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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
( X ) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2002
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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
- -------- ----------
(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
--------------
(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
- -------------------- -----------------------
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 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 May 31, 2002
----- ------------------------------
Common Stock 2,000
THIS DOCUMENT CONSISTS OF 37 PAGES
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 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, our liquidity.
Our liquidity is dependent upon the liquidity of our ultimate parent, Xerox
Corporation ("XC", and together with its subsidiaries, "Xerox"). Accordingly,
certain disclosures contained herein relate to events and transactions that
affect the liquidity of Xerox, even if they do not directly affect our
liquidity.
In October 2000, Xerox announced a turnaround program designed to help ensure
liquidity, re-establish profitability and build a solid foundation for future
growth. The Turnaround Program encompassed four major components: (i) asset
sales of $2-$4 billion; (ii) cost reductions designed to reduce spending by at
least $1 billion annually; (iii) the transition of equipment financing to third
party vendors and (iv) a focus on core business of providing document processing
systems, solutions and services to customers. The sales of assets are largely
completed. The success of the remainder of the turnaround program is dependent
upon successful and timely restructuring of the cost base, placement of greater
operational focus on the core business, and completion of the transfer of the
financing of customer equipment purchases to third parties. Cost base
restructuring is dependent upon effectively and timely reducing the number of
employees, closing and consolidating facilities, outsourcing certain
manufacturing and logi stics operations, reducing operational expenses and
successfully implementing process and systems changes.
Xerox's liquidity is currently provided through its own cash generation from
operations and various financing strategies including the monetization of
receivables. Xerox is currently funding its customer financing activities from
available sources of liquidity including cash on hand, unregistered capital
markets offerings and receivables monetizations. There is no assurance that
Xerox will be able to continue to fund its customer financing activities at
present levels. Xerox continues to negotiate and implement third-party vendor
financing programs and to actively pursue alternative forms of financing
including receivables monetizations. These initiatives are expected to
significantly improve Xerox's liquidity going forward. Xerox's ability to
continue to offer customer financing and be successful in the placement of its
equipment with customers is largely dependent upon successful implementation of
its third party financing initiatives.
2
In September 2001, XC entered into framework agreements with General Electric
Capital Corporation (GE Capital) under which GE Capital will 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 In anticipation of GE Capital becoming
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 will ultimately run-off. Further, pursuant to the New Credit
Facility (discussed below), we are precluded from purchasing any new contracts
receivable from XC in the future. Xerox's discussions to consider monetizing
portions of its existing U.S. finance receivables portfolio as it pursues
alternative forms of financing could further reduce our portfolio.
XC has 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, $2.8 billion (including the entire $1.0 billion we had borrowed)
has been repaid. The remaining $4.2 billion has been refinanced under the terms
of a new Amended and Restated Credit Agreement (the "New Credit Facility"),
which is more fully discussed in Note 7 this Report on Form 10-Q. We cannot
borrow under the New Credit Facility, and we are also precluded from purchasing
new contracts from XC. Subject to certain limits, all obligations under the New
Credit Facility are secured by liens on substantially all domestic assets of XC
and by liens on the assets of substantially all of its U.S. subsidiaries
(excluding us) and are guaranteed by substantially all of its 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").
The New Credit Facility contains affirmative and negative covenants of XC
including limitations on issuance of debt and preferred stock; certain
fundamental changes; investments and acquisitions; mergers; certain transactions
with affiliates; creation of liens; asset transfers; hedging transactions;
payment of dividends; inter-company loans and certain restricted payments; and a
requirement to transfer excess foreign cash, and excess cash of ours, as
defined, to XC in certain circumstances. It also contains additional financial
covenants, including minimum EBITDA and net worth levels, maximum leverage
(total adjusted debt divided by EBIDTA, as defined), and maximum capital
expenditures limits. The Senior Notes contain several similar, though generally
less restrictive, affirmative and negative covenants of Xerox.
Any failure of XC to be in compliance with any material provision of the New
Credit Facility 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, such failure by
XC to be in compliance could also have a material adverse effect on our
liquidity and operations.
3
XEROX CREDIT CORPORATION
Form 10-Q
March 31, 2002
Table of Contents Page
Part I - Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets 5
Consolidated Statements of Income 6
Consolidated Statements of Cash Flows 7
Notes to Consolidated Financial Statements 8
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition
Results of Operations 10
Capital Resources and Liquidity 11
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 35
Part II - Other Information
Item 1. Legal Proceedings 36
Item 2. Changes in Securities 36
Item 3. Defaults Upon Senior Securities 36
Item 4. Submission of Matters to a Vote of Security Holders 36
Item 5. Other Information 36
Item 6. Exhibits and Reports on Form 8-K 36
Signature 38
Exhibits
Exhibit 12 (a)
Computation of Ratio of Earnings to Fixed Charges (Xerox
Credit Corporation)
Exhibit 12 (b)
Computation of Ratio of Earnings to Fixed Charges (Xerox
Corporation)
4
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
XEROX CREDIT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In Millions)
ASSETS
March 31, December 31,
2002 2001
--------- ------------
(UNAUDITED)
Cash and cash equivalents $ - $ -
Investments:
Contracts receivable 2,806 3,244
Unearned income (268) (331)
Allowance for losses (68) (78)
------- -------
Total investments 2,470 2,835
Notes receivable - Xerox and affiliates 1,729 1,377
Derivative and Other assets 87 76
------- -------
Total assets $ 4,286 $ 4,288
======= =======
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities:
Notes payable within one year:
Commercial paper $ - $ -
Current portion of notes payable after one year 1,601 1,630
Current portion of secured borrowing 109 130
Notes payable after one year 1,755 1,743
Secured borrowing due after one year - 24
Due to Xerox Corporation, net 52 40
Accounts payable and accrued liabilities 20 10
Derivative Liabilities 56 53
------- -------
Total liabilities 3,593 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 454 424
Accumulated other comprehensive income (3) (8)
-------- -------
Total shareholder's equity 693 658
------- -------
Total liabilities and shareholder's equity $ 4,286 $ 4,288
======= =======
See accompanying notes.
5
XEROX CREDIT CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(In Millions)
Three Months Ended
March 31,
2002 2001*
---- ----
Earned income:
Contracts receivable $ 61 $ 126
Xerox note receivable 25 -
--- ---
Total earned income 86 126
--- ---
Expenses:
Interest 31 77
Derivative fair value adjustments, net 3 (1)
General and administrative 3 3
--- ---
Total expenses 37 79
--- ---
Income before income taxes 49 47
Provision for income taxes 19 18
--- ---
Net income before cumulative effect of
change in accounting principle 30 29
Cumulative effect of change in accounting principle
(less income tax benefit of $1) - (3)
--- ---
Net income $ 30 $ 26
=== ===
See accompanying notes.
*As Restated, see Note 2.
6
XEROX CREDIT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In Millions)
Three Months Ended
March 31,
2002 2001*
---- ---- -
Cash Flows from Operating Activities
Net income $ 30 $ 26
Adjustments to reconcile net income to net cash
provided by operating activities:
Net loss (gain) on derivative instruments 2 (1)
Net change in other operating assets and liabilities (2) 6
Change in due to Xerox Corporation, net 12 12
---- ----
Net cash provided by operating activities 42 43
---- ----
Cash Flows from Investing Activities
Purchases of investments - (417)
Proceeds from investments 325 487
Advances to Xerox, net (352) -
Proceeds from sales of contracts receivables 38 -
Proceeds from sale of other assets - 23
---- ----
Net cash provided by investing activities 11 93
---- ----
Cash Flows from Financing Activities
Change in commercial paper, net - (32)
Proceeds from notes with Xerox and affiliates, net - 24
Principal payments on long-term debt (53) (128)
--- ----
Net cash used in financing activities (53) (136)
--- ----
Increase in cash and cash equivalents - -
Cash and cash equivalents, beginning of period - -
---- ----
Cash and cash equivalents, end of period $ - $ -
===== =====
See accompanying notes.
* As restated, see Note 2.
7
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Basis of Presentation:
The unaudited consolidated interim financial statements presented herein
have been prepared by Xerox Credit Corporation (referred to below as "us", "we"
or "our") in accordance with the accounting policies described in our Annual
Report on Form 10-K for the Year ended December 31, 2001. You should read the
consolidated financial statements in conjunction with the notes to such Annual
Report. The condensed balance sheet information has been derived from such
financial statements.
In our opinion, all adjustments (including normal recurring adjustments) which
are necessary for a fair statement of operating results for the interim periods
presented have been made. Interim results of operations are not necessarily
indicative of the results for the full year.
The prior year's unaudited condensed consolidated financial statements as of and
for the quarter ended March 31, 2001 have been restated (See Note 2).
We and Xerox Corporation ("XC") engage in extensive intercompany transactions
and we receive 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.
Liquidity - Our liquidity is dependent upon the liquidity of our ultimate
parent, Xerox Corporation (XC, and together with its subsidiaries, Xerox).
Accordingly, the following is a disclosure regarding the liquidity of both XC
and us.
Historically, XC's primary sources of funding have been cash flows from
operations, borrowings under our commercial paper and term funding programs, and
securitizations of accounts and finance receivables. Funds were used to finance
customers' purchases of Xerox equipment, and for working capital requirements,
capital expenditures and business acquisitions. Xerox-specific business
challenges, which have been previously discussed, coupled with significant
competitive and industry changes and adverse economic conditions, began to
negatively affect XC's operations and liquidity in 2000. These challenges, which
were exacerbated by significant technology and acquisition spending, impacted
Xerox's and our cash availability and created marketplace
concerns regarding XC's liquidity, which led to credit rating downgrades and
restricted, access to capital markets.
XC's and our access to many of the aforementioned sources is currently limited
due to the below investment grade rating on XC's and our debt. XC's and our debt
rating have been reduced several times since October 2000. These rating
downgrades have had a number of significant negative impacts on us and XC,
including the unavailability of uncommitted bank lines, very limited ability to
utilize derivative instruments to hedge foreign and interest currency exposures,
thereby increasing volatility to changes in exchange rates, and higher interest
rates on borrowings. Additionally, as more fully disclosed below, XC is required
to maintain minimum cash balances in escrow on certain borrowings,
securitizations, swaps and letters of credit. These restricted cash balances are
not considered cash or cash equivalents on XC's balance sheet.
