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    2008 Annual Report


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    “Bottom line: yes, we are feeling the impact of the recession; yes, we are moving aggressively to reduce costs, generate cash and weather the storm; but no, we are neither giving up on 2009 nor mortgaging our future by compromising on investments that will give us momentum as we come out of the economic downturn.” Anne M. Mulcahy Chairman and Chief Executive Officer


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    Financial overview (in millions, except EPS) 2008 2007 Total revenue $ 17,608 $ 17,228 Equipment sales 4,679 4,753 Post sale revenue 12,929 12,475 Net income 230 1,135 Adjusted net income* 985 1,135 Diluted earnings per share 0.26 1.19 Adjusted earnings per share* 1.10 1.19 Net cash provided by operating activities 939 1,871 Adjusted cash from core operations* 1,721 2,083 * 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. 1 10 47 Financial Overview Our Business Financial Statements 2 25 95 Letter to Shareholders Management’s Discussion and Officers Analysis of Financial Condition and 8 96 Results of Operations Board of Directors Shareholder Information Financial overview (in millions, except EPS) Xerox 2008 Annual Report 1


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    Dear fellow shareholders: Typically, we manage changes in currency through pricing, but this currency decline was so swift and so significant that pricing couldn’t catch up. I point this out not as an excuse, but It will come as no surprise to you that Xerox shareholders as an illustration of the roller-coaster nature of this economy. have been negatively impacted by the economic crisis that has ricocheted around the world in recent months. Through three quarters of 2008, we were on the path to another year of solid performance. That trajectory changed dramatically “ The wonderful people I am privileged in the fourth quarter. to lead at Xerox are focused with One example will make the point. Our developing markets passion and grit on those things we organization was on track to deliver another year of double- can control. This attitude and focus digit revenue growth. Through the first three quarters of 2008, revenue was up 17 percent. Starting in mid-November, helped us turn in credible performance the bottom fell out with breathtaking speed, resulting in in a very difficult year.” a fourth-quarter revenue decline of 14 percent in our developing markets. Although we are hardly immune from the recessionary turmoil, we are better positioned than most to navigate through it. Our value proposition is supported by the strength of our “ Although we are hardly immune financial position and the resiliency of our recurring revenue from the recessionary turmoil, we stream that is driven by installs of Xerox technology and are better positioned than most multi-year contracts for Xerox services. More than 70 percent of our revenue and 80 percent of our cash flow is generated to navigate through it.” from our annuity-based business model, making for a solid and reliable asset, especially in tough economies. Last year, Some of the sudden shift was due to a rapid decline in the our annuity delivered $12.9 billion in revenue – up 4 percent Russian and Eastern European economies. But 11 points from 2007 – and helped us generate more than $1.7 billion of the 14-point decline was due to major – some would say in adjusted cash from core operations* – or $1.36 per share in wild – shifts in currency in several developing markets. adjusted free cash flow.* * 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. 2


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    Given our cash flow, healthy cash balance – $1.2 billion at the That’s all looking in the rear-view mirror. I don’t have to be end of 2008 – and a $2 billion credit facility, we remain quite a psychic to know that you have little patience for that – confident in our financial position and have no need to access especially in these turbulent times. Neither do I. I’ve met with the capital markets in the foreseeable future. It’s certainly an many investors in recent months and I keep hearing three advantaged position in this economy. questions asked over and over: Although we are keenly aware that there is much we cannot • What are you doing to confront the recession right now? control, the wonderful people I am privileged to lead at Xerox • What are you doing to make sure you come out of this crisis are focused with passion and grit on those things we can with a full head of steam? control. This attitude and focus helped us turn in credible performance in a very difficult year: • Why should I continue to invest in Xerox? • Total revenue for 2008 was $17.6 billion – that’s an increase Fair enough. Let me answer each of those questions as of $380 million, or 2 percent, over 2007. candidly and succinctly as I can. • Full-year net income was $230 million including a litigation charge. Excluding this and certain other charges, adjusted net income was $985 million.* “ The highly respected Gartner • We generated $939 million of operating cash flow. Adjusted organization lists us as a “Magic cash from core operations for the year was $1.7 billion.* Quadrant” market leader in managed • Through the 5 percent of our revenue invested in innovation, print services, as well as for printers we continued to expand our portfolio of document and multifunction systems.” management technology and services – already the broadest in the industry and in our history. • And we continued to expand distribution, bringing the Xerox Actions to Minimize Impact of the Recession brand to more businesses of any size all around the world. We are doing everything possible to reduce cost – everything The proof points are everywhere. The highly respected Gartner that doesn’t mortgage our future. We took a $349 million organization lists us as a “Magic Quadrant” market leader in restructuring charge in the fourth quarter of 2008 that has managed print services, as well as for printers and multifunction resulted in the elimination of about 3,400 jobs. We expect that systems that print, copy, fax and scan all in one device. Our new the restructuring will deliver $200 million in savings this year. offerings last year garnered some 230 awards from industry groups and media around the world. I could go on, but you get the point. Third parties are validating our progress and our leadership in virtually every aspect of our business. Xerox 2008 Annual Report 3


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    2008 bonuses have been scaled back substantially and people Net income on bonus plans will receive no salary increases this year. (millions) Expenses like training and travel have been significantly cut back. External hiring has to be approved by me personally. 1,210 We’ve accelerated the consolidation of manufacturing 1,135 facilities around the world, stopped the production of 978 985* products made in very low volume, and consolidated 859 operations wherever we can. We’ve realigned our support operations – including human resources, training, finance and marketing – to achieve better synergy at lower cost. We’ve streamlined product development and engineering by 230* combining two product development organizations into one. ’04 ’05 ’06 ’07 ’08 So we are taking a long list of actions aimed at getting our expenses aligned with the realities of faltering economies in just about every corner of the globe. Our investments over Post-sale revenue the years in Lean Six Sigma have given us a set of tools and (included in total revenue – millions) processes that simplify and reduce the cost of managing our global operations. For us, it’s not an event, but a way of life. 12,929 The management team I’m privileged to lead is a seasoned 12,475 11,242 11,438 group that knows all about belt-tightening and is eager to 11,182 deliver the best possible shareholder value that conditions allow. You place a lot of trust in us. It’s something we take very seriously. Emerging with a Full Head of Steam At the same time, we are not mortgaging our future. We are ’04 ’05 ’06 ’07 ’08 continuing to invest for growth and we are continuing to stick to the fundamentals – starting with listening to our customers. One of the things I’m proudest of is the customer-centric culture we’ve developed at Xerox. We have a proven track Color revenue record that demonstrates that our customers increasingly see (included in total revenue – millions) us not as a vendor, but as a partner. 6,669 6,356 5,578 4,928 4,188 ’04 ’05 ’06 ’07 ’08 * 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. 4


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    Net cash from Our combination of document services, affordable and operating activities innovative color technology, and broader distribution to (millions) businesses of any size positions us exceptionally well to attack a $132 billion market. Here’s how: 1,871 1,750 We provide document services that help businesses work 1,617 1,554* faster and smarter with lower costs. Today businesses rely 1,420 on us to help reduce their infrastructure costs by optimizing how they manage their document technology and handle 939 enterprise-wide printing needs. Also core to our document services offerings is our expertise in converting paper to digital and helping customers seamlessly track, edit, share and save ’04 ’05 ’06 ’07 ’08 documents in any form. In a world where 15.2 trillion pages are printed each year and $650 billion in productivity is lost each year due to the Gross margins overload of information, our ability to simplify the way work (percent) gets done helps customers save up to 30 percent on their document management costs. That’s a figure that is getting more and more attention as we speak to our customers these 41.6 41.2 40.6 days, many of whom are looking for ways to contain cost 40.3 38.9 and reduce paper. That may seem counter-intuitive coming from a company known for putting marks on pages, but it’s actually a sweet spot for us, especially in what we call “document-intensive” industries like legal, healthcare, financial services and education. Increasingly we’re partnering with IT services companies ’04 ’05 ’06 ’07 ’08 like CSC and HCL Technologies to integrate our strength in document management with their capabilities in managing enterprise-wide IT systems. And, we are the preferred global imaging partner for IBM Managed Business Process Services, Selling, administrative a unit of IBM Global Technology Services. Under our worldwide and general costs agreement, we’re scanning and imaging millions of (percent of revenue) documents for IBM and their customers. 26.7 We provide affordable color printing systems that cut 26.2 25.7 25.2 25.0 through the clutter with high-impact communications. Xerox continues to benefit from making color printing affordable for businesses of any size. Revenue from color now represents more than 41 percent of our total revenue. ’04 ’05 ’06 ’07 ’08 Xerox 2008 Annual Report 5


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    The billions of pages printed on Xerox color systems grew By acquiring nine office technology dealers in the last two 24 percent last year, and total significantly more than any of years and launching 19 products in 2008 designed for small our competitors. In fact, according to estimates by InfoTrends, and mid-size businesses (SMB), we have significantly increased a leading independent research firm, Xerox’s DocuColor®, our penetration in the SMB marketplace. In fact, the number iGen3® and iGen4™ presses accounted for approximately of installs for our desktop printers and multifunction systems one-half of the total worldwide color pages printed by grew 10 percent last year, largely due to more channels selling high-speed digital systems. the Xerox brand. With the broadest portfolio of color printing systems on the market, we continue to create new business opportunities in production printing through color technology and systems “ Our recurring revenue stream such as the Xerox iGen4™ Press and Xerox 700, both of which represents more than 70 percent launched in 2008. of our total revenue. That gives us This year we’ll shake up the industry even more with the introduction of a color multifunction system that breaks down some cushion in challenging economic the cost barrier of color printing in the office through exclusive times and helps fuel the $1.7 billion solid ink technology, which not only lessens the impact on a in cash that we expect to generate business’ bottom line but also on the environment. this year from core operations.” Bottom line: yes, we are feeling the impact of the recession; “ One of the things I’m proudest of is yes, we are moving aggressively to reduce costs, generate the customer-centric culture we’ve cash and weather the storm; but no, we are neither giving up on 2009 nor mortgaging our future by compromising developed at Xerox. We have a proven on investments that will give us momentum as we come out track record that demonstrates that of the economic downturn. our customers increasingly see us not The Case for Xerox as an Investment as a vendor, but as a partner.” We firmly believe that we will navigate through this set of challenges and emerge stronger than ever. I say that for several reasons. We have more distribution channels to bring Xerox’s We continue to enhance our leadership position in document technology and services to more businesses of any size, technology. Last year, Xerox inventors earned more than anywhere around the world. For decades, we’ve had the 600 U.S. utility patents. We currently hold more than 8,900 largest and best direct sales force in our industry. Currently active patents in the U.S. and, together with our research it’s over 7,500 strong – one of our crown jewels and an asset partner Fuji Xerox, we have received over 55,000 worldwide that gives us a competitive advantage. That’s backed up by patents in our history. Global Imaging Systems, our wholly-owned and growing network of U.S. dealers, as well as an equally impressive Our research leadership yields the best and broadest set of partnership with agents, concessionaires, resellers and more – offerings in our industry. Over the past three years, we have giving Xerox the largest, broadest and most professional launched more than 80 products – including 29 new products distribution network in our industry. last year with about the same number expected this year. 6


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    Our distribution and services capacity is also the best and We are proud of but not content with the competitive broadest in our industry. Through our vast and growing advantage we have created in our industry. We know it’s a network of direct sales, agents, resellers, Global Imaging never-ending battle but it’s one we’re eager to wage. We feel partners and distributors, we do business in over 160 countries. the same way about corporate responsibility. Even in the worst This is a huge competitive advantage, as customers depend of times, we continue to make appropriate investments in on us for global account management and increasingly the communities in which we work and live. We continue to want to move documents around the world with speed, ease be a leader in diversity in all its forms. We continue to fight and security. for a sustainable world and a greener planet. Our strategic bets in the marketplace are paying off in We don’t have our heads in the sand about the challenges areas like color and document services. Color pages now we face, yet we believe we are better positioned than most represent 18 percent of total pages printed on Xerox to meet the obstacles that 2009 will certainly bring our way. technology, up from 12 percent in 2007. We lead the industry There are likely to be winners and losers when the dust finally in the number of color pages printed. In services, we generated settles. We feel confident we will be a winner. $3.5 billion in annuity revenue last year, a year-over-year increase of 3 percent. Our recurring revenue stream represents more than 70 percent of our total revenue. That gives us some cushion Anne M. Mulcahy in challenging economic times and helps fuel the $1.7 billion Chairman and Chief Executive Officer in cash that we expect to generate this year from core operations. Note: Color results exclude Global Imaging Systems performance. Our leadership team is battle-tested and results-driven. Non-GAAP Reconciliation They are an unusual mix of Xerox veterans, new leaders who Adjusted Net Income/EPS Full-year 2008 have recently emerged from the ranks and people who joined (in millions, except per share amounts) Net Income EPS Net Income – As Reported $ 230 0.26 us from other leading companies. They are all driven by one Adjustments: goal – the success of Xerox measured by the value we deliver Q4 2008 Restructuring and asset impairment charges 240 0.27 Q4 2008 Equipment write-off 24 0.03 to our shareholders. Q1 2008 Provision for litigation matters 491 0.54 Net Income – As Adjusted $ 985 1.10 Last but hardly least is the quality and dedication of our workforce. Together with our technology and our distribution, Adjusted Net Cash from Operating Activities/ Cash from Core Operations they provide the knowledge and the passion to bring value to (in millions) Full-year 2008 Full-year 2007 our customers. When I visit customers, it’s our people they Operating Cash – As Reported $ 939 $ 1,871 Payments for securities litigation 615 — want to talk about. Customers sing the praises of Xerox people Operating Cash – As Adjusted $ 1,554 $ 1,871 and want to talk about their focus on solving problems, their Increase (decrease) in finance receivables (164) (119) Increase in equipment on operating leases 331 331 can-do attitude, and their desire to do whatever it takes to get Cash from Core Operations – As Adjusted $ 1,721 $ 2,083 the job done. At the end of the day, Xerox people spell the Adjusted Free Cash Flow/Free Cash Flow Per Share difference between failure and success. (in millions, except per-share data, shares in thousands) Full-year 2008 Operating Cash Flow – As Reported $ 939 So we are feeling good about where we are. There is a fair Payments for securities litigation, net 615 Capital expenditures (206) amount of disruption in our industry – some of it brought on Internal-use software (129) by the economy but much of it brought on by Xerox. Over the Adjusted Free Cash Flow (FCF) $ 1,219 Adjusted Weighted Average Shares Outstanding 895,542 past few years, we have upped the ante considerably on the Adjusted Free Cash Flow Per Share $ 1.36 technology we have brought to market. We have both built and acquired new document services offerings. And we have expanded our distribution. Xerox 2008 Annual Report 7


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    Board of Directors 1. Anne M. Mulcahy 6. Robert A. McDonaldA, B Chairman and Chief Executive Officer Chief Operating Officer Xerox Corporation The Procter & Gamble Company 5 6 7 8 10 Norwalk, CT Cincinnati, OH 4 3 2 1 9 2. Ursula M. Burns 7. Charles PrinceD President Chairman Xerox Corporation Sconset Group Norwalk, CT Vice Chairman and A: Member of the Audit Committee B: Member of the Compensation Committee Chairman of the Board of Advisors 3. Glenn A. BrittA, B C: Member of the Corporate Governance Committee Stonebridge International LLC D: Member of the Finance Committee President and Chief Executive Officer Retired Chairman and Time Warner Cable Chief Executive Officer Stamford, CT Citigroup Inc. 4. Ann N. ReeseC, D New York, NY Executive Director 8. Mary Agnes WilderotterD Center for Adoption Policy Chairman and Chief Executive Officer Rye, NY Frontier Communications Corporation 5. Vernon E. Jordan, Jr.**B, C Stamford, CT Senior Managing Director 9. N. J. Nicholas, Jr.B, D Lazard Frères & Co., LLC Investor New York, NY New York, NY Of Counsel, Akin, Gump, Strauss, Hauer & Feld, LLP 10. William Curt HunterA, C Washington, DC Dean, Tippie College of Business University of Iowa Iowa City, IA Richard J. Harrington*A Retired President and Chief Executive Officer The Thomson Corporation Stamford, CT * Not pictured ** Mr. Jordan is not standing for reelection at the 2009 Annual Meeting of Shareholders 8


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    10 49 91 Our Business Consolidated Statements of Cash Flows Report of Independent Registered Public Accounting Firm 25 50 Management’s Discussion and Analysis Consolidated Statements of 92 of Financial Condition and Results of Shareholders’ Equity Quarterly Results of Operations Operations (Unaudited) 51 47 Notes to the Consolidated 93 Consolidated Statements of Income Financial Statements Five Years in Review 48 90 96 Consolidated Balance Sheets Reports of Management Shareholder Information Xerox 2008 Annual Report 9


