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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended: June 30, 2004

 

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

incorporation or organization)

 

(I.R.S. Employer

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 by a check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes ¨ No x

 

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 July 31, 2004


Common Stock

   2,000

 

THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT.

 

THIS DOCUMENT CONSISTS OF 26 PAGES

 



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Forward - Looking Statements

 

From time to time we and our representatives may provide information, whether orally or in writing, including certain statements in this Quarterly Report on Form 10-Q 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,” “should,” 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, expected or intended. 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 contained in this Quarterly Report on Form 10-Q and other public statements we make. Such factors include, but are not limited to, the following:

 

Our liquidity is dependent upon the liquidity of our ultimate parent, Xerox Corporation (“XC”). Accordingly, certain disclosures contained herein relate to events and transactions that affect the liquidity of XC and its subsidiaries (collectively, “Xerox”).

 

In 2001, XC announced several Framework Agreements with General Electric Capital Corporation and/or its affiliates (“GE”), including one under which GE would become Xerox’s primary equipment-financing provider in the U.S. Pursuant to this agreement, in October 2002, Xerox completed an eight-year agreement in the U.S. (the “Loan Agreement”) under which GE became the primary equipment financing provider in the U.S., through monthly loans secured by Xerox’s new U.S. lease originations. The Loan Agreement calls for GE to provide funding in the U.S., through 2010, of up to $5 billion, outstanding during any time, subject to normal customer acceptance criteria and secured by portions of Xerox’s current lease receivables. The Loan Agreement also includes opportunities to increase financing levels over time, based on Xerox’s revenue growth.

 

In anticipation of the transactions described above, we stopped purchasing new contracts receivable from XC effective July 1, 2001, which will cause our existing portfolio to ultimately run-off. Further, pursuant to the 2003 Credit Facility (discussed below), we are precluded from purchasing any new contracts receivable from XC. Our portfolio could be further reduced if we sell contracts receivable back to XC, including sales made in connection with future securitizations by XC.

 

The long-term viability and profitability of Xerox’s customer financing activities are dependent, in part, on Xerox’s ability to borrow and the cost of borrowing in the credit markets. This ability and cost, in turn, are dependent on Xerox’s credit ratings. Xerox’s access to the public debt markets is expected to be limited to the non-investment grade segment, which results in higher borrowing costs, until Xerox’s credit ratings have been restored to investment grade. Xerox is currently funding much of its customer financing activity through third-party financing arrangements, including several with GE in various geographies, cash generated from operations, cash on hand, capital markets offerings and securitizations. There is no assurance that Xerox will be able to continue to fund its customer financing activity at present levels. Xerox continues to negotiate and implement third-party vendor financing programs and continues to actively pursue alternative forms of financing including securitizations and secured borrowings. Xerox’s ability to continue to offer customer financing and be successful in the placement of equipment with customers is largely dependent upon maintaining Xerox’s third party financing arrangements and, longer term, upon having its credit ratings restored to investment grade. If Xerox is unable to continue to offer customer financing, it could materially affect its results of operations, financial condition and liquidity.

 

Xerox’s liquidity is a function of its ability to successfully generate cash flow from an appropriate combination of efficient operations and improvements therein, financing from third parties, access to capital markets and securitizations of Xerox’s finance receivables portfolios. With $2.5 billion of cash and cash equivalents on hand at June 30, 2004 and borrowing capacity under its 2003 Credit Facility of $700 million, less $15 million utilized for letters of credit, Xerox believes its liquidity (including operating and other cash flows that it expects to generate) will be sufficient to meet operating requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months; however, Xerox’s ability to maintain sufficient liquidity going forward depends on its

 

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ability to generate cash from operations and access to the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond its control.

 

The 2003 Credit Facility contains affirmative and negative covenants including limitations on: issuance of debt and preferred stock; investments and acquisitions; mergers; certain transactions with affiliates; creation of liens; asset transfers; hedging transactions; payment of dividends and certain other payments and intercompany loans. The 2003 Credit Facility contains financial maintenance covenants, including minimum EBITDA, as defined, maximum leverage (total adjusted debt divided by EBITDA), annual maximum capital expenditures limits and minimum consolidated net worth, as defined. The indentures governing Xerox’s outstanding senior notes contain similar covenants. They do not, however, contain any financial maintenance covenants, except the fixed charge coverage ratio applicable to certain types of payments. The Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to Xerox’s vendor financing program provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of June 30, 2004, $2.6 billion was outstanding under this Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At June 30, 2004, Xerox was in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and expects to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on its liquidity, results of operations and financial condition. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to Xerox. If GECC were to make no further loans to Xerox, and assuming a similar facility was not established, it would materially adversely affect Xerox’s liquidity and its ability to fund its customers’ purchases of Xerox equipment and this could materially adversely affect Xerox’s results of operations. Because we are dependent upon Xerox for our liquidity and have guaranteed the obligations of Xerox under the 2003 Credit Facility, any failure by Xerox to be in compliance with any material provision or any covenant of the 2003 Credit Facility, the senior notes or the Loan Agreement could also have a material adverse effect on our liquidity, results of operations and financial condition.