8
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
On June 21, 2002, XC permanently repaid $2.8 billion on the outstanding
revolving credit facility. An amended $4.2 billion facility replaced the
previous $7 billion facility. However, XC currently has no incremental borrowing
capacity under the facility as the entire $4.2 billion is outstanding as of such
date. Of the $2.8 billion payment, $1.0 billion represented a repayment of all
of our borrowings under the Old Revolver. We are not and will not become a
borrower under the New Credit Facility. In addition, pursuant to the New Credit
Facility, we are prohibited from purchasing any new contracts receivable from
XC.
The New Credit Facility is discussed in more detail in Note 7. The New Credit
Facility contains more stringent financial covenants than the prior facility,
including the following:
... Minimum EBITDA based on rolling quarters, as defined;
... Maximum leverage (total adjusted debt:EBITDA, as defined);
... Maximum capital expenditures (annual test);
... Minimum consolidated net worth (quarterly test, as defined);
Any failure of XC to be in compliance with any material provision of the New
Credit Facility could have a material adverse effect on XC's liquidity and
operations and, because we are dependent upon XC for our liquidity and we have
guaranteed the obligations of XC under the New Credit Facility, such failure by
XC to be in compliance could also have a material adverse effect on our
liquidity and operations.
In addition, as part of XC's Turnaround Plan, XC has taken significant steps to
improve its liquidity, including asset sales, monetizations of portions of our
receivables portfolios, and general financings including issuance of high yield
debt and preferred securities. Since early 2000, XC has been restructuring its
cost base. It has implemented a series of plans to resize its workforce and
reduce its cost structure through such restructuring initiatives. Key factors
influencing Xerox's liquidity include its ability to generate cash flow from an
appropriate combination of operating improvements as anticipated in the
Turnaround Plan and continued execution of the initiatives described above. XC
believes its projected liquidity is sufficient to meet current operating cash
flow requirements and satisfy its 2002 scheduled debt maturities and other cash
flow requirements. However, Xerox's ability to meet obligations beyond 2002 is
dependent on its ability to generate positive cash flow from a combination of
operating improvements, capital markets transactions, third party vendor
financing programs and receivable monetizations. Failure to implement these
initiatives could have a material effect on Xerox's liquidity and operations and
it would need to implement alternative plans that could include additional asset
sales, additional reductions in operating costs, deferral of capital
expenditures, further reductions in working capital and further debt
restructurings. While XC believes it can successfully complete the alternative
plans, if necessary, there can be no assurance that such alternatives would be
available or that Xerox would be successful in implementing them.
9
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Correction of Error in Comparative Financial Statements:
Our 2001 first quarter financial statements have been restated to reflect a
correction to interest expense resulting from an error in calculating accrued
interest on an interest rate swap in 2000. The correction was properly reflected
in the 2000 consolidated financial statements, as restated. A summary of the
restated amounts are as follows:
(in millions) 2001 1st Quarter 2001 1st Quarter
As Reported Adjustment Restated
Interest Expense $ 82 5 $ 77
Net Income 23 3* 26
* Net of $2 million of taxes
(3) 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 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.
(4) Accounting Changes:
In 2001, the Financial Accounting Standards Board issued Statements of Financial
Accounting Standards No. 141 "Business Combinations" (SFAS No. 141), No. 142
"Goodwill and Other Intangible Assets" (SFAS No. 142), No. 143 "Accounting for
Asset Retirement Obligations" (SFAS No. 143) and No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets" (SFAS No. 144). We adopted these
standards in 2002, The adoption of these standards is not expected to have any
significant impact on our financial reporting.
In 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44
and 64, Amendment of FASB Statement No. 13 and Technical Corrections." The
Statement rescinds Statement 4 which required all gains and losses from
extinguishment of debt to be aggregated and, when material, classified as an
extraordinary item net of related income tax effect. Statement 145 also amends
Statement 13 to require that certain lease modifications having economic effects
similar to sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. We are required to implement this standard for
transactions occurring after May 15, 2002 and do not expect this Statement will
have any significant impact on our financial reporting. We implemented the
provisions related to the rescission of Statement 4 in the second quarter of
2002.
10
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(5) Sale of Contracts Receivable:
In November 2001, XC entered into an agreement with GE Capital providing for the
sale by XC, from time-to-time, of certain lease contracts in the U.S. to a
special purpose entity (SPE) of XC, against which GE Capital would provide a
series of secured loans, up to a maximum amount of $2.6 billion ("Monetization
Agreement"). In connection with the Monetization Agreement, during the first
quarter of 2002 we sold to XC an aggregate of $38 million 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
nor retained interests in the receivables sold and all the risk of loss in such
receivables was transferred back to XC.
(6) Notes Receivable - Xerox and affiliates
We will make demand loans to XC of all proceeds from the sale or collection of
our receivables. As of March 31, 2002 and December 31, 2001, demand loans to XC
totaled $1,729 million and $1,377 million, respectively. 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 demand note dated
November 20, 2001 ("Master Demand Note") between XC and us) and dividing by two
(2) and then adding 2.00% (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. A copy of the Master Demand Note is filed as an exhibit to
our Annual Report on Form 10-K for the Year Ended December 31, 2001.
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.
(7) Subsequent Events:
On May 1, 2002, Xerox Capital Services, LLC (XCS), XC's U.S. venture with GECC,
became operational. XCS, a consolidated entity of XC, manages Xerox's customer
administration and leasing activities in the U.S. including credit approval,
order processing, billing and collections. Upon commencement of the XCS joint
venture, XCS replaced XC as the provider of billing, collection and other
administrative services to us. Accordingly, subsequent to May 2002, we will pay
a fee to XCS rather than to XC, for these services. The fees paid are expected
to be equal to fees paid to XC.
In connection with XC's Monetization Agreement with GE Capital, in May 2002, we
sold back to XC an aggregate of $215 million 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.
On June 21, 2002, XC entered into an Amended and Restated Credit Agreement (the
"New Credit Facility") with a group of lenders, replacing the $7 Billion
Revolving Credit Agreement dated October 22, 1997 among XC, us 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, as
Agents (the "Old Revolver"). At that time, XC permanently repaid $2.8 billion of
the Old Revolver. Of the $2.8 billion payment, we paid all of our $1.0 billion
of borrowings under the Old Revolver using proceeds from XC's repayment to us on
the Master Demand Note (see Note 6). We are not and will not become a borrower
under the New Credit Facility. In addition, pursuant to
11
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
the terms of the New Credit Facility, we are prohibited from purchasing any new
contracts receivable from XC.
Under the New Credit Facility, there is currently $4.2 billion of loans
outstanding, consisting of three tranches of term loans totaling $2.7 billion
and a $1.5 billion revolving facility that includes a $200 million letter of
credit sub-facility. The three term loan tranches include a $1.5 billion
amortizing "Tranche A" term loan maturing on April 30, 2005, a $500 million
"Tranche B" term loan, and a $700 million "Tranche C" term loan which matures on
September 15, 2002. XC is currently, and will remain, the borrower of all of the
term loans.
XC is required to repay a total of $400 million of the Tranche A loan and $5
million of the Tranche B loan in semi-annual installments in 2003, and a total
of $600 million of the Tranche A loan and $5 million of the Tranche B loan in
semi-annual installments in 2004. The remaining portions of the term loans
contractually mature on April 30, 2005, but XC could be required to repay
portions earlier upon the occurrence of certain events, as described below. In
addition, all loans under the New Credit Facility mature upon the occurrence of
a change of control. Subject to certain limits described in the following
paragraph, all obligations under the New Credit Facility are secured by liens on
substantially all domestic assets of XC and by liens on the assets of
substantially all of its U.S. subsidiaries (excluding us) and are guaranteed by
substantially all of its 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 terms of certain of XC's outstanding public bond indentures, the
outstanding amount of obligations under the New Credit Facility that can be
secured by assets (the "Restricted Assets") of (i) XC and (ii) XC's
non-financing subsidiaries that have a consolidated net worth of at least $100
million, without triggering a requirement to also secure those
indentures, is limited to the excess of (a) 20% of XC's consolidated net worth
(as defined in XC's public bond indentures) over (b) a portion of the
outstanding amount of certain other debt that is secured by the Restricted
Assets. Accordingly, the amount of the debt secured under the New Credit
Facility by the Restricted Assets (the "Restricted Asset Security Amount") will
vary from time to time with changes in XC's consolidated net worth. The
Restricted Assets secure the Tranche B loan (up to the Restricted Asset Security
Amount); any Restricted Asset Security Amount in excess of the outstanding
Tranche B loan secures, on a ratable basis, the other outstanding loans under
the New Credit Facility.
The New Credit Facility loans generally bear interest at LIBOR plus 4.50%,
except that the Tranche B loan bears interest at LIBOR plus a spread that varies
between 4.00% and 4.50% depending on the Restricted Asset Security Amount in
effect from time to time. Specified percentages of any net proceeds XC receives
from capital market debt issuances, equity issuances or asset sales during the
term of the New Credit Facility must be used to reduce the amounts outstanding
under the New Credit Facility, and in all cases any such amounts will first be
applied to reduce the Tranche C loan. Once the Tranche C loan has been repaid,
or to the extent that such proceeds exceed the outstanding Tranche C loan, any
such prepayments arising from debt and equity proceeds will first permanently
reduce the Tranche A loans, and any amount remaining thereafter will be
proportionally allocated to repay the then-outstanding balances of the revolving
loans and the Tranche B loans and to reduce the revolving commitment
accordingly. Any such prepayments arising from asset sale proceeds will first be
proportionally allocated to permanently reduce any outstanding Tranche A loans
and Tranche B loans, and any amounts remaining thereafter will be used to repay
the revolving loans and to reduce the revolving commitment accordingly.
Notwithstanding the foregoing
12
XEROX CREDIT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
description, the revolving loan commitment cannot be reduced below $1 billion as
a result of such prepayments.
