our R&D maintenance, supplies and financing – that we generally investment portfolio with our strategic planks: leading the recognize over the term of the lease agreement, and that color transition, enabling the “New Business of Printing”, we report as “post sale and other revenue” and “finance and enhancing customer value through services. 2006 income” revenue. In those arrangements that do not R&D spending focused primarily on the development of qualify as sales-type leases, which have increased as a high-end business applications to drive the “New result of our services-led strategy, we recognize the entire Business of Printing”, on extending our color capabilities, monthly payment over the term of the lease agreement, and on lower-cost platforms and customer productivity whether rental or operating lease, and report it in “post enablers that drive the digitization of the office. The sale and other revenue.” Our accounting policies for Xerox iGen3, an advanced next-generation digital revenue recognition for leases and bundled arrangements printing press that produces photographic-quality prints are included in Note 1 – Summary of Significant indistinguishable from offset, and Xerox’s proprietary Accounting Policies to the Consolidated Financial Solid Ink technology for the office are examples of the Statements in our 2006 Annual Report. type of breakthrough technology we developed and that 21


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    we expect will drive future growth. We include in our In the U.S., we own approximately 560 trademarks, R,D&E expenses our sustaining engineering expenses, either registered or applied for. These trademarks have a which are the hardware engineering and software perpetual life, subject to renewal every ten years. We development costs we incur after we launch a product. vigorously enforce and protect our trademarks. We hold a perpetual trademark license for “DocuColor.” Our R&D is strategically coordinated with that of Fuji Xerox, which Competition invested $660 million in R&D in Although we encounter aggressive competition in all 2006, $720 million in 2005 and areas of our business, we are the leader or among the leaders in each of our principal business segments. Our $704 million in 2004. competitors range from large international companies to relatively small firms. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, distribution, and customer service and support. To Patents, Trademarks and Licenses remain competitive, we invest in and develop new products and services and continually improve our We are a technology company. With our Xerox Palo existing offerings. Our key competitors include Canon, Alto Research Center (“PARC”) subsidiary, we were Ricoh, IKON, Hewlett-Packard, and, in certain areas of awarded nearly 560 U.S. utility patents in 2006. We were the business, Pitney Bowes, Kodak, Océ, Konica-Minolta ranked 39th on the list of companies that were awarded and Lexmark. We believe that our brand recognition, the most U.S. patents during the year and would have reputation for document knowledge and expertise, been ranked 36th with the inclusion of PARC patents. innovative technology, breadth of product offerings, With our research partner, Fuji Xerox, we were awarded global distribution channels, our customer relationships over 800 U.S. utility patents in 2006. Our patent portfolio and large customer base are important competitive evolves as new patents are awarded to us and as older advantages. We and our competitors continue to develop patents expire. As of December 31, 2006, we held and market new and innovative products at competitive approximately 8,300 design and utility U.S. patents. prices, and, at any given time, we may set new market These patents expire at various dates up to 20 years or standards for quality, speed and function. more from their original filing dates. While we believe that our portfolio of patents and applications has value, in general no single patent is essential to our business or any individual segment. In addition, any of our proprietary rights could be challenged, invalidated, or circumvented or may not provide significant competitive advantages. In the U.S., we are party to numerous patent- licensing agreements, and in a majority of them, we license or assign our patents to others, in return for revenue and/or access to their patents. Most of the patent licenses expire concurrently with the expiration of the last patent identified in the license. In 2006, with our PARC subsidiary, we added approximately 25 agreements to our portfolio of patent licensing agreements, and either we or our PARC subsidiary was a licensor in 22 of the agreements. We also have a number of cross-licensing agreements with companies with substantial patent portfolios, including Canon, Microsoft, IBM, Hewlett Packard and Océ. Those agreements vary in subject matter, scope, compensation, significance and time. 22


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    Marketing and Distribution Department of State and are subject to U.S. economic sanctions. We maintain an export and sanctions compliance program and believe that we have been and are in compliance with U.S. laws and government Our brand is a valuable resource and regulations for these countries. In addition, we had no continues to be recognized in the assets, liabilities, or operations in these countries other than liabilities under the distribution agreements. After top ten percent of all U.S. brands. observing required prior notice periods, Xerox Limited terminated its distribution agreements related to Sudan and Syria in August 2006 and terminated its distribution We manage our business based on the principal agreement related to Iran in December 2006, and now has business segments described above. However, we have only legacy obligations such as providing spare parts and organized the marketing and selling of our products and supplies to these third parties. In 2006, we had total solutions according to geography and channel types. We revenues of $15.9 billion, of which approximately $9.6 sell our products and solutions directly to customers million was attributable to Iran and less than $0.7 million through our worldwide sales force and through a network in total was attributable to Sudan and Syria. As a result of of independent agents, dealers, value-added resellers and the termination of these agreements, we anticipate that systems integrators. Increasingly, we use our direct sales our revenues attributable to these countries will decline. force to address our customers’ more advanced In January 2006, Xerox Limited entered into a five- technology, solutions and services requirements, while year distribution agreement with an unaffiliated third expanding our use of cost-effective, indirect distribution party covering distribution of our products in Libya. channels, for basic product offerings. Libya is also designated as a state sponsor of terrorism by We market our Phaser line of color and the U.S. Department of State. The decision to enter into monochrome laser-class and solid ink printers through this distribution agreement was made in light of recent office information technology industry resellers, who U.S. federal government actions that have lifted the typically access our products through distributors. In countrywide embargo previously imposed on Libya. Our 2006, we increased the product offerings available sales in Libya through this distribution agreement will be through a two-tiered distribution model in Europe and subject to our export and sanctions compliance program DMO. Through a multi-phased rollout, we will continue and will be according to the U.S. laws and government to increase offerings through this lower-cost distribution regulations that relate to Libya. channel for our Office portfolio. We are increasing our use of partners to improve our Service market coverage. Through alliances with Premier Partners and Fuji Ennovation, we expanded coverage to As of December 31, 2006, we had a worldwide market our DocuColor series to commercial printers. Our service force of approximately 12,000 employees and an alliance with Electronic Data Systems (“EDS”) is extensive variable contract service force. We are designed to integrate EDS’ information technology expanding our use of cost-effective remote service (“IT”) services with our document management systems technology for basic product offerings while utilizing our and services to provide customers with full IT direct service force and a variable contract service force infrastructure support. to address customers’ more advanced technology In Europe, Africa, the Middle East, India, and parts requirements. The increasing use of a variable contract of Asia, we distribute our products through Xerox service force is consistent with our strategy to reduce Limited, a company established under the laws of service costs while maintaining high-quality levels of England, and related non-U.S. companies all of which we service. We believe that our service force represents a refer to as Xerox Limited. Xerox Limited enters into significant competitive advantage in that the service force distribution agreements with unaffiliated third parties covering distribution of our products in some of the countries located in these regions, and previously entered into agreements with unaffiliated third parties covering distribution of our products in Iran, Sudan, and Syria. Iran, Sudan, and Syria, among others, have been designated as state sponsors of terrorism by the U.S. 23


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    is continually trained on our products and their diagnostic International Operations equipment is state-of-the-art. We offer service 24 hours a day, 7 days a week, in major metropolitan areas around the world, providing a consistent and superior level of We are incorporating by reference the financial service worldwide. measures by geographical area for 2006, 2005 and 2004 that are included in Note 2 – Segment Reporting to the Consolidated Financial Statements in our 2006 Annual Manufacturing Outsourcing Report. We are currently in the first one-year automatic renewal period under a five year master supply Contract Signings agreement with Flextronics, a global electronics manufacturing services company, to outsource portions of manufacturing for our Office segment. Our inventory We believe that contract signings provide a purchases from Flextronics currently represent meaningful measure of future business prospects for approximately 20% of our overall worldwide inventory document management services. Contract signings procurement. We have agreed to purchase from represent management’s estimate of the total contract life Flextronics some products and consumables within value of managed services and value-added services specified product families. Flextronics must acquire contracts signed within the period. This estimate includes inventory in anticipation of meeting our forecasted new contracts, renewals, extensions, and amendments to requirements and must maintain sufficient manufacturing existing contracts. The total contract life value is defined capacity to satisfy these requirements. Under certain as the average monthly commitment minimum multiplied circumstances, we may be obligated to repurchase by the number of months in the contract, plus an estimate inventory that remains unused for more than 180 days or of any other revenue related to the contract, but not becomes obsolete, or on the termination of the supply included in the minimum. If a contract does not have a agreement. monthly commitment minimum, management develops We acquire other Office products from various third an estimate based on historical and expected usage parties, to increase the breadth of our product portfolio, patterns and other relevant information. Our contracts and to meet channel requirements. We also have have terms that generally range from 3 to 5 years. During arrangements with Fuji Xerox under which we purchase 2006, signings for document management services were some products from and sell other products to Fuji Xerox. up about 15% from 2005. Some of these purchases and sales are the result of mutual research and development arrangements. Our remaining manufacturing operations are primarily located in Backlog Rochester, New York and Dundalk, Ireland for our high-end production products and consumables, and in We believe that backlog, or the value of unfilled Wilsonville, Oregon for solid ink products, consumable orders, is not a meaningful indicator of future business supplies, and components for our Office segment products. prospects because of the significant proportion of our revenue that follows equipment installation, the large Fuji Xerox volume of products we deliver from shelf inventories, and the shortening of product life cycles. Fuji Xerox Co., Limited is an unconsolidated entity in which we currently own 25% and FUJIFILM Holdings Seasonality Corporation (“FujiFilm”) owns 75%. Fuji Xerox develops, manufactures and distributes document processing products in Japan, China, Hong Kong and Our revenues are affected by such factors as the other areas of the Pacific Rim, Australia and New introduction of new products, the length of the sales Zealand. We retain significant rights as a minority cycles, and the seasonality of technology purchases. As a shareholder. Our technology licensing agreements with result, our operating results are difficult to predict. These Fuji Xerox ensure that the two companies retain factors have historically resulted in lower revenue in the uninterrupted access to each other’s portfolio of patents, first quarter than in the immediately preceding fourth technology and products. quarter. 24


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    Other Information Xerox is a New York corporation, organized in 1906, and our principal executive offices are located at 800 Long Ridge Road, P. O. Box 1600, Stamford, Connecticut 06904-1600. Our telephone number is (203) 968-3000. On the Investor Information section of our Internet website, you will find our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. We make these documents available as soon as we can after we have filed them with, or furnished them to, the Securities and Exchange Commission. Our Internet address is http://www.xerox.com. 25


