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FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
( X ) Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended: December 31, 2002
OR
( ) Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from: to
Commission file number: 1-8133
XEROX CREDIT CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 06-1024525
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 First Stamford Place, Stamford, Connecticut 06904
(Address of principal executive offices) (Zip Code)
(203) 325-6600
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
7.20% Notes due 2012 New York Stock Exchange
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Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes: X No:
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Not Applicable
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the close of the latest practicable date.
Class Outstanding as of February 28, 2003
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Common Stock 2,000
THIS DOCUMENT CONSISTS OF 75 PAGES
1
Forward - Looking Statements
From time to time we and our representatives may provide information, whether
orally or in writing, including certain statements in this Annual Report on Form
10-K which are forward-looking. These forward-looking statements and other
information are based on our beliefs as well as assumptions made by us based on
information currently available.
The words "anticipate," "believe," "estimate," "expect," "intend," "will," and
similar expressions, as they relate to us, are intended to identify forward-
looking statements. Such statements reflect our current views with respect to
future events and are subject to certain risks, uncertainties and assumptions.
Should one or more of these risks or uncertainties materialize, or should
underlying assumptions prove incorrect, actual results may vary materially from
those described herein as anticipated, believed, estimated, intended or
expected. We do not intend to update these forward-looking statements.
We are making investors aware that such forward-looking statements, because they
relate to future events, are by their very nature subject to many important
factors which could cause actual results to differ materially from those
contained in the forward-looking statements. Such factors include, but are not
limited to, the following:
Our liquidity is dependent upon the liquidity of our ultimate parent, Xerox
Corporation ("XC"). Accordingly, certain disclosures contained herein relate to
events and transactions that affect the liquidity of XC and its subsidiaries
(collectively, "Xerox").
In 2001, XC announced several Framework Agreements with General Electric ("GE"),
including one under which GE would become Xerox's primary equipment-financing
provider in the U.S Pursuant to this agreement, in October 2002, XC completed an
eight-year agreement in the U.S. (the "New U.S. Vendor Financing Agreement")
under which GE Vendor Financial Services became the primary equipment financing
provider in the U.S., through monthly securitizations of XC's new U.S. lease
originations. In addition to the $2.5 billion funded by GE prior to this
transaction, which is secured by portions of XC's current lease receivables, the
New U.S. Vendor Financing Agreement calls for GE to provide funding in the U.S.,
through 2010, of up to $5 billion, outstanding during any time, subject to
normal customer acceptance criteria. The New U.S. Vendor Financing Agreement
also includes opportunities to increase financing levels over time, based on
Xerox's revenue growth.
In anticipation of the transactions described above, we stopped purchasing new
contracts receivable from XC effective July 1, 2001, which will cause our
existing portfolio to ultimately run-off. Further, pursuant to the New Credit
Facility (discussed below), we are precluded from purchasing any new contracts
receivable from XC after June 20, 2002. Xerox is considering securitizing
portions of its existing U.S. finance receivables portfolio which is not subject
to the GE agreements, which could further reduce our portfolio.
The long-term viability and profitability of Xerox's customer financing
activities is dependent, in part, on Xerox's ability to borrow and the cost of
borrowing in the credit markets. This ability and cost, in turn, is dependent on
Xerox's credit ratings. On a worldwide basis, Xerox is currently funding its
customer financing activity from the aforementioned New U.S. Vendor Financing
Agreement, other finance receivable securitizations, cash generated from
operations, unregistered capital markets offerings and cash on hand. There is no
assurance that Xerox will be able to continue to fund its customer financing
activity at present levels. Xerox continues to negotiate and implement
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securitizations and third-party vendor financing programs , and to actively
pursue other alternative forms of financing. These initiatives are expected to
improve Xerox's liquidity going forward. Xerox's ability to continue to offer
customer financing and be successful in the placement of equipment with
customers is largely dependent upon successful implementation of Xerox's third
party vendor financing initiatives.
The adequacy of Xerox's continuing liquidity depends on its ability to
successfully generate cash from an appropriate combination of operating
improvements, financing from third parties, capital markets transactions and
additional asset sales, including sales or securitizations of Xerox's
receivables portfolios. Xerox believes its liquidity (including operating and
other cash flows it will generate) will be sufficient to meet operating cash
flow requirements as they occur and to satisfy all scheduled debt maturities for
at least the next twelve months; however, Xerox's ability to maintain positive
liquidity going forward is highly dependent on achieving its expected operating
results, including capturing the benefits from restructuring activities, and
continuing to complete announced vendor financing and other initiatives that are
discussed in this Annual Report on Form 10-K. There is no assurance that these
initiatives will be successful. Failure to successfully complete these
initiatives could have a material adverse effect on Xerox's liquidity and
operations, and could require Xerox to consider further measures, including
additional restructurings, deferring planned capital expenditures, reducing
discretionary spending, selling additional assets and if necessary,
restructuring existing debt. Because we are dependent upon XC for our liquidity,
any such material adverse effect on Xerox's liquidity and operations could also
have a material adverse effect on our liquidity and operations.
As announced on June 21, 2002, Xerox successfully completed the renegotiation of
its $7 billion Revolving Credit Agreement (the "Old Revolver"). Of the original
$7 billion in loans outstanding under the Old Revolver, $3.5 billion has now
been repaid (including all of our $1.02 billion of debt then outstanding) and
the remaining $3.5 billion is outstanding under the new Amended and Restated
Credit Agreement (the "New Credit Facility"). A full discussion of the New
Credit Facility and the final maturity dates of the various loans contained
therein is included in Note 6 and the Capital Resources and Liquidity section in
this Annual Report on Form 10-K. We cannot borrow under the New Credit Facility.
The New Credit Facility also precludes us from purchasing new contracts from XC,
and requires us to transfer all of our excess cash, as defined, to XC. Subject
to certain limits, all obligations under the New Credit Facility are guaranteed
by substantially all of XC's U.S. subsidiaries (including us). Our guaranty of
obligations under the New Credit Facility, however, is subordinated to all of
our capital markets debt outstanding as of June 21, 2002. In connection with the
New Credit Facility, substantially all of XC's U.S. subsidiaries (including us)
also guaranteed XC's $600 million of 9-3/4% Senior Notes and Euro 225 million of
9-3/4% Senior Notes due 2009 (collectively, the "Senior Notes").
XC is in full compliance with the covenants and other provisions of the New
Credit Facility and expects to be in compliance for at least the next twelve
months. The Senior Notes contain several similar, though generally less
restrictive, affirmative and negative covenants of Xerox. Any failure of Xerox
to be in compliance with any material provision of the New Credit Facility or
the Senior Notes could have a material adverse effect on XC's liquidity and
operations and, because we are dependent upon XC for our liquidity and have
guaranteed the obligations of XC under the New Credit Facility and the Senior
Notes, such failure by XC to be in compliance could also have a material adverse
effect on our liquidity and operations.
3
PART I
ITEM 1. Business
Xerox Credit Corporation, a Delaware corporation (together with its subsidiaries
herein called the "Company", or "us" or "we" or "our" unless the context
otherwise requires), was organized on June 23, 1980. All of our outstanding
capital stock is owned by Xerox Financial Services, Inc. (XFSI), a holding
company, which is wholly-owned by Xerox Corporation (XC and together with its
subsidiaries Xerox unless the context otherwise requires).
We are primarily a funding entity, engaged until July 2001 in purchasing
long-term non-cancelable contracts receivable from XC which arise from
installment sales and lease contracts originated by the domestic marketing
operations of XC, and we raised debt in the capital markets to fund purchases of
these receivables.
Prior to July 2001, the financing of Xerox equipment was generally carried out
by us in the United States, and internationally by certain of XC's foreign
financing subsidiaries and divisions in most countries where Xerox operates. As
part of Xerox's Turnaround Program (see Capital Resources and Liquidity - Xerox
Corporation), Xerox is transitioning equipment financing to third parties
whenever practicable.
In September 2001, Xerox entered into framework agreements with General Electric
(GE) under which GE (or an affiliate thereof) would manage Xerox's customer
administrative functions, provide secured financing for XC's existing portfolio
of finance receivables and become the primary equipment financing provider for
Xerox customers in the U.S Xerox and GE entered into definitive agreements in
2001 and 2002. In May 2002, Xerox Capital Services (XCS), XC's U.S. venture with
GE, became operational. XCS now manages Xerox's customer administration
functions in the U.S. including credit approval, order processing, billing and
collections. In October 2002, XC completed an eight-year agreement in the U.S.
(the "New U.S. Vendor Financing Agreement"), under which GE became the primary
equipment financing provider in the U.S., through monthly securitizations of
Xerox's new lease originations up to a maximum amount of $5.0 billion. This
agreement was effectively a replacement of an agreement entered into in November
2001 whereby GE purchased XC receivables up to a maximum of $2.6 billion.
In anticipation of GE becoming the primary equipment financing provider for
Xerox customers in the U.S., we stopped purchasing new contracts receivable from
XC effective July 1, 2001 and our existing portfolio of contracts will
ultimately run-off as amounts are collected or contracts are sold back to XC as
part of its efforts to securitize existing receivables. XC continues to pursue
alternative forms of financing including securitization of portions of its U.S.
finance receivables portfolio, which underlies our contracts receivable. Any
such future securitizations by XC could further reduce our portfolio.
We have no international operations and do not purchase receivables from
international customers. Terms of our purchased contracts receivable range
primarily from three to five years. These purchases, and the subsequent
administration of the receivables by XC, have historically been undertaken
pursuant to the Amended and Restated Operating Agreement between XC and us (the
Operating Agreement). Under the Operating Agreement, XC transferred to us
whatever security interest it had in the receivables and equipment.
As noted, historically, we paid XC a fee to provide billing, collection and
other services related to the administration of the receivables that we
purchased from XC. Since XC provided these services, we maintained minimal
facilities and had no separate infrastructure or employees. Also, as noted
4
above, on May 1, 2002, XCS became operational and now manages XC's customer
administration and leasing activities in the U.S. Accordingly, subsequent to May
1, 2002, XCS manages our contracts instead of XC, and we now pay a fee to XCS
rather than to XC for these services. The fees we pay to XCS have been and are
expected to be equal to the fees paid to XC.
Pursuant to a Support Agreement between XC and us, XC has agreed to retain 100%
ultimate ownership of our voting capital stock and make periodic payments to us
to the extent necessary to ensure that our annual pre-tax earnings available for
fixed charges equal at least 1.25 times our fixed charges. The Support Agreement
specifically provides that XC is not directly or indirectly guaranteeing any of
our indebtedness, liabilities or obligations. The Support Agreement may not be
terminated or modified while any of our debt is outstanding.
Prior to 2000, we paid dividends to XFSI to the extent appropriate to ensure the
maintenance of a target debt-to-equity ratio. It was our intent to maintain a
target debt-to-equity ratio of 8 to 1. However, due to our cessation of
receivables purchases from XC and our decision to run-off or sell the existing
portfolio, we will no longer maintain a specific debt-to-equity ratio, and we
have no current intention to pay any dividends. We will continue to loan to XC,
on a demand basis, all proceeds from the sale or collection of our receivables.
In addition, we will demand repayment of these loan amounts from XC as and to
the extent necessary to repay our maturing debt obligations, fund our
operations, or for such other purposes that we determine appropriate.
ITEM 2. Properties
We do not directly own any facilities. Our principal executive offices in
Stamford, Connecticut are leased facilities of approximately 500 square feet of
office space. Xerox's North American Solutions Group, located in Rochester, New
York, uses less than 1,000 square feet of office space to house the personnel
that support our operations. These facilities are deemed adequate by management.
ITEM 3. Legal Proceedings
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
5
PART II
ITEM 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
Because we are a wholly owned subsidiary, there is no market for our common
shares. Dividends declared during the five years ended December 31 were as
follows (in millions):
1998 - None; 1999 - $170; 2000 - None; 2001 - None; and 2002 - None.
ITEM 6. Selected Financial Data
5 Years in Review
(Dollars in millions) 2002 2001 2000 1999 1998
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Operations:
Earned income:
Contracts receivable $ 175 $ 400 $ 441 $ 435 $ 388
Xerox Note Receivable 100 - - - -
Income before income taxes 142 91 137 180 137
Net income 97 53 83 110 82
Financial position:
Contracts receivable 1,151 3,244 6,355 5,653 5,789
Total assets 2,662 4,288 5,494 4,940 5,039
Consolidated capitalization
Short-term debt 470 1,760 880 2,902 3,720
Long-term debt 1,382 1,767 3,856 1,330 647
Total debt 1,852 3,527 4,736 4,232 4,367
Common shareholder's equity 763 658 613 530 590
Selected Data and Ratios
Common shareholders of record at year-end 1 1 1 1 1
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Due to the fact that our liquidity is dependent upon the liquidity of XC, our
ultimate parent, Item 7 includes both our Management's Discussion and Analysis
of Financial Condition and Results of Operations (MD&A) and XC's MD&A. Certain
matters discussed in XC's MD&A will relate to events and transactions that do
not directly affect our liquidity.
RESULTS OF OPERATIONS - XEROX CREDIT CORPORATION
Until July 2001, our sole business was to purchase non-cancelable contracts
receivable arising from installment sales and lease contracts originated by the
domestic marketing operations of XC. Substantially all commercial, federal
government and taxable state and local government transactions originated by XC
were sold to us. However, in anticipation of the agreements between XC and GE,
we stopped purchasing new contracts receivable from XC effective July 1, 2001.
Our existing portfolio of contracts receivable will ultimately run-off as
amounts are collected or are sold back to XC as part of XC's securitization
strategy.
Contracts receivable income represents income earned under an agreement with XC
pursuant to which we undertook the purchases noted above. In 2002, we did not
purchase receivables from XC compared to purchases of $908 million and $2,496
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million in 2001 and 2000, respectively. The decrease in receivable purchases in
2001 was due to the cessation of purchases from XC effective July 1, 2001, as
described above. Income from the Xerox note receivable represents amounts earned
on funds we have advanced to XC under the XC Master Demand Note (the Demand
Note).
During 2001, XC entered into an agreement with GE whereby XC agreed to sell
certain finance receivables in the U.S. to a special purpose entity (SPE) of XC,
against which GE provided a series of loans. This agreement was subsequently
amended as part of a new agreement entered into in October 2002, under which GE
became the primary equipment financing provider in the U.S., through monthly
securitizations of XC's new lease originations up to a maximum amount of $5.0
billion outstanding at any one time. In connection with these agreements, during
2002 and 2001 we sold contracts receivable to XC aggregating $451 million and
$949 million, respectively. The sales to XC were accounted for as sales of
contracts receivable at approximately book value, which approximated fair value.
Total earned income was $275 million, $400 million and $441 million for the
years ending December 31, 2002, 2001 and 2000, respectively. Contracts
receivable income declined by $225 million and $41 million in 2002 and 2001,
respectively. The declines reflect the decrease in the portfolio of contracts
receivable as a result of our decision to discontinue purchasing receivables
from XC in July 2001 as well as the sales of contracts receivable back to XC in
2001 and 2002. Although the balance of contracts receivable was significantly
reduced by December 31, 2001, the majority of the sales back to XC in 2001 did
not occur until the fourth quarter. Accordingly, the decline in earned income
for 2001 was mitigated as average receivables in 2001 were only 11 percent below
2000 levels. Earned income of $100 million on the Demand Note in 2002 partially
offset the decline in contracts receivable income.
Interest expense was $122 million, $261 million and $292 million for the years
ending December 31, 2002, 2001 and 2000, respectively. The decrease in 2002
reflects lower debt levels, as collections and sales of existing receivables
together with our cessation of new contract purchases have allowed us to reduce
our debt. Further, as a result of most of our match funding (pay fixed/receive
variable) swaps either maturing or terminating in 2001 and 2002, the majority of
our debt bears interest at variable rates and therefore we benefited from the
lower interest rates in 2002 as compared to 2001. The 2001 decrease reflects
lower debt levels resulting from a reduction in the portfolio size. As discussed
above, although the portfolio was significantly reduced by year-end 2001, the
majority of the decrease did not occur until the fourth quarter of 2001, thereby
mitigating the decline in interest expense.
Prior to the fourth quarter of 2000, both Xerox and we had employed a match
funding policy for financing assets and related liabilities. Under this policy,
the interest and currency characteristics of the indebtedness were, in most
cases, matched to the interest and currency characteristics of the contract
receivables, and short-term debt was classified on our balance sheets as
long-term if we had the intent and ability to extend the maturities of that
debt. The credit rating downgrades of XC's and our debt in 2000 and 2001
significantly changed the nature of our indebtedness and impacted our ability to
continue with our historical match funding policy. We now expect to pay down our
outstanding obligations as they contractually mature, and our debt has been
classified in the consolidated balance sheets accordingly.
The mark-to-market valuation of our interest rate derivatives resulted in a net
loss of $5 million and $37 million in 2002 and 2001, respectively. The loss in
2002 primarily reflects the accretion of the loss booked at the adoption of SFAS
No. 133 in Accumulated Other Comprehensive Income for our match funding swaps of
$13 million. This was partially offset by net gains on
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our cross-currency interest rate swaps associated with our Yen denominated
borrowings. While all of our derivative instruments are intended to economically
hedge currency and interest rate risk, differences between the contract terms of
our derivatives and the related underlying debt result in our inability to
obtain hedge accounting treatment in accordance with SFAS No. 133. This results
in mark-to-market valuation of these derivatives directly through earnings,
which increases volatility in our earnings. The loss in 2001 primarily reflects
the recognition of the change in fair value on our derivative contracts of
approximately $20 million directly through earnings as a result of our inability
to obtain hedge accounting. The balance reflects the accretion of the loss
booked at the adoption of SFAS No. 133 in Accumulated Other Comprehensive Income
for our match funding swaps.
General and administrative expenses were $6 million in 2002 compared to $11
million in 2001 and $12 million in 2000. These expenses are incurred to
administer the contracts receivable purchased from XC. The decline in 2002
reflects the lower level of receivables in 2002 compared to 2001. The 2001 and
2000 expense levels were substantially unchanged, as the average level of
contracts receivable was consistent in those years.
The effective income tax rate was 31.7 percent in 2002, compared to 38.9 percent
in 2001 and 2000. The decrease in our effective tax rate during 2002 was due to
a reduction in our estimated state tax as a result of our exit from doing
business in several states over the past several years. In addition, the 2002
effective tax rate reflects benefits arising from the favorable resolution of
audits and certain other tax-related issues.
Application of Critical Accounting Policies
In preparing the financial statements and accounting for the underlying
transactions and balances, we apply our financial policies as disclosed in our
Notes to the Consolidated Financial Statements. The application of our
accounting policies generally does not involve significant estimates or
management's judgment.
From time-to-time, in the normal course of business, we securitize or sell
contracts receivable with or without recourse and/or discounts. The receivables
are removed from the Consolidated Balance Sheet at the time they are sold and
the risk of loss has transferred to the purchaser. However, we maintain risk of
loss on any retained interest in such receivables. Sales and transfers that do
not meet the criteria for surrender of control, or that were sold to a
consolidated special purpose entity (non-qualified special purpose entity)under
SFAS No. 140, are accounted for as secured borrowings. These transactions are
often complex, involve highly structured contracts between us and the buyer or
transferee and involve strict accounting rules application. The key distinction
in the application of the accounting rules to the structured contracts and
similar transactions (sale versus a secured borrowing) is the inclusion or
exclusion of the related receivables and or associated obligations that would or
would not be included in our Consolidated Balance Sheet, as well as any gain or
loss that would result in a sale transaction. In order for a transaction to
qualify as a sale, several accounting requirements must be met including the
surrender of control over the receivables and the existence of a bankruptcy
remote contract structure. Transactions not meeting these requirements must be
accounted for as secured borrowings.
When we sell receivables, the value assigned to the retained interests in
securitized contracts receivable is based on the relative fair values of the
retained interest and sold in the securitization. We estimate fair value based
on the present value of future expected cash flows using management's best
estimates of the key assumptions, consisting of receivable amounts, anticipated
credit losses and discount rates commensurate with the risks involved. Gains
8
or losses on the sale of the receivables depend in part on the previous carrying
amount of the financial assets involved in the transfer, allocated between the
assets sold and the retained interests based on their relative fair value at the
date of transfer.
CAPITAL RESOURCES AND LIQUIDITY - XEROX CREDIT CORPORATION
XC manages our cash and liquidity resources as part of its U.S. cash management
system. Accordingly, any cash we generate is immediately loaned to XC, and we
generally do not maintain cash balances. Our liquidity is dependent on the
continued liquidity of XC. Due to our cessation of receivables purchases from XC
in 2001 and our sale of portions of our existing portfolio of contracts
receivable, funds collected since mid-2001 have exceeded cash usage
requirements, and all such excess funds have been loaned to XC under the
interest-bearing Demand Note. We have made in the past, and will continue to
make, demand loans to XC of all proceeds from the sale or collection of our
contracts receivable, and we will continue to demand repayment of these loan
amounts as and to the extent necessary to repay our maturing debt obligations
and fund our operations.
Net cash provided by operating activities was $154 million in 2002 compared to
$6 million of cash usage in 2001. The increase was primarily due to a $91
million change in the cash collateral requirements on certain derivative
contracts. During 2001, we paid $47 million to collateralize certain
cross-currency derivative contracts. During 2002, $44 million of that collateral
was released to us. In addition, higher net income due primarily to lower
interest expense also contributed to the increase. Net cash used in operating
activities was $6 million in 2001 compared with net cash provided of $74 million
in 2000. Adding back the net losses on derivative instruments of $23 million in
2001, net income was slightly lower in 2001 reflecting the decline in contracts
receivable during 2001. The net change in operating assets and liabilities,
reflecting a $35 million use of cash in 2001, is the result of lower tax and
interest accruals primarily due to lower income and debt levels, respectively.
Operating cash usage in 2001 also reflects collateralization payments of $47
million associated with certain derivative contracts.