The New Credit Facility contains affirmative and negative covenants including
limitations on issuance of debt and preferred stock, certain fundamental
changes, investments and acquisitions, mergers, certain transactions with
affiliates, creation of liens, asset transfers, hedging transactions, payment of
dividends, inter-company loans and certain restricted payments, and a
requirement to transfer excess foreign cash, as defined, and our excess cash to
Xerox in certain circumstances. Despite a general limitation on the creation of
liens, the New Credit Facility provides for the creation of liens from time to
time in connection with the monetization or other financing of discrete pools of
receivables, leases and other financial assets by XC and its subsidiaries. Thus,
the New Credit Facility does not affect XC's or our ability to continue to
monetize receivables, including, in the case of XC, under the agreements with
GECC and others. In addition to other defaults customary for facilities of this
type, defaults on debt of, or bankruptcy of, XC or certain of its subsidiaries
would constitute a default under the New Credit Facility.
The New Credit Facility also contains financial covenants which the Old Revolver
did not contain, including:
* Minimum EBITDA (rolling four quarters, as defined)
* Maximum Leverage (total adjusted debt:EBITDA, as defined)
* Maximum Capital Expenditures (annual test)
* Minimum Consolidated Net Worth (quarterly test, as defined)
In connection with the New Credit Facility, substantially all of XC's U.S.
subsidiaries, including us, 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"). The Senior Notes contain several similar,
though generally less restrictive, affirmative and negative covenants.
Any failure of XC to be in compliance with any material provision of the New
Credit Facility 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, such failure by
XC to be in compliance could also have a material adverse effect on our
liquidity and operations.
Copies of the New Credit Facility and certain related agreements and copies of
the indentures and related supplemental indentures for the Senior Notes (which
contain our guaranty), are incorporated by reference as exhibits to our Annual
Report on Form 10-K for the Year Ended December 31, 2001.
13
Item 2. Management's Discussion and Analysis of Results of Operations and
- ---------------------------------------------------------------------------
Financial Condition
- ---------------------
Due to the fact that our liquidity is dependent upon the liquidity of XC, our
ultimate parent, Item 2 includes both our Management's Discussion and Analysis
of Financial Condition and Results of Operations (MD&A) and portions of XC's
MD&A. Each MD&A, or portion thereof, is separately presented. 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
Capital, and GE Capital 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. Our existing portfolio of contracts receivable will
ultimately run-off as amounts are collected or contracts are sold back to XC as
part its continued monetization of the existing receivables portfolio.
Contracts receivable income represents income earned under an agreement with XC
pursuant to which we undertook the purchases noted above. The receivables arose
primarily from XC equipment being sold under non-cancellable installment sales
and lease contracts including any residual income related to such leases. Income
from the Xerox note receivable represents amounts earned on funds advanced to XC
under the Master Demand Note.
Total earned income was $86 million and $126 million for the first quarter of
2002 and 2001, respectively. Contracts receivable income declined by $65 million
reflecting 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 receivables back to XC primarily in the fourth quarter of 2001.
Offsetting the decline was earned income of $25 million in 2002 on the XC Master
Demand Note.
Interest expense was $31 million and $77 million for the first quarter of 2002
and 2001, respectively. The decrease reflects lower debt levels as a result the
discontinuance of new purchases of contracts receivable and collections on
existing receivables being used to pay down debt in 2001. In addition, as a
result of most of our match funding swaps (pay fixed/receive variable) either
maturing or terminating in 2001, the majority of our debt is variable based and
therefore we benefited from the lower interest rates in the first quarter of
2002 as compared to the first quarter of 2001.
The net loss from the mark-to-market valuation of our interest rate derivatives
recorded in earnings was $3 million in the first quarter 2002 as compared to a
gain of $1 million in 2001. The loss in the first quarter of 2002 reflects
losses on our remaining portfolio of fixed to variable swaps. 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
underlying related 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.
Operating and administrative expenses were $3 million for both the first
quarters of 2002 and 2001. These expenses are primarily incurred to administer
the contracts receivable purchased from XC.
The effective income tax rate for the first quarter of 2002 was 38.9%, which is
unchanged from the first quarter and full year of 2001.
14
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 remitted to XC, and we do not
maintain cash balances. Our liquidity is also dependent on the continued
liquidity of XC. Due to our cessation of receivables purchases from XC in 2001
and our decision to run-off or sell our existing portfolio of contracts
receivable, funds collected since mid-2001 have been loaned to XC under an
interest bearing Master Demand Note. We will continue to make demand loans to XC
of all proceeds from the sale or collection of our receivables and we are
required to continue to lend such amounts to XC under the terms of the New
Credit Facility discussed below. We will continue to 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.
Net cash provided by operating activities was $42 million in the first quarter
2002 as compared to $43 million in the first quarter 2001.
The add back for the net change in the Due to Xerox Corporation account of $12
million in both first quarter of 2002 and 2001, is primarily due to the increase
in income tax accruals due to Xerox as the first quarter tax payments are not
made until April.
Net cash provided by investing activities was $11 million in the first quarter
2002 as compared to $93 million in the first quarter of 2001. The 2002 amount
reflects the decision to discontinue purchasing new receivables from XC after
July 1, 2001 resulting in net collections from investments of $325 million,
compared to $70 million in 2001. The 2001 amount reflects reduced XC equipment
sale activity, as new contract purchases were not enough to offset collections
in that quarter. 2002 also reflects proceeds of $38 million from the sale of
receivables back to XC as described in Note 5 to the Consolidated Financial
Statements. Offsetting contract collections and proceeds from the sale of
receivables were advances of $352 million to XC under the Master Demand Note.
2001 includes $23 million associated with the sale of certain assets.
The changes in operating and investing cash flows resulted in net cash used in
financing activities of $53 million in the first quarter of 2002, compared to
$136 million in the first quarter of 2001. 2002 reflects principal payments on
long-term debt as no proceeds from new debt were received. 2001 reflects
principal payments on long-term debt and commercial paper of $128 million and
$32 million, respectively.
As of March 31, 2002, we had approximately $3.5 billion of debt outstanding of
which approximately $1.8 billion has been paid or is expected to be paid in
2002. This includes $1.0 billion due under the Old Revolver (as defined below)
which was repaid on June 21, 2002 (see below). 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 remaining maturing obligations.
On June 21, 2002, XC entered into an Amended and Restated Credit Agreement (the
"New Credit Facility") with a group of lenders, replacing the $7 Billion
Revolving Credit Agreement (the "Old Revolver") dated October 22, 1997. On June
21, 2002 we repaid the entire $1.0 billion we owed under the Old Revolver as
part of XC's total permanent repayment of $2.8 billion under the Old Revolver.
We are not, and will not become, a borrower under the New Credit Facility. In
addition, pursuant to the New Credit Facility, we are prohibited from purchasing
any new contracts receivable from XC. In connection with the aforementioned $1.0
billion repayment, XC paid us $1.0 billion of the then-outstanding balance on
the Master Demand Note.
In connection with XC's Monetization Agreement with GE Capital, in May 2002, we
sold back to XC an aggregate of $215 million 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 monetization of portions of its U.S. finance receivables
15
portfolio, which underlies our contracts receivable. Any such future
monetizations 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.
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. 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. However, the
recent downgrades of our and XC's indebtedness have effectively eliminated our
ability to manage this exposure as our ability to currently enter into new
derivative contracts is severely constrained. Furthermore, the debt downgrades
triggered various contractual provisions, which required us to collateralize or
repurchase a number of derivative contracts, which were then outstanding. While
we have been able to replace some derivatives on a limited basis, our current
debt ratings restrict our ability to utilize derivative agreements to manage the
risks associated with interest rate and some foreign currency fluctuations,
including our ability to continue effectively employing our match funding
strategy described below. For this reason, we anticipate increased volatility in
our results of operations due to market changes in interest rates and foreign
currency rates. Therefore, while our overall risk management strategy is as
explained below, our ability to employ that strategy effectively has been
severely limited. Any further downgrades of XC's or our debt could further limit
our ability to execute this risk management strategy effectively.
To assist in managing our interest rate exposure and match funding our principal
assets, we routinely use certain financial instruments, primarily interest rate
swap agreements. We enter into interest rate swap agreements to manage interest
rate exposure, although the recent downgrades of our indebtedness have limited
our ability to manage this exposure. Virtually all customer financing assets
earn fixed rates of interest. Accordingly, through the use of interest rate
swaps in conjunction with the contractual maturity terms of outstanding debt, we
"lock in" an interest spread by arranging fixed-rate interest obligations with
maturities similar to the underlying assets. This practice effectively
eliminates the risk of a major decline in interest margins resulting from
adverse changes in the interest rate environment. Conversely, this practice also
effectively eliminates the opportunity to materially increase
margins when interest rates are declining. More specifically,
pay-fixed/receive-variable interest rate swaps are often used in place of more
expensive fixed-rate debt for the purpose of match funding fixed-rate customer
contracts. Pay-variable/receive-variable interest rate swaps (basis swaps) are
used to transform variable rate, medium-term debt into commercial paper or local
currency LIBOR rate obligations. Pay-variable/receive-fixed interest rate swaps
are used to transform term fixed-rate debt into variable rate obligations. Where
possible, the transactions performed within each of these three categories have
enabled the cost-effective management of interest rate exposures. We do not
enter into derivative instrument transactions for trading purposes and employ
long-standing policies prescribing that derivative instruments are only to be
used to achieve a set of very limited match funding and liquidity objectives.
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 Quarterly
Report on Form 10-Q for the Quarter Ended March 31, 2002.
16
READER'S NOTE: THE FOLLOWING DISCUSSION HAS BEEN EXCERPTED DIRECTLY FROM XEROX
CORPORATION'S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED MARCH 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 QUARTERLY REPORT ON FORM
10-Q FOR THE QUARTER ENDED MARCH 31, 2002 FILED SEPARATELY WITH THE SEC.
Summary
Throughout the following Financial Review, all referenced amounts reflect the
above described restatement adjustments.
In addition to the quarterly information provided in this document, selected
financial information for the five quarter period ending March 31, 2002 will be
provided in a supplemental Current Report on Form 8-K in the next several days.
2002 Revenues of $3.9 billion declined 10 percent from $4.3 billion in the first
quarter of 2001, reflecting continued economic weakness and marketplace
competition. Approximately one-third of the decline was due to our exit from the
Small Office/Home Office (SOHO) business in the second half of 2001, reductions
in our Developing Markets Operations (DMO) and unfavorable currency. In our
Office segment, Document Centre digital multifunction and color revenues grew.