 

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XEROX CREDIT CORPORATION

Form 10-Q

June 30, 2004

 

Table of Contents

 

              Page

Part I - Financial Information

    
   

Item 1. Financial Statements (Unaudited)

    
         Condensed Consolidated Balance Sheets    5
         Condensed Consolidated Statements of Income    6
         Condensed Consolidated Statements of Cash Flows    7
         Notes to Condensed Consolidated Financial Statements    8
   

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

    
         Results of Operations    10
         Capital Resources and Liquidity    10
         Xerox Corporation Discussion    12
   

Item 4. Controls and Procedures

   17

Part II - Other Information

    
   

Item 1. Legal Proceedings

   18
   

Item 5. Other Information

   18
   

Item 6. Exhibits and Reports on Form 8-K

   18

Signature

   19

Exhibit(s)

   20

 

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 and Earnings to Combined Fixed Charges and Preferred Stock Dividends (Xerox Corporation).
Exhibit 31    (a)      Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     (b)      Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32           Certification of CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements

 

XEROX CREDIT CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(In Millions, except share data)

 

    

      June 30,      

2004


    December 31,
2003


 
                                             ASSETS                 

Investments:

                

Contracts receivable

   $ 183     $ 331  

Unearned income

     (10 )     (21 )

Allowance for losses

     (5 )     (8 )
    


 


Total investments, net

     168       302  

Notes receivable - Xerox and affiliates

     2,153       2,034  

Other assets

     25       25  
    


 


Total assets

   $ 2,346     $ 2,361  
    


 


LIABILITIES AND SHAREHOLDER’S EQUITY  

Liabilities:

                

Notes payable due within one year

   $ 924     $ —    

Notes payable after one year

     563       1,501  

Due to Xerox Corporation, net

     14       37  

Accounts payable and other liabilities

     5       6  
    


 


Total liabilities

     1,506       1,544  
    


 


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

     598       575  
    


 


Total shareholder’s equity

     840       817  
    


 


Total liabilities and shareholder’s equity

   $ 2,346     $ 2,361  
    


 


 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CREDIT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

(In Millions)

 

     Three months
Ended June 30,


    Six months
Ended June 30,


 
     2004

    2003

    2004

    2003

 

Earned Income:

                                

Contracts receivable

   $ 5     $ 16     $ 11     $ 39  

Xerox note receivable

     27       23       49       46  
    


 


 


 


Total earned income

     32       39       60       85  
    


 


 


 


Expenses:

                                

Interest

     13       20       27       40  

Gain on derivative instruments, net

     (8 )     (1 )     (5 )     (6 )

General and administrative

     1       —         1       1  
    


 


 


 


Total expenses

     6       19       23       35  
    


 


 


 


Income before income taxes

     26       20       37       50  

Provision for income taxes

     10       7       14       18  
    


 


 


 


Net income

   $ 16     $ 13     $ 23     $ 32  
    


 


 


 


 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CREDIT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(In Millions)

 

    

Six months

Ended June 30,


 
     2004

    2003

 

Cash Flows from Operating Activities

                

Net income

   $ 23     $ 32  

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

                

Gain on derivative instruments, net

     (5 )     (6 )

Net change in operating assets and liabilities

     —         5  
    


 


Net cash provided by operating activities

     18       31  
    


 


Cash Flows from Investing Activities

                

Proceeds from investments

     126       333  

Net change in derivative collateralization

     —         2  

Proceeds from sales of contract receivables

     8       122  

Net advances to Xerox

     (152 )     (236 )
    


 


Net cash (used in)/provided by investing activities

     (18 )     221  
    


 


Cash Flows from Financing Activities

                

Principal payments on long-term debt and secured borrowings

     —         (267 )
    


 


Net cash used in financing activities

     —         (267 )
    


 


Decrease in cash and cash equivalents

     —         (15 )

Cash and cash equivalents, beginning of year

     —         15  
    


 


Cash and cash equivalents, end of year

   $ —       $ —    
    


 


 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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XEROX CREDIT CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(1) Basis of Presentation:

 

The unaudited condensed 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 2003 Annual Report on Form 10-K (the 2003 Annual Report) and the interim period reporting requirements of Form 10-Q. Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. You should read the unaudited condensed consolidated financial statements in conjunction with such 2003 Annual Report and the notes thereto.

