全錄公司 (XRX) 2004 Q2 法說會逐字稿

Good morning, ladies and gentlemen. And welcome to the Xerox Corporation's second quarter 2004 earnings release conference, hosted by Anne Mulcahy, chairman and chief executive officer. She's joined by Lawrence Zimmerman, senior vice president and chief financial officer. During this call, Ms. Mulcahy and Mr. Zimmerman will refer to slides which are available on the Xerox's web site, at www.xerox.com/investors. At the request of Xerox Corporation's today's meeting will be tape recorded. Taping and rebroadcasting of this call are prohibited without express written permission of Xerox.

After the presentation, there will be a question and answer session.

During this meeting Ms. Mulcahy and Mr. Zimmerman will make comments that constitute forward-looking statements. Actual results could differ materially from those projected as such forward-looking statements. Information concerning certain factors that could cause actual results to differ materially is included in the company's 2004 report 10-Q for the period ending March 31st, 2004 and filed with the SEC. The company does not intend to update any forward-looking statement made during this meeting.

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

Thank you. Good morning, everyone and thanks for joining us today.

We're going to begin with slide 4 which provides a summary of our second quarter results. So we are pleased with our earnings performance, operational improvements. And demand for new technology and services contributed to another strong quarter of earnings. Better than expected earnings at 21 cents per share and as previously communicated these results included the 2 cent gain from the sale of ScanSoft in Q2, which was largely offset by restructuring charges.

So let me review highlights from the quarter. A continuing increase in install activity leading to a 5% increase in equipment sales. Strong demand for our color technology, both in office and production markets, and color by the way now represents 25% of our total revenue. And however postsale was lighter than we expected primarily driven by disappointing postsale results in Latin America, which is why we are accelerating our movement to two-tier distribution in this region. We remain confident that our strong product pipeline and flexible business model can adjust to fluctuations in revenue mix enabling continued earnings expansion.

We delivered improved profit margins. Gross margins of 41.3% represents a significant sequential improvement and is consistent with our full year expectations of gross margins in the range of 41 to 42%.

SAG declined 4%, lead by substantial improvement in bad debt. We are really pleased with SAG results especially considering the investments in the Q2 Drupa trade show and the adverse impact of currency. And Larry is going to discuss these improvements in more detail.

Another quarter of strong cash flow. 256 million after contributing 252 million to pension plans which contributed to a healthy worldwide cash position of $2.5 billion, after significant debt reductions. And after assessing our strong first-half earnings performance and considering the positive momentum for our new technology and services, we're raising our full year expectations, and I will provide more detail on this later in the call.

First I would like to spend a few minutes on revenue and installs and Larry will walk you through the income statement and cash flow and before we take your questions I will wrap one a few thoughts on Q3 and full year expectations.

So on slide 5, let's begin with the revenue story. Q2 total revenue was down 2% and includes a two-point currency benefit and this currency benefit was a little bit less than expected. The revenue highlight is at the growth areas of our business, which now represent about 73% of our revenue increased 4%, driven by strong growth in color, particularly, and light production.

In value-added services, which is really becoming a burgeoning business opportunity, we saw a significant increase in revenue, largely due to major contract signings for content and asset management, imaging and consulting. And these annuity-based contracts are strengthening our postsales stream over time.

As I mentioned, color continues to be a highlight with total color revenue up 17%. Color now represents about 25% of total revenue. Yet, it's still only accounts for about 4% of total pages printed on Xerox technology. So the opportunity for color remains huge, in equipment sales and the flow through to postsale.

The major declining area of our business, Light Lens and SOHO was down 37% in the quarter. But for Q2 these declining areas now represent only about 7% of total revenue; although the decline has accelerated this year.

As I mentioned, we're disappointed in the results from DMO which declined 6% in the quarter, reflecting the impact of weak results in Latin America. And this accelerating decline in Light Lens and postsale weakness in Latin America will postpone the turn in postsale; however, overall revenue guidance remains the same as committed due to stronger equipment sales.

So if you turn to slide 6, in the production business, color installs were up 17%, due to the iGen3 and DocuColor 5252. Production black and white was up 13%, reflecting strong demands for the Nuvera 100, 120 copier printer as well as continued strength with the Xerox 2101.

And, as you know, both of these products are considered light production systems. So their success offset decreases in monochrome publishing and printing.

At Drupa we announced the expanded Nuvera digital production systems. So sales of our DocuTech line were impacted this quarter as customers anticipated this advanced Nuvera line which began shipping in Q4 with full ramp up in 2005. And through our partner Fuji Xerox, iGen3 is now being sold in Japan with impressive initial demand especially in the banking industry. And iGen3 is now available in every major North American and European market, as well as new Latin America and eastern European markets.

In fact, rapid solutions group which serves the financial and healthcare industries recently purchased six Xerox iGen3s to produce full color digitally produced books and other documents. And the installation of an iGen3 at a commercial print shop in St. Petersburg, Russia, came just in time to complete the largest variable printing order in the history of the city. One million personalized items were sent to citizens by the largest electricity provider.

