全錄公司 (XRX) 2005 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Xerox Corp. second-quarter 2005 earnings release conference call hosted by Anne Mulcahy, Chairman and Chief Executive Officer. She is 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 investor website at www.Xerox.com/investor.

At the request of Xerox Corp. today's meeting will be tape recorded. Taping and rebroadcasting of this call are prohibited without prior -- without express permission of Xerox. After the presentation there will be a question-and-answer session. (OPERATOR INSTRUCTIONS).

During this meeting Ms. Mulcahy and Mr. Zimmerman will make comments that constitute forward-looking statements. This presentation contains forward-looking statements as defined in the Private Securities Litigation Reform Act. These statements reflect management's prime beliefs and expectations and are subject to risks, uncertainties and assumptions. Should one or more of these risks and uncertainties materialize or should underlying assumptions prove incorrect, actual results may differ materially from those described in such statements.

Information concerning certain factors that could cause actual results to differ materially is included in the Company's first-quarter 2005 Form 10-Q filed with the SEC. The Company assumes no obligation to update any forward-looking statements as a result of new information or future events or developments. At this time I would like to turn the meeting over to Ms. Mulcahy. You may begin.

Thank you all for joining us today. If you'll turn to slide 4 we'll provide a summary of our Q2 results. We delivered earnings per share of $0.40 which includes $0.33 from the previously announced tax benefit which was partially offset by $0.13 of restructuring. The tax benefit and the restructuring charge netted out to $0.02 more than we initially expected and Larry will walk you through that detail shortly. Excluding these items EPS is $0.20 per share, a bit lower than our expected range for the quarter. This was primarily due to pressure on gross margins which, at 39%, reflects continuing pressure on product mix.

In response we're accelerating certain actions that are aligned with our cost competitiveness efforts and will help improve margins in the future. We fully expect that these actions plus the benefit of new products will significantly improve earnings in the second half of this year especially in Q4. In addition, strong DMO (ph) performance, the full benefit of our product launches, and flow through from restructuring actions will result in a very strong Q4. This performance will keep us within the range of our full-year guidance, most likely in the low end of the range.

Revenue was clearly a highlight in the second quarter as our new technology, especially color systems, drove up equipment sales. In fact, equipment sales from color alone were up 22%. We introduced 25 products this quarter, 24 of them late last month in our office portfolio, and demand for this new technology will fortify our second-half growth. Our SAG improved as a percent of revenue and the balance sheet remains healthy with operating cash flow of 290 million, that's after contributing 230 million to our U.S. pension plan. We now have 2.1 billion in cash and short-term investments and at the same time we reduced year-over-year debt by 2.1 billion.

Larry will walk you through the financial statements, but first I'd like to spend a few minutes on revenue and installs. And before we take your questions I'll wrap up with thoughts on Q3 and our full year expectations. So if you would turn to slide 5, here's a look at our revenue trends, all of which are trending positively. Again, the sale of new technology boosted equipment sales up 4% in the quarter, a trend that we expect will continue with our product launches from last month build momentum in the marketplace.

Color is a significant driver of this growth and helps to offset declines in black and white office and publishing. As you know, sales of our digital systems flow through to post sale growth in the future driving top line gains. Our investment in innovation is starting to support post sale performance with post sale up 1%. The drag from older Light Lens products was offset this quarter by good news in post sale from digital, growth in color pages and a modest benefit from DMO. With only 2 points of currency in Q2 this is our strongest post sale quarter since the turnaround, another proof point of the effectiveness of our strategy.

Total revenue in the quarter was up 2%, an improving trend, and again, one that will continue this year. We believe the combination of equipment sale growth from new technology and post sale increases from digital systems provide a run rate that will deliver 3% revenue growth in the second half of this year. Considering deferred cap revenue results and the second half growth expectations we now expect to deliver full year revenue growth of 2%.

So if you'll turn to slide 6, production revenues were flat in the quarter with 4% growth in production digital. Production color revenue grew 26% in the quarter largely due to strong sales of the Xerox iGen3 and DocuColor 8000. These products contributed to an 18% increase in production color install activity and, along with other high-volume systems, drove strong production color page growth. There are now more than 15,000 Xerox DocuColor systems in the marketplace, a number that far exceeds any of our closest competitors. And with the launch of the DocuColor 7000 in May, our production color portfolio is definitely the broadest in the industry.

In production monochrome activity was up 1%, an improving install trend largely due to the success of the Xerox 4110 digital copier printer that launched in March. The outperforming sales activity in light production offset softer sales of the Nuvera digital production system. And the net effect of this played into the product mix dynamic and impacted gross margins. We continue to see an improving trend in Nuvera activity that will flow-through to stronger second-half results.