 

Certain reclassifications have been made to prior year information to conform to the current year presentation.

 

All adjustments which are necessary for a fair presentation for the interim periods presented have been made. Interim results of operations are not necessarily indicative of the results for the full year.

 

We engage in extensive intercompany transactions with Xerox Corporation (“XC”) and receive most 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 and our ultimate ability to pay our notes in full are dependent upon the liquidity of our ultimate parent, XC (XC, together with its subsidiaries, “Xerox”). Accordingly, the following disclosures address both our liquidity and that of Xerox, even though not all factors affecting Xerox’s liquidity directly affect our liquidity. Such disclosure should be read in the context in which they are provided.

 

Xerox manages its worldwide liquidity using internal cash management practices which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which Xerox operates, (2) the legal requirements of the agreements to which Xerox is party and (3) the policies and cooperation of the financial institutions it utilizes to maintain and provide cash management services.

 

With $2.5 billion of cash and cash equivalents on hand at June 30, 2004 and borrowing capacity under its 2003 Credit Facility of $700 million, less $15 million utilized for letters of credit, Xerox believes its liquidity (including operating and other cash flows that it expects to generate) will be sufficient to meet operating requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Xerox’s ability to maintain sufficient liquidity going forward depends on its ability to continue to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond its control.

 

The 2003 Credit Facility contains affirmative and negative covenants, financial maintenance covenants and other limitations. The indentures governing Xerox’s outstanding senior notes contain several affirmative and negative covenants. The senior notes do not, however, contain any financial maintenance covenants. Xerox’s U.S. Loan Agreement with General Electric Capital Corporation (“GECC”) (effective through 2010) relating to Xerox’s vendor financing program (the “Loan Agreement”) provides for a series of monthly secured loans up to $5 billion outstanding at any time. As of June 30, 2004, $2.6 billion was outstanding under the Loan Agreement. The Loan Agreement, as well as similar loan agreements with GE in the U.K. and Canada, incorporates the financial maintenance covenants contained in the 2003 Credit Facility and contains other affirmative and negative covenants.

 

At June 30, 2004, Xerox was in full compliance with the covenants and other provisions of the 2003 Credit Facility, the senior notes and the Loan Agreement and it expects to remain in full compliance for at least the next twelve months. Any failure to be in compliance with any material provision or covenant of the 2003 Credit Facility or the senior notes could have a material adverse effect on Xerox’s liquidity and operations. Failure to be in compliance with the covenants in the Loan Agreement, including the financial maintenance covenants incorporated from the 2003 Credit Facility, would result in an event of termination under the Loan Agreement and in such case GECC would not be required to make further loans to Xerox. If GECC were to make no further loans to Xerox and assuming a similar facility was not established, it would materially adversely affect Xerox’s liquidity and its ability to fund its customers’ purchases of Xerox equipment and this could materially adversely affect Xerox’s results of operations. Because we are dependent upon Xerox

 

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XEROX CREDIT CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

for our liquidity and have guaranteed the obligations of Xerox under the 2003 Credit Facility, any failure by Xerox to be in compliance with any material provision or any covenant of the 2003 Credit Facility, the senior notes or the Loan Agreement could also have a material adverse effect on our liquidity, results of operations and financial condition.

 

(2) Sales of Contracts Receivable:

 

During 2001, XC entered into an agreement with General Electric Capital Corporation (“GECC”) whereby XC agreed to sell certain finance receivables in the U.S. to a special purpose entity (SPE) of XC, against which GECC provided a series of loans. This agreement was subsequently amended as part of a new agreement entered into in October 2002, under which GECC became the primary equipment financing provider in the U.S., through monthly securitizations of XC’s new lease originations up to a maximum amount of $5.0 billion outstanding at any one time.

 

In connection with these agreements, we sold contracts receivable to XC aggregating $3 million and $8 million during the second quarter and first half of 2004, respectively. No contracts receivable were sold to XC during the second quarter of 2003 and $122 million were sold to XC during the first half of 2003. 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.