Net cash provided by investing activities was $1,665 million in 2002 compared to
$1,236 million in 2001. Both amounts reflect the run-off of our contracts
receivable portfolio as a result of the decision to discontinue purchasing new
receivables from XC after July 1, 2001. Accordingly, net collections from
investments were $1,359 million and $998 million in 2002 and 2001, respectively,
as new purchases of investments ceased in the third quarter of 2001. 2002 and
2001 also reflect proceeds of $451 million and $1,592 million, respectively,
from the sale of receivables back to XC as described in Note 2 to the
Consolidated Financial Statements. In 2002 and 2001, contract collections and
proceeds from the sale of receivables were partially offset by net advances to
XC as required and described in Note 4. The advances to XC reflect our receipt
of $1,020 million from XC in the second quarter of 2002 that we used to repay
our revolver debt in connection with XC's negotiation of the New Credit
Facility. 2001 includes $23 million associated with the sale of certain assets.
Net cash used in investing activities of $622 million in 2000 reflects the fact
that purchases of investments exceeded collections from investments.
In connection with XC's financing agreement with GE, during 2002 and 2001, we
sold back to XC an aggregate of $451 million and $949 million, respectively, of
contracts receivable. The sales to XC were accounted for as sales of contracts
receivable at book value, which approximated fair value. We have no continuing
involvement or retained interests in the receivables sold and all the risk of
loss in such receivables was transferred back to XC. XC continues to pursue
alternative forms of financing including securitization of portions of its U.S.
finance receivables portfolio, which underlies our contracts
9
receivable. Any such future securitizations by XC could further reduce our
portfolio if we sell contracts receivable back to XC. Any funds received on such
sales will be loaned to XC under the interest bearing Master Demand Note.
The changes in operating and investing cash flows resulted in net cash used in
financing activities of $1,804 million in 2002 compared to $1,230 million in
2001. 2002 reflects principal payments on long-term debt, primarily the $1,020
million repayment of our revolver debt, as no proceeds from new debt were
received. 2001 reflects payments on notes with Xerox and affiliates and
principal payments on long-term debt of $643 million and $555 million,
respectively. 2001 also includes payments of $32 million on commercial paper.
Net cash provided by financing activities was $548 million in 2000. Cash
provided in 2000 primarily reflects the proceeds associated with term funding,
partially offset by payments on notes with Xerox and affiliates and principal
payments on long-term debt.
As of December 31, 2002, we had approximately $1.9 billion of debt outstanding.
We believe that the funds collected from our existing portfolio of contracts
receivable as well as amounts due under the Master Demand Note with XC will be
sufficient to meet our remaining maturing obligations.
New Credit Facility
- -------------------
In June 2002, Xerox entered into an Amended and Restated Credit Agreement (the
"New Credit Facility") with a group of lenders, replacing its prior $7 billion
facility (the "Old Revolver"). At that time, Xerox permanently repaid $2.8
billion of the Old Revolver, which included our repayment of the $1.02 billion
that we had borrowed. Xerox subsequently also repaid a portion of the New Credit
Facility. At December 31, 2002, the New Credit Facility consisted of two
tranches of term loans totaling $2.0 billion and a $1.5 billion revolving credit
facility that includes a $200 million letter of credit subfacility. We cannot
borrow under the New Credit Facility. At December 31, 2002, $3.5 billion was
outstanding under the New Credit Facility.
Subject to certain limits described in the following paragraph, all obligations
under the New Credit Facility are guaranteed by substantially all of XC's U.S.
subsidiaries (including us). Our guaranty of obligations under the New Credit
Facility, however, is subordinated to all of our capital markets debt
outstanding as of June 21, 2002. In connection with the New Credit Facility,
substantially all of XC's U.S. subsidiaries (including us) also guaranteed XC's
$600 million of 9-3/4% Senior Notes and Euro 225 million of 9-3/4% Senior Notes
due 2009 (collectively, the "Senior Notes").
In addition to other defaults customary for facilities of this type, a default
on debt, or bankruptcy, of Xerox Corporation or certain of its subsidiaries,
would constitute a default under the New Credit Facility.
At December 31, 2002, Xerox was in compliance with all aspects of the New Credit
Facility including financial covenants, and expects to be in compliance for at
least the next twelve months. Failure to be in compliance with any material
provision or covenant of the New Credit Facility could have a material adverse
effect on its and our liquidity and operations.
Refer to the Xerox Corporation MD&A in the following section and Notes 1 and 7
for a full description of the New Credit Facility.
Financial Risk Management
- -------------------------
We are exposed to market risk from changes in interest rates and foreign
currency exchange rates that could affect our results of operations and
financial condition. Our current below investment-grade debt ratings effectively
constrain our ability to fully use derivative contracts as part of
10
our risk management strategy described below, especially with respect to
interest rate management. Accordingly, we are exposed to increased volatility in
our results of operations.
However, as more fully described in Note 1, we stopped purchasing new contracts
receivable from XC effective July 1, 2001 and our existing portfolio of
contracts will ultimately run-off as amounts are collected or contracts are sold
back to XC as part of its efforts to securitize existing receivables. As a
result of this decision, our exposures have effectively been limited to the
current balances of receivables and related debt and will decrease over time as
receivables are collected or sold and debt is repaid.
We adopted Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" (SFAS No. 133), as of January 1,
2001. The adoption of SFAS No. 133 is expected to increase the future volatility
of reported earnings and other comprehensive income. In general, the amount of
volatility will vary with the level of derivative and hedging activities and the
market volatility during any period. However, as noted above, our volatility is
limited since our ability to enter into new derivative contracts is constrained
and the business is in run-off as a result of the decision to discontinue the
purchase of new receivables from XC.
We have historically entered into certain derivative contracts, including
interest rate swap agreements and foreign currency swap agreements to manage
interest rate and foreign currency exposures. The fair market values of all of
our derivative contracts change with fluctuations in interest rates and/or
currency rates, and are designed so that any change in their values is offset by
changes in the values of the underlying exposures. Our derivative instruments
are held solely to hedge economic exposures; we do not enter into derivative
instrument transactions for trading or other speculative purposes and we employ
long-standing policies prescribing that derivative instruments are only to be
used to achieve a set of very limited objectives.
Contracts receivable assets earn fixed rates of interest, while a significant
portion of our debt bears interest at variable rates. Historically we have
attempted to manage our interest rate risk by "match-funding" the financing
assets and related debt, including the use of interest rate swap agreements.
However, as our credit ratings declined, our ability to continue this practice
became constrained.
At December 31, 2002, we had $1,142 million of variable rate debt, including our
pay variable interest-rate swaps. The nominal value of pay fixed interest-rate
swaps were $194 million.
Many of the financial instruments we use are sensitive to changes in interest
rates. Interest rate changes result in fair value gains or losses on our term
debt and interest rate swaps, due to differences between current market interest
rates and the stated interest rates within the instrument. The change in fair
value at December 31, 2002, from a 10% change in market interest rates would be
approximately $40 million for our interest rate sensitive financial instruments.
Our currency and interest rate hedging activities are typically unaffected by
changes in market conditions as forward contracts, options and swaps are
normally, when possible, held to maturity consistent with our objective to lock
in currency rates and interest rate spreads on the underlying transactions.
Since our liquidity is heavily dependent upon the liquidity of our ultimate
parent, XC, we are including the following excerpts from Management's Discussion
and Analysis of Financial Statements and Results of Operations, including
Capital Resources and Liquidity, as reported in the Xerox Corporation 2002
Annual Report on Form 10-K.
11
READER'S NOTE: THE FOLLOWING DISCUSSION HAS BEEN EXCERPTED DIRECTLY FROM XEROX
CORPORATION'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002.
DEFINED TERMS HEREIN MAY NOT NECESSARILY HAVE THE SAME MEANING AS THE SAME
DEFINED TERMS HAVE IN OTHER PARTS OF THIS DOCUMENT. SUCH TERMS SHOULD BE READ IN
THE NARROW CONTEXT IN WHICH THEY ARE DEFINED IN THIS SECTION. REFERENCES TO
"WE", "OUR", AND "US" REFER TO XEROX CORPORATION. ADDITIONALLY, AMOUNTS AND
EXPLANATIONS CONTAINED IN THIS SECTION ARE MEANT TO GIVE THE READER ONLY A
GENERAL SENSE OF XC'S OPERATIONS, CAPITAL RESOURCES AND LIQUIDITY. ACCORDINGLY,
THESE EXCERPTS SHOULD BE READ IN THE CONTEXT OF THE XC CONSOLIDATED FINANCIAL
STATEMENTS, WHICH ARE INCLUDED IN XEROX CORPORATION'S 2002 ANNUAL REPORT ON FORM
10-K FILED SEPARATELY WITH THE SEC.
12
Summary of Total Company Results:
The following is a summary of our results ($ in millions, except share amounts):
Year Ended December 31,
----------------------------------
2002 2001 2000
-------- -------- ---------
Revenue $ 15,849 $ 17,008 $ 18,751
Net income (loss) 91 (94) (273)
Diluted Earnings (Loss) per share $ 0.02 $ (0.15) $ (0.48)
Revenues: A substantial portion of our consolidated revenues is derived from
operations outside of the United States where the U.S. dollar is not the
functional currency. We generally do not hedge the translation effect of
revenues denominated in currencies where the local currency is the functional
currency. When compared with the average of the major European and Canadian
currencies on a revenue-weighted basis, the U.S. dollar was approximately 4
percent weaker in 2002 than in 2001 and three percent stronger in 2001 than in
2000. As a result, foreign currency translation favorably impacted total revenue
growth by approximately one percentage point in 2002 and unfavorably impacted
revenue growth by about one percentage point in 2001. Additionally, in 2002,
currency devaluations in Brazil continued to impact our results, as the
Brazilian Real devalued 19 percent against the U.S. dollar. The devaluation was
22 percent and 2 percent in 2001 and 2000, respectively.
Total revenues of $15.8 billion in 2002 declined 7 percent from 2001. Economic
weakness and competitive pressures persisted throughout the year, however year
over year revenue declines moderated during the year, reflecting the success of
numerous recent product launches in our color and monochrome digital
multifunction target markets. Approximately one quarter of the decline was due
to our prioritization of more profitable revenue which resulted in reduced
revenue in our Developing Markets Operations segment ("DMO"), reflecting a
reduction in the number of printers and copiers at customer locations, primarily
in Brazil and Argentina. In addition, approximately 15 percent of the decline
was due to the discontinuation of equipment sales and declining supplies sales
due to our SOHO exit in the second half of 2001. Approximately 10 percent of the
decline reflects lower financing income revenue, resulting from lower equipment
installations and our exit from the financing business in certain European
countries. The remainder of the decline was due to a mix of economic weakness,
continued competitive pressures and market transition from light-lens to digital
technology. This resulted in continued declines in older light-lens products, as
customers continue to transition to new digital technology, only modestly offset
by growth in production color, monochrome digital multifunction, and color
printers, reflecting the success of our new products in these key areas.
Total revenues of $17.0 billion in 2001 declined 9 percent from 2000, primarily
reflecting the adverse impact of marketplace competition, further weakening of
the worldwide economy and our reduced participation in aggressively priced bids
and tenders as we focused on improving our profitability. In addition,
approximately one quarter of the decline reflected the absence of revenues due
to our exit from the SOHO business in the second half of 2001 and the sale of
our China operations in 2000. Approximately 20 percent of the decline reflects
lower revenue in DMO, also due to our decision to prioritize more profitable
revenue.
Revenues by Type: Revenues and year-over-year changes by type of revenues were
as follows ($ in millions):
Revenues
--------
Year Ended December 31, Percent Change
---------------------- --------------
2002 2001 2000 2002 2001
---- ---- ---- ---- ----
Equipment sales $ 3,901 $ 4,329 $ 5,264 (10)% (18)%
Post sale and other revenue 10,948 11,550 12,325 (5)% (6)%
Finance income 1,000 1,129 1,162 (11)% (3)%
-------- -------- --------
Total Revenues $ 15,849 $ 17,008 $ 18,751 (7)% (9)%
======== ======== ========
A reconciliation of the above presentation of revenues to the revenue
classifications included in our Consolidated Statements of Income is as follows
($ in millions):
13
Year Ended December 31,
-----------------------
2002 2001 2000
---- ---- ----
Sales ........................................ $ 6,752 $ 7,443 $ 8,839
Less: Supplies, paper and other sales ........ (2,851) (3,114) (3,575)
-------- -------- --------
Equipment Sales .............................. $3,901 $ 4,329 $ 5,264
======== ======== ========
Service, outsourcing and rentals ............. $ 8,097 $ 8,436 $ 8,750
Add: Supplies, paper and other sales ......... 2,851 3,114 3,575
-------- -------- --------
Post sale and other revenue .................. $ 10,948 $ 11,550 $ 12,325
======== ======== ========
2002 Equipment sales of $3.9 billion declined 10 percent from $4.3 billion in
2001 and included a benefit of one-percentage point from currency. Year over
year equipment sales declines moderated throughout 2002, reflecting the success
of our 2002 product launches in the key areas of monochrome digital
multifunction, as well as in Production and Office color. Approximately 35
percent of the decline was due to a decrease in light lens equipment sales due
to customers that transitioned to digital technology. Less than 5 percent of our
2002 Equipment sales were for light lens devices and we expect this declining
trend to continue. Approximately 30 percent of the Equipment sales decline was
due to our exit from the SOHO segment in 2001 and the remainder of the decline
was caused by a combination of the weak economy, marketplace competition and
price pressures which approximated 5 to 10 percent and our decision to reduce
participation in aggressively priced bids and tenders in Europe, as we
reoriented our focus from market share to profitable revenue.
2001 Equipment sales of $4.3 billion declined 18 percent from $5.3 billion in
2000 and included an unfavorable currency impact of one percentage point. Over
one-third of the decline was due to our exit from the SOHO segment in 2001 and
the sale of our China operations in 2000. Approximately one quarter of the
decline was due to customers that transitioned from light lens to digital
technology. The balance of the decline reflected a combination of economic
weakness, competitive price pressures which approximated 5 to 10 percent, and
our decision to reduce participation in aggressively priced bids and tenders in
Europe, as we reoriented our focus from market share to profitable revenue.
Post sale and other revenue consists of service, supplies, paper, rental,
facilities management and other revenues derived from the equipment installed at
customer locations and the volume of prints and copies that our customers make
on that equipment, as well as associated services. 2002 Post sale and other
revenue of $10.9 billion, declined 5 percent from $11.5 billion in 2001,
including a favorable impact of one-percentage point from currency. Over half of
the total decline in 2002 Post sale and other revenue was due to a reduction in
the amount of equipment installations at certain DMO customer locations, as a
result of reduced placements in recent periods and our exit from the SOHO
segment in the second half of 2001. The balance of the decline included lower
page print volumes and customers that transitioned from light lens to digital
technology, reflecting weak monochrome equipment installations in the Production
and Office segments which have not yet been offset by growth in color. Within
post sale and other revenue, 2002 supplies, paper and other sales of $2.9
billion declined 8 percent from 2001 predominantly due to supplies declines
reflecting our second half 2001 SOHO exit, lower DMO equipment installations and
production and office light lens declines. Service, outsourcing and rental
revenue of $8.1 billion declined 4 percent from 2001 predominantly due to lower
rental revenues a the result of a reduction in the level of equipment
installations at certain DMO customers in both current and prior periods.
2001 Post sale and other revenue of $11.5 billion, declined 6 percent from $12.3
billion in 2000 and included the adverse impact from currency translation of
one-percentage point. Approximately 40 percent of the decline occurred in our
DMO segment as a result of reduced equipment installations in that segment and
15 percent was due to the sale of our China operations in 2000. The remainder of
the decline resulted from decreases in Production monochrome and Office light
lens, and our decision to prioritize more profitable revenue, which were only
partially offset by strong double-digit growth in color and monochrome digital
multifunction. Within post sale and other revenue, 2001 supplies, paper and
other sales of $3.1 billion declined 13 percent from 2000 due to lower paper
sales reflecting reduced volumes and reduced Production, Office and DMO supplies
revenues reflecting the declines discussed above. Service, outsourcing and
rental revenue of $8.4 billion were 4 percent lower than 2000 as lower service
and rental revenues were only partially offset by document outsourcing growth.
2002 Finance income revenue declined 11 percent from 2001, reflecting lower 2002
equipment sales, our full exit from the financing business in the Nordic
countries and in Italy, as well as our partial exit of this business in The
Netherlands and Germany. 2001 Finance income revenue declined 3 percent from
2000, reflecting lower equipment sales and the initial effects of our transition
to a third party finance provider in the Nordic countries.
Finance income is primarily impacted by equipment lease originations and
interest rates. The most significant factor is the level of equipment lease
originations; accordingly, we expect that Finance income will decline in 2003,
reflecting lower equipment lease originations in recent years. In addition,
Finance income will be reduced to the extent we sell portions of our financing
businesses, similar to the Nordic countries and Italy, or enter into agreements
with third parties to provide financing directly to our customers. Since the
vast majority of our third-party financing arrangements have been structured as
secured borrowings, the lease receivables remain on our balance sheet and are
expected to continue generating Finance income. As a result of the above
factors, we expect the trend of the decreasing Finance income to stabilize,
although periodic fluctuations will occur as a result of the level of equipment
sales and interest rates.
We expect equipment sales to grow modestly in 2003, as our 2002 and planned 2003
product launches should enable us to strengthen our market position. Our ability
to increase post sale revenue is dependent on our success increasing the amount
of our equipment at customer locations and the volume of pages generated on that
equipment. In 2003, we expect post sale and other revenue declines will continue
to moderate as equipment sales increase and our services and solutions increase
utilization of the equipment. Accordingly, we expect a modest total revenue
decline in 2003.
14
Employee Stock Ownership Plan: As more fully discussed in Note 16 to the
Consolidated Financial Statements, our Board of Directors reinstated the
dividend on our Employee Stock Ownership Plan ("ESOP") in 2002, which resulted
in a reversal of compensation expense previously recorded. The reversal of
compensation expense corresponded to the line item in the Consolidated Statement
of Income for 2002 where the charge was originally recorded and included $28 in
both Cost of Sales and Selling, administrative and general expenses and $11 in
Research and Development expenses. Of the total compensation expense originally
recorded, $34 million and $33 million was recognized in 2002 and 2001,
respectively. As such, 2002 benefited by $33 million of excess compensation
expense reversal that was recorded in 2001. There is no corresponding earnings
per share improvement in 2002, since the EPS calculation requires deduction of
dividends declared from reported net income in arriving at net income available
to common shareholders. In the fourth quarter 2002, an additional $11 million of
dividends were declared.
Gross Margin: Gross margin by revenue classification was as follows:
Year Ended December 31,
----------------------
2002 2001 2000
---- ---- ----
Total gross margin 42.4% 38.2% 37.4%
Sales 37.8% 30.5% 31.2%
Service, outsourcing and rentals 44.0% 42.2% 41.1%
Finance income 59.9% 59.5% 57.1%
The 2002 gross margin of 42.4 percent improved 4.2 percentage points from 2001.
1.4 percentage points of the increase reflects our second half 2001 SOHO exit.
Improved manufacturing and service productivity, which was more than offset by
lower prices accounted for approximately one percentage point of improvement and
higher margins in our DMO operating segment also contributed about 0.5
percentage points of the improvement. The balance of the increase includes the
favorable ESOP compensation expense adjustment, favorable transaction currency,
lower inventory charges associated with restructuring actions and improved
document outsourcing margins associated with our focus on profitable revenue.
2002 Sales gross margin improved by 7.3 percentage points from 2001.
Approximately 2.6 percentage points of the improvement was due to our SOHO exit,
about 1.3 percentage points of the improvement was due to increases in DMO, 0.6
percentage points was due to lower inventory charges associated with
restructuring actions and the balance was largely due to manufacturing
productivity, which was more than offset by competitive price pressures. 2002
Service, outsourcing and rentals margins improved by 1.8 percentage points
from 2001 reflecting the benefits of expense productivity actions and more
profitable document outsourcing contracts.
The 2001 gross margin of 38.2 percent increased 0.8 percentage points from 2000,
as improved manufacturing and service productivity more than offset unfavorable
mix and competitive price pressures, particularly in the production monochrome
area. 2001 Sales gross margin declined by 0.7 percentage points due to higher
manufacturing expenses resulting from lower volume and plant utilization as well
as a lower level of high margin licensing and software revenues. These
improvements were partially offset by increased margins in our printer business.
2001 Service, outsourcing and rentals margin improved by 1.1 percentage points
due primarily to service expense reductions and facilities maintenance gross
margin improvements, partially offset by declines in DMO.
Finance income margins of approximately 60 percent reflect interest expense
related to our financing operations. Equipment financing interest rates are
determined based on a combination of actual interest expense incurred on
financing debt, as well as our estimated cost of funds, applied against the
estimated level of debt required to support our financed receivables. The
estimate is based on an assumed ratio of debt as compared to our finance
receivables. This ratio ranges from 80-90% of our average finance receivables.
This methodology has been consistently applied for all periods presented. We
expect our 2003 Finance income gross margin to be in line with 2002.
Research and Development: 2002 research and development ("R&D") spending of $917
million, was $80 million lower than 2001. Approximately 40 percent of the
decline was due to our SOHO exit, another 40 percent of the decline reflects
both benefits from cost restructuring actions and the receipt of external
funding and the balance reflects the previously discussed favorable ESOP
compensation expense adjustment. R&D spending represented our continued
investment in technological development, particularly color, to maintain our
position in the rapidly changing document processing market. We believe our R&D
remains technologically competitive. Our R&D is strategically coordinated with
that of Fuji Xerox, which invested $580 million in R&D in 2002, which together
with our R&D spending resulted in a combined total of $1.5 billion. To maximize
the synergies of our relationship, our R&D expenditures are focused on the
Production segment while Fuji Xerox R&D expenditures are focused on the Office
segment. In 2002, we were awarded over 700 U.S. patents ranking us 19th on the
list of companies that had been awarded the most U.S. patents during the year.
Together with Fuji Xerox, we were awarded close to 900 U.S. patents in 2002. Our
patent portfolio evolves as new patents are awarded to us and as older patents
expire. As of December 31, 2002, we held approximately 7,700 U.S. patents. These
patents expire at various dates
15
up to 17 years from the date of award. While we believe that our portfolio of
patents and applications has value, in general no single patent is essential to
our business or the individual segments. In addition, any of our proprietary
rights could be challenged, invalidated or circumvented, or may not provide
significant competitive advantages.