Monochrome Production Publishing (DocuTech) revenues stabilized. Production
color, Production Printing and light lens revenues declined. See Note 8 to the
Condensed Consolidated Financial Statements for further discussion.
The first quarter 2002 net loss of $46 million or $0.06 cents per share,
included after tax restructuring charges of $101 million ($146 million pre-tax),
an after tax charge of $44 for permanently impaired capitalized software ($72
million pre-tax), net after tax losses from unhedged foreign currency exposures
of $22 million. These were offset by an after-tax gain of $12 million ($19
million pre-tax) related to proceeds received from sale of stock an insurance
company in a demutualization. 2001 first quarter net income of $222 million or
$0.28 cents per share included the following net after-tax items: a $304 million
gain ($769 million pre-tax) on the sale of half our interest in Fuji Xerox,
after tax restructuring charges of $81 million ($129 million pre-tax), unhedged
foreign currency gains of $44 million ($64 million pre-tax), and an after tax
$17 million extraordinary gain ($28 million pre-tax) reflecting the early
retirement of debt. See Note 2 to the Condensed Consolidated Financial
Statements for further discussion.
Pre-Currency Growth
To understand the trends in our business, we believe that it is helpful to
adjust revenue and expense growth (except for ratios) to exclude the impact of
changes in the translation of European and Canadian currencies into U.S.
dollars. We refer to this adjusted growth as "pre-currency growth".
17
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 in the 2002 first quarter was
approximately 4 percent stronger than the 2001 first quarter. As a result,
foreign currency translation unfavorably impacted revenue growth by
approximately one percentage point in the first quarter 2002.
Revenues by Type
Year-over-year post-currency changes by type of revenue were as follows:
First Quarter
2002 vs. 2001
--------------
Equipment Sales (19)%
Post Sale and Other Revenue (7)%
Financing Income (10)
Total Revenue(1) (10)
(1)Total sales revenue in the Condensed Consolidated Statement of Operations
includes equipment sales noted above as well as supplies and paper and other
revenue that is included in "Post Sale and Other Revenue" in the above table.
Equipment sales typically represent approximately 20-25 percent of total
revenue. The majority of our equipment sales are in North America and Europe.
Equipment sales in the first quarter of 2002 declined 19 percent (17 percent
pre-currency) from the first quarter of 2001, reflecting competitive pressures,
continued weakness in the economy and our focus on profitable revenue.
Approximately 25 percent of the decline was due to our exit from the SOHO
business.
Post sale and other revenues include service, document outsourcing, rentals,
supplies and paper, which represent the revenue streams that follow equipment
placement, as well as revenue not associated with equipment placement, such as
royalties. Post sale and other revenues declined 7 percent (6 percent
pre-currency) in the first quarter of 2002 compared to the 2001 first quarter,
largely driven by declines in equipment populations reflecting reduced
placements in earlier periods and lower page print volumes.
Document outsourcing revenues are split between equipment sales and post sale
and other revenue. Where document outsourcing contracts include revenue
accounted for as equipment sales, this revenue is included in equipment sales,
and all other document outsourcing revenues, including service, equipment
rental, supplies, paper, and labor are included in post sale and other revenues.
Total 2002 first quarter document outsourcing revenue declined from the 2001
first quarter. In the 2002 first quarter, the backlog of future estimated
document outsourcing revenue declined 9 percent to approximately $7.1 billion
compared to approximately $7.8 billion in the 2001 first quarter. Our backlog is
determined as the estimated services to be provided under committed contracts as
of a point in time. We expect total document outsourcing revenue to continue to
decline.
Financing Income declined 10 percent (8 percent pre-currency) in the first
quarter 2002 from the first quarter 2001 reflecting continued equipment sale
declines, lower implicit interest rates and the initial effects of our
transition to third party financing. Third party financing arrangements were in
place for the full quarter in our Nordic countries and began in the Netherlands
in February.
18
Key Ratios and Expenses
The trend in key ratios was as follows:
March 31, 2002
2001 2002
Total Gross Margin 34.7% 41.0%
R&D % Revenue 5.8% 6.0%
SAG % Revenue 26.8% 30.3%
First quarter 2002 gross margin of 41.0 percent improved 6.3 percentage points
from 34.7 percent in the first quarter 2001. Approximately half the increase
reflects the prior liquidation of equipment inventory associated with our SOHO
exit as well as improvements in DMO. Improved manufacturing and service
productivity; favorable product mix and lower cost of borrowings for our finance
business more than offset the adverse impact of competitive price pressures.
Research and development (R&D) expense of $230 million was $21 million lower in
the 2002 first quarter than the 2001 first quarter. The R&D expense reduction
primarily reflects our exit from SOHO, helped further by benefits from cost
restructuring actions. R&D spending in the 2002 first quarter represented 6.0
percent of revenue as we continue to invest in technological development,
particularly color, to maintain our position in the rapidly changing document
processing market. We expect 2002 R&D spending will represent approximately 5-6
percent of revenue, a level that we believe is adequate to remain
technologically competitive. Xerox R&D remains strategically coordinated with
Fuji Xerox.
Selling, administrative and general (SAG) expenses increased by $20 million to
$1,169 million in the 2002 first quarter from $1,149 million in the 2001 first
quarter. In the first quarter of 2002, we reevaluated the development of a
customer service, software development program for field service operations,
which based on an analysis of pilot and field testing results indicated that the
capitalized software could not be used as originally intended and was therefore
impaired future spending associated with the software. Consequently, it was
formally decided that we should abandon the future spending associated with the
software as a result of these testing issues. Accordingly, we recorded a $72
million charge in SAG in the first quarter. The increase also includes increased
advertising spending in conjunction with our sponsorship of the Winter Olympics.
The advertising campaign focuses on three key components of our product
offerings: color made easy and affordable, just in time publishing solutions,
and variable printing applications. These increases were partially offset by
reduced expenses due to our SOHO exit and the benefits of our restructuring
program. Bad debt expense increased $19 million to $103 million in the first
quarter 2002 primarily due to higher provisions in certain DMO countries
including Argentina.
During the fourth quarter of 2000 we announced a Turnaround Program in which we
outlined a wide-ranging plan to sell assets, cut costs and strengthen our
strategic core business. We announced plans that were designed to reduce costs
by at least $1 billion annually, the majority of which affected 2001. In the
first quarter 2002 we took additional actions which are expected to further
reduce costs by approximately $100 million in 2002. As part of these
cost-cutting measures, we continue to record additional charges for initiatives
under the Turnaround Program. The recognition of such charges is based on having
a formal and committed plan, in accordance with existing accounting rules. As a
result of these actions and changes in estimates related to previously
established reserves, in the first quarter 2002 we provided an incremental $146
million ($101 million after taxes), net of reversals of $10 million primarily to
complete our open initiatives under the Turnaround Program. We expect additional
provisions will be required in 2002
19
as additional plans are finalized and are committed to. The restructuring
reserve balance at March 31, 2002 for the Turnaround Program was $221 million.
In 2001, we began a separate restructuring program associated with the
disengagement from our SOHO business. The provision associated with this action
totaled $239 million and included amounts for asset impairments; lease
cancellation, purchase decommitment and other exit costs; and severance and
employee separation. The SOHO disengagement reserve balance at March 31, 2002
was $25 million and relates to severance and other costs that will be paid
during 2002.
In the 2002 first quarter, worldwide employment declined by 4,300 to 74,600 as a
result of 2,700 employees leaving the company, largely under our restructuring
programs, and the transfer of 1,600 employees to Flextronics.
As discussed in the Notes to the Condensed Consolidated Financial Statements to
this Quarterly Report on Form 10-Q, we adopted new accounting rules that
eliminate the amortization of goodwill effective January 1, 2002. The new rules
also provides for no goodwill amortization on any acquisitions that occurred
after June 30, 2001. The amount of goodwill amortization recorded in the first
quarter of 2001 was $16 million, net of tax.
Other Expenses, Net
Other expenses, net for the quarters ended March 31, 2002 and 2001 were as
follows:
Three Months
Ended March 31,
-------------------
($ in millions) 2002 2001
-------- --------
Non-financing interest expense.............................. 81 $162
Currency (gains) losses, net................................ 24 (64)
Amortization of goodwill (2001 only) and intangible assets.. 10 23
Interest Income............................................. (21) (24)
Gain on sale of investment.................................. (19) -
SEC Civil Penalty........................................... 10 -
All other, net.............................................. 5 (4)
-------- --------
Total....................................................... $90 $ 93
-------- --------
Other expenses, net were $90 million in the first quarter 2002 and $93 million
in the first quarter 2001. Significantly lower non-financing interest expense,
reflected lower debt levels and reduced borrowing costs. Net currency losses of
$24 million in 2002, primarily reflect the devaluation of the Argentine Peso
compared to net exchange gains of $64 million in 2001 primarily related to gains
on Yen denominated debt. These currency exposures are the result of net unhedged
positions largely caused by our restricted access to the derivatives markets.
Although we have been able to re-enter the derivatives market on a limited basis
in 2002 to hedge certain balance sheet exposures, we continue to remain largely
unhedged in our Latin American affiliates. Accordingly, we may continue to
experience volatility in this area in the future. The sale of Prudential
Insurance Company common stock associated with that company's demutualization
generated a $19 million gain in the first quarter 2002. In the first quarter
2002, we accrued the $10 million civil penalty associated with our settlement
with the SEC. See Note 2 to the Condensed Consolidated Financial Statements for
further discussion.
20
Income Taxes, Equity in Net Income of Unconsolidated Affiliates and Minorities
Interests in Earnings of Subsidiaries
Pre-Tax loss was $53 million in the first quarter 2002 compared to pre-tax
income of $638 million in the first quarter 2001.
In the 2002 first quarter, we recorded an income tax benefit of $20 million
compared to an income tax expense of $427 million in the first quarter of 2001.
The 2001 first quarter income tax expense primarily related to the gain on the
sale of half our interest in Fuji Xerox. The effective tax rate for the first
quarter 2002 was 37.7 percent and reflects differences between calculating the
effective tax rate on an annual basis.
Our effective rate will change based on nonrecurring events (such as new
Turnaround Program initiatives) as well as recurring factors including the
geographical mix of income before taxes and the related tax rates in those
jurisdictions. In the normal course of business, we expect that our 2002
effective tax rate will be in the low to mid 40 percent range.