 

(3) Due to/from Xerox:

 

As of June 30, 2004 and December 31, 2003, demand loans to XC totaled $2,153 million and $2,034 million, respectively. These amounts, up to a balance of $2,750 million, bear interest at a rate equal to the sum of (i) the simple average of the H.15 Two-Year Swap Rate and the H.15 Three-Year Swap Rate (each as defined in the Master Note between Xerox and us) plus (ii) 2.00% (200 basis points). The rates, including the 200 basis points were 5.51% and 4.46% at June 30, 2004 and December 31, 2003, respectively. The H.15 is a Federal Reserve Board Statistical Release (published weekly) that contains daily interest rates for selected U.S. Treasury, money market and capital markets instruments. We will demand repayment of these loan amounts from XC to the extent necessary to repay our maturing debt obligations, fund our operations or for such other purposes that we determine to be appropriate. Our demand loans made to XC are evidenced by the amended Master Demand Note with XC (the “Master Demand Note”), a copy of which was filed as an exhibit to our 2003 Annual Report on Form 10-K. We from time to time receive non-interest bearing loans from Xerox. Amounts payable to Xerox of $14 million and $37 million as of June 30, 2004 and December 31, 2003, respectively, are non-interest bearing.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Because our liquidity and our ultimate ability to pay our notes in full are dependent upon the liquidity of XC, 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 from its Quarterly Report on Form 10-Q for the quarter ended June 30, 2004. 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 affect us directly.

 

RESULTS OF OPERATIONS - XEROX CREDIT CORPORATION

 

Total earned income was $32 million and $39 million for the second quarters of 2004 and 2003, respectively, and $60 million and $85 million for the first half of 2004 and 2003, respectively. Contracts receivable income represents amounts earned under an agreement with XC pursuant to which we purchased installment sales and lease contracts from XC prior to July 2001. Contracts receivable income declined by $11 million and $28 million for the second quarter and first half of 2004, respectively, compared to the second quarter and first half of 2003 reflecting the decrease in the portfolio of contracts receivable as a result of the decision to stop purchasing new contracts from XC, our sales of receivables back to XC, as well as contracts in the portfolio reaching maturity. Earned income on the XC Master Demand Note was $27 million and $49 million in the second quarter and first half of 2004, respectively, and $23 million and $46 million in the second quarter and first half of 2003, respectively. This income represents amounts earned on funds we have advanced to XC under the Master Demand Note.

 

Interest expense was $13 million and $20 million for the second quarters of 2004 and 2003, respectively, and $27 million and $40 million for the first half of 2004 and 2003, respectively. The decrease reflects lower debt levels, as the result of scheduled debt payments made during 2003.

 

The mark-to-market valuation of our interest rate derivatives resulted in a net gain of $8 million and $5 million for the second quarter and first half of 2004, respectively, as compared to a net gain of $1 million and $6 million in the second quarter and first half of 2003, respectively. These results are due to changes in the valuation of our cross-currency interest rate swaps associated with our Yen denominated borrowings. 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.

 

General and administrative expenses were $1 million for both the second quarter and first half of 2004, compared to an immaterial amount and $1 million for the second quarter and first half of 2003, respectively. These expenses are primarily incurred to administer the contracts receivable purchased from XC.

 

The effective income tax rate for the second quarter of 2004 was 37.0 percent and for the first half of 2004 was 37.3 percent compared to 38.0 percent in the first quarter of 2004. The effective income tax rate for the second quarter and the first half of 2003 was 37.0. percent compared to 39.3 percent for the full year 2003. The changes in effective tax rates reflect the changes in the applicable state tax rates.

 

CAPITAL RESOURCES AND LIQUIDITY - XEROX CREDIT CORPORATION

 

Net cash provided by operating activities was $18 million in the first half of 2004 compared to $31 million in the first half of 2003. The decrease in cash provided by operating activities in the first half of 2004 from the first half of 2003 was primarily due to the decrease in net income, which reflects the decline in contracts receivable income.

 

Net cash used in investing activities was $18 million in the first half of 2004 compared to net cash provided of $221 million in the first half of 2003. Both amounts reflect the run-off of our contracts receivable portfolio as a result of the decision to discontinue purchasing new receivables from XC after July 1, 2001 and the loan of collected funds to Xerox. Accordingly, net collections from investments were $126 million and $333 million in the first half of 2004 and 2003, respectively, as new purchases of investments ceased in the third quarter of 2001. Cash used in investing activities also reflects proceeds of $8 million and $122 million in the first half of 2004 and 2003, respectively, from the sale of receivables back to XC as described in Note 2 to the Condensed Consolidated Financial Statements. In the first

 

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half of 2004 and 2003, contract collections and proceeds from the sale of receivables were offset by net advances to XC of $152 million and $236 million, respectively. The net advances to XC represent the net cash from operations, proceeds from investments and sales of receivables, offset, to the extent required, by cash for scheduled principle payments.