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    Our Business We are a $17.6 billion technology and services enterprise and a leader in the global document market. We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions and services. Overview References in this section to “we,” “us,” “our,” the “Company” and solutions with which businesses can easily and affordably print “Xerox” refer to Xerox Corporation and its subsidiaries unless the books, create personalized documents for their customers, and context specifically states or implies otherwise. scan and route digital information. Our services expertise is unmatched and includes helping businesses develop online We provide the document industry’s broadest portfolio of document archives, analyzing how employees can most efficiently document systems and services for businesses of any size. Digital share documents and knowledge in the office, operating in-house systems include high-end printing and publishing systems; digital print shops or mailrooms, and building Web-based processes for presses, advanced and basic multifunctional devices (“MFD’s”) personalizing direct mail, invoices, brochures and more. We also which can print, copy, scan and fax; digital copiers; laser and solid offer software, support and supplies, such as toner, paper and ink. ink printers and fax machines. We provide software and workflow We serve a $132 billion market (in billions) � $25 Production Production $25 We are the leading provider in the market that offers a complete family of monochrome and color production systems, business development tools and workflow solutions. We are creating new market opportunities in targeted application areas with digital printing as a complement to Services traditional offset printing. $26 � $26 Services Our value-added services deliver solutions, which not only optimize enterprise output spend and infrastructure, but also streamline, simplify and digitize our customers’ document-intensive business processes. � $81 Office Office We are well positioned to capture growth by leading the transition to color and by reaching new $81 customers with our broad offerings and expanded distribution channels. This estimate, and the market estimates that follow, are calculated by leveraging third-party forecasts from firms such as International Data Corporation and InfoSource in conjunction with our assumptions about our markets. The document industry is transitioning to digital systems, to color, these trends play to the strengths of our product and service and to an increased reliance on electronic documents. More and offerings and represent opportunities for future growth in the $132 more, businesses are creating and storing documents digitally and billion market we serve. using the Internet to exchange electronic documents. We believe 10 Xerox 2008 Annual Report


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    Our Strategy Execute Expand Secure Future Optimize on Growth Distribution Technology Productivity Initiatives Leadership and Infrastructure We are well-positioned to lead in this large and growing market through: Executing on Growth Initiatives – We are driving the New Business of Printing opportunity by identifying applications which are suitable for digital • Accelerating the transition to color – We have the broadest production. color portfolio in the industry and leading technologies. – Our leading business development tools, workflow and digital – Color is the fastest growing portion of our market and technology, led by our market-making Xerox iGen® estimated at $44 billion. technology, uniquely positions us to meet the increasing demand for short-run, customized and quick-turnaround – Economic cost and quality improvements are driving the offset quality printing. transition from black-and-white to color. Expanding our Distribution Channels – We continue to capture growth opportunities within the • We continue to expand our presence in the small and mid-size black-and-white segment of our core markets, which we business (“SMB”) market through the acquisition of Veenman estimate is a $62 billion market. B.V. in the European market, as well as additional acquisitions made by Global Imaging Systems, Inc. in the U.S. markets. • Building on services leadership – We lead the industry with end-to-end Document Management Services and we participate • We are maintaining our investments in Developing Markets, a in three areas of the outsourcing services market: high-growth market opportunity. – Infrastructure Outsourcing, where we help our customers to • We are capitalizing on our Graphic Arts coverage investments to reduce their enterprise spend through differentiated capture the opportunity associated with the New Business of technology, skills and automation. Printing. Securing Future Technology Leadership – Application Outsourcing, where we help our customers to streamline their document intensive business processes • Through advancing our heritage of innovation, we are yielding a through automation and deployment of software broad technology portfolio. applications and tools. • We are capitalizing on breakthrough ink technologies such as Solid Ink and Cured Gel Ink. – Business Process Outsourcing, where our customers leverage our global delivery capability and proprietary • Expanding our Document Management Technologies that production imaging software to manage both high volume optimize the capabilities of our products and streamline standardized activities as well as lower volume complex customers’ processes. workflows. Optimizing Productivity and Infrastructure • Driving the New Business of Printing® – We continue to • We are improving the efficiency and effectiveness of our create new market opportunities with digital printing as a infrastructure and complement to traditional offset printing through a market transition we call the “New Business of Printing”. • Optimizing our resources to support innovation and growth. Xerox 2008 Annual Report 11


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    Our Business Our Business Model Fundamentals Annuity Cash Expanded Model Generation Earnings One fundamental of our business model is our annuity model. Post was post sale revenue that includes equipment maintenance and sale revenue growth is driven by increasing equipment installation consumable supplies, among other elements. We sell the majority which increases the number of page-producing machines in the of our equipment through sales-type leases that we record as field (“MIF”) and by expanding the document management equipment sale revenue. Equipment sales represented 27% of our services we offer our customers. 73% of our 2008 total revenue 2008 total revenue. Revenue stream 27% � 73% Approximately 73% of our revenue, “post sale” includes annuity-based revenue from maintenance, services, supplies and financing, as well as revenue from rentals and operating lease arrangements. � 27% The remaining 27% of our revenue comes from equipment 73% sales, from either lease arrangements that qualify as sales for accounting purposes or outright cash sales. The number of equipment installations and the growth in Our consistent cash flow from operations is driven by recurring document management services are key indicators of post sale revenues; this, along with modest capital investments, enables us revenue trends. The mix of color pages is also a significant to provide a return to shareholders through: indicator of post sale revenue trends because color pages use more • Expanding our distribution through acquisitions; consumables per page than black-and-white. In addition, expanding our market, particularly within the New Business of • Buying back shares under our share repurchase program and Printing, is key to increasing pages and we have developed tools • Maintaining our quarterly dividend. and resources to be the leader in this large market opportunity. We anticipate expanding our future earnings through: • Modest revenue growth; • Driving cost efficiencies to balance gross profit and expense; • Leveraging our share repurchase and • Making accretive acquisitions. 12 Xerox 2008 Annual Report


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    Acquisitions Segment Information To further strengthen our distribution capacity, in 2008 we Our reportable segments are Production, Office and Other. We completed several acquisitions. present operating segment financial information in Note 2 – Segment Reporting in the Consolidated Financial Statements, We acquired Veenman B.V. (“Veenman”), expanding our reach into which we incorporate by reference here. We have a very broad and the small and mid-size business market in the Netherlands. diverse base of customers by both geography and industry, Veenman is the Netherlands’ leading independent distributor of ranging from SMB to graphic communications companies, office printers, copiers and multifunction devices serving small and governmental entities, educational institutions and large fortune mid-size businesses. 1000 corporate accounts. None of our business segments depends Global Imaging Systems, Inc. (“GIS”) acquired Saxon Business upon a single customer, or a few customers, the loss of which Systems, an office equipment supplier with offices throughout would have a material adverse effect on our business. Florida and three smaller acquisitions: Better Quality Business Systems, Precision Copier Service Inc. DBA Sierra Office Solutions and Inland Business Systems of Chico. Revenues by business segment (in millions) $2,543 � $9,828 Office Our Office segment serves global, national and small to mid- size commercial customers, as well as government, education and other public sector customers. � $5,237 Production Our Production segment provides high-end digital monochrome and color systems designed for customers in the $5,237 $9,828 graphic communications industry and for large enterprises. � $2,543 Other Our Other segment primarily includes revenue from paper sales, wide-format systems, value-added services and Global Imaging Systems network integration solutions and electronic presentation systems. Xerox 2008 Annual Report 13


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    Our Business Production In 2008, we continued to build on our unmatched product breadth, world class market and business development tools and integrated We provide high-end digital monochrome and color systems end-to-end applications. Below are some of the key designed for customers in the graphic communications industry accomplishments that enabled us to achieve our goals: and for large enterprises. These high-end devices enable digital on-demand printing, digital full-color printing and enterprise printing. We are the only manufacturer in the market that offers a Our 2008 Production Accomplishments complete family of cut sheet monochrome production systems Right Business Model from 65 to 288 pages per minute (“ppm”), color production Our commitment to our customers starts before technology is systems from 40 to 110 ppm and a complete line of continuous discussed and extends long after a solution is installed. It includes feed printers from 250 to 1,064 ppm. In addition, we offer a sharing with them resources, strategies and tools that will help variety of pre-press and post-press options and the industry’s them grow their businesses with digital printing. broadest set of workflow software. • ProfitAccelerator®: This robust set of tools and programs With our Freeflow® digital workflow collection of software designed to maximize our customers’ investment in digital technology solutions, our customers can improve all aspects of printing equipment expanded in 2008 and now includes more their processes, from content creation and management to than 80 tools. It brings together Xerox’s unparalleled experience production and fulfillment. Our digital technology, combined with and expertise, world-class resources and industry-leading total document solutions and services that enable personalization support. Some of the newest additions include a “Value-Based and printing on demand, delivers value that improves our Pricing Guide,” the “Picture Me Profitable Kit” to assist customers customers’ business results. in pursuing the personalized photo products opportunity, and the “ProfitQuick® Investment Planner” financial modeling tool 2008 Production Goals that will help customers increase productivity and achieve cost Our 2008 goals for the Production segment were to continue to and efficiency savings. strengthen our leadership position in monochrome and color and to build on the power of digital printing. Our New Business of • New Business of Printing Services: Business Development Printing strategy complements the traditional offset market and Services was created in direct response to customer demand and continues to transform our industry. We are enabling print provides both training and professional services to help print providers in graphic communications and large enterprises to profit providers increase page volume and revenue. Service offerings and grow by meeting their customers’ specific business needs with are available to support Sales & Marketing, Workflow and just-in-time, one-to-one and e-based services – rather than simply Application Development efforts, and are delivered at the manufacturing a printed piece. Having the right business modelSM, customers’ location or via the web. These offerings include the right workflowSM and the right technologySM are fundamental creating marketing and sales management plans, sales force to this transformation. training, designing for digital, color management, implementing direct mail/marketing campaigns, Transpromo applications and We continued our application-focused approach to assist our more. The offerings are deployed by a dedicated team of Xerox customers in implementing solutions in four major categories. This business development consultants and industry experts. approach provided our customers end-to-end applications for Collaterals by Request, Books, Transactional/Promotional and Right Workflow Direct Mail. We lead the digital production workflow market by helping customers become more profitable – reducing costs, streamlining During the 2008 drupa tradeshow that is held every four years, we operations and enabling new applications. Our FreeFlow Digital announced 12 new offerings and 50 applications; building on our Workflow Collection makes it easy for customers to complement heritage of innovation and our in-depth understanding of both the traditional offset printing through the integration of digital printing industry and customer requirements. printing into existing environments for efficient hybrid print We continued to increase installations of our flagship Digital Color manufacturing. In 2008 we enhanced our collection to include: Production Presses. We are the industry leader in the number of pages produced on digital production color presses, with our • Xerox FreeFlow Process Manager®: Software that provides flagship Xerox iGen4® Digital Production Press, iGen3® Digital automated, “touchless” file preparation and decision making to Production Press and DocuColor® Digital Presses. Over 325 automate prepress and eliminate manual production steps. customers have installed two or more iGen presses to meet their increased demand. 14 Xerox 2008 Annual Report


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    • Xerox FreeFlow Variable Information Suite: Software that • Xerox DocuColor 5000AP: In July we launched a 50 ppm full- delivers the maximum productivity for personalized and color production system which provides excellent print customized documents including the award winning specialty resolution, color reproduction and reliability for a wide range of effects that help print providers minimize document security application and weights, all at rated speed. concerns. These effects include MicroText marks, Correlation • Automated Color Quality Suite: In May, we introduced the Marks, Glossmark®, FlorescentMark, and InfraRed text. Automated Color Quality Suite (“ACQS”) Press Matching System • FreeFlow Print Server: A powerful print server that delivers for our flagship Xerox iGen3 90 and 110 Digital Production superior performance, advanced workflow interoperability, Presses, offering high performance plus quality that match state-of-the-art color management, and a common workflow for offset printing. The new ACQS enables faster press set up, Xerox production printers. quicker time to production, greater color stability and automated Pantone color matching. In November, we launched • FreeFlow Express to Print: A simple prepress automation tool this offering on the Xerox 8000AP and 7000AP, bringing these designed specifically for the light and mid production new quality capabilities to these Digital Color Presses. environments. Easily add tabs, covers, inserts, barcodes, page numbers and more and see changes through the robust visual • Xerox 490/980 Color Continuous Feed Printing System: We interface. Simple automation is provided with over 50 pre-built launched the world’s fastest toner based full color roll fed printer templates that make Express to Print easy to use and easy to that produces up to 986 full color duplex images per minute in install on a computer. May for Europe and part of developing markets and in November for North America and the rest of developing markets. With its Right Technology Flash Fusing Technology, this system is ideal for the For more than two decades, we have delivered innovative Transactional/Promotional and Direct Mail market segments that technologies that have revolutionized the production printing require high speed, high volume variable data printing. industry. In 2008 we continued to bring innovative products to the markets that included: • Xerox 650/1300 Continuous Feed Printing System: In February, this new monochrome continuous feed printer was • Xerox iGen4 Digital Production Press: We unveiled in May at made available worldwide. This monochrome roll feed printer drupa the new iGen4, the industry’s most productive and highest also leverages flash fusing technology to print a wide variety of quality cut sheet digital press. The iGen4 features advanced substrates up to 1300 images per minute. This system supports color management that allows print providers to consistently numerous applications within the transactional/promotional and achieve and maintain offset and photo image quality. With new direct mail segments and is ideal for books and manuals. patented technologies, the iGen4 automates many operator tasks for greater uptime. With productivity gains of 25-35 • Xerox Nuvera® 288 Digital Perfecting System: In October, percent, the iGen4 increases the run-length to be break-even the fastest cut sheet monochrome duplex printer in the market with offset for greater press utilization and capacity. For expanded its sheet feed capability up to 12.6” x 19.3” and added commercial printers, photo finishers, book printers, direct mail a new Roll Feed DocuConverter with Grain Rotation supporting a houses and digital service providers, the iGen4 delivers a more host of new applications. This system, with its benchmark image efficient and cost-effective way to produce more pages and quality, flexibility of substrates and reliability, enables achieve greater profits. applications such as book publishing. • Xerox 700 Digital Color Press: We expanded our full color • Xerox Nuvera 100/120/144 EA Digital Production Systems: offerings with the launch of the Xerox 700 Digital Color Press at With its Emulsion Aggregate (“EA”) toner for greater reliability drupa in May. The Xerox 700 at 70 ppm offers enhanced color and image quality, the Nuvera EA family expanded its portfolio reproduction capabilities as well as an exceptional matte finish of finishing alternatives. In October we announced the that is winning over customers worldwide. A wide range of availability of Xerox Tape Bind, CEM DocuConverter and C.P. feeding and finishing options at an entry level price enables Bourg/Watkiss Power Square 200® Booklet Maker. This modular, print providers to adopt digital technology or expand their scalable print engine also expands digital printing applications digital printing business. due to its high quality and flexibility of substrates. Xerox 2008 Annual Report 15


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    Our Business Office • Phaser 3635 MFP: Launched in May, the Phaser 3635MFP is a 35 ppm printer that provides advanced security options such as Xerox develops and manufactures a range of color and image overwriting, encryption and authentication. This product black-and-white multifunction, printer, copier and fax products. Our is designed for small and mid-size business workgroups, and Office segment serves global, national and small to mid-size offers features like a color touchscreen user interface and robust commercial customers as well as government, education and other scanning features to promote ease-of-use and productivity. public sector customers. Office systems and services, which include monochrome devices at speeds up to 95 ppm and color devices up • Phaser 5550: Launched in May, this 50 ppm printer offers to 70 ppm, include our family of CopyCentre®, WorkCentre® and tabloid and letter/legal printing, as well as advanced software WorkCentre Pro digital multifunction systems, Phaser® desktop features like PhaserSMART®. PhaserSMART is an online printers and MFD’s as well as DocuColor printer/copiers for the troubleshooting tool that helps diagnose and solve potential specific needs of graphic intensive organizations and facsimile issues, prevent maintenance calls and increase reliability. This products. product also offers duplex printing and optional additional paper handling features. We offer a complete range of services and solutions in partnership with independent software vendors that allow our customers to • WorkCentre 5016/5020: In May, Xerox introduced its first analyze, streamline, automate, secure and track their digital sub-$1,000 A3/tabloid MFD family in developing markets. The workflows, which we then use to identify the most efficient, 16/20 ppm family offers basic copying, printing and scanning productive mix of office equipment and software for that business, capabilities for small workgroups that are price sensitive. helping to reduce the customer’s document-related costs. • WorkCentre 5222/5225/5230: In May, we introduced a new 25/30 ppm monochrome platform designed to help SMB and 2008 Office Goals enterprise workgroups increase productivity on an entry-level Our 2008 Office goals were to drive to a leadership position in color device with high-end features such as our Extensible Interface to extend our market reach, particularly in the SMB market and Platform, full-system common criteria certification, and booklet continue to expand our Office Services and Solutions business. We making capabilities. In September, the 5200 series was broadened our product line and complemented our industry- expanded with the addition of a 22 ppm configuration as well as leading product offerings with expanded distribution in order to color scanning capability on the Workcentre 5225A/5230A increase our machines-in-field (“MIF”) and capture more pages, configurations. building the foundation for future post sale revenue growth. • WorkCentre 5600 Series: We refreshed the 5600 series We continued to drive color in our Office segment by significantly monochrome platform with updated controller software to keep enhancing our already strong color product portfolio, making color pace with today’s ever changing IT standards and more affordable, easier to use, faster and more reliable while protocols. With support for IPv6 and compatibility with maintaining our leadership position in black-and-white. The Microsoft’s Web Services on Devices, the WorkCentre 5600 breadth of our product portfolio is unmatched. Our color-capable series – with speeds ranging from 32 ppm to 87 ppm – becomes laser devices provide an attractive color entry point, our patented even more powerful for IT professionals. solid ink technology offers unmatched ease of use, vibrant color • WorkCentre Bookmark 40/55 Multifunction Copier/Printer: A image quality and economic color run costs, and our top of the line robust book copier at its core, it is the ideal solution for libraries, color laser products provide superior image quality coupled with universities, and other public vending environments. It features industry-leading productivity and reliability. Below are some of the an angled side panel support that protects books’ spines while key accomplishments that enabled us to achieve our goals: copying, and offers solid durability, ease-of-use and powerful solutions for streamlining unique workflows. 2008 Office Accomplishments • WorkCentre 7346 Multifunction Printer & EFI Workflows: In • Phaser 6125: In February, we announced the Phaser 6125, a 12 May we introduced a high-end version of the WorkCentre 7300 ppm color, 16 ppm black-and-white printer. This product is an series system featuring fast print speeds of up to 40 ppm in color extension of the Phaser 6130 line, and offers a small footprint, and 45 ppm in black-and-white for busy workgroups. The strong processing capability and Emulsion Aggregate High WorkCentre 7300 series was also enhanced with optional EFI Quality (“EA-HQ”) toner technology for clear, crisp printing. workflow capabilities. 16 Xerox 2008 Annual Report