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    Management’s Discussion and Analysis of Results of Operations and Financial Condition The following Management’s Discussion and Throughout this document, references to “we,” Analysis (“MD&A”) is intended to help the reader “our,” the “Company” and “Xerox” refer to Xerox understand the results of operations and financial Corporation and its subsidiaries. References to “Xerox condition of Xerox Corporation. MD&A is provided as a Corporation” refer to the stand-alone parent company and supplement to, and should be read in conjunction with, do not include its subsidiaries. our consolidated financial statements and the accompanying notes. Executive Overview We are a technology and services enterprise and a consulting and assessments, managed services, imaging leader in the global document market, developing, and hosting, and document intensive business process manufacturing, marketing, servicing and financing the improvements. industry’s broadest portfolio of document equipment, We deliver advanced technology through focused solutions and services. Our industry is undergoing a series investment in research and development and offset lower of transformations from older technology light lens prices through continuous improvement of our cost base. devices to digital systems, from black-and-white to color, The majority of our revenue is recurring revenue and from paper documents to an increased reliance on (supplies, service, paper, outsourcing and rentals), which electronic documents. We believe we are well positioned we collectively refer to as post sale revenue. Post sale as these transformations play to our strengths and revenue is heavily dependent on the amount of equipment represent opportunities for future growth, since our installed at customer locations and the utilization of those research and development investments have been focused devices. As such, our critical success factors include on digital and color offerings and our acquisitions have hardware installations, which stabilize and grow our focused on expanding our services and software installed base of equipment at customer locations, page capabilities. volume growth and higher revenue per page. Connected We operate in competitive markets and our multifunction devices, new services and solutions are key customers demand improved solutions, such as the ability drivers to increase equipment usage. The transition to to print offset quality color documents on-demand; color is the primary driver to improve revenue per page, improved product functionality, such as the ability to as color documents typically require significantly more print, copy, fax and scan from a single device; and lower toner coverage per page than traditional black-and-white prices for the same functionality. Customers are also printing. increasingly demanding document services such as Financial Overview In 2006, we grew revenue, expanded earnings and We maintained our focus on cost management significantly improved our overall financial condition and throughout 2006. While 2006 gross margins of 40.6% were liquidity. Our continued investments in the growing areas 0.6-percentage points below 2005, we continued to more of digital production and office systems, particularly with than offset lower prices with productivity improvements. respect to color products, contributed to the majority of our Gross margins continued to be impacted by a change in equipment sales being generated from products launched in overall product mix reflecting a higher proportion of sales the last two years. Total revenue increased 1% over the of products with lower gross margins. We reduced selling, prior year, as growth in our post sale annuities more than administrative and general (“SAG”) expenses as offset declines in equipment sales and finance income. Post administrative and general expense efficiencies more than sale and other revenues increased 3% as compared to prior offset increased bad debt expense. We continued to invest year. Total color revenue was up 13% over the prior year in research and development, prioritizing our investments reflecting our investments in this market. to the faster growing areas of the market. 26


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    Our 2006 balance sheet strategy focused on balance of $1.5 billion. Our prospective balance optimizing operating cash flows, maintaining debt levels sheet strategy includes: optimizing operating cash flows; primarily to support our customer financing operations, maintaining our investment grade credit ratings; replacing secured debt collaterized by our finance achieving an optimal cost of capital; rebalancing secured receivables with new unsecured debt, and returning and unsecured debt; and effectively deploying cash to value to shareholders through acquisitions and our deliver and maximize long-term shareholder value. Our announced share repurchase programs. The successful strategy also includes maintaining an appropriate implementation of this strategy in 2006 enabled us to leverage of our financing assets (finance receivables and significantly improve our financial position, return to equipment on operating leases) and an appropriate level investment grade and finish the year with a cash, cash of non-financing debt. equivalents and short-term investments Currency Impacts To understand the trends in the business, we believe translation effect of revenues or expenses denominated in that it is helpful to analyze the impact of changes in the currencies where the local currency is the functional translation of foreign currencies into U.S. dollars on currency. revenues and expenses. We refer to this analysis as Approximately half of our consolidated revenues are “currency impact” or “the impact from currency”. derived from operations outside of the United States Revenues and expenses from our Developing Markets where the U.S. dollar is not the functional currency. Operations (“DMO”) are analyzed at actual exchange When compared with the average of the major European rates for all periods presented, since these countries currencies on a revenue-weighted basis, the U.S. dollar generally have volatile currency and inflationary was unchanged in both 2006 and 2005 and 10% weaker in environments, and our operations in these countries have 2004. As a result, the foreign currency translation impact historically implemented pricing actions to recover the on revenue was negligible in 2006 and 2005. impact of inflation and devaluation. We do not hedge the Summary Results: Revenues for the three years ended December 31, 2006 were as follows: Year Ended December 31, Percent Change (in millions) 2006 2005 2004 2006 2005 Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,457 $ 4,519 $ 4,480 (1)% 1% Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,598 10,307 10,308 3% — Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 840 875 934 (4)% (6)% Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,895 $15,701 $15,722 1% — Total Color revenue included in total revenue . . . . . . . . . . . . . . . . . . . . . $ 5,578 $ 4,928 $ 4,188 13% 18% The following presentation reconciles the above information to the revenue classifications included in our Consolidated Statements of Income: Year Ended December 31, (in millions) 2006 2005 2004 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,464 $ 7,400 $ 7,259 Less: Supplies, paper and other sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,007) (2,881) (2,779) Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,457 $ 4,519 $ 4,480 Service, outsourcing and rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,591 $ 7,426 $ 7,529 Add: Supplies, paper and other sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,007 2,881 2,779 Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,598 $10,307 $10,308 27


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    Total 2006 Revenue of $15,895 million increased • Overall our 2006 post-sale annuity revenue, 1% from the prior year comparable period. There was a including Post sale and other revenue and Finance negligible impact from currency on total revenue for the income, increased 2% and comprised 72% of total year ended December 31, 2006 as compared to the prior revenue. year. Total revenue included the following: Total 2005 Revenue of $15,701 million was • 1% decline in equipment sales, including a benefit comparable to the prior year period. Currency impacts on from currency of 1-percentage point, primarily total revenue were negligible for the year. Total 2005 reflecting revenue declines in Office and revenue included the following: Production black-and-white products, which were • 1% growth in Equipment sales, including a partially offset by revenue growth from color negligible impact from currency, primarily products and growth in DMO. reflecting revenue growth from color in Office and • 3% growth in post sale and other revenue, including Production, low-end black-and-white office a benefit from currency of 1-percentage point, products as well as growth in DMO. These growth primarily reflecting growth in digital Office and areas were partially offset by revenue declines in Production products and DMO, offset by declines higher-end office black-and-white products, and in light lens and licensing revenue. black-and-white production products. • 13% growth in color revenue. Color revenue of • Comparable Post sale and other revenues, including $5,578 million comprised 35% of total revenue for a negligible impact from currency, primarily the year ended December 31, 2006 compared to reflecting revenue growth from digital products and 31% for the year ended December 31, 2005. in DMO which were partially offset by declines in • 4% decline in Finance income, including a benefit light lens. from currency of 1-percentage point, reflecting • 6% decline in Finance income, including benefits lower average finance receivables. from currency of 1-percentage points, which reflects lower finance receivables. Net income and diluted earnings per share for the three years ended December 31, 2006 were as follows: Year Ended December 31, (in millions, except share amounts) 2006 2005 2004 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,210 $ 978 $ 859 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.22 $0.94 $0.86 2006 Net income of $1,210 million, or $1.22 per 2005 Net income of $978 million, or $0.94 per diluted share, included the following: diluted share, included the following: • $472 million income tax benefit related to the • $343 million after-tax benefit related to the favorable resolution of certain tax matters from the finalization of the 1996-1998 IRS audit. 1999-2003 IRS audit. • $84 million after-tax ($115 million pre-tax) charge • $68 million (pre-tax and after-tax) for litigation for litigation matters relating to the MPI arbitration matters related to probable losses on Brazilian panel decision and probable losses for other legal labor-related contingencies. matters. • $46 million tax benefit resulting from the resolution • $58 million after-tax ($93 million pre-tax) gain of certain tax matters associated with foreign tax related to the sale of our entire equity interest in audits. Integic Corporation (“Integic”). • $9 million after-tax ($13 million pre-tax) charge • $247 million after-tax ($366 million pre-tax) from the write-off of the remaining unamortized restructuring and asset impairment charges. deferred debt issuance costs as a result of the termination of our 2003 Credit Facility. 2004 Net income of $859 million, or $0.86 per • $257 million after-tax ($385 million pre-tax) diluted share, included the following: restructuring and asset impairment charges. • $83 million after-tax ($109 million pre-tax) gain related to the sale of substantially all of our investment in ContentGuard Holdings, Inc. (“ContentGuard”). 28


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    • $38 million after-tax pension settlement benefit • $57 million after-tax ($86 million pre-tax) from Fuji Xerox. restructuring and asset impairment charges. • $30 million after-tax ($38 million pre-tax) gain from the sale of our investment in ScanSoft, Inc. (“ScanSoft”). Application of Critical Accounting Policies In preparing our Consolidated Financial Statements leases qualify as sales-type capital leases, equipment and accounting for the underlying transactions and revenue is recognized upon delivery or installation of the balances, we apply various accounting policies. We equipment as sale revenue as opposed to ratably over the consider the policies discussed below as critical to lease term. The critical elements that we consider with understanding our Consolidated Financial Statements, as respect to our lease accounting are the determination of their application places the most significant demands on the economic life and the fair value of equipment, management’s judgment, since financial reporting results including the residual value. For purposes of determining rely on estimates of the effects of matters that are the economic life, we consider the most objective inherently uncertain. Specific risks associated with these measure to be the original contract term, since most critical accounting policies are discussed throughout this equipment is returned by lessees at or near the end of the MD&A, where such policies affect our reported and contracted term. The economic life of most of our expected financial results. For a detailed discussion of the products is five years since this represents the most application of these and other accounting policies, refer to frequent contractual lease term for our principal products Note 1 – Summary of Significant Accounting Policies, to and only a small percentage of our leases are for original the Consolidated Financial Statements. terms longer than five years. There is no significant after- Senior management has discussed the development market for our used equipment. We believe five years is and selection of the critical accounting policies, estimates representative of the period during which the equipment and related disclosures, included herein, with the Audit is expected to be economically usable, with normal Committee of the Board of Directors. Preparation of this service, for the purpose for which it is intended. annual report requires us to make estimates and Revenue Recognition Under Bundled Arrangements: assumptions that affect the reported amount of assets and We sell most of our products and services under bundled liabilities, as well as disclosure of contingent assets and lease arrangements, which typically include equipment, liabilities. These estimates and assumptions also impacted service, supplies and financing components for which the revenues and expenses during the reporting period. customer pays a single negotiated monthly fixed price for Although actual results may differ from those estimates, all elements over the contractual lease term. These we believe the estimates are reasonable and appropriate. arrangements typically also include an incremental, In instances where different estimates could reasonably variable component for page volumes in excess of have been used in the current period, we have disclosed contractual page volume minimums, which are often the impact on our operations of these different estimates. expressed in terms of price per page. Revenues under In certain instances, such as with respect to revenue these arrangements are allocated, considering the relative recognition for leases, because the accounting rules are fair values of the lease and non-lease deliverables prescriptive, it would not have been possible to have included in the bundled arrangement, based upon the reasonably used different estimates in the current period. estimated relative fair values of each element. Lease In these instances, use of sensitivity information would deliverables include maintenance and executory costs, not be appropriate. Changes in assumptions and estimates equipment and financing, while non-lease deliverables are reflected in the period in which they occur. The generally consist of supplies and non-maintenance impact of such changes could be material to our results of services. Our revenue allocation for the lease deliverables operations and financial condition in any quarterly or begins by allocating revenues to the maintenance and annual period. executory costs plus profit thereon. The remaining Revenue Recognition for Leases: Our accounting for amounts are allocated to the equipment and financing leases involves specific determinations under applicable elements. We perform extensive analyses of available lease accounting standards, which often involve complex verifiable objective evidence of equipment fair value and prescriptive provisions. These provisions affect the based on cash selling prices during the applicable period. timing of revenue recognition for our equipment. If the The cash selling prices are compared to the range of 29