 

No cash was used in financing activities in the first half of 2004 compared to net cash used of $267 million in the first half of 2003. The cash usage in the first half of 2003 reflects principal payments on long-term debt, as no proceeds from new debt were received.

 

As of June 30 2004, we had approximately $1.5 billion of debt outstanding. We believe that the funds collected from our existing portfolio of contracts receivable as well as amounts due under the Master Demand Note with XC will be sufficient to meet our remaining obligations as they mature.

 

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. As a result of XC’s improved liquidity and financial position, management believes our ability to utilize derivative contracts as part of our risk management strategy, described below, has likewise improved. However, we ceased purchasing new contracts receivable from XC during 2001 and our existing portfolio of contracts will ultimately run-off as amounts are collected or contracts are sold back to XC. As a result, our exposures have effectively been limited to the current balances of receivables and related debt and will decrease over time as our portfolio of receivables is collected or sold and debt is repaid. In addition, our Master Demand Note with XC earns interest at a market rate, further limiting our exposure.

 

We had historically entered into certain derivative contracts, including interest rate swap agreements and foreign currency swap agreements, to manage interest rate and foreign currency exposures. The fair market values of all of our derivative contracts change with fluctuations in interest rates and/or currency rates, and are designed so that any change in their values is offset by changes in the values of the underlying exposures. Our derivative instruments are held solely to hedge economic exposures; we do not enter into derivative instrument transactions for trading or other speculative purposes and we employ long-standing policies prescribing that derivative instruments are only to be used to achieve a set of very limited objectives.

 

Parent Company Disclosures

 

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 June 30, 2004.

 

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READER’S NOTE: THE FOLLOWING DISCUSSION HAS BEEN EXCERPTED DIRECTLY FROM XEROX CORPORATION’S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004. 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 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, WHICH ARE INCLUDED IN XEROX CORPORATION’S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004 FILED SEPARATELY WITH THE SEC.

 

Summary

 

     Three Months
Ended June 30,


   

Six Months

Ended June 30,


 

($ In millions)


   2004

    2003

    2004

    2003

 

Equipment sales

   $ 1,070     $ 1,023     $ 2,052     $ 1,921  

Post sale and other revenue

     2,549       2,643       5,156       5,251  

Finance income

     234       254       472       505  
    


 


 


 


Total Revenues

   $ 3,853     $ 3,920     $ 7,680     $ 7,677  
    


 


 


 


Reconciliation to Condensed Consolidated Statements of Income

                                

Sales

   $ 1,759     $ 1,696     $ 3,440     $ 3,285  

Less: Supplies, paper and other sales

     (689 )     (673 )     (1,388 )     (1,364 )
    


 


 


 


Equipment sales

   $ 1,070     $ 1,023     $ 2,052     $ 1,921  
    


 


 


 


Service, outsourcing & rentals

   $ 1,860     $ 1,970     $ 3,768     $ 3,887  

Add: Supplies, paper and other sales

     689       673       1,388       1,364  
    


 


 


 


Post sale and other revenue

   $ 2,549     $ 2,643     $ 5,156     $ 5,251  
    


 


 


 


 

Total second quarter 2004 revenues of $3.9 billion declined 2 percent from the 2003 second quarter including a 2-percentage point benefit from currency. Equipment sales grew 5 percent in the second quarter 2004 reflecting the success of our recent color and light production product launches, as well as a 2-percentage point benefit from currency. 2004 second quarter post sale and other revenue declined 4 percent from the 2003 second quarter as declines in Developing Market Operations (“DMO”), driven by Latin America, and older light lens technology products were partially offset by digital office and production color growth as well as a 2-percentage point currency benefit. The DMO and light lens declines reflect a reduction of equipment at customer locations and related page volume declines. Finance income declined 8 percent, including a 2-percentage point benefit from currency.