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    • Xerox 700 Digital Color Press: Launched in May, this light An increasingly important part of our offering is value-added production color device with an embedded controller brings services, which utilizes our document industry knowledge and productivity, excellent print quality and flexibility to those experience. Our value-added services deliver solutions that looking to adopt digital technology or expand their digital optimize our customers’ document output and infrastructure costs capabilities. while streamlining, simplifying, and digitizing their document- intensive business processes. Through Xerox’s imaging centers, a • WorkCentre 4260: Launched in September, the WC 4260 is company can scan and digitize documents to create secure, Xerox’s fastest desktop multifunction system with speeds up to accessible and searchable online information archives, such as a 55 ppm. It offers workflow tools such as ID Copy Card, Fax library of car-rental contracts or construction blueprints. Often our Forward to Email, automatic two sided printing and competitive value-added services solutions lead to larger managed services security features. This product is designed to promote contracts which include our equipment, supplies, service, and labor. productivity in small and medium business workgroups. We report revenue from managed services contracts in the Production or Office segments. In 2008, the combined value- • Phaser 3300 MFP: Launched in September, the Phaser 3300 added services and managed services revenue, including MFP offers print/copy speeds up to 30 ppm and offers equipment, totaled $3.8 billion. automatic two-sided printing. This product offers color scanning to USB, email or the network. It is equipped with Xerox Scan to In our wide-format systems business, we offer document PC Desktop® which allows users to send a document from the processing products and devices designed to reproduce large MFP to their desktop for viewing, editing or storing. engineering and architectural drawings up to three feet by four feet in size. In 2008 we launched: Other • Xerox 8254E and 8264E Wide Format Printers: Introduced in The Other segment primarily includes revenue from paper sales, June, further enables customers to print robust, colorful large value-added services, wide-format systems and GIS network format graphic applications on a broad range of substrates integration solutions and electronic presentation systems. quickly and easily. We sell cut-sheet paper to our customers for use in their document • Xerox 6279 Wide Format Printer: This printer continues our processing products. The market for cut-sheet paper is highly successful tradition in the CAD environment with its unsurpassed competitive and revenues are significantly affected by pricing. Our ease of operation and benchmark image quality. strategy is to charge a premium over mill wholesale prices, which is adequate to cover our costs and the value we add as a distributor, as well as to provide unique products that enhance the New Business of Printing and color output. Xerox 2008 Annual Report 17


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    Our Business Revenue inception, that is, a sales-type lease. We allocate the remaining portion of the monthly minimum payments to the various elements We sell the majority of our products and services under bundled of the lease based on fair value – service, maintenance, supplies and lease arrangements, in which our customers pay a monthly amount financing – that we generally recognize over the term of the lease for the equipment, maintenance, services, supplies and financing agreement, and that we report as “post sale revenue”. In those over the course of the lease agreement. These arrangements are arrangements that do not qualify as sales-type leases, which have beneficial to our customers and to us since, in addition to increased as a result of our services-led strategy, we recognize customers receiving a bundled offering, these arrangements allow revenue over the term of the lease agreement, whether rental or us to maintain the customer relationship for future sales of operating lease, and report it in “post sale revenue.” Our accounting equipment and services. policies for revenue recognition for leases and bundled We analyze these arrangements to determine whether the arrangements are included in Note 1 – Summary of Significant equipment component meets certain accounting requirements such Accounting Policies in the Consolidated Financial Statements in our that the equipment fair value should be recorded as a sale at lease 2008 Annual Report. Revenues by geography (in millions) $2,475 � $9,122 U.S. � $6,011 Europe � $2,475 Other Areas Revenues by geography based on the location of the unit reporting the revenue and includes exports sales. About 50% of our revenue $6,011 $9,122 is generated from customers outside the U.S. 18 Xerox 2008 Annual Report


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    Research and Development Our R&D is strategically coordinated with Fuji Xerox, which invested $788 million in R&D in 2008, $672 million in 2007 and $660 million in 2006. Investment in R&D is critical for competitiveness in our fast-paced Our R&D drives innovation and customer value by: markets where more than two-thirds of our equipment sales are • Creating new differentiated products and services; from products launched during the past two years. Research activities are conducted in the United States, Canada and Europe – • Enabling cost competitiveness through disruptive products and often in collaboration with Fuji Xerox Co., Ltd. (“Fuji Xerox”). services; • Enabling new ways to serve customers and • Creating new business opportunities that drive future growth and reach new customers. R,D&E expenses (in millions) $884 $912 $922 R&D $134 $148 $161 Sustaining Engineering $750 $764 $761 ’08 ’07 ’06 To ensure our success, we have aligned our R&D investment indistinguishable from offset, the Xerox Nuvera 288 Digital portfolio with our growth initiatives of accelerating the transition Perfecting System which boasts the fastest (288 duplex to color, enhancing customer value by building on our services impressions per minute) digital duplex monochrome cut-sheet leadership and by driving the New Business of Printing . 2008 R&D printer in the industry, and Xerox’s proprietary Solid Ink technology spending focused primarily on the development of high-end for the office are examples of the type of breakthrough technology business applications to drive the New Business of Printing, we have developed and that we expect will drive future growth. extending our color capabilities, expanding our services offerings Sustaining engineering expenses, which are the hardware and delivering lower-cost platforms and customer productivity engineering and software development costs we incur after we enablers. The Xerox iGen family, advanced next-generation digital launch a product, are included in our R,D&E expenses. printing presses that produce photographic-quality prints Xerox 2008 Annual Report 19


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    Our Business Patents, Trademarks and Licenses 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 We are a technology company. Including our Xerox Palo Alto others, in return for revenue and/or access to their patents. Most Research Center (“PARC”) and XMPie subsidiaries, we were patent licenses expire concurrently with the expiration of the last awarded 609 U.S. utility patents in 2008. We were ranked 31st on patent identified in the license. In 2008, we added 11 agreements the list of companies that were awarded the most U.S. patents to our portfolio of patent licensing agreements, and either we or during the year and would have been ranked about 27th with the PARC was a licensor in all 11 of the agreements. We are also a inclusion of PARC and XMPie patents. Including our research party to a number of cross-licensing agreements with companies partner Fuji Xerox Co., Ltd (“Fuji Xerox”), we were awarded over 940 that hold substantial patent portfolios, including Canon, Microsoft, U.S. utility patents in 2008. Our patent portfolio evolves as new IBM, Hewlett Packard, Océ, Sharp, Samsung and Seiko Epson. patents are awarded to us and as older patents expire. As of These agreements vary in subject matter, scope, compensation, December 31, 2008, we held approximately 8,900 design and significance and time. utility U.S. patents. These patents expire at various dates up to 20 years or more from their original filing dates. While we believe that In the U.S., we own approximately 570 trademarks, either our portfolio of patents and applications has value, in general no registered or applied for. These trademarks have a perpetual life, single patent is essential to our business or any individual segment. subject to renewal every ten years. We vigorously enforce and In addition, any of our proprietary rights could be challenged, protect our trademarks. invalidated, or circumvented or may not provide significant competitive advantages. Our brand is a valuable resource and continues to be ranked among the top percentile of the most valuable global brands. Competition a network of independent agents, dealers, value-added resellers, systems integrators and the Web. In the U.S. GIS continues to Although we encounter aggressive competition in all areas of our expand its network of office technology suppliers to serve an ever- business, we are the leader or among the leaders in each of our expanding base of small and mid-size businesses. We utilize our principal business segments. Our competitors range from large direct sales force to address our customers’ more advanced international companies to relatively small firms. We compete on technology, solutions and services requirements, and use cost- the basis of technology, performance, price, quality, reliability, effective indirect distribution channels for basic product offerings. brand, distribution and customer service and support. To remain competitive we invest in and develop new products and services In large enterprises, we follow a services-led approach that enables and continually improve our existing offerings. Our key competitors us to address two basic challenges facing large enterprises: include Canon, Ricoh, Hewlett-Packard, and, in certain areas of the • How to optimize infrastructure to be both cost effective and business, Pitney Bowes, Kodak, Océ, Konica-Minolta and Lexmark. globally consistent. We believe that our brand recognition, reputation for document • How to improve the value proposition and communication with knowledge and expertise, innovative technology, breadth of their customers. product offerings, global distribution channels, customer In response to these needs, we offer a go-to-market approach that relationships and large customer base are important competitive leads with the largest direct sales and service delivery force in the advantages. We and our competitors continue to develop and industry available on a globally consistent manner. This can range market new and innovative products at competitive prices, and, at from hardware, software or services in whatever combination is any given time, we may set new market standards for quality, necessary to meet the needs of that customer. speed and function. We market our Phaser line of color and monochrome laser-class and solid ink printers primarily through office information Marketing and Distribution technology resellers, who typically access our products through We manage our business based on the principal business segments distributors. We continue to expand our distribution partnerships in described earlier. However, we have organized the marketing, selling North America through additional information technology resellers and distribution of our products and solutions according to and by enhancing our network of independent agents. We also geography and channel type. We sell our products and solutions continued to increase product offerings available through a directly to customers through our worldwide sales force and through two-tiered distribution model in Europe and developing markets. 20 Xerox 2008 Annual Report


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    We operate in over 160 countries worldwide. We develop, manufacture, market and support document management systems, supplies and services through a variety of distribution channels around the world. � North American Operations � Developing Markets North American Operations includes the United States and Developing Markets supports more than 130 countries. Canada. � Fuji Xerox � Xerox Europe Fuji Xerox, an unconsolidated entity of which we own 25%, Xerox Europe covers 17 countries across Europe. develops, manufactures and distributes document management systems, supplies and services. Our reselling relationship with key partners contributed to our which streamline our customers’ workflows enabling them to market coverage expansion and new business penetration. reduce costs, improve operational efficiencies and drive new Through our global reseller alliance with Fujifilm, we distribute our business opportunities. production products and solutions to graphic communications In Europe, Africa, the Middle East, India, and parts of Asia, we customers as well as photo specialty markets spanning Retail, distribute our products through Xerox Limited, a company Professional Lab and Processing Center businesses. In 2008, we established under the laws of England, and related non-U.S. signed additional country-level contracts with Fujifilm Graphics companies which we refer to collectively as Xerox Limited. Xerox Systems in Europe and developing markets to extend Xerox digital Limited enters into distribution agreements with unaffiliated third production systems reach to new commercial print customers and parties to provide distribution of our products in many of the prospects. We continue to use our alliances to integrate “best in countries located in these regions, and previously entered into class” information technologies and services to deliver improved agreements with unaffiliated third parties providing distribution of workflow and document output management enabling our our products in Iran, Sudan, and Syria. Iran, Sudan and Syria, customers to accelerate profitable revenue growth in their among others, have been designated as state sponsors of terrorism businesses. Through the world-class Xerox Business Partner by the U.S. Department of State and are subject to U.S. economic Program we are able to deliver an extensive portfolio of products Xerox 2008 Annual Report 21


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    Our Business sanctions. We maintain an export and sanctions compliance Customer Financing program and believe that we have been and are in compliance with U.S. laws and government regulations for these countries. In We finance a large portion of customer purchases of Xerox addition, we have no assets, liabilities, or operations in these equipment through our bundled lease arrangements. We believe countries other than liabilities under the distribution agreements. that financing facilitates customer acquisition of Xerox technology After observing required prior notice periods, Xerox Limited and enhances our value proposition to the customer while terminated its distribution agreements with distributors servicing providing Xerox a profitable revenue stream and a strong return on Sudan and Syria in August 2006 and terminated its distribution equity. agreement with the distributor servicing Iran in December 2006. As a result of our customer financing program, we benefit by Now, Xerox only has legacy obligations to third parties such as gaining in-depth knowledge of the products being leased and a providing spare parts and supplies to these third parties. In 2008, deep understanding of the customer base and their use of our we had total revenues of $17.6 billion, of which approximately $7.4 technology. This knowledge allows us to effectively manage the million was attributable to Iran and less than $0.2 million in total credit and residual value risk normally associated with financing. was attributable to Sudan and Syria. Our financing risk is further mitigated because the majority of our In January 2006, Xerox Limited entered into a five-year distribution lease contracts are non-cancelable and include cancellation agreement with an unaffiliated third party covering distribution of penalties approximately equal to the full value of the lease our products in Libya. Libya is also designated as a state sponsor of receivables. terrorism by the U.S. Department of State. The decision to enter Because our lease contracts permit customers to pay for into this distribution agreement was made in light of recent U.S. equipment over time rather than at the date of installation, we federal government actions that have lifted the countrywide maintain a certain level of debt to support our investment in these embargo previously imposed on Libya. Our sales in Libya through lease contracts. We fund our customer financing activity through a this distribution agreement will be subject to our export and combination of cash generated from operations, cash on hand, sanctions compliance program and will be conducted according to borrowings under bank credit facilities and proceeds from capital the U.S. laws and government regulations that relate to Libya. market offerings. At December 31, 2008 we had $7.3 billion of Globally, we have 57,100 direct employees. We have over 7,500 Sales Professionals, over 13,000 Managed Service Employees at customer sites and over 13,000 Technical Service Employees. In addition, we have over 6,500 Agents and Concessionaires and over 10,000 resellers. 22 Xerox 2008 Annual Report


