全錄公司 (XRX) 2003 Q4 法說會逐字稿

[Operator instructions] At this time I would like to turn the meeting over to Ms. Mulcahy. Ms. Mulcahy, you may begin.

Thank you, and good morning. Thanks for joining us today. I'm going to begin with slide 4, which provides a summary of our quarter 4 results. And as you can see, our focus is clear and consistent. We're serving the right markets with the right offerings and the right business model. It's the right approach, and it's working.

We had better than expected earnings: 22 cents EPS, including a 3 cent benefit from a reduced litigation reserve, which means we exceeded our full year expectations.

Highlights in the quarter include increase in equipment sales, installs, and market share. Continued focus on productivity and expense management, leveraging our earnings, and Q4 cash flow was exceptionally strong--close to a billion dollars in the quarter.

Larry's going to walk you through the income statement and cash flow in a moment, but I'd like to spend a few minutes on revenue and installs. And before we take your questions, I'll wrap up with a look at the full year results and a few thoughts on Q1 as well.

So if you'll turn to slide 5, our equipment sales trends continue to show improvement, both pre and post currencying. We had 11% growth in Q4, with a currency benefit of 7 points on equipment sales.

About 60% of all equipment sales in Q4 generated from the 38 new products we've launched over the last two years. So a solid proof point that our return on R&D investments is really delivering as expected. Increasing equipment sales in key markets represents an important element of our revenue growth and strategy.

More systems in the field that depend on Xerox supplies and service, business that flows through to our post sales revenue and has a sustaining benefit for our top-line results.

As expected, post sale declined due to the impact from the light lens decline, but Q4 total revenue was up 1%, including a 6 point currency benefit. The equipment sales growth we are experiencing is expected to flow through to post sales growth during the second half of 2004.

So if you'll turn to slide 6, here's a closer look at the revenue story. In Q4, the growth areas of our business, which now represent about 73% of our revenue, grew 10%. The declining area of light lens and [soho] were down 32%, but for Q4, these declining areas made up only 8% of total revenue.

The trend is definitely playing as we projected. We're capturing wins through services led technology offerings that add customer value and give Xerox a competitive edge.

Let me give you one example. United Technologies, seeking to reduce costs and increase productivity, engaged Xerox for an overhaul of their document management infrastructure. The agreement, which is expected to reduce UTC's current document spend by millions, includes Xerox production and office systems integrated with our document services.

And by the way, color continues to be a highlight, with total color revenue up 20%, largely due to the success of our DocuColor series. Color revenue now represents about 23% of total revenue. Color accounts for about 3 1/2% of total pages printed on Xerox technology. These results are indicative of the leverage that color has on our results, and the huge opportunity for color that remains in equipment sales, and the flow through to post sale.

This is really an important indicator for future revenue growth. More placements, more pages printed in color, Xerox color. And more color supports our top line for equipment sales and post sale revenue.

So if you'll turn to slide 7, spending a minute on our production segment highlights. Building on strength in digital color, production color installs were up 19%. Install growth of 22% in production black and white, due to the headway we're making in light production with strong demand for the Xerox 2101.

Production printing was up 6%, reflecting solid growth and continuous speed, a new market for Xerox that's building momentum. Black and white publishing was down in the quarter, but we know that there is a positive buzz in the marketplace about the new DocuTech platform.

The market's poised to embrace the new product, and businesses are delaying purchases of current DocuTech systems in anticipation of new ones.

Preliminary US Q3 year-over-year market share reports indicate that Xerox has gained share in all our key production segments. So, for Q3 2003 market share, as compared to Q3 2002, black and white publishing--and these are US results--our share was up 11 points, bringing our US share to 68%.

our US share up 2 points, bringing our share to 98%. Segment 6, US shares up 3 points, bringing our share to 22% from basically a non-position a year ago. And production color, our US share, is up 12 points, bringing our share to 59%.

We don't have European Q3 market share numbers yet, but we expect similarly strong results. And based on solid install growth, we belive we'll see increases in Q4 market share performance for both the US and Europe.

[IJEN-3] activity is right on target, with our expectations of 125 to 150 installs, and we're now selling (IJEN-3] in 34 markets and expect an accelerated install pace this year.

The strong combination of our systems and services continues to give Xerox the advantage over hardware-only competitors. For example, Owens Corning renewed a 5 year document services agreement with Xerox global services for customer communication services, print procurement, and facilities management, and more. New services include translation, print-on-demand, digital design, and fulfillment.

So if you'll turn to slide 8, we'll spend a moment on our office segment highlights. Q4 was the first full quarter that all our new office products were in the market. And we are clearly seeing the benefits, with strong demand from small and medium sized businesses driving growth in office digital.