 

Total first half 2004 revenues of $7.7 billion were comparable to those for the six month period ended June 30, 2003 and included a 4-percentage point benefit from currency. Equipment sales increased 7 percent reflecting the success of our recent color and light production product launches and a 4-percentage point benefit from currency. Post sale and other revenues declined 2 percent as declines in older light lens technology products and DMO, driven by Latin America, were partially offset by digital office and production color growth as well as a 3-percentage point benefit from currency. The light lens and DMO declines reflect a reduction of equipment at customer locations and related page volume declines.

 

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2004 second quarter net income of $208 million, or $0.21 per diluted share, included an after-tax gain of $30 million ($38 million pre-tax) from the previously announced sale of Xerox’s ownership interest in ScanSoft, Inc. (“ScanSoft”) and after-tax restructuring charges of $21 million ($33 million pre-tax). Second quarter 2003 net income of $86 million, or $0.09 per diluted share, included a $45 million after-tax loss ($73 million pre-tax) on the early extinguishment of debt related to the write-off of the remaining unamortized fees associated with our terminated 2002 credit facility, as well as after-tax restructuring charges of $23 million ($37 million pre-tax).

 

Net income for the six months ended June 30, 2004 was $456 million or $0.46 per diluted share compared with net income of $21 million or $0.00 per diluted share for the same period in the prior year. Net income for the first half of 2004 included an after-tax gain of $83 million ($109 million pre-tax) related to the sale of all but 2 percent of our 75 percent equity interest in ContentGuard Holdings, Inc. (“ContentGuard”), an after-tax gain of $30 million ($38 million pre-tax) from the ScanSoft sale and after-tax restructuring charges of $25 million ($39 million pre-tax). Net income for the first half of 2003 included a $183 million ($300 million pre-tax) charge related to the Berger v. Retirement Income Guarantee Plan Litigation, a $45 million after-tax loss ($73 million pre-tax) on the early extinguishment of debt related to the remaining unamortized fees associated with the terminated 2002 Credit Facility, and after-tax restructuring charges of $28 million ($45 million pre-tax).

 

Capital Resources and Liquidity

 

Cash Flow Analysis

 

The following summarizes our cash flows for the six months ended June 30, 2004 and 2003 as reported in our Condensed Consolidated Statement of Cash Flows in the accompanying Condensed Consolidated Financial Statements:

 

     Six Months Ended
June 30,


 
($ In millions)    2004

    2003

 

Operating Cash Flows

   $ 499     $ 841  

Investing Cash Flows (Usage)

     301       (104 )

Financing Cash Usage

     (698 )     (1,363 )

Effect of exchange rate changes on cash and cash equivalents

     (37 )     18  
    


 


Increase (decrease) in cash and cash equivalents

     65       (608 )

Cash and cash equivalents at beginning of period

     2,477       2,887  
    


 


Cash and cash equivalents at end of period

   $ 2,542     $ 2,279  
    


 


 

Cash flows from operating activities for the six months ended June 30, 2004 were $499 million and reflect pre-tax income of $474 million and the following non-cash items: depreciation and amortization of $343 million, provisions for receivables and inventory of $98 million and net gains on the sale of businesses and assets of $50 million. In addition, net reductions of finance and accounts receivable generated $361 million of operating cash flow. Offsetting these positive items were pension contributions of $249 million, primarily reflecting our election to contribute $210 million to our U.S. plans in April 2004 for the purpose of making those plans 100 percent funded on a current liability basis under government funding rules. In addition, $136 million of income tax payments, $131 million of inventory usage, primarily due to new product introductions, $104 million of restructuring payments and $102 million of on lease equipment investment, further reduced our operating cash flow. The 2004 operating cash flow was $342 million lower than 2003 primarily due to higher pension contributions of $197 million, higher cash usage relating to inventory of $148 million to support our new product introductionsand increased other working capital uses of $178 million, partially offset by reduced restructuring payments of $149 million.

 

Cash flows from investing activities for the six months ended June 30, 2004 of $301 million included proceeds of $186 million from the sale of businesses and investments, primarily consisting of $66 million from the ContentGuard sale, $79 million from the Scansoft sale and $36 million from a preferred stock investment. In addition, $191 million was released from restricted cash during the period primarily relating to the renegotiation of certain secured borrowing arrangements with GE, and $39 million of proceeds were received

 

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from the sale of certain excess land and buildings. These proceeds were partially offset by capital expenditures and internal use software spending of $115 million. The 2003 period included $103 million of capital and internal use software spending and a $34 million increase in restricted cash balances principally related to our secured financing activity, partially offset by $29 million of proceeds from the sale of businesses.

