全錄公司 (XRX) 2002 Q2 法說會逐字稿

- differ materially is included in the company's first quarter 10-Q filed June 30th, 2002. At this time I would like to turn the meeting over to Miss Anne Mulcahy. You may begin.

Good morning. Thank you for joining us today. By now you have seen our second quarter results which includes earnings of 12 cents per share. A return to profitability that reflects the company's strongest performance in two years. It is an important milestone in the transformation of our company and speaks to the effective execution of our plan to return Xerox to good health and build value for our stakeholders.

I will introduce Larry Zimmerman our new Chief Financial Officer that will review the assessment of the business as well as the company's liquidity's position. Following Larry, I will discuss our expectations for the rest of the year.

Before I begin the Q2 review I would like to comment on the recent financial announcements. First, as we committed in April we completed the renegotiation 6 our credit facility paying down 2.8 billion, and refinancing the remaining 2.4 million. New credit totals two loans. The remaining term loans on the revolving line of credit have a final maturity of April 30th, 2005. This new arrangement includes a higher interest expense and some additional covenants that we expected and have factored into our business forecast.

As we said before our intent is to continue strengthening Xerox's financial position ensuring maximum flexibility. The successful negotiation of the revolver is a step in the right direction.

The good news on the revolver was followed shortly by the filing of Xerox' 2001 10-K, including a restatement for years 1997 to 2000, as well as adjustments to previously announced 2001 results.

Certainly this was a complex and massive document and I recognize that members of the investment community have taken substantial time to understand the detail of the issues and I appreciate your efforts in providing a balance and fair analysis.

To bring a final close to this issue I believe it is critical that I reiterate: Of the bulk of our issues with the SEC had to do with the accounting methodology that we used to account for revenues from bundled lease contracts. The issue had to do with timing and issue of revenue but not the amount or value. Under the terms of the settlement we neither admitted nor denied the allegations. The issues do not relate to creation of revenue. All the revenue is real and represents clear customer commitments. The monetary value of customers contracts has not changed and there is no impact on the cash that has been received or its contractually due to be received.

With the change in methodology all our bundles contract revenue has been reapplied by revenue streams, equipment, service, rental, financing, and supplies and by year. As a result the restatement reflects a revenue reduction of about 1.9 billion dollars or roughly 2% of total revel from the five-year period which will flow through to future years. An important fact that is absent from most media reports. Let me be very clear.

Xerox, the company, has settled with the SEC. We changed our methodology for accounting. We completed an audit for recent years. We put this issue behind us and we are moving on.

In fact, our results today are evidence that indeed we have. Despite economic challenges, Xerox has maintained its relentless focus, executing on a set of turn around objectives that are designed to ensure the long-term success of our company. And we have delivered.

For Q2 our intense focus on operational improvements has strengthened the bottom line leading to net income for the quarter of 93 million dollars or 12 cents per share, that includes restructuring of (inaudible), and three cent loss from unhedged currency. Operational metrics are trending in the right direction. Let me start with gross margins that improved by 3.4 percentage points to 42.5%.

Approximately two-thirds of this increase reflects our exit last year from the [Soho Bliss] with the remaining increase due to improved manufacturing and service productivity. All of which more than offsets competitive pricing pressures in the quarter.

More good news. SG and A spending declined 9% in the quarter reaching the lowest level in more than two and a half years. We expect our full year SG and A bend to be less than SG and A expenses from two years ago. This reduction is a strong indicator of the benefits from the cost initiatives that offset (inaudible) in advertising spends and professional fees with the SEC settlement, the state and other related activities.

Operating cash flow was 541 million dollars in the quarter. We certainly expect to continue generating positive cash for the balance of the year. While we focused on cost reduction there is one area in which quite intentionally we have sustained our investments. Research and development spending for the quarter remains consistent at 6% of revenue.

Last year we told you that we had exceeded our 1 billion dollar cost reduction target delivering more than 1.1 billion dollars in savings out of analyzed cost base. We said we would take additional actions to offset revenue declines from the economic environment. These actions included the reduction of 2200 positions in the second quarter bring Xerox's worldwide employment to 72, 400. Year to date we implemented initiatives that will reduce costs by an additional 175 million dollars. And we will restructure, capturing additional savings as we continue to transform and strengthen our business model.