Color was again a highlight, with color [MSP's] up 25%, and color printing up 30%. Our [fazer] color printers, which are based on our proprietary solid ink technology, are winning acceptance in the marketplace as an alternative to color laser. And our Xerox office color line is the broadest in the industry, and we are not stopping.

We'll continue to bring new technology to market that will attract new customers and retain existing ones. A good example, like Office Depot, which signed a deal for us in Q4 to supply a digital Xerox digital black and white, and color [MSP] systems in more than 890 of Office Depot's North American print and copy centers.

In the electronics systems sector of Northrup Grumman, has signed a multi-year outsourcing agreement with Xerox that includes asset management, as well as systems and software to help the division control costs and streamline their document infrastructure.

As it relates to market share, our preliminary US Q3 year-over-year market share reports indicate share gains, despite the competitive landscape, Q3 2003 office market share, as compared to Q3 2002.

Black and white digital copies, and [MSD's], our US share is up a point to 14%. Color digital copiers and [MSD's], our US share is up 2 points to 26%. And again we are not resting on our laurels.

On Thursday, we're making a significant announcement about new platforms and services in both production and office, and they'll open new markets and offer new growth opportunities.

So, if you'll turn to slide 9, our developing market segment continues to improve. DMO equipment sales are up 21%, and revenue grew 1%. The post sale decline of 6% is a 5 point improvement from last quarter, and total revenue improved 3 points from last quarter.

Certainly, there are still some challenging economies in our developing market's operations, so we're keeping our expectations balanced with the variables in this tough marketplace.

But there truly are some bright spots, like Russia, which continues to grow as the transfer to digital technology accelerates. Russia actually represents about 11% of our DMO total revenue, up from 9% at the end of 2002. And more regions are recognizing the advantages of integrating our service and systems offerings.

For example, Egypt Telecom signed a $15 million contract for Xerox to upgrade it's printing technology, including the installation of 75 DocuPrint systems, networking of all devices, and a one-to-one marketing solution for the customization of their customer brochures.

So I have to say on the revenue front, it's good news in every region, in every business segment. And Larry has an equally impressive story to tell. Larry?

Thank you, Anne, and good morning everyone. As Anne covered, we exceeded our expectations for the 4th quarter, as well as for the full year. I believe that each quarter of 2003 demonstrated our ability to meet our commitments, and manage our business consistent with our model.

If you go to slide 11, this is a summary of all the significant highlights of the quarter, which I will then cover in the next few slides. We delivered on our commitments by exceeding our expectations, with 22 cents of earning's per share, including 3 cent positive effect of reduced litigation reserve.

Revenue cost and expense and cash management are all demonstrating the model is working. Total revenue was up 1%, equipment sales grew 11%, with a 6-7% positive effect of currency, and it's four quarters in a row with growth in equipment sales.

Post sale decline is moderating, and as Anne said, continued growth in our investment areas showed 10% growth for 73% of our business. Gross profit margin at 42.5%, once again productivity off-setting price declines.

SAG is down in absolute dollars, as well as down to 25.9% of revenue, and non-financing interest expense is down $30 million year to year. Cash performance continues to deliver with 1 billion of operating cash flow for the quarter, and 2 billion cash flow for the year.

We paid down $1.2 billion of non-securitized debt within this quarter, and 2.7 billion for the year, ending with a cash balance of $2.5 billion. Our securitization strategy continues to perform with 59% of our receivables secured, and 39% of our debt securitized.

And finally, our year end non-financing debt to capital ratio is 39%, down from 67% in 2002, and going to 25% in 2004. Let's go to slide 12.

This is a summary of the total P&L, the significant points that we covered, the revenue up in both equipment sales and for total revenue. Gross profit margin at 42.5%, and there is a $50 million non-recurring licensing fee in 2002's gross profit margin growth .7% and in this year's gross profit margin because of the product cycle of [IGEN-3], where sustaining engineering is now charged to cost and not to R&D. There's a .3 decline from what it would have been.

So you can see that there is consistent performance in year-to-year in gross profit margin.

Our R&D investment and our commitment to invest in R&D has not changed.

The reduction in dollars is associated with productivity, as well as the shift of sustaining the engineering the cost. We spent $120 million in restructuring, somewhat more than we talked about in the third quarter. And other is primarily the improvement in non-financing interest expense $30 million year to year, and again, our earning per share at 22 cents, with a 3 cent positive effect with a litigation charge. All results are consistent with our model.