2001 R&D spending of $997 million declined by $67 million from 2000. Over half
the reduction reflects the second half 2001 SOHO disengagement, with the balance
due to cost reduction initiatives in 2000 and 2001.
Selling, Administrative and General Expenses: Selling, administrative and
general ("SAG") expense information was as follows ($ in millions):
Year Ended December 31,
-----------------------
2002 2001 2000
---- ---- ----
Total Selling, administrative and general expenses $ 4,437 $ 4,728 $5,518
SAG as a percentage of revenue 28.0% 27.8% 29.1%
2002 SAG expense of $4,437 million declined by $291 million from 2001. The
reduction includes lower bad debt expenses of $106 million, lower SOHO spending
of $84 million and a $34 million favorable property tax adjustment in North
America. These decreases were partially offset by $106 million of internal-use
software impairment charges, $65 million of higher advertising and marketing
communications spending, $18 million of increased professional fees and $26
million of losses associated with the exit from certain leased facilities. The
balance of the reduction primarily reflects employment reductions associated
with our cost base restructuring which has resulted in lower labor, benefit and
related expenses.
2001 SAG expense of $4,728 million declined $790 million from 2000 reflecting
significantly lower labor costs and other benefits derived from our cost
reduction initiatives, temporarily lower advertising and marketing
communications spending of $88 million and reduced SOHO spending of $62 million,
partially offset by increased professional costs related to litigation,
regulatory issues and related matters of $52 million.
We expect 2003 total SAG expense reductions in line with the 2002 decline.
Bad debt expense included in SAG, was $332 million, $438 million and $472
million in 2002, 2001 and 2000, respectively. Lower expense in 2002 is due to
improved customer administration, collection practices and credit approval
policies, as well as our revenue declines. 2001 provisions were lower than 2000
due to lower equipment sales, partially offset by reserve increases due to the
weakened worldwide economy. Bad debt expenses as a percent of total revenue were
2.1 percent, 2.6 percent, and 2.5 percent for 2002, 2001 and 2000, respectively.
As with Finance income, the bad debt provision will be impacted to the extent we
sell portions of our financing businesses, including existing receivables, or
enter into agreements with third parties to provide financing directly to our
customers. Any provision for customer credit would accordingly be factored in
the proceeds we receive from the counterparty and the resultant revenue or gain
recognized on the sale of equipment or receivables. However, as noted above,
since most of our transactions with third parties involve secured borrowing
structures, the associated finance receivables will remain in our Consolidated
Balance Sheets. Accordingly, in these cases the provision for bad debts will
continue to be recorded as usual and therefore no impact to our Consolidated
Statements of Income is expected.
Restructuring Programs: Starting in late 2000, as a part of the Turnaround
Program, we implemented work force resizing and cost reduction actions that
reduced SAG expenses and improved gross margins by approximately $800 million in
annualized savings during 2001 and an additional $300 million, for a total of
$1.1 billion in annualized savings during 2002. These savings resulted from
reducing layers of management, consolidating operations, reducing administrative
and general spending, capturing service productivity savings from our digital
products and tightly managing discretionary spending. We reduced our costs in
our Office operating segment by moving to lower cost indirect sales and service
channels and by outsourcing our office products manufacturing. In 2002, we
implemented additional restructuring initiatives under the Turnaround Program
related additional worldwide employee severance actions, reflecting continued
streamlining of existing operations, the elimination of redundant resources and
the consolidation of activities into other existing operations and the Fourth
Quarter 2002 Restructuring Program. These initiatives resulted in an additional
$200 million of cost savings in 2002. Prospectively, we expect the annualized
savings to be approximately $1.7 billion in 2003 as compared to 2000 spending
levels from these programs.
In addition to the work force resizing and cost reduction actions, we also sold
$2.7 billion of assets as part of the Turnaround Program. These sales were
primarily focused on improving our liquidity, as well as transitioning a portion
of our equipment financing to third parties in some geographies, a portion of
our manufacturing activities to Flextronics and exiting certain non-core
businesses.
The most significant of the sales included the sale of half of our 50 percent
ownership interest in Fuji Xerox in 2001 to Fuji Photo Film Co., Ltd. ("Fuji
Film") and our China operations in 2000 to Fuji Xerox,, in order to improve our
liquidity. In connection with the sale of Fuji Xerox, we received $1.3 billion
in cash and recorded a pre-tax gain of $773 million. Under the agreement Fuji
Film's ownership interest in Fuji Xerox increased from 50 percent to 75 percent.
Our ownership interest decreased to 25 percent and we retain significant rights
as a minority shareholder. We account for our investment in Fuji Xerox under the
equity method, both before and after the sale of the additional 25 percent.
Subsequent to the sale, we have maintained our product distribution and
technology agreements that ensure that both parties have access to each other's
portfolio of patents, technology and products. Fuji Xerox continues to sell
products to us as well as collaborate with us on R&D. In 2000, we recognized
approximately $73 million of equity income from Fuji Xerox in our Consolidated
Statement of Income. Our equity income from Fuji Xerox in 2002 and 2001 was
approximately $45 million for both years.
The sale of our China operations to Fuji Xerox generated cash of $550 million
and a pre-tax gain of $200 million. In connection with the sale, Fuji Xerox also
assumed $118 million of indebtedness. Our China operations had $262 million of
revenue in 2000, which is included in the accompanying Consolidated Statement of
Income. While Fuji Xerox is our affiliate, we believe the negotiations for this
transaction were similar to those that would have been entered into with an
unaffiliated third party, both in terms of price and conditions. Both parties
were represented by separate legal counsel. The sale of our China operations had
no operational impact, other than the permanent reduction in sales. Given the
sale to Fuji Xerox, however, we retained our equity share of the China
operations' net income.
We sold our leasing business in four Nordic countries in 2001 and our leasing
business in Italy in 2002 to a company now owned by GE. These sales were aligned
with our strategy of transitioning portions of our equipment financing to third
parties. We received $352 million in cash and retained interests in certain
finance receivables for the sale of the Nordic leasing business and $200 million
in cash, plus the assumption of $20 million in debt for the sale of our leasing
business in Italy. The sale of the Nordic leasing business approximated book
value. We recognized a pre-tax loss from the sale in Italy of approximately $27
million primarily related to the recognition of cumulative translation
adjustment losses and final sale contingency settlements. The impact of both of
these transactions was to eliminate finance receivables from our balance sheet
approximating the proceeds received from the sales, thereby improving our
liquidity. GE will be providing the ongoing financing for these customers in
these countries. Removing the finance receivable portfolios and essentially
outsourcing the financing to GE, will result in future reductions in finance
income and financing interest expense, as well as general and administrative
costs.
In addition to these sales, we also entered into a purchase and supply agreement
with Flextronics, a global electronics manufacturing services company. Pursuant
to the purchase agreement, we sold our operations in Toronto, Canada;
Aguascalientes, Mexico; Penang, Malaysia; Venray, The Netherlands and Resende,
Brazil to Flextronics for $167 million. In addition, Flextronics purchased the
related inventory, property and equipment. We expect these sales, to a company
that specializes in manufacturing as their core competency, will help us reduce
manufacturing costs and help effectively manage our inventory levels. In total,
approximately 4,100 employees in these operations transferred to Flextronics.
For further discussion, refer to Note 4 to our Consolidated Financial
Statements.
We also exited certain non-core businesses in 2001 and 2002. These sales
included the sale of Katun Corporation in 2002, a supplier of after market
copier/printer parts and supplies, for net proceeds of $67 million and the sale
of Delphax in 2001, a manufacturer of high-speed electron beam imaging digital
printing systems and related parts, supplies and services, for net proceeds of
$16 million. These sales were essentially break-even. The sale of these
businesses did not have a material effect on our financial position, results of
operations or cash flows.
At this time, we have substantially completed our restructuring initiatives,
although we expect 2003 restructuring charges of approximately $115 million as
further described in Note 2 to our Consolidated Financial Statements.
16
Worldwide employment declined by approximately 11,100 in 2002, to approximately
67,800, largely as a result of our restructuring programs, and the transfer of
employees to Flextronics, as part of our office manufacturing outsourcing.
Worldwide employment was approximately 78,900 and 91,500 at December 31, 2001
and 2000, respectively.
Other Expenses, Net: Other expenses, net for the three years ended December 31,
2002 consisted of the following ($ in millions):
Year Ended December 31,
------------------------------
2002 2001 2000
------- ------ ------
Non-financing interest expense $ 350 $ 480 $ 592
Currency losses (gains), net 77 (29) (103)
Legal and regulatory matters 37 -- --
Amortization of goodwill (2001 and 2000) and intangibles 36 94 86
Interest income (77) (101) (77)
Gain on early extinguishment of debt (1) (63) --
Business divestiture and asset sale (gains) losses (1) 10 (67)
Purchased in-process research and development -- -- 27
All other, net 24 53 93
------ ----- ------
$ 445 $ 444 $ 551
====== ===== ======
2002 non-financing interest expense was $130 million lower than 2001 reflecting
lower debt levels throughout 2002 and lower borrowing costs in the first half of
the year, partially offset by higher interest rates and borrowing costs in the
second half of the year associated with the terms of the New Credit Facility.
Lower borrowing costs reflect the continued decline in interest rates throughout
2002, coupled with our higher proportion of variable rate debt in 2002 as
compared to 2001. Our current credit ratings are below investment grade and
effectively constrain our ability to fully use derivative contracts to manage
interest rate risk. Accordingly, although we benefited from lower interest rates
in 2002, we have greater exposure to volatility in our results of operations.
2002 non-financing interest expense included net gains of $12 million from the
mark-to-market valuation of our interest rate swaps. Differences between the
contract terms of our interest rate swaps and the underlying related debt
restricts hedge accounting treatment in accordance with Statement of Financial
Accounting Standards No. 133 "Accounting for Derivative and Hedging Activities"
("SFAS No. 133"), which required us to record the mark-to-market valuation of
these derivatives directly to earnings. 2001 non-financing interest expense was
$112 million lower than 2000, reflecting lower interest rates and lower debt
levels. Non-financing interest expense in 2001 included net losses of $2 million
from the mark-to-market of our interest rate swaps. Due to the inherent
volatility in the interest rate markets, we are unable to predict the amount of
the above noted mark-to-market gains or losses in future periods. Such gains or
losses could be material to the financial statements in any future reporting
period.
Net currency losses (gains) result from the re-measurement of unhedged foreign
currency-denominated assets and liabilities, the spot/forward premiums on
foreign exchange forward contracts in those markets where we have been able to
restore economic hedging capability and economic hedges of anticipated
transactions for which we do not qualify for cash flow hedge accounting
treatment under SFAS No. 133. In the first half of 2002, we incurred $57 million
of exchange losses, primarily in Brazil and Argentina due to the devaluation of
the underlying currencies. In the latter half of 2002, we have been able to
restore hedging capability in the majority of our key markets. Therefore, the
$20 million of currency losses in the second half of 2002 primarily represents
the spot/forward premiums on foreign exchange forward contracts and unfavorable
currency movements on economic hedges of anticipated transactions not qualifying
for hedge accounting treatment. In 2001, exchange gains on yen debt of $107
million more than offset losses on Euro loans of $36 million, a $17 million
exchange loss resulting from the peso devaluation in Argentina and other
currency exchange losses of $25 million. In 2000, large gains on both the yen
and Euro loans contributed to the $103 million gain. The 2001 and 2000 currency
gains and losses were the result of net unhedged positions largely caused by our
restricted access to the derivatives markets beginning in the fourth quarter
2000. Despite restoration of hedging capability in our key markets in the latter
half of 2002, we are unable to predict the amount of the re-measurement gains or
losses in future periods resulting from our remaining unhedged positions, due to
the inherent volatility in the foreign currency markets. Such gains or losses
could be material to the financial statements in any future reporting period.
Legal and regulatory matters includes $27 million of expenses related to certain
litigation, indemnifications and associated claims, as well as the $10 million
penalty incurred in connection with our settlement with the SEC. See Note 15 to
the Consolidated Financial Statements for additional information.
Prior to 2002, goodwill and other intangible asset amortization related
primarily to our acquisitions of the remaining minority interest in Xerox
Limited in 1995 and 1997, XL Connect in 1998 and Color Printing and Imaging
Division of Tektronix, Inc.
17
("CPID") in 2000. Effective January 1, 2002 and in connection with the adoption
of SFAS No. 142, we no longer record amortization of goodwill. Intangible assets
continue to be amortized over their useful lives. Further discussion is provided
in Note 1 to the Consolidated Financial Statements.
Interest income is derived primarily from our significant invested cash balances
since the latter part of 2000. 2002 interest income was lower than 2001 due to
lower invested cash balances in the second half of 2002, resulting from the
pay-down of the Old Revolver, as well as lower interest rates. 2001 interest
income was $24 million higher than 2000 due to higher interest income resulting
from a full year of invested cash balances in 2001, partially offset by lower
interest from tax audit refunds. We expect 2003 interest income to be lower than
2002 based on projected lower average cash balances.
In 2002, we retired $52 million of long-term debt through the exchange of 6.4
million shares of common stock valued at $51 million. In 2001, we retired $374
million of long-term debt through the exchange of 41 million shares of common
stock valued at $311 million. The shares were valued using the daily volume
weighted average price of our common stock over a specified number of days prior
to the exchange, based on contractual terms. These transactions resulted in
gains of $1 million and $63 million in 2002 and 2001, respectively.
(Gains) losses on business divestitures and asset sales include the sales of our
leasing business in Italy, our investment in Prudential Insurance Company common
stock and our equity investment in Katun Corporation all in 2002, the sale of
our Nordic leasing business in 2001 and the sale of our North American paper
product line and a 25 percent interest in ContentGuard in 2000, as well as
miscellaneous land, buildings and equipment in all years. Further discussion of
our divestitures follows and is also contained in Note 4 to the Consolidated
Financial Statements.
Purchased in-process research and development related to a 2000 acquisition. The
charge represented the fair value of acquired research and development projects
that were determined not to have reached technological feasibility as of the
date of the acquisition.
Gain on Affiliate's Sale of Stock: In 2001 and 2000, gain on affiliate's sale of
stock of $4 million and $21 million, respectively, reflects our proportionate
share of the increase in equity of ScanSoft Inc., resulting from issuance of
their stock in connection with one of their acquisitions. The 2000 gain was
partially offset by a $5 million charge reflecting our share of in-process
research and development associated with one of their acquisitions, which is
included in equity in net income of unconsolidated affiliates. ScanSoft, an
equity affiliate, is a developer of digital imaging software that enables users
to leverage the power of their scanners, digital cameras and other electronic
devices.
Income Taxes: The following table summarizes our consolidated income tax
(benefits) and the related effective tax rate for each respective period:
Year Ended December 31,
----------------------
2002 2001 2000
---- ---- ----
Pre-tax income (loss) $252 $394 $ (367)
Income taxes (benefits) 60 497 (70)
Effective tax rate 23.8% 126.1% 19.1%
The difference between the 2002 consolidated effective tax rate of 23.8 percent
and the U.S. federal statutory income tax rate of 35 percent relates primarily
to the recognition of tax benefits resulting from the favorable resolution of a
foreign tax audit of approximately $79 million, tax law changes of approximately
$26 million, as well as the impact of ESOP dividends. Such benefits were offset,
in part, by tax expense recorded for the on-going examination in India, the sale
of our interest in Katun Corporation, as well as recurring losses in certain
jurisdictions where we are not providing tax benefits.
The difference between the 2001 effective tax rate and the U.S. federal
statutory income tax rate, relates primarily to the recognition of deferred tax
asset valuation allowances of $247 million from our recoverability assessments,
the taxes incurred in connection with the sale of our partial interest in Fuji
Xerox and recurring losses in low tax jurisdictions. The gain for tax purposes
on the sale of Fuji Xerox was disproportionate to the gain for book purposes as
a result of a lower tax basis in the investment. Other items favorably impacting
the tax rate included a tax audit resolution of approximately $140 million and
additional tax benefits arising from prior period restructuring provisions.
The difference between the 2000 effective tax rate and the U.S. federal
statutory income tax rate, relates primarily to recurring losses in low tax
jurisdictions, the recognition of deferred tax asset valuation allowances
resulting from our recoverability assessments, as offset by $125 million of
additional tax benefits arising from the favorable resolution of tax audits.
18
Our effective tax rate will change based on nonrecurring events (such as new
restructuring actions) as well as recurring factors including the geographical
mix of income before taxes. We expect our 2003 consolidated effective tax rate
will approximate 40 percent.
Equity in Net Income of Unconsolidated Affiliates: Equity in net income of
unconsolidated affiliates is principally related to our 25 percent share of Fuji
Xerox income, subsequent to our sale of 25 percent of Fuji Xerox in March 2001.
Equity in net income in 2002 of $54 million was in line with our 2001 result of
$53 million, as compared with $66 million in 2000. The 2000 results primarily
reflected our 50 percent ownership share in Fuji Xerox, partially offset by our
$37 million share of a restructuring charge recorded by Fuji Xerox.
Minorities Interest in Earnings of Subsidiaries: Minorities interest in earnings
of subsidiaries includes the minority share of subsidiaries that we do not own,
as well as dividends on our preferred securities. The increase of $50 million in
2002 to $92 million from 2001, primarily relating to a full year of the
quarterly distributions on the Convertible Trust Preferred Securities, issued in
November 2001, as more fully discussed in Note 16 to the Consolidated Financial
Statements.
19
Acquisitions: In January 2000, we acquired the Color Printing and Imaging
Division of Tektronix, Inc. ("CPID") for $907 million in cash, net of an $18
million purchase price adjustment received in 2001, including $73 million paid
by Fuji Xerox for the Asia/Pacific operations. CPID manufactures and sells color
printers, ink and related products and supplies. At that time, the acquisition
accelerated us to the number two market position in office color printing,
improved our reseller and dealer distribution network and provided us with
scalable solid ink technology. The acquisition also enabled significant product
development and expense synergies with our monochrome printer organization.
Business Performance by Segment: Our reportable segments are consistent with how
we manage the business and how we view the markets we serve. Our reportable
segments are as follows: Production, Office, DMO, SOHO, and Other. The table
below summarizes our business performance by operating segment for the
three-year period ended December 31, 2002. Revenues and associated percentage
changes, along with operating profits and margins by segment are included.
Segment operating profit (loss) excludes certain non-segment items, such as
restructuring charges and gains on sales of businesses, as further described in
Note 9 to the Consolidated Financial Statements where we present a
reconciliation of segment profit/(loss) to pre-tax profit (loss) as presented in
our Consolidated Statements of Income.
Operating segment information for 2001 has been adjusted to reflect a change in
operating segment structure that was made in 2002. The nature of the changes
related primarily to corporate expense and other allocations associated with
internal reorganizations made in 2002, as well as decisions concerning direct
applicability of certain overhead expenses to the segments. The adjustments
increased (decreased) full year 2001 revenues as follows: Production--($16
million), Office--($16 million), DMO--($1 million), SOHO--$3 million and
Other--$30 million. The full year 2001 segment profit was increased (decreased)
as follows: Production--$12 million, Office--$24 million, DMO--$32 million,
SOHO--$2 million and Other--($70 million). The operating segment information for
2000 has not been restated, as it was impracticable to do so. Therefore, we have
presented 2002 and 2001 on the new basis and 2002, 2001 and 2000 on the old
basis.
20
New Basis Old Basis
------------------------- ----------------------------------
2002 2001 2002 2001 2000
---- ---- ---- ---- ----
Total Revenue
Production $ 5,615 5,883 $ 5,635 $ 5,899 $ 6,332
Office 6,605 6,910 6,620 6,926 7,060
DMO 1,758 2,026 1,758 2,027 2,619
SOHO 244 410 244 407 599
Other 1,627 1,779 1,592 1,749 2,141
---------- ---------- --------- -------- ---------
Total $ 15,849 $ 17,008 $ 15,849 $ 17,008 $ 18,751
========== ========== ========= ======== =========
Memo: Color $ 2,803 $ 2,759 $ 2,808 $ 2,762 $ 2,612
Segment Operating Profit (Loss)
Production $ 625 466 $ 613 $ 454 $ 463
Office 498 365 493 341 (180)
DMO 62 (125) 53 (157) (93)
SOHO 82 (195) 82 (197) (293)
Other (289) (143) (263) (73) 225
---------- ---------- --------- -------- ---------
Total $ 978 $ 368 $ 978 $ 368 $ 122
========== ========== ========= ======== =========
Operating Margin
Production 11.1 % 7.9 % 10.9 % 7.7 % 7.3 %
Office 7.5 % 5.3 % 7.4 % 4.9 % (2.5)%
DMO 3.5 % (6.2)% 3.0 % (7.7)% (3.6)%
SOHO 33.6 % (47.6)% 33.6 % (48.4)% (48.9)%
Other (17.8)% (8.0)% (16.5)% (4.2)% 10.5 %
Total 6.2 % 2.2 % 6.2 % 2.2 % 0.7 %
Production: Production revenues include production publishing, production
printing, color products for the production and graphic arts markets as well as
digital and light-lens copiers over 90 pages per minute, sold predominantly
through direct sales channels in North America and Europe. Production revenues
represented 35 percent (new basis) of both 2002 and 2001 revenues.
2002 Production revenues declined 5 percent from 2001 (new basis), and included
a benefit of approximately 1.5 percentage points from currency. High single
digit declines in Production monochrome revenues were only partially offset by
mid single digit growth in Production color revenues. Production monochrome
declines reflect continued customer transition from light-lens to digital
equipment, movement to distributed printing and other electronic media and the
weak economy. Growth in Production color revenue reflects continued strong
growth in our DocuColor 2000 series. The DocuColor 2000 series, launched in
2000, at speeds of 45 and 60 pages per minute established an industry standard
by producing near offset-quality, full color prints including customized
one-to-one printing at a variable cost of less than 10 cents per page. The
series was complemented by the launch of the DocuColor 6060 during the second
half of 2002. Mid-Range color revenue also increased, fueled by the successful
launch of the DocuColor 1632 and DocuColor 2240 midrange printer/copiers in the
second half of 2002.