As important are the actions we are taking to strengthen our liquidity and restructure our balance sheet, and Larry Zimmerman will fill new on these details.

As you know Larry joined Xerox at CFO on June 31st after years at IBM. His extensive knowledge and demonstrated success in worldwide (inaudible) planning complements the strength of Xerox's management edema team. We are delighted to have him on board. Larry.

Thank you, Anne. Good morning everyone. It certainly is great to be here today particularly on this day when we have good news to share with you. As you might imagine a lot of people asked me why I came to Xerox. So that's probably a good place to begin. My decision was based on my desire to be part of a large global company with a strong brand and market presence. Leading edge technology, excellent people, and a solid leadership.

Xerox has all of these. I wanted one other thing, a place where my skills matched the needs of the company and complemented those of the CEO. I found all of that at Xerox. So what are my first impressions of Xerox? I found smart, hard-working high integrity loyal employees. What I expected. I found significant focus and progress on ensuring the company is competitive on technology and cost. What I expected.

And finally I found the leadership to be focused on the right issues with the resolve to continue to be aggressive, exactly what I expected.

I know we continue to be in the spotlight, but the real story at Xerox is about all of the hard decisions that have been made and effectively executed in the last two years.

I believe I am at the right place at the right time. Now why am I confident in the future success of the company? Three reasons. First it is clear to me we are continuing to make operational improvements that will support sustained profitability and improve liquidity. This is fundamental to our success. This management team has the mind-set and the perseverance to set tough expectations and meet them. You have seen that over the past year and a half and I can tell you that it is even more impressive to see it from the inside.

Second, the management team and the entire organization are focused on future growth. Growth and operational improvements at the same time. We understand that we need to do both, cut costs and grow revenue. Third, this company has developed a deep understanding of customer needs. We have superior technology to meet those needs, and a clear strategy to make sure we marry the two. Stabilizing revenues and then a return to growth will take some time but the question is not if but how soon.

So what do I see as my role and my priorities? First, and foremost, to drive improved performance reflective of an investment grade company. We will get there by delivering sustained profitability generating operational cash and making Xerox a more efficient company. We have a clearer road map for all three and the resolve to make them happen. We get there by strengthening the balance sheet, monitoring key financial metrics including total debt to EBITDA, operating cash flow to total debt and EBITDA to interest expense. We are clearly committed to moving these metrics to investment grade levels.

Second, we will also continue to improve the control environment. We have a strong commitment to the highest integrity of internal controls and financial reporting. Anne, the management team and I are totally committed to this. Here are some initiatives we are implementing. Ensuring roles and responsibilities are clear throughout the finance function, which includes reinforcing the roles of our chief accountant, internal auditors, Ernst and Young, and our external auditors, Price Waterhouse Coopers. Reviewing, re-engineering and simplifying our reporting systems and processes and finally piloting company peer reviews are a great way to benchmark arm's length feedback and external perspectives.

These new initiatives further strengthen the actions already implemented in the last two years. Third, you can expect us to continue our efforts to improve efficiency in all areas of the business. By improving our cost base and our processes, we will become more competitive on a global basis.

Finally, all of these priorities lead to a most important goal, building shareholder value and confidence. On this point, building confidence and trust, I learned over the years that trust is something you earn. And I believe it starts with me. My objective with you is to be predictable and accountable. I will be straightforward with you and I expect the same in return. Good open two-way communication is the goal.

Consistently delivering what we commit is how we will continue to build value and confidence. Now let's turn to how we are going - doing on one of our key priorities, liquidity. We started the quarter with 4.7 billion in cash and ended June with 1.9 billion. During the second quarter we paid down approximately 4.2 billion of debt, including the 2.8 billion payment on the revolver. We received cash proceeds of about 700 million from additional GE Capital loans secured by receivables in the United States, the United Kingdom and Germany, and we received 200 million from the sale of our equipment financing business in Italy.

Importantly, net cash flow from operations was 541 million in the quarter, about 60% of this cash was generated from the run off from the finance receivables portfolio with a balance primarily from income from operations. Our total debt of 14.3 billion is down 3.2 billion from the end of the first quarter. 2.1 billion of debt comes due in the second half of this year with another 3.7 due in 2003.

We expect to meet these debt obligations and the related interest payments through a combination of operating cash flows including cash flows of a run off of 10.9 million gross receivables portfolio and additional finance receivables securitizations.