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    values included in our lease accounting systems. The Accounts and Finance Receivables Allowance for range of cash selling prices must be reasonably consistent Doubtful Accounts and Credit Losses: We perform with the lease selling prices, taking into account residual ongoing credit evaluations of our customers and adjust values that accrue to our benefit, in order for us to credit limits based upon customer payment history and determine that such lease prices are indicative of fair current creditworthiness. We continuously monitor value. Our pricing interest rates, which are used in collections and payments from our customers and determining customer payments, are developed based maintain a provision for estimated credit losses based upon a variety of factors including local prevailing rates upon our historical experience and any specific customer in the marketplace and the customer’s credit history, collection issues that have been identified. While such industry and credit class. Our pricing interest rates are credit losses have historically been within our reassessed quarterly based on changes in local prevailing expectations and the provisions established, we cannot rates in the marketplace and are adjusted to the extent guarantee that we will continue to experience credit loss such rates vary by twenty-five basis points or more, rates similar to those we have experienced in the past. cumulatively, from the last rate in effect. The pricing Measurement of such losses requires consideration of interest rates generally equal the implicit rates within the historical loss experience, including the need to adjust for leases, as corroborated by our comparisons of cash to current conditions, and judgments about the probable lease selling prices. effects of relevant observable data, including present economic conditions such as delinquency rates and Residual Values for Equipment under Lease: financial health of specific customers. We recorded bad Residual values represent the recorded estimated fair debt provisions of $87 million, $72 million, and $110 value of equipment as of the end of the lease. Residual million in SAG expenses in our Consolidated Statements values associated with equipment under sales-type leases of Income for the years ended December 31, 2006, 2005 are included as a component of our net finance and 2004, respectively. The current level of our provision receivables balance and amounted to $89 million and $87 for doubtful accounts reflects improvements in customer million at December 31, 2006 and 2005. Residual values administration, receivables aging, write-off trends, associated with equipment under operating leases collection practices and credit approval policies. represent the recorded estimated salvage value at the end As discussed above, in preparing our Consolidated of the lease term and are included as a component of Financial Statements for the three year period ended equipment on operating leases, net and amounted to $41 December 31, 2006, we estimated our provision for million and $48 million at December 31, 2006 and 2005. doubtful accounts based on historical experience and Equipment under operating leases and similar customer-specific collection issues. This methodology arrangements are depreciated to estimated salvage value has been consistently applied for all periods presented. over their estimated useful lives. During the five year period ended December 31, 2006, We review residual values regularly and, when our allowance for doubtful accounts ranged from 3.0% to appropriate, adjust them based on estimates of expected 5.2% of gross receivables. Holding all other assumptions market conditions at the end of the lease, including the constant, a 1-percentage point increase or decrease in the impacts of future product launches, changes in allowance from the December 31, 2006 rate of 3.0% remanufacturing strategies and the expected lessee would change the 2006 provision by approximately $110 behavior at the end of the lease term. Impairments to million. residual values occur when available information Historically, about half of the provision for doubtful indicates that the decline in recorded value is other than accounts relates to our finance receivables portfolio. This temporary and we would therefore not be able to fully provision is inherently more difficult to estimate than the recover the recorded values. Impairments on residual provision for trade accounts receivable because the values are recognized as losses in the period in which the underlying lease portfolio has an average maturity, at any estimate is changed or as a revision in depreciation time, of approximately two to three years and contains estimates for sales-type leases and operating leases, past due billed amounts, as well as unbilled amounts. The respectively. We did not record any residual value estimated credit quality of any given customer and class impairment charges for the year ended December 31, of customer or geographic location can significantly 2006. We recorded $4 million and $3 million in residual change during the life of the portfolio. We consider all value impairment charges for the years ended available information in our quarterly assessments of the December 31, 2005 and 2004, respectively. adequacy of the provision for doubtful accounts. 30


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    Pension and Post-retirement Benefit Plan pension and post-retirement benefit obligations and the Assumptions: We sponsor pension plans in various forms net periodic pension and other post-retirement benefit in several countries covering substantially all employees cost is the rate that we use to discount our future who meet eligibility requirements. Post-retirement anticipated benefit obligations. The discount rate reflects benefit plans cover primarily U.S. employees for the current rate at which the pension liabilities could be retirement medical costs. Several statistical and other effectively settled considering the timing of expected factors that attempt to anticipate future events are used in payments for plan participants. In estimating this rate, we calculating the expense, liability and asset values related consider rates of return on high quality fixed-income to our pension and post-retirement benefit plans. These investments included in various published bond indexes, factors include assumptions we make about the discount adjusted to eliminate the effects of call provisions and rate, expected return on plan assets, rate of increase in differences in the timing and amounts of cash outflows healthcare costs, the rate of future compensation related to the bonds. In the U.S. and the U.K., which increases and mortality, among others. For purposes of comprise approximately 80% of our projected benefit determining the expected return on plan assets, we utilize obligations, we consider the Moody’s Aa Corporate Bond a calculated value approach in determining the value of Index and the International Index Company’s iBoxx the pension plan assets, as opposed to a fair market value Sterling Corporate AA Cash Bond Index, respectively in approach. The primary difference between the two the determination of the appropriate discount rate methods relates to a systematic recognition of changes in assumptions. The weighted average rate we will utilize to fair value over time (generally two years) versus measure our pension obligation as of December 31, 2006 immediate recognition of changes in fair value. Our and calculate our 2007 expense will be 5.3%, which is an expected rate of return on plan assets is then applied to increase from 5.2% used in determining 2006 expense. the calculated asset value to determine the amount of the Assuming settlement losses in 2007 are consistent with expected return on plan assets to be used in the 2006; our 2007 net periodic pension cost is expected to determination of the net periodic pension cost. The be approximately $50 million lower than 2006 primarily calculated value approach reduces the volatility in net as a result of plan design changes and an increase in the periodic pension cost that can result from using the fair discount rate. market value approach. The difference between the actual On a consolidated basis, we recognized net periodic return on plan assets and the expected return on plan pension cost of $425 million, $414 million, and $421 assets is added to, or subtracted from, any cumulative million for the years ended December 31, 2006, 2005 and differences that arose in prior years. This amount is a 2004, respectively. The costs associated with our defined component of the net actuarial (gain) loss and is subject contribution plans, which are included in net periodic to amortization to net periodic pension cost over the pension cost, were $70 million, $71 million and $69 average remaining service lives of the employees million for the years ended December 31, 2006, 2005 and participating in the pension plan. 2004, respectively. Pension cost is included in several Total actuarial losses as of December 31, 2006 were income statement components based on the related $1.6 billion, as compared to $1.9 billion at December 31, underlying employee costs. Pension and post-retirement 2005. The change from December 31, 2005 relates to benefit plan assumptions are included in Note 14 – improved asset returns as compared to expected returns Employee Benefit Plans to the Consolidated Financial and an increase in the discount rate. The total actuarial Statements. Holding all other assumptions constant, a loss will be amortized in the future, subject to offsetting 0.25% increase or decrease in the discount rate would gains or losses that will change the future amortization change the 2007 projected net periodic pension cost by amount. We have utilized a weighted average expected approximately $33 million. Likewise, a 0.25% increase rate of return on plan assets of 7.8% for 2006 expense, or decrease in the expected return on plan assets would 8.0% for 2005 expense and 8.1% for 2004 expense, on a change the 2007 projected net periodic pension cost by worldwide basis. In estimating this rate, we considered approximately $19 million. the historical returns earned by the plan assets, the rates Refer to Note 1 – “New Accounting Standards and of return expected in the future and our investment Accounting Changes” to the Consolidated Financial strategy and asset mix with respect to the plans’ funds. Statements for further information regarding adoption of The weighted average expected rate of return on plan SFAS No. 158, “Employers’ Accounting for Defined assets we will utilize to calculate our 2007 expense will Benefit Pension and Other Postretirement Plans, on be 7.6%. amendment of FASB Statements No. 87, 88, 106 and Another significant assumption affecting our 132(R).” 31