2001 Production revenue declined 7 percent (old basis) from 2000, including an
unfavorable one percentage point impact due to currency. Production monochrome
revenue declines reflected competitive product introductions, movement to
distributed printing and electronic substitutes, and weakness in the worldwide
economy. Revenue from our DocuTech production publishing products, which has
been continually refreshed and expanded since its 1990 launch, declined in 2001
reflecting the 1999 introduction of a competitive product. In production
printing, we have maintained our strong market leadership in both 2002 and 2001,
however, revenue decreased reflecting declines in the transaction printing
market. 2001 production color revenues increased 2 percent (old basis) from
2000, including strong DocuColor 2000 series growth, partially offset by
declines in older products reflecting introduction of competitive offerings and
the effects of the weakened worldwide economy in the second half of the year.
2002 Production operating profit of $625 million (new basis) improved $159
million from 2001 and operating margin expanded 3.2 percentage points to 11.1
percent reflecting improvements in gross margin and lower SAG including reduced
bad debt levels.
2001 Production operating profit was similar to 2000 and the operating margin
improved to 7.7 percent (old basis) as we realized benefits from our Turnaround
Program.
Office: Office revenues include our family of Document Centre digital
multifunction products, color laser, solid ink and monochrome laser printers,
digital and light-lens copiers under 90 pages per minute, and facsimile products
sold through direct and indirect sales channels in North America and Europe.
Office revenues represented 42 percent (new basis) of 2002 revenues compared
with 41 percent in 2001.
2002 Office revenues declined 4 percent (new basis) from 2001 including a one
percentage point benefit from currency. Declines in older light lens products
were only partially offset by growth in monochrome digital multifunction devices
and
21
office color printers. Office color printer revenue grew in the mid single
digits reflecting the success of the 2002 launches of the Phaser 6200 laser and
8200 solid ink printers and strong Phaser color printers and Document Centre
Color Series 50 post sales revenue growth. Monochrome digital multifunction
revenues grew in the mid-single digits reflecting strong post sale growth and
the initial benefits of the launch of the Document 500 series in the second half
of 2002.
2001 Office revenues declined 2 percent (old basis) from 2000 including a one
percent adverse impact from currency. Strong double-digit Office color growth
was more than offset by monochrome declines. Office color revenue growth was
driven by the Document Centre Color Series 50 and strong color printer equipment
sales, including the Phaser 860 solid ink and Phaser 7700 laser printers. 2001
Office monochrome revenues declined as growth in digital multifunction was more
than offset by declines in light lens as customers continued to transition to
digital technology. This decline was exacerbated further by our reduced
participation in very aggressively priced competitive customer bids and tenders
in Europe, as we prioritized profitable revenue over market share. Monochrome
declines were slightly mitigated by the successful North American launch of the
Document Centre 490 in September 2001.
2002 Office operating profit of $498 million (new basis) improved by $133
million from 2001 and the operating margin expanded by 2.2 percentage points to
7.5 percent. The operating profit improvement was driven by improved gross
margins, as we focused on more profitable revenue, improved our manufacturing
and service productivity and reduced SAG expenses.
2001 operating profit of $341 million (old basis) improved compared to a $180
million loss in 2000, reflecting higher gross margins and decreased SAG expenses
due to restructuring activities.
DMO: DMO includes operations in Latin America, the Middle East, India, Eurasia,
Russia and Africa. DMO revenues represented 11 percent of 2002 revenues, as
compared to 12 percent of 2001 revenues.
2002 DMO revenue declined 13 percent from 2001 entirely due to reductions in
post sale revenue as the result of decreases in the amount of equipment at
customer locations and a 19 percent currency devaluation in Brazil.
2001 DMO revenue declined 23 percent (old basis) from 2000, with approximately
45 percent of that decline due to the December 2000 sale of our China
operations. An additional one-third of the 2001 DMO decline was due to lower
post sale revenue, as a result of a lower number of printers and copiers at
customer locations and a currency devaluation of 22 percent in Brazil. The
remainder of the decline was due to lower equipment revenue, which resulted from
implementation of a new business model that emphasizes liquidity and profitable
revenue rather than market share.
2002 DMO operating profit of $62 million (new basis), was $187 million better
than 2001. The profit improvement was due to lower SAG spending resulting from
our cost base actions and lower bad debt levels, as well as, significant gross
margin improvement, reflecting our focus on profitability and lower bad debt
levels. DMO continued to refine its business model in 2002, by transitioning
equipment financing to third parties, improving credit requirements for
equipment sale transactions and implementing additional cost reduction actions.
In addition, we implemented a strategy to move to distributors in smaller
countries, including Jamaica and Nigeria, which we expect will benefit
operations by removing fixed costs.
The 2001 DMO loss of $157 million (old basis) was due to the revenue decline
from the preceding year, weak gross margins and the currency devaluation in
Argentina. These declines were only partially offset by initial cost
restructuring benefits.
SOHO: We announced our disengagement from our worldwide SOHO business in June
2001 and sold our remaining equipment inventory by the end of that year. SOHO
revenues now consist primarily of profitable consumables for the inkjet printers
and personal copiers previously sold through retail channels in North America
and Europe.
2002 SOHO segment profit of $82 million (new basis) improved $277 million from
2001 due to the sales of high margin supplies as compared to losses previously
incurred on equipment sales. We expect sales of these supplies to decline over
time as the existing equipment population is replaced.
The 2001 SOHO segment loss improved by $96 million (old basis) or 32 percent
from 2000. Despite a gross margin decline, significant SAG and R&D reductions,
following our June 2001 disengagement, resulted in substantially lower operating
losses in 2001 and a return to profitability in the fourth quarter.
Other: Over half of the revenues in our Other segment are derived from sales of
paper, approximately, one quarter are from Xerox Engineering Systems ("XES"),
and the remainder are derived from Xerox Connect ("XConnect"), Xerox Technology
Enterprises ("XTE") and other sources including consulting services, royalty and
license revenues. XES is a business that sells equipment used for special
engineering applications, XConnect is a network service business aimed at
optimizing office
22
efficiency and providing solutions and XTE consists of a collection of high
technology start-up entities. The Other segment profit (loss) includes the
profit (loss) from the previously mentioned sources, equity income received from
Fuji Xerox and certain costs which have not been allocated to the businesses
including non-financing and other corporate costs.
2002 Other revenues declined 9 percent (new basis), from 2001. Approximately
half of the decline was due to lower revenues in XES and XConnect, an additional
15 percent related to lower paper sales consistent with other post sale revenue
declines, partially offset by licensing revenue and royalties. XES revenue
declined principally due to lower dealer equipment revenue, while XConnect
declines were due to a reduced emphasis on third-party equipment installations.
The remainder of the declines were consistent with other aspects of our
business.
2001 Other revenues of $1,749 million (old basis) declined 18 percent from 2000.
Approximately 25 percent of the revenue decline was due to lower paper sales,
consistent with our post sale declines. Another 25 percent decline was
attributable to lower XTE revenues due to the sale of a business in 2000, the
closing of one business in 2001, and the deconsolidation of two small
investments during 2001 due to changes in ownership structure and the resultant
change to equity accounting. XES revenue represented 20 percent of the decline
principally due to increased European competition and lower post sale revenue
resulting from lower machine populations. XConnect revenue also accounted for 20
percent of the decline due to a decreased emphasis on third-party equipment
installations. The remaining decline was consistent with other aspects of our
business.
2002 Other segment loss of $289 million (new basis), increased by $146 million
from 2001, principally due to the write-off of internal use software of $106
million, higher pension and benefit expense of $93 million and higher
advertising expenses of $62 million. These increased costs were partially offset
by lower non-financing interest expense of $130 million, the $33 million
beneficial year over year impact of the ESOP expense adjustment and the $50
million profit from licensing revenue.
The 2001 Other segment loss of $73 (old basis) reflects additional ESOP
compensation expense necessitated by the elimination of the ESOP dividend of $33
million, higher professional fees related to litigation and SEC issues and
related matters of $52 million. 2000 results benefited from the gains on the
sales of our North American paper business of $40 million, a 25 percent interest
in ContentGuard of $23 million and a $21 million gain on our ScanSoft
affiliate's sale of stock.
New Accounting Standards:
During 2002 and 2001, the Financial Accounting Standards Board ("FASB") issued
several new accounting standards which effect the recognition and measurement
and/or disclosure of business combinations, goodwill and intangible assets,
impairment or disposals of long-lived assets, gains on extinguishment of debt,
costs associated with exit or disposal activities and stock-based compensation.
We have adopted these new standards in whole or in part, as applicable, during
the year ended December 31, 2002. The effects of these new standards are
discussed in the relevant sections of this MD&A and in more detail in Note 1 to
the Consolidated Financial Statements.
In addition, the FASB has recently issued the following applicable standards and
interpretations that we have not yet adopted:
- - Statement of Financial Accounting Standards No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS 143"),
- - FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45"),
- - FASB Interpretation No. 46, "Consolidation of Variable Interest Entities"
("FIN 46").
We have adopted the disclosure provisions of FIN 45 and FIN 46 as of December
31, 2002.
We do not expect the adoption of SFAS No. 143, FIN 45 and FIN 46 to have a
material effect on our financial position or results of operations.
23
Capital Resources and Liquidity:
References to "Xerox Corporation" below refer to the stand-alone parent company
and do not include subsidiaries. References to "we," "our" or "us" refer to
Xerox Corporation and its subsidiaries.
Cash Flow Analysis: The following summarizes our cash flows for the years ended
December 31, 2002, 2001 and 2000 as reported in our Consolidated Statement of
Cash Flows in the accompanying consolidated financial statements ($ in
millions):
2002 2001 2000
------- ------- -------
Operating cash flows $ 1,876 $ 1,566 $ 207
Investing cash flows (usage) 197 873 (855)
Financing cash (usage) flows (3,292) (189) 2,255
Effect of exchange rate changes on cash 116 (10) 11
------- ------- -------
(Decrease) increase in cash and cash equivalents (1,103) 2,240 1,618
Cash and cash equivalents at beginning of year 3,990 1,750 132
------- ------- -------
Cash and cash equivalents at end of year $ 2,887 $ 3,990 $ 1,750
======= ======= =======
2002 Versus 2001: For the year ended December 31, 2002, operating cash flows of
$1,876 million include net income before restructuring and other non-cash
items of $2,124 million and finance receivable reductions of $754 million due to
collection of receivables from prior year's sales without an offsetting
receivables increase due to lower equipment sales in 2002, together with a
transition to third-party vendor financing arrangements in the Nordic countries,
Italy, Brazil and Mexico. These cash flows were partially offset by $442 million
of tax payments, including $346 million related to the 2001 sale of half of our
interest in Fuji Xerox, $392 million of restructuring related cash payments,
approximately $300 million of other working capital uses, primarily related to
the October 2002 termination of our U.S. revolving accounts receivable
securitization, $127 million of on-lease equipment expenditures and a $138
million cash contribution to our pension plans.
The $310 million improvement in operating cash flow versus 2001 reflects
increased finance receivable collections of $666 million, the absence of cash
payments related to the 2001 early termination of derivative contracts of $148
million and lower on-lease equipment spending of $144 million. The decline in
2002 on-lease equipment spending reflected declining rental placement activity
and populations, particularly in our older-generation light-lens products. These
items were partially offset by higher cash taxes of $385 million, higher pension
contributions of $96 million and increased working capital uses of over $300
million, much of which was caused by the accounts receivable securitization
termination noted above. In addition, cash flow generated by reducing inventory
during 2002 occurred at a much slower rate than in 2001 as inventory reductions
were offset by increased requirements for new product launches.
Investing cash flows for the year ended December 31, 2002 consisted primarily of
proceeds of $200 million from the sale of our Italian leasing business, $53
million related to the sale of certain manufacturing locations to Flextronics,
$67 million related to the sale of our interest in Katun and $19 million from
the sale of our investment in Prudential common stock. These inflows were
partially offset by our capital and internal use software spending of $196
million. Investing cash flows in 2001 largely consisted of the $1,768 million of
cash received from sales of businesses, including one half of our interest in
Fuji Xerox, our leasing businesses in the Nordic countries and certain
manufacturing assets to Flextronics. These cash proceeds were offset by capital
and internal use software spending of $343 million, a $255 million payment
related to our funding of trusts to replace Ridge Reinsurance letters of credit,
$115 million of payments for the funding of escrow requirements related to the
lease contracts transferred to GE, $229 million of payments for the funding of
escrow requirements related to the 2002 and 2003 scheduled distribution payments
for the trust preferred securities and $29 million of payments for other
contractual requirements.
Financing activities for the year ended December 31, 2002 consisted of $2.8
billion of debt repayments on the Old Revolver and $710 million on the New
Credit Facility, $1.9 billion of other scheduled payments of maturing debt, and
dividends of $67 million on our preferred stock. These cash outflows were
partially offset by proceeds of $746 million from our 9.75 percent Senior Notes
offering and $1.4 billion of net proceeds from secured borrowing activity with
GE and other vendor financing partners. Financing activities for the comparable
2001 period consisted of scheduled debt repayments of $2.4 billion and dividends
on our common and preferred stock of $93 million. These outflows were offset by
net proceeds from secured borrowing activity of $1,350 million and proceeds from
the issuance of trust preferred securities of $1.0 billion.
2001 Versus 2000: For the year ended December 31, 2001 operating cash flows of
$1,566 million reflected net income before restructuring charges and other
non-cash items of $2,312 million (including a net gain of $304 related to the
sale of half our interest in Fuji Xerox). Operating cash flow improved
significantly compared to 2000, primarily due to working capital improvements.
Although our revenue declined, which normally leads to
24
a reduction in receivables and payables balances, our collections of receivables
exceeded our payments on accounts payable and other current liability accounts
by approximately $500 million. We reduced our inventory balances and spending
for on-lease equipment by approximately $480 million. We also had a one-year
benefit of approximately $350 million associated with the timing of taxes due on
the gain from our sale of half our interest of Fuji Xerox, which we did not have
to pay until first quarter 2002. The overall impact of our reported net loss on
our operating cash flows, after considering the impacts of non-cash items
associated with restructuring charges, provisions, tax valuation allowances and
gains did not vary significantly between 2001 and 2000.
Investing cash flows were higher in 2001 primarily due to $1,768 million of cash
received from the sales of businesses, including Fuji Xerox and our leasing
businesses in the Nordic countries. These cash proceeds were greater than the
$640 million received from the sale of businesses in 2000. In 2001 we also
reduced capital spending and internal-use software spending significantly. Other
factors contributing to the 2001 improvement were the acquisition of CPID in
2000, which utilized cash of $856 million, while in 2001 we were required to
fund $628 million of certain escrow and insurance trusts based on contractual
requirements.
Our 2001 financing cash flows largely consisted of a net repayment of
approximately $1.1 billion of debt, offset by a private placement of $1.0
billion of trust preferred securities. The suspension of dividends on our common
and preferred stock also positively impacted our cash flows in 2001. 2000
financing activities consisted of net borrowing of $2.9 billion, which funded
the CPID acquisition and increased our cash balance, partially offset by common
and preferred stock dividends of $587 million.
Capital Structure and Liquidity: Historically, we have provided equipment
financing to a significant majority of our customers. Because the finance leases
allow our customers to pay for equipment over time rather than at the date of
purchase, we have needed to maintain significant levels of debt to provide
operating liquidity, as liquidity generated from receivable collections has
generally been used to fund new equipment leases. A significant portion of our
debt is directly related to the funding requirements of our financing business.
During the years ended December 31, 2002 and 2001, we originated loans, secured
by finance receivables, with cash proceeds of $3,055 million and $2,418 million,
respectively. Approximately half of our total finance receivable portfolio has
been securitized at December 31, 2002 compared with 24 percent a year earlier.
We expect to increase the proportion of our finance receivables which are
securitized to approximately 60 percent by the end of 2004. The following table
compares finance receivables to financing-related debt as of December 31, 2002
($ in millions):
Finance
Receivables Debt/(2)/
----------- ---------
Finance Receivables Encumbered by Loans/(1)/:
GE Loans - U.S. and Canada $ 2,777 $ 2,642
Merrill Lynch Loan - France 413 377
U.S. Asset-backed notes 247 139
XCC securitizations 101 7
------- --------
Subtotal - Special Purpose Entities 3,538 3,165
GE Loans - UK 691 529
GE Loans - Other Europe 95 95
Other Europe 113 111
------- --------
Total 4,437 $ 3,900
========
Unencumbered Finance Receivables 4,568
-------
Total Finance Receivables/(3)/ $ 9,005
=======
(1) Encumbered finance receivables represent the book value of finance
receivables that secure each of the indicated loans.
(2) Represents the debt secured by finance receivables, including
transactions utilizing special purpose entities, which are described below.
(3) Includes (i) Billed portion of finance receivables, net (ii) Finance
receivables, net and (iii) Finance receivables due after one year, net as
included in the Consolidated Balance Sheets as of December 31, 2002.
25
As of December 31, 2002, debt secured by finance receivables was approximately
28 percent of total debt. As we increase the proportion of our finance
receivables that are securitized, we expect this percentage to increase to
approximately 40 percent by the end of 2004.
The following represents our aggregate debt maturity schedule ($ in millions):
2003 2004 2005 2006 Thereafter
First Quarter $ 626 $ 992
Second Quarter 1,315 907
Third Quarter 658 910
Fourth Quarter 1,778 1,100
------ ------
Full Year $4,377 $3,909 $4,016 $ 56 $1,813
====== ====== ====== ====== ======
Of the full year amounts shown in the above table, $1,887 million and $1,426
million for 2003 and 2004, respectively, relate to debt secured by finance
receivables. For a discussion on the contractual maturities of our mandatorily
redeemable preferred securities, refer to the section entitled "Contractual Cash
Obligations and Other Commercial Commitments and Contingencies."
The following table summarizes our secured and unsecured debt as of December 31,
2002:
New Credit Facility - debt secured within the 20 percent net worth $ 875/(1)/
limitation
New Credit Facility - debt secured outside the 20 percent net worth
limitation 50
Debt secured by finance receivables 3,900
Capital leases 40
Debt secured by other assets 90
-------
Total Secured Debt 4,955
-------
New Credit Facility - unsecured 2,565/(1)
Senior Notes 852
Subordinated debt 575
Other Debt 5,224
--------
Total Unsecured Debt 9,216
--------
Total Debt $ 14,171
========
(1) The amount of New Credit Facility debt secured under the 20 percent
consolidated net worth limitation represents an estimate based on
Consolidated Net Worth at December 31, 2002 and the amount of other debt,
as defined, secured under the 20 percent limitation. Any change to the
amount indicated would correspondingly change the amount of the unsecured
portion of the New Credit Facility.
Liquidity, Financial Flexibility and Funding Plans: We manage our worldwide
liquidity using internal cash management practices, which are subject to (1) the
statutes, regulations and practices of each of the local jurisdictions in which
we operate, (2) the legal requirements of the agreements to which we are parties
and (3) the policies and cooperation of the financial institutions we utilize to
maintain such cash management practices. In 2000, our operational issues were
exacerbated by significant competitive and industry changes, adverse economic
conditions, and significant technology and acquisition spending. Together, these
conditions negatively impacted our liquidity, which from 2000 to 2002 led to a
series of credit rating downgrades, eventually to below investment grade.
Consequently, our access to capital and derivative markets has been restricted.
The downgrades also required us to cash-collateralize certain derivative and
securitization arrangements to prevent them from terminating, and to immediately
settle terminating derivative contracts. Further, we are required to maintain
minimum cash balances in escrow on certain borrowings and letters of credit. In
addition, the SEC would not allow us to publicly register any securities
offerings while their investigation, which commenced in June 2000, was ongoing.
This additional constraint essentially prevented us from raising funds from
sources other than unregistered capital markets offerings and private lending or
equity sources. Consequently, our credit ratings, which were already under
pressure, came under greater pressure since credit rating agencies often include
access to capital sources in their rating criteria.
While the 2002 conclusion of the SEC investigation removed our previous
inability to access public capital markets, we expect our ability to access
unsecured credit sources to remain limited as long as our credit ratings remain
below investment
26
grade, and we expect our incremental cost of borrowing will remain relatively
high as a result of our credit ratings and could potentially result in our
having to increase our level of intercompany lending to our affiliates.
Our current ratings are as follows:
Senior Senior Corporate
Secured Debt Unsecured Debt Credit Rating Outlook
------------ -------------- ------------- -------
Moody's B1 B1 B1 Negative
S&P BB- B+ BB- Negative
Fitch BB- BB- BB- Negative
As a result of the various factors described above, in 2000 we abandoned our
historical liquidity practice of repaying debt with available cash and relying
on low interest commercial paper borrowings. Instead, we have been accumulating
cash in an effort to maintain financial flexibility. We expect to maintain a
minimum cash balance of at least $1 billion on an ongoing basis.
Financing Business and Restructuring: In 2000, as part of our Turnaround
Program, we announced our intent to exit the financing business, wherever
practical, in order to reduce our consolidated debt levels and accelerate the
liquidity within our finance receivable portfolios. We altered our strategy in
2002, announcing plans to securitize our finance receivables, thereby retaining
the customer relationship and financing income.
Other Turnaround initiatives included selling certain assets, improving
operations, and reducing annual costs by over $1 billion. These initiatives are
expected to significantly improve our liquidity going forward. We have (1)
securitized portions of our existing finance receivables portfolios, (2)
implemented vendor financing programs with third parties in the United States,
The Netherlands, the Nordic countries, Italy, Brazil and Mexico, (3) announced
major initiatives with GE and other third party vendors to securitize our
finance receivables in other countries, including the completion of the New U.S.
Vendor Financing Agreement (see Note 5 to our Consolidated Financial
Statements), (4) sold several non-core assets and (5) reduced our annual costs
by $1.7 billion.
As more fully discussed in Note 5 to the Consolidated Financial Statements, we
have completed the following securitization initiatives:
. In June 2001, we announced several Framework Agreements with GE under
which they became our primary equipment-financing provider in the
U.S., Canada, Germany and France. In October 2002 we finalized an
eight year U.S. arrangement and funding commenced in the fourth
quarter of 2002. We are currently negotiating other GE arrangements
under the respective Framework Agreements.