To provide additional financial flexibility we intend to take advantage of the appropriate opportunities to access the capital markets. Capital spending was about 45 million for the quarter, and is 71 million on a year to date basis. We expect it to increase in the second half and expect our 2002 full year spendings to be close to our prior year spending level of 219 million.

Let me now provide you with a brief update on the third part of vendor financing, in our business.

Diversified portfolio is 10.9 billion of gross finance receivables support the debt - the financing debt. About 85% of our finance in receivables portfolio runs off in three years.

In the second quarter we continued to make good progress. First, we successfully launched Xerox Capital Services with the GE Capital in the U.S. to manage our back office places where we are already seeing positive results. In April we announced an additional billion dollars in the U.S. of securitizations arrangements with GE Capital to fund current year activations of which we received 496 million net of fees.

We are continuing to execute on the details of transaction funding on GEC, and examining alternatives for the most least disruptive mechanism with the objective to have this in place by the end of the year.

We also made steady progress in Europe during the quarter. In Italy we sold our leasing business to third party who is providing an on going exclusive equipment financing to our customers. In Germany we began financing some of our equipment transactions with GEC. In France we continued contract negotiations with GEC as well as the work required with the various French regulatory agencies. We have already implemented third party financing arrangements in the Netherlands and in the Nordic countries.

In Latin America we implemented third party financing arrangements this quarter in Brazil and Mexico. Additionally, we do have third party arrangements in place in a number of smaller countries in which we operate.

Let me reaffirm our expectations by vendor financing. By the end of the year we expect two-thirds of all lease we previously would have financed ourselves will be financed through third parties. This will happen through direct financing, receivable securitization and ongoing secured borrowings.

Finally I want to discuss how you should think about our business going forward. I would like to make three points. First, the restatement is done. There are - these are historical results and reflective of our business under our new accounting methodologies. The second point our 10-K indicates we anticipate recognizing revenues of 1.9 billion through 2006 including 800 million this year. This reflects a cumulative impact of the revenue adjustments to periods prior to 2002.

This adjustment needs to be calibrated against the following offsetting factors: The lease is in the effect at the time of the restatement are subject to marketplace activity such as trades and cancellations. The application of new accounting methodology and other accounting changes will result in more revenue being recognized over time versus up-front as equipment sales.

We have shifted our business in Latin America to an operating lease model and we have plans to move a portion of our document outsourcing arrangements to an operating lease basis in line with customer requirements.

My third point is our recurring revenues post sale and financing now account for about three quarters of our total revenue up from about two-thirds on a prerestated basis. The key message you should take away from these points is the changes to our business model will result in a more predictable revenue stream as we realize over time a greater share of recurring revenues and less equipment sales revenue.

So let me sum up. I am delighted to be here. I found what I expected. Great people, great leadership, clear strategic direction, opportunity for growth, and the will to do the right things to make Xerox successful. I am confident we are on the right track to build shareholder value and restore Xerox to investment grade.

Thanks for your time. And now let me turn it back to Anne.

Thanks, Larry. With the fundamentals of our operations substantially improved and our financial position strengthened, we have laid the foundation to grow market share threw new product launches and expanded sales channels. The recap of the revenues for the second quarter. We reported Q2 revenue of 4 billion dollars decline of 8 million from Q1. 30% of the decline is due to exit last year from the Soho equipment business, as well as reductions and developing market operations.

We have been talking a lot about the changes we are making to our business model in DMO. It is a significant transition to a structure which is designed to prioritize cash and profitable revenue. It is paying off. Key DMO regions are stabilizing in the entire DMO business was profitable in Q2 despite currency exchange losses. Revenue declined operations in north American and Europe delivered another quarter of profits recording the flow through, and strong parts in our key segments. Most impressive is our office color, which is from the Phaser 6200 laser printer and Phaser 8200. Both printers launched in May and both are winning customers and competitors market share. From North America and Europe we project a gain in market share gained by the.

In office black and white, the digital multifunction line was more than offset by declines in light lens copiers. We continue to take action on driving up revenues.

As growth we are well positioned to capture through superior technology and competitive prices. We have raised the bar with the launch of the Document Center 500 series that offers features for small and midsized work groups at lower manufacturing costs for Xerox and lower prices for our customers. These are the first products brought to market in collaboration with Flextronics.