We are on track to achieve our full-year target of 4 to 5 hundred installs and print volumes remain impressive with some iGen3 customers printing in excess of 2 million pages per month.

Drupa was a huge success for us. It exceeded our expectations with more than 110,000 visitors attending the Xerox showcase and solidifying our leadership position in the digital production market.

We announced seven new offerings, secured a series of new multi million dollar customer contracts including many for iGen3s and are clearly recognizing a strong return on this marketing investment. And we'll continue this positive momentum with more announcements at Chicago's Graf Expo show in October.

So if you turn to slide 7, in the office, we continue to expand our portfolio, introduced four new products which we launched during the second quarter. We definitely offer the industry's broadest line of color and monochrome systems and those systems were winners of 14 industry awards in the past month.

Total office revenue was down 3%, largely due to Light Lens declines and lower priced products; however, install activity remained strong. Office black and white and digital systems were up 25%, with continued success from the desktop multi function devices in our segment 1 and we had growth in segments 2 through 5. In particular, we saw strong growth in the segment 3 to 5 space, up 11%, driven by the WorkCentre and WorkCentre pro series.

Color again fortified results with installs for office color, multi function devices up 40%, and color printing up 54%, largely due to the phaser solid ink and laser printers.

And supporting our office business, the Xerox office document assessment continues to be an important asset for customers when want to decrease costs by closely scrutinizing how much they spend on documents and why.

Toyota motor sales in the U.S. did just that, and chose to upgrade their print infrastructure to digital selecting Xerox to replace more than 280 competitive products with Xerox digital systems. The same is true on nova solutions where through an ODA, or office document assessment, we reduced their document assets by 50% across all locations.

They have transitioned more than 80% of their sites from stand alone devices to all in one network Xerox WorkCentre systems. And building on our strong global relationship with Staples, their UK operations recently ordered 200 new Xerox printers and MSDs, including phaser, WorkCentre and DocuColor systems. And not resting on our laurels, we are ramping up more office product introductions in the second half of this year.

So if you turn to slide 8, let's review results in our developing markets operations. Equipment sales increased 11%, and this was largely due to strong performance in Russia, as well as central and eastern Europe. In these geographies and other emerging markets, where we successfully implemented a two-tiered office distribution model, we are generating about 40% of total DMO revenues. We're delivering equipment sales growth of 20% and total revenue growth in the range of 15 to 20%.

But as I mentioned earlier results in Latin America had a significant impact on our revenue in the quarter especially postsale, as we saw rapid declines in our rental revenues. And this represented actually about one half of our overall postsale decline.

So, DMO, operating profit was $8 million in the quarter and that was largely because lower revenues in Latin America were not offset with sufficient cost and expense reductions.

So a tough quarter in Latin America, but a clear opportunity for improvement and here's what we are doing... To expand our sales region in Latin America, we are accelerating the transition to a two-tiered distributor model for the office while focusing our direct sales force on our production offerings. We're also aligning our cost base to this new model and centralizing several support offices for the region. And all those related restructuring investments are already modeled into our expectations.

The transition to this new model has begun. And you can be assured that we're working this issue intently, and as we have demonstrated, we intend to execute with precision to ensure these actions deliver significant improvements.

So finally a quick wrap-up on revenue. Our strategy is clearly centered on growth opportunities in office digital, production digital with an emphasis on color, as well as value-added services. And our Q2 results closely align with the positive momentum in these areas. So that tells me that our technology investments are paying off, especially since about two-thirds of Q2 equipment sales came from products we have launched in the last two years. And our ramp up in global services was clearly the right position with services now leading many of our large enterprise wins.

So now Larry is going walk you through the financials. Larry?

Thank you, Anne and good morning. The second quarter was another positive step for Xerox. We exceeded our expectations and earnings and delivered significant margin expansion. Equipment sales growth, coupled with productivity improvements delivered above committed results. Positive balance sheet and cash performance continues with the end result less debt, less interest expense, and more cash.

Slide 10. Total revenue declined 2% in the quarter and as Anne mentioned the currency benefit was less than it had been recently. At current spot rates, we would expect a 2 to 3 percentage point currency benefit, for 3Q and the full year. Equipment sales were up 5%, delivering a sixth straight quarter of growth, including double digit growth in color and value-added services.

While equipment sales continue to grow, postsale and financing declined 4%, and I will discuss this on slide 11. As you can see, the growth areas of our business continue to grow, as a proportion of the total. They now represent 68% of postsale revenue. These areas grew 4%, and contributed 3 points to total postsale growth.

Light Lens and SOHO contributed five points to the decline, and the rate of decline is modestly accelerating. Light Lens and SOHO now represent about 9% of our revenue, so that this drag will diminish over time. DMO declined 12%.

Excluding the impact of Latin America, postsale and financing would have declined 2%, and the constant currency trend would have shown further improvement.