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    finance receivables and $0.6 billion of equipment on operating We are currently in the second year of a master supply agreement leases, or Total Finance assets of $7.9 billion. We maintain an with Flextronics, a global electronics manufacturing services assumed 7:1 leverage ratio of debt to equity as compared to our company, to outsource portions of manufacturing for our Office Finance assets and therefore a significant portion of our $8.4 segment. The agreement has a three year term, with two billion of debt is associated with our financing business. additional one-year extension periods at our option. Our inventory purchases from Flextronics currently represent approximately 15% In addition to being an excellent customer retention vehicle, our of our overall worldwide inventory procurement and production. customer financing program also achieves an attractive gross Our pricing for inventory sourced through Flextronics is generally margin which provides us a reasonable return on our investment in market based. We have agreed to purchase from Flextronics some this business. This program is also a strong value proposition for products and consumables within specified product families our customers because it provides them a bundled monthly although we do have the ability to source product from other payment for their document management needs and an attractive suppliers without penalty to extent needed. Flextronics is required financing alternative. to acquire inventory based on our forecasted requirements and must maintain sufficient manufacturing capacity to satisfy these Service requirements. Under certain circumstances, we may become As of December 31, 2008, we had a worldwide service force of obligated to purchase inventory that remains unused for more approximately 13,000 employees and an extensive variable than 180 days, becomes obsolete or remains unused on the contract service force. We continue to expand our use of cost- termination of the supply agreement. If Flextronics were unable to effective remote service technology for basic product offerings continue to supply product, it would not result in a material while utilizing our direct service force and a variable contract disruption to our business because Flextronics primarily provides service force to address customers’ more advanced technology contract assembly labor and we continue to manage the inbound requirements. The increasing use of a variable contract service sourcing and supply chain management of raw materials and force is consistent with our strategy to reduce service costs while sub-assembly parts. In addition, we own the tooling and maintaining high-quality levels of service. We believe that our technology that Flextronics currently uses to produce our products; service force represents a significant competitive advantage there are a number of alternative suppliers that could replace the because it is continually trained on our products and its diagnostic contract assembly labor Flextronics provides and we have business equipment is state-of-the-art. We offer service 24 hours a day, resumption plans in place for Flextronics and other similar 7 days a week, in major metropolitan areas around the world, suppliers. providing a consistent and superior level of service worldwide. We acquire other office products from various third parties in order to increase the breadth of our product portfolio and meet channel Manufacturing and Supply requirements. We have arrangements with Fuji Xerox under which we purchase and sell products, some of which are the result of Our manufacturing and distribution facilities are located around mutual research and development arrangements. Refer to Note 7 – the world. The company’s largest manufacturing site is in Webster, Investments in Affiliates, at Equity in the Consolidated Financial N.Y., where we make fusers, photoreceptors, Xerox iGen and Statements in our 2008 Annual Report for additional information Nuvera systems, components, consumables and other products. regarding our relationship with Fuji Xerox. Additionally this year, updates were made at the EA Toner plant in Webster, N.Y. that was built in 2007 to give the plant the flexibility to meet demand for both first and second generations of EA Fuji Xerox Toner. This allows the plant to produce the new breakthrough Ultra Fuji Xerox is an unconsolidated entity in which we currently own a Low-Melt EA Toner. Our remaining primary manufacturing 25% interest and FUJIFILM Holdings Corporation (“FujiFilm”) owns operations are located in: Dundalk, Ireland for our high-end a 75% interest. Fuji Xerox develops, manufactures and distributes production products and consumables; and Wilsonville, Oregon for document processing products in Japan, China, Hong Kong, other solid ink products, consumable supplies, and components for our areas of the Pacific Rim, Australia and New Zealand. We retain Office segment products. We also have a major facility in Venray, significant rights as a minority shareholder. Our technology Netherlands, that handles supplies manufacturing and supply licensing agreements with Fuji Xerox ensure that the two chain management for the eastern hemisphere. companies retain uninterrupted access to each other’s portfolio of patents, technology and products. Xerox 2008 Annual Report 23


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    Our Business International Operations Other Information We are incorporating by reference the financial measures by Xerox is a New York corporation, organized in 1906, and our geographical area for 2008, 2007 and 2006 that are included in principal executive offices are located at 45 Glover Avenue, P.O. Note 2 – Segment Reporting in the Consolidated Financial Box 4505, Norwalk, Connecticut 06856-4505. Statements in our 2008 Annual Report. See also the risk factors Our telephone number is (203) 968-3000. entitled “Our business, results of operations and financial condition may be negatively impacted by economic conditions abroad, On the Investor Information section of our Internet website, you including fluctuating foreign currencies and shifting regulatory will find our annual reports on Form 10-K, quarterly reports on Form schemes.” in Part 1, Item 1A of this Form 10K. 10-Q, current reports on Form 8-K and any amendments to these reports. We make these documents available as soon as we can Backlog after we have filed them with, or furnished them to, the Securities and Exchange Commission. We believe that backlog, or the value of unfilled orders, is not a meaningful indicator of future business prospects because of the Our Internet address is http://www.xerox.com significant proportion of our revenue that follows equipment installation, the large volume of products we deliver from shelf inventories and the shortening of product life cycles. Seasonality Our revenues are affected by such factors as the introduction of new products, the length of the sales cycles and the seasonality of technology purchases. As a result, our operating results are difficult to predict. These factors have historically resulted in lower revenue in the first quarter than in the immediately preceding fourth quarter. 24 Xerox 2008 Annual Report


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    Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis (“MD&A”) is our installed base of equipment at customer locations, page intended to help the reader understand the results of operations volume growth and higher revenue per page. Key drivers to and financial condition of Xerox Corporation. MD&A is provided as increase equipment usage are connected multifunction devices, a supplement to, and should be read in conjunction with, our new services and solutions. The transition to color is the primary consolidated financial statements and the accompanying notes. driver to improve revenue per page, as color documents typically require significantly more toner coverage per page than traditional Throughout this document, references to “we,” “our,” the black-and-white printing. In addition, our growing services business, “Company” and “Xerox” refer to Xerox Corporation and its including offerings such as managed print services which help subsidiaries. References to “Xerox Corporation” refer to the stand- customers reduce their costs, also drives post sale revenue. alone parent company and do not include its subsidiaries. In 2008, we completed several acquisitions to further strengthen Executive Overview our distribution capacity and expand our reach in the small to mid-size business (“SMB”) market. Global Imaging Systems, Inc. We are a technology and services enterprise and a leader in the (“GIS”) acquired Saxon Business Systems (“Saxon”), an office global document market, developing, manufacturing, marketing, equipment supplier with offices throughout Florida, as well as three servicing and financing the industry’s broadest portfolio of additional smaller businesses – Better Quality Business Systems, document equipment, solutions and services. Increasingly, Precision Copier Service Inc. DBA Sierra Office Solutions and Inland businesses are digitally creating and storing documents and using Business Systems of Chico. We also acquired Veenman B.V. the Internet to exchange electronic documents. More customers (“Veenman”), expanding our reach into the SMB market in Europe. are seeking to gain efficiencies in their document management Veenman is Netherlands’ leading independent distributor of office processes and are looking to us for document-related services to printers, copiers and multifunction devices serving small and achieve those efficiencies. We believe these trends play to the mid-size businesses. strengths of our product and service offerings and represent opportunities for future growth in the $132 billion market we serve. These transformations also represent opportunities for future Financial Overview growth since our research and development investments have been focused on digital, color and services offerings and our 2008 was an extremely challenging year due to worldwide acquisitions have focused on expanding our services, software and economic weakness, particularly in the second half of the year. The distribution capabilities. unfavorable economic conditions, as well as a rapid shift in currency exchange rates and the related impact on foreign We operate in a global business environment, serving a wide range currency revenue and purchases put significant pressure on the of customers with about 50 percent of our revenue generated from business in 2008. The downturn in the economy adversely customers outside the U.S. Our markets are competitive. Customers impacted equipment sales to large enterprises, as well as revenues are demanding document services such as assessment consulting, from high volume production systems. In the fourth quarter of managed services, imaging and hosting and document intensive 2008, the increasingly wide-spread economic concerns found business process improvements. Additionally, our customers customers and partners prioritizing cash and delaying decisions on demand improved technology solutions, such as the ability to print major contracts. In addition, our distribution partners reduced their offset quality color documents on-demand; improved product inventories of supplies at year end, which negatively impacted our functionality, such as the ability to print, copy, fax and scan from a post sale revenue. single device; and lower prices for the same functionality. Revenue from our developing markets were also negatively Our business model is built upon an annuity model that yields impacted by the dramatic weakening of the Russian and eastern consistent strong cash flow, expanded earnings and enables us to European economies. provide good returns to shareholders. The majority of our revenue (supplies, service, paper, outsourcing, rentals and financing) is Despite the difficult economic conditions in the second half of recurring, which we collectively refer to as post sale revenue. This 2008, total revenue in 2008 increased 2% over the prior year, recurring revenue provides a significant degree of stability to our reflecting 4% growth in post sale revenue offset by a 2% decline revenue, profits and cash flow. Post sale revenue currently in equipment sales revenue. Total color revenue of $6.7 billion was represents more than 70 percent of the Company’s revenue and is up 5% over the prior year, benefiting from our investments in this driven by the amount of equipment installed at customer locations market and post sale revenue for document management services and the utilization of that equipment. As such, our critical success (also referred to as “Xerox Global Services”) of $3.5 billion increased factors include equipment installations, which stabilize and grow 3% over 2007. Xerox 2008 Annual Report 25


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    Management’s Discussion 2008 total gross margin of 38.9% was 1.4-percentage points Our prospective balance sheet strategy includes: optimizing below the prior year. Pricing, product mix and unfavorable operating cash flows; maintaining our investment grade credit exchange rates on our Yen based inventory purchases were only ratings; achieving an optimal cost of capital; and effectively partially offset by cost productivity improvements. Selling, deploying cash to deliver and maximize long-term shareholder administrative and general (“SAG”) expenses as a percent of value through acquisitions, share repurchase and dividends. revenue were 25.7 percent or 0.7-percentage points higher than However, due to the current economic uncertainty, we have no the prior year. SAG expenses increased due to the full year inclusion immediate plans for further share repurchases at this time. Our of GIS, higher bad debt provisions and increased marketing strategy also includes appropriately leveraging our financing assets investments partially offset by restructuring savings. Additionally, (finance receivables and equipment on operating leases). we continued to invest in research and development and to prioritize our investments in the faster growing areas of the market. Currency Impacts Research, development and engineering (“RD&E”) expenses were 5% of revenue in 2008, which is consistent with the prior year. Our To understand the trends in our business, we believe that it is investments in the growing areas of digital production and office helpful to analyze the impact of changes in the translation of systems, particularly with respect to color products, contributed to foreign currencies into U.S. Dollars on revenues and expenses. We more than two-thirds of our equipment sales being generated from refer to this analysis as “currency impact” or “the impact from products launched in the last two years. currency”. Revenues and expenses from our developing markets are analyzed at actual exchange rates for all periods presented, since Changes in our revenue mix – both from geographic and product these countries generally have volatile currency and inflationary line perspectives – have reduced our gross profit margins. This, environments, and our operations in these countries have combined with uncertain economic conditions, required us to take historically implemented pricing actions to recover the impact of actions to adjust our cost and expense profile. Accordingly, we inflation and devaluation. We do not hedge the translation effect recognized pre-tax restructuring charges of $429 million for 2008 of revenues or expenses denominated in currencies where the local actions in order to reduce our cost base and provide increased currency is the functional currency. flexibility in our business in this depressed or recessionary economy. Refer to Note 9 – Restructuring and Asset Impairment Approximately 50% of our consolidated revenues are derived from Charges in the Consolidated Financial Statements for further operations outside of the United States where the U.S. Dollar is not information. the functional currency. When compared with the average of the major European currencies and Canadian Dollar on a revenue- Our balance sheet strategy focused on optimizing operating cash weighted basis, the U.S. Dollar was 3% weaker in 2008 and 9% flows and returning value to shareholders through acquisitions, weaker in 2007, each compared to the prior year. As a result, the share repurchase and dividends. We continue to maintain debt foreign currency translation impact on revenue was a 1% benefit levels primarily to support our customer financing operations. Cash in 2008 and a 3% benefit in 2007. flow from operations was $939 million in 2008 and included $615 million of net securities-related litigation payments as we resolved Currency exchange rates fluctuated significantly in the fourth two long standing securities litigation cases. Cash used for quarter 2008. The U.S. Dollar strengthened significantly in the investments was $441 million and included capital expenditures of fourth quarter 2008 as compared to the currencies of our major $335 million and acquisitions of $155 million. Cash used for foreign operations – the Euro, Pound Sterling and Canadian Dollar. financing of $311 million reflected continued net repayments of The foreign currency translation impact on revenue from this secured borrowings of $227 million; $812 million for share fluctuation in exchange rates was a 3% point benefit through the repurchases; and $154 million for dividends, partially offset by net third quarter 2008 as compared to a 5% detriment in the fourth cash flows from new borrowings of $926 million. New borrowings quarter 2008. If U.S. Dollar exchange rates against these major included $1.4 billion of Senior Notes in an April 2008 public currencies remain at their current levels we expect it will have an offering. We finished the year with cash and cash equivalents of estimated 5% to 6% negative impact on total revenue in the first $1.2 billion. half of 2009. 26 Xerox 2008 Annual Report


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    Summary Results in our 2007 results,(2) equipment sales revenue decreased 5%, with a 1-percentage point benefit from currency. Overall price declines of between 5%- 10% as well as product mix more than Revenue offset overall growth in install activity. Revenues for the three years ended December 31, 2008 were as • 5% growth in color revenue.(3) Color revenue of $6,669 million in follows: 2008 represented 41% of total revenue, excluding GIS, Year Ended December 31, Percent Change compared to 39% in 2007 reflecting: (in millions) 2008 2007 2006 2008 2007 – 10% growth in color post sale revenue to $4,590 million. Equipment sales $ 4,679 $ 4,753 $ 4,457 (2)% 7% Color post sale revenue represented 37% and 35% of post Post sale revenue(1) 12,929 12,475 11,438 4 % 9% sale revenue, in 2008 and 2007, respectively.(4) Total Revenue $17,608 $17,228 $15,895 2% 8% – Color equipment sales revenue declined 4% to $2,079 million. Color equipment sales represented 50% of total Reconciliation to Consolidated Statements of Income equipment sales, in 2008 and 2007,(4) respectively. Sales $ 8,325 $ 8,192 $ 7,464 – 24%(5) growth in color pages. Color pages represented Less: Supplies, paper 18%(5) and 12% of total pages in 2008 and 2007, and other sales (3,646) (3,439) (3,007) respectively. Equipment sales $ 4,679 $ 4,753 $ 4,457 Total 2007 revenue increased 8% compared to the prior year and Service, outsourcing includes the results of GIS since May 9, 2007, the effective date of and rentals $ 8,485 $ 8,214 $ 7,591 our acquisition. When including GIS in our 2006 results,(2) our 2007 Finance income 798 822 840 total revenue increased 4%. Currency had a 3-percentage point Add: Supplies, paper positive impact on total revenues. Total revenues included the and other sales 3,646 3,439 3,007 following: Post sale revenue $12,929 $12,475 $11,438 • 9% increase in post sale revenue, or 6% including GIS in our Memo: Color(3) $ 6,669 $ 6,356 $ 5,578 5% 14% 2006 results.(2) This included a 3-percentage point benefit from currency. Growth in GIS, color products, developing markets and Total 2008 revenue increased 2% compared to the prior year and document management services more than offset the decline in was flat when including GIS in our 2007 results.(2) Currency had a black-and-white digital office revenue and light lens product 1-percentage point positive impact on total revenues. Total revenue. The components of post sale revenue increased as revenues included the following: follows: • 4% increase in post sale revenue, or 2% including GIS in our – 8% increase in service, outsourcing and rentals revenue to 2007 results.(2) This included a 1-percentage point benefit from $8,214 million reflected the inclusion of GIS, growth in currency. Growth in GIS, color products and document document management services and technical service management services offset the declines in high-volume revenue. black-and-white printing systems, black-and-white multifunction – Supplies, paper and other sales of $3,439 million grew 14% devices and light lens product revenue. The components of post year-over-year due to the inclusion of GIS as well as growth in sale revenue increased as follows: developing markets. – 3% increase in service, outsourcing, and rentals revenue to • 7% increase in equipment sales revenue, or a decrease of 1% $8,485 million reflected the full year inclusion of GIS, and when including GIS in our 2006 results.(2) This included a growth in document management services. 3-percentage point benefit from currency. Growth in office – Supplies, paper, and other sales of $3,646 million grew 6% multifunction color and production color install activity was year-over-year due to the full year inclusion of GIS as well as offset by overall price declines of between 5%-10%, declines in growth in color supplies and paper sales. production black-and-white products and color printers, as well as an increased proportion of equipment installed under • 2% decrease in equipment sales revenue. There was no impact operating lease contracts where revenue is recognized over-time from currency on equipment sales revenue. When including GIS in post sale. Xerox 2008 Annual Report 27