If we go to slide 13, a summary of cost and expense trends, your can see that gross profit margin changes by quarter are very small and are based on mix and the seasonality of the quarter, but it is consistently in our model range of 41 to 42%.

The same point is true on SAG, our model is to drive to the mid-20s by 2005, and with the help of revenue growth, we will accomplish that. 25.9% for the quarter continues to show our ability to manage SAG, and it is notable at most of the reduction on the dollars is associated with G and A and bad debts.

The key points are productivity improvements and significant bad debt improvement. In fact, bad debts, as a percent of revenue, was 2 1/2% in fourth quarter '01, 1.7% in fourth quarter '02, and now is 1% in fourth quarter '03. Huge improvement.

Slide 14, please. The title of this chart is Excellent Cash Performance, and I think that's exactly what I would say about our cash performance. It was excellent. Key points are cash from OPs, 971 million for the quarter, 1.9 billion for the full year, and it's all driven by strong earnings and operational performance.

Inventory improved in both the quarter and for the full year, 127 and 62 million, and AR essentially flat in the fourth quarter, in a growth quarter, down 164 million for the full year.

Two other key points for the fourth quarter as we grow or grew equipment sales, the finance receivables will be an investment in cash, for the most part secure securitized. With that investment, we had $1 billion of cash from operations.

And for the full year, we had $345 million of restructuring payments, and $672 million of pension payments, of which about 325 million of pension was pull ahead from 2004 to 2003-- so a billion dollars-- and still we had almost $2 billion of cash from operations.

Cap Ex was 71 million in the quarter and 197 million for the year, and cash from financing needs a little more explanation.

First, our security station strategy drove more cash in the fourth quarter and should be more balanced in the future.

Second, you can see that we decreased our other than securitized debt by $1.2 billion in the fourth quarter and 2.7 billion for the full year. The story is really [inaudible] than that because as you know, we paid off a $3.5 billion credit facility.

We recapitalized the balance sheet with significantly more equity and linked converts. So a very positive cash flow and balance sheet story.

Let's go to slide 15. This chart summarizes all the progress and performance achieved on the liquidity side of our business.

As you can see back in 2000, we had 18.6 billion of debt; only .7 was securitized. So 17.9 billion of unsecuritized contrasted to 2003, with $11.2 billion of debt, 4.4 securitized and 6.8 nonsecuritized debt. So looking at $17.9 billion to 16.8 of nonsecuritized debt.

As I said before, we reduced year to year $3 billion from 2002 to 2003, and our securitization debt went up to 39%. Cash from operations continues to perform, and I think you can see a year in and year out performance here of 1-8-2-0 and 1-9 of cash performance.

Our debt maturities are nicely balanced with our cash generation and cash position, and finally, we have $2.5 billion of cash on hand. And all this leads me to the final chart, which represents our reduction in leverage.

Given our financing business with a portfolio of $9 billion, we want to look at our debt to capital ratio and a non-financing business basis, which assumes a financing business leverage of 7 to 1.

On this basis, our debt to capital ratio was 67% in 2002, and is now at 39%. Our goal is to reduce to 25% by year end 2004, and by 2005, have almost all of our debt associated with our financing business. Our recapitalization, and our cash management shown on the previous slides, speak to our continued focus and success in strengthening our balance sheet in all areas.

So in conclusion, I'd say the fourth quarter completed a very successful year with positive momentum. We are encouraged by all aspects of our business, and we believe we can continue to deliver consistent, predictable results to our shareholders. Thanks for listening and I'll turn it back to Anne.

Thanks, Larry, and I'll start on slide 18, really beginning where Larry left off, which really stated that Q4 was a strong quarter and it ended a powerful and positive year for Xerox.

You'll look at our full year results and expectations, and in just about every category we exceeded expectations. Our cash balance, consistently all year, was well above the billion dollar boundary. Our debt below 12 billion, at 11.2, and that reflects about a $3 billion decrease in debt.

We exceeded and had more positive equipment sales growth than anticipated, at 7%, versus the low single-digit expectation. Right on in total revenue with regard to projections, with a very modest decline. Our gross margins ended the year above the range that we'd set.

SAG was an absolute reduction in both cost and ratio, and as revenue improves, we will clearly make our expectation of getting to the mid-20s.

So we've delivered on our commitments, exceeded in many cases, and looking at an operational compare, you'll see we ended the year with earnings per share of 58 cents, which excludes the charges associated with [Burger] and the 2002 credit facility.

So this chart tells the story: significant year over year earnings improvement driven by strong equipment sales that are fueling Xerox's future top line growth, and operational efficiencies that deliver benefits to the bottom line.