Operating profit in our office business improved by 40 million dollars in the quarter to 138 million dollars, an important measurement of the progress we made to strengthen the key business. Operating margin improved by 2.7 percentage points to 8.3% reflecting our focus on more profitable revenue and benefits of cost reduction activities.

We are seeing similar progress in production business. It improved year over year from 2 points to 9.1% despite competitive price pressures. Color again is the headline in this core business with the DocuColor 2000 product line, DocuColor 2060 and 45. And the DocuColor 12. These increases were offset from the previous generation of color products, a gap we plan to close with a new product. That offers competitive speeds and benchmark costs of less than 10 cents a page. Q2 the production monochrome business declined showing market declines in North America and Europe. However through the DocuTech line we continue to solidify (inaudible) gaining share despite the overall market decline.

Finally the revenue story wouldn't be complete without the we minder of the initiative to drive future growth. We are accelerating the marketing initiative and continue to do so through the year. We launched products in the office and production markets, and are adding answers to our customers in areas like wireless document retrieval, and printing as well as knowledge and content management.

We are also strengthening and expanding our marketplace coverage. Our sales territories are virtually full. Direct sales force is focusing more and more on the high value end of the market while we significantly expand our (inaudible) to teleweb and indirect channels. Our customers are responding.

Multimillion dollar contracts and renewals were signed in Q2 with companies like Verizon, Siemens Medical Systems, Atomic Energy, Sarah Lee, U.S. Department of Agriculture, and University of Tennessee just to name a few.

Many of these deals represent competitive knockouts, a growing trend. In fact, this week we signed a major public sector contract in Colorado knocking out 140 Cannon products. It is clear we are winning customer confidence by providing the technology support and service to help customers find better ways to do great work. We aim to win the confidence of all of our key stakeholders by building value in the company.

We are doing that by executing with precision on well defined strategies, and focusing on operational performance and core growth opportunities by generating cash and reducing debt by fostering innovation and superior technology, and developing superior people and investors in the long-term investment of Xerox. Underlying all of our operations and financial reporting is a commitment to ensure the highest ethical standards and integrity of Xerox's global business.

As we head in the second half of this year, we will continue to build momentum. However, we expect the continued economic uncertainty will challenge the top line in the second half. For the balance of the year we expect earnings to be in the range of 9 to 12 cents per share reflecting the continued benefit of operational improvements, partially offset by higher interest expenses and intensified focus on restructuring activities and higher effective tax rate. So clearly, we are on track to deliver full year profitability.

In closing, let me reiterate that we feel good. No. Great about our Q2 results. The company's operational performance in the quarter demonstrates that we have effectively execute and delivered on all our turn around objectives. Our customers are responding. Our employees are encouraged. And our momentum continues to build.

I can't say it enough, our performance is all about building value for our shareholders and customers. We are making progress and it shows. So I thank you for joining us today. Larry and I will now be pleased to take your questions. 00:26:47

Thank you. If you have a question please press the one on your touch-tone phone. All participants are asked to limit themselves to one question.

Our first question comes from Jonathan Rosenzweig from Salomon Smith Barney.

Congratulations on a great operational performance. Just some clarifications. Anne, can, can you give us any idea what the charges will look like ahead. You mentioned second half of revenue would be challenged by the economy that is not in a real surprise, can you give us some idea. Are we expecting growth in the second half or expecting it to be down and down low single digits, some parameters to put around that.

John, I think on restructuring I mentioned that we do tend to intensify restructuring during the second half. We did not do a lot of restructuring in Q2. We had a lot going on with the restatement and reaudit. But we do intend to pick up the pace in the second half. I think that will be somewhere, you know, potentially around 175 million. I think we are very foe kissed on certainly executing precisely against well defined restructuring plans. We are still working on that. I think that is a reasonable range.

After taxes?

No.

Before tax.

Yes. I think on revenue, our expectations are that revenue will continue to I am proving sequentially, John, but not grow. And will continue to certainly see revenue decline at a lower rate. I think there are a couple of things here that are important.

Obviously, sequential improvement is really important to us as we look at the revenue flow. But a lot of the new products that we have introduced certainly we have introduced as very competitive prices so that we will see more leverage on the activity and share results than we will see on the revenue results. But most importantly we will see a better hit as it relates to the growth profit line because of the efficiencies of the new products we are bringing to market.