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    Management’s Discussion • 14% growth in color revenue.(3) Color revenue of $6,356 million 2007 Net income of $1,135 million, or $1.19 per diluted share, in 2007 comprised 39% of total revenue, compared to 35% in included $30 million after-tax charge for our share of Fuji Xerox 2006 reflecting: (“FX”) restructuring charges. – 18% growth in color post sale revenue to $4,180 million. 2006 Net income of $1,210 million, or $1.22 per diluted share, Color post sale revenue represented 35% and 31% of post included the following: sale revenue, in 2007 and 2006, respectively.(4) • $472 million income tax benefit related to the favorable – 7% growth in color equipment sales revenue to $2,176 resolution of certain tax matters from the 1999-2003 IRS audit. million. Color equipment sales represented 49% and 45% of • $68 million (pre-tax and after-tax) for probable losses on total equipment sales, in 2007 and 2006, respectively.(4) Brazilian labor-related contingencies. – 31% growth in color pages. Color pages represented 12% • $46 million tax benefit resulting from the resolution of certain and 9% of total pages in 2007 and 2006, respectively.(4) tax matters associated with foreign tax audits. (1) Post sale revenue is largely a function of the equipment placed at customer locations, the volume of prints and copies that our customers make on that equipment, the mix of color • $9 million after-tax ($13 million pre-tax) charge from the pages and associated services. write-off of the remaining unamortized deferred debt issuance (2) The percentage point impacts from GIS reflect the revenue growth year-over-year after including GIS’s results for 2007 and 2006 on a proforma basis. See “Non-GAAP Financial costs as a result of the termination of our 2003 Credit Facility. Measures” section for an explanation of this non-GAAP measure. (3) Color revenues represent a subset of total revenues and excludes the impact of GIS’s • $257 million after-tax ($385 million pre-tax) restructuring and revenues. asset impairment charges. (4) As of December 31, 2008, total color, color post sale and color equipment sales revenues comprised 41%, 37% and 50%, respectively, if calculated on total, total post sale, and total equipment sales revenues, including GIS. GIS is excluded from the color information Application of Critical Accounting Policies presented, because the breakout of the information required to make this computation for all periods is not available. In preparing our Consolidated Financial Statements and (5) Pages include estimates for developing markets, GIS and printers. accounting for the underlying transactions and balances, we apply various accounting policies. Senior management has discussed the Net Income development and selection of the critical accounting policies, Net income and diluted earnings per share for the three years estimates and related disclosures, included herein, with the Audit ended December 31, 2008 were as follows: Committee of the Board of Directors. We consider the policies discussed below as critical to understanding our Consolidated (in millions, except per share amounts) 2008 2007 2006 Financial Statements, as their application places the most Net income $ 230 $1,135 $1,210 significant demands on management’s judgment, since financial Diluted earnings per share $0.26 $ 1.19 $ 1.22 reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates 2008 Net income of $230 million, or $0.26 per diluted share, could have reasonably been used, we disclosed the impact of these included the following: different estimates on our operations. In certain instances, like revenue recognition for leases, the accounting rules are • $491 million after-tax charges ($774 million pre-tax) associated prescriptive; therefore, it would not have been possible to with securities-related litigation matters as well as other reasonably use different estimates. Changes in assumptions and probable litigation-related losses including $36 million for the estimates are reflected in the period in which they occur. The Brazilian labor-related contingencies. impact of such changes could be material to our results of • $292 million after-tax charge ($426 million pre-tax) for second, operations and financial condition in any quarterly or annual third and fourth quarter 2008 restructuring and asset period. impairment actions. • $24 million after-tax charge ($39 million pre-tax) for an Office product line equipment write-off. • $41 million income tax benefit from the settlement of certain previously unrecognized tax benefits. 28 Xerox 2008 Annual Report


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    Specific risks associated with these critical accounting policies are objective evidence of equipment fair value based on cash selling discussed throughout the MD&A, where such policies affect our prices during the applicable period. The cash selling prices are reported and expected financial results. For a detailed discussion of compared to the range of values included in our lease accounting the application of these and other accounting policies, refer to systems. The range of cash selling prices must be reasonably Note 1 – Summary of Significant Accounting Policies, in the consistent with the lease selling prices, taking into account residual Consolidated Financial Statements. values, in order for us to determine that such lease prices are indicative of fair value. Revenue Recognition for Leases Our pricing interest rates, which are used in determining customer Our accounting for leases involves specific determinations under payments, are developed based upon a variety of factors including applicable lease accounting standards, which often involve local prevailing rates in the marketplace and the customer’s credit complex and prescriptive provisions. These provisions affect the history, industry and credit class. We reassess our pricing interest timing of revenue recognition for our equipment. If a lease rates quarterly based on changes in the local prevailing rates in the qualifies as a sales-type capital lease, equipment revenue is marketplace. These interest rates have been historically adjusted if recognized upon delivery or installation of the equipment as sale the rates vary by twenty-five basis points or more, cumulatively, revenue as opposed to ratably over the lease term. The critical from the last rate in effect. The pricing interest rates generally elements that we consider with respect to our lease accounting are equal the implicit rates within the leases, as corroborated by our the determination of the economic life and the fair value of comparisons of cash to lease selling prices. In light of worldwide equipment, including the residual value. For purposes of economic conditions prevailing at the end of 2008, we expect to determining the economic life, we consider the most objective continually review this methodology in 2009 to ensure that our measure to be the original contract term, since most equipment is pricing interest rates are reflective of changes in the local returned by lessees at or near the end of the contracted term. The prevailing rates in the marketplace. economic life of most of our products is five years since this represents the most frequent contractual lease term for our Allowance for Doubtful Accounts and Credit Losses principal products and only a small percentage of our leases are for We perform ongoing credit evaluations of our customers and original terms longer than five years. There is no significant after- adjust credit limits based upon customer payment history and market for our used equipment. We believe five years is current creditworthiness. We continuously monitor collections and representative of the period during which the equipment is payments from our customers and maintain a provision for expected to be economically usable, with normal service, for the estimated credit losses based upon our historical experience and purpose for which it is intended. any specific customer collection issues that have been identified. While such credit losses have historically been within our Revenue Recognition Under Bundled Arrangements expectations and the provisions established, we cannot guarantee that we will continue to experience credit loss rates similar to those We sell the majority of our products and services under bundled we have experienced in the past. Measurement of such losses lease arrangements, which typically include equipment, service, requires consideration of historical loss experience, including the supplies and financing components for which the customer pays a need to adjust for current conditions, and judgments about the single negotiated monthly fixed price for all elements over the probable effects of relevant observable data, including present contractual lease term. Typically these arrangements include an economic conditions such as delinquency rates and financial incremental, variable component for page volumes in excess of health of specific customers. We recorded bad debt provisions of contractual page volume minimums, which are often expressed in $188 million, $134 million and $87 million in SAG expenses in our terms of price per page. Revenues under these arrangements are Consolidated Statements of Income for the years ended allocated, considering the relative fair values of the lease and December 31, 2008, 2007 and 2006, respectively. non-lease deliverables included in the bundled arrangement, based upon the estimated relative fair values of each element. Lease Historically, the majority of the bad debt provision relates to our deliverables include maintenance and executory costs, equipment finance receivables portfolio. This provision is inherently more and financing, while non-lease deliverables generally consist of difficult to estimate than the provision for trade accounts supplies and non-maintenance services. Our revenue allocation for receivable because the underlying lease portfolio has an average lease deliverables begins by allocating revenues to the maturity, at any time, of approximately two to three years and maintenance and executory costs plus profit thereon. The contains past due billed amounts, as well as unbilled amounts. The remaining amounts are allocated to the equipment and financing estimated credit quality of any given customer and class of elements. We perform extensive analyses of available verifiable customer or geographic location can significantly change during Xerox 2008 Annual Report 29


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    Management’s Discussion the life of the portfolio. We consider all available information in our primarily to actual losses on plan assets in 2008 as compared to quarterly assessments of the adequacy of the provision for expected returns partially offset by an increase in the discount doubtful accounts. rate. The total actuarial loss will be amortized in the future, subject to offsetting gains or losses that will change the future The current economic environment has increased the risk of amortization amount. non-collection of receivables. We have accordingly considered this increased risk in the evaluation and assessment of our allowance We have utilized a weighted average expected rate of return on for doubtful accounts at year-end. Collection risk is somewhat plan assets of 7.6% for 2008, 7.6% for 2007 and 7.8% for 2006, mitigated by the fact that our receivables are fairly well dispersed on a worldwide basis. In estimating this rate, we considered the among a diverse customer base both in size and geography. Days historical returns earned by the plan assets, the rates of return sales outstanding remained fairly flat year-over-year. In addition, expected in the future and our investment strategy and asset mix the aging of receivables has not increased significantly. Accounts with respect to the plans’ funds. receivable balances greater than 60 days outstanding were 17% During 2008, the actual loss on plan assets was $1.5 billion, of total gross accounts receivables at December 31, 2008 as primarily as a result of the significant declines in the equity compared to 15% at December 31, 2007. However, we continue to markets during the fourth quarter of 2008. In estimating the 2009 assess our receivable portfolio in light of the current economic expected rate of return we considered this significant decline in the environment and its impact on our estimation of the adequacy of fair value of our plan assets as well as potential changes in our the allowance for doubtful accounts. investment mix, partly in response to the significant volatility As discussed above, in preparing our Consolidated Financial expected in the equity markets for the foreseeable future. The Statements for the three year period ended December 31, 2008, weighted average expected rate of return on plan assets we will we estimated our provision for doubtful accounts based on utilize for 2009 will be 7.4% as compared to 7.6% in 2008. historical experience and customer-specific collection issues. This For purposes of determining the expected return on plan assets, we methodology has been consistently applied for all periods utilize a calculated value approach in determining the value of the presented. During the five year period ended December 31, 2008, pension plan assets, as opposed to a fair market value approach. our reserve for doubtful accounts ranged from 3.0% to 4.2% of The primary difference between the two methods relates to a gross receivables. Holding all other assumptions constant, a systematic recognition of changes in fair value over time (generally 1-percentage point increase or decrease in the reserve from the two years) versus immediate recognition of changes in fair value. December 31, 2008 rate of 3.4% would change the 2008 provision Our expected rate of return on plan assets is then applied to the by approximately $98 million. calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net Pension and Post-Retirement Benefit Plan Assumptions periodic pension cost. The calculated value approach reduces the We sponsor defined benefit pension plans in various forms in volatility in net periodic pension cost that can result from using the several countries covering substantially all employees who meet fair market value approach. The difference between the actual eligibility requirements. Post-retirement benefit plans cover return on plan assets and the expected return on plan assets is primarily U.S. employees for retirement medical costs. Several added to, or subtracted from, any cumulative differences that statistical and other factors that attempt to anticipate future arose in prior years. This amount is a component of the net events are used in calculating the expense, liability and asset actuarial gain or loss. values related to our pension and post-retirement benefit plans. Another significant assumption affecting our pension and post- These factors include assumptions we make about the discount retirement benefit obligations and the net periodic pension and rate, expected return on plan assets, rate of increase in healthcare other post-retirement benefit cost is the rate that we use to costs, the rate of future compensation increases and mortality. discount our future anticipated benefit obligations. The discount Difference between these assumptions and actual experiences are rate reflects the current rate at which the pension liabilities could reported as net actuarial gains and losses and are subject to be effectively settled considering the timing of expected payments amortization to net periodic pension cost over the average for plan participants. In estimating this rate, we consider rates of remaining service lives of the employees participating in the return on high quality fixed-income investments included in various pension plan. published bond indices, adjusted to eliminate the effects of call Cumulative actuarial losses for our pension plans as of provisions and differences in the timing and amounts of cash December 31, 2008 were $1.8 billion, as compared to $1 billion at outflows related to the bonds. In the U.S. and the U.K., which December 31, 2007. The change from December 31, 2007 relates comprise approximately 80% of our projected benefit obligations, 30 Xerox 2008 Annual Report


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    we consider the Moody’s Aa Corporate Bond Index and the the expected timing of the reversals of existing temporary International Index Company’s iBoxx Sterling Corporate AA Cash differences and tax planning strategies. If we continue to operate Bond Index, respectively, in the determination of the appropriate at a loss in certain jurisdictions or are unable to generate sufficient discount rate assumptions. Due to the recent, unprecedented future taxable income, or if there is a material change in the actual events in the financial markets associated with the current credit effective tax rates or time period within which the underlying environment, there is a greater than usual disparity in yields temporary differences become taxable or deductible, we could be among the bonds included in the various indices used to determine required to increase the valuation allowance against all or a our pension discount rates. Given this disparity, we carefully significant portion of our deferred tax assets resulting in a evaluated our existing methodologies for determining our pension substantial increase in our effective tax rate and a material adverse discount rates and refined those methodologies to the extent impact on our operating results. Conversely, if and when our required to ensure we selected an appropriate discount rate. The operations in some jurisdictions were to become sufficiently weighted average discount rate we utilized to measure our pension profitable to recover previously reserved deferred tax assets, we obligation as of December 31, 2008 and to calculate our 2009 would reduce all or a portion of the applicable valuation allowance expense was 6.3%, which is an increase of 0.4% from 5.9% used in the period when such determination is made. This would result in in determining our 2008 expense. The increase is primarily driven an increase to reported earnings in such period. Adjustments to our by our U.K. and Canadian plans. valuation allowance, through charges to income tax expense, were $17 million, $14 million and $12 million for the years ended Assuming settlement losses in 2009 are consistent with 2008, our December 31, 2008, 2007 and 2006, respectively. There were 2009 net periodic defined benefit pension cost is expected to be other (decreases) increases to our valuation allowance, including approximately $20 million higher than 2008, primarily as a result the effects of currency, of $(136) million, $86 million and $45 of the reduction in the expected return on plan assets due to lower million for the years ended December 31, 2008, 2007 and 2006, asset values and increased amortization of actuarial gains and respectively, that did not affect income tax expense in total as losses partially offset by an increase in the discount rate. there was a corresponding adjustment to deferred tax assets or On a consolidated basis, we recognized net periodic pension cost of other comprehensive income. Gross deferred tax assets of $3.8 $254 million, $315 million and $425 million for the years ended billion and $3.6 billion had valuation allowances of $628 million December 31, 2008, 2007 and 2006, respectively. The costs and $747 million at December 31, 2008 and 2007, respectively. associated with our defined contribution plans, which are included We are subject to ongoing tax examinations and assessments in in net periodic pension cost, were $80 million, $80 million and $70 various jurisdictions. Accordingly, we may incur additional tax million for the years ended December 31, 2008, 2007 and 2006, expense based upon our assessment of the more-likely-than-not respectively. Pension cost is included in several income statement outcomes of such matters. In addition, when applicable, we adjust components based on the related underlying employee costs. the previously recorded tax expense to reflect examination results. Pension and post-retirement benefit plan assumptions are included Our ongoing assessments of the more-likely-than-not outcomes of in Note 14 – Employee Benefit Plans in the Consolidated Financial the examinations and related tax positions require judgment and Statements. Holding all other assumptions constant, a 0.25% can materially increase or decrease our effective tax rate as well as increase or decrease in the discount rate would (decrease)/increase impact our operating results. the 2009 projected net periodic pension cost by $(13) million or $18 million, respectively. Likewise, a 0.25% increase or decrease in We file income tax returns in the U.S. Federal jurisdiction and the expected return on plan assets would change the 2009 various foreign jurisdictions. In the U.S. we are no longer subject to projected net periodic pension cost by $11 million. U.S. Federal income tax examinations by tax authorities for years before 2007. With respect to our major foreign jurisdictions, we are Income Taxes and Tax Valuation Allowances no longer subject to tax examinations by tax authorities for years We record the estimated future tax effects of temporary before 2000. differences between the tax bases of assets and liabilities and Legal Contingencies amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We follow very specific We are involved in a variety of claims, lawsuits, investigations and and detailed guidelines in each tax jurisdiction regarding the proceedings concerning securities law, intellectual property law, recoverability of any tax assets recorded in our Consolidated environmental law, employment law and ERISA, as discussed in Balance Sheets and provide valuation allowances as required. We Note 16 – Contingencies in the Consolidated Financial Statements. regularly review our deferred tax assets for recoverability We determine whether an estimated loss from a contingency considering historical profitability, projected future taxable income, should be accrued by assessing whether a loss is deemed probable Xerox 2008 Annual Report 31


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    Management’s Discussion and can be reasonably estimated. We assess our potential liability Our annual impairment test of goodwill is performed in the fourth by analyzing our litigation and regulatory matters using available quarter. The estimated fair values of the Company’s reporting information. We develop our views on estimated losses in units were based on discounted cash flow models derived from consultation with outside counsel handling our defense in these internal earnings forecasts and assumptions. The assumptions and matters, which involves an analysis of potential results, assuming a estimates used in those valuations incorporated the expected combination of litigation and settlement strategies. Should impact of the challenging economic environment that has developments in any of these matters cause a change in our persisted over the past year. In performing our 2008 impairment determination as to an unfavorable outcome and result in the test, the following were the overall composite long-term need to recognize a material accrual, or should any of these assumptions regarding revenue and expense growth, which were matters result in a final adverse judgment or be settled for the basis for estimating future cash flows used in the discounted significant amounts, they could have a material adverse effect on cash flow model: 1) revenue growth 3%; 2) gross margin 39-40%; our results of operations, cash flows and financial position in the 3) RD&E 4-5%; 4) SAG 24-25%; and 5) return on sales 8-9%. We period or periods in which such change in determination, judgment believe these estimated assumptions are appropriate for our or settlement occurs. circumstances, in-line with historical results and consistent with our forecasted long-term business model. These assumptions also have Business Combinations and Goodwill considered the current economic environment. The application of the purchase method of accounting for business Based on those valuations, we determined that the fair values of combinations requires the use of significant estimates and our reporting units exceeded their carrying values and no goodwill assumptions in the determination of the fair value of assets impairment charge was required during the fourth quarter. In light acquired and liabilities assumed in order to properly allocate of the continued difficult economic conditions and the fact that purchase price consideration between assets that are depreciated the Company’s stock has been generally trading below net book and amortized from goodwill. Our estimates of the fair values of value per share over the past quarter, we reassessed our assets and liabilities acquired are based upon assumptions believed assumptions as of December 31, 2008. We do not believe the to be reasonable, and when appropriate, include assistance from recent general downturn in the U.S. equity markets is independent third-party appraisal firms. representative of any fundamental change in our business. Based on current results and expectations, we determined that the fair As a result of our acquisition of GIS, as well as other prior year values of our reporting units continue to exceed their carrying acquisitions, we have a significant amount of goodwill. Goodwill is values and determined that no goodwill impairment charge was tested for impairment annually or more frequently if an event or required as of December 31, 2008. circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires Refer to Note 1 – Summary of Significant Accounting Policies – judgment, including the identification of reporting units, “Goodwill and Intangible Assets” for further information regarding assignment of assets and liabilities to reporting units, assignment our goodwill impairment testing, as well as Note 8 – Goodwill and of goodwill to reporting units and determination of the fair value Intangible Assets, Net in the Consolidated Financial Statements for of each reporting unit. We estimate the fair value of each reporting further information regarding goodwill by operating segment. unit using a discounted cash flow methodology. This requires us to use significant judgment including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long- term rate of growth for our business, the useful life over which cash flows will occur, determination of our weighted average cost of capital for purposes of establishing a discount rate and relevant market data. 32 Xerox 2008 Annual Report