So what happened to postsale and financing revenue in Latin America? First, we still have a large base of Light Lens equipment, much of which is on rental contracts, and the revenues are entirely in postsale. We are experiencing increased cancellations in these areas, as customers stray to new digital equipment, predominantly low-end office equipment. We recognize the need to do more effective jobs of covering the market with two-tiered distribution.

So what does this mean? The Light Lens declines will eventually resolve themselves as they get smaller over time. We will begin to make improvements in Latin America, through implementation of the two-tiered distribution model in the office and focus our direct sales force on our production offerings.

Postsale and financing improvements will be driven by growth in our investment areas, particularly color, but the transition to total postsale growth is going to take a longer time than we had expected, due to the challenges in Latin America; however, we remain committed to our full-year revenue expectations.

Slide 12. Since we covered revenue, I'm going to focus on the remainder of the P&L. Gross profit margin of 41.3% improved 1.5 points from the first quarter, down 1.1 year-over-year.

Approximately one point of the decline was due to an increased proportion of monochrome desk top multifunction office printing and digital production sales. Next. 3/10th of a point was due to iGen3 sustaining engineering and will lap that year-over-year decline in the third quarter.

And the good news is that the pricing environment is essentially unchanged from what we have experienced over the last several quarters. So our productivity improvements are offsetting price investments.

R&D expense reflects improved productivity, as we capture benefits from our platform development strategy, as well as the commercial launch of iGen3. We'll see additional platform benefits, more product launches, as the year progresses.

SAG expenses were down $39 million to 21.3% of revenue in spite of $24 million in adverse currency and a sizable Drupa trade show investment. Bad debts and G&A both had excellent results. Bad debts were down $39 million year-over-year and are now running at just under 1% of revenue. Other reflects significant interest expense improvement, down $64 million year-over-year, a big boost to our pretax profit margin now and in the future.

Also included in other net are the $38 million gain on the sale of ScanSoft largely offset by incremental restructuring expenses and last year's $73 million credit facility fee writeoff following completion of the 2003 recapitalization. These improvements all contributed to margin expansion of 4.3 percentage point increase in our pretax profit margin this quarter, 2.4 percentage points without last year's credit facility writeoff.

Our tax rate for the quarter was 33.5, and includes a domestic tax refund. We anticipate that for the second half of the year, the tax rate will approximate 40%, bringing the full year tax rate to around 37%.

Bottom line, very effective cost and expense management which enabled earnings of 21 cents.

Slide 13. Cash performance continues to be good with $256 million of cash from operations including a $ 2 million pension payment that makes our U.S. pension plans fully funded on a current liability basis.

Strong earnings was the primary driver of cash from operations in this quarter, and with operating cash flow of about 500 million through first half of the year, we believe we are on track to generate a billion and a half for the full year.

Capital expenditures for the quarter were $47 million, and $95 million year-to-date. We still expect to spend between $225 and 250 million for the year.

Also included in cash flows from investing was $158 million, released from restricted cash, primarily relating to the renegotiation of secured borrowing arrangements with GE, further evidence of our improved financial performance.

Secured debt increased during the quarter, reflecting the completion of a new agreement with GE for a three-year, $400 million revolving credit facility secured by U.S. accounts receivable. At June 30th, we had funded $187 million.

We have reduced total debt by 1.5 billion year-over-year to $10.3 billion, of which $4.3 billion is secured by financed receivables and we ended the quarter strong with $2.5 billion in cash.

So in summary, every 90-day period has its own set of challenges, but we are committed to achieve shareholder value and returns. In Q1, we achieved our goals in spite of lower gross profit margins. This quarter our challenge is centered more on our Latin American operations. In both cases we addressed the problem, overachieved in other areas of our business ,and delivered on our commitment. We believe we have clearly demonstrated the flexibility of our business model, as well as the strength and the determination of our management team.

Thank you for your time and now I will give it back to Anne.

Thanks, Larry. So if you turn to slide 15, we remain committed to our revenue expectations of flat to modestly positive for the full year. And we expect to see modest revenue growth during the second half of the year, driven primarily by strength in equipment sales.

As I mentioned at the beginning of the call, our strong earnings performance for the first half of the year along with accelerating demands for our new technology and services gives us the confidence to raise our full year earnings expectations.

We now believe 2004 full year earnings will be around 82 cents per share. However, due to fluctuating market conditions, we're most comfortable with the range of 80 to 84 cents per share up from our guidance of 67 to 72 cents provided at the investor conference last November.

Now, keep in mind that this includes an 8 cent gain from the Q1 ContentGuard sale which we expect to only partially offset with 4 cents per share of additional marketing and restructuring investments planned for the balance of the year. And that investment is roughly split 50/50 between marketing investments and restructuring.

Those additional marketing investments include primarily additional print ads to support color, office, and new monochrome production offerings, in other words, demand creation and some TV advertisements focus on color and value-added services capabilities.