Equity in Net income of unconsolidated affiliates consists of our remaining 25
percent share of Fuji Xerox income as well as income from other smaller equity
investments. Total equity in net income for the first quarter 2002 was $8
million higher than the first quarter 2001. Despite the 2001 sale of half our
interest in Fuji Xerox, our 2002 first quarter share of total Fuji Xerox net
income was unchanged, reflecting favorable tax adjustments in the 2002 first
quarter and an unfavorable 2001 first quarter transition adjustment related to
the adoption of SFAS No. 133. In addition to Fuji Xerox, other affiliates had
improved performance in the 2002 first quarter contributing to the $8 million
improvement.
Minorities interest in earnings of subsidiaries increased by $17 million to $24
million in the first quarter 2002 primarily due to the quarterly distribution on
the Convertible Trust Preferred Securities issued in November 2001.
Business Performance by Segment
Our business segments are as follows: Production, Office, DMO, SOHO, and Other.
The table below summarizes our business performance by segment for the quarters
ended March 31, 2001 and 2002. Revenues and associated percentage changes, along
with operating profits and margins by segment are included. Segment operating
profit is determined as defined in Note 10 of the Notes to the Consolidated
Financial Statements in our 2001 Annual Report on Form 10-K.
Year-over-year revenue growth rates by segment are as follows (dollars are in
billions):
First Quarter
2002 over 2001
Total Revenues (10)%
Production (9)
Office (6)
DMO (11)
SOHO (43)
Other (19)
Memo: Color (8)
21
Operating margins by segment are as follows (dollars are in millions):
First Quarter
2002 over 2001
Total Operating Margin 2.7%
Production 7.9
Office 5.5
DMO (1.1)
SOHO 38.6
Other (29.1)
Production revenues include production publishing, production printing, color
products for the production and graphic arts markets and light-lens copiers over
90 pages per minute sold predominantly through direct sales channels in North
America and Europe. Revenues in the first quarter of 2002 declined 9 percent (8
percent pre currency) from the 2001 first quarter. 2002 first quarter monochrome
production publishing revenues stabilized. Monochrome production printing and
light lens reflect total market declines related to the continued movement to
distributed printing and electronic substitutes and customer transition from
light lens to digital offerings. During the 2002 first quarter production color
revenue declined, as growth from our DocuColor 2000 products was more than
offset by declines in older color products reflecting continued marketplace
competition and the weak economy, particularly in the graphic arts market. The
DocuColor 2000 remains the most successful product in its market segment with
over 5,000 units installed to date. Production revenues represented 34 percent
of total revenue in the first quarter of 2002 and 2001.
2002 first quarter operating margins stabilized at approximately 8 percent,
reflecting cost reductions and improved product mix as we convert light lens
placements to digital. These improvements more than offset competitive price
pressure.
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. First
quarter 2002 revenue declined by 6 percent (5 percent pre currency) from the
2001 first quarter reflecting reduced participation in very aggressively priced
competitive bids and tenders in Europe. Monochrome revenues declined as growth
in digital, including the European launch of the Document Centre 490 was
insufficient to offset light lens declines. Digital devices now represent over
95 percent of our combined office light lens and digital equipment revenues.
Office color revenue growth reflects strong performance from the Document Centre
Color Series 50 and Phaser 860 solid ink and Phaser 7700 laser printers. Office
revenues represented approximately 42 percent of total revenues for the first
quarter 2002 and 41 percent in the 2001 first quarter.
Operating profit in the Office segment increased year-over-year from $47 million
in the first quarter of 2001 to $91 million in the first quarter of 2002. The
increase reflects significantly improved gross margins driven by our focus on
more profitable revenue, favorable product mix reflecting the launches of our
Document Centre 480 and 490 multifunction devices and improved manufacturing and
service productivity.
DMO includes operations in Latin America, the Middle East, India, Eurasia,
Russia and Africa. DMO revenue declined 11 percent (9 percent pre currency) in
the 2002 first quarter. Approximately half the decline was due to major economic
disruptions in Argentina and Venezuela. Brazil, which represented 5 percent of
total Xerox revenue in the 2002 first quarter, declined, reflecting the weak
economy and our continued focus on liquidity and profitable revenue rather than
market share.
22
DMO incurred a $5 million loss in the 2002 first quarter, a $65 million
improvement from the 2001 first quarter, in spite of a significant loss in
Argentina due to the economic disruption in that country. Gross margin improved
significantly reflecting the benefits from implementation of the new business
model and improved productivity. In addition, SAG spending declined as we
realize the benefits of our cost base and resizing initiatives.
We announced our disengagement from our worldwide SOHO business in June 2001.
SOHO revenues now consist primarily of consumables for the inkjet printers and
personal copiers previously sold through indirect channels in North America and
Europe. First quarter 2002 SOHO revenues declined 43 percent from 2001,
primarily due to the absence of equipment revenue. First quarter 2002
profitability reflects continued sales of high margin consumables for the
existing equipment population. We expect sales of these supplies to continue in
2002, but also expect SOHO revenues and profits to decline over time as the
existing population of Xerox equipment is replaced.
Other includes revenues and costs associated with paper sales, Xerox Engineering
Systems (XES), Xerox Connect, Xerox Technology Enterprises (XTE), our investment
in Fuji Xerox, consulting and other services. Other segment profit (loss)
includes certain costs that have not been allocated to the business including
non-financing interest and other non-allocated costs. The 2002 first quarter
revenue declined 19 percent (18 percent pre currency) due to lower paper revenue
and lower Xerox Connect revenues. The increased loss reflects the previously
discussed $72 million write off of capitalized software, as well as, higher
advertising expense, unfavorable currency impacts, the SEC civil penalty
partially offset by lower non financing interest expense and the gain on the
Prudential demutualization.
Other
In January 2002, we completed additional asset sales to transfer our office
product manufacturing operations to Flextronics. The companies completed the
sale of our plants in Venray, The Netherlands and Resende, Brazil for
approximately $26 million plus the assumption of certain liabilities and subject
to certain closing adjustments. Approximately 1,600 Xerox employees in these
operations transferred to Flextronics. We have begun to transfer work to
Flextronics from our printed circuit board factories in El Segundo, California
and Mitcheldean, England and our customer replaceable unit plant in Utica, New
York. We plan to complete this by the end of the third quarter 2002.
We continue to make progress transitioning our equipment financing to third
party vendors. This progress is detailed in the following Capital Resources and
Liquidity section.
Capital Resources and Liquidity
Liquidity, Financial Flexibility and Funding Plans:
Historically, our primary sources of funding have been cash flows from
operations, borrowings under our commercial paper and term funding programs, and
securitizations of accounts and finance receivables. We used these funds to
finance customers' purchases of our equipment and for working capital
requirements, capital expenditures and business acquisitions. Our operations and
liquidity began to be negatively impacted in 2000 by Xerox-specific business
challenges, which have been discussed in the Notes to the Consolidated Financial
Statements included in our 2001 Annual Report on Form 10-K. These challenges
were exacerbated by significant competitive and industry changes, adverse
economic conditions, and significant technology and acquisition spending.
Together, these challenges and conditions negatively impacted our cash
availability and created marketplace concerns regarding our liquidity, which led
to credit rating downgrades and restricted our access to capital markets.
23
In addition to the limited access to capital markets which resulted from our
credit rating downgrades, we have been unable to access the public capital
markets. This is because, as a result of the SEC investigation since June 2000
and the accounting issues raised by the SEC, the SEC Staff advised us that we
could not make any public registered securities offerings. This additional
constraint had the effect of limiting our means of raising funds to those of
unregistered capital markets offerings and private lending or equity sources.
Our credit ratings became even more important, since credit rating agencies
often include access to other capital sources in their rating criteria.
During 2000, 2001, and 2002, these rating downgrades, together with the recently
concluded review by the SEC, adversely affected our liquidity and financial
flexibility, as follows:
. Since October 2000, uncommitted bank lines of credit and the unsecured
public capital markets have been largely unavailable to us.
. On December 1, 2000, Moody's reduced its rating of our senior debt to below
investment grade, significantly constraining our ability to enter into new
foreign-currency and interest rate derivative agreements, and requiring us
to immediately repurchase certain of our then-outstanding derivative
agreements for $108 million.
. In the fourth quarter 2000, as a result of our lack of access to unsecured
bank and public credit sources, we drew down the entire $7.0 billion
available to us under our Revolving Credit Agreement (the "Old Revolver"),
primarily to maintain financial flexibility and pay down debt obligations as
they came due.
. On October 23, 2001, Standard & Poors (S&P) reduced its rating of our senior
debt to below investment grade, further constraining our ability to enter
into new derivative agreements, and requiring us to immediately repurchase
certain of our then-outstanding out-of-the-money interest-rate and
cross-currency interest-rate derivative agreements for a total of $148
million.
. To minimize the resulting interest and currency exposures from these events,
we have subsequently restored some derivative trading, with several
counterparties, on a limited basis. However, virtually all such new
arrangements either require us to post cash collateral against all
out-of-the-money positions, or else have very short terms (e.g., as short as
one week). Both of these types of arrangements potentially use more cash
than standard derivative arrangements would otherwise require.
. On May 1, 2002, Moody's further reduced its rating of our senior debt,
requiring us to post additional collateral against certain derivative
agreements currently in place. This downgrade also constituted a termination
event under our existing $290 million U.S. trade receivable securitization
facility, which we are currently renegotiating with the counterparty, as
described more fully below.
. On June 11 and 21, 2002, S&P lowered and affirmed its rating of our senior
unsecured and senior secured debt, which to date has not had any incremental
adverse effects on our liquidity.
24
As of June 26, 2002, our senior and short-term debt ratings and outlooks were as
follows:
Senior Short Term Outlook
Debt Debt Rating
Rating
-------- ------------- -------------
Moody's B1 Not Prime Negative
S&P* BB-/B+* B* Negative*
Fitch BB** B Negative**
*Effective June 11, 2002, S&P lowered our Corporate credit rating, and
downgraded our senior debt, to BB- and maintained us on CreditWatch with
Negative implications. Upon receipt of commitments from the banks who are party
to our New Credit Facility, S&P affirmed the Corporate credit rating and our
senior secured debt at BB-with a Negative Outlook, and downgraded our senior
unsecured debt to B+.