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    Operations Review Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Production, Office and Other. See Note 2 – Segment Reporting in the Consolidated Financial Statements for further discussion on our segment operating revenues and segment operating profit. Revenues by segment for the years ended 2008, 2007 and 2006 were as follows: Year Ended December 31, (in millions) Production Office Other Total 2008 Equipment sales $ 1,325 $ 3,105 $ 249 $ 4,679 Post sale revenue 3,912 6,723 2,294 12,929 Total Revenues $ 5,237 $ 9,828 $ 2,543 $17,608 Segment Profit (Loss) $ 394 $ 1,062 $ (165) $ 1,291 Operating Margin 7.5% 10.8% (6.5)% 7.3% 2007 Equipment sales $ 1,471 $ 3,030 $ 252 $ 4,753 Post sale revenue 3,844 6,443 2,188 12,475 Total Revenues $ 5,315 $ 9,473 $ 2,440 $17,228 Segment Profit (Loss) $ 562 $ 1,115 $ (89) $ 1,588 Operating Margin 10.6% 11.8% (3.7)% 9.2% 2006 Equipment sales $ 1,491 $ 2,786 $ 180 $ 4,457 Post sale revenue 3,564 5,926 1,948 11,438 Total Revenues $ 5,055 $ 8,712 $ 2,128 $15,895 Segment Profit (Loss) $ 504 $ 1,010 $ (124) $ 1,390 Operating Margin 10.0% 11.6% (5.8)% 8.7% In 2008 we revised our segment reporting to integrate the Developing Markets Operations (“DMO”) into the Production, Office and Other segments. DMO is a geographic region that has matured to a level where we now manage it on the basis of products sold, consistent with our North American and European geographic regions. All prior periods presented have been restated accordingly. Note: Install activity percentages include the Xerox-branded product shipments to GIS. Xerox 2008 Annual Report 33


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    Management’s Discussion Segment Revenue and Operating Profit 2007 Operating profit of $562 million increased $58 million from 2006. The increase is primarily the result of higher gross profit and Production lower R,D&E, partially offset by an increase in bad debt expense. Revenue Office 2008 Production revenue of $5,237 million decreased 1%, including a 1-percentage point benefit from currency, reflecting: Revenue 2008 Office revenue of $9,828 million increased 4%, including a • 2% increase in post sale revenue as growth from color, 1-percentage point benefit from currency, as well as the benefits continuous feed and light production products offset declines in from our expansion in the SMB market through GIS and Veenman. revenue from black-and-white high-volume printing systems and Revenue for 2008 reflects: light lens devices. • 4% increase in post sale revenue, reflecting the full year • 10% decrease in equipment sales revenue, primarily reflecting inclusion of GIS as well as growth from color multifunction pricing declines in both black-and-white and color production devices and color printers partially offset by declines in systems, driven in part by weakness in the U.S. black-and-white digital devices. Office post sale revenue was negatively impacted in the fourth quarter of 2008 by declines in • 1% increase in installs of production color products driven in channel supply purchases, including lower purchases within part by Xerox 700 and iGen4TM activity as well as color developing markets. continuous feed. • 2% increase in equipment sales revenue, reflecting the full year • 6% decline in installs of production black-and-white systems inclusion of GIS as well as growth from color digital products driven primarily by declines in installs of light production which more than offset declines from black-and-white devices systems. primarily due to price declines and product mix. 2007 Production revenue of $5,315 million increased 5%, • 24% color multifunction device install growth led by strong including a 4-percentage point benefit from currency, reflecting: demand for Xerox WorkCentre® and Phaser® products. • 8% increase in post sale and other revenue, including a • 8% increase in installs of black-and-white copiers and 4-percentage point benefit from currency, as growth from digital multifunction devices, including 8% growth in Segment 1&2 products more than offset declines in revenue from older light products (11-30 ppm) and 8% growth in Segment 3-5 products lens technology. (31-90 ppm). Segment 3-5 installs include the Xerox 4595, a 95 ppm device with an embedded controller. • 1% decrease in equipment sales revenue, including a 3-percentage point benefit from currency, reflecting growth in • 12% increase in color printer installs. production color systems offset by declines in black-and-white 2007 Office revenue of $9,473 million increased 9%, including a production printing systems and light production and an 3-percentage point benefit from currency, reflecting: increased proportion of equipment installed under operating lease contracts where revenue is recognized over-time in post • 9% increase in post sale revenue, reflecting the inclusion of GIS sale. since May 2007 as well as growth from color multifunction devices and color printers. • 6% growth in installs of production color products driven by • 9% increase in equipment sales revenue, reflecting the inclusion DocuColor® 242/252/260 family, DocuColor 5000 and iGen3® of GIS since May 2007 as well as color multifunction products activity. install growth. • 8% decline in installs of production black-and-white systems • 65% color multifunction device install growth led by strong reflecting declines in installs of both high-volume and light demand for Xerox WorkCentre products. production systems. • 5% increase in installs of black-and-white copiers and multifunction devices, including 4% growth in Segment 1&2 Operating Profit products (11-30 ppm) and 7% growth in Segment 3-5 products 2008 Operating profit of $394 million decreased $168 million from (31-90 ppm) that includes the 95 ppm device with an embedded 2007. The decrease is primarily the result of lower revenue and controller. lower gross margins due to pricing and product mix as well as increased SAG expenses. • 10% decline in color printer installs due to lower OEM sales. 34 Xerox 2008 Annual Report


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    Operating Profit 2008 Total gross margin decreased 1.4-percentage points 2008 Operating profit of $1,062 million decreased $53 million compared to 2007 as price declines and mix of approximately from 2007. The decrease was primarily due to lower gross profits 2.0-percentage points were only partially offset by cost reflecting lower margins as well as higher SAG expenses partially productivity improvements. Cost improvements were limited by an offset by the full year inclusion of GIS. unfavorable impact on product costs of approximately 0.5-percentage points from the significant strengthening of the 2007 Operating profit of $1,115 million increased $105 million Yen versus the U.S. Dollar and Euro. The negative impact of from 2006. The increase was primarily due to the inclusion of GIS 0.3-percentage points from an Office product line equipment since May 2007 and higher gross profits partially offset by higher write-off was offset by positive adjustments related to the SAG expenses. capitalized costs for equipment on operating leases and European product disposal costs. Other • Sales gross margin decreased 2.2-percentage points primarily due to the approximately 2.5-percentage point impact of price Revenue declines as well as channel and product mix. Cost improvements, 2008 Other revenue of $2,543 million increased 4% primarily which historically tend to offset price declines, were limited in reflecting the full year inclusion of GIS and increased paper 2008 by the adverse impact of the strengthening Yen on our revenue partially offset by lower revenue from wide format inventory purchases. systems. There was no impact from currency. Paper comprised approximately 50% of Other segment revenue. • Service, outsourcing and rentals margin decreased 0.8-percentage points primarily due to mix as price declines of 2007 Other revenue of $2,440 million increased 15%, including a 1.3-percentage points were offset by cost improvements. Mix 3-percentage point benefit from currency, primarily reflecting the reflects margin pressure from document management services. inclusion of GIS since May 2007 as well as increased paper and value-added services revenues. Paper comprised approximately • Financing income margin of approximately 62% remained 50% of Other segment revenue. comparable to 2007. Since a large portion of our inventory procurement is from Japan, Operating Loss the strengthening of the Yen versus the U.S. Dollar and Euro in 2008 Operating loss of $165 million increased $76 million from 2008 significantly impacted our product cost. The Yen 2007 reflecting lower wide format revenue, higher foreign strengthened approximately 14% against the U.S. Dollar and 6% exchange losses and lower interest income partially offset by gains against the Euro in 2008 as compared to 2007. A significant on sales of assets. portion of that strengthening occurred in the fourth quarter 2008 when the Yen strengthened 17% against the U.S. Dollar and 29% 2007 Operating loss of $89 million decreased $35 million from against the Euro as compared to prior year. We expect product 2006 reflecting higher revenue as well as lower currency exchange costs and gross margins to continue to be negatively impacted in losses and litigation charges, partially offset by higher interest 2009 if Yen exchange rates remain at current levels. expense and lower gains on the sales of businesses and assets. 2007 Total Gross margin was down slightly as compared to 2006 as cost improvements were offset by price and product mix. Costs, Expenses and Other Income • Sales gross margin increased 0.2-percentage points primarily as Gross Margin cost improvements and other variances more than offset the Gross margins by revenue classification were as follows: 2.0-percentage point impact of price declines. • Service, outsourcing and rentals margin decreased Year Ended December 31, 0.3-percentage points as cost improvements and other variances 2008 2007 2006 did not fully offset price declines and unfavorable product mix of Sales 33.7% 35.9% 35.7% approximately 2.0-percentage points. Service, outsourcing and rentals 41.9% 42.7% 43.0% • Financing income margin declined 2.1-percentage points Finance income 61.8% 61.6% 63.7% reflecting additional interest expense due to higher interest Total Gross margin 38.9% 40.3% 40.6% rates. Xerox 2008 Annual Report 35


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    Management’s Discussion Research, Development and Engineering Expenses Selling, Administrative and General Expenses (“SAG”) (“R,D&E”) Year Ended December 31, Change We invest in technological development, particularly in color, and (in millions) 2008 2007 2006 2008 2007 believe our R,D&E spending is sufficient to remain technologically Total SAG competitive. expenses $4,534 $4,312 $4,008 $222 $304 Year Ended December 31, Change SAG % revenue 25.7% 25.0% 25.2% 0.7pts (0.2)pts (in millions) 2008 2007 2006 2008 2007 2008 SAG expenses of $4,534 million were $222 million higher Total R,D&E expenses $884 $912 $922 $28 $10 than 2007, including a $12 million unfavorable impact from R,D&E % revenue 5.0% 5.3% 5.8% (0.3)pts (0.5)pts currency. The SAG expense increase was the result of the following: 2008 R,D&E of $884 million decreased $28 million from 2007. We • $94 million increase in selling expenses primarily reflecting the expect our 2009 R,D&E spending to approximate 4% to 5% of full year inclusion of GIS, investments in selling resources and total revenue. marketing communications and unfavorable currency partially offset by lower compensation. • R&D of $750 million decreased $14 million from 2007. Our R&D is strategically coordinated with that of Fuji Xerox, which • $75 million increase in general and administrative (“G&A”) invested $788 million and $672 million in R&D in 2008 and expenses primarily from the full year inclusion of GIS and 2007, respectively. Much of the reported Fuji Xerox R&D increase unfavorable currency. was caused by changes in foreign exchange rates. • $54 million increase in bad debt expense reflecting increased • Sustaining engineering costs of $134 million were $14 million write-offs, particularly in the fourth quarter 2008, which included lower than 2007 due primarily to lower spending related to several high value account bankruptcies in the U.S., U.K. and environmental compliance activities and maturing product Germany. platforms in the Production segment. 2007 SAG expenses of $4,312 million were $304 million higher • R,D&E as a percentage of revenue declined 0.3-percentage than 2006, including a $141 million negative impact from points reflecting the capture of efficiencies following a currency. The SAG expense increase was the result of the following: significant number of new product launches over the past two • $93 million increase in selling expenses primarily reflecting the years as well as leveraging our current R,D&E investments to negative impact from currency and the inclusion of GIS. This support our GIS operations. increase was partially offset by lower costs reflecting the 2007 R,D&E of $912 million decreased $10 million from 2006. benefits from the 2006 restructuring programs intended to realign our sales infrastructure. • R&D of $764 million increased $3 million from 2006. Our R&D is strategically coordinated with that of Fuji Xerox, which invested • $164 million increase in G&A expenses primarily from the $672 million and $660 million in R&D in 2007 and 2006, inclusion of GIS, unfavorable currency and information respectively. technology investments. • Sustaining engineering costs of $148 million were $13 million • $47 million increase in bad debt expense primarily as a result of lower than 2006 due primarily to lower spending related to an increase in reserves for several customers in Europe as well as environmental compliance activities and maturing product a 2006 reduction in expense due to adjustments to the reserves platforms in the Production segment. to reflect improvement in write-offs and aging. • R,D&E as a percentage of revenue declined 0.5-percentage points as we leveraged our current R,D&E investments to support GIS operations. 36 Xerox 2008 Annual Report


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    Bad debt expense included in SAG was $188 million, $134 million Other Expenses, Net and $87 million in 2008, 2007 and 2006, respectively. Bad debt Other expenses, net for each of the three years ended expense as a percent of total revenue increased in the fourth December 31, 2008, 2007 and 2006 consisted of the following: quarter 2008 but was 1.1% in 2008 as compared to 0.8% and 0.5% for 2007 and 2006, respectively. Despite the fourth quarter Year Ended December 31, 2008 increase in the provision and write-offs, days sales (in millions) 2008 2007 2006 outstanding at December 31, 2008 remained fairly flat year-over- Non-financing interest expense $ 262 $263 $239 year and the aging of receivables as compared to historical levels Interest income (35) (55) (69) has not increased significantly. However, due to the current Gain on sales of businesses and assets (21) (7) (44) economic conditions, there is an increased risk for our provision for Currency losses, net 34 8 39 bad debts to trend higher in 2009 as compared to 2008. At Amortization of intangible assets 54 42 41 December 31, 2008, bad debt reserves, as a percentage of Legal matters 781 (6) 89 receivables, were comparable to year end 2007. All other expenses, net 47 50 41 Restructuring and Asset Impairment Charges Total Other expenses, net $1,122 $295 $336 For the years ended December 31, 2008, 2007 and 2006 we recorded net restructuring and asset impairment charges (credits) Non-financing interest expense: 2008 non-financing interest of $429 million, $(6) million and $385 million, respectively. The expense was flat compared to 2007, as the benefit of lower 2008 net charge included $357 million related to headcount interest rates was offset by higher average non-financing debt reductions of approximately 4,900 employees primarily in North balances. In 2007 non-financing interest expense increased America and Europe and lease termination and asset impairment primarily due to higher average non-financing debt balances as charges of $72 million primarily reflecting the exit from certain well as higher interest rates. leased and owned facilities resulting from a rationalization of our Interest income: Interest income is derived primarily from our worldwide operating locations. These actions applied equally to invested cash and cash equivalent balances. The decline in interest both North America and Europe with approximately half focused income in 2008 was primarily due to lower average cash balances on SAG expense reductions, approximately a third on gross margin and rates of return. The decline in 2007 was primarily due to lower improvements and the remainder focused on the optimization of average cash balances partially offset by higher rates of return. R,D&E investments. We expect to realize savings in 2009 of approximately $250 million as a result of the 2008 restructuring Gain on sales of businesses and assets: 2008 gain on sales of actions. Restructuring activity was minimal in 2007 and the related business and assets primarily consisted of the sale of certain credit of $6 million primarily reflected changes in estimates for surplus facilities in Latin America. prior years’ severance costs. The 2006 net charge included $318 The 2006 gain on sales of businesses and assets primarily million related to headcount reductions of approximately 3,400 consisted of $15 million on the sale of our Corporate headquarters, employees in North America and Europe, and lease termination $11 million on the sale of a manufacturing facility and $10 million and asset impairment charges of $67 million primarily reflecting receipt from escrow of additional proceeds related to our 2005 sale the relocation of certain manufacturing operations and the exit of Integic. from certain leased and owned facilities. The restructuring reserve balance as of December 31, 2008, for all programs was $352 Currency losses net: Currency losses primarily result from the million of which approximately $325 million is expected to be re-measurement of foreign currency-denominated assets and spent over the next twelve months. Refer to Note 9 – Restructuring liabilities, the cost of hedging foreign currency-denominated assets and Asset Impairment Charges in the Consolidated Financial and liabilities, the mark-to-market of foreign exchange contracts Statements for further information regarding our restructuring utilized to hedge those foreign currency-denominated assets and programs. liabilities and the mark-to-market impact of hedges of anticipated Worldwide Employment transactions, primarily future inventory purchases, for those that we do not apply cash flow hedge accounting treatment. Worldwide employment of 57,100 as of December 31, 2008 decreased approximately 300 from December 31, 2007, primarily The 2008 currency losses were primarily due to net reflecting the reductions from restructuring partially offset by re-measurement losses associated with our Yen-denominated additions as a result of 2008 acquisition activity. Worldwide payables, foreign currency denominated assets and liabilities in our employment was approximately 57,400 and 53,700 at developing markets and the cost of hedging. The currency losses December 31, 2007 and 2006, respectively. on Yen-denominated payables were largely limited to the first Xerox 2008 Annual Report 37