So if you turn to slide 16, let me quickly recap. Through technology investments, a strong focus on services, and solid operational performance, we delivered earnings that exceeded our expectations. We're taking the necessary actions to address weaknesses in the quarter and deliver growth through expanded sales channels, competitive offerings, and new technology.

And that puts us on track to raise our full year earnings expectations and to expect Q3 earnings in the range of 11 to 15 cents per share, which includes one cent from the incremental marketing investments that I've just referenced.

We remain quite confident in our business model, which is able to quickly adapt to changing market conditions, in our award-winning product portfolio which is second to none in the industry, and in our expanding global service business, which delivers the efficiencies of smart document management to businesses large to small. And in our ability to continue to delivering on our commitments building value and winning in the market place. That's why we are raising full year earnings expectations and remain confident in earnings expectations for 2005.

So thank you for your time, and Larry and I would now be pleased to take your questions.

Thank you. If you have a question, please press star one on your touch-tone phone. All participants are asked to limit themselves to one question. Once again, please press star one on your touch-tone phone. Our first question comes from Jay Vleeschhouwer from Merrill Lynch. Please go ahead.

Thanks. Good morning. I would like to start first with your comments on the postponement of recovery of postsale or consumables. Do you have a new target date or could you say whether, if you exclude the deterioration of Latin America consumables, that otherwise for everything else, your postsale and consumables would still be increasing as planned starting in Q4?

Okay, Jay, let me take it. First of all, I just want to -- it's really not consumables in Latin America that created the issue. It's rental revenues that are actually being converted, if you will, to kind of low-end, you know, sale devices. So the consumables are not an issue. As we indicated in the earnings announcement, if you took out the impact of the Latin American decline, then the trend would have continued to improve in postsale going forward.

So that really is the changing element here. And we want to be kind of responsible in terms of making sure that we have a degree of precision as we kind of go through the balance of the year, and look towards 2005. So we do believe that it will postpone the turn in postsale; however, we also are delivering better equipment sale than we had anticipated and therefore, believe we're okay with regard to our total revenue projections. And we're confident enough that we can reinforce our full year earnings guidance for 2005 as well.

So we do view this as temporary and one that we're addressing very quickly and very intensely. And I think we need another quarter to really kind of see what the -- the results of our restructuring in Latin America deliver to give you the kind of precision with regard to the postsale turn we would like to.

So what we're really prepared to do today is to kind of reiterate our confidence and bottom line returns. It's a little bit of a mix between equipment sales and postsales but we do believe this is temporary and we have got the right actions in place to address it as quickly as possible.

All right. And on these calls, you often talk about updated market share data. And --

Yep.

I would like to -- you didn't talk about that this morning. So if we could focus on that for a second. Starting first with U.S. mono, for instance. According to the available data, for instance, from data Quest have pretty good share in segments 4 in particular, better in segments 2 to 3. I'm wondering in in the segments where you have been particularly strong, in terms of your share you could comment on how you are doing there, in terms of maintaining or building share and similarly in color --

Yep.

-- the data in the U.S. indicate you had pretty good shares in segments 2 to 3 and that the U.S. has also moved much more quickly to faster speed machines, it would seem than Europe on average. So if you could talk about those trends and share indicators.

Yeah. Let me give you just a summary kind of, of the segments I will do it, really, worldwide, Jay and give you a sense of where we are.

I think it would be fair to characterize the office and as you know shares always kind of lag and therefore when I talk about shares it's going to be Q1 and it won't necessarily take on the impact of some of the strong install numbers we have in Q2.

But in office black and white, the multi function market, we're kind of holding our own and the market, obviously is not growing, and, therefore, we're kind of holding our share in that space. You are absolutely right. Our share is better in the high end of office black and white multi function than it is in the low end.

But quite frankly, we want to participate and lead in all segments, but we're pleased particularly to see this quarter, you know -- last quarter we talked to you about segments 3 to 5 being somewhat weak and this quarter they came back very strong with 11% growth. So hopefully you see that in the share numbers going forward, but I characterize it as kind of flat share and not a lot of movement in office black and white.

Office color there was a lot of volatility in the quarter. It was driven by a low-end entry. So from a box share perspective, it was moving very quickly. We did have very good share at the high end of office color, but at the low end -- there was some dislocation on the low end, that did reduce overall share for us in the -- in the color office market, but we're quite confident that on a page basis, we're holding our own. And the second half for us is going to be a really strong half of product launches too. So we think we can kind of capture back some lost ground.

In the production market, you would look at and say the whole production market for us was defined by our progress in light production which was really very, very positive in share as well as in revenue. And without the new publishing device, it kind of slowed considerably in the publishing and the printing market.

As a matter of fact, the market was slow.

And what we did see, I would say, was -- we did see a lot of what, I will call -- characterize as very aggressive placements on the part of Heidelberg prior to the conversion to Kodak, and so that did drive a little bit of share loss in the publishing and the printing market but we are quite confident that Nuvera is going to be a significant answer there.