We are optimistic in terms of certainly our ability to increase activity, build share, sequentially progress on the revenue front and frankly get a better hit for every dollar of revenue.

Just to clarify, it is 9 to 12 cents in the second half for Q3 and Q4, and 175 pretax restructuring for the second half combined?

Absolutely. The only thing I would say is on the restructuring, we are still working very hard at quantifying and making sure we have the specific plans in place. That's a range I think more than a precise number.

Are your revenue assumptions you kind of went through including benefits from foreign exchange or is that excluding it.

Totally excluding any currency impacts.

Next question comes from the Ben Reitzes of UBS Warburg.

Two-part liquidity question. First, clarification on the cash flow. As I add up the two quarters, and the way I like to look at cash flow, and you can tell me if it is valid. I exclude financing. And if I include interest payments versus operating cash flow, I have about negative 25 million. And I was wondering how that will play out in the second half of the year if you expect to generate cash against your - including interest payments in the second half of the year. And then I have a follow-up liquidity clarification.

Ben, I am actually going to have Greg Taylor, our treasurer answer that question. I might begin and talk a little bit about cash flow and certainly 541 million in the second quarter represented I think - we I think we might have mentioned about 300 from finance and cash flow, but a positive contribution on the non-finance and cash flow, you know over 200 million. I don't want to lose sight of the fact that non-financing cash flow was strong, driven by net income improvements. I think it is important to keep the finance and cash flow in mind because it obviously is part of the entire liquidity strategy as we look to our debt and the fact that the vast majority of our debt is in financing. And the financing cash flow which I think we said 85% of it runs off in the next three years. It certainly is critical, you know to that.

I will now turn it over to Greg, and see if he can characterize a little bit about your question. I am not sure we do include interest. I don't think we do, Ben. That's separate calculation for us. But let me have Greg address the cash flow.

Ben, in our cash flow we talked about for the quarter 540 million cash flow from praising activities. That does include the interest payments in that line item. It also includes the interest income on our finance receivables. So there is a degree of symmetry. An important point I think to look at for the first half is in the first quarter we had a large payment for Fuji Xerox of 346 million dollars tax payments on our sale of Fuji Xerox that occurred in the prior year. The proceeds of which would have been treated previously as investing activities, below cash flow from operations. If you exclude that item, first half we have generated from cash flow from operations of close to a billion dollars. And we are continuing to target those improvements through the second half. And the only item that is of significance that would affect what is in our plan will be the level of cash restructuring payments as Anne talked earlier about what we are targeting the second half, as well as the movements on revenues.

Maybe off-line we can talk about it. I am talking about the operating cash flow line, and EBITDA line, and interest payments below. And if you add the numbers out, accounting for interest, -

Many ways to look at this and we have chosen to go with the operating cash flow definition, included in our GAAP statement.

Ben, we will be happy to spend more time and make sure we fully respond to your question.

When you look at a leasing business, maybe Larry has insight on this, what typically happens is that when you have a large leasing business, you have a large deferred tax benefit. And you are able to reap that benefit in your free cash flow over the time that you are building your lease portfolio. Now that you guys are getting out of the leasing business, and downsizing that, is there some kind of catch up in tax payments that we can effect, see later on, and what does that do to your cash flows? I assume if you are shrinking your lease portfolio you would no longer have that tax benefit. I am wondering what the cash flow benefit is over the next few years. Do you have any insight.

Only insight. I don't think there is a catch up on any cash tax payments. It is not something you are looking back at in a different way.

And there are different tax implications - you are right - to not being in the leasing business and still being in - being in outright sales. Cash payments on the tax books probably go up when - as you move forward with that.

Is there anything quantifiable to versus what we are going to see maybe this year and then how that will be next when you cross into the two-thirds threshold?

I don't have anything quantifiable right now, but that's something we can talk about.

Next question comes from Gibboney Huske from Credit Suisse First Boston.

Thank you very much. Can you give us an update what your expectations are in terms of funding events for the second half? I know you still have spending left under the U.S. GE Capital deal and other things you are expecting. Can you give us a sense where you are at this point?