. In April 2001, we sold our leasing businesses in four Nordic countries
to a company now owned by GE retained interests in certain finance
receivables. These sales are part of an agreement under which that
company will provide ongoing, exclusive equipment financing to our
customers in those countries.
. In December 2001, we formed a joint venture with De Lage Landen
International BV (DLL) which manages equipment financing, billing and
collections for our customers' equipment orders in the Netherlands.
This joint venture began funding in the first quarter of 2002. DLL
owns 51 percent of the venture and provides the funding to support new
customer leases. We own the remaining 49 percent of this
unconsolidated venture.
. In March 2002, we signed agreements with third parties in Brazil and
Mexico under which those third parties became our primary equipment
financing providers in those countries. Funding under both of these
arrangements commenced in the second quarter of 2002.
. In April 2002, we sold our leasing business in Italy to a company
recently acquired by GE, as part of an agreement under which GE will
provide on-going, exclusive equipment financing to our customers in
Italy.
. In December 2002, we securitized existing state and local government
finance receivables in the U.S. with GE.
. In December 2002, we securitized existing finance receivables in
France with a 364-day financing with Merrill Lynch (ML). ML intends to
replace this financing with a long-term public secured offering during
2003.
. In December 2002, we received a series of financings from our
unconsolidated joint venture with DLL, secured by our lease
receivables in Holland.
. In December 2002, we received loans from GE secured by finance
receivables in Germany.
27
New Credit Facility: In June 2002, we entered into an Amended and Restated
Credit Agreement (the "New Credit Facility") with a group of lenders, replacing
our prior $7 billion facility (the "Old Revolver"). At that time, we permanently
repaid $2.8 billion of the Old Revolver and subsequently paid $710 million on
the New Credit Facility. At December 31, 2002, the New Credit Facility consisted
of two tranches of term loans totaling $2.0 billion and a $1.5 billion revolving
credit facility that includes a $200 million letter of credit subfacility. At
December 31, 2002, $3.5 billion was outstanding under the New Credit Facility.
At December 31, 2002 we had no additional borrowing capacity under the New
Credit Facility since the entire revolving facility was outstanding, including a
$10 million letter of credit under the subfacility. Xerox Corporation is the
only borrower of the term loans. The revolving loans are available, without
sub-limit, to Xerox Corporation and to Xerox Canada Capital Limited ("XCCL"),
Xerox Capital Europe plc ("XCE"), and other foreign subsidiaries as defined.
Xerox Corporation is the borrower of all but $50 million of the revolver at
December 31, 2002. The size and contractual maturities of the loans are as
follows ($ in millions):
2003 2004 2005 Total
---- ---- ---- -----
Tranche A Term Loan $ 400 $ 600 $ 500 $ 1,500
Tranche B Term Loan 5 5 490 500
Revolving Facility - - 1,490 1,490
------- ------- ------- -------
Total $ 405 $ 605 $ 2,480 $ 3,490
======= ======= ======= =======
We are required to repay portions of the loans earlier than their scheduled
maturities with specified percentages of any proceeds we receive from capital
market debt issuances, equity issuances or asset sales during the term of the
New Credit Facility, except that the revolving facility cannot be reduced below
$1 billion, as a result of such prepayments. Additionally, all loans under the
New Credit Facility become due and payable upon the occurrence of a change in
control.
Subject to certain limits described in the following paragraph, all obligations
under the New Credit Facility are secured by liens on substantially all of the
domestic assets of Xerox Corporation and by liens on the assets of substantially
all of our U.S. subsidiaries (excluding Xerox Credit Corporation ("XCC")), and
are guaranteed by substantially all of our U.S. subsidiaries. In addition, a
revolving loan outstanding to XCCL ($50 million at December 31, 2002) is secured
by all of its assets, and is guaranteed by certain defined material foreign
subsidiaries.
Under the terms of certain of our outstanding public bond indentures, the amount
of obligations under the New Credit Facility that can be (1) secured by assets
(the "Restricted Assets") of (a) Xerox Corporation and (b) our non-financing
subsidiaries that have a consolidated net worth of at least $100 million,
without (2) triggering a requirement to also secure those indentures, is limited
to the excess of (1) 20 percent of our consolidated net worth (as defined in the
public bond indentures) over (2) the outstanding amount of certain other debt
that is secured by the Restricted Assets. Accordingly, the amount of New Credit
Facility debt secured by the Restricted Assets (the "Restricted Asset Security
Amount") will vary from time to time with changes in our consolidated net worth.
The amount of security provided under this formula accrues first to the benefit
of Tranche B loans and then to the benefit of Tranche A Loans and Revolving
Loans, ratably.
The assets of XCE, XCCL and other subsidiaries guaranteeing the New Credit
Facility are not Restricted Assets because those entities are not restricted
subsidiaries as defined in our public bond indentures. Consequently, the amount
of New Credit Facility debt secured by their assets is not subject to the
foregoing limits. However, these guarantees are enforceable only to the extent
of the New Credit Facility borrowings in Europe and Canada.
The New Credit Facility loans generally bear interest at LIBOR plus 4.50
percent, except that the Tranche B term loan bears interest at LIBOR plus a
spread that varies between 4.00 percent and 4.50 percent depending on the amount
by which the Restricted Asset Security Amount exceeds the outstanding Tranche B
loan.
The New Credit Facility, a copy of which we have filed with the SEC as Exhibits
4 (l)(1) and 99.6 to our Current Reports on Form 8-K dated June 21, 2002 and
September 26, 2002, respectively, contains affirmative and negative covenants.
The New Credit Facility contains financial covenants that the Old Revolver did
not contain. Certain of the more significant covenants under the New Credit
Facility are summarized below (this summary is not complete and is in all
respects subject to the actual provisions of the New Credit Facility):
.. Excess cash of certain foreign subsidiaries and of Xerox Credit
Corporation, a wholly-owned subsidiary, must be transferred to Xerox
Corporation at the end of each fiscal quarter; for this purpose, "excess
cash" generally means cash maintained by certain foreign subsidiaries taken
as a whole in excess of their aggregate working capital and other needs in
the ordinary course of business (net of sources of funds from third
parties), including reasonably anticipated needs for repaying debt and
other obligations and making investments in their businesses. In certain
circumstances, we are not required to transfer cash to Xerox Corporation,
if the transfer cannot be made in a tax efficient manner or if it would be
considered a breach of fiduciary duty by the directors of the foreign
subsidiary;
.. Minimum EBITDA (a quarterly test that is based on rolling four quarters)
ranging from $1.0 to $1.3 billion; for this purpose, "EBITDA" (Earnings
before interest, taxes, depreciation and amortization) generally means
EBITDA (excluding interest and financing income to the extent included in
consolidated net income), less any amounts spent for software development
that are capitalized;
.. Maximum leverage ratio (a quarterly test that is calculated as total
adjusted debt divided by EBITDA) ranging from 4.3 to 6.0;
.. Maximum capital expenditures (annual test) of $330 million per fiscal year
plus up to $75 million of any unused amount carried over from the previous
year; for this purpose, "capital expenditures" generally mean the amounts
included on our statement of cash flows as "additions to land, buildings
and equipment", plus any capital lease obligations incurred;
28
.. Minimum consolidated net worth ranging from $2.9 billion to $3.1 billion;
for this purpose, "consolidated net worth" generally means the sum of the
amounts included on our balance sheet as "Common shareholders' equity,"
"Preferred stock," "Company-obligated, mandatorily redeemable preferred
securities of subsidiary trust holding solely subordinated debentures of
the Company," except that the currency translation adjustment effects and
the effects of compliance with FAS 133 occurring after December 31, 2001
are disregarded, the preferred securities (whether or not convertible)
issued by us or by our subsidiaries which were outstanding on June 21, 2002
will always be included, and any capital stock or similar equity interest
issued after June 21, 2002 which matures or generally becomes mandatorily
redeemable for cash or puttable at holders' option prior to November 1,
2005 is always excluded; and
.. Limitations on: (i) issuance of debt and preferred stock; (ii) creation of
liens; (iii) certain fundamental changes to corporate structure and nature
of business, including mergers; (iv) investments and acquisitions; (v)
asset transfers; (vi) hedging transactions other than in those in the
ordinary course of business and certain types of synthetic equity or debt
derivatives, and (vii) certain types of restricted payments relating to
our, or our subsidiaries', equity interests, including payment of cash
dividends on our common stock; (viii) certain types of early retirement of
debt, and (ix) certain transactions with affiliates, including intercompany
loans and asset transfers.
The New Credit Facility generally does not affect our ability to continue to
monetize receivables under the agreements with GE and others. Although we cannot
pay cash dividends on our common stock during the term of the New Credit
Facility, we can pay cash dividends on our preferred stock, provided there is
then no event of default. In addition to other defaults customary for facilities
of this type, defaults on other debt, or bankruptcy, of Xerox Corporation, or
certain of our subsidiaries, would constitute defaults under the New Credit
Facility.
At December 31, 2002, we are in compliance with all aspects of the New Credit
Facility including financial covenants and expect to be in compliance for at
least the next twelve months. Failure to be in compliance with any material
provision or covenant of the New Credit Facility could have a material adverse
effect on our liquidity and operations.
As previously mentioned, in October 2002, we completed an eight-year agreement
in the U.S. (the "New U.S. Vendor Financing Agreement"), under which GE Vendor
Financial Services, a subsidiary of GE, became our primary equipment financing
provider in the U.S., through monthly securitizations of our new lease
originations. In addition to the $2.5 billion already funded by GE prior to this
agreement, which is secured by portions of our current U.S. lease receivables.
The New U.S. Vendor Financing Agreement calls for GE to provide funding in the
U.S. on new lease originations, of up to an additional $5 billion outstanding at
anytime, during the eight year term, subject to normal customer acceptance
criteria. The $5 billion limit may be increased to $8 billion subject to
agreement between the parties. The new agreement contains mutually agreed
renewal options for successive two-year periods.
Under this agreement, we expect GE to fund approximately 70 percent of new U.S.
lease originations at over-collateralization rates, which vary over time, but
are expected to be approximately 10 percent of the net receivables balance. The
securitizations will be subject to interest rates calculated at each monthly
loan occurrence at yield rates consistent with average rates for similar market
based transactions. Consistent with the loans already received from GE, the
funding received under this new agreement will be recorded as secured borrowings
and the associated receivables will be included in our Consolidated Balance
Sheet. GE's commitment to fund under this new agreement is not subject to our
credit ratings. There are no credit rating defaults that could impair future
funding under this agreement. This agreement contains cross default provisions
related to certain financial covenants contained in the New Credit Facility and
other significant debt facilities. Any default would impair our ability to
receive subsequent funding until the default was cured or a waiver was received.
As of December 31, 2002, we were in compliance with all covenants and expect to
be in compliance for at least the next twelve months.
In 2002 and 2001, we received financing totaling $1,845 million and $1,175
million, respectively, from GE, secured by lease receivables in the U.S. Net
fees of $16 million were capitalized as debt issue costs. In connection with
these transactions, $150 million was required to be held in escrow, as security
for our continuing obligations under transferred contracts. At December 31,
2002, the remaining balance of $2,323 million was included as debt in our
Consolidated Balance Sheet.
In May 2002, we launched the Xerox Capital Services ("XCS") venture with GE,
under which XCS now manages our customer administration and leasing activities
in the U.S., including various financing programs, credit approval, order
processing, billing and collections. We account for XCS as a consolidated entity
since we are responsible to fund all of its operations, and, further, all events
of termination result in GE receiving their entire equity investment, with total
ownership reverting to us.
Summary - Financial Flexibility and Liquidity: With $2.9 billion of cash and
cash equivalents on hand at December 31, 2002, we believe our liquidity
(including operating and other cash flows we expect to generate) will be
sufficient to meet operating cash flow requirements as they occur and to satisfy
all scheduled debt maturities for at least the next twelve months. Our ability
to maintain sufficient liquidity going forward is highly dependent on achieving
expected operating results, including capturing the benefits from restructuring
activities, and completing announced finance receivable securitization and other
initiatives. There is no assurance that these initiatives will be successful.
Failure to successfully
29
complete these initiatives could have a material adverse effect on our
liquidity, operations and financial position, and could require us to consider
further measures, including deferring planned capital expenditures, reducing
discretionary spending, selling additional assets and, if necessary,
restructuring existing debt.
Our access to the public debt markets is expected to be limited to the
non-investment grade segment until our debt ratings have been restored to
investment grade. Specifically, until our credit ratings improve, we will be
unable to access the commercial paper markets or obtain unsecured bank lines of
credit. Improvements in our credit ratings depend on (1) our ability to
demonstrate sustained profitability growth and operating cash generation and (2)
continued progress on our finance receivable securitization initiatives.
However, there is no assurance on the timing of when our ratings may be restored
to investment grade by the rating agencies.
We intend to access the non-investment grade public debt markets until our
credit ratings are restored to investment grade. This, together with possible
opportunistic access to the equity or equity-linked markets, can provide
significant sources of additional funds until full access to the public debt
markets is restored.
Contractual Cash Obligations and Other Commercial Commitments and Contingencies:
At December 31, 2002, we had the following contractual cash obligations and
other commercial commitments and contingencies:
Contractual Cash Obligations including cumulative preferred securities ($ in
millions):
2003 2004 2005 2006 2007 Thereafter
---- ---- ---- ---- ---- ----------
Long-term debt .............................. $3,980 $3,909 $4,016 $ 56 $ 296 $ 1,517
Short-term debt ............................. 397 -- -- -- -- --
Minimum operating lease commitments ......... 238 202 157 124 71 346
------ ------ ------ ----- ----- -------
Total contractual cash obligations ...... $4,615 $4,111 $4,173 $ 180 $ 367 $ 1,863
====== ====== ====== ===== ===== =======
Cumulative Preferred Securities: As of December 31, 2002, we have four series of
outstanding preferred securities as summarized below. The redemption
requirements and the annual cumulative dividend requirements on our outstanding
preferred stock are as follows:
. Series B Convertible Preferred Stock ("ESOP Shares"): The balance at
December 31, 2002 was $508 million, net of deferred ESOP benefits, and
is redeemable in shares of common stock or cash, at our option, as
employees with vested shares leave the Company. Annual cumulative
dividend requirements are $6.25 per share. Dividends declared but not
yet paid amounted to $11 million at December 31, 2002. At December 31,
2002, we had 7,023,437 shares issued and outstanding.
. 7.5 percent Convertible Trust Preferred Securities: The balance at
December 31, 2002 was $1,016 million, and is putable in 2004 in cash
or in shares of common stock at a redemption value of $1,035 million
at the holders' option. Annual cumulative distribution requirements of
approximately $78 million are $3.75 per Preferred Security on 20.7
million securities. The first three years' dividend requirements were
funded at issuance and are invested in U.S. Treasury securities held
by a separate trust. As of December 31, 2002, $151 million of the
original $229 million remained in the trust.
. 8 percent Convertible Trust Preferred Securities: The balance at
December 31, 2002 was $640 million, and is redeemable in 2027 at a
redemption value of $650 million. Annual cumulative dividend
requirements are $80 per security on 650,000 securities or $52 million
per year.
. Canadian Deferred Preferred Stock: The balance at December 31, 2002
was $45 million, and is redeemable in 2006. Annual cumulative non-cash
dividend requirements will increase this amount to its 2006 redemption
value of approximately $56 million.
Other Commercial Commitments and Contingencies:
Flextronics: As previously discussed, in 2001 we outsourced certain
manufacturing activities to Flextronics under a five-year agreement. During
2002, we purchased approximately $1 billion of inventory from Flextronics. We
anticipate that we will purchase approximately $900 million of inventory from
Flextronics during 2003 and expect to increase this level commensurate with our
sales in the future.
Fuji Xerox: We had product purchases from Fuji Xerox totaling $727 million, $598
million, and $812 million in 2002, 2001 and 2000, respectively. Our purchase
commitments with Fuji Xerox are in the normal course of business and typically
have a lead time of three months. We anticipate that we will purchase
approximately $700 million of products from Fuji Xerox in 2003.
30
Other Purchase Commitments: We enter into other purchase commitments with
vendors in the ordinary course of business. Our policy with respect to all
purchase commitments is to record losses, if any, when they are probable and
reasonably estimable. We currently do not have, nor do we anticipate, material
loss contracts.
EDS Contract: We have an information management contract with Electronic Data
Systems Corp. to provide services to us for global mainframe system processing,
application maintenance and enhancements, desktop services and helpdesk support,
voice and data network management, and server management. In 2001, we extended
the original ten-year contract through June 30, 2009. Although there are no
minimum payments required under the contract, we anticipate making the following
payments to EDS over the next five years (in millions): 2003--$331; 2004--$320;
2005--$311; 2006--$299; 2007--$288. The estimated payments are the result of an
EDS and Xerox Global Demand Case process that has been in place for eight years.
Twice a year, using this estimating process based on historical activity, the
parties agree on a projected volume of services to be provided under each major
element of the contract. Pricing for the base services (which are comprised of
global mainframe system processing, application maintenance and enhancements,
desktop services and help desk support, voice and data management) were
established when the contract was signed in 1994 based on our actual costs in
preceding years. The pricing was modified through comparisons to industry
benchmarks and through negotiations in subsequent amendments. Prices and
services for the period July 1, 2004 through June 30, 2009 are currently being
negotiated and should be finalized by December 31, 2003. As such, the amounts
above are subject to change. We can terminate the contract with six months
notice, as defined in the contract, with no termination fee. We have an option
to purchase the assets placed in service under the EDS contract, should we elect
to terminate such contract and either operate those assets ourselves or enter a
separate contract with a similar service provider.
Pension and Other Post-Retirement Benefit Plans: We sponsor pension and other
post-retirement benefit plans. As discussed in Note 13 to the Consolidated
Financial Statements, our collective pension plans were underfunded by $2.0
billion at December 31, 2002. Our post-retirement plan, which is a non-funded
plan, had a benefit obligation of $1.6 billion at December 31, 2002. Our 2002
cash outlays for these plans were $138 million for pensions and $102 million for
other post-retirement plans. Our anticipated cash outlays for 2003 are $170
million for pensions and $115 million for other post-retirement plans.
Other Funding Arrangements:
Special Purpose Entities: From time to time, we have generated liquidity by
selling or securitizing portions of our finance and accounts receivable
portfolios. We have typically utilized qualified special-purpose entities
("SPEs") in order to implement these transactions in a manner that isolates, for
the benefit of the securitization investors, the securitized receivables from
our other assets which would otherwise be available to our creditors. These
transactions are typically credit-enhanced through over-collateralization. Such
use of SPEs is standard industry practice, is typically required by
securitization investors and makes the securitizations easier to market. None of
our officers, directors or employees or those of any of our subsidiaries or
affiliates hold any direct or indirect ownership interests in, or derive
personal benefits from, any of these SPEs. We typically act as service agent and
collect the securitized receivables on behalf of the securitization investors.
Under certain circumstances, we can be terminated as servicing agent, in which
event the SPEs may engage another servicing agent and we would cease to receive
a servicing fee, although no such circumstances have occurred to date. We are
not liable for non-collection of securitized receivables, or otherwise required
to make payments to the SPEs except to the limited extent that the securitized
receivables did not meet specified eligibility criteria at the time we sold the
receivables to the SPEs or we fail to observe agreed upon credit and collection
policies and procedures.
Substantially all of our SPE transactions were accounted for as borrowings, with
the debt and related assets remaining on our balance sheets. Specifically, in
addition to the U.S. and Canadian loans from GE and the ML loan in France
discussed above, which utilized SPEs as part of their structures, we have
entered into the following similar transactions:
. In 2000 through 2002, Xerox Corporation and Xerox Canada Limited
("XCL") operated securitization facilities that engaged in continuous
sales of certain accounts receivable in the U.S. and Canada. The
facility allowed up to $315 million and $38 million, respectively, of
receivables to be outstanding to investors in the facility. As these
receivables were collected, new receivables were purchased. In May
2002, a Moody's downgrade constituted an event of termination under
the U.S.agreement, which we allowed to terminate in October 2002. In
February 2002, a downgrade of our Canadian debt by Dominion Bond
Rating Service caused the event of termination, in turn causing the
remaining Canadian facility to no longer purchase receivables, with
collections used to repay previously repurchased receivables. This
facility was fully repaid in 2002.
. In 1999, XCL securitized certain finance receivables, generating gross
proceeds of $345 million. At December 31, 2002, approximately $30
million was outstanding.
In summary, at December 31, 2002, amounts owed by these receivable-related SPEs
to their investors totaled $3,195 million, $3,165 million of which is reported
as debt in our Consolidated Balance Sheet. A detailed description of these
transactions is included in Note 5 to the Consolidated Financial Statements. We
also utilized SPEs in our Trust Preferred Securities transactions. Refer to Note
16 to the Consolidated Financial Statements for a description of the Trust
Preferred Securities transactions.
31
Financial Risk Management:
We are exposed to market risk from changes in foreign currency exchange rates
and interest rates that could affect our results of operations and financial
condition. Our current below investment-grade credit ratings effectively
constrain our ability to fully use derivative contracts as part of our risk
management strategy described below, especially with respect to interest rate
management. Accordingly, our results of operations are exposed to increased
volatility. As further discussed in Note 1 to the Consolidated Financial
Statements, we adopted SFAS No. 133 as of January 1, 2001. The adoption of SFAS
No. 133 has increased the volatility of reported earnings and other
comprehensive income. In general, the amount of volatility will vary with the
level of derivative and hedging activities and the market volatility during any
period.
We have historically entered into certain derivative contracts, including
interest rate swap agreements, foreign currency swap agreements, forward
exchange contracts and purchased foreign currency options, to manage interest
rate and foreign currency exposures. The fair market values of all our
derivative contracts change with fluctuations in interest rates and/or currency
rates and are designed so that any change in their values is offset by changes
in the values of the underlying exposures. Our derivative instruments are held
solely to hedge economic exposures; we do not enter into derivative instrument
transactions for trading or other speculative purposes and we employ
long-standing policies prescribing that derivative instruments are only to be
used to achieve a very limited set of objectives.