 

Cash flows from financing activities for the six months ended June 30, 2004 primarily consisted of net payments on term and other debt of $909 million, and dividends on our Series B and C preferred stock of $55 million, partially offset by net proceeds on secured borrowings with lease financing sources of $220 million, including $187 million of proceeds from the new U.S. accounts receivable facility described below, and proceeds from stock option exercises of $47 million. Financing activities for the 2003 period primarily consisted of net proceeds from secured borrowing activity of $167 million and the following activity related to the completion of our June 2003 recapitalization plan- net proceeds from the convertible preferred stock offering of $889 million, net proceeds from the common stock offering of $451 million and other net cash outflows related to debt of $2,001 million. In addition, we made debt payments of $560 million associated with our Convertible Subordinated Debentures due 2018 which were repaid in April 2003 upon exercise of a put option by the holders and $295 million of net cash payments on term and other debt.

 

The following table compares finance receivables to financing-related debt as of June 30, 2004:

 

($ In millions)    Finance
Receivables


   Secured
Debt


Finance Receivables Encumbered by Loans (1) :

             

GE Loans – U.S.

   $ 2,862    $ 2,555

GE Loans – Canada

     510      441

GE Loans – U.K.

     708      635

Merrill Lynch and Asset-Based Loan – France

     526      409

DLL-Netherlands, Spain and Belgium

     358      292
    

  

Total – Finance Receivable Securitizations

   $ 4,964    $ 4,332
           

Unencumbered Finance Receivables

   $ 3,301       
    

      

Total Finance Receivables (2)

   $ 8,265       
    

      

 

(1) Encumbered Finance receivables represent the book value of finance receivables that secure each of the indicated loans.

 

(2) Includes (i) Billed portion of finance receivables, net (ii) Finance receivables, net and (iii) Finance receivables due after one year, net as included in the condensed consolidated balance sheets as of June 30, 2004.

 

Our scheduled debt maturities for the remainder of 2004 and 2005 by quarter, and 2006, 2007, 2008 by year and thereafter are as follows:

 

(in millions)    2004

   2005

   2006

   2007

   2008

   Thereafter

First Quarter

          $ 568                            

Second Quarter

            1,346                            

Third Quarter

   $ 754      355                            

Fourth Quarter

     1,551      349                            
    

  

  

  

  

  

Full Year

   $ 2,305    $ 2,618    $ 904    $ 873    $ 836    $ 2,734
    

  

  

  

  

  

 

Of the debt maturities shown in the table above, the amount that relates to debt secured by finance receivables for the years 2004, 2005, 2006, 2007, 2008 and thereafter are as follows: $1,106 million, $1,530 million, $871 million, $373 million, $452 million and $0, respectively. These debt maturities reflect the renegotiation of the payment terms for certain of our U.S. GE secured borrowings during the second quarter 2004 which extended their maturity.

 

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Swap Termination

 

During the first quarter 2004, we entered into two transactions as part of our overall interest rate risk and cost management program. We terminated interest rate swaps with a notional value of $600 million and a fair value of $60 million, including $5 million of accrued interest, during the first half of 2004. The terminated swaps were previously designated and accounted for as fair value hedges against the $600 million Senior Notes due 2009. Accordingly, the corresponding $55 million fair value adjustment to the Senior Notes is being amortized to earnings over the remaining term of the notes. We also entered into pay variable/receive fixed interest rate swaps with a notional amount of $600 million associated with the 2027 liability to Capital Trust I. These swaps were designated and accounted for as fair value hedges.

 

Liquidity, Financial Flexibility and Funding Plans:

 

We manage our worldwide liquidity using internal cash management practices, which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are a party and (3) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services.

 

Our current credit ratings remain unchanged from December 31, 2003 and are as follows:

 

    

Senior Unsecured Debt


   Outlook

  

Comments


Moody’s (1) (2)

   B1    Stable    The Moody’s rating was upgraded from B1 (with a negative outlook) in December 2003.

S&P

   B+    Negative    The S&P rating on Senior Secured Debt is BB-.

Fitch

   BB    Stable    The Fitch rating was upgraded from BB- (with a negative outlook) in June 2003.

 

(1) In December 2003, Moody’s assigned to Xerox a first time SGL-1 rating.

 

(2) On June 29, 2004, Moody’s issued a press release placing the long-term debt rating of Xerox and its supported subsidiaries under review for possible upgrade.

 

Our ability to obtain financing and the related cost of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. Our current credit ratings are below investment grade and we expect our access to the public debt markets to be limited to the non-investment grade segment until our ratings have been restored. Specifically, until our credit ratings improve, it is unlikely we will be able to access the low-interest commercial paper markets or to obtain unsecured bank lines of credit.