** On June 28, 2002, Fitch announced that it expects to downgrade our senior
unsecured debt by one notch, pending its review of our 2001 Annual Report on
Form 10-K, which we filed with the Securities and Exchange Commission earlier
that day, as well as this Quarterly Report on Form 10-Q.
We expect our limited access to unsecured credit sources to result in higher
borrowing costs going forward, and to potentially result in Xerox Corporation
having to increase its level of intercompany lending to affiliates and/or to
guarantee portions of their debt.
Actions Taken to Address Liquidity Issues:
In the fourth quarter of 2000, as a result of the various factors described
above, we began accumulating cash in an effort to maintain financial
flexibility, rather than continuing our historical practice of using available
cash to voluntarily pay down debt. To the extent possible, and except as
otherwise prohibited under the New Credit Facility described below, we expect to
continue this practice of accumulating cash for the foreseeable future.
New Credit Facility:
On June 21, 2002, we entered into an Amended and Restated Credit Agreement (the
"New Credit Facility") with a group of lenders, replacing the Old Revolver. At
that time, we permanently repaid $2.8 billion of the $7 billion Revolving Credit
Agreement (the "Old Revolver"). Accordingly, there is currently $4.2 billion
outstanding under the New Credit Facility, consisting of three tranches of term
loans totaling $2.7 billion and a $1.5 billion revolving facility that includes
a $200 million letter of credit sub-facility. The three term loan tranches
include a $1.5 billion amortizing "Tranche A" term loan, a $500 million "Tranche
B" term loan, and a $700 million "Tranche C" term loan maturing on September 15,
2002. Xerox Corporation is currently, and will remain, the borrower of all of
the term loans. The revolving loans are available, without sub-limit, to Xerox
Corporation, Xerox Canada Capital Limited (XCCL), Xerox Capital Europeplc (XCE)
and other foreign subsidiaries, as requested by us from time to time, that meet
certain qualifications. We are required to repay a total of $400 million of the
Tranche A loan and $5 million of the Tranche B loan in semi-annual installments
in 2003, and a total of $600 million of the Tranche A loan and $5 million of the
Tranche B loan in semi-annual installments in 2004. The remaining portions of
the Tranche A and Tranche B term loans and the revolving facility contractually
mature on April 30, 2005. We could be required to repay portions of the loans
earlier than their scheduled maturities upon the occurrence of certain events,
as described below. In addition, all loans under the New Credit Facility mature
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 domestic
assets of Xerox Corporation and by liens on the assets of substantially all of
our U.S. subsidiaries (excluding Xerox Credit Corporation), and are guaranteed
by substantially all of our U.S. subsidiaries. In addition, revolving loans
outstanding from time to time to
25
XCE (currently $605 million) are also secured by all of XCE's assets and are
also guaranteed on an unsecured basis by certain foreign subsidiaries that
directly or indirectly own all of the outstanding stock of XCE. Revolving loans
outstanding from time to time to XCCL (currently $300 million) are also secured
by all of XCCL's assets and are also guaranteed on an unsecured basis by our
material Canadian subsidiaries, as defined (although the guaranties of the
Canadian subsidiaries will become secured by their assets in the future if
certain events occur).
Under the terms of certain of our outstanding public bond indentures, the
outstanding amount of obligations under the New Credit Facility that can be
secured by assets (the "Restricted Assets") of (i) Xerox Corporation and (ii)
our non-financing subsidiaries that have a consolidated net worth of at least
$100 million, without triggering a requirement to also secure these indentures,
is limited to the excess of (a) 20 percent of our consolidated net worth (as
defined in the public bond indentures) over (b) a portion of the outstanding
amount of certain other debt that is secured by the Restricted Assets.
Accordingly, the amount of the debt secured under the New Credit Facility by the
Restricted Assets (the "Restricted Asset Security Amount") will vary from time
to time with changes in our consolidated net worth. The Restricted Assets secure
the Tranche B loan up to the Restricted Asset Security Amount; any Restricted
Asset Security Amount in excess of the outstanding Tranche B loan secures, on a
ratable basis, the other outstanding loans under the New Credit Facility. The
assets of XCE, XCCL and many of the subsidiaries guarantying 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 debt under the New Credit Facility secured by their assets is not subject to
the foregoing limits.
The New Credit Facility loans generally bear interest at LIBOR plus 4.50
percent, except that the Tranche B loan bears interest at LIBOR plus a spread
that varies between 4.00 percent and 4.50 percent depending on the Restricted
Asset Security Amount in effect from time to time. Specified percentages of any
net proceeds we receive from capital market debt issuances, equity issuances or
asset sales during the term of the New Credit Facility must be used to reduce
the amounts outstanding under the New Credit Facility, and in all cases any such
amounts will first be applied to reduce the Tranche C loan. Once the Tranche C
loan has been repaid, or to the extent that such proceeds exceed the outstanding
Tranche C loan, any such prepayments arising from debt and equity proceeds will
first permanently reduce the Tranche A loans, and any amount remaining
thereafter will be proportionally allocated to repay the then-outstanding
balances of the revolving loans and the Tranche B loans and to reduce the
revolving commitment accordingly. Any such prepayments arising from asset sale
proceeds will first be proportionally allocated to permanently reduce any
outstanding Tranche A loans and Tranche B loans, and any amounts remaining
thereafter will be used to repay the revolving loans and to reduce the revolving
commitment accordingly (except that the revolving loan commitment cannot be
reduced below $1 billion as a result of such prepayments).
The New Credit Facility contains affirmative and negative covenants including
limitations on issuance of debt and preferred stock, certain fundamental
changes, investments and acquisitions, mergers, certain transactions with
affiliates, creation of liens, asset transfers, hedging transactions, payment of
dividends, intercompany loans and certain restricted payments, and a requirement
to transfer excess foreign cash, as defined, and excess cash of Xerox Credit
Corporation to Xerox Corporation in certain circumstances. The New Credit
Facility does not affect our ability to continue to monetize receivables under
the agreements with GE Capital and others, which are discussed below. No cash
dividends can be paid on our Common Stock for the term of the New Credit
Facility. Cash dividends may be paid on preferred stock provided there is then
no event of default. In addition to other defaults customary for facilities of
this type, defaults on debt of, or bankruptcy of, Xerox Corporation or certain
subsidiaries would constitute a default under the New Credit Facility.
26
The New Credit Facility also contains financial covenants which the Old Revolver
did not contain, including:
. Minimum EBITDA (rolling four quarters, as defined)
. Maximum Leverage (total adjusted debt divided by EBITDA, as defined)
. Maximum Capital Expenditures (annual test)
. Minimum Consolidated Net Worth (quarterly test, as defined)
Failure to be in compliance with any material provision of the New Credit
Facility could have a material adverse effect on our liquidity and operations.
We expect total fees and expenses incurred in connection with the New Credit
Facility to approximate $125 million, the majority of which was paid at closing.
These amounts will be deferred and amortized over the three year term of the New
Credit Facility.
Turnaround Program:
In 2000 we announced a global Turnaround Program which included initiatives to
sell certain assets, improve operations and liquidity, and reduce annual costs
by at least $1 billion. Through March 31, 2002, and since that time, we have
made significant progress toward these objectives.
With respect to asset sale initiatives:
. In the fourth quarter of 2000 we sold our China operations to Fuji Xerox,
generating $550 million of cash and transferring $118 million of debt to
Fuji Xerox.
. In March 2001, we sold half of our interest in Fuji Xerox to Fuji Photo Film
Co., Ltd. for $1,283 million in cash (we paid $346 million in taxes in March
2002 related to this sale).
. In the fourth quarter of 2001, we received cash proceeds of $118 million
related to the sales to Flextronics of certain of our manufacturing
facilities, and in 2002 we received additional net cash proceeds of $26
million related to the sales of additional facilities under that agreement.
With respect to operational and liquidity improvements, we have announced major
initiatives with GE Capital and other vendor financing partners, and we have
completed several transactions, including (1) implementation of third-party
vendor financing programs in the Netherlands, the Nordic countries, Brazil,
Mexico, and Italy and (2) monetizations of portions of our existing finance
receivables portfolios. We have several other similar transactions currently
being negotiated, and we continue to actively pursue alternative forms of
financing. These initiatives, when completed, are expected to significantly
improve our liquidity going forward.
In connection with general financing initiatives:
. During 2001, we retired $377 million of long-term debt through the exchange
of 41.1 million shares of our common stock, which increased our net worth by
$351 million.
. In November 2001, we sold $1,035 million of Convertible Trust Preferred
Securities, and placed $229 million of the proceeds in escrow to fund the
first three-years' distribution requirements. Total proceeds, net of
escrowed funds and transaction costs, were $775 million.
. In January 2002, we sold $600 million of 9 3/4 percent Senior Notes and
(euro) 225 million of 9 3/4 percent Senior Notes, for cash proceeds totaling
$746 million, which is net of fees and original-issue discount. These notes
mature on January 15, 2009, and contain several affirmative and negative
covenants which are similar to those in the New Credit Facility. Taken as a
whole, the Senior Notes covenants are less restrictive than the covenants
contained in the New Credit Facility. In addition, our Senior Notes do not
contain any financial maintenance covenants or scheduled amortization
payments. The Senior Notes covenants (1) restrict certain transactions,
including new borrowings, investments and the payment of dividends, unless
we meet certain financial measurements and ratios, as defined, and (2)
restrict our use of proceeds from certain other transactions including
27
asset sales. In connection with the June 21, 2002 closing of the New
Credit Facility, substantially all of our U.S. subsidiaries guaranteed these
notes. In order to reduce the immediate cost of this borrowing, we entered into
derivative agreements to swap the cash interest obligations under the dollar
portion of these notes to LIBOR plus 4.44 percent. We will be required to
collateralize any out-of-the-money positions on these swaps.
In connection with vendor financing and related initiatives:
. In 2001, we received $885 million in financing from GE Capital, secured by
portions of our finance receivable portfolios in the United Kingdom. At
March 31, 2002, the remaining balances of these loans totaled $402 million.