Our primary foreign currency market exposures include the Japanese Yen, Euro,
Brazilian Real, British Pound Sterling and Canadian Dollar. Historically, for
each of our legal entities, we have generally hedged foreign currency
denominated assets and liabilities, primarily through the use of derivative
contracts. Despite our current credit ratings, we have been able to restore
significant hedging activities with currency-related derivative contracts during
2002. Although we are still unable to hedge all our currency exposures, we are
currently utilizing the re-established capacity primarily to hedge currency
exposures related to our foreign-currency denominated debt.
We typically enter into simple unleveraged derivative transactions. Our policy
is to use only counterparties with an investment-grade or better rating and to
monitor market risk and exposure for each counterparty. We also utilize
arrangements allowing us to net gains and losses on separate contracts with all
counterparties to further mitigate the credit risk associated with our financial
instruments. Based upon our ongoing evaluation of the replacement cost of our
derivative transactions and counterparty credit-worthiness, we consider the risk
of a material default by a counterparty to be remote.
Due to our credit ratings, many of our derivative contracts and several other
material contracts at December 31, 2002 require us to post cash collateral or
maintain minimum cash balances in escrow. These cash amounts are reported in our
Consolidated Balance Sheets within Other current assets or other long-term
assets, depending on when the cash will be contractually released. Such
restricted cash amounts totaled $77 million at December 31, 2002.
Assuming a 10 percent appreciation or depreciation in foreign currency exchange
rates from the quoted foreign currency exchange rates at December 31, 2002, the
potential change in the fair value of foreign currency-denominated assets and
liabilities in each entity would be insignificant because all material currency
asset and liability exposures were hedged as of December 31, 2002. A 10 percent
appreciation or depreciation of the U.S. Dollar against all currencies from the
quoted foreign currency exchange rates at December 31, 2002, would have a $349
million impact on our Cumulative Translation Adjustment portion of equity. The
amount permanently invested in foreign subsidiaries and affiliates -- primarily
Xerox Limited, Fuji Xerox and Xerox do Brasil -- and translated into dollars
using the year-end exchange rates, was $3.5 billion at December 31, 2002, net of
foreign currency-denominated liabilities designated as a hedge of our net
investment.
Interest Rate Risk Management: Virtually all customer-financing assets earn
fixed rates of interest, while a significant portion of our debt bears interest
at variable rates. Historically we have attempted to manage our interest rate
risk by "match-funding" the financing assets and related debt, including through
the use of interest rate swap agreements. However, as our credit ratings
declined, our ability to continue this practice became constrained.
At December 31, 2002, we had $7 billion of variable rate debt, including the
$3.5 billion outstanding under the New Credit Facility and the notional value of
our pay-variable interest-rate swaps. The notional value of our offsetting
pay-fixed interest-rate swaps was $1.2 billion.
Our loans related to vendor financing, from parties including GE, are secured by
customer-financing assets and are designed to mature ratably with our collection
of principal payments on the financing assets which secure them. The interest
rates on those loans are fixed. As a result, the vendor financing loan programs
create natural match-funding of the financing assets to the related debt. As we
implement additional finance receivable securitizations and continue to repay
existing debt, the portion of our financing assets which is match-funded against
related secured debt will increase. On a consolidated basis,
32
including the impact of our hedging activities, weighted-average interest rates
for 2002, 2001 and 2000 approximated 5.0 percent, 5.5 percent and 6.2 percent,
respectively.
Many of the financial instruments we use are sensitive to changes in interest
rates. Interest rate changes result in fair value gains or losses on our term
debt and interest rate swaps, due to differences between current market interest
rates and the stated interest rates within the instrument. The loss in fair
value at December 31, 2002, from a 10 percent change in market interest rates
would be approximately $201 million for our interest rate sensitive financial
instruments. Our currency and interest rate hedging are typically unaffected by
changes in market conditions as forward contracts, options and swaps are
normally held to maturity consistent with our objective to lock in currency
rates and interest rate spreads on the underlying transactions.
We anticipate continued volatility in our results of operations due to market
changes in interest rates and foreign currency rates which we are currently
unable to hedge.
READER'S NOTE: THIS CONCLUDES THE DISCUSSION EXCERPTED DIRECTLY FROM XEROX
CORPORATION'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002.
33
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information set forth in the twelfth through eighteenth paragraphs under the
caption "CAPITAL RESOURCES AND LIQUIDITY - XEROX CREDIT CORPORATION" in Item 7
above is hereby incorporated by reference in answer to this Item.
ITEM 8. Financial Statements and Supplementary Data
Our consolidated financial statements and the notes thereto and the report
thereon of PricewaterhouseCoopers LLP, independent accountants, are set forth on
pages 46 through 65 hereof.
ITEM 9. Disagreements on Accounting and Financial Disclosure
On October 4, 2001, our ultimate parent, XC ended the engagement of KPMG LLP
(KPMG) and retained PricewaterhouseCoopers LLP (PricewaterhouseCoopers) as its
independent auditors. The Audit Committee of XC's Board of Directors and the
Board of Directors of XC approved the decision to change independent
accountants.
Consistent with XC's decision to change its independent accountants, and not
because of any disputes or disagreements between us and KPMG, on October 25,
2001 our Board of Directors likewise approved the decision to change our
independent accountants. Accordingly, effective as of October 4, 2001, we ended
the engagement of KPMG and retained PricewaterhouseCoopers as our independent
accountants for the fiscal year ended December 31, 2001. The reports of KPMG on
our financial statements for each of the fiscal years ended December 31, 2000
and December 31, 1999 contained no adverse opinion or disclaimer of opinion and
were not qualified or modified as to uncertainty, audit scope or accounting
principles. For the fiscal years ended December 31, 2000 and December 31, 1999
and through October 25, 2001, there were no disagreements with KPMG on any
matter of accounting principles or practices, financial statement disclosure or
audit scope or procedure which, if not resolved to the satisfaction of KPMG,
would have caused it to make reference to the subject matter of such
disagreement in its reports on our financial statements for such fiscal years.
Nor were there any reportable events within the meaning of Item 304(a)(1)(v) of
Regulation S-K for the fiscal years ended December 31, 2000 and December 31,
1999 and through October 25, 2001. Our Board of Directors authorized KPMG to
respond fully to inquiries of PricewaterhouseCoopers concerning the matters
addressed in the Current Report on Form 8-K dated October 25, 2001 that we filed
with the SEC.
The Current Report on Form 8-K dated October 25, 2001 that we filed with the SEC
contained the following text taken from Item 4 of a Current Report on Form 8-K
dated September 28, 2001 that XC filed with the SEC. This information is
provided to give the reader a full understanding of the events and circumstances
that led XC to replace its auditors.
"On October 4, 2001, Xerox Corporation ("Company") determined to change the
Company's independent accountants, and, accordingly, ended the engagement of
KPMG LLP ("KPMG") in that role and retained PricewaterhouseCoopers LLP as its
independent accountants for the fiscal year ending December 31, 2001. The Audit
Committee of the Board of Directors (the "Audit Committee") and the Board of
Directors of the Company approved the decision to change independent
accountants.
The reports of KPMG on the financial statements of the Company for each of the
fiscal years ended December 31, 2000 and December 31, 1999 contained no adverse
opinion or disclaimer of opinion and were not qualified or modified as to
34
uncertainty, audit scope or accounting principles. Except to the extent
discussed below, for the fiscal years ended December 31, 2000 and December 31,
1999 and through the date of this report, there were no disagreements with KPMG
on any matter of accounting principles or practices, financial statement
disclosure or audit scope or procedure which, if not resolved to the
satisfaction of KPMG, would have caused it to make reference to the subject
matter of such disagreement in its reports on the financial statements for such
fiscal years. Nor, except to the extent discussed below, were there any
reportable events within the meaning of Item 304(a)(1)(v) of Regulation S-K for
the fiscal years ended December 31, 2000 and December 31, 1999 and through the
date of this report. With respect to the matters discussed below, the Audit
Committee discussed them with KPMG and authorized KPMG to respond fully to
inquiries of PricewaterhouseCoopers LLP concerning them.
In March 2001, KPMG informed management and the Audit Committee that it wished
to expand significantly the scope of its audit work in connection with the audit
of the Company's 2000 financial statements. KPMG proposed that certain
additional procedures be performed, including that the Audit Committee appoint
Special Counsel to conduct an inquiry into certain issues, which procedures were
performed in March, April and May 2001.
While the expanded procedures were being performed, KPMG informed the Audit
Committee and management that KPMG was unwilling to rely on representations by
two employees in one of the Company's geographic operating units. Management
removed those employees from responsibility in connection with the Company's
system of financial reporting.
As a result of observations during its 2000 audit, and other information
discussed with the Audit Committee, KPMG reported certain material weaknesses in
the Company's internal control systems and made recommendations concerning
certain components of the Company's business:
- KPMG emphasized the importance for internal control of the tone set by
the Company's top management. KPMG noted that, as a result of its
audit and information reported by Special Counsel, it believed there
was evidence that management was not successful in setting the
appropriate tone with respect to financial reporting. It recommended
that the Company take steps to remediate appropriately those issues.
Certain personnel changes have been made based in part on KPMG views
offered to the Audit Committee and management.
- Customer Business Operations (CBO) in the Company's North American
Solutions Group. KPMG noted issues with regard to CBO's ability to bill
customers accurately for services, and noted that difficulties in that
area had resulted in unfavorable billing adjustments during 2000.
Although KPMG recognized that the Company had initiated several steps
to address this issue, it concluded that it remained unclear when those
changes would result in sustained improvement in reducing non-cash
resolution adjustments of billing differences. It acknowledged that
this weakness did not suggest that the net trade receivable account
balance is unreasonably stated at December 31, 2000, but that proper
reporting required extensive evaluation of billing adjustments during
the fourth quarter. KPMG suggested various business and operational
changes to address this issue.
- Communication of Accounting and Control Policies. KPMG noted that
policy documents need to be updated, among other things to address
issues identified by the Company's worldwide audit function. Special
Counsel and KPMG, recommended that the Company also provide increased
formal training to ensure that its personnel understand the accounting
and control guidance in its policies.
35
- Consolidation and Corporate-Level Entries. KPMG observed that the
Company's quarterly consolidation process is manually intensive,
requiring numerous adjustments at corporate financial reporting
levels. It recommended that the Company's Consolidated Financial
Information System be augmented to enhance the monitoring and review
of corporate-level and manual entries, and further that the Company
ensure adequate segregation of duties in the preparation and approval
of such entries.
- Appropriateness of the Concessionaire Business Model in Latin American
Countries. KPMG noted that during 2000, analysis by the Company's
worldwide audit function indicated that certain issues existed with
respect to this business model, including that certain concessionaires
may lack economic substance independent of the Company, and that
certain business practices involving concessionaires resulted in
allowances with respect to receivables in 2000. KPMG suggested periodic
assessment of the financial position of prospective and existing
concessionaires, and that the Company monitor its business relationship
with them to ensure that they are substantive independent distributors
of the Company's products.
In addition to those items, KPMG noted that organizational changes, including
the Company's turnaround program and associated reductions in headcount, had and
would continue to stress the Company's internal control structure. KPMG
recommended that the Company take steps to ensure that issues likely to impact
the control environment receive appropriate management attention. KPMG also
recommended improved balance sheet account reconciliation and analysis on a
global basis, in particular with respect to intercompany balances.
The foregoing matters were considered by KPMG in connection with their 2000
audit and did not result in any adverse opinion or disclaimer of opinion or any
qualification or modification as to uncertainty, audit scope or accounting
principles. KPMG's auditor's report dated May 30, 2001 contained a separate
paragraph stating that the Company's 1999 and 1998 consolidated financial
statements had been restated.
The Company commenced actions in fiscal 2000 and expanded actions in fiscal 2001
which, collectively, it believes have addressed the above-discussed matters.
The Company has provided KPMG a copy of this Report and requested KPMG to
furnish it with a letter addressed to the Securities and Exchange Commission
stating whether it agrees with the statements made herein. A copy of such
letter, dated October 4, 2001, is filed as an Exhibit to the Company's Form
8-K."
36
PART III
ITEM 10. Directors and Executive Officers of the Registrant
Directors
Our directors are elected annually by Xerox Financial Services, Inc. (XFSI), our
sole shareholder, to serve for one year until their successors have been elected
and shall have qualified. There are no family relationships between any of the
directors. Our current directors are:
Director Other
Name Age Since Occupation Directorships
Gary R. Kabureck 49 2001 Assistant Corporate Xerox Canada Inc.
Controller and Chief
Accounting Officer, Xerox
Xerox Corporation Investments
2001 - Present; Europe B.V.
Assistant Corporate
Controller, Xerox Corp.
2000-2001; Vice President
and Controller, Financial
Services North American
Solutions Group, Xerox
Corp. 1999-2000; Vice
President and Controller,
Financial Services U.S.
Customer Operations,
Xerox Corp. 1997-1999
John F. Rivera 39 2001 Director, Cash None
Strategies and
Planning, Xerox Corp.
2000-Present; Director,
Corporate Financial
Planning, 2000; Manager,
Financial Reporting and
Analysis, Xerox Corp.
1999-2000; Manager,
Business Arrangements and
Internal Control Programs
Xerox Corp., 1997-1999;
Manager, Accounting Policy
Projects, Xerox Corp.
1995-1997
Peter K. Gallagher 41 2002 Director, Accounting None
Policy and Control, Xerox
Corp., 2000 - Present;
Manager, Accounting
Policy Projects, Xerox
Corp. 1997-2000
37
Executive Officers
Our executive officers are elected annually by our Board of Directors, to hold
office until their successors have been elected and shall have qualified. There
are no family relationships between any of the executive officers. Our current
executive officers are:
Officer
Name Age Since Office
- ---- --- ----- ------
Gary R. Kabureck 49 2000 Chairman, President and Chief Executive
Officer
John F. Rivera 39 2001 Vice President, Treasurer and Chief
Financial Officer
Peter K. Gallagher 41 2002 Controller
Section 16(a) Beneficial Ownership Reporting Compliance
Not applicable because all of our outstanding capital stock is owned by XFSI, a
holding company, which is wholly-owned by XC.
ITEM 11. Executive Compensation
None of our directors or executive officers receive any compensation for
services rendered to us or to our subsidiaries.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
All of our outstanding capital stock is owned by XFSI, a holding company, which
is wholly-owned by XC. None of our directors or executive officers hold, or
possess any rights to acquire, any of our capital stock.
ITEM 13. Certain Relationships and Related Transactions
In the past, we frequently and routinely entered into material transactions with
our ultimate parent, XC, pursuant to the Operating Agreement between XC and us,
and otherwise in the ordinary course of business. Although we have discontinued
purchases of contracts receivable from XC under the Operating Agreement (and,
pursuant to the New Credit Facility, are precluded from purchasing any new
contracts receivable from XC), we nonetheless continue to enter into material
transactions with XC. These transactions and other business relationships
between us and XC are disclosed in the responses to: Part I, Item 1 "Business";
Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and
Results of Operations"; Part II, Item 8 "Financial Statements and Supplementary
Data" and Part IV, Item 15 "Exhibits, Financial Statement Schedules and Reports
on Form 8-K", Exhibits 10(a) "Amended and Restated Operating Agreement", 10(b)
"Support Agreement" and 10(c) "Tax Allocation Agreement"; of this Annual Report
on Form 10-K. All of our directors and executive officers are employees, and in
some cases officers, of XC, but do not have any direct or indirect material
interest in such transactions.
All amounts collected on our contracts receivable and all proceeds from the sale
of contracts receivable back to XC, are currently loaned immediately back to XC
under an interest bearing demand note agreement (XC Master Demand Note). The XC
Master Demand Note agreement is included as Exhibit 10 (d) to this Annual Report
on Form 10-K. The XC Master Demand Note earns interest at a rate equal to the
result of adding the H.15 Two-Year Swap Rate and H.15 Three-Year Swap Rate (each
as defined in the XC Master Demand Note) and dividing by two (2) and then adding
2.00% (200 basis points). We will demand repayment of
38
these loan amounts from XC as and to the extent necessary to repay our maturing
debt obligations, fund our operations, or for such other purposes that we
determine appropriate.
Subject to certain limitations, all XC and other obligations under the New
Credit Facility are guaranteed by substantially all of XC's U.S. subsidiaries,
including us. Our guaranty of obligations under the New Credit Facility,
however, is subordinated to all of our capital markets debt outstanding as of
June 21, 2002. Under the New Credit Facility, all of our cash in excess of the
amounts required to make principal and interest payments on our debt and/or
required to meet our ordinary course expenses, in each case for the then next
succeeding fiscal quarter, is transferred to XC on a regular basis. In
connection with the New Credit Facility, substantially all of XC's U.S.
subsidiaries, including us, have also guaranteed XC's obligations under $600
million of 9-3/4% Senior Notes and Euro 225 million of 9-3/4% Senior Notes due
2009 (collectively, the "Senior Notes").
ITEM 14. Controls and Procedures
Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we conducted an
evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures, as defined in Rules 13a-14(c) and 15d-14(c) under the
Securities Act of 1934, within 90 days of the filing date of this report (the
"Evaluation Date"). Based on this evaluation, our principal executive officer
and principal financial officer concluded as of the Evaluation Date that our
disclosure controls and procedures were effective such that the material
information required to be included in our Securities and Exchange Commission
("SEC") reports is recorded, processed, summarized and reported within the time
periods specified in SEC rules and forms relating to Xerox Credit Corporation,
including our consolidated subsidiaries, and was made known to them by others
within those entities, particularly during the period when this report was being
prepared.
In addition, there were no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to the
Evaluation Date. We have not identified any significant deficiencies or material
weaknesses in our internal controls, and therefore there were no corrective
actions taken.
39
PART IV
ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(1) Index to Financial Statements and financial statements schedules,
filed as part of this report:
Report of Independent Accountants
Consolidated balance sheets at December 31, 2002 and 2001
Consolidated statements of income for each of the years in the
three-year period ended December 31, 2002
Consolidated statements of shareholder's equity for each of the
years in the three-year period ended December 31, 2002
Consolidated statements of cash flows for each of the years in the
three-year period ended December 31, 2002
Notes to consolidated financial statements
All schedules are omitted as they are not applicable or the
Information required is included in the consolidated financial
statements or notes thereto.
(2) Supplemental Data:
Quarterly Results of Operations
(3) The exhibits filed herewith are set forth in the Exhibit Index
included herein.
(a) Current Reports on Form 8-K dated September 26, 2002 (filed October 2,
2002) and October 21, 2002 reporting Item 5 "Other Events" were filed
during the last quarter of the period covered by this Report.
40
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
XEROX CREDIT CORPORATION
________________________________________
(NAME AND TITLE) John F. Rivera, Vice President,
Treasurer and Chief Financial Officer
March 31, 2003
Pursuant to the requirement of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of Registrant and in
the capacities and on the date indicated.
March 31, 2003
Principal Executive Officer:
Gary R. Kabureck ________________________________________
Chairman, President, Chief Executive
Officer and Director
Principal Financial Officer:
John F. Rivera ________________________________________
Vice President, Treasurer,
Chief Financial Officer and Director
Principal Accounting Officer:
Peter K. Gallagher ________________________________________
Controller and Director
41
CEO CERTIFICATIONS
I, Gary R. Kabureck, Chairman, President and Chief Executive Officer, certify
that:
1. I have reviewed this annual report on Form 10-K of Xerox Credit Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
March 31, 2003
42
_____________________________
Gary R. Kabureck
Principal Executive Officer
43
CFO CERTIFICATIONS
I, John F. Rivera, Vice President, Treasurer and Chief Financial Officer,
certify that:
1. I have reviewed this annual report on Form 10-K of Xerox Credit Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
March 31, 2003
44
_______________________________
John F. Rivera
Principal Financial Officer
45
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholder of Xerox Credit Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of shareholder's equity and of cash flows
present fairly, in all material respects, the financial position of Xerox Credit
Corporation and its subsidiaries ("the Company") at December 31, 2002 and 2001,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As disclosed in Note 1, the Company and its ultimate parent, Xerox Corporation,
engage in extensive intercompany transactions, and the Company receives all of
its operational and administrative support from Xerox Corporation. Such
transactions cannot be presumed to be carried out on the same basis as
transactions among wholly-unrelated parties. Additionally, as disclosed in Note
4, the Company had notes receivable from Xerox Corporation at December 31, 2002
amounting to $1,594 million. Accordingly, the Company is dependent on Xerox
Corporation complying with its contractual obligations.
PricewaterhouseCoopers LLP
Stamford, Connecticut
February 28, 2003
46
XEROX CREDIT CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2002 and 2001
(In Millions)
ASSETS
2002 2001
---- ----
Cash and cash equivalents $ 15 $ -
Investments:
Contracts receivable 1,151 3,244
Unearned income (99) (331)
Allowance for losses (28) (78)
------- -------
Total investments 1,024 2,835
Notes receivable - Xerox and affiliates 1,594 1,377
Other assets 29 76
------- -------
Total assets $ 2,662 $ 4,288
======= =======
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities:
Notes payable within one year:
Current portion of notes payable $ 463 $ 1,630
Current portion of secured borrowing 7 130
Notes payable after one year 1,382 1,743
Secured borrowing due after one year - 24
Due to Xerox Corporation, net 31 40
Accounts payable and accrued liabilities 15 10
Derivative Liabilities 1 53
------- -------
Total liabilities 1,899 3,630
------- -------
Shareholder's Equity:
Common stock, no par value, 2,000 shares
authorized, issued, and outstanding 23 23
Additional paid-in capital 219 219
Retained Earnings 521 424
Accumulated other comprehensive income (loss) - (8)
------- -------
Total shareholder's equity 763 658
------- -------
Total liabilities and shareholder's equity $ 2,662 $ 4,288
======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
47
XEROX CREDIT CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2002, 2001 and 2000
(In Millions)
2002 2001 2000
---- ---- ----
Earned Income:
Contracts receivable $ 175 $ 400 $ 441
Xerox note receivable 100 - -
----- ----- -----
Total earned income 275 400 441
===== ===== =====
Expenses:
Interest 122 261 292
Derivative instruments fair value
adjustments 5 37 -
General and administrative 6 11 12
----- ----- -----
Total expenses 133 309 304
----- ----- -----
Income before income taxes 142 91 137
Provision for income taxes 45 35 54
----- ----- -----
Income before cumulative effect
of change in accounting principle 97 56 83
Cumulative effect of change in
accounting principle, net - (3) -
----- ----- -----
Net income $ 97 $ 53 $ 83
===== ===== =====
The accompanying notes are an integral part of the consolidated financial
statements.