Gibboney, I will start and I think we have announced an agreement as it relates to funding with GE Capital that will certainly allow for two more (inaudible) of funding throughout the balance of the year, a third and fourth quarter funding event. We also talked about our expectations in Europe as well, that revolve around certainly Germany and France. Primarily Germany, and France. Other small countries. Those are the ones that were out looking as well to take place for the balance of the year. Those are the primary ones we are looking at and built into the plan for the balance of the year.

Is that about 500 million for the incremental GE Capital based on the U.S. number is that right? Or is it a little more?

Little bit more. Could be roughly 600 million for the U.S. And in addition to Europe there are possibility of additional funding from Canada as well. We have had past fundings with the Canadian portfolio with GE.

Gibboney, Larry mentioned we are certainly more than adequately prepared with regard to the funding that we have talked about in order to meet certainly our maturing debt. But that we may be tapping the capital markets opportunistically at some point as well.

Did you get size expectations? I know there have been some questions around how Germany and France would actually be implemented and, yeah, the size as it would occur this year. Is that settled at this point? Can you give me any sort of range?

Germany from a portfolio point of view has closed on a (inaudible) of the German portfolio, and it was roughly below 100 million dollars. And we are now moving Germany towards more business activations opposed to the (inaudible). France is a movable target depending what is happening with the regulatory environment as we are working with GE on the existing portfolio.

On an operating perspective, you said you indicated sequentially expected improve but revenue to be down year over year. Just thinking about the (inaudible) of Q3. Seasonally with Europe it is very weak. But at the same time you obviously have a lot of new product shipping that seems on a top line perspective foreign exchange would be favorable if current trends hold up. Does that mean you go against the seasonal trend of being down?

No. I am glad you asked that question. I need to clarify. Year over year kinds of comparisons we expect to improve on the revenue front. But there is no question that seasonally our third quarter is always weaker and driven by Europe. So it doesn't mean that it will be sequentially better from Q2 to Q3. But the declines will be sequentially better when you do the year over year comparisons.

Do you have a sense of timing or the logistics in terms of covenant reset that is built into your credit agreement and when we would get additional color on what the new covenants are?

Certainly by the end of September.

Our next question comes from Peter Ausnit of Deutsche Banc.

Thank you. Congratulations on the quarter. Can you separate the effects of the economy from composition in the last quarter?

I think probably the best way to talk about it Peter is really to talk more about market share I would look and say although Q2 market share really isn't out, we are obviously tracking it very, very closely. I would say in most of our key segments we have either maintained or grown share in the segments we are participating in. So overall we feel that we are gaining ground as it relates to our competitive faceoff. And therefore, a lot more of the revenue issue quite frankly is economically driven than competitively driven. Now having said that, obviously there is a lot of competition in the market and certainly we are keeping a very close eye on the competition and taking it very seriously. But I would say that although it is preliminary, our Q2 data from a share perspective would say in key categories we have either stabilized or gained share.

Okay. And obviously congratulations on that then.

To follow up on Gibboney's question, you discussed opportunistically tapping the capital markets at some point when your operations are more stable and when you have turned around the company still further.

Can you give us some sense of the size of the capital raising that you have considered at this point?

I would say it is not about the operational strength of the company. We think the company is really pretty stabilized and strong operationally. I think it has more to do with the economy and really judging when it is opportunistic for us to tap the capital markets. I think that will be both timing and size. It would be difficult to characterize it at this point in time.

Lastly, I guess we can assume all of the securitizations and all of the capital you have gotten from GE and other third parties, those are captured on the balance sheet at this time?

Yes.

Our next question comes from Steven Weber of SG Cowen.

Couple of questions. Number one, could you - what kind of seasonality are you planning from an equipment sales standpoint from the fourth quarter. In last years you got a big bump. And are you counting on - how much of that are you counting on. When do you expect to see revenue and equipment sales grow on a year on year basis? Will it happen in fourth quarter or are we looking out into 2003?

A couple of things on - this is specifically about equipment sales revenue?

Yes. But you can talk about revenue broadly too, if you would.

I think we would look at Q4 and say from an absolute perspective we do expect seasonality to deliver the strongest equipment sales revenue of the year. It won't be perhaps as strong as it has been in the past for a couple of reasons.

As I discussed before, you know, we are certainly looking at new products having a big impact on certainly share and activity of but because of the fact that they are priced so competitively, the revenue hit might not be as strong although certainly the gross profit flow through will be quite positive. In absolute terms Q4 will be the strongest quarter. I would say on a comparative basis I think we are looking at flat year over year.