In production color, I think you know we've -- the data has begun to split it into kind of low production color and high production color. In low production color, there's really only one entry it's the Konica offering, and if you look at production in total, it kind of equates and iGen3 to Konica, which obviously, you know, is not appropriate from a market perspective.

The high end of production color, we held our share. We are doing great. We had two-thirds of the market and page volumes are absolutely terrific.

In the low end it was really the Konica/Minolta story and that's an area that's clearly been impacted by the launch of a single new product. But overall on the page share basis we feel very, very confident.

Thank you.

Okay.

Thank you. Our next question comes from Jack Kelly from Goldman Sachs. Please go ahead.

Good morning.

Hi, Jack.

Could you just focus a little bit more on Latin America, I guess in terms of a couple of respects. Number one, maybe where it was in terms of percent of sales at the end of the second quarter.

Secondly, this move to two-tiered distribution, can you just kind of give us some numbers on where you are, you know, the distributors have you lined up, where -- where you might be at the end of the year, versus where you are now.

And just, third, in terms of the falloff in the second quarter versus whatever the experience was in the first quarter, again, just Latin America, I mean, what actually triggered that? You mentioned rental revenues but they were probably going down prior to this. Was there any kind of, you know, event, whether it's, you know, new competition or something that made the second quarter as bad as it was.

Okay. And, you know, I want to also characterize we clearly have an operational issue that we're addressing in Latin America. It is, you know two, years back we had more of an asset risk issue in Latin America that we solved and restructured in Latin America so we didn't have that risk.

I think I would characterize it, if you look at the percent of sales, they were much stronger in Q1 than they were in Q2, as a matter of fact, total revenue declined by 6% in Latin America. 6% of total revenue, so it's a fairly minimal portion, but declining at, you know, a rapid rate.

We only -- we had about 11% growth in equipment sales in Latin America, which was all driven by Russia and some of the eastern European entities versus Latin America, but that's also slower than usual.

And the postsale piece really was very specifically associated with Latin America. And what happened is we just saw, quite frankly, a real shift. And you're right. We knew this was -- we had been working on kind of implementing two-tier distribution. This is not something that just came on to our radar screen, but it did accelerate in Q2 and the impact really was from printer vendors and the fact that it really did dislocate a lot of the Light Lens population quicker than we anticipated.

So we are well on our way. We have a management team that's literally living in the specific parts of the world, signing up our distribution partners, getting the infrastructure in place to support a two-tiered distribution, and we're quite confident that we can get it moving quite quickly in terms of a change in structure.

But it really was an acceleration of a trend that we had already seen, and it really caused to us kind of reassess the pace of our two-tiered distribution implementation and we've adjusted that pace to be a lot more intense and quicker.

Any sense of when that would stabilize, Anne? I mean it's a tough question but --

Yeah. You know, I think it is hard to say, and, you know, we clearly expect to see improvements and positive signals coming out of this quarter, but, you know, as you know, postsale is -- it's not something that reacts as quickly as the equipment sale does, so I think we would hope to see some significant improvements on the equipment sale side, and that the postsale will improve a little bit less quickly based upon the implementation of the two-tiered distribution model.

Just finally a question for Larry. Larry, you gave us -- in terms of the gross margin decline, year-over-year, you gave us a couple of components of it. You mentioned price productivity. Didn't give a number, but I guess backing into it, it was a plus two?

Yeah.

Is that right?

I didn't want to guild the lily. [Laughter ]

Okay. Thank you.

Thanks, Jack.

Thank you. Our next question comes from Ben Reitzes with UBS.

Yeah. Thank you. Good morning.

Hi, Ben.

Hi. An Anne, could you just -- I I'm going to ask around the postsale question again, but also in terms of total revenue. The second quarter performance in revenue was, I guess, the lowest sequential improvement since 2001. How would you characterize that? Is that the postsale? Or was there anything that was below expectations that led to that or was that in line with what you think seasonal trends should be, maybe with -- with this type of economic environment?

And then, just with regard to that kind of postsale, how does postsale go into the gross margin? The gross margin, obviously improved, Larry, but with postsale, maybe a little below what people were thinking. So I would assume that it improved probably due to pricing and productivity, but if you can characterize that, that would be helpful. And then how that trend is going to go into the third quarter. Thank you.

Okay, Ben, I think actually the biggest differential in terms of the pace of revenue had to do with currency and not the operational fundamentals. We were actually pretty pleased with the equipment sale growth of 5%, and thought it reflected, you know, with the exception of the production, publishing and printing market where we've got kind of a new product lag in terms of the impact it will have on the full portfolio, we were pretty pleased. And if you look in the office across all of our new product areas, it looked good.

So I would look at currency as being the biggest driver for some of the differences in terms of the pace of -- of revenue.