48
XEROX CREDIT CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
Years Ended December 31, 2002, 2001 and 2000
(In Millions)
Accumulated
Additional Other
Common Paid-In Retained Comprehensive
Stock Capital Earnings Income Total
------ ---------- -------- ------------- -----
Balance at December 31, 1999 $ 23 $ 219 $ 288 $ - $ 530
Net Income - - 83 - 83
------ ----- ----- ------ -----
Balance at December 31, 2000 23 219 371 - 613
Net Income - - 53 - 53
SFAS No. 133 transition
adjustment, net - - - (20) (20)
Net changes on cash flow hedges - - - 12 12
-----
Comprehensive Income - - - - 45
------ ------ ----- ------ -----
Balance at December 31, 2001 23 219 424 (8) 658
Net Income - - 97 - 97
Net changes on cash flow hedges - - - 8 8
-----
Comprehensive Income - - - - 105
------ ----- ----- ------ -----
Balance at December 31, 2002 $ 23 $ 219 $ 521 $ - $ 763
====== ===== ===== ====== =====
The accompanying notes are an integral part of the consolidated financial
statements.
49
XEROX CREDIT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2002, 2001 and 2000
(In Millions)
2002 2001 2000
---- ---- ----
Cash Flows from Operating Activities
Net income $ 97 $ 53 $ 83
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Net loss on derivative instruments 4 23 -
Net change in operating assets and liabilities 9 (35) (9)
Net change in Derivative collateralization 44 (47) -
------- ------- -------
Net cash provided by (used in) operating activities 154 (6) 74
------- ------- -------
Cash Flows from Investing Activities
Purchases of investments (908) (2,496)
Proceeds from investments 1,359 1,906 1,874
Proceeds from sales of contract receivables 451 1,592 -
Net Advances to Xerox (145) (1,377) -
Proceeds from sale of other assets - 23 -
------- ------- -------
Net cash provided by (used in) investing activities 1,665 1,236 (622)
------- ------- -------
Cash Flows from Financing Activities
Change in commercial paper, net - (32) (128)
Payments on notes with Xerox and affiliates, net - (643) (287)
Proceeds from long-term debt - - 2,690
Proceeds from secured borrowings - - 411
Principal payments of long-term debt and
secured borrowings (1,804) (555) (2,138)
------- ------- -------
Net cash provided by (used in) financing activities (1,804) (1,230) 548
------- ------- -------
Increase in cash and cash equivalents 15 - -
Cash and cash equivalents, beginning of year - - -
------- ------- -------
Cash and cash equivalents, end of year $ 15 $ - $ -
======= ======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
50
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of Xerox Credit
Corporation (the Company, we, our or us) and its subsidiaries. We are a
wholly-owned subsidiary of Xerox Financial Services, Inc. (XFSI), which is in
turn wholly-owned by Xerox Corporation (XC, and together with its consolidated
subsidiaries, Xerox). All significant transactions between the Company and its
subsidiaries have been eliminated.
Description of Business
Until July 2001, we were a domestic funding entity for XC. We have no
international operations. Each month, we purchased non-cancelable installment
sale and lease contracts originated by the domestic marketing operations of XC
during the previous month. We historically raised debt in the capital markets to
fund our purchases of these contracts. Purchases of contracts from XC and the
subsequent administration of those receivables by XC were undertaken pursuant to
an Operating Agreement between XC and us. Under the Operating Agreement, XC
transferred to us whatever security interest it had in its receivables and
equipment.
The purchase price of the contracts was calculated as the present value of the
future contractual cash flows. The interest rates utilized to discount the
future cash flows to present value were determined based on published
"reference" interest rates plus a prescribed spread. The interest rate utilized
for the cost calculation was adjusted monthly as each new set of contracts was
purchased.
Historically, we paid a fee to XC for which XC provided all billing, collection
and other services related to the administration of our contracts receivable .
On a monthly basis, we cash-settled the net open account between XC and us for
fees and amounts we owed to XC for contracts purchased, net of receivable
amounts XC collected on our behalf. Since all services necessary to our business
were provided by XC, we maintained minimal facilities and had no separate
infrastructure or employees. The Company and XC engage in extensive intercompany
transactions and the Company receives all of our operational and administrative
support from XC. By their nature, transactions involving related parties cannot
be presumed to be carried out on the same basis as transactions among
wholly-unrelated parties.
In September 2001, Xerox entered into framework agreements with General Electric
(GE) including one in the U.S. under which GE (or an affiliate thereof) would
manage Xerox's customer administrative functions, provide secured financing for
XC's existing portfolio of finance receivables and become the primary equipment
financing provider for Xerox customers. Thereafter, Xerox and GE entered into
definitive agreements in 2001 and 2002. In May 2002, Xerox Capital Services
(XCS), XC's U.S. venture with GE, became operational. XCS now manages Xerox's
customer administration functions in the U.S. including credit approval, order
processing, billing and collections. In October 2002, XC completed an eight-year
agreement in the U.S. (the "New U.S. Vendor Financing Agreement"), under which
GE became the primary equipment financing provider in the U.S., through monthly
securitizations of Xerox's new lease originations up to a maximum amount of $5.0
billion. This agreement was effectively a
51
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
replacement of an agreement entered into in November 2001 whereby GE purchased
XC receivables up to a maximum of $2.6 billion.
As noted, historically, XC provided billing, collection and other services
related to the administration of the receivables that we purchased from XC. XCS
now manages Xerox's customer administration and leasing activities in the U.S.
including credit approval, order processing, billing and collections.
Accordingly, XCS also now provides these services to us and subsequent to May 1,
2002, we now pay a fee to XCS, rather than to XC, for these services. The fees
we pay to XCS have been and are expected to be similar to the fees paid to XC.
Liquidity
- ---------
Our liquidity is dependent upon the liquidity of our ultimate parent,
XC Accordingly, the following is a disclosure regarding the liquidity of both
Xerox and us, even if it does not directly affect our liquidity.
Xerox manages its worldwide liquidity using internal cash management practices,
which are subject to (1) the statutes, regulations and practices of each of the
local jurisdictions in which it operates, (2) the legal requirements of the
agreements to which Xerox is a party and (3) the policies and cooperation of the
financial institutions it utilizes to maintain such cash management practices.
In 2000, Xerox-specific operational issues were exacerbated by significant
competitive and industry changes, adverse economic conditions, and significant
technology and acquisition spending. Together, these conditions negatively
impacted its liquidity, which from 2000 to 2002 led to a series of credit rating
downgrades, eventually to below investment grade. Consequently, Xerox's access
to capital and derivative markets has been restricted. The downgrades also
required it to cash-collateralize certain derivative and securitization
arrangements to prevent them from terminating, and to immediately settle
terminating derivative contracts. Further, Xerox is required to maintain minimum
cash balances in escrow on certain borrowings and letters of credit. In
addition, the SEC would not allow Xerox to publicly register any securities
offerings while its investigation, which commenced in June 2000, was ongoing.
This additional constraint essentially prevented Xerox from raising funds from
sources other than unregistered capital markets offerings and private lending or
equity sources. Consequently, Xerox's credit ratings, which were already under
pressure, came under greater pressure since credit rating agencies often include
access to capital sources in their rating criteria.
While the conclusion of the SEC investigation removes Xerox's previous inability
to access public capital markets, Xerox expects its ability to access unsecured
credit sources to remain restricted as long as its credit ratings remain below
investment grade, and Xerox expects its incremental cost of borrowing to
increase as a result of such credit ratings.
In June 2002, Xerox entered into an Amended and Restated Credit Agreement (the
"New Credit Facility") with a group of lenders, replacing its prior $7 billion
facility (the "Old Revolver"). At that time, Xerox permanently repaid $2.8
billion of the Old Revolver and subsequently paid $710 million on the New Credit
Facility. At December 31, 2002, the New Credit Facility consisted of two
tranches of term loans totaling $2.0 billion and a $1.5 billion revolving credit
facility that includes a $200 million letter of credit subfacility. At December
31, 2002, $3.5 billion was outstanding under the New Credit Facility. At
December 31, 2002 Xerox had no additional borrowing capacity under the New
Credit Facility since the entire revolving facility was outstanding, including a
$10 million letter of credit under the subfacility.
52
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The New Credit Facility contains affirmative and negative covenants. The New
Credit Facility contains financial covenants that the Old Revolver did not
contain. Certain of the material covenants under the New Credit Facility are
summarized below (this summary is not complete, and is in all respects, subject
to the actual provisions of the New Credit Facility):
.. Excess cash of certain foreign subsidiaries and of Xerox Credit Corporation,
a wholly-owned subsidiary, must be transferred to Xerox at the end of each
fiscal quarter; for this purpose, "excess cash" generally means cash
maintained by certain foreign subsidiaries taken as a whole in excess of
their aggregate working capital and other needs in the ordinary course of
business (net of sources of funds from third parties), including reasonably
anticipated needs for repaying debt and other obligations and making
investments in their businesses. In certain circumstances, Xerox is not
required to transfer cash to Xerox Corporation, its parent company, if the
transfer cannot be made in a tax efficient manner or if it would be
considered a breach of fiduciary duty by the directors of the foreign
subsidiary;
.. Minimum EBITDA (a quarterly test that is based on rolling four quarters)
ranging from $1.0 to $1.3 billion; for this purpose, "EBITDA" (Earnings
before interest, taxes, depreciation and amortization) generally means
EBITDA (excluding interest and financing income to the extent included in
consolidated net income), less any amounts spent for software development
that are capitalized;
.. Maximum leverage ratio (a quarterly test is calculated as total adjusted
debt divided by EBITDA) ranging from 4.3 to 6.0;
.. Maximum capital expenditures (annual test) of $330 million per fiscal year
plus up to $75 million of any unused amount carried over from the previous
year; for this purpose, "capital expenditures" generally mean the amounts
included on Xerox's statement of cash flows as "additions to land, buildings
and equipment", plus any capital lease obligations incurred;
.. Minimum consolidated net worth ranging from $2.9 billion to $3.1 billion;
for this purpose, "consolidated net worth" generally means the sum of the
amounts included on Xerox's balance sheet as "common shareholders' equity,"
"preferred stock," "company-obligated, mandatorily redeemable preferred
securities of subsidiary trust holding solely subordinated debentures of
Xerox," except that the currency translation adjustment effects and the
effects of compliance with FAS 133 occurring after December 31, 2001 are
disregarded, the preferred securities (whether or not convertible) issued by
Xerox or by Xerox's subsidiaries which were outstanding on June 21, 2002
will always be included, and any capital stock or similar equity interest
issued after June 21, 2002 which matures or generally becomes mandatorily
redeemable for cash or puttable at holders' option prior to November 1, 2005
is always excluded; and
.. Limitations on: (i) issuance of debt and preferred stock; (ii) creation of
liens; (iii) certain fundamental changes to corporate structure and nature
of business, including mergers; (iv) investments and acquisitions; (v) asset
transfers; (vi) hedging transactions other than in those in the ordinary
course of business and certain types of synthetic equity or debt
derivatives, and (vii) certain types of restricted payments relating to both
our and/or our subsidiaries' equity interests, including payment of cash
dividends on Xerox's common stock; (viii) certain types of early retirement
of debt, and (ix) certain transactions with affiliates, including
intercompany loans and asset transfers.
The New Credit Facility generally does not affect Xerox's ability to continue to
securitize receivables under the agreements it has with General Electric and
others. Although Xerox cannot pay cash dividends on its common stock during the
term of the New Credit Facility, it can pay cash dividends on its preferred
stock, provided there is then no event of default. In addition to other defaults
customary for facilities of this type, defaults on its other debt, or
bankruptcy, or certain of its subsidiaries, would constitute defaults under the
New Credit Facility.
At December 31, 2002, Xerox was in compliance with all aspects of the New Credit
Facility including financial covenants and expects to be in compliance for at
least the next twelve months. Failure to be in compliance with any material
provision or covenant of the New Credit Facility could have a material adverse
effect on its liquidity and operations.
With $2.9 billion of cash and cash equivalents on hand at December 31, 2002,
Xerox believes its liquidity (including operating and other cash flows it
expects to generate) will be sufficient to meet operating cash flow requirements
as they occur and to satisfy all scheduled debt maturities for at least the next
twelve months. Xerox's ability to maintain sufficient liquidity going forward is
highly dependent on achieving expected operating results, including capturing
the benefits from restructuring activities, and completing announced finance
receivables securitizations. There is no assurance that these initiatives will
be successful. Failure to successfully complete these initiatives could have a
material adverse effect on Xerox's liquidity and its operations, and could
require Xerox to consider further measures, including
53
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
deferring planned capital expenditures, reducing discretionary spending, selling
additional assets and, if necessary, restructuring existing debt. Xerox also
expects that its ability to fully access commercial paper and other unsecured
public debt markets will depend upon improvements in its credit ratings, which
in turn depend on its ability to demonstrate sustained profitability growth and
operating cash generation and continued progress on its vendor financing
initiatives. Until such time, Xerox expects some bank credit lines to continue
to be unavailable, and Xerox intends to access other segments of the capital
markets as business conditions allow, which could provide significant sources of
additional funds until full access to the unsecured public debt markets is
restored.
Recognition of Earned Income
We utilize the interest method for the recognition of earned income associated
with contracts receivable. Under this method, the difference between the amount
of gross contracts receivable and the cost of the contract is recorded as
unearned income. The unearned income is amortized into income over the life of
the contract using an effective yield method.
Cash and Cash Equivalents
All highly liquid investments, if any, with a maturity of three months or less
at date of purchase are considered to be cash equivalents.
Restricted Investments
At December 31, 2002, we had $2 million of cash held in escrow as collateral for
out-of-the-money positions on certain derivative contracts. These restricted
amounts are included in Other assets, net in the balance sheet as of December
31, 2002. The amount of required collateral will change based on changes in the
fair value of the underlying derivative contracts.
Securitizations and Transfers of Financial Instruments
Sales, transfers and securitizations of recognized financial assets are
accounted for under Statement of Financial Accounting Standards No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities" (SFAS No. 140). From time to time, in the normal course of
business, we may securitize or sell contracts receivable with or without
recourse and/or discounts. The receivables are removed from the Consolidated
Balance Sheet at the time they are sold and the risk of loss has transferred to
the purchaser. However, we maintain risk of loss on any retained interest in
such receivables. Sales and transfers that do not meet the criteria for
surrender of control or were sold to a consolidated special purpose entity
(non-qualified special purpose entity) under SFAS No. 140 are accounted for as
secured borrowings.
When we sell receivables the value assigned to the retained interests in
securitized contracts receivable is based on the relative fair values of the
interest retained and sold in the securitization. We estimate fair value based
on the present value of future expected cash flows using management's best
estimates of the key assumptions, consisting of receivable amounts, anticipated
credit losses and discount rates commensurate with the risks involved. Gains or
losses on the sale of the receivables depend in part on the previous carrying
amount of the financial assets involved in the transfer, allocated
54
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
between the assets sold and the retained interests based on their relative fair
value at the date of transfer.
Allowance for Losses
As part of the administrative services it provides to us, XCS computes the
allowance for losses on all of our contracts based upon historical experience
and current trends. When we purchase contracts from XC, we deduct the portion of
XC's allowance allocable to the purchased contracts from the purchase price and
record it as Allowance for Losses. If more contracts are charged off than were
forecast in the initial allowance-for-loss calculation, XC reimburses us for the
excess charge-offs. Conversely, if charge-off experience is better than
forecast, XCC reimburses XC for the difference between the original forecast and
amounts ultimately realized. The resultant effect of the above is to relieve us
of any exposure to losses associated with the contracts, and therefore, no bad
debt expense is included in our Consolidated Statements of Income.
Charge-Off of Delinquent Receivables
We charge-off delinquent receivables against established reserves as soon as it
becomes probable that we will not collect the receivables through normal means.
Fair Value of Financial Instruments
The fair value of cash and equivalents and commercial paper approximate carrying
amounts due to the short maturities of these instruments. There were no balances
outstanding for commercial paper as of December 31, 2002 and 2001. The fair
value of investments, notes payable, and interest rate swaps are discussed in
Notes 2, 6, and 8, respectively.
New Accounting Standards and Accounting Changes
In 2001 and 2002, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards No. 141 "Business Combinations,"
No. 142 "Goodwill and Other Intangible Assets," No. 143 "Accounting for Asset
Retirement Obligations," No. 144 "Accounting for the Impairment or Disposal of
Long-Lived Assets," No. 145 "Rescission of FASB Statements No. 4, 44 and 64,
Amendment of FASB Statement No. 13 and Technical Corrections," No. 146
"Accounting for Costs Associated with Exit or Disposal Activities," No. 148
"Accounting for Stock-Based Compensation - Transition and Disclosure an
amendment of FASB Statement No. 123" ("SFAS No. 148"), FASB Interpretation No.
45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), and FASB
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46").
We have adopted, or are planning to adopt, each of these statements as required,
but we do not expect any of these statements to have any significant impact on
our financial reporting because we do not have any transactions that are
affected by these statements.
Effective January 1, 2001, we adopted Statement of Financial Accounting
Standards, No. 133, "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS No. 133"), which requires companies to recognize all
derivatives as assets or liabilities measured at their fair value, regardless of
the purpose or intent of holding them. Gains or losses resulting from changes in
the fair value of derivatives are recorded each period in current earnings or
other comprehensive income, depending on whether a derivative is designated as
part of a hedge transaction and, if it is, depending on the type
55
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
of hedge transaction. Changes in fair value for derivatives not designated as
hedging instruments and the ineffective portions of hedges are recognized in
earnings in the current period. The adoption of SFAS No. 133 resulted in a net
cumulative after-tax loss of $3 in the accompanying Consolidated Statement of
Income and a net cumulative after-tax loss of $20 in Accumulated Other
Comprehensive Income which is included in the accompanying Consolidated Balance
Sheets. Further, as a result of recognizing all derivatives at fair value,
including the differences between the carrying values and fair values of related
hedged assets, liabilities and firm commitments, we recognized a $10 million
increase in assets and a $33 million increase in liabilities.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). This interpretation expands
the disclosure requirements of guarantee obligations and requires the guarantor
to recognize a liability for the fair value of the obligation assumed under a
guarantee. The disclosure requirements of FIN 45 are effective as of December
31, 2002, and require information as to the nature of the guarantee, the maximum
potential amount of future payments that the guarantor could be required to make
under the guarantee, and the current amount of the liability, if any, for the
guarantor's obligations under the guarantee. The recognition requirements of FIN
45 are to be applied prospectively to guarantees issued or modified after
December 31, 2002. The only significant guarantees that we have relate to our
guarantee of all obligations of Xerox under the New Credit Facility (which is
discussed in Notes 1 and 7) as well as our guarantee of XC's $600 million of
9-3/4% Senior Notes and Euro 225 million of 9-3/4% Senior Notes due 2009. We do
not expect the requirements of FIN 45 to have a material impact on our results
of operations, financial position, or liquidity.
Reclassifications
Certain prior year balances have been reclassified to conform to the current
year presentation.
(2) Investments
Contracts receivable represent purchases from XC as described in Note 1. These
receivables arise from XC equipment sales under installment sales and lease
contracts. Contract terms on these receivables range primarily from three to
five years. We did not purchase any receivables from XC in 2002, as compared to
$908 million in 2001, and $2,496 million in 2000. The Company was charged $6
million in 2002, $11 million in 2001, $12 million in 2000 for administrative
costs associated with the contracts receivable purchased.
56
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The Company estimates that the fair value of these investments approximates
their carrying amounts at December 31, 2002 and 2001.
The scheduled maturities of customer financing contracts receivable at December
31, 2002 are as follows (in millions):
2003 $ 615
2004 359
2005 153
2006 20
2007 3
Thereafter 1
------
total $1,151
======
Experience has shown that a portion of these contracts receivable will be
prepaid prior to maturity. Accordingly, the preceding schedule of contractual
maturities should not be considered a forecast of future cash collections.
Sales of Contracts
In July 2001, we sold back to XC $643 million of contracts receivable as part of
a structured transaction in which XC transferred receivables to a special
purpose entity (SPE). Our sale of contracts to XC was accounted for as a sale at
book value, which approximated fair value. The SPE in turn sold $513 million of
floating-rate asset-backed notes to third-party investors. XC received cash
proceeds of $480 million net of $3 million of fees in connection with this
transaction. We have no continuing involvement nor retained interests in the
receivables sold and all risk of loss in such receivables was transferred back
to XC.
In connection with XC's financing agreement with GE, during 2002 and 2001, we
sold back to XC an aggregate of $451 million and $949 million, respectively, of
contracts receivable. The sales to XC were accounted for as sales of contracts
receivable at book value, which approximated fair value. We have no continuing
involvement or retained interests in the receivables sold and all the risk of
loss in such receivables was transferred back to XC.
Secured Borrowings
In 2000, we transferred $457 million of contracts receivable to a special
purpose entity for cash proceeds of $411 million and a subordinated intercompany
loan of $46 million. The transfer agreement included a repurchase option;
accordingly, the proceeds were accounted for as a secured borrowing. At December
31, 2002, the balance of the transferred receivables was $101 million, and is
included in total investments, net in the Consolidated Balance Sheet. The
remaining secured borrowing balance was $7 million and is included in Debt. The
balance was fully paid off in January, 2003.
(3) Allowance for Losses
The analysis of the Allowance for Losses for the three-year period ending
December 31, 2002 is as follows ($ in millions):
57
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Additions
Balance Charged Retained Balance
at to at at
Beginning Costs Time End
of and of of
Period Expenses Purchase Deductions Period
------ -------- -------- ---------- ------
(A)
2002
Allowance for losses $ 78 $ - $ 0 $ 50 $ 28
2001
Allowance for losses $ 140 $ - $ 27 $ 89 $ 78
2000
Allowance for losses $ 138 $ - $ 66 $ 64 $ 140
(A) Amounts written-off, net of recoveries.