I should add to that as well that with the restatement and the changes in our accounting methodology, a lower portion of our revenue is now in equipment sales versus recurring revenues. I think we used to be about a one-third two-thirds company, meaning a third in equipment sales, and two-thirds in annuity, now it is about 25% in equipment sale and three quarters in recurring revenues. Which we think is a good thing. But it does impact the leverage that we have in equipment sales going forward.

So that kind of talks to the Q4 piece, and some dynamics going on. I think it is really difficult for us to talk about revenue based upon the economic impact. And I think it is really very dependent quite frankly on seeing a stronger return in the economy and the IT spend for us to be able to project certainly beyond Q4. I would say we are being pretty conservative and looking to deliver we think some strong operational expectations without the dependency on strong revenue growth.

If I could follow up. You have talked some about the pricing of these new products and the gross profit. You had pretty impressive step up in sales gross margins and overall gross margins in the second quarter. Can you talk on how sustainable that is. And I am particularly referencing back to the 10-K that said you expected at that point at least you expected - which is not that far back - but you expected 40%. Are you more positive at this point?

Obviously I think it is fair to say gross margins exceeded our expectations for Q2, at 42.5%. Apart from that the exit to Soho, that obviously had a big contribution, its service and manufacturing productivity of the we are really seeing really terrific flow through. I think more than - it is more than offsetting any price settings we are feeling in the marketplace. I am not looking to sustain a 42.5% going forward. We will make investments to really begin to leverage the top line.

What we have in the business model I would say would be good. But I think for the remainder of the year we will remain north of 40% for sure.

Next question from Shannon Cross from Merrill Lynch.

I wanted to drill more down into the costs. Just looking at like you were talking about the gross margin. But how much of this - or is any of it attributable to earlier than expected benefit from Flextronics? And then on the SG and A side, what do you anticipate in terms of continuing head count reductions?

Okay. We are pretty pleased with Flextronics. Although I would have to say that it is still early days to declare victory in terms of flow threw.

I would say this, we were seeing less and less productivity in our office business in terms of manufacture and flow through prior to outsourcing to Flex. And we certainly have seen Flex deliver good news to us. Although that should get better over time as we have more experience with them.

So we are really pleased with plex. Although I think it would be fair to say we still haven't seen what I would call the full capabilities of Flex from a productivity perspective. On the other hand, some flow through on the cost side, the good news was on the high end where we did deliver excellent productivity. Obviously the Xerox part of the manufacturing value chain. So I think that was also good news.

As it relates to SG and A. I think we are still focused in our business model. We said we expect to get into the low 20s, on SG and A. We are on a steady pass - we took 110 million downs in the second quarter. And reduction. We are on a steady path to reduce SG and A. We are doing it thoughtfully. But we will continue on that path from an absolute standpoint.

Cost reduction side, obviously we stated we are looking to deliver that next billion dollars of cost reduction and you don't do that without impacting head count. So we will continue to reduce head count. And we will certainly announce those actions as we go.

Can you give us any idea, because you mentioned that SG and A was hit by some extent of professional (inaudible) relating to the accounting restatements and the lawyers have to get paid and all of that.

Any idea on the magnitude of that in the quarter?

Far too much. I think it has been pretty well disclosed in some of the statements we did on the restatement. And I can't be totally precise. I think the charges associated with the reaudit and restatement were about 22 million additional fees. And plus all of the legal fees which unfortunately were also quite high.

I am gonna estimate somewhere between 30 and 50 million dollars of fees that I would call certainly non-repeatable as we go forward.

Those would have been in the first two quarters of the year?

Yeah. Although the second quarter was the intense portion of it particularly with regard to the auditing fees.

And then you hadn't mentioned I don't think anything on Igen3. Any update there?

I think we are obviously in beta test at customer locations. We said when we finished with Ipax and on demand we wouldn't continue to update the amount of reservation orders that we have. But we are really pleased. We think it is going really well. We are confident about the expectations we set for next year with regard to three to four hundred installs. And we will be launching in Q4.

Next question comes from Solin Cho of Morgan Stanley.

It looked like the DMO return to profitability might have occurred a little sooner than we expected. Was there anything one time that occurred in the second quarter to drive the profitability? Or should we expect continued improvement from here?