On postsale, you know, I think Larry described it pretty well. If you looked at our growth areas, the postsale of our growth areas grew at 3%. The biggest impact of postsale is really still the five points of negative impact that you are getting from Light Lens and SOHO. And, you know to some extent, the quicker it goes, the healthier we'll be, because it's -- it becomes diminimus and then we don't have that kind of hanging. It is accelerating a little bit, which makes it, perhaps, tough within the quarter. But for the long term of the company, the quicker we unhook from that Light Lens legacy, the better off we'll be. And that's why when the turn occurs, it will be more dramatic in the sense that we won't have any of that lag with the Light Lens side of it.

You know, the other differential was in terms of postsale revenue, pace of improvement really was this Latin America issue. So we are very focused. We've got it nailed in terms of the problem. We've got the actions in place. It is not a broad-based issue for the business. The fundamentals are great. The office and the production businesses are very healthy. So it is something that we kind of have our eyes on very discretely and will address.

Gross margins on postsale are very good. So we're quite pleased. And, you know, quarter to quarter, they -- they really did respond to the kind of productivity improvement and discipline we put in place which is, I think, why Larry indicated, you know, I think one of the things that this team is really done well is that the adaptability of addressing issues quickly and seeing positive results is something that really developed, I think, a lot of discipline around. So postsale margins, I think were positive, and we'll continue to focus on making sure that we match our productivity and the investment strategies so that we see those kinds of returns in postsale.

But the biggest contributor to the positive gross margin move was productivity and price?

Yes. And I think -- you know, price we said was pretty much consistent in the sense that, you know, we haven't seen any deteriorating trends on price. We still see price investments being made, particularly in the office, but it's not accelerating by any means.

And then just, did you say how much the Olympics were going to cost in the quarter so we know maybe in the future what the real comp is?

We've never talked about how much the Olympics cost, but it would be fair to say that they cost more than Drupa.

Okay.

Okay. Thanks.

Thank you. Our next question comes from Stephen Weber from SG Cowen. Please go ahead.

Good morning.

Hi, Steve.

Talk about where you stand with your sales force in terms of coverage. What's happening with the sales productivity? And then I have a couple of follow-ups.

Okay. And, you know, I think the sales force is in really good shape. Our coverage, actually, in -- and I'm just now -- I just looked at all of our quarterly productivity numbers and coverage numbers. Coverage, actually, is going up a bit, and -- which is great. That's the first time we've actually seen -- you know if you looked at our SAG and pulled it apart, I think one of the best pieces of news is is that we made investments in selling while we aggressively took down the SG&A, so our SAG ratios are positive. But it didn't come at the expense of selling, just the opposite.

We're getting stronger. We made investments in building up our Tigress group and our global services group as well. And sales productivity looks really very good, both in terms of revenue and installs. We're very pleased with sales productivity, and when you see increases like 36% in global services, you can see that that strategy is really beginning to pull through. And certainly, the install kind of numbers that we're putting on the board really do demonstrate the kind of per head productivity we're seeing in sales.

It's really stable. Our retention rates are really high. I think in the U.S., they're at retention -- I think the turnover rate is 4%, and it's lower than that in Europe, so we're really pleased with sales retention.

And one of things we don't talk a lot about is, you know, although the work force is pretty constant, we've made a lot of investments, we actually hired 1,000 people in the second quarter, many of whom went into building the capacity for iGen3 and global services.

So, you know, while we're adapting and taking down in other places where we can get productivity-like service. But -- so overall I would say the sales force is really strong and in good shape.

Okay. Could you -- your R&D numbers continue to come down, can you just give us some guidance about what we ought to expect in the second half, maybe that's a question for Larry, and -- and perhaps similarly for SG&A expenses.

Well, I will take R&D and Larry can take SAG but I think you shouldn't expect that we're going to be aggressively taking down R&D. I think we talked about this --- sustaining engineering expense that's moved that will kind of become clearer next quarter because we'll finally have an apples-to-apples comparison. And we're seeing some productivity on our platform strategy, but overall we still think we'll be about 5% of revenues full year for R&D.

I think on SAG we're trying to go towards our model. So 27.2 or 3% in this quarter is moving towards the model. I think what you'll see is that we have opportunity to continue to improve on bad debts.

As you know, bad debts is sort of a rear view mirror. You look at how you've done and then you're able to take down a provision that you've taken. So I think we'll some benefits there and we're going to continue to focus in our cost competitive work on the G&A side.

So, you know, and then maybe if we do a really good job there, we can invest more on the sales side to make sure we have the coverage we need. So I think it's consistent with what our model -- and we're going to continue to work on the G&A and bad debts and admin side of it.

And lastly -- last November, at the analyst meeting when you put out that kind of preliminary guidance on '05, you talked about being able to do 5% or hopeful of doing 5% revenue growth. Your basis is probably coming off a little different, but do you -- do you think the ingredients are still there to do 5% revenue growth next year, or has that been postponed by the Latin America problem?

Well, Steve, I think hopefully one of our reasons for reiterating our earnings expectations for, you know, 90 cents to $1 for 2005, was really to give you a degree of confidence about our ability to deliver the model. We're going through our planning process right now, and, you know, so we're not -- there's no reason to change anything right now. But we're going through our line item planning process and clearly we'll be updating the model, but we have no reason to change anything that we provided to you last November in terms of 2005 at this point in time.