. In the second quarter 2001, we sold our leasing businesses in four Nordic
countries to Resonia Leasing AB for $352 million in cash plus retained
interests in certain finance receivables for total proceeds of approximately
$370 million. These sales are part of an agreement under which Resonia will
provide on-going, exclusive equipment financing to our customers in those
countries.
. In July 2001, we transferred U.S. lease contracts to a trust, which in turn
sold $513 million of floating-rate asset-backed notes. We received cash
proceeds of $480 million, net of $3 million of fees, plus a retained
interest of $30 million, which we will receive when the notes are repaid,
which we expect to occur in August 2003. The transaction was accounted for
as a secured borrowing. At March 31, 2002, the remaining debt totaled $329
million.
. In September 2001, we announced a U.S. Framework Agreement (the "USFA") with
GE Capital's Vendor Financial Services group, under which GE Capital will
become the primary equipment-financing provider for our U.S. customers. We
expect funding under the USFA to be in place in 2002 upon completion of
systems and process modifications and development.
. In November 2001, we entered into an agreement with GE Capital which
provides for a series of loans, secured by certain of our finance
receivables in the United States, up to an aggregate of $2.6 billion,
provided that certain conditions are met at the time the loans are funded.
These conditions, all of which we currently meet, include maintaining a
specified minimum debt rating with respect to our senior debt. In the fourth
quarter of 2001, we received two secured loans from GE Capital totaling
$1,175 million. Cash proceeds of $1,053 million were net of $115 million of
escrow requirements and $7 million of fees. In March 2002, we received our
third secured loan from GE Capital totaling $266 million. Cash proceeds of
$229 million were net of $35 million of escrow requirements and $2 million
of fees. At March 31, 2002, the remaining balances of these loans totaled
$1,304 million. In May 2002, we received our fourth secured loan from GE
Capital, totaling $499 million. Cash proceeds of $496 million were net of $3
million of fees. Through June 26, 2002 approximately $1.9 billion of loans
have been funded under this agreement.
. In November 2001, we announced a Canadian Framework Agreement (the "CFA")
with the Canadian division of GE Capital's Vendor Financial Services group,
similar to the agreement in the U.S., under which GE Capital will become the
primary equipment-financing provider for our Canadian customers. We expect
the CFA to be completed in 2002. In February 2002 we received a $291 million
loan from GE Capital, secured by certain of our finance receivables in
Canada. Cash proceeds of $281 million were net of $8 million of escrow
requirements and $2 million of fees. At March 31, 2002, the remaining
balance of this loan was $294 million.
. In December 2001, we announced that we would be forming a joint venture with
De Lage Landen International BV (DLL) to manage equipment financing, billing
and collections for our customers' financed equipment orders in the
Netherlands. This joint venture was formed and began funding in the first
quarter of 2002. DLL owns 51 percent of the venture and provides the funding
to support new customer leases, and we own the remaining 49 percent of this
unconsolidated venture.
. In December 2001, we announced European framework agreements with GE
Capital's European Equipment Finance group, under which GE Capital will
28
become the primary equipment-financing provider for our customers in France
and Germany. We expect these agreements to be completed in 2002.
. In March 2002, we signed agreements with third parties in Brazil and Mexico
under which those third parties will be our primary equipment financing
provider 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 third party for
$207 million in cash plus the assumption of $20 million of debt. We can also
receive retained interests up to approximately $30 million, based on the
occurrence of certain future events. This sale is part of an agreement under
which the third-party will provide on-going, exclusive equipment financing
to our customers in Italy.
. In May 2002, we received an additional loan from GE Capital of $106 million
secured by portions of our lease receivable portfolio in the U.K.
. In May 2002, we received a $77 million loan from GE Capital, secured by
certain of our finance receivables in Germany. Cash proceeds of $65 million
were net of $12 million of escrow requirements.
Cash and Debt Positions:
With $4.7 billion of cash and cash equivalents on hand at March 31, 2002, (and
approximately $1.8 billion on hand as of June 26, 2002, after giving effect to
the refinancing under the New Credit Facility) we believe our liquidity is
sufficient to meet current operating cash flow requirements and to satisfy all
scheduled debt maturities through March 31, 2003.
As a result of the New Credit Facility discussed above, our debt maturities have
changed. Significantly less debt will now mature in 2002 than would have become
due had the Old Revolver not been refinanced. In addition, a portion of our
available cash has been used to retire some of the debt under the Old Revolver.
The following represents our aggregate debt maturity schedules by quarter for
2002 and 2003, and reflects the New Credit Facility and related principal
payments discussed above (in billions):
2002 2003
First Quarter ___ $0.5
Second Quarter $4.2 1.2
Third Quarter 1.1 0.4
Fourth Quarter 0.9 1.3
---- ----
Full Year $6.2 $3.4
==== ====
Additionally, as discussed throughout this Quarterly Report on Form 10-Q, we
have reached a settlement with the SEC as to all matters that were under
investigation. It is our expectation that the resolution of these matters will
restore our ability to access the public capital markets and reduce our earlier
reliance on other funding sources including non-public capital markets. Our
current plans include accessing the public capital markets in 2002, however, we
are not dependent on such access to maintain adequate liquidity through March
31, 2003.
Plans to Strengthen Liquidity and Financial Flexibility Beyond 2002:
Our ability to maintain sufficient liquidity through March 31, 2003 is highly
dependent on achieving expected operating results, including capturing the
benefits from restructuring activities, and completing announced vendor
financing and other initiatives. There is no assurance that these initiatives
will be successful. Failure to successfully complete these initiatives could
have a material adverse effect on our liquidity and our operations, and could
require us to consider further measures, including deferring planned capital
expenditures, modifying current restructuring plans, reducing discretionary
spending, selling additional assets and, if necessary, restructuring existing
debt.
We also expect that improvements in our debt ratings, and our related ability to
fully access certain unsecured public debt markets, namely the commercial
29
paper markets, will depend on (1) our ability to demonstrate sustained EBITDA
growth and operating cash generation and (2) continued progress on our vendor
financing initiatives, as discussed above. Until such time, we expect some bank
lines to continue to be unavailable, and we intend 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.
Other Funding Arrangements:
Securitizations, and Use of 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 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 any of these SPEs. We typically act as service
agent and collect the securitized receivables on behalf of the securitization
investors. Under certain circumstances, including the downgrading of our debt
ratings by one or more rating agencies, 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 the debt rating downgrade provisions have been
triggered in some of our securitization agreements, the securitization investors
and/or their agents have not elected to remove us as administrative servicer as
of this time. 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.
Most 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
July 2001 asset-backed notes transaction and the U.S. and Canadian loans from GE
Capital discussed above, which utilized SPEs as part of their structures, as of
March 31, 2002, we have entered into the following similar transactions which
were accounted for as debt on our balance sheets:
. In the third quarter 2000, Xerox Credit Corporation (XCC) securitized
certain finance receivables in the United States, generating gross proceeds
of $411 million. As of March 31, 2002, the remaining debt under this
facility totaled approximately $110 million.
. In 1999, XCC securitized certain finance receivables in the United States,
generating gross proceeds of $1,150 million. At March 31, 2002, the
remaining obligations in this facility totaled $39 million, and were
substantially repaid as of June 26, 2002.
We have also entered into the following SPE transactions which were accounted
for as sales of receivables:
. In 2000, Xerox Corporation and Xerox Canada Limited (XCL) securitized
certain accounts receivable in the U.S. and Canada, generating gross
proceeds of $315 million and $38 million, respectively. In December 2000, as
a result of the senior debt downgrade by Moody's discussed above, both
entities negotiated waivers with their respective counterparties to prevent
the facilities from entering "wind-down" mode. As part of its waiver
negotiation, Xerox Corporation renegotiated the $315 million U.S. facility,
reducing its size to $290 million. The May 2002 Moody's downgrade
constituted an event of termination under this agreement, which we are
currently renegotiating. Failure to successfully renegotiate the facility
could result in the suspension of its revolving features, whereupon we
30
would be unable to sell new accounts receivable into the facility, and our
availability would wind down. In February 2002, the size of the Canadian
facility was reduced in order to make certain receivables eligible under the
GE Capital Canadian transaction described above. Also in February 2002, a
downgrade of our Canadian debt by Dominion Bond Rating Service caused the
Canadian counterparty to withdraw its waiver, in turn causing the remaining
Canadian facility at that time to enter into wind-down mode. This facility
has subsequently been fully repaid.
. In 1999, XCL securitized certain finance receivables, generating gross
proceeds of $345 million. At March 31, 2002, the remaining obligations in
this facility totaled $76 million, and we expect them to be fully paid in
2002. At March 31, 2002, this is the only outstanding SPE transaction with
recourse provisions that could be asserted against us.
In summary, at March 31, 2002, amounts owed by these receivable-related SPEs to
their investors totaled $2,435 million, of which $359 million represented
transactions we treated as asset sales, and the remaining $2,076 million is
reported as Debt in our Condensed Consolidated Balance Sheet. A detailed
discussion of the terms of these transactions, including descriptions of our
retained interests, is included in Note 6 to the Consolidated Financial
Statements of the 2001 Annual Report. We also utilized SPEs in our Trust
Preferred Securities transactions. Refer to Note 17 to the Consolidated
Financial Statements in the 2001 Annual Report for a detailed description of
these transactions.
Secured Debt - Summary:
As of March 31, 2002, after giving effect to the New Credit Facility, we have
approximately $930 million of debt which is secured by assets that are measured
against the 20 percent consolidated net worth limitation described above. In
addition, we have $3,802 million of debt which is secured by assets that are not
measured against that 20 percent limitation, in most cases because the
applicable borrowing entities are considered financing subsidiaries under the
public indenture definitions.
Equity Put Options:
During 1999, we sold 0.8 million equity put options, respectively, for proceeds
of $0.4 million. Equity put options give the counterparty the right to sell our
common shares back to us at a specified strike price. In January 2001, we paid
$28 million to settle the put options we issued in 1999, which we funded by
issuing 5.9 million unregistered common shares. There were no put options
outstanding as of March 31, 2002.
Cash Management:
Xerox and its material subsidiaries and affiliates manage their worldwide cash,
cash equivalents and liquidity resources through internal cash management
systems, which include established policies and procedures. They are subject to
(1) the statutes, regulations and practices of the local jurisdictions in which
the companies operate, (2) the legal requirements of the agreements to which the
companies are parties and (3) the policies and cooperation of the financial
institutions utilized by the companies to maintain such cash management systems.