I think it would be fair so say that the amount exceeded our expectations in terms of return to profitability.

Although it is modest profitability, the fact is that it also was offset against more than 20 million dollars against negative currency. It was a stronger return to profitability than showed. I would say the big swing factors in DMO, the Latin market in general definitely performed quite well despite all the economic volatility. We have put such tremendous focus on the Brazil market which is important to us with regard to cost and efficiency. And that obviously flowed through as well.

In addition, we continued to even get what we would call pretty good results from our mid-east and Russia group where even despite all of the volatility they are managing the situation quite well. And I think it really goes to a kind of new business model for DMO is really in place and kicking in, in terms of really focusing in on reducing debt, generating cash and profitable transactions. They have done a really good execution job.

Certainly from a revenue perspective, there has been no great increase in revenue in DMO, but I think with a return to profitability we now with return to profitability since it is returned to health.

Not a return to the red, it is sustained profitability and some improvement the second half?

Certainly nothing unusual other than operational execution that drove the good results of DMO.

I wanted to make sure I understand the explanation for the delay in the closing of the GE closing agreement in the GE North America. It sounds like the language changed a little bit. Can you update us on what is dragging down the closing of that agreement?

Actually, we have said our intent was to get it in place by the end of the year. I would say that we have been looking at many options with regard to how we do transaction funding, and it is based upon efficiency. We have talked to you about the fact that from - we want to make it seamless for our customers. There are systems considerations. But we believe that we have certainly a direction now with GE that is being worked and will meet the commitment in terms of getting it in place. I think it is also important to note that we have an agreement with GE for funding. So it is not that from that perspective there is any cash impact as it relates to the current scenario.

So we are doing it right. We are making sure we understand all of the details. And we are very comfortable with GE's commitment.

And then just finally as it relates to cash flow, you talked about additional restructuring charges in the second half of roughly 175 million. Should we assume that the bulk of that is cash outlays and you will spend that in '02, therefore we should add that to the guidance you gave at the end of '01 in terms of restructuring outlays? Or how should we think about the restructuring outlays given the additional charges you expect to take?

I think there is a fair level of consistency with regard to the cash payments. I think we have looked anywhere between I would say 150 to 200 in terms of a range as it relates to cash versus the actual restructuring charges. So no big difference that I think you would build in.

Then you would expect to make those payments this year as opposed to stretching it into next year.

Some could flow into 2003. But there are probably some from the last two quarters that are flowing in. I think it is a good number.

Last question from Jack Kelly of Goldman Sachs.

Good morning. Very nice quarter. Two questions. You referred to the cost cutting, Anne, the 1.1 billion singled out last year. Can you remind us on how that might hit in '02 and '03, those are annualized numbers.

Number two, it was mentioned by the end of the year two-thirds of your financing will be outsourced for copiers. Where do we stand at the half versus the two-thirds number at the end of the year?

Let me talk about cost restructuring first. If you would, we calculated the first billion through the end of 2001. And obviously that flows through to all of the lines, if you will in the statement, certainly the vast majority of it flowing through to the bottom line.

And I think you may have picked up as well that our SG and A alone will have been reduced by a billion dollars from the end of 2001 until the end of this year. It - excuse me - from the end of 2000 to the end of 2002. Over a two year period of time we will have reduced SG and A by a billion dollars. And we still think we have got more opportunity there.

We have also characterized for the first half of this year that we have now implemented another 175 million dollars worth of cost actions, if you will, that certainly primarily address certainly SG and A as well as I think the service economics. So you can continue to see from us continuing reports on additional actions that we identify as it relates to quite frankly bottom line impact for the full year. And we will do that quarter by quarter.

So I am going to talk about the financing. I think we set an expectation for two-thirds of the portfolio. The new originations to be financed through third parties by the end of the year. We think we are on track, roughly to get there by the end of the year, and if we look today it is about - probably around 50% in terms of the amount today. That would be certainly in the U.S. Z thank you.

Well, I do want to just thank you all again for joining us today. We appreciate your time. Q2 was certainly an intense quarter for Xerox, culminating in the positive results we announced today. We look forward to sharing more good news to come. Have a great day.

Ladies and gentlemen, this does conclude today's teleconference, thank you for participating. You may now 00:57:40 disconnect.