So finally, slide 19, our growth strategy is working. Through our services-led technology wins we've accelerated activity and installs, we've gained share, and we've increased equipment sales.

Especially notable is our continued success with color, where we hold the leadership position with the industry's broadest product. And these are all critical drivers of future revenue growth as the annuities stream from new installs as [inaudible] post-sale revenue.

In our business model, we remain diligent about costs, and we're and utilizing [Lean 6 Sigma] to deliver unending productivity. We're focused on generating cash, and [inaudible] profitability in every business division and in every operation around the world.

So considering our confidence in continued equipment sale growth and strong operational performance, we certainly remain comfortable with Q1 expectations in the range of 13 to 16 cents per share. And for full year 2004, we remain comfortable with our 67 to 72 cent cent guidance and are optimistic that we could be at the high end of the range.

We were proud of our 2003 successful results. We're confident, we're focused, we're aggressive and we're winning. And stay tuned because there will be more good news to come. So as Larry said, thanks for your attention and your time, and we would be delighted now to take your questions.

[Operator instructions]. The first question is from Stephen Webber from SG Cowen. Please go ahead, sir.

Good morning. Could you remark to pricing. It seems to me in the fourth quarter the pricing pressure moderated some, and it's been my thesis that most of the pricing effect that you have been incurring in 2003 was really largely self-inflicted and that the marketplace has really reasonably sane at this point. Could you just talk to that, and then I have one quick follow-up question.

We don't call it self-inflicted. We call them strategic investments. There is no question they were planned clearly to be aggressive and gain share.

We are price investments in production in the fourth quarter remained around 5%. We did see some moderation in the office price investments. We had been at about 10%. We are now seeing it between 5 and 10, so your comments are correct.

I think a couple of notes in this area. One is that those are equipment pricing investments. And as you know, the post sale area, the pricing pressure has been much less in low single digits.

And also that we are continuing to really manage the price investments by offsetting, more than offsetting, quite frankly,with productivity, the price investments that we're making.

But we feel pretty confident that it is flattening out in terms of the pricing environment.

My second question is, could you talk to your sales coverage and then talk about at the end you talked about going to a more two-tiered distribution. Will the two-tiered distribution help or hurt equipment sales numbers in 2004?

I know you want to put out these print engines so you can get the post-sales revenue, but I'm really interested in whether there's a short term negative impact on equipment sales.

Well, in overall coverage, I think it's important. We solidified and strengthened our direct sales channels. We've been absolutely increasing our indirect sales channels and we've been investing and scaling up our teleweb.

So coverage overall is certainly something that is stronger at the end of 2003 than it was at the end of 2002. We are ramping up two-tier considerably. We've been particularly aggressive in Europe.

And we expect in 2004, for office devices, we will see about 95% of our office technology distributed through two-tier distribution. And we saw it install increases in Q4 that give us every reason to believe that this will deliver the volume that we anticipate, and we are beginning to actually stretch the portfolio of technology available to our distributors and resellers in North America, as well with some of the new low-end multi-function devices.

There is no question that we will see an increase in equipment sales. We will see certainly a little bit lower margin as it relates to the product we put through two-tier, but it's more than offset with regard to the install increases, and therefore the increasing equipment sales.

And that is the strategy, and we've seen it work in Europe.

Okay. Thank you very much.

You're welcome.

The next question is from Carol Sabbagha from Lehman Brothers. Please state your question.

Thanks. Just a couple of questions, one on the post sale expectation for post sale to be up sometime in the second half of '03. What are the very broad assumptions that go behind that? I presume part of it is equipment sales growth and installs. What are you thinking around those numbers?

Are you assuming for increase for the number of pages for existing installations? And lastly, how much of a better impact on revenues are we expecting from the shift to more color pages?

Okay, Carol, let me talk a little bit about post sale. If you look at our precurrency trend through 2003, it did moderate. As a matter of fact, if you take out the one time licensing deal if Q4, it was actually the best post sale performance all year.

So we have seen what I would call slow and steady progress on post sale that we do expect to continue. And the biggest driver of the post sale turnaround will be equipment sale and primarily color equipment sale, obviously because of the leverage that color brings to the portfolio. So color is certainly the most important lever in the turnaround and post sale. We do see more pages as it relates to digital connected installs.

So obviously the decline--I think we talked about our light lens portion being about 8% of the total, which is down significantly. As more and more of the base gets to be digital, then the page story on digital connected gets better as well.

And we do continue and have outlooked progress through 2004, with a positive turn by the end of 2004.

And a question on the broader market in general. You clearly gained share in the quarter and this year, but can you talk about what you think in '03 the market itself did, and what you're looking for in '04?