Okay. Great. Thank you.

Thank you, Steve.

Thank you. Our next question comes from Shannon Cross from Cross Research. Please go ahead.

Good morning.

Hi, Shannon. Just a couple of questions here. One regarding the value-added services while, you know, although a relatively small contributor to revenue, just curious what kind of margins we can expect from that. And, also, if there's any upfront investment that we could think about with regard to some of the of the major contracts that you've signed. Okay, on the margin side, I think our model would suggest that, you know, obviously our services business has a lower margin than our hardware and software businesses do, and -- but they are -- they obviously have less assets associated with them so the returns are pretty strong.

So I think mid-20s and even, perhaps, to high 20s is a reasonable expectation for services business that quite frankly is pulling through and driving a ton of other business. And -- and clearly, you know, is a front end to a lot of the major contracts that we've signed.

Your question was about front-end investment on some of these services contracts?

Yeah, just making sure there's no surprises coming.

No. As a matter of fact, I think, you know, as we scale this business, some of the front-end investments are already embedded, quite frankly, in the results that we've been delivering. We've been scaling and investing in global services now for about six quarters, hiring investments. When I talk about 1,000 people, a lot of those people came on board to run our practices and really be project managers for our services business.

So I think the opportunity for us going forward is -- as this business gets bigger and starts to scale, the returns look a lot better because a lot of the investments are behind us.

Okay. And then with regard to your comments regarding strong product launches in the second half of '04, can you give us an idea of -- maybe a little more color on how they're divided among office, production, black and white, and color. You know, we're all sort of waiting for one high-quality color product that should be coming. Any other color you can give would be appreciated.

Well, you know, I think it's fair to say that Graf Expo will be a significant event for us in terms of announcement, not just one, as well. There will be multiple announcements at Graf Expo so it's not just a single product. So we're pretty excited about that..

And on the office, I think we're going to keep pace with the kind of announcements we've been making, which is constant, you know, either refreshes or new platforms in the office that continue to strengthen the line, and, you know, give us the ability to gain share.

Obviously, you know, color capable is huge for us and that will be a big focus as it relates to the office technology, but, did but you will see announcements throughout the office portfolio.

Okay. And then with regard to the -- what's going on in color laser right now, I would assume you were referring to the $500 HP color laser that's hit the channels in terms of share shift in office color. I'm just curious what you think -- if you guys think you need to reach a $500 price point, with some of your color laser? I mean, obviously, the page speeds are wildly different, you guys are above 20 there, and they are at, like, four

Yeah.

But where do you see Xerox sort of fitting in trends in that --

Well, by the way, color printing for us is really -- the last share data was very good and very strong and we gained share and quite frankly HP lost share in the color printer business for Q1. So we felt pretty good about that. That was due to, by the way, the launch of the 8400 which was at the $1,000 price point, and has been wildly successful in both quarters. We did just introduce, as well, a product called 6100, which is at kind of 699, but better features, better functionality than anything else in its class. So we are competing very nicely, I think, in that section of the market. So, I think between the 8400 and the 6100, we've got some good participation in that. You're right. It's not the source of pages. You know, you;'re looking at something like our 7700 and there's, you know, one of those equals ten of the really low volume printers. But I think it was great that we gained shares and fight for pressure on the low-end pricing side, but we, I think, are stronger than we've ever been with the 6100 and the 8400 in thos segments.

Okay. And then one final question for Larry. Can you just confirm your new -- or Anne can answer too --confirm your new range that you provided does include the 40% tax -- a refund of 40% tax break for the second half of '04.

Yes. We said that it would be 40% for the second half, and that would average to a full year rate of 37.

Okay. Great. Thanks.

Thank you. Our next question comes from Carol Sabbagha from Lehman Brothers. Please go ahead.

Thanks. This is actually Meghan Talbot calling for Carol.

Hi.

Hi. I was wondering if you could talk a little bit more about the office. Two things mainly. The postsale trends, hate to bring them up again, but did [inaudible] a little bit this quarter, but just how we can look at that going forward and what's going on there.

And secondly the margin increased significantly in the office this quarter, although you've talked about some negative product mix from the top line. You mentioned selling infrastructure efficiency in your release. So I just wanted to see if you would talk a little more about what's happening in the margin in the office.

Okay. I think that the margin did improve in the office and I think it improved by a little bit more than 2 points, which was a pretty strong return. And we were pleased. And a lot of that actually came from the mix piece of the equation. I mentioned that in segments 3 through 5 we actually, you know, had very good performance which was a huge rebound from Q1.

So the richness, if you will, of the office mix, was very helpful. And it came from, you know, I think, you know, 25% growth in black and white. In our color MFDs, 40% install growth, color printers 54% growth.