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    Management’s Discussion quarter 2008 as a result of the significant and rapid weakening of Income Taxes the U.S. Dollar and Euro versus the Yen. Year Ended December 31, The 2006 currency losses primarily reflected the mark-to-market of (in millions) 2008 2007 2006 derivative contracts which are economically hedging anticipated Pre-tax (loss) income $(114) $1,438 $ 808 foreign currency denominated payments. The mark-to-market Income tax (benefits) expenses (231) 400 (288) losses were primarily due to the strengthening of the Euro against Effective tax rate 202.6% 27.8% (35.6)% other currencies, in particular the Canadian Dollar, U.S. Dollar and the Yen, as compared to the weakening Euro in 2005. The 2008 effective tax rate of 202.6% reflected the tax benefits from certain discrete items including the net provision for litigation Amortization of intangible assets: 2008 amortization of matters; the second, third and fourth quarter restructuring and intangible assets expense of $54 million reflects amortization asset impairment charges; the product line equipment write-off; expense of $33 million for intangible assets acquired as part of our and the settlement of certain previously unrecognized tax benefits. recent acquisitions. Excluding these items, the adjusted effective tax rate was 21.5%*. 2007 amortization of intangible assets expense of $42 million The adjusted 2008 effective tax rate was lower than the U.S. reflects amortization expense of $16 million associated with statutory tax rate primarily reflecting the benefit to taxes from the intangible assets acquired as part of our acquisition of GIS, geographical mix of income before taxes and the related effective partially offset by reduced amortization from prior years due to the tax rates in those jurisdictions, the utilization of foreign tax credits full amortization of certain intangible assets from previous and tax law changes. acquisitions. The 2007 effective tax rate of 27.8% was lower than the U.S. Legal matters: In 2008 legal matters consisted of the following: statutory rate primarily reflecting tax benefits from the geographical mix of income before taxes and the related effective • $721 million reflecting provisions for the $670 million court tax rates in those jurisdictions and the utilization of foreign tax approved settlement of Carlson v. Xerox Corporation (“Carlson”) credits as well as the resolution of other tax matters. These and other pending securities-related cases, net of expected benefits were partially offset by changes in tax law. insurance recoveries. On January 14, 2009, the United States Court for the District of Connecticut entered a Final Order and The 2006 effective tax rate of (35.6%) was lower than the U.S. Judgment approving the settlement in the Carlson litigation. statutory rate primarily due to the tax benefits of $518 million from the resolution of tax issues associated with the 1999-2003 • $36 million for probable losses on Brazilian labor-related IRS audits and other domestic and foreign tax audits; tax benefits contingencies. Following an assessment of the most recent trend of $19 million as a result of tax law changes and tax treaty in the outcomes of these matters, we reassessed the probable changes; and $11 million from the reversal of a valuation estimated loss and, as a result, recorded an additional reserve of allowance on deferred tax assets associated with foreign net $36 million in the fourth quarter of 2008. operating loss carryforwards, as well as the geographical mix of • $24 million associated with probable losses from various other income before taxes and related effective tax rates in those legal matters. jurisdictions. These benefits were partially offset by losses in certain jurisdictions where we are not providing tax benefits and In 2006 legal matters consisted of the following: continue to maintain deferred tax valuation allowances. • $68 million for probable losses on Brazilian labor-related Our effective tax rate will change based on nonrecurring events as contingencies. well as recurring factors including the geographical mix of income • $33 million associated with probable losses from various legal before taxes and the related effective tax rates in those matters partially offset by $12 million of proceeds from the jurisdictions and available foreign tax credits. In addition, our Palm litigation matter. effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be Refer to Note 16 – Contingencies in the Consolidated Financial predictable. We anticipate that our effective tax rate for 2009 will Statements for additional information regarding litigation against approximate 28%, excluding the effect of any discrete items. the Company. * See the “Non-GAAP Measures” section for additional information. 38 Xerox 2008 Annual Report


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    Equity in Net Income of Unconsolidated Affiliates Recent Accounting Pronouncements 2008 equity in net income of unconsolidated affiliates of $113 Refer to Note 1 – Summary of Significant Accounting Policies in million is principally related to our 25% share of Fuji Xerox (“FX”) the Consolidated Financial Statements for a description of recent income. The $16 million increase from 2007 is primarily due to a accounting pronouncements including the respective dates of $14 million reduction in our share of FX restructuring charges. adoption and the effects on results of operations and financial condition. 2007 equity in net income of unconsolidated affiliates reflects a reduction from 2006 of $17 million, primarily due to $30 million for our after-tax share of FX restructuring charges. Capital Resources and Liquidity Cash Flow Analysis The following summarizes our cash flows for each of the three years ended December 31, 2008, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements: Change (in millions) 2008 2007 2006 2008 2007 Net cash provided by operating activities $ 939 $ 1,871 $ 1,617 $ (932) $ 254 Net cash used in investing activities (441) (1,612) (143) 1,171 (1,469) Net cash used in financing activities (311) (619) (1,428) 308 809 Effect of exchange rate changes on cash and cash equivalents (57) 60 31 (117) 29 Increase (decrease) in cash and cash equivalents 130 (300) 77 430 (377) Cash and cash equivalents at beginning of period 1,099 1,399 1,322 (300) 77 Cash and cash equivalents at end of period $1,229 $ 1,099 $ 1,399 $ 130 $ (300) Cash Flows from Operating Activities Net cash provided by operating activities was $1,871 million for the year ended December 31, 2007. The $254 million increase in Net cash provided by operating activities was $939 million for the cash was primarily due to the following: year ended December 31, 2008. The $932 million decrease in cash was primarily due to the following: • $348 million increase in pre-tax income before restructuring, depreciation, other provisions and net gains. • $330 million decrease in pre-tax income before litigation and restructuring. • $108 million increase in other liabilities primarily reflecting the absence of the prior year payment of $106 million related to the • $615 million decrease due to net payments for the settlement MPI litigation. of the securities-related litigation. • $57 million increase reflecting lower pension contributions to our • $90 million decrease due to higher net income tax payments, U.S. pension plans. primarily resulting from the absence of prior year tax refunds. • $30 million increase as a result of lower restructuring payments due to minimal activity in 2007. • $74 million decrease primarily due to lower benefit and compensation accruals. • $114 million decrease due to year-over-year inventory growth of $54 million primarily related to increased product launches in • $71 million decrease due to higher inventory levels as a result of 2007, as well as a $60 million increase in equipment on lower equipment and supplies sales in 2008. operating leases reflecting higher operating lease install activity. • $136 million increase from accounts receivable due to strong • $73 million decrease due to a lower net run-off of finance collection effectiveness throughout 2008. receivables. • $107 million increase from derivatives, primarily due to the • $49 million decrease primarily due to higher accounts receivable termination of certain interest rate swaps in fourth quarter reflecting increased revenue, partially offset by $110 million 2008. year-over-year benefit from increased receivables sales. Xerox 2008 Annual Report 39


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    Management’s Discussion • $45 million decrease due to lower benefit accruals, partially programs with GE in the United Kingdom and Canada of $634 offset by higher accounts payable due to the timing of million and Merrill Lynch in France for $469 million as well as the payments to vendors and suppliers. repayment of secured borrowings to DLL of $153 million. The remainder reflects lower payments associated with our GE U.S. Cash Flows from Investing Activities secured borrowings. Net cash used in investing activities was $441 million for the year • $888 million decrease from lower net cash proceeds from ended December 31, 2008. The $1,171 million increase in cash was unsecured debt. 2008 reflects the issuance of $1.4 billion in primarily due to the following: Senior Notes, $250 million from a private placement borrowing • $1,460 million increase due to less cash used for acquisitions. and net payments of $354 million on the Credit Facility and 2008 acquisitions included $138 million for Veenman B.V. and $370 million on other debt. 2007 reflects the issuance of $1.1 Saxon Business Systems as compared to $1,568 million for GIS billion Senior Notes, $400 million from private placement and its additional acquisitions in the prior year. borrowings and net proceeds of $600 million on the Credit Facility, offset by net payments of $286 million on other debt. • $192 million decrease due to lower funds from escrow and other restricted investments in 2008. The prior year reflected funds • $180 million decrease due to additional purchases under our received from the run-off of our secured borrowing programs. share repurchase program. • $134 million decrease in other investing cash flows due to the • $154 million decrease due to common stock dividend payments. absence of proceeds from liquidations of short-term investments. • $79 million decrease due to lower proceeds from the issuance of common stock, reflecting a decrease in stock option exercises as Net cash used in investing activities was $1,612 million for the year well as lower related tax benefits. ended December 31, 2007. The $1,469 million decrease in cash was primarily due to the following: • $33 million decrease due to share repurchases related to employee withholding taxes on stock-based compensation • $1,386 million decrease due to $1,615 million in 2007 vesting. acquisitions primarily comprised of $1,568 for GIS and its additional acquisitions and $30 million for Advectis, Inc., as Net cash used in financing activities was $619 million in year compared to $229 million in acquisitions in 2006 comprised of ended December 31, 2007. The $809 million increase in cash was Amici, LLC and XMPie, Inc. primarily due to the following: • $123 million decrease in other investing cash flows reflecting the • $538 million increase due to higher net cash proceeds from absence of the 2006 $122 million distribution related to the sale unsecured debt. This reflects the May 2007 issuance of the $1.1 of investments held by Ridge Re. billion Senior Notes, the issuances of two zero coupon bonds in • $65 million decrease due to higher capital and internal use 2007 resulting in net proceeds of approximately $400 million, software investments in 2007. and the net drawdown of $600 million under the 2007 Credit Facility. These higher net proceeds were partially offset by the • $57 million decrease due to higher 2006 proceeds from sales of March 2006 issuance of the $700 million Senior Notes and the land, buildings and equipment, which included the sale of our August 2006 issuance of an additional $650 million of Senior corporate headquarters and a parcel of vacant land. Notes, as well as, higher repayments on other unsecured debt in • $162 million increase due to a reduction in escrow and other 2007 as compared to 2006. restricted investments in 2007, as we continue to run-off our • $437 million increase due to lower purchases under our share secured borrowing programs. repurchase program as cash was invested in acquisitions. Cash Flows from Financing Activities • $100 million increase relating to the 2006 payment of our Net cash used in financing activities was $311 million for the year liability to Xerox Capital LLC in connection with their redemption ended December 31, 2008. The $308 million increase in cash was of Canadian deferred preferred shares. primarily due to the following: • $278 million decrease due to higher net repayments of secured • $1,642 million increase from lower net repayments on secured financing. Refer to Note 4-Receivables, net in the consolidated debt. 2007 reflects termination of our secured financing financial statements for further information. 40 Xerox 2008 Annual Report


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    Financing Activities At December 31, 2008, less than 1% of total debt was secured by finance receivables and other assets compared to 4% at Customer Financing Activities December 31, 2007. We provide equipment financing to the majority of our customers. Because finance leases allow our customers to pay for equipment (in millions) 2008 2007 over time rather than at the date of installation, we maintain a Principal Debt Balance $ 8,201 $7,465 certain level of debt to support our investment in these customer Less: Net unamortized discount (6) (13) finance leases. We currently fund our customer financing activity Add: FAS 133 fair value adjustments 189 12 through cash generated from operations, cash on hand, Total Reported Debt 8,384 7,464 borrowings under bank credit facilities and proceeds from capital Less: Current maturities and short-term debt (1,610) (525) markets offerings. We also have funding available through a Total long-term debt $ 6,774 $6,939 secured borrowing arrangement with General Electric Capital Corporation (“GECC”) referred to as the Loan Agreement. Principal debt balance at December 31, 2008 and 2007 includes We have arrangements in certain international countries and short-term debt of $61 million and $99 million, respectively. Refer domestically through the acquisition of GIS, where third party to Note 11 – Debt in the Consolidated Financial Statements for financial institutions originate lease contracts directly with our additional information regarding the above balances. customers. In these arrangements, we sell and transfer title of the equipment to these financial institutions. Generally, we have no Liquidity, Financial Flexibility and Other Financing continuing ownership rights in the equipment subsequent to its Activity sale; therefore, the related receivable and debt are not included in Liquidity our Consolidated Financial Statements. We manage our worldwide liquidity using internal cash The following represents total finance assets associated with our management practices, which are subject to (1) the statutes, lease or finance operations as of December 31, 2008 and 2007: regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which (in millions) 2008 2007 we are a party and (3) the policies and cooperation of the financial Total Finance receivables, net(1) $7,278 $ 8,048 institutions we utilize to maintain and provide cash management Equipment on operating leases, net 594 587 services. Total finance assets, net $7,872 $8,635 Our liquidity is a function of our ability to successfully generate cash flows from a combination of efficient operations and The reduction of $763 million in Total finance assets, net includes improvement therein, access to capital markets, securitizations, unfavorable currency of $473 million. funding from third parties and borrowings secured by our finance (1) Includes (i) billed portion of finance receivables, net, (ii) finance receivables, net and receivables portfolios. Our ability to maintain positive liquidity (iii) finance receivables due after one year, net as included in the Consolidated Balance going forward depends on our ability to continue to generate cash Sheets as of December 31, 2008 and 2007. from operations and access to financial markets, both of which are The following tables summarize our debt as of December 31, 2008 subject to general economic, financial, competitive, legislative, and 2007: regulatory and other market factors that are beyond our control. (in millions) 2008 2007 The following is a discussion of our liquidity position as of December 31, 2008: Debt secured by finance receivables $ 56 $ 275 Capital leases 9 19 • As of December 31, 2008, total cash and cash equivalents was Total Secured Debt 65 294 $1.2 billion and our borrowing capacity under our Credit Facility Senior Notes 7,574 5,781 was $1.7 billion, reflecting $246 million outstanding borrowings Credit Facility 246 600 and no outstanding letters of credit. In addition we currently Other Debt 499 789 have approximately $1.0 billion available under the Loan Total Unsecured Debt 8,319 7,170 Agreement through 2010, which has not been accessed in almost three years. Total Debt $8,384 $7,464 • We have consistently delivered strong cash flow from operations over the past three years driven by the strength of our annuity based revenue model. Cash flows from operations were $939 Xerox 2008 Annual Report 41


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    Management’s Discussion million, $1,871 million and $1,617 million for the years ended have the right to prepay any outstanding loans or to terminate the December 31, 2008, 2007 and 2006, respectively. Cash flows Credit Facility without penalty. Failure to be in compliance with any from operations in 2008 included $615 million in net payments material provision or covenant of these agreements could have a for our securities litigation. material adverse effect on our liquidity and operations and our ability to continue to fund our customers’ purchase of Xerox • Our debt maturities are in line with historical and projected cash equipment. flows and are spread over the next ten years as follows (in millions): Refer to Note 11 – Debt and Note 4 – Receivables, Net in the Consolidated Financial Statements for additional information Year Amount regarding the above noted transactions and Loan Agreement, 2009 $1,610 respectively. 2010 962 2011 802 2012 1,169 Share Repurchase Programs 2013 1,138 The Board of Directors has authorized share repurchase programs 2014 69 totaling $4.5 billion through December 31, 2008, which included 2015 — additional authorizations of $1.0 billion in both January and July of 2016 950 2008. Since launching this program in October 2005, we have 2017 501 repurchased 194.1 million shares, totaling approximately $2.9 2018 and thereafter 1,000 billion. Refer to Note 17 – Shareholders’ Equity – “Treasury Stock” Total $8,201 in the Consolidated Financial Statements for further information regarding our share repurchase programs. On January 15, 2009, we repaid in-full at maturity, our outstanding U.S. Dollar and Euro-denominated 9.75% Senior Notes. The total Although we have $1.6 billion of remaining authorization, at the repayment of approximately $900 million was made using cash on current time, we have no immediate plans for further share hand and the proceeds of a $400 million borrowing under our repurchases. Credit Facility. Dividends Debt Activity The Board of Directors declared a 4.25 cent per share dividend on common stock in each quarter of 2008. Credit facility: In February 2008, we exercised our right under our $2.0 billion Credit Facility to request a one-year extension of the Financial Instruments maturity date. Lenders representing approximately $1.4 billion (or Refer to Note 13 – Financial Instruments in the Consolidated approximately 70%) of the commitments under the Credit Facility Financial Statements for additional information regarding our agreed to the extension and the portion represented by these derivative financial instruments. Lenders now has a maturity date of April 30, 2013, with the remaining portion of the Credit Facility to mature on April 30, 2012. In October 2008, we amended our Credit Facility to increase the permitted leverage ratio (debt/consolidated EBITDA) to a fixed ratio of 3.75x. The amendment also included a re-pricing of the Credit Facility such that borrowings will bear interest at LIBOR plus an all-in spread that will vary between 1.25% and 4.00% subject to our credit rating and percent of Credit Facility utilization at the time of borrowing. Based upon our current rating and utilization, the all-in spread is 1.75%. Capital markets offerings and other: In 2008, we raised net proceeds of $1.4 billion through the issuance of Senior Notes and $250 million from a private placement transaction. Loan covenants and compliance: At December 31, 2008, we were in full compliance with the covenants and other provisions of the Credit Facility, our Senior Notes and the Loan Agreement. We 42 Xerox 2008 Annual Report