Well, I think the market got stronger in '03. And clearly from a market standpoint, we saw the greatest strength in Q4, just in terms of any kind of positive economic trend.

I think we saw a momentum in color-- both production and office color--that was really significant from a market growth perspective, and we looked at things like production color installs grew about 8% in Q3.

They grew 19% in Q4, similar as it relates to certainly production Mono even from Q3 to Q4, and continued strong double digit gains in all of our office categories as well.

So, yeah, we think things have gotten better and we're for the first time saying we anticipate probably a little bit of market good news in 2004 based upon the trend that we're seeing. And the strongest part of that will be in color, as the market accelerates to color.

The opportunity for us with only 3 1/2% of our pages in color right now is just enormous, having the broadest product line available to the marketplace. So we think that's great news for 2004 and subsequent years as well.

Thank you very much.

Thank you, Carol.

The next question is from Shannon Cross from Cross Research. Please go ahead, ma'm.

Good morning, guys.

Hi, Shannon.

Can you talk a little bit about any holes you see in your product set? It seems you have covered the basis over the last couple of years; assuming you will upgrade to your [docutech] line and expansion of your printer business, that I think we're going hear about shortly. So can you talk about where you think your product set is positioned today?

And also, if you could address -- there is a lot of discussion out there about some of these color capable devices that are basically priced at black and white pricing but allow for variable cost color printing, and the potential of those to open up a larger addressable market more in sort of the core office.

Can you talk about those two potentials?

Well, I think you are right. Two years ago, and even a year ago, we talked about some significant gaps in the product line that we were certainly investing in at that point from an R&D perspective.

But with what we've brought to market to date, there is no question that we don't see any major holes in the product line. The light production device, the 2101, is doing really well in the marketplace and taking share from both Cannon and Rico, so we are really pleased with the success of that.

That was the most significant issue that we had. And over the last two years, we've actually introduced 38 new products. So it's really been an outstanding year in terms of introducing technology to the marketplace.

And I think we will talk about on Thursday, new platform announcements that certainly aren't filling gaps but are adding strength with a real opportunity I think to excel, both in color and black and white, in some areas where we already have certainly very good products available.

So from that perspective, I think we are in great shape and about to get in much better shape on Thursday from a product competitiveness. And I've got to tell you, we are really focused on staying ahead of that curve in terms of product competitiveness with both the pace and the economics of the technology that we are announcing.

Okay. And then--

Color capable is certainly very much a part of our strategy. If you look at our 1632 and 2240, they actually model the color capable approach, which basically talks about what we call no nonsense black and white, which is black and white at comparable prices to a black and white device with then color available on the device.

But I think we are building to the point where a single device can meet all the needs in the office and color capable is a part of that.

Okay. And just one follow-up for Larry. Can you give us any idea of any potential changes to your capital structure you may be kicking around since you put out the shelf registration in late December?

We have no real plans right now. We did that just because of normal cost of business. A company this size, it makes sense to have a shelf out there. We will address the market when it makes sense for the company and the shareholders.

Okay. Thanks, guys.

Thanks, Shannon.

Ben Reitzes from UBS Warburg is on line with a question. Please go ahead.

Good morning, thank you. Hi. Couple things, [droopa] is coming up along with some trade shows, I believe. Do you anticipate any pauses in buying or surge in buying related to the trade show activity this year? Maybe around your new products, that could cause maybe some volatility in earnings, both to the up and to the down, like some other years that we saw maybe in the '90s?

And then also just to follow up, what tax rate should we use for the year, Larry? And it seems that the pension hit that you guys discuss in your [MDNA] of 4 cents, is that lower or higher incrementally for '04 than you thought? I thought it sounded lower.

We're not certainly expecting [droopa] to create any downside volatility for us. Quite frankly, with the lineup of technology,[IJEN-3], the DocuColor lineup, including the 5050 and the recent 5252, certainly the DocuTech line, enhanced by Thursday's announcement. I think [droopa's ] going to be a home run for Xerox in terms of comparative technology available the the commercial print marketplace.

So, we're really bullish on it. We're not holding back. We clearly have a strong portfolio today that's available for order taking, so we don't expect it will cost us any demand issues in the short term. But certainly, [droopa] is always an opportunity to potentially accelerate some of that demand as it relates to the commercial print audience.

I guess a better way to say it is potentially the timing of the show. Does that do anything to the second half loaded nature of the year potentially, or is it no big deal? We just power through the year?

Well, I think we'll power through the year. I think one thing that [droopa] will help is our expectations for [IJEN-3]. That happens to be kind of a second half loaded market anyway, in terms of the production market, and [droopa] will help realize those expectations. So I think we've incorporated that into our guidance.