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    Income Taxes and Tax Valuation Allowances: We Interpretation No. 48, “Accounting for Uncertainty in record the estimated future tax effects of temporary Income Taxes – an Interpretation of FASB Statement differences between the tax bases of assets and liabilities No. 109,” beginning January 1, 2007. The adoption of this and amounts reported in our Consolidated Balance interpretation will change the way we evaluate Sheets, as well as operating loss and tax credit recognition and measurement of uncertain tax positions. carryforwards. We follow very specific and detailed Refer to Note 1 – “New Accounting Standards and guidelines in each tax jurisdiction regarding the Accounting Changes” to the Consolidated Financial recoverability of any tax assets recorded in our Statements for further information regarding the adoption Consolidated Balance Sheets and provide necessary of this interpretation. valuation allowances as required. We regularly review We are subject to ongoing tax examinations and our deferred tax assets for recoverability considering assessments in various jurisdictions. Accordingly, we historical profitability, projected future taxable income, may incur additional tax expense based upon our the expected timing of the reversals of existing temporary assessment of the probable outcomes of such matters. In differences and tax planning strategies. If we continue to addition, when applicable, we adjust the previously operate at a loss in certain jurisdictions or are unable to recorded tax expense to reflect examination results. Our generate sufficient future taxable income, or if there is a ongoing assessments of the probable outcomes of the material change in the actual effective tax rates or time examinations and related tax positions require judgment period within which the underlying temporary differences and can materially increase or decrease our effective tax become taxable or deductible, we could be required to rate as well as impact our operating results. increase the valuation allowance against all or a Legal Contingencies: We are involved in a variety of significant portion of our deferred tax assets resulting in a claims, lawsuits, investigations and proceedings substantial increase in our effective tax rate and a material concerning securities law, intellectual property law, adverse impact on our operating results. Conversely, if environmental law, employment law and ERISA, as and when our operations in some jurisdictions were to discussed in Note 16 – Contingencies to the Consolidated become sufficiently profitable to recover previously Financial Statements. We determine whether an estimated reserved deferred tax assets, we would reduce all or a loss from a contingency should be accrued by assessing portion of the applicable valuation allowance in the whether a loss is deemed probable and can be reasonably period when such determination is made. This would estimated. We assess our potential liability by analyzing result in an increase to reported earnings in such period. our litigation and regulatory matters using available Adjustments to our valuation allowance, through (credits) information. We develop our views on estimated losses in charges to income tax expense, were $12 million, $(38) consultation with outside counsel handling our defense in million, and $12 million for the years ended these matters, which involves an analysis of potential December 31, 2006, 2005 and 2004, respectively. There results, assuming a combination of litigation and were other increases/(decreases) to our valuation settlement strategies. Should developments in any of allowance, including the effects of currency, of $45 these matters cause a change in our determination as to an million, $61 million, and $(21) million for the years unfavorable outcome and result in the need to recognize a ended December 31, 2006, 2005 and 2004, respectively, material accrual, or should any of these matters result in a that did not affect income tax expense in total as there final adverse judgment or be settled for significant was a corresponding adjustment to deferred tax assets or amounts, they could have a material adverse effect on our other comprehensive income. Gross deferred tax assets of results of operations, cash flows and financial position in $3.9 billion and $3.6 billion had valuation allowances of the period or periods in which such change in $647 million and $590 million at December 31, 2006 and determination, judgment or settlement occurs. 2005, respectively. We plan on adopting FASB Results of Operations Segment Revenue Our reportable segments are consistent with how we and consumable supplies. The Production segment manage the business and view the markets we serve. Our includes black-and-white products, which operate at reportable segments are Production, Office, DMO and speeds over 90 pages per minute (“ppm”) and color Other. Our offerings include hardware, services, solutions products which operate at speeds over 40 ppm, excluding 32


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    50 ppm products with an embedded controller. Products operations in Latin America, Brazil, the Middle East, include the Xerox iGen3® digital color production press, India, Eurasia, Central and Eastern Europe and Africa. Xerox Nuvera™, DocuTech®, DocuPrint®, Xerox 4110™ This segment’s sales consist of office and production and DocuColor® families, as well as older technology products including a large proportion of office devices light-lens products. These products are sold and printers which operate at speeds of 11-40 ppm. predominantly through direct sales channels in North Management serves and evaluates these markets on an America and Europe to Fortune 1000, graphic arts, aggregate geographic basis, rather than on a product government, education and other public sector customers. basis. The segment classified as Other includes several The Office segment includes black-and-white products units, none of which met the thresholds for separate that operate at speeds up to 90 ppm, and color devices up segment reporting. This group primarily includes Xerox to 40 ppm, as well as, 50 ppm color devices with an Supplies Business Group (predominantly paper), value- embedded controller. Products include the suite of added services, Wide Format Systems, Xerox Technology CopyCentre®, WorkCentre®, and WorkCentre Pro digital Enterprises, royalty and licensing revenues, equity net multifunction systems, DocuColor color multifunction income and non-allocated Corporate items. Paper sales products, color laser, solid ink and monochrome laser were approximately 60% of Other segment revenues in desktop printers, digital and light-lens copiers and 2006. Other segment profit includes the operating results facsimile products. These products are sold through direct from these entities, other less significant businesses, our and indirect sales channels in North America and Europe equity income from Fuji Xerox, and certain costs that to global, national, small and mid-size commercial have not been allocated to the Production, Office and customers as well as government, education and other DMO segments, including non-financing interest as well public sector customers. The DMO segment includes our as other items included in Other expenses, net. Revenue by segment for the years ended 2006, 2005 and 2004 were as follows: (in millions) Production Office DMO Other Total 2006 Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,343 $2,368 $ 605 $ 141 $ 4,457 Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,913 4,760 1,327 1,598 10,598 Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323 497 6 14 840 Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,579 $7,625 $1,938 $1,753 $15,895 2005 Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,368 $2,436 $ 558 $ 157 $ 4,519 Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,830 4,670 1,245 1,562 10,307 Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342 512 9 12 875 Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,540 $7,618 $1,812 $1,731 $15,701 2004 Equipment sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,358 $2,431 $ 503 $ 188 $ 4,480 Post sale and other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,880 4,644 1,194 1,590 10,308 Finance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 552 10 20 934 Total Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,590 $7,627 $1,707 $1,798 $15,722 Equipment Sales Equipment sales reflect the results of our technology 2006 Equipment sales of $4,457 million declined 1% investments and the associated product launches as from 2005 reflecting: approximately two-thirds of 2006 equipment sales were • Currency benefit of 1-percentage point. generated from products launched in the past 24 months. • Growth in color products and DMO offset by declines in high-end black-and-white Production products. 33


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    • Strong install activity in Color products and Office 2005 Equipment sales of $4,519 million increased black-and-white products including, entry 1% from 2004 reflecting: production color, iGen3 and office multifunction • Negligible impact from currency. color products, were partially offset by overall price • Growth in lower-end office black-and-white declines. devices, color printers, as well as office and • Growth in color equipment sales of 9%. The pace production color systems, which more than offset of color equipment sales growth was impacted by declines in other monochrome office and lower OEM color printer sales. Color sales monochrome production products. represented approximately 45% of total equipment • Growth in color equipment sales of $329 million or sales in the year ended December 31, 2006 versus 22%, from the prior comparable period. Color 41% in the comparable prior period. equipment sales represented 41% of total equipment sales versus 34% for the prior year comparable period. Production 2006 Equipment sales declined 2% including a benefit 2005 Equipment sales increased 1% from 2004, from currency of 1-percentage point, as price declines of primarily reflecting install growth with a negligible less than 5% were partially offset by strong color install impact from currency, partially offset by price declines of activity. Production system install activity for 2006, approximately 5% and product mix. Production system included the following: install activity for 2005 included the following: • 74% growth in installs of production color products • 30% growth in installs of production color products largely driven by strong activity in the DocuColor® largely driven by strong iGen3, DocuColor 240/250, DocuColor 5000 and DocuColor 240/250, and DocuColor 7000/8000 activity. 7000/8000, as well as an increase in iGen3 installs. • 9% growth in installs of black-and-white • Installs of production black-and-white systems production systems reflecting the success of the were flat year-over-year. This included 16% growth 4110 light production system, as well as growth in in installs of black-and-white light production production publishing systems. systems, reflecting continued success of the 4110 light production system, which was more than offset by 21% declines in installs of high-end black-and-white systems. Office 2006 Equipment sales declined 3% including a benefit 2005 Equipment sales were comparable to 2004, from currency of 1-percentage point, reflecting price including a negligible impact from currency. Strong declines of less than 10%, which more than offset the install growth was offset by price declines of growth in office color multifunction and black-and-white approximately 7% and product mix, which reflected an products. In addition, an increased proportion of Office increased proportion of lower-end equipment sales. Office equipment installed under operating lease contracts are product install activity for 2005 included the following: recognized in post sale revenue. Office product install • 22% install growth in black-and-white digital activity for 2006 included the following: copiers and multifunction devices driven by strong • 35% install growth in office color multifunction sales of Segments 1-2 devices (11-30 ppm), which systems. more than offset declines of Segments 3-5 devices • 8% install growth in black-and-white digital copiers (31-90 ppm). and multifunction devices. Install growth was • 51% install growth in office color multifunction driven by 15% growth in Segments 3-5 devices systems driven in part by strong sales of the (31-90 ppm) and 7% growth in Segments 1-2 DocuColor 240/250, which was announced during devices (11-30 ppm). the second quarter of 2005. • 5% decline in color printers as compared to 111% • 111% improvement in install activity for color growth in the comparable 2005 periods. The printers driven by OEM sales. decline reflects lower 2006 OEM sales. 34


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    DMO DMO Equipment sales consist of office and production production black-and-white and production color systems. products, including a large proportion of sales of Equipment sales in 2005 increased 11% from 2004, Segments 1-2 office devices. Equipment sales in 2006 primarily reflecting strong growth in Eurasia and Central increased 8% from 2005, reflecting strong sales of and Eastern Europe. Segments 1-2 devices, as well as install growth in light Other 2006 and 2005 Equipment sales declined 11% and 16%, by lower component sales included in value-added respectively from prior years comparable periods, driven services offerings. Post Sale and Other Revenue Post sale revenue is largely a function of the products and older light lens technology. 2005 post sale equipment placed at customer locations, the volume of and other revenue declined 2% from 2004, as declines in prints and copies that our customers make on that older light lens technology were only partially offset by equipment and the mix of color pages, as well as revenue growth from digital products. associated services. Office: 2006 Post sale and other revenue grew 2% 2006 Post sale and other revenues of $10,598 million from 2005, including a benefit from currency of grew 3% from 2005, with our growth areas (“digital 1-percentage point, as growth in revenue from color office, digital production and value-added services”) multifunction products, black-and-white and color collectively growing 5% and DMO growing 7%, partially printers, were partially offset by declines in offset by a 39% decline in analog light lens products. black-and-white multifunction and older light lens Analog revenues of $302 million represented 3% of 2006 technology. 2005 post sale and other revenue increased post sale revenue compared to $494 million or 5% of 1% from 2004, primarily reflecting a 1-percentage point 2005 post sale revenue. Color post sale and other revenue benefit from currency and growth in digital grew 16% for 2006. Color sales represented 31% of post black-and-white, color printing and color multifunctional sale and other revenue in 2006 versus 28% in 2005. In products. These positive effects were partially offset by 2006, approximately 9% of our pages were printed on declines in older light lens technology. color devices, which is up from 7% in 2005. DMO: 2006 Post sale and other revenue grew 7% 2005 Post sale and other revenues of $10,307 million from 2005, driven primarily by growth in revenue from were comparable to the prior year period, with our growth supplies, color products and services. 2005 post sale and areas (“digital office, digital production and value-added other revenue grew 4% from 2004, reflecting growth in services”) collectively growing 5% and DMO growing Eurasia and Central and Eastern Europe, more than 4%, more than offsetting a 40% decline in analog light offsetting declines in Brazil. lens products. Color post sale and other revenue grew Other: 2006 Post sale and other revenue increased 15% for 2005, and color sales represented 28% of post 3% from 2005, including a benefit from currency of sale and other revenue in 2005 versus 24% in 2004. In 1-percentage point, primarily driven by increased paper 2005, approximately 7% of our pages were printed on sales and value-added services. Paper comprised color devices, which is up from 5% in 2004. approximately two-thirds of 2006 Other segment post sale Production: 2006 Post sale and other revenue and other revenue. 2005 post sale and other revenue increased 3% from 2005, including a benefit from declined 2% from 2004, including a negligible impact currency of 1-percentage point, primarily reflecting from currency, as declines in SOHO and other revenues growth in color products which was partially offset by were partially offset by growth in value-added services. declines in revenue from high-end black-and-white digital 2007 Projected Revenues Excluding currency impacts, we expect 2007 combined with products and applications launched during revenue to grow modestly driven by continued increases the past 2 years, and the businesses acquired in 2006, will in post sale revenue. We anticipate that new launches enable us to further strengthen our market position. 35