 

Accounts Receivable Financing

 

In June 2004 we completed a transaction with General Electric Capital Corporation for a three-year $400 million revolving credit facility secured by U.S. accounts receivable. As of June 30, 2004, approximately $187 million was drawn, secured by $305 million of accounts receivable. This arrangement is being accounted for as a secured borrowing as both the accounts receivable and related borrowings are reflected in our condensed consolidated balance sheets.

 

Summary—Financial Flexibility and Liquidity:

 

With $2.5 billion of cash and cash equivalents on hand at June 30, 2004 and borrowing capacity under our 2003 Credit Facility of $700 million, less $15 million utilized for letters of credit, we believe our liquidity (including operating and other cash flows that we expect to generate) will be sufficient to meet operating requirements as they occur and to satisfy all scheduled debt maturities for at least the next twelve months. Our ability to maintain sufficient liquidity going forward depends on our ability to continue to generate cash from operations and access the financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

 

Financial Risk Management

 

As a multinational company, 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. As a result of our improved liquidity and financial position, our ability to utilize derivative contracts as part of our risk management strategy, described below, has substantially improved. Certain of these hedging arrangements do not qualify

 

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for hedge accounting treatment under SFAS No. 133. Accordingly, our results of operations are exposed to some volatility, which we attempt to minimize or eliminate whenever possible. The level of volatility will vary with the level of derivative hedges outstanding, as well as the currency and interest rate market movements in the period.

 

We enter into limited types of derivative contracts, including interest rate swap agreements, foreign currency swap agreements, cross currency interest rate swap agreements, forward exchange contracts, purchased foreign currency options and purchased interest rate collars, to manage interest rate and foreign currency exposures. The fair market values of all our derivative contracts change with fluctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Our derivative instruments are held solely to hedge economic exposures; we do not enter into derivative instrument transactions for trading or other speculative purposes and we employ long-standing policies prescribing that derivative instruments are only to be used to achieve a very limited set of objectives.

 

Our primary foreign currency market exposures include the Japanese yen, Euro, British pound sterling, Brazilian real, and Canadian dollar. For each of our legal entities, we generally hedge foreign currency denominated assets and liabilities, primarily through the use of derivative contracts. In entities with significant assets and liabilities, we use derivative contracts to hedge the net exposure in each currency, rather than hedging each asset and liability separately. We typically enter into simple unleveraged derivative transactions. Our policy is to transact derivatives only with counterparties having an investment-grade or better rating and to monitor market risk and exposure for each counterparty. We also utilize arrangements with each counterparty that allow us to net gains and losses on separate contracts. This further mitigates the credit risk associated with our financial instruments. Based upon our ongoing evaluation of the replacement cost of our derivative transactions and counterparty credit worthiness, we consider the risk of a material default by any of our counterparties to be remote.

 

Some of our derivative contracts and several other material contracts at June 30, 2004 require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are reported in our Consolidated Balance Sheets within Other current assets or other long-term assets, depending on when the cash will be contractually released.

 

READER’S NOTE: THIS CONCLUDES THE DISCUSSION EXCERPTED DIRECTLY FROM XEROX CORPORATION’S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004.

 

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Item 4. Controls and Procedures

 

(a) Evaluation of Disclosure Controls and Procedures

 

Under the supervision, and with the participation of our management, including our principal executive officer and principal financial officer, as of the end of the period covered by this report, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our Securities and Exchange Commission (“SEC”) reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms relating to Xerox Credit Corporation, including our consolidated subsidiaries, and was made known to them by others within those entities, particularly during the period when this report was being prepared.

 

(b) Changes in Internal Controls

 

During our second fiscal quarter, there were no significant changes in our internal controls over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, such controls.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

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 Ratio of Earnings to Fixed Charges (Xerox Credit Corporation).
    (b)    Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends(Xerox Corporation).
Exhibit 31   (a)    Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
    (b)    Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32        Certification of CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

  (b) Reports on Form 8-K.

 

None.

 

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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
       

(Registrant)

August 9, 2004

      BY:  

/s/ JOHN F. RIVERA

               

John F. Rivera

               

Vice President, Treasurer and

               

Chief Financial Officer

 

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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 Ratio of Earnings to Fixed Charges (Xerox Credit Corporation).
    (b)    Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends(Xerox Corporation).
Exhibit 31   (a)    Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
    (b)    Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32        Certification of CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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