At March 31, 2002 and 2001, cash and cash equivalents on hand totaled $4,747
million and $2,777 million, respectively, and total debt was $17,416 million and
$18,004 million, respectively. Total debt net of cash (Net Debt) decreased by
$106 million in the first quarter of 2002 and decreased by $1,660 million in the
first quarter of 2001. The consolidated ratio of total debt to common and
preferred equity was 7.6:1 and 7.0:1 as of March 31, 2002, and 2001,
31
respectively. The increase in this ratio in 2002 reflects net losses during that
12-month period, together with incremental borrowings during that same period,
the proceeds of which were used to accumulate cash rather than being used to
repay other debt.
The following represents the results of our cash flows for the first quarter of
2002 and 2001 included within our Condensed Statement of Cash Flows in the
accompanying Condensed Consolidated Financial Statements:
2002 2001
------- -------
Operating Cash Flows $ 89 $ 89
Investing Cash Flows (Usage) (13) 1,235
Financing Cash Flows (Usage) 704 (259)
Foreign Currency Impacts (23) (38)
------- -------
Net Change in Cash Balance 757 1,027
Cash - Beginning of year 3,990 1,750
------- -------
Cash - End of year $4,747 $2,777
======= =======
Excluding a tax payment of $346 million related to the sale of a portion of our
interest in Fuji Xerox, first Quarter 2002 operating cash flows improved as
compared to the previous year comparable period. This was primarily due to
working capital improvements in accounts payable. This was further enhanced by a
high rate of collections of our finance receivables in spite of a decline in
sales.
Investing cash flows were lower in the first quarter of 2002 primarily due to
cash received in the first quarter of 2001 from the sale of half of our share in
Fuji Xerox.
Our first quarter 2002 financing activities largely consisted of the high yield
debt offering and new secured borrowings from our agreements with GECC in
Canada.
Refer to our EBITDA-based cash flows discussion below to understand the way we
look at cash flows from a treasury and cash management perspective, and for
explanations of cash flows for first quarter 2002 compared to 2001.
Historically, we separately managed the capital structures of our non-financing
operations and our captive financing operations. Consistent with our continuing
efforts to exit the customer equipment financing business, we now use EBITDA and
operating cash flow to measure our liquidity, and we no longer distinguish
between financing and non-financing operations in our liquidity management
processes. We define EBITDA as earnings before interest expense, income taxes,
depreciation, amortization, minorities' interests, equity in income of
unconsolidated affiliates, and non-recurring and non-operating items. We believe
that EBITDA provides investors and analysts with a useful measure of liquidity
generated from recurring operations. EBITDA is not intended to represent an
alternative to either operating income or cash flows from operating activities
(as those terms are defined in GAAP). While EBITDA is frequently used to analyze
companies, the definition of EBITDA we employ, as presented herein, may differ
from definitions of EBITDA employed by other companies.
32
The following is a summary of EBITDA, operating and other cash flows for the
quarters ended March 31, 2002 and 2001:
2002 2001
------- Restated
--------
Non-financing revenues $3,594 $3,999
Non-financing cost of sales 2,184 2,669
------- --------
Non-financing gross profit 1,410 1,330
Research and development expense (230) (251)
Selling, administrative and general expenses (1,169) (1,149)
Depreciation and amortization expense, 309 338
------- --------
excluding goodwill and intangibles
Adjusted EBITDA 320 268
Working capital and other changes (28) (21)
On-Lease equipment spending (36) (94)
Capital spending (26) (69)
Restructuring payments (122) (156)
------- --------
Operating Cash Flow* 108 (72)
Interest payments (130) (263)
Financing cash flow 442 383
Debt borrowings (repayments), net 702 (212)
Dividends and other non-operating items (45) (92)
Proceeds from sales of businesses (320)** 1,283
------- --------
Net Increase in Cash $ 757 $ 1,027
======= ========
*The primary difference between this amount and the Cash Flows from Operations
reported in our GAAP Statements of Cash Flows, is the inclusion of Capital
Spending in, and the exclusion of Financing Cash Flow and Interest Payments
from, the amount shown above.
**EBITDA cash flows includes the tax payments associated with the Fuji Xerox
sale explained below. Such amount is included in operating activities for our
GAAP cash flow financial statement.
2002 first quarter EBITDA operating cash flow of $108 million increased by $180
million, from $(72) million usage in the prior year. The improvement was driven
by gross profit improvements, lower on-lease equipment spending, lower capital
spending, and lower restructuring spending. The decline in capital spending was
due primarily to significant spending constraints. The decline in on-lease
equipment spending reflected declining rental placement activity and
populations, particularly in our older-generation light lens products.
Significantly lower interest payments in first quarter 2002 reflected reductions
of our debt levels together with lower market interest rates.
The increase in EBITDA financing cash flow in 2002 reflected lower finance
receivable originations resulting from lower equipment sales in 2002 compared to
2001, offset partially by a decline in financing income, as lower levels of
equipment resulted in a reduction in our finance receivable portfolios.
Dividends and other non-operating items used $45 million of cash in 2002,
compared to usage of $92 million in 2001. This improvement was due to cash
savings resulting from our elimination and suspension of our common and Series B
Preferred dividends, respectively, which we announced in July 2001.
In 2002, we used $320 million related to the sales of businesses, including the
payment of taxes due on the sale of half our interest in Fuji Xerox in 2001. In
summary, EBITDA operating and financing cash flow improvements in first quarter
2002 combined with new borrowings, funded interest and tax obligations and
allowed us to increase our cash on hand by $757 million.
Cash restructuring payments were $122 million and $156 million in first quarter
2002 and 2001, respectively. The status of the restructuring reserves is
discussed in Note 5 to the Condensed Consolidated Financial Statements.
33
Financial Risk Management:
We are typical of multinational corporations because 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. Accordingly, we
have historically entered into derivative contracts, including interest rate
swap agreements, forward exchange contracts and foreign currency swap
agreements, to manage such 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 such transactions for trading purposes, and we employ long-standing
policies prescribing that derivative instruments are only to be used to achieve
a set of very limited objectives. As described above, our ability to currently
enter into new derivative contracts is severely constrained. Therefore, while
the following paragraphs describe our overall risk management strategy, our
current ability to employ that strategy effectively has been severely limited.
Currency derivatives are primarily arranged to manage the risk of exchange rate
fluctuations associated with assets and liabilities that are denominated in
foreign currencies. Our primary foreign currency market exposures include the
Japanese Yen, Euro, Brazilian Real, British Pound Sterling and Canadian Dollar.
For each of our legal entities, we have historically hedged a significant
portion of all foreign-currency-denominated cash transactions. From time to time
(when cost-effective) foreign-currency-denominated debt and foreign-currency
derivatives have been used to hedge international equity investments.
Virtually all customer-financing assets earn fixed rates of interest. Therefore,
we have historically sought to "lock in" an interest rate spread by arranging
fixed-rate liabilities with maturities similar to those of the underlying
assets, and we have funded the assets with liabilities in the same currency. As
part of this overall strategy, pay-fixed-rate/receive-variable-rate interest
rate swaps are often used in place of more expensive fixed-rate debt.
Additionally, pay-variable-rate/receive-fixed-rate interest rate swaps are used
from time to time to transform longer-term fixed-rate debt into variable-rate
obligations. The transactions performed within each of these categories enable
more cost-effective management of interest rate exposures by eliminati ng the
risk of a major change in interest rates. We refer to the effect of these
practices as "match funding" customer financing assets.
Consistent with the nature of economic hedges, unrealized gains or losses from
interest rate and foreign currency derivative contracts are designed to offset
any corresponding changes in the value of the underlying assets, liabilities or
debt.
Pay fixed-rate and receive variable-rate swaps are often used in place of more
expensive fixed-rate debt. Additionally, pay variable-rate and receive
fixed-rate swaps are used from time to time to transform longer-term fixed-rate
debt into variable-rate obligations. The transactions performed within each of
these categories enable more cost-effective management of interest rate e
xposures. The potential risk attendant to this strategy is the non-performance
of the swap counterparty. We address this risk by arranging swaps with a diverse
group of strong-credit counterparties, regularly monitoring their credit ratings
and determining the replacement cost, if any, of existing transactions.
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. Our currency and
interest rate hedging are typically unaffected by changes in market conditions
as forward contracts, options and swaps are normally held to
34
maturity consistent with our objective to lock in currency rates and interest
rate spreads on the underlying transactions.
As described above, the downgrades of our debt during 2000, 2001 and 2002,
together with the recently-concluded SEC investigation, significantly reduced
our access to capital markets. Furthermore, several of the debt downgrades
triggered various contractual provisions which required us to collateralize or
repurchase a number of derivative contracts which were then outstanding. While
we have been able to replace some derivatives on a limited basis, our current
debt ratings restrict our ability to utilize derivative agreements to manage the
risks associated with interest rate and some foreign currency fluctuations,
including our ability to continue effectively employing our match funding
strategy. For this reason, we anticipate increased volatility in our results of
operations due to market changes in interest rates and foreign currency rates.
READER'S NOTE: THIS CONCLUDES THE DISCUSSION EXCERPTED DIRECTLY FROM XEROX
CORPORATION'S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED MARCH 31,
2002.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The information set forth under the caption "Capital Resources and Liquidity"
in Item 2 above is hereby incorporated by reference in answer to this Item.
35
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 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.
Incorporated by reference to Exhibit 3(b) to
Registrant's Annual Report on Form 10-K for the
Year Ended December 31, 2001.
Exhibit 12 (a) Computation of the Company's Ratio of
Earnings to Fixed Charges.
(b) Computation of Xerox's Ratio of Earnings
to Fixed Charges.
(b) Reports on Form 8-K.
Current Reports on Form 8-K dated January 7, 2002, January 17,
2002, March 7, 2002 and March 27, 2002 reporting Item 5 "Other
Events" were filed during the quarter for which this Quarterly
Report is filed.
36
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
XEROX CREDIT CORPORATION
July 1, 2002 BY: /S/ John F. Rivera
--------------------
John F. Rivera
Vice President, Treasurer and
Chief Financial Officer
37