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    Growth in post sale and other revenue will be driven by pages generated on that equipment, as well as growth in our success at increasing the amount of our equipment at document management services. customer locations, the volume of pages and mix of color Segment Operating Profit Segment Operating profit and operating margin for the three years ended December 31, 2006 were as follows: (in millions) Production Office DMO Other Total 2006 Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 403 $ 832 $124 $ 31 $1,390 Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.8% 10.9% 6.4% 1.8% 8.7% 2005 Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 427 $ 819 $ 64 $ 151 $1,461 Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.4% 10.8% 3.5% 8.7% 9.3% 2004 Operating Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 511 $ 779 $ 35 $(125) $1,200 Operating Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.1% 10.2% 2.1% (7.0)% 7.6% Production: 2006 Operating profit declined $24 • $13 million pre-tax write-off of the remaining million from 2005, reflecting reduced gross margins unamortized deferred debt issuance costs associated impacted by product mix, price declines and higher bad with the termination of our 2003 Credit Facility that debt expense, partially offset by both lower R,D&E occurred in 2006. spending and selling expenses. The reduction in R,D&E • Lower 2006 interest income of $12 million and reflects benefits from our platform strategy to launch new increased non-financing interest expense of $8 technology and lower spending related to environmental million. compliance activities. The above were partially offset by the following: 2005 Operating profit declined $84 million from • Increased paper profit due to increased sales as well 2004, primarily reflecting reduced gross margins as reduced SAG expenses primarily from impacted by mix, and higher selling expenses, which organizational streamlining. were partially offset by improvements in G&A and • $44 million in gains on sale of assets. R,D&E efficiencies. 2005 Operating profit increased $276 million as Office: 2006 Operating profit increased $13 million compared to 2004, principally due to: from 2005, reflecting reduction in SAG expenses partially • Reduced interest expense of $157 million, primarily offset by lower gross profit. 2005 Operating profit due to lower average debt balances. increased $40 million primarily reflecting lower SAG, • Higher interest income of $63, which includes $57 partially offset by lower gross margins impacted by mix million associated with the finalization of the 1996- and higher R,D&E. 1998 IRS audit. DMO: 2006 Operating profit increased $60 million • An improvement in aggregate currency gains and from 2005, reflecting higher gross profit and reduction in losses of $68 million. SAG expenses, including improvement in bad debt • A gain on the sale of Integic of $93 million. expenses. 2005 Operating profit increased $29 million • These items were partially offset by the absence of from 2004, primarily reflecting increasing revenues and the $38 million pension settlement gain from Fuji operating margin contributions from Eurasia and Central Xerox in 2004, as well as the absence of the $38 and Eastern Europe. million gain from the 2004 sale of our ownership interest in ScanSoft. Other: 2006 Operating profit declined $120 million from 2005, principally due to: Refer to Note 2 – Segment Reporting in the • Absence of the 2005 $93 million gain related to the Consolidated Financial Statements, for further discussion sale of Integic and the 2005 $57 million interest on our reportable segment operating revenue and income benefit from the finalization of the 1996- operating profit. 1998 Internal Revenue Service tax audit. 36


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    Gross Margins 2006 Finance income gross margin of 63.7% improved 1.0-percentage point and 2005 Finance income Gross margins by revenue classification were as gross margin of 62.7% declined 0.4-percentage points due follows: to changes in interest costs specific to equipment financing. Equipment financing interest is determined Year Ended December 31, based on an estimated cost of funds, applied against the (in millions) 2006 2005 2004 estimated level of debt required to support our net finance Total Gross margin . . . . . . . . . . 40.6% 41.2% 41.6% receivables. Prior to 2006, the estimated cost of funds was Sales . . . . . . . . . . . . . . . . . 35.7% 36.6% 37.4% primarily based on our secured borrowing rates. As a Service, outsourcing and result of the reduction in our level of secured borrowings, rentals . . . . . . . . . . . . . . 43.0% 43.3% 43.0% Finance income . . . . . . . . 63.7% 62.7% 63.1% effective January 1, 2006 the estimated cost of funds is based on a blended rate for term and duration comparable 2006 Gross margin of 40.6% decreased by to available borrowing rates for a BBB rated company as 0.6-percentage points from 2005 due to product mix. of the end of each period. This change in basis did not Price declines of 1.4-percentage points were offset by materially impact the calculated amount of Equipment productivity improvements and other variances of finance interest expense and accordingly did not impact 1.4-percentage points. 2005 Gross margin of 41.2% comparability between the periods. The estimated level of decreased 0.4-percentage points from 2004 reflecting a debt is based on an assumed 7 to 1 leverage ratio of debt/ decline in product mix of 1.3-percentage points reflecting equity as compared to our average finance receivable a higher proportion of sales in office printers and light balance during the applicable period. production systems. Price declines of 1.5-percentage Research, development and engineering points were more than offset by cost improvements of (“R,D&E”) of $922 million in 2006 was $21 million 2.3-percentage points. lower than the prior year primarily due to lower 2006 Sales gross margin of 35.7% decreased environmental compliance spending. We expect 2007 0.9-percentage points from 2005 as price declines of R,D&E spending to approximate 5-6% of total revenue. 2.1-percentage points exceeded the combined impacts of Research and development (“R&D”) of $761 million productivity improvements, product mix and other in 2006 increased from the prior year by $6 million variances of 1.2-percentage points. 2005 Sales gross reflecting higher expenditures in the Production and margin of 36.6% decreased 0.8-percentage points from Office segments primarily related to expected 2007 2004 driven by product mix declines of 1.5-percentage product launches. We invest in technological points. Price declines of 2.2-percentage points were more development, particularly in color, and believe our R&D than offset by cost improvements of 2.4-percentage points. spending is sufficient to remain technologically Product mix reflects a higher proportion of sales of competitive. Our R&D is strategically coordinated with products with lower gross margins, including office that of Fuji Xerox, which invested $660 million and $720 printers and light production systems, and a lower million in R&D in 2006 and 2005, respectively. 2005 proportion of sales of products with higher gross margins R&D expense of $755 million was $5 million lower than such as higher end office black-and-white multifunction the prior year, primarily reflecting lower expenditures in devices and high-end production black-and-white systems. the Production segment, which were partially offset by increased spending in the Office segment. The lower 2006 Service, outsourcing and rentals margin of spending in the Production segment was as a result of 43.0% decreased 0.3-percentage points from 2005 as product launches, and cost efficiencies that we captured product mix decline of 1.3-percentage points exceeded from our platform development strategy. the impact of productivity improvements, price and other Sustaining engineering costs of $161 million variances of 1.0-percentage points. 2005 Service, decreased by $27 million from the prior year, reflecting outsourcing and rental margin of 43.3% increased lower spending related to environmental compliance 0.3-percentage points driven by cost improvements of activities and maturing product platforms. Refer to 2.6-percentage points, which more than offset by prices Note 1 – “Basis of Presentation” in the Consolidated declines of 1.1-percentage points and product mix Financial Statements for additional information. declines of 0.9-percentage points. 37


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    Selling, administrative and general expenses adjustments to the reserves, as the result of improvements (“SAG”) SAG expense information was as follows (in in write-offs and aging. This favorable trend in write-offs, millions): receivables aging and collections continues to be reflected in our current year bad debt expense. Bad debt expense as Year Ended December 31, Amount Change a percent of total revenue was 0.5%, 0.5% and 0.7% for 2006 2005 2004 2006 2005 2006, 2005 and 2004, respectively. Total SAG For the three years ended December 31, 2006, 2005 expenses . . . . . $4,008 $4,110 $4,203 $(102) $(93) and 2004 we recorded restructuring and asset SAG as a impairment charges of $385 million, $366 million and percentage $86 million, respectively, primarily related to headcount of revenue . . . 25.2% 26.2% 26.7% (1.0)% (0.5)% reductions of approximately 3,400, 3,900 and 1,900 employees, respectively, across all geographies and In 2006, SAG expenses decreased primarily as a segments. 2006 actions associated with these changes result of the following: primarily include the following: technical service; service • $58 million reduction in selling expenses compared infrastructure and global back-office optimization; to 2005 included lower marketing spending and continued R&D efficiencies and productivity headcount reductions. improvements; supply chain optimization to ensure, for • $59 million reduction in general and administrative example, alignment to our global two-tier model (“G&A”) expenses as the result of continued implementation; and selected off-shoring opportunities. expense management initiatives, including benefits Lease termination and asset impairment charges of $67 from restructuring. million included within these charges primarily relate to • $15 million increase in bad debt expense to $87 the relocation of certain manufacturing operations as well million for 2006. as an exit from certain leased and owned facilities. The In 2005, SAG expenses decreased primarily as a remaining restructuring reserve balance as of result of the following: December 31, 2006, for all programs was $337 million. • An $86 million reduction in G&A expenses due to We expect prospective annualized savings associated with continued expense management initiatives. the 2006 actions to be approximately $300 million, with • A $38 million decrease in bad debt expense. over half of the savings expected to be in gross margin • A partially offsetting increase in selling expenses of and the rest in SAG and R,D&E. Refer to Note 9 – $31 million from 2004 due to additional spending Restructuring and Asset Impairment Charges in the for advertising and marketing programs to support Consolidated Financial Statements for further information product launches and other selling expenses, as regarding our restructuring programs. well as, special compensation payments related to Worldwide employment of 53,700 as of the 2005 merit increase process. These increases in December 31, 2006 declined approximately 1,500 from selling expenses were partially offset by the December 31, 2005, primarily reflecting reductions absence of $28 million Olympic marketing expense attributable to our restructuring programs and other that occurred in 2004. attrition partially offset by hiring in strategic business Bad debt expense included in SAG was $87 million, areas and the hiring of former contract employees in $72 million and $110 million in 2006, 2005 and 2004, certain Latin American subsidiaries. Worldwide respectively. The 2005 reduction in bad debt expense employment was approximately 55,200 and 58,100 at reflected the benefits associated with recoveries and December 31, 2005 and 2004, respectively. 38