In addition to strong sales of systems, like the iGen3 to the graphic communications community, we're continuing to win integrated products and services contracts that draw on our strength in document management. For example, Xerox Global Services is now managing General Mills' in-house document production and mailroom services and companies like Ernst & Young have expanded their relationship with Xerox by adding new Xerox production systems and relying on our scanning and training services.

So if you'd turn to slide 7 -- in our office business total revenue was up 2% in the quarter with digital revenue growing 6%. Revenue from office color grew 13%. Installs of color MSP's were up 69% largely due to the demand for the WorkCentre Pro color systems and the success of our solid ink WorkCentre 2424 that launched in March. And we expect continued good news and activity from these significant launches. Strong growth in office color printing continued in Q2, up 155% driven by laser printers including a benefit from our OEM business.

In office digital black and white revenue was up 1% and installs were up 29%. Similar to last quarter, this dynamic is the result of a shift in product mix with significant activity growth in segments one and two. Segment one alone was up 33%. We had 25% digital install growth in segments two to five, heavily weighted toward lower-priced units in segment two.

And as I mentioned, we announced 24 new office projects late June that target a $60 billion opportunity and add even more breadth to our office portfolio and they include -- the DocuColor 240250 multifunction systems that print up to 50 pages per minute; four new Phaser network color printers; and 18 CopyCentre and WorkCentre systems that range in speeds from 32 to 75 pages per minute. With order taking for most of these systems starting this month in North America and extending to Europe by September 1st, we'll see the initial benefit of this launch in Q3 ramping up to stronger Q4.

Similar to the production market, our services led approach with large enterprises gives Xerox the competitive advantage like at Hasbro where Xerox is now equipping their enterprise with multifunction systems and providing asset management and help desk support.

So if you'll turn to slide eight -- performance continues to improve in DMO, our developing markets. Yet considering the volatility in certain markets, we're not taking our eye off the ball and we do expect that we'll see some sequential variations as the recovery in Latin America progresses. Certainly our growth pattern in markets like Russia and Central and Eastern Europe remain a strong highlight of our DMO results. And we're duplicating in Latin America the two-tier distribution model that worked so well in other regions.

Our focus is on building a stable and efficient distribution capacity for both office and production while improving the productivity of the infrastructure to support this model. And we're making progress. It's a big task but we have the right team and processes in place to effectively implement this strategy. And we expect that DMO performance will deliver positive results in the second half.

So a quick summary before I hand it over to Larry. Strong revenue performance in the quarter is proof that our investment in innovation is paying off. The headline is color which is fueling today's equipment sales and will drive even stronger future post sale results. We're taking the actions to improve our margins as a result of product mix shifting to lower margin sales. Our focus is on cost competitiveness and aligning our entire business model with the changing demands of today's digital marketplace.

Again, considering the ramp up of new products this year and the benefits of our leaner business model, we're confident that full-year earnings will be within our guidance and I'll talk more about Q3 and the full year in a moment. But first, here's Larry to walk you through these financials. Larry?

Thank you, Anne, and good morning. Let me begin with a brief characterization of this 90-day period. We are pleased with our top-line growth and positive trends in equipment sale and post sale. Our growth areas, digital office and production as well as DMO, delivered positive results and support our growth strategy. Gross profit margin was impacted due to product mix. We're now seeing significantly increased sales of lower margin office desktop products as well as decreased sales of high-end black and white products. This lower margin put pressure on earnings resulting in a second-quarter EPS on an adjusted basis that is slightly below our guidance of $0.21 to $0.24 per share.

We have already taken a number of actions to address our cost competitiveness. For example, much of the restructuring we announced is aimed at improving the productivity of our technical service operations as well as reducing manufacturing costs. At the same time, as Anne mentioned, we announced an array of new black and white and color products which will improve the mix as we go forward. As important, I believe that the success of Xerox's color strategy, post sale growth and continued progress in DMO will have a future positive effect on gross profit margin.

Our cash performance in 2Q remains outstanding. Cash flow from operations was 290 million, debt was down 1.5 billion from last quarter, non-financing debt to capital ratio was at 15% and we ended the quarter with 2.1 billion of cash and short-term investments. Before I move on, the favorable tax audit and restructuring complicates the P&L this quarter so we added a couple of slides to provide clarity.

Slide ten, let's start with revenue. To quickly reiterate Anne's comments, revenue was a positive story in 2Q and a strong proof point of our long-term growth strategy. Our targeted growth areas were up 4% in the quarter; digital office was up 6% and digital production was up 4%. A tough year-over-year compare impacted our value added services line for the quarter, a bit of an anomaly considering our strong growth trends in this business. However, a very large contract signing in 2Q of last year impacts this quarter's year-over-year comparison. Going forward, we continue to have a strong pipeline and are tracking at double-digit revenue growth for the full year.