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    Credit Ratings We are currently rated investment grade by all major rating agencies. As of January 31, 2009 the ratings were as follows: Senior Unsecured Debt Outlook Moody’s Baa2 Positive Standard & Poors (“S&P”) BBB Stable Fitch BBB Stable Contractual Cash Obligations and Other Commercial Commitments and Contingencies At December 31, 2008, we had the following contractual cash obligations and other commercial commitments and contingencies: (in millions) 2009 2010 2011 2012 2013 Thereafter Long-term debt, including capital lease obligations(1) $ 1,610 $ 962 $ 802 $ 1,169 $ 1,138 $ 2,520 Minimum operating lease commitments(2) 223 188 151 100 84 123 Liability to subsidiary trust issuing preferred securities(3) — — — — — 648 Retiree Health Payments 105 99 99 98 97 445 Purchase Commitments Flextronics(4) 700 — — — — — EDS Contracts(5) 239 137 77 77 77 16 Other(6) 17 12 11 — — — Total contractual cash obligations $2,894 $1,398 $1,140 $1,444 $1,396 $3,752 (1) Refer to Note 11– Debt in our Consolidated Financial Statements for additional information and interest payments related to long-term debt (amounts above include principal portion only). (2) Refer to Note 6 – Land, Buildings and Equipment, Net in our Consolidated Financial Statements for additional information related to minimum operating lease commitments. (3) Refer to Note 12 – Liability to Subsidiary Trust Issuing Preferred Securities in our Consolidated Financial Statements for additional information and interest payments (amounts above include principal portion only). (4) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently in the second year of the Master Supply Agreement. The term of this agreement is three years, with two additional one year extension periods at our option. The amounts discussed in the table reflect our estimate of purchases over the next year and are not contractual commitments. (5) EDS Contract: We have an information management contract with Electronic Data Systems Corp. (“EDS”) through June 30, 2009. Services to be provided under this contract include support for global mainframe system processing, application maintenance, workplace and service desk, voice and data network management and server management. In 2008, the contracts for global mainframe system processing and workplace and service desk were extended through December 2013 and March 2014, respectively. In January 2009, the contract for voice and data network management services was revised and extended through March 2014. There are no minimum payments required under this contract. The amounts disclosed in the table reflect our estimate of probable minimum payments for the periods shown. We can terminate the 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. Xerox 2008 Annual Report 43


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    Management’s Discussion Pension and Other Post-Retirement Benefit Plans internal transfer of inventory, municipal service taxes on rentals We sponsor pension and other post-retirement benefit plans that and gross revenue taxes. We are disputing these tax matters and may require periodic cash contributions. Our 2008 cash fundings intend to vigorously defend our position. Based on the opinion of for these plans were $299 million for pensions and $105 million for legal counsel and current reserves for those matters deemed our retiree health plans. Our required cash fundings for 2009 are probable of loss, we do not believe that the ultimate resolution of approximately $108 million for pensions and approximately $105 these matters will materially impact our results of operations, million for our retiree health plans. Cash contribution requirements financial position or cash flows. The labor matters principally relate for our domestic tax qualified pension plans are governed by the to claims made by former employees and contract labor for the Employment Retirement Income Security Act (“ERISA”) and the equivalent payment of all social security and other related labor Internal Revenue Code. Cash contribution requirements for our benefits, as well as consequential tax claims, as if they were regular international plans are subject to the applicable regulations in each employees. Following our assessment of the most recent trends in country. The expected 2009 pension contributions do not include the outcomes of these matters, we reassessed the probable contributions to the domestic tax-qualified plans because none are estimated loss and, as a result, recorded an additional reserve of required due to the availability of a credit balance which resulted $36 million in 2008. As of December 31, 2008, the total amounts from funding prior to 2008 in excess of minimum requirements. related to the unreserved portion of the tax and labor This credit balance can be utilized in lieu of any 2009 pension contingencies, inclusive of any related interest, amounted to contributions. However, once the January 1, 2009 actuarial approximately $839 million, with the decrease from the valuations and projected results as of the end of the 2009 December 31, 2007 balance of $1.1 billion primarily related to measurement year are available, the desirability of additional currency partially offset by the additional reserve. In connection contributions will be assessed. Based on these results, we may with the above proceedings, customary local regulations may voluntarily decide to contribute to these plans, even though no require us to make escrow cash deposits or post other security of contribution is required. In prior years, after making this up to half of the total amount in dispute. As of December 31, 2008 assessment, we decided to contribute $165 million and $158 we had $167 million of escrow cash deposits for matters we are million in 2008 and 2007, respectively, to our domestic tax disputing and there are liens on certain Brazilian assets with a net qualified plans in order to make them 100% funded on a current book value of $30 million and additional letters of credit of liability basis under the ERISA funding rules. approximately $88 million. Generally, any escrowed amounts would be refundable and any liens would be removed to the extent Our retiree health benefit plans are non-funded and are almost the matters are resolved in our favor. We routinely assess all these entirely related to domestic operations. Cash contributions are matters as to probability of ultimately incurring a liability against made each year to cover medical claims costs incurred in that year. our Brazilian operations and record our best estimate of the The amounts reported in the above table as retiree health ultimate loss in situations where we assess the likelihood of an payments represent our estimated future benefit payments. ultimate loss as probable. Fuji Xerox Other Contingencies and Commitments We purchased products, including parts and supplies, from Fuji As more fully discussed in Note 16 – Contingencies in the Xerox totaling $2.1 billion, $1.9 billion and $1.7 billion in 2008, Consolidated Financial Statements, we are involved in a variety of 2007 and 2006, respectively. Our purchase commitments with Fuji claims, lawsuits, investigations and proceedings concerning Xerox are in the normal course of business and typically have a securities law, intellectual property law, environmental law, lead time of three months. We do not anticipate 2009 purchases employment law and the Employee Retirement Income Security from Fuji Xerox to exceed 2008 levels. Related party transactions Act. In addition, guarantees, indemnifications and claims may arise with Fuji Xerox are discussed in Note 7 – Investments in Affiliates, during the ordinary course of business from relationships with at Equity in the Consolidated Financial Statements. suppliers, customers and nonconsolidated affiliates. Brazil Tax and Labor Contingencies Nonperformance under a contract including a guarantee, As of December 31, 2008, our Brazilian operations are involved in indemnification or claim could trigger an obligation of the various litigation matters and have been the subject of numerous Company. We determine whether an estimated loss from a governmental assessments related to indirect and other taxes as contingency should be accrued by assessing whether a loss is well as disputes associated with former employees and contract deemed probable and can be reasonably estimated. Should labor. The tax matters, which comprise a significant portion of the developments in any of these areas cause a change in our total contingencies, principally relate to claims for taxes on the determination as to an unfavorable outcome and result in the 44 Xerox 2008 Annual Report


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    need to recognize a material accrual, or should any of these utilized to hedge economic exposures as well as reduce earnings matters result in a final adverse judgment or be settled for and cash flow volatility resulting from shifts in market rates. Refer significant amounts, they could have a material adverse effect on to Note 13 –Financial Instruments in the Consolidated Financial our results of operations, cash flows and financial position in the Statements for further discussion on our financial risk period or periods in which such change in determination, judgment management. or settlement occurs. Assuming a 10% appreciation or depreciation in foreign currency exchange rates from the quoted foreign currency exchange rates Unrecognized Tax Benefits at December 31, 2008, the potential change in the fair value of As of December 31, 2008, we had $170 million of unrecognized foreign currency-denominated assets and liabilities in each entity tax benefits. This represents the tax benefits associated with would not be significant because all material currency asset and various tax positions taken, or expected to be taken, on domestic liability exposures were economically hedged as of December 31, and international tax returns that have not been recognized in our 2008. A 10% appreciation or depreciation of the U.S. Dollar financial statements due to uncertainty regarding their resolution. against all currencies from the quoted foreign currency exchange The resolution or settlement of these tax positions with the taxing rates at December 31, 2008 would have an $824 million impact on authorities is at various stages and therefore we are unable to our cumulative translation adjustment portion of equity. The make a reliable estimate of the eventual cash flows by period that amount permanently invested in foreign subsidiaries and affiliates, may be required to settle these matters. In addition, certain of primarily Xerox Limited, Fuji Xerox, Xerox Canada Inc. and Xerox do these matters may not require cash settlement due to the Brasil, and translated into Dollars using the year-end exchange existence of credit and net operating loss carryforwards as well as rates, was $8.2 billion at December 31, 2008. other offsets, including the indirect benefit from other taxing jurisdictions that may be available. Interest Rate Risk Management Off-Balance Sheet Arrangements The consolidated weighted-average interest rates related to our debt and liabilities to subsidiary trust issuing preferred securities for Although we rarely utilize off-balance sheet arrangements in our 2008, 2007 and 2006 approximated 6.6%, 7.1%, and 6.8%, operations, we enter into operating leases in the normal course of respectively. Interest expense includes the impact of our interest business. The nature of these lease arrangements is discussed in rate derivatives. Note 6 – Land, Buildings and Equipment, Net in the Consolidated Financial Statements. Additionally, we have utilized special purpose Virtually all customer-financing assets earn fixed rates of interest. entities (“SPEs”) in conjunction with certain financing transactions. The interest rates on a significant portion of the Company’s term The SPEs utilized in conjunction with these transactions are debt are fixed. consolidated in our financial statements. These transactions, which As of December 31, 2008, approximately $1.1 billion of our debt are discussed further in Note 4 – Receivables, Net in the and liability to subsidiary trust issuing preferred securities carried Consolidated Financial Statements, have been accounted for as variable interest rates, including the effect of pay-variable interest secured borrowings with the debt and related assets remaining on rate swaps we are utilizing with the intent to reduce the effective our balance sheets. Although the obligations related to these interest rate on our high coupon debt. transactions are included in our balance sheet, recourse is generally limited to the secured assets and no other assets of the Company. The fair market values of our fixed-rate financial instruments are sensitive to changes in interest rates. At December 31, 2008, a Refer to Note 16 – Contingencies in the Consolidated Financial 10% change in market interest rates would change the fair values Statements for further information regarding our guarantees, of such financial instruments by approximately $317 million. The indemnifications and warranty liabilities. recent market events have not required us to materially modify or change our financial risk management strategies with respect to Financial Risk Management our exposures to interest rate and foreign currency risk. We are exposed to market risk from foreign currency exchange rates and interest rates, which could affect operating results, financial position and cash flows. We manage our exposure to these market risks through our regular operating and financing activities and, when appropriate, through the use of derivative financial instruments. These derivative financial instruments are Xerox 2008 Annual Report 45


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    Management’s Discussion Non-GAAP Financial Measures Adjusted Effective Tax Rate We have reported our financial results in accordance with generally The effective tax rate for the year ended December 31, 2008 is accepted accounting principles (“GAAP”). A reconciliation of the discussed using non-GAAP financial measures that exclude the following non-GAAP financial measures to the most directly effects of charges associated with an equipment write-off; second, comparable financial measures calculated and presented in third and fourth quarter 2008 restructuring and asset impairments; accordance with GAAP are set forth below: certain litigation matters and the settlement of certain previously unrecognized tax benefits. Management believes that it is helpful Adjusted Revenue to exclude these effects to better understand and analyze the current period’s effective tax rate given the discrete nature of We discussed the revenue growth for the year ended December 31, these items. 2008 using non-GAAP financial measures. To understand trends in the business, we believe that it is helpful to adjust the revenue Year Ended December 31, 2008 growth rates to illustrate the impact of the acquisition of GIS by Pre-Tax Income Effective including their estimated revenue for the comparable 2007 and (in millions) Income Taxes Tax Rate 2006 periods. We refer to this adjusted revenue as “As Adjusted” in As Reported $ (114) $(231) 202.6% the following reconciliation table. Revenue “As Adjusted” adds Restructuring and asset GIS’s revenues from January 1, 2006 to May 8, 2007 to our 2006 impairment charges 426 134 and 2007 reported revenue. Management believes these measures Equipment write-off 39 15 give investors an additional perspective on revenue trends, as well Litigation 774 283 as the impact to the Company of the acquisition of GIS that was Tax settlements — 41 completed in May 2007. As Adjusted $1,125 $ 242 21.5% Year Ended December 31 % Change (in millions) 2008 2007 2006 2008 2007 Management believes that these non-GAAP financial measures provide an additional means of analyzing the current period results Equipment Sales against the corresponding prior period results. However, these Revenue: non-GAAP financial measures should be viewed in addition to, and As Reported $ 4,679 $ 4,753 $ 4,457 (2)% 7% not as a substitute for, the Company’s reported results prepared in As Adjusted $ 4,679 $ 4,938 $ 4,992 (5)% (1)% accordance with GAAP. Post Sale Revenue: As Reported $12,929 $12,475 $11,438 4% 9% Forward Looking Statements As Adjusted $12,929 $12,681 $12,000 2% 6% This Annual Report contains forward-looking statements as Total Revenues: defined in the Private Securities Litigation Reform Act of 1995. The As Reported $17,608 $17,228 $15,895 2% 8% words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” As Adjusted $17,608 $17,619 $16,992 — 4% “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. These statements reflect management’s current beliefs, assumptions and expectations and are subject to a number of factors that may cause actual results to differ materially. Information concerning these factors is included in our 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”). We do not intend to update these forward-looking statements, except as required by law. 46 Xerox 2008 Annual Report


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    Xerox Corporation Consolidated Statements of Income Year Ended December 31, (in millions, except per-share data) 2008 2007 2006 Revenues Sales $ 8,325 $ 8,192 $ 7,464 Service, outsourcing and rentals 8,485 8,214 7,591 Finance income 798 822 840 Total Revenues 17,608 17,228 15,895 Costs and Expenses Cost of sales 5,519 5,254 4,803 Cost of service, outsourcing and rentals 4,929 4,707 4,328 Equipment financing interest 305 316 305 Research, development and engineering expenses 884 912 922 Selling, administrative and general expenses 4,534 4,312 4,008 Restructuring and asset impairment charges 429 (6) 385 Other expenses, net 1,122 295 336 Total Costs and Expenses 17,722 15,790 15,087 (Loss) Income before Income Taxes and Equity Income (114) 1,438 808 Income tax (benefits) expenses (231) 400 (288) Equity in net income of unconsolidated affiliates 113 97 114 Net Income $ 230 $ 1,135 $ 1,210 Basic Earnings per Share $ 0.26 $ 1.21 $ 1.25 Diluted Earnings per Share $ 0.26 $ 1.19 $ 1.22 The accompanying notes are an integral part of these Consolidated Financial Statements. Xerox 2008 Annual Report 47


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    Xerox Corporation Consolidated Balance Sheets December 31, (in millions, except share data in thousands) 2008 2007 Assets Cash and cash equivalents $ 1,229 $ 1,099 Accounts receivable, net 2,184 2,457 Billed portion of finance receivables, net 254 304 Finance receivables, net 2,461 2,693 Inventories 1,232 1,305 Other current assets 790 682 Total current assets 8,150 8,540 Finance receivables due after one year, net 4,563 5,051 Equipment on operating leases, net 594 587 Land, buildings and equipment, net 1,419 1,587 Investments in affiliates, at equity 1,080 932 Intangible assets, net 610 621 Goodwill 3,182 3,448 Deferred tax assets, long-term 1,692 1,349 Other long-term assets 1,157 1,428 Total Assets $ 22,447 $ 23,543 Liabilities and Shareholders’ Equity Short-term debt and current portion of long-term debt $ 1,610 $ 525 Accounts payable 1,446 1,367 Accrued compensation and benefits costs 625 673 Other current liabilities 1,769 1,512 Total current liabilities 5,450 4,077 Long-term debt 6,774 6,939 Liability to subsidiary trust issuing preferred securities 648 632 Pension and other benefit liabilities 1,747 1,115 Post-retirement medical benefits 896 1,396 Other long-term liabilities 694 796 Total Liabilities 16,209 14,955 Common stock, including additional paid-in-capital 3,313 4,096 Treasury stock, at cost — (31) Retained earnings 5,341 5,288 Accumulated other comprehensive loss (2,416) (765) Total Shareholders’ Equity 6,238 8,588 Total Liabilities and Shareholders’ Equity $ 22,447 $ 23,543 Shares of common stock issued 864,777 919,013 Treasury stock — (1,836) Shares of common stock outstanding 864,777 917,177 The accompanying notes are an integral part of these Consolidated Financial Statements. 48 Xerox 2008 Annual Report

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