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    Other Expenses, Net: Other expenses, net for the three years ended December 31, 2006 consisted of the following: Year Ended December 31, (in millions) 2006 2005 2004 Non-financing interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $239 $ 231 $363 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (69) (138) (75) Gain on sales of businesses and assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) (97) (61) Currency losses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 5 73 Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 38 37 Legal matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 115 9 Minorities’ interests in earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 15 8 Loss on extinguishment of debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 — — All other expenses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 55 15 Total Other expenses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $336 $ 224 $369 Non-financing interest expense: In 2006 • $11 million on the sale of a manufacturing facility. non-financing interest expense increased due to higher • $10 million receipt from escrow of additional interest rates partially offset by lower average debt proceeds related to our first quarter 2005 sale of balances. 2005 non-financing interest expense decreased Integic. The proceeds were placed in escrow upon due to lower average debt balances as a result of the sale of Integic pending completion of an scheduled term debt repayments and medium-term note indemnification period, which ended in 2006. redemptions, as well as the full-year effect of the In 2005, gain on sales of businesses and assets December 2004 Capital Trust II liability conversion. primarily consist of the $93 million gain on the sale of Interest income: Interest income is derived primarily Integic. In 2004, gains on the sale of businesses and assets from our invested cash and cash equivalent balances and primarily reflect the $38 million pre-tax gain from the interest resulting from periodic tax settlements. In 2006, sale of our ownership interest in ScanSoft, as well as, interest income decreased primarily due to: gains totaling $14 million related to the sale of certain • Absence of $57 million of interest income excess land and buildings in Europe and Mexico. associated with the 2005 settlement of the 1996- 1998 IRS audit. (Refer to Note 15 – Income and Currency gains and losses: Currency gains and Other Taxes in the Consolidated Financial losses primarily result from the re-measurement of Statements). foreign currency-denominated assets and liabilities, the • Lower average cash balances partially offset by cost of hedging foreign currency-denominated assets and higher rates of return. liabilities, the mark-to-market of any foreign exchange contracts utilized to hedge those foreign currency- In 2005, interest income increased primarily due to: denominated assets and liabilities and the mark-to-market • A $57 million increase associated with the previously disclosed settlement of the 1996-1998 impact of hedges of anticipated transactions, primarily IRS audit. future inventory purchases, for which we do not generally • A $23 million increase primarily reflecting higher apply cash flow hedge accounting treatment. rates of return from our money market funds. In 2006, 2005 and 2004 currency losses totaled $39 • Partially offset by the absence of $26 million of million, $5 million and $73 million respectively. The 2006 interest income related to a 2004 domestic tax increase in currency losses primarily reflected the refund. mark-to-market of derivative contracts which are Gain on sales of businesses and assets: 2006 gain on economically hedging anticipated foreign currency sales of businesses and assets primarily consisted of the denominated payments. The mark-to-market losses were following: primarily due to the strengthening of the Euro against other • $15 million on the sale of our Corporate currencies, in particular the Canadian Dollar, U.S. Dollar headquarters. (Refer to Note 6 – Land, buildings and Japanese Yen, as compared to the weakening Euro in and equipment, net in the Consolidated Financial 2005. The decrease in 2005 from 2004 was primarily due Statements for further information.) to the strengthening of the U.S. and Canadian Dollars 39


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    against the Euro and the Yen in 2005, as compared to the In 2004, legal matters expenses consisted of costs weakening U.S. Dollar in 2004, and decreased costs of associated with the resolution of legal and regulatory hedging foreign currency denominated assets and liabilities matters, none of which was individually material, due to lower spot/forward premiums in 2005. partially offset by the adjustment of an estimate associated with a previously recorded litigation accrual. Legal matters: In 2006 legal matters expenses Refer to Note 16 – Contingencies in the consisted of the following: Consolidated Financial Statements for additional • $68 million for probable losses on Brazilian labor- information regarding litigation against the Company. related contingencies – see Note 16 – Contingencies within the Consolidated Financial Loss on extinguishment of debt: 2006 loss of $15 Statements for additional details. million includes the $13 million write-off of remaining • $33 million associated with probable losses from unamortized deferred debt issuance costs associated with various legal matters partially offset by $12 million the termination of our 2003 Credit Facility and a $2 of proceeds from the Palm litigation matter. The million loss associated with the mortgage repayment in remaining proceeds from the Palm litigation matter connection with the sale of our Corporate headquarters. of $11 million are associated with a license and are All other expenses, net: In 2006 all other expenses, recorded in Sales as licensing revenue. net decreased due to the absence of the following 2005 In 2005, legal matters expenses consisted of the items: following: • $15 million for losses sustained from Hurricane • $102 million, including $13 million for interest Katrina related to property damage and impaired expense, related to the MPI arbitration panel ruling. receivables. • $13 million related to other legal matters, primarily • $26 million charge related to the European Union reflecting charges for probable losses on cases that Waste Directive. have not yet been resolved. Income tax (benefits) expenses were as follows (in millions): Year Ended December 31, 2006 2005 2004 Pre-tax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 808 $830 $ 965 Income tax (benefits) expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (288) (5) 340 Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35.6)% (0.6)% 35.2% The 2006 effective tax rate of (35.6%) was lower The 2005 effective tax rate of (0.6)% was lower than than the U.S. statutory rate primarily due to: the U.S. statutory tax rate primarily due to: • Tax benefits of $518 million from the resolution of • Tax benefits of $253 million, associated with the tax issues associated with domestic and foreign tax finalization of the 1996-1998 IRS audit. audits. • Tax benefits of $42 million primarily from the • Tax benefits of $19 million as a result of tax law realization of foreign tax credits offset by the changes and tax treaty changes. geographical mix of income and the related tax • $11 million from the reversal of a valuation rates in those jurisdictions. allowance on deferred tax assets associated with • Tax benefits of $31 million from the reversal of a foreign net operating loss carryforwards. valuation allowance on deferred tax assets • The geographical mix of income and related associated with foreign net operating loss effective tax rates in those jurisdictions. carryforwards. This reversal followed a • These benefits were partially offset by losses in re-evaluation of their future realization resulting certain jurisdictions where we are not providing tax from a refinancing of a foreign operation. benefits and continue to maintain deferred tax • These impacts were partially offset by losses in valuation allowances. certain jurisdictions where we are not providing tax benefits and continue to maintain deferred tax valuation allowances. 40


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    The 2004 effective tax rate of 35.2% was Income from Discontinued Operations: Income comparable to the U.S. statutory tax rate primarily from discontinued operations, net of tax, for the years reflecting: ended December 31, 2005 and 2004 was as follows (in • The impact of nondeductible expenses and $20 millions): million of unrecognized tax benefits primarily 2005 2004 related to recurring losses in certain jurisdictions where we maintained deferred tax asset valuation Insurance Group Operations tax allowances. benefits . . . . . . . . . . . . . . . . . . . . . . . . . . $ 53 $— • Partially offset by tax benefits from other foreign Gain on sale of ContentGuard, net of adjustments, including earnings taxed at different income taxes of $26 . . . . . . . . . . . . . . . . — 83 rates, tax law changes of $14 million and other Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 53 $ 83 items that are individually insignificant. As disclosed in Note 15 – Income and Other Taxes, Our effective tax rate will change based on in June 2005 the 1996-1998 Internal Revenue Service nonrecurring events as well as recurring factors including the (“IRS”) audit was finalized. Of the total tax benefits geographical mix of income before taxes and the related tax realized, $53 million was attributed to our discontinued rates in those jurisdictions as well as available foreign tax operations. In the first quarter 2004, we sold all but 2% of credits. In addition, our effective tax rate will change based our 75% ownership interest in ContentGuard Inc, on discrete or other nonrecurring events (such as audit (“ContentGuard”) to Microsoft Corporation and Time settlements) that may not be predictable. We anticipate that Warner Inc. for $66 million in cash. The sale resulted in our effective tax rate for 2007 will approximate 33%, an after-tax gain of approximately $83 million ($109 excluding the effect of any discrete items. million pre-tax) and reflects our recognition of Equity in Net Income of Unconsolidated cumulative operating losses. The revenues, operating Affiliates: Equity in net income of unconsolidated results and net assets of ContentGuard were immaterial affiliates of $114 million, principally related to our 25% for all periods presented. ContentGuard, which was share of Fuji Xerox income, which increased by $16 originally created out of research developed at the Xerox million in 2006 as compared to 2005, primarily due to Palo Alto Research Center (“PARC”), licenses improved operational performance. intellectual property and technologies related to digital rights management. During 2005, we sold our remaining interest in ContentGuard. Recent Accounting Pronouncements: Refer to Note 1 – Summary of Significant Accounting Policies in the Consolidated Financial Statements for a description of recent accounting pronouncements including the respective dates of adoption and the effects on results of operations and financial condition. Capital Resources and Liquidity Cash Flow Analysis: The following summarizes our cash flows for each of the three years ended December 31, 2006, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements: Amount Change (in millions) 2006 2005 2004 2006 2005 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . $ 1,617 $ 1,420 $ 1,750 $ 197 $ (330) Net cash (used in) provided by investing activities . . . . . . . . . . . . . . (143) (295) 203 152 (498) Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . (1,428) (2,962) (1,293) 1,534 (1,669) Effect of exchange rate changes on cash and cash equivalents . . . . . 31 (59) 81 90 (140) Increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . 77 (1,896) 741 1,973 (2,637) Cash and cash equivalents at beginning of period . . . . . . . . . . . . . . . 1,322 3,218 2,477 (1,896) 741 Cash and cash equivalents at end of period . . . . . . . . . . . . . . . . . . $ 1,399 $ 1,322 $ 3,218 $ 77 $(1,896) 41


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    Cash, cash equivalents and Short-term investments reported in our Consolidated Financial Statements were as follows: 2006 2005 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,399 $1,322 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 244 Total Cash, cash equivalents and Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,536 $1,566 For the year ended December 31, 2006, net cash For the year ended December 31, 2006, net cash provided by operating activities, increased $197 million from investing activities increased $152 million from from 2005 primarily as a result of the increased net 2005 primarily as a result of the following: income of $232 million, as well as the following • $354 million due to an increase in proceeds from additional items: the net sale of short-term investments in 2006 of • $173 million increase due to lower inventories. $107 million, as compared to the net purchases of • $87 million increase due to lower net tax payments $247 million in 2005, as 2005 represented the including a $34 million refund associated with the initial year we purchased short-term investments to settlement of the 1999 to 2003 IRS tax audit. supplement our investment income. • $62 million decrease due to a lower net run-off of • $77 million due to higher proceeds from the sale of finance receivables. our Corporate headquarters and other excess land • $51 million decrease due to higher restructuring and buildings. payments related to previously reported actions. • $48 million due to higher proceeds from • $96 million decrease due to a lower year-over-year divestitures and investments, reflecting: reduction in other current and long-term assets. • $122 million related to the sale of investments • $77 million decrease due to a reduction in other held by Ridge Re* in 2006. current and long-term liabilities, primarily • $21 million distribution from the liquidation of reflecting the $106 million payment relating to the our investment in Xerox Capital LLC in 2006. previously disclosed MPI legal matter. • $96 million of proceeds from the sale of Integic in 2005. For the year ended December 31, 2005, net cash • Partially offsetting these items were the following: provided by operating activities, decreased $330 million • $229 million due to payments related to the from 2004 primarily as a result of the following: acquisition of Amici, LLC and XMPie, Inc. • $258 million decrease due to modest growth in • $57 million increase in capital expenditures and accounts receivable in 2005 compared to a decline internal use software. in 2004. • Lower cash generation of $42 million due to a • $83 million decrease due to lower finance lower net reduction of escrow and other receivable run-off. restricted investments. • $124 million decrease due to higher inventory * In March 2006 Ridge Re, a wholly owned growth in 2005 compared to 2004 reflecting an subsidiary included in discontinued operations, increase in the number of new products. executed an agreement to complete its exit from • Partially offsetting these items were lower tax the insurance business. As a result of this payments of $96 million due to refunds from audit agreement and pursuant to a liquidation plan, and other tax settlements, as well as, the timing of excess cash held by Ridge Re was distributed payments associated with restructuring. back to the Company (Refer to Note 21 – • Partially offsetting lower pension contributions of Divestitures and Other Sales in the $21 million. Consolidated Financial Statements for further We expect 2007 operating cash flows in the range of information). $1.2 billion to $1.5 billion, as compared to $1.6 billion in 2006. 42