Okay, thanks.

And Larry?

Yeah, tax rate. I always recommend that you use the plan for the tax rate that I use when I plan and look at our forecast--that I use 40%. And our statutory rate is below that, but with all the audits that go on in every country in the world for every company, and tax valuations and tax assets it's hard to predict within a point. So I think that's a good working number to use for a tax rate.

On the pensions, your question was -- $65 million--

You expect it to be higher?

Did you? Isn't that lower than what you thought it would be? Or is that the--

You don't know these numbers until you get to the end of the year and you evaluate what the pension and the actuaries--evaluate what the pension is. So, I'm not sure it was much lower than we thought it would be all along.

Obviously if the stock market hadn't gone up it would have had a different effect, but I don't think it's off particularly that would be significant.

I've got to follow-up with a follow-up to Shannon's question about the shelf. With the momentum and cash flow and earnings, have you been in touch with the rating agencies, or is there anything that you guys could give color on as far as working about any accretive debt reduction moves that are left in the tank?

I think we are always keeping in touch with the rating agencies and providing an update, and we did see a little bit of positive reaction from Moody's rates recently. So hopefully, the trend is in the right direction.

But I think the balance sheet and the progress we made then speaks for itself in terms of where we are and obviously as it relates to both securitized debt and nonsecuritized debt. The progress is extraordinary and where we are headed is just better news.

So hopefully, that message is loud and clear.

Okay. Thanks a lot.

Thank you.

The next question is from Jack Kelly from Goldman Sachs. Please go ahead, sir.

Good morning.

Hey, Jack.

Just a couple questions, and a follow-up on the pricing environment question, Anne. Basically, it said it looked like things were leveling out , which would indicate that the price declines in '04 would be equivalent to '03.

I know it's a tough question, but could you give us -- maybe wrap some numbers around that broadly in terms of post sale and equipment? And then secondly, on the on use of cash. Aside from kind of a defensive use of cash, which has been to pay down debt and restore the balance sheet, given the fact that you are considerably ahead of what you consider your minimum cash balance should be, is there anything more offensive you can do with that? I'm just thinking broadly, acquisitions or other things.

Okay. So, pricing environment, I would say that we kind of look at the '04 environment consistent with the second half of '03.

I think the first half was more aggressive and flattened out in the second half and that those kind of 5% in the production environment and perhaps a little bit north of 5%, but clearly between 5 and 10 is something we planned for in 2004 and feel is more than sufficient to both retain and gain in the marketplace.

We may see some volatility between color and black and white in that environment. I think you will see in some areas, particularly mid range color a little bit more aggressive pricing environment and I think that in the black and white environment we will see more stability.

So overall, I think our assumptions for 2004 are credible based upon the history we had in the last couple of quarters and we have been planning more than adequately for price investments.

On uses of cash to your point, I would kind of characterize us as being opportunistic as it relates to acquisitions. I don't think we are looking at major kinds of acquisitions.

Clearly strategic acquisitions that would particularly strengthen our global services business is something that we will constantly be gauging and deciding whether acquisitions or partnerships are the best route to follow.

We don't feel constrained by cash as it relates to insuring that -- ensuring we are on pace with regard to our services business.

Thank you.

Craig Ellis from Soloman Smith Barney is online with a question. Please state your question.

Thanks. Good morning, Anne. Good morning, Larry. First, Larry, just looking at the cost of sales trends over the last three quarters, it looks like they are starting to bump up and be be a little bit higher than what we saw in the prior year. Should we expect that to stabilize, and is some of that just currency creeping in there?

I think the cost of sales that you see is the shipments of [IJEN-3].

That's sustaining engineering switch.

That was three-tenths of a point change in margin in the fourth quarter. So, that's the bulk of it, I think.

Okay, and then when I look at the first quarter and your outlook, it seems like the tail winds would be new product launch activity on the cost side what you are doing with Lean Six Sigma and probably some ongoing currency help. Head winds would be tougher equipment comparisons and probably seasonally slower equipment spending. Is that fair way to recap how to look at the first quarter?

Yeah, I actually think it is, Craig. There is no question that Q4 is strongest quarter of the year. And Q1 certainly wouldn't be at the same level as Q4.

But I think we are quite pleased with what we see with regard to the pace of demand. So there is no reason for us not to be optimistic about Q1 as well.

But there is no question new product launches would be in our favor and the momentum we build from Q4 will be in our favor and it's more just seasonal kinds of scenarios.

And as it relates to the year-over-year piece, because we've been building momentum all year, we still see certainly high single digit increases in equipment sales, and that's a positive place to be.