So overall, the office is really moving at a very, very nice pace. And I think, you know, we're really pleased with the progress and it's showing in the returns. This is an area where mix is really important. Obviously, price investments we saw, once again, between 5 and 10 percent. A little bit more color than black and white now. We're seeing a little bit more aggressive pricing in color. But, you know, we think that office is really solidly in place in terms of, you know, both the sale rate, as well as postsale.

If you looked at -- if you kind of delayered the postsale story in office, that's where most of the Light Lens decline is hitting. It's really being impacted by the Light Lens decline, much more so than even production. So the digital office is actually looking pretty good.

Great. Thanks. And just a quick follow-up on, Anne, on equipment sales growth. It sounds like from your comments that 4Q is going to be a pretty strong quarter with the Graf Expo. So from your comments can we kind of assume that equipment sales, you know, stay essentially at the same rate in 3Q and maybe 4Q is where we see an acceleration?

Well, generally speaking, 4Q is always our strongest equipment sales quarter. So, yes, seasonally we would expect Q4 to be very strong and with the benefit of new products and Graf Expo, yes, we think the momentum going into Q4 will be very strong. You know, I think Q3 would be -- seasonally it's not as strong, generally speaking, as Q4, but we're still confident about equipment sales revenue growth and continued momentum. So I think it would be fair to say that we expect the second half to be stronger than the first half in equipment sales.

Great. Thanks a lot.

Okay.

Thank you. Your next question comes from Chris Whitmore from Deutsche Bank. Please go ahead.

Thanks a lot. Two quick questions. Back to equipment/gross margin. That was a bit better than what I was looking for. If we look out over the next couple of quarters, how do you expect mix to play into that -- that margin going forward? And do you think you can still outpace the pricing pressure with productivity improvements in the back half of the year?

Yep. Actually we think it'll get a little bit better. And some of it's mix, but I would say more of it's due to productivity as well as the scaling of iGen3 and Tigress products, which, you know, as we get more of them in the field to offset the cost investments that come at the front end of our product launch, the margins get stronger. So I think that we expect slight improvement and, you know, we watch that very carefully. But a lot of the investment news on the iGen and the Tigress were really taken on in the last couple of quarters. Tigress, by the way, is Nuvera. I -- sorry.

Well, as Nuvera ramps, will that be a positive contributor on a mix basis to the gross margin?

Absolutely. And particularly in comparison to the like production 2101.

Great. Thanks a lot.

You're welcome. I think we have time for one more question.

Thank you. And our last question comes from Bill Shope from J.P. Morgan. Please go ahead.

Okay. Great. Thanks.

Hi, Bill.

Hi, how are you?

Good.

Just a few quick questions. First of all, with the backlog you probably built in Drupa, are we going to see those sales pop into the third quarter or is it going to be shifted more towards the fourth quarter.

And then, in terms of overall corporate spend rate, did you see any reluctance from the large corporates to close large contracts at the end of the quarter?

And then, finally, just to dig back into the postsales issues once more. In the past two quarters, you've seen somewhat expected fluctuations, first it was in a little bit of margin weakness last quarters. This quarter, obviously, Latin America problems. Is there any risk that, perhaps, we're not going to see the same general postsales attach rate that you previously anticipated that you've previously experienced and the reason is beyond Latin America, particularly given the increasing [inaudible] at the low-end sales?

Okay. So let me start first about backlog. I think it's fair to say that what Drupa really did for us was give us the kind of prospect dates that we wanted to deliver the full year expectations for the production business. Q4, even without Drupa, is, you know, just the strongest and kind of -- the strongest quarter of the year. I think you'll see Q3 stronger than it usually is based upon the fact that we have this very strong prospect base coming out of Drupa and going into Graf Expo.

So I think you'll still see the leverage in Q4, but hopefully Q3 will be stronger than normal, which is not necessarily our strongest quarter from a seasonality perspective. But because of the momentum we've got in the production business, I think we'll see that.

On corporate spend, I don't think we could suggest that we're seeing anything terribly different than we've seen in the past. So no major change. I think we've been pretty consistent and modest about our views in terms of the economy. And we'd probably stay right there and say no significant change. It's really -- we've seen more change based upon the strength of product launches and, you know, kind of the value services that we're bringing that help customers deal with reducing their infrastructure costs. That's really been the driver for a lot of the growth that we're seeing.

And then on the postsale side, no, we really believed kind of there's a tax rate and I assume by that you mean kind of the ratio between kind of equipment sales and postsales. It's really stayed quite strong, and, you know, clearly although the low end model is a little bit different, the consumables part of the low end offsets the traditional approach. So it's as rich from a postsales perspective, in some ways richer, because the equipment sales are so stressed. And so we expect postsale to continue to be modeled fairly consistently going forward.

Okay. Great. Thank you.

Well, thank you all. I appreciate, you know, your participation this morning. We thank you for your interest and have a great weekend.

Thank you. Ladies and gentlemen, this concludes our Xerox Corporation second quarter 2004 earnings release conference call. You may disconnect and thank you for participating.