(4) Notes Receivable - Xerox and affiliates
Pursuant to the requirements of the New Credit Facility, we will make demand
loans to XC of all proceeds from the sale or collection of our receivables. As
of December 31, 2002, demand loans to XC totaled $1,594 million. These loans
bear interest at a rate equal to the result of adding the H.15 Two-Year Swap
Rate and H.15 Three-Year Swap Rate (each as defined in the Master Note between
Xerox and us) and dividing by two (2) and then adding 2.000% (200 basis points).
We will demand repayment of these loan amounts from XC as and to the extent
necessary to repay our maturing debt obligations, fund our operations, or for
such other purposes that we determine to be appropriate.
The H.15 is a Federal Reserve Board Statistical Release (published weekly) which
contains daily interest rates for selected U.S. Treasury, money markets and
capital markets instruments.
(5) Sale of Assets
In 1990, we discontinued our third-party financing business. As of December
2000, we had one leveraged lease remaining from this business which was included
in Other assets in our Consolidated Balance Sheet. In the first quarter of 2001,
this last remaining third party lease was sold for proceeds of $23 million. The
sale resulted in no gain or loss.
(6) Notes Payable
A summary of notes payable at December 31, 2002 and 2001 follows:
(In Millions)
2002 2001
---- ----
Notes due 2002 $ - $ 229
0.80% Yen Denominated Medium Term Notes due 2002 - 381
Notes due 2003(a) 463 465
1.50% Yen Denominated Medium Term Notes due 2005 845 762
2.00% Yen Denominated Medium Term Notes due 2007 255 231
Medium Term Notes due 2008 (b) 25 25
Medium Term Notes due 2012 (b) 125 125
58
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Medium Term Notes due 2013 (b) 57 60
Medium Term Notes due 2014 (b) 50 50
Medium Term Notes due 2018 (b) 25 25
Secured borrowings due 2001-2003 (c) 7 154
Revolving credit agreement, maturing in 2002(d) - 1,020
------ -------
Subtotal $1,852 $ 3,527
Less current maturities (470) (1,760)
------ -------
Total Notes Payable after one year $1,382 $ 1,767
====== =======
(a) The weighted-average interest rate at 12/31/02 was 6.61%
(b) Medium Term Notes due in 2008 through 2018 have a weighted-average interest
rate of 6.76% percent and are callable by us. We do not expect to call the notes
during 2003.
(c) Refer to Note 2 for further discussion of secured borrowings.
(d) Refer to Note 7 for further discussion of the revolving credit agreement.
The carrying amounts on certain debt instruments have been adjusted by
transition adjustments associated with the adoption of SFAS No. 133.
Expected principal repayments on notes payable during the next five years are
(in millions):
2003 $ 470
2004 -
2005 845
2006 -
2007 and Thereafter 537
-------
Total $ 1,852
=======
Certain of our debt agreements allow us to redeem outstanding debt, usually at
par, prior to scheduled maturity. Outstanding debt issues with such call
features are classified on the balance sheet and in the preceding five-year
maturity summary according to final scheduled maturity, which is in accordance
with our current expectations. The actual decision as to early redemption is
made at the time the early redemption option becomes exercisable and will be
based on economic and business conditions at that time.
Cash interest paid on notes payable for 2002, 2001, and 2000 was $124 million,
$277 million, and $252 million, respectively. Any original issue discount and
other expenses associated with the debt offerings are amortized over the term of
the related issue. Interest payments on commercial paper for 2001 and 2000 were
$0.3 million and $59 million, respectively. The weighted-average commercial
paper interest rate for 2000 was 6.5 percent. At December 31, 2002 and 2001, we
had no commercial paper outstanding.
At December 31, 2002 and 2001, carrying values of notes payable totaled $1,852
million and $3,527 million, respectively. The fair values of our notes payable
at December 31, 2002 and 2001 were $1,377 million and $3,050 million,
respectively, based on quoted market prices for our notes or those of comparable
issuers with similar features and maturity dates.
59
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
We have no plans to retire our notes payable prior to their call or final
maturity dates.
(7) Lines of Credit
As of December 31, 2001, Xerox had $7 billion of loans outstanding (including
our $1.02 billion) under a fully-drawn revolving credit agreement (Old Revolver)
due October 22, 2002, which was entered into in 1997 with a group of lenders. On
June 21, 2002, Xerox made a $2.8 billion paydown of the Old Revolver, including
our full payment of the $1.02 billion we had borrowed, and entered into a $4.2
billion Amended and Restated Credit Agreement with the same group of lenders
(the "New Credit Facility"), which replaced the Old Revolver. The final stated
maturity of the New Credit Facility is April 30, 2005. The New Credit Facility
originally included three tranches of term debt totaling $2.7 billion, a
fully-drawn $1.5 billion revolving facility (the "Revolving Facility"), which
may be repaid and reborrowed, and a $200 million letter of credit sub-facility.
In the third quarter 2002, Xerox repaid a $700 million term-loan tranche, and in
the fourth quarter 2002 Xerox repaid $10 million of the Revolving Facility in
order to create capacity to issue a letter of credit under the sub-facility.
Accordingly, as of December 31, 2002, $3,490 million was outstanding under the
New Credit Facility, consisting of two tranches of term loans totaling $2
billion and $1,490 million under the Revolving Facility. XC is the only borrower
under the term loans. The Revolving Facility is available, without sub-limit, to
Xerox and to certain subsidiaries including Xerox Canada Capital Limited (XCCL),
Xerox Capital Europe plc, and other foreign subsidiaries as defined. At December
31, 2002, all of the Revolving Facility, except for $50 million held by XCCL,
was borrowed by XC. The New Credit Facility loans generally bear interest at
LIBOR plus 4.50 percent, except that a $500 million term-loan tranche bears
interest at LIBOR plus a spread that varies between 4.00 percent and 4.50
percent, depending on the amount secured.
We cannot borrow under the New Credit Facility, and we have guaranteed the New
Credit Facility on a subordinated basis. The New Credit Facility also requires
us to loan excess cash, as defined, to XC, and prohibits us from acquiring new
contracts receivable from XC.
(8) Financial Instruments
Because we hold debt that is denominated in foreign currencies and/or bears
interest at variable rates, we are exposed to changes in market interest rates
and foreign currency exchange rates that could affect our results of operations
and financial condition. We have been able to fully hedge our foreign currency
exposure through a combination of currency swaps with XC and certain third
parties, however, our current below investment-grade debt ratings may constrain
our ability to use derivative contracts as needed in the future. Accordingly, we
are exposed to increased volatility in our results of operations.
As a result of our decision to allow our contracts receivable portfolio to
run-off, our exposures have effectively decreased as we paid off existing debt,
and our exposure will continue to decrease over time as debt is repaid.
60
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
We adopted Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" (SFAS No. 133), as of January 1,
2001. The adoption of SFAS No. 133 has increased the volatility of reported
earnings and other comprehensive income. In general, the amount of volatility
will vary with the level of derivative and hedging activities and the market
volatility during any period. However, as noted above, our volatility is limited
since our ability to enter into new derivative contracts is constrained and the
business is in run-off as a result of the decision to discontinue the purchase
of new receivables from XC.
We have historically entered into certain derivative contracts, including
interest rate swap agreements and foreign currency swap agreements to manage
interest rate and foreign currency exposures. The fair market values of all of
our derivative contracts change with fluctuations in interest rates and/or
currency rates, and are designed so that any change in their values is offset by
changes in the values of the underlying exposures. Our derivative instruments
are held solely to hedge economic exposures; we do not enter into derivative
instrument transactions for trading or other speculative purposes and we employ
long-standing policies prescribing that derivative instruments are only to be
used to achieve a set of very limited objectives.
Interest Rate Risk Management:
Contracts receivable assets earn fixed rates of interest, while a significant
portion of our debt bears interest at variable rates. Historically we have
attempted to manage our interest rate risk by "match-funding" the financing
assets and related debt, including the use of interest rate swap agreements.
However, as our credit ratings declined, our ability to continue this practice
became constrained.
At December 31, 2002, we had $1,142 million of variable rate debt, including our
pay variable interest-rate swaps. The nominal value of pay fixed interest-rate
swaps were $194 million.
Single Currency Interest Rate Swaps:
- ------------------------------------
At December 31, 2002 and 2001 we had outstanding single currency interest rate
swap agreements with aggregate notional amounts of $194 million and $683
million, respectively. The net asset/(liability) fair values at December 31,
2002 and 2001 were $(8) million and $(9) million, respectively.
Foreign Currency Interest Rate Swaps:
- -------------------------------------
In cases where we issue foreign currency-denominated debt, we enter into
cross-currency interest rate swap agreements, whereby we swap the proceeds and
related interest payments with a counterparty. In return, we receive and
effectively denominate the debt in U.S. Dollars.
At December 31, 2002 and 2001, we had outstanding Yen/U.S. Dollar cross currency
interest rate swap agreements with aggregate notional amounts of $1,135 million
and $1,373 million, respectively. The net asset/(liability) fair values at
December 31, 2002 and 2001 were $(26) million and $(247) million, respectively.
During 2000, as a result of the reductions in our debt ratings, we were required
to terminate certain third party Yen/U.S. Dollar cross-currency interest rate
swaps for 115 billion yen that were scheduled to mature from 2002 to 2007. We
entered into new cross-currency interest rate swaps with XC to replace these
terminated derivative agreements. The U.S. dollar notional value
of these intercompany swaps were $607 million and $877 million at December 31,
2002 and 2001 respectively, and are included in the notional amounts noted
61
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
above. The intercompany derivatives are accounted for in accordance with SFAS
No. 133 in a manner similar to third party derivative contracts.
SFAS. No. 133 Results -
- -----------------------
While our existing portfolio of interest rate derivative instruments is intended
to economically hedge interest rate risks to the extent possible, differences
between the contract terms of our derivatives and the underlying related debt
reduce our ability to obtain hedge accounting in accordance with SFAS No. 133.
This results in mark-to-market valuation of the majority of our derivatives
directly through earnings, which accordingly leads to increased earnings
volatility. During 2002 and 2001, we recorded net losses of $5 million and $30
million, respectively from the mark-to-market valuation of interest rate
derivatives for which we did not apply hedge accounting.
During 2002, hedge accounting was not applied to any of our interest rate
derivatives. During 2001, third-party Yen/U.S. dollar cross-currency interest
rate swaps with a notional amount of 65 billion yen were designated and
accounted for as fair-value hedges. The net ineffective portion recorded to
earnings during 2001 was a loss of $7 million and is included in Derivative
instruments fair value Adjustments, net. All components of each derivatives gain
or loss were included in the assessment of hedge effectiveness. Hedge accounting
was discontinued in the fourth quarter 2001, after the swaps were terminated and
moved to a different counterparty, because the new swaps did not satisfy certain
SFAS No. 133 requirements.
The aggregate notional amounts of all interest rate swaps by maturity date and
type at December 31, 2002 and 2001 follow:
(In Millions)
2002 2001
---- ----
Pay fixed/receive variable $ 194 $ 428
Pay variable/receive fixed 1,135 1,628
------ ------
$1,329 $2,056
====== ======
Average interest rates paid 2.93% 3.35%
====== ======
Average interest rates received 1.61% 2.19%
====== ======
The fair values for all interest rate swap agreements are calculated by the
Company based on market conditions and supplemented with quotes from banks. They
represent amounts we would receive (pay) to terminate/replace these contracts.
We have no present plans to terminate /replace a significant portion of these
agreements prior to their scheduled maturities. The maturities of our swaps
outstanding as of December 31, 2002 are as follows: 2003 - $47 million, 2004 -
$53 million, 2005 - $967 million, 2006 - none, 2007 and thereafter - $262
million.
We had a remaining after-tax loss in Accumulated Other Comprehensive Income of
$8 million at December 31, 2001 associated with the SFAS No. 133 transition
adjustment recorded during 2001. The transition adjustment was recorded for cash
flow derivatives in place at transition. This balance was reclassified to
earnings during 2002 and no balance remains at December 31, 2002.
62
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(9) Income Taxes
XCC and XC file consolidated U.S. income tax returns. Generally, pursuant to the
tax allocation arrangement between XC and us, we record our tax provisions on a
separate company basis and make payments to XC for taxes due or receive payments
from XC for tax benefits utilized. In connection with the tax allocation
arrangement, we paid XC $45 million, 75 million, and $53 million, in 2002, 2001
and 2000, respectively. In addition, during 2002, we received a refund of prior
year taxes paid of $26 million. In years 2002, 2001, and 2000, amounts paid to
taxing authorities for our operations not included in XC's consolidated tax
returns were insignificant.
The components of income before income taxes and the provision for income taxes
are as follows:
(In Millions)
2002 2001 2000
---- ---- ----
Income before income taxes: $ 142 $ 91 $ 137
====== ====== ======
Federal income taxes
Current $ 18 $ 53 $ 54
Deferred 24 (21) (6)
State income taxes
Current 2 5 7
Deferred 1 (2) (1)
------ ------ ------
Total provision for income taxes $ 45 $ 35 $ 54
====== ====== ======
A reconciliation of the effective tax rate from the U.S. Federal statutory tax
rate follows:
2002 2001 2000
---- ---- ----
U.S. Federal statutory rate 35.0% 35.0% 35.0%
Audit resolutions and other tax-related issues (5.3) - -
State income taxes, net of Federal
income tax benefit 2.0 3.9 3.9
---- ---- ----
Effective tax rate 31.7% 38.9% 38.9%
==== ==== ====
The decrease in our 2002 effective tax rate was due to a reduction in our
estimated state tax rate as a result of our exit from doing business in several
states over the past several years. In addition, the 2002 effective tax rate
reflects benefits of approximately $8 million arising from the favorable
resolution of audits and certain other tax-related issues.
The tax effects of temporary differences that give rise to significant portions
of deferred taxes at December 31, 2002 and 2001 follows:
(In Millions)
2002 2001
---- ----
Tax effect of future tax deductions:
Net unrealized derivative and
exchange losses $ - $ 21
Real estate and other - 12
Tax effect of future taxable income:
Asset securitizations - (4)
Net unrealized derivative and exchange gains (7) -
63
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Leveraged leases and other(1) - (4)
------ ------
Total deferred tax asset (liability), net $ (7) $ 25
====== ======
(1) See Note 6 for description of sale of leveraged lease in 2001.
(10) Xerox Corporation Support Agreement
The terms of a Support Agreement with XC provide that we will receive income
maintenance payments, to the extent necessary, so that our earnings shall not be
less than 1.25 times our fixed charges. For purposes of this calculation, both
earnings and fixed charges are as formerly defined in Section 1404 (formerly
Section 81(2)) of the New York Insurance Law. In addition, the agreement
requires that XC retain 100 percent ownership of our voting capital stock. There
have been no payments made under this agreement since 1990.
(11) Quarterly Results of Operations (Unaudited)
A summary of interim financial information follows:
(In Millions)
First Second Third Fourth
Quarter Quarter Quarter Quarter Total
------- ------- ------- ------- -----
2002:
Earned income $ 86 $ 81 $ 58 $ 50 $ 275
Interest expense 31 39 27 25 122
Derivative instruments fair
value adjustments, net 3 (2) 5 (1) 5
General and administrative
expenses 3 1 1 1 6
------ ------ ------ ------ ------
Income before income taxes 49 43 25 25 142
Income taxes (a) 19 17 10 (1) 45
------ ------ ------ ------ ------
Net income $ 30 $ 26 $ 15 $ 26 $ 97
====== ====== ====== ====== ======
(a) The decrease in the Fourth Quarter 2002 tax provision was due to a
reduction in our estimated state tax rate as a result of our exit from
doing business in several states over the past several years. In
addition, the Fourth Quarter 2002 tax provision reflects benefits of
approximately $8 million arising from the favorable resolution of
audits and certain other tax-related issues.
First Second Third Fourth
Quarter Quarter Quarter Quarter Total
------- ------- ------- ------- -----
2001:
Earned income $ 126 $ 121 $ 91 $ 62 $ 400
Interest expense 77 84 63 37 261
Derivative instruments fair
value adjustments, net (1) 8 15 15 37
General and administrative
expenses 3 3 3 2 11
------ ------ ------ ------ ------
Income before income taxes 47 26 10 8 91
Income taxes 18 10 4 3 35
------ ------ ------ ------ ------
Income before cumulative effect
of change in accounting
principle 29 16 6 5 56
64
Cumulative effect of change in
accounting principle (3) - - - (3)
------ ------ ------ ------ ------
Net income $ 26 $ 16 $ 6 $ 5 $ 53
====== ====== ====== ====== ======
65
XEROX CREDIT CORPORATION
Form 10-K
For the Year Ended December 31, 2002
Index of Exhibits
Document
- --------
(3)(a) Articles of Incorporation of Registrant filed with the Secretary of
State of Delaware on June 23, 1980, as amended by Certificates of
Amendment thereto filed with the Secretary of State of Delaware on
September 12, 1980 and September 19, 1988, as further amended by
Certificate of Change of Registered Agent filed with the Secretary of
State of Delaware on October 7, 1986.
Incorporated by reference to Exhibit (3)(a) to Registrant's Annual
Report on Form 10-K for the Year Ended December 31, 1999.
(b) By-Laws of Registrant, as amended through September 1, 1992.
(4)(a) Indenture dated as of October 2, 1995, between Registrant and State
Street Bank and Trust Company (State Street), relating to unlimited
amounts of debt securities which may be issued from time to time by
Registrant when and as authorized by Registrant's Board of Directors
(the October 1995 Indenture).
Incorporated by reference to Exhibit 4(a) to Registrant's Registration
Statement Nos. 33-61481 and 333-29677.
(b) $7,000,000,000 Revolving Credit Agreement dated October 22, 1997,
among Xerox Corporation (Xerox), Registrant and certain Overseas
Borrowers, as Borrowers, various lenders and Morgan Guaranty Trust
Company of New York, The Chase Manhattan Bank, Citibank, N.A. and Bank
One, National Association (as successor by merger with The First
National Bank of Chicago), as Agents.
Incorporated by reference to Exhibit 4(d) to Registrant's Quarterly
Report on Form 10-Q for the quarter ended September 30, 2000.
(c)(1) Indenture dated as of January 17, 2002 between Xerox and Wells Fargo
Bank Minnesota, National Association ("Wells Fargo"), as trustee,
relating to Xerox's 9-3/4% Senior Notes due 2009 (Denominated in U.S.
Dollars) ("January 17, 2002 U.S. Dollar Indenture").
Incorporated by reference to Exhibit (4)(h)(1) to Xerox Corporation's
Annual Report on Form 10-K for the Year Ended December 31, 2001.
(2) Indenture dated as of January 17, 2002 between Xerox and Wells Fargo
Bank, as trustee, relating to Xerox's 9-3/4% Senior Notes due 2009
(Denominated in Euros) ("January 17, 2002 Euro Indenture").
Incorporated by reference to Exhibit (4)(h)(2) to Xerox Corporation's
Annual Report on Form 10-K for the Year Ended, December 31, 2001.
(3) First Supplemental Indenture dated as of June 21, 2002 between Xerox
Corporation and Wells Fargo, as trustee, to the January 17, 2002 U.S.
Dollar Indenture.
66
Incorporated by reference to Exhibit (4)(h)(5)to Xerox
Corporation's Current Report on Form 8-K dated June 21, 2002.
(4) First Supplemental Indenture dated as of June 21, 2002 between
Xerox Corporation and Wells Fargo, as trustee, to the January 17,
2002 Euro Indenture.
Incorporated by reference to Exhibit (4)(h)(6) to Xerox
Corporation's Current Report on Form 8-K dated June 21, 2002.
(d)(1) Amended and Restated Revolving Credit Agreement, dated as of June
21, 2002, among Xerox Corporation and the Overseas Borrowers, as
Borrowers, various Lenders and Bank One, N.A., JPMorgan Chase Bank
and Citibank, N.A., as Agents (the "Amended Credit Agreement").
Incorporated by reference to Exhibit 4 (l) (1) to Xerox
Corporation's Current Report on Form 8-K dated June 21, 2002.
(2) Guarantee and Security Agreement dated as of June 21, 2002 among
Registrant, the Subsidiary Guarantors and Bank One, N.A., as
Agent, relating to the Amended Credit Agreement.
Incorporated by reference to Exhibit 4 (l) (2) to Xerox
Corporation's Current Report on Form 8-K dated June 21, 2002.
(e) Instruments with respect to long-term debt where the total amount
of securities authorized thereunder does not exceed 10% of the
total assets of Registrant and its subsidiaries on a consolidated
basis have not been filed. Registrant agrees to furnish to the
Commission a copy of each such instrument upon request.
(10)(a) Amended and Restated Operating Agreement originally made and
entered into as of November 1, 1980, amended and restated as of
June 30, 1998, between Registrant and Xerox.
Incorporated by reference to Exhibit 10(a) of Registrant's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1998.
(b) Support Agreement dated as of November 1, 1980, between Registrant
and Xerox.
Incorporated by reference to Exhibit 10(b) to Registration
Statement No. 2-71503.
(c) Tax Allocation Agreement dated as of January 1, 1981, between
Registrant and Xerox.
Incorporated by reference to Exhibit 10(c) to Registration
Statement No. 2-71503.
(d) Master Note dated November 20, 2001 between Registrant and Xerox
Corporation
Incorporated by reference to Exhibit 10(d) of Registrant's Annual
Report on Form 10-K for the year ended December 31, 2001.
(12)(a) Computation of Registrant's Ratio of Earnings to Fixed Charges.
(b) Computation of Xerox' Ratio of Earnings to Fixed Charges.
67
(21) Subsidiaries of Registrant
(23) Consent of PricewaterhouseCoopers LLP.
(99.1) Certification of CEO and CFO pursuant to 18 U.S.C.ss.1350 as adopted
pursuant toss.906 of the Sarbanes-Oxley Act of 2002.
68