Okay. And then following up on the expense, Larry. You've got a real good bad debt expense in the third quarter. Looking at that in the SG&A, is there any further room to take that down from here or should we look at that being flat as a percentage of sales going forward?

Yeah. I think if you look at this by quarter, it's going to vary in different ways. You can't always take something from the fourth quarter and extrapolate it out. But I think year to year you will see an improved trend here.

And lastly, and this is for you, based on your conversations with CIOs and purchasing managers and kind of looking at your three different end markets with commercial printing and print for pay enterprise, can you just recap where you see the greatest strength and what some of the spending priorities are among those different constituencies as you look out over 2004?

Well, I think for our commercial accounts, speaking to CIOs, we are pleased certainly, that we see opportunity picking up, but I have to say that it's driven by our services-led offerings.

It's driven by more of an optimizing infrastructure, really providing value. It's not just a technology-based sales. We've been focused, I think rightfully so, on making sure that our services-led enterprise selling approach is really what's driving the vast majority of our wins in the commercial marketplace.

As it relates to commercial printing, clearly this is going to be a market that will go digital. We are absolutely seeing a pickup over the last few years in the commercial marketplace, which came from a very difficult time with a lot of consolidation, to a point where we're absolutely seeing a lot more activity via the success of [IJEN] and DocuColor, of which the majority of the [IJEN] places by far in the commercial print marketplace.

And I think we crossed the 200 million page mark, and the vast majority of that is in commercial print. So we're pretty bullish about commercial print. I think there has been a real bifurcation in commercial print. The strong have gotten stronger, and the weak are no longer there.

Our offerings really appeal to the commercial print market where there clearly want to make the transition as appropriate from some pieces of offset to digital. I think the print-for-pay market has been very strong. We talked about, certainly, Office Depot.

I'd say if we looked at our print-for-pay market, we really had a great second half with our print-for-pay market across the board, driven by the growth in color.

And the fact is, is that with the best color technology in the marketplace, print-for-pay are pretty tough critics and they're going to buy the best technology and hold us to clearly helping them be more profitable. And that's been a real win for us in terms of the color growth we've seen across the board.

So I would say in all segments we are seeing improvement. And it's a combination of certainly a little bit better market conditions, but I think a portfolio that's helping our customers deal with the economic climate.

So I think it's really a combination of what we bring to them, as well as a little bit of market tail wind.

And do you see your customers increasing their spending in the areas where you're competing? Or do you see really just a shift between the competitive players and how does that factor into your thinking for '04?

I think in traditional, particularly black and white technology, we see it as a shift. Color and services provide growth. So we are absolutely seeing new sources of revenue. It's not just a shift.

I think we are gaining share from our competitors, but we're also seeing new sources of revenue from color and a lot of our global solutions that we are bringing to our customers.

Thanks Larry, thanks Anne.

The next question is from Jay Vleeschhouwer from Merrill Lynch. Please go ahead, sir.

Thanks. Good morning. I would like to ask first about your competition and particularly as it relates to sales and market coverage.

Based on some meetings we had with some of your competitors in Japan last month, it seemed to us, very broadly speaking anyway, that Canon on the one hand was in pretty good shape, while on the other hand Konika Minolta and Rico were going through various integration or [inaudible] coverage or channel transition issues.

What are your thoughts in terms of how your competitors are shaping up as far as their market coverage is concerned? Also, in terms of developing markets, you mentioned Russia was doing well, on the other hand those same competitors are very heavily focused on building up the sales capacity in China. So perhaps you can talk about that?

Okay. Let me just focus on particularly Canon, Rico, Konika Minolta. I mean, when we do a deep dive on share analysis, we've taken share in various segments from both Canon and Rico, but there's no question more share from Rico than Canon.

I do think that Canon's a little bit better positioned with regard to coverage. Although, think the recent announcement from HP on the Konika Minolta line has actually created some competition among Canon, Rico, and Konika Minolta. ted more competition between them, as you look at some place like Icon being the distributor for all three.

I'm actually -- I think what we're seeing is some competition from within versus competition that's clearly headed toward Xerox. So overall, I think Rico's been a little weaker. Canon's been stronger, but quite frankly, it's totally been centered in mid range color; that's really where they've been strongest. And Konika Minolta, I think, is still very much in process with regard to both their own distribution, as well as their agreements with HP.

We are using the opportunity, obviously, to both solidify and build on the very stable and strong distribution structure that we have across cross the world.