We continue to see improvement in our developing markets with DMO delivering an improved second quarter. However, considering the volatility of DMO countries, we remain intensely focused on driving improvements. Light Lens and SOHO continue to decline at a high percentage, but are a smaller portion of the total, 3.8% down from 6.6% in second quarter of last year. Total revenue grew -- total color revenue grew 17% year-over-year and the sequential trends continue to improve with color equipment sales up 22% in second quarter versus 16% in first quarter. Color now represents 29% of our total revenue, but only about 7% of our pages are printed on color devices so the opportunity remains huge.

Slide 11, this slide drills down on our post sale and financing revenue performance. 5% digital growth drove a 1% gain in post sale -- total post sale. This digital growth contributed 3 points to total post sale growth. Progress in DMO contributed about 0.5 point and post sale revenue from other areas contributed another 0.5 point. Combined these areas more than offset the 3 point decline in Light Lens. This is a trend we expect will continue in the future. Light Lens and SOHO continue to rapidly decline and are a small portion of the total, 5% down from 9% a year ago. Post sale color was up 15% and now represents 25% of total post sale revenue. Again, only about 7% of our total pages are printed on color devices. Color pages generate about five times more revenue and gross profit dollars than black and white pages.

In summary, the declines in Light Lens and SOHO continue to put less pressure on post sale results. At the same time, post sale has strengthened by DMO improvements in growth and digital office and digital production. Therefore we remain confident that post sale will help contribute to total full year revenue growth.

Slide 12, before I cover the specifics of the P&L, let me summarize the tax benefit and the expected effect of the restructuring. As a reminder, this tax benefit is the result of the completion of a 1996 to 1998 IRS tax audit. 260 of this benefit is due to a 2002 tax law change that allowed us to recognize the benefit for capital losses from the sale of our insurance group operations. The balance is related to the favorable resolution of other tax matters.

Let's start with the full year effect. The tax benefit is 343 million or $0.33 per share. This is 13 more than was initially announced. We anticipate restructuring initiatives will result in a full year after-tax charge of 200 million or $0.19 per share. Therefore, the net increase on our full-year guidance of $0.90 to $1 is $0.14 per share. For the second quarter the entire tax benefit of 343 million or $0.33 was booked. 130 or $0.13 per share of the restructuring was booked in second quarter and we expect the remainder, $0.06, will be booked in the second half once our plans are finalized. For the quarter the tax benefit and restructuring netted 213 million after taxes or $0.20 per share. This is 23 more than was initially announced.

Slide 13, on to the P&L. To provide clarity we added a couple of columns to highlight the tax and restructuring adjustments circled in red and to provide a look at the business as usual adjusted P&L. Under the IRS audit column 57 million is the interest booked on the tax benefit. Further down the 233 million is the tax benefit associated with continuing operations. 53 million is the tax benefit associated with discontinued operations which is the portion of the tax benefit related to a specific business that we exited. This equals 343 million, the $0.33 benefit I just presented on the previous slide.

Now to restructuring. 194 million of restructuring was booked in the second quarter; 64 million is the tax effect on the 194 million. After tax the restructuring nets to 130 million or $0.13 per share. So on an adjusted basis netting out the tax benefit and restructuring $0.40 becomes $0.20 per share. Gross margin is 39% lower than expectations. For the first after the year gross margin is at 40%. As we mentioned, the margin is driven by mix not price. The key drivers of the mix shift are growth in segments one and two versus segments three through five, growth in office printers and increased growth in lower margin geographies.

As we go forward I do expect to see improvements in gross profit margin driven by our new black and white digital product announcements as well as improvements in post sale. In the meantime we feel it is necessary to take action to reduce our cost base going forward to ensure that we meet our goals. More than half the restructuring targets are manufacturing and service costs. So we now have reduced our costs going forward and we still have an expectation that mix will improve. We have reacted quickly to changes in the environment and we are making midcourse corrections, ensuring our business goals are achieved without losing sight of where we want to be in the future.

We believe margin for the full year will be around 40% to 41%, slightly below our initial expectations. R&D and SAG are in line with our expectations with sales investments, lower bad debts and reduced infrastructure costs.

Two other quick points. Interest expense is lower, non-financing interest expense was down 22 million or 26% in the second quarter. We're also making some changes to drive a lower tax rate. This quarter we had a 25% tax rate versus 33 last year largely due to lower expenses in one of our jurisdictions which can now use tax assets to lower our rate. In quarter one our tax rate was 40%. We expect the full year tax rate to be about 36% excluding the tax benefit from the audit finalization. The result again is EPS of $0.20 driven by strong revenue and pressure on gross profit margin which we have taken actions to address.