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    For the year ended December 31, 2005, net cash unsecured debt, of $1,187 million, as contrast to the from investing activities decreased $498 million from 2006 net borrowings of term and other unsecured 2004 primarily as a result of the following: debt of $1,276 million. The 2006 net borrowings • $247 million from the net purchases of short-term primarily reflect the 2016 Senior Notes borrowing investments which were intended to increase our of $700 million in March 2006, 2017 Senior Notes return on available cash. borrowing of $500 million in August 2006 and the • Decrease of $143 million due to a lower net 2009 Senior Notes borrowing of $150 million in reduction of escrow and other restricted August 2006. investments due to the 2004 renegotiation of certain • $42 million due to higher proceeds from the secured borrowing arrangements and scheduled issuance of common stock, resulting from increases releases from an escrow account of supporting in exercised stock options. interest payments on our prior liability to a trust • Partially offsetting these items were the following: issuing preferred securities. • $636 million higher cash usage for the • Decrease of $86 million due to lower proceeds acquisition of common stock under the from divestitures and investments, net reflecting: authorized share repurchase programs. • 2005 proceeds of $105 million primarily • $269 million higher net repayments on secured consisting of $96 million from the sale of our borrowings. equity interest in Integic Corporation. • $100 million payment of liability to Xerox • 2004 proceeds of $191 million primarily Capital LLC in connection with their consisting of $66 million from the redemption of Canadian deferred preferred ContentGuard sale, $79 million from the shares in February 2006. ScanSoft sale and $36 million from a preferred For the year ended December 31, 2005, net cash stock investment. used in financing activities increased $1.7 billion from • Decrease of $48 million due to lower proceeds 2004 primarily as a result of the following: from the sale of excess land and buildings. • A $1.5 billion reduction in proceeds from new • Partially offsetting these items was a $15 million secured financings, reflecting a rebalancing of our decrease in capital and internal use software secured and unsecured debt portfolio. expenditures. • $433 million cash usage for the acquisition of We expect 2007 capital expenditures including common stock under the authorized October 2005 internal use software to approximate $300 million. share repurchase program. • A partially offsetting $235 million decrease in net For the year ended December 31, 2006, net cash payments on term and other debt reflecting lower used in financing activities decreased $1.5 billion from debt maturity obligations. 2005 primarily as a result of the following: • $2,463 million lower usage primarily resulting from the 2005 net repayments on term and other Financing Activity Customer Financing Activities and Secured Debt: portion of our customer financing activity through We provide equipment financing to the majority of our secured borrowing arrangements with GE, De Lage customers. Because the finance leases allow our Landen Bank (“DLL”) and Merrill Lynch. While terms customers to pay for equipment over time rather than at and conditions vary somewhat between countries, in the date of installation, we maintain a certain level of debt general these arrangements call for the financial to support our investment in these customer finance counterparty to provide loans secured by lease leases. We currently fund our customer financing activity originations in the country for which it has been through cash generated from operations, cash on hand, contracted to be the funding source. Most arrangements capital markets offerings and third-party secured funding are transacted through bankruptcy remote special purpose arrangements. entities and the transfers of receivables and equipment to In the United States, Canada, the U.K., the these entities are generally intended to be true sales at Netherlands, and France, we are currently funding a law. Under these arrangements, secured debt matches the 43


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    terms of the underlying finance receivables it supports, contracts directly with our customers. In these which eliminates certain significant refinancing, pricing arrangements, we sell and transfer title to the equipment and duration risks associated with our financing. As part to these financial institutions and generally have no of our continued objective to reduce our level of secured continuing ownership rights in the equipment subsequent debt, in November 2006, we delivered notice to GE, our to its sale, as such the related receivable and debt are not secured lender in the U.K., moving the final funding date included in our Consolidated Financial Statements. for that program from June 2010 to June 2007. At December 31, 2006 and 2005, all of the lease The following represents our total finance assets receivables and related secured debt are consolidated in associated with our lease or finance operations as of our financial statements because we are determined to be December 31, 2006 and 2005, respectively: the primary beneficiary of the arrangements and frequently the counterparties have various types of 2006 2005 recourse to us. The lease receivables sold represent the Total Finance receivables, net(1) . . . . . . $7,844 $7,849 collateral for the related secured debt and are not Equipment on operating leases, net . . . 481 431 available for general corporate purposes until the related debt is paid off. All of these arrangements are subject to Total Finance Assets, net . . . . . . . . . . $8,325 $8,280 usual and customary conditions of default including cross-defaults. In the remote circumstance that an event (1) Includes (i) billed portion of finance receivables, net, of default occurs and remains uncured, in general, the (ii) finance receivables, net and (iii) finance counterparty can cease providing funding for new lease receivables due after one year, net as included in the originations. Consolidated Balance Sheets as of December 31, Information on restricted cash that is the result of 2006 and 2005. these third party secured funding arrangements is Refer to Note 4 – Receivables, Net in the included in Note 1 – “Restricted Cash and Investments” Consolidated Financial Statements for further information to the Consolidated Financial Statements and disclosure regarding our third party secured funding arrangements as of the amounts for new funding and debt repayments are well as a comparison of finance receivables to our included in the accompanying Consolidated Statement of financing-related debt as of December 31, 2006 and 2005. Cash Flows. As of December 31, 2006, approximately 31% of total We also have arrangements in certain countries in finance receivables were encumbered as compared to which third party financial institutions originate lease 44% at December 31, 2005. The following represents our aggregate debt maturity schedule as of December 31, 2006: Debt Secured Other Unsecured by Finance Secured Total (in millions) Debt Receivables Debt Debt 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 295 $1,178 $ 12 $1,485(1) 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 722 5 736 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,055 109 5 1,169 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687 44 2 733 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 6 — 806 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,212 — 4 2,216 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,058 $2,059 $ 28 $7,145 (1) Quarterly secured and unsecured total debt maturities for 2007 are $215 million, $421 million, $626 million and $223 million for the first, second, third and fourth quarters, respectively. 44


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    The following table summarizes our secured and Liquidity, Financial Flexibility and unsecured debt as of December 31, 2006 and 2005: Other Financing Activity: (in millions) 2006 2005 Liquidity: We manage our worldwide liquidity Term Loan . . . . . . . . . . . . . . . . . . . . . . $ — $ 300 using internal cash management practices, which are Debt secured by finance subject to (1) the statutes, regulations and practices of receivables . . . . . . . . . . . . . . . . . . . . 2,059 2,982 each of the local jurisdictions in which we operate, Capital leases . . . . . . . . . . . . . . . . . . . . 28 38 (2) the legal requirements of the agreements to which we Debt secured by other assets . . . . . . . . — 213 are a party and (3) the policies and cooperation of the Total Secured Debt . . . . . . . . . . . 2,087 3,533 financial institutions we utilize to maintain and provide Senior Notes . . . . . . . . . . . . . . . . . . . . . 4,224 2,862 cash management services. Subordinated debt . . . . . . . . . . . . . . . . 19 19 As of December 31, 2006, we had $1.5 billion of Other Debt . . . . . . . . . . . . . . . . . . . . . . 815 864 cash, cash equivalents and short-term investments, and Total Unsecured Debt . . . . . . . . . 5,058 3,745 borrowing capacity under our 2006 Credit Facility of approximately $1.235 billion. Our ability to maintain Total Debt $7,145 $7,278 positive liquidity going forward depends on our ability to continue to generate cash from operations and access the At December 31, 2006, approximately 29% of total financial markets, both of which are subject to general debt was secured by finance receivables and other assets economic, financial, competitive, legislative, regulatory compared to 49% at December 31, 2005. Consistent with and other market factors that are beyond our control. our objective to rebalance the ratio of secured and unsecured Share Repurchase Programs: The board of debt, we expect payments on secured loans will continue to directors has authorized programs for the repurchase of exceed proceeds from new secured loans in 2007. the Company’s common stock totaling $2.0 billion as of Credit Facility: In April 2006, we entered into a December 31, 2006. Since launching our stock buyback $1.25 billion unsecured revolving credit facility including program in October 2005, we have repurchased a $200 million letter of credit subfacility (the “2006 100.6 million shares, totaling approximately $1.5 billion Credit Facility” or “facility”). The facility allows us to of the $2.0 billion authorized. increase from time to time, with willing lenders, the Refer to Note 18 – Common Stock and Note 22 – overall size of the 2006 Credit Facility to an aggregate Subsequent Event in the Consolidated Financial amount not to exceed $2 billion. The facility is available, Statements for further information regarding our share without sublimit, to certain of our qualifying subsidiaries. repurchase programs. The facility replaces our 2003 Credit Facility that was Loan Covenants and Compliance: At December 31, terminated upon effectiveness of the 2006 Credit Facility. 2006, we were in full compliance with the covenants and As of December 31, 2006, we had outstanding letters of other provisions of the 2006 Credit Facility, the senior credit of $15 million and no borrowings under the 2006 notes and the Loan Agreement. Any failure to be in Credit Facility. In conjunction with the 2006 Credit compliance with any material provision or covenant of the Facility, debt issuance costs of $5 million were deferred. 2006 Credit Facility or the senior notes could have a In connection with the effectiveness of the 2006 material adverse effect on our liquidity and operations. Credit Facility, we terminated the 2003 Credit Facility in Failure to be in compliance with the covenants in the Loan April 2006 and repaid all advances outstanding Agreement, including the financial maintenance covenants thereunder, including a $300 million secured term loan, incorporated from the 2006 Credit Facility, would result in with a combination of cash on hand and proceeds from an event of termination under the Loan Agreement and in the capital markets offerings. The termination of the 2003 such case General Electric Capital Corporation (“GECC”) Credit Facility resulted in the second quarter 2006 would not be required to make further loans to us. If write-off of the remaining unamortized deferred debt GECC were to make no further loans to us and assuming a issuance costs of $13 million ($9 million after-tax). similar facility was not established and that we were Refer to Note 11 – Debt to the Consolidated unable to obtain replacement financing in the public debt Financial Statements for further information regarding markets, it could materially adversely affect our liquidity our 2006 Credit Facility. and our ability to fund our customers’ purchases of our equipment and this could materially adversely affect our results of operations. We have the right at any time to 45