In terms of developing markets, I mentioned Russia, but quite frankly, we've seen-- certainly, as you can see from our DMO results, year-over- year improvement just about everywhere,

Russia being certainly one of the strongest. And in terms of China, we are really pleased we got this obviously equity relationship and partnership distribution relationship with Fuji Xerox, and therefore, participate with great strength through Fuji Xerox as it relates to our Asia/Pacific territories. And that's really been great news for us, not just on the technology agreements side, where we get some very strong color technology from Fuji Xerox, but also from the distribution side in terms of being able to see the gains from Asia/Pacific, particularly China, without having to invest heavy cost in providing coverage in that part of the world.

Okay. By way of follow-up, particularly given the large number of new products you introduced and more to come, in what way over the last year or so do you think you have most improved your manufacturing edge in terms of either process or procurement during those considerations, versus your competition? Where do you think you might most have some kind of cost of revenue advantage?

Well, it's a great question. And I would say that the biggest win for us, obviously, was the decision we made two years ago was to outsource our office manufacturing to Flextronics.

It's not only yielded to our expectations, but exceeded our expectation with regard to manufacturing productivity. As our volumes are increasing, it's clear that even gets to be a more efficient partnership for us.

So I don't think there is any question that the decision to outsource in the office manufacturing arena was one that provided a great deal of competitiveness for Xerox. At the same time, we're focused on the manufacturing that we do well, the high end systems manufacturing that we do for our DocuTech line and our [IJEN] line.

So that has proven to be-- and I think you'll see not only in current products but in future products--that our margins are going to be extremely healthy and therefore, indicative of the value chain we got.

And when I look back and see what we did in procurement three years ago and what we do today, the contrast is extraordinary in terms of the efficiency delivered. So that's an area where [inaudible] Sigma over the last year has been extremely useful in giving us some great bottom-line returns.

So all in all, I think the flex relationship number one, and then just getting much better as a company and cost efficiency in areas like procurement.

One last one for Larry. Your inventories declined sequentially from the third to the fourth quarter. Do you regard that as a normal seasonal change, or do you think you now have a structurely higher returns ratio built into the model?

Well, I think it's both. I think you do have a lot of shipments obviously in the fourth quarter with this equipment sales. But I think also that our turn rates got better.

We're actually pretty proud of doing two things at the same time there, trying to make all those shipments in December and lowering our turn.

I think we have time for one more question.

Our last question is from Chris Whitmore from Deutsche Bank. Please go ahead, sir.

Couple questions here. Can you just briefly talk about the impact from foreign exchange on the earnings line?

The impact of foreign exchange was a really small number. I don't think it's a material number that affected the earnings.

Secondly, on cash flow from operations, Larry. You mentioned there is about a billion dollar of impact from things like restructuring and pension payments that won't likely recur.

Were there other things that offset that billion dollars? In other words, when we talk about cash flow from OPs staying at the same level in '04 versus '03, that seems a bit conservative.

Can you talk a little bit about your outlook for cash flow from operations next year?

I think the biggest offset to that is we've gotten a significant benefit from a source of cash from our portfolio and receivables going down. And as equipment sales have done well in 2003 and will continue to do well in 2004, that's going to be a more neutral event.

And to the extent that's a neutral event or in fact an investment, like it was slightly in the fourth quarter, that's a real change. The depreciation numbers came down significantly year to year. Those are going to be smaller declines.

So I think there are a balancing things. I think the great thing about our cash flow is I think consistently we are going to be able to throw off this significant amount of cash. And whether it's going to be 100 million or 150 million is going to depend on how good we are in inventory and accounts receivable next year.

Great. And just lastly on the equipment gross margins, we mentioned earlier the pricing environment seemed to be moderating a little bit. Can we assume there is a little upward bias to the equipment operating margin into next year? Thanks a lot.

Chris, I don't necessarily think we are planning on it. We have a very large and broad equipment portfolio. So mix is always a big part, certainly, as well as price of the portfolio.

We're doing more for small and medium sized customers in segments one and two, which carry a little bit lower equipment margin. And also, as we introduce new products, we do go through a scale to maturity that improves equipment margin over time.

So when we give you, certainly, our estimates for growth margin for 2004, it's really not assuming any particular upside on equipment margin. Okay.

Well, once again I just wanted to--as I mentioned earlier, remind you that we will be making more positive news on Thursday with both new platforms and new digital solutions that will create new growth opportunities.

We'll be in New York City with about 1,000 of our customers, and feel free to check out Xerox.com to join us via the web. And once again, thank you for your participation. We appreciate your interest in Xerox and have a great day.

Thank you. Ladies and gentlemen, that does conclude today's teleconference. Thank you for participating. You may now disconnect.