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    prepay without penalty any loans outstanding under or Capital Markets Offerings and Other: Refer to terminate the 2006 Credit Facility. Note 11 – Debt in the Consolidated Financial Statements for additional information regarding the 2006 issuance of Financial Instruments: Refer to Note 13 – our 2016 Senior Notes, 2017 Senior Notes and Floating Financial Instruments in the Consolidated Financial 2009 Senior Notes, which raised aggregate net proceeds Statements for additional information regarding our of $1.3 billion. derivative financial instruments. Credit Ratings: During 2006, Moody’s and Fitch upgraded our credit rating to investment grade. Our credit ratings as of January 30, 2007 were as follows: Senior Unsecured Debt Outlook Comments Moody’s(1) .............. Baa3 Positive The Moody’s rating was upgraded from Ba1 in November 2006. The outlook remains positive since being upgraded in November 2006. Standard & Poors BB+ Positive The S&P rating was upgraded from BB- in March 2006 (“S&P”)(2) . . . . . . . . . . . . . and the outlook was revised from stable to positive in January 2007. Fitch(3) . . . . . . . . . . . . . . . . . BBB- Stable The Fitch rating was upgraded from BB+ in August 2006. (1) In November 2006, Moody’s upgraded the Senior Unsecured rating from Ba1 to Baa3, a one notch upgrade. Moody’s maintains a Positive Outlook on the credit. In conjunction with the upgrade to investment grade ratings for the senior unsecured debt, Moody’s has withdrawn all Loss Given Default assessments and Speculative Grade Liquidity ratings as they are only appropriate for non-investment grade issuers. Moody’s ratings upgrades also included: Senior unsecured shelf registration to Baa3 from Ba1; Trust preferred to Ba1 from Ba2; subordinated shelf registration to Ba1 from Ba2 and preferred shelf registration to Ba1 from Ba2. (2) In March 2006, S&P upgraded the Senior Unsecured and Corporate Credit rating from BB- to BB+, a two notch upgrade. At the same time, S&P revised its outlook from Positive to Stable on all associated ratings, affirmed the short-term speculative-grade rating at B-1 and upgraded the ratings on Subordinated debt from B to BB- and Preferred Stock from B- to B+. As a result of the rating change, S&P removed Xerox from Credit Watch in March 2006. In January 2007, S&P revised its outlook from Stable to Positive on all associated ratings. (3) In August 2006, Fitch upgraded its debt ratings and assigned a stable outlook on Xerox. Fitch had upgraded the senior unsecured debt of Xerox from BB+ to BBB- and also upgraded the Trust Preferred securities from BB- to BB, both one notch upgrades. In March 2006, Fitch affirmed its ratings and positive outlook on Xerox in conjunction with its 2016 Senior Notes offering. Fitch had upgraded the senior unsecured debt of Xerox from BB to BB+, and also upgraded the Trust Preferred securities from B+ to BB-, both one notch upgrades in August 2005. Our credit ratings, which are periodically reviewed investment grade, we expect effective implementation of by major rating agencies, have substantially improved our management strategies will return the company’s over the past three years. Even though as of January 30, senior unsecured debt to investment grade by all major 2007, our current S&P credit rating still remains below rating agencies in the future. 46


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    Contractual Cash Obligations and Other Commercial Commitments and Contingencies: At December 31, 2006, we had the following contractual cash obligations and other commercial commitments and contingencies (in millions): Year 1 Years 2-3 Years 4-5 2007 2008 2009 2010 2011 Thereafter Long-term debt, including capital lease obligations(1) ........ $1,485 $ 736 $1,169 $733 $ 806 $2,216 Minimum operating lease commitments(2) . . . . . . . . . . . . . . . . . 189 161 124 102 84 158 Liabilities to subsidiary trusts issuing preferred securities(3) . . . — — — — — 624 Retiree Health Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 115 123 127 128 665 Purchase Commitments Flextronics(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644 — — — — — EDS Contracts(5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 270 132 — — — Other(6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 30 30 — — — Total Contractual Cash Obligations . . . . . . . . . . . . . . . . . . . $2,736 $1,312 $1,578 $962 $1,018 $3,663 (1) Refer to Note 11 – Debt to our Consolidated Financial Statements for interest payments by us as well as for additional information related to long-term debt (amounts above include principal portion only). (2) Refer to Note 6 – Land, Buildings and Equipment, net to our Consolidated Financial Statements for additional information related to minimum operating lease commitments. (3) Refer to Note 12 – Liability to Subsidiary Trusts Issuing Preferred Securities to our Consolidated Financial Statements for interest payments by us as well as for additional information related to liabilities to subsidiary trusts issuing preferred securities (amounts above include principal portion only). (4) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently operating under a one-year automatically renewed agreement which may expire on November 30, 2007, but is subject to automatic renewal for an additional one year period. We expect to enter into a negotiated renewal agreement in 2007 which has a term of at least three years. (5) EDS Contracts: We have an information management contract with Electronic Data Systems Corp. (“EDS”) to provide services to us for global mainframe system processing, application maintenance and support, desktop services and helpdesk support, voice and data network management, and server management through June 30, 2009. There are no minimum payments required under the contract. We can terminate the current contract for convenience with six months notice, as defined in the contract, with no termination fee and with payment to EDS for costs incurred as of the termination date. Should we terminate the contract for convenience, we have an option to purchase the assets placed in service under the EDS contract. (6) Other Purchase Commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts. Other Commercial Commitments and Contingencies Pension and Other Post-Retirement Benefit Plans: applicable regulations in each country. The expected 2007 We sponsor pension and other post-retirement benefit pension contributions do not include contributions to the plans that may require periodic cash contributions. Our domestic tax-qualified plans because these plans currently 2006 cash fundings for these plans were $355 million for exceed the ERISA minimum funding requirements for the pensions and $98 million for other post-retirement plans. plans’ 2006 plan year. However, once the January 1, 2007 Our anticipated cash fundings for 2007 are approximately actuarial valuations and projected results as of the end of $130 million for defined benefit pensions and the 2007 measurement year are available, the desirability approximately $100 million for other post-retirement of additional contributions will be assessed. Based on plans. Cash contribution requirements for our domestic these results, we may voluntarily decide to contribute to tax qualified pension plans are governed by the these plans, even though no contribution is required. In Employment Retirement Income Security Act (“ERISA”) prior years, after making this assessment, we decided to and the Internal Revenue Code. Cash contribution contribute $228 million and $230 million in 2006 and requirements for our international plans are subject to the 2005, respectively, to our domestic tax qualified plans in 47


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    order to make them 100% funded on a current liability tax matters and intend to vigorously defend our position. basis under the ERISA funding rules. In addition, our debt Based on the opinion of legal counsel, we do not believe ratings, which are periodically reviewed by major rating that the ultimate resolution of these matters will agencies, have steadily improved over the past three materially impact our results of operations, financial years. Since the rating on the Company’s senior position or cash flows. The labor matters principally unsecured debt has now reached investment grade, the relate to claims made by former employees and contract Company will have increased flexibility when labor for the equivalent payment of all social security and considering these funding decisions. other related labor benefits, as well as consequential tax Our other post-retirement benefit plans are claims, as if they were regular employees. Following our non-funded and are almost entirely related to domestic assessment of a negative trend in recent settlements and a operations. Cash contributions are made each year to decision to change our legal strategy, we reassessed the cover medical claims costs incurred in that year. The probable estimated loss on these matters and, as a result, amounts reported in the above table as retiree health recorded an additional provision of $68 million in 2006. payments represent our estimated future benefit As of December 31, 2006, the total amounts related to the payments. unreserved portion of the tax and labor contingencies, inclusive of any related interest, amounted to Fuji Xerox: We had product purchases from Fuji approximately $960 million, with the increase from Xerox totaling $1.7 billion, $1.5 billion, and $1.1 billion December 31, 2005 balance of $900 million primarily in 2006, 2005 and 2004, respectively. Our purchase related to indexation, interest and currency partially offset commitments with Fuji Xerox are in the normal course of by the additional provision. In connection with the above business and typically have a lead time of three months. proceedings, customary local regulations may require us We anticipate that we will purchase approximately $1.7 to make escrow cash deposits or post other security of up billion of products from Fuji Xerox in 2007. Related party to half of the total amount in dispute. As of December 31, transactions with Fuji Xerox are discussed in Note 7 – 2006 we had $154 million of escrow cash deposits for Investments in Affiliates, at Equity to the Consolidated matters we are disputing and there are liens on certain Financial Statements. Brazilian assets with a net book value of $18 million and Brazil Tax and Labor Contingencies: At additional letters of credit of approximately $60 million. December 31, 2006, our Brazilian operations were Generally, any escrowed amounts would be refundable involved in various litigation matters and have been the and any liens would be removed to the extent the matters subject of numerous governmental assessments related to are resolved in our favor. We routinely assess all these indirect and other taxes as well as disputes associated matters as to probability of ultimately incurring a liability with former employees and contract labor. The tax against our Brazilian operations and record our best matters, which comprise a significant portion of the total estimate of the ultimate loss in situations where we assess contingencies, principally relate to claims for taxes on the the likelihood of an ultimate loss as probable of internal transfer of inventory, municipal service taxes on occurring. rentals and gross revenue taxes. We are disputing these Off-Balance Sheet Arrangements Although we generally do not utilize off-balance discussed further in Note 4 – Receivables, Net to the sheet arrangements in our operations, we enter into Consolidated Financial Statements, have been accounted operating leases in the normal course of business. The for as secured borrowings with the debt and related assets nature of these lease arrangements is discussed in Note remaining on our balance sheets. Although the obligations 6 – Land, Buildings and Equipment, Net to the related to these transactions are included in our balance Consolidated Financial Statements. Additionally, we sheet, recourse is generally limited to the secured assets utilize special purpose entities (“SPEs”) in conjunction and no other assets of the Company. with certain financing transactions. The SPEs utilized in Refer to Note 16 – Contingencies for further conjunction with these transactions are consolidated in information regarding our guarantees, indemnifications our financial statements in accordance with applicable and warranty liabilities. accounting standards. These transactions, which are 48

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