Before I leave this slide I want to briefly discuss an accounting change we will be making. In addition to R&D we incurred sustaining engineering costs related to our products. These costs are currently included in cost of sales. Beginning in the third quarter we will establish a new line item in our P&L entitled "research, development and engineering" which will include sustaining engineering and these costs will no longer be reflected in cost of sale. This is the way many other companies classify these expenditures and this representation will provide clearer visibility to our investments. In addition, this presentation also reflects the way we manage our business.

Slide 14, our cash capability continues to yield great results. In the quarter cash flow from operations was 290 million after making a $230 million U.S. pension contribution. Finance receivables were a modest source of cash in the quarter but down sequentially from the first quarter due to our strong revenue performance. AR and inventory grew modestly in the quarter also driven by our revenue performance.

In addition, we invested 61 million in on-lease equipment of which a significant portion is from are shift to flexible operating leases. This shift to flexible leased offerings impacted equipment sales by 1.5 points. We expect this to be a continuing trend. June year-to-date cash flow from operations is 627 million, that's 128 million higher than the prior year. In the second quarter we started investing in short-term securities for a better return on investment. This moved 190 million from our cash balance to short-term investments. You can see this change in the investing section of this cash flow.

CapEx was 43 million in the quarter. For the full year we still expect to be about 250 million. In the quarter we made a 1 million payment on our unsecured debt and secured debt decreased 500 million bringing total debt down 1.5 billion in the quarter. Our cash balance of 1.9 billion plus our short-term investments of 190 million resulted in a total of 2.1 billion in cash and short-term investments.

Slide 15, here's a look at the key points on the balance sheet. Healthy cash flow enabled a 2.1 debt reduction from last year, at the same time the cash balance is strong. Debt is almost totally aligned with our financing business. Our debt to capital ratio for our core business is down to 15%, a huge reduction from 39% last year. Second, secured debt is down more than 800 million this year, a trend that will continue.

So in wrapping up, my view of the quarter is quite positive on the revenue front including equipment sales, post sale and color. We announced significant strategic cost competitive initiatives, had positive SAG performance, excellent cash and total balance sheet, and finally gross profit margin pressures which we have addressed and will continue to address going forward. With revenue growth, operational improvements and continued strong cash performance in the second half we're executing on a well-defined plan to deliver another year of expanded earnings. Now back to Anne.

Thanks, Larry. So we've been consistent in saying that our performance this year will ramp up in the second half, especially considering the major product launches. So for the third quarter we expect to deliver earnings in the range of $0.16 to $0.18 per share, this includes additional restructuring charges of $0.01 per share; a strong second half, especially through 3% revenue growth and continued improvements to boost margins will keep us within our earnings guidance for the full year.

We now expect full-year GAAP earnings will be at the lower end of the $1.04 to the $1.14 range. This range is consistent with the initial guidance we set of $0.90 to $1.00. It includes the net benefit from the IRS tax settlement backing out anticipated additional restructuring charges. And slide 18 provides more detail on this breakdown.

Our confidence is based on these five factors. First, our leadership in color is delivering top-line growth and will continue to fuel healthy long-term gains in both equipment and post sale revenues. Second, 95% of our office product line has been refreshed in the past two years. This new technology offered through expanded sales channel gives us more presence and competitive power in the marketplace. Third, we're winning more and more contracts through Xerox Global Services and expect a double-digit increase in revenue from value added services while driving hardware sales. Fourth, we're taking focused actions to respond to pressure on margins and keeping a close eye on costs to ensure that our operations deliver strong bottom-line results. And lastly, effective execution is the core strength of this leadership team. We deliver on our commitments and we believe our efforts this year will again yield double-digit earnings growth.

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

(OPERATOR INSTRUCTIONS). Jay Vleeschhouwer, Merrill Lynch.

First question on gross margin. It's been below the nominal range in three of the last six quarters including in the second quarter and I understand your references to mix. But perhaps you could help us understand the disparity in margin between the low-end product and the higher end product so that we could get a better handle on the mix influences. And given how often this has now come up in the last year and a half at least, would it be better, do you think, to perhaps widen the range of gross margin or perhaps lower the low-end of the nominal range?

Maybe to begin where you ended, Jay, we basically have adjusted the range and said that certainly for the year we're planning on a 40 to 41 gross margin expectation versus the 41 to 42. There's no question and it's important that we kind of quantify what these mix issues are. It is not price. Price has remained stable and no real anomalies at all that we're seeing in pricing whatsoever. The gross margin pressure really comes from three places. The first is the shift in office mono from the segments three to five to segments one to two.

On equipment gross margin there's about a 10 point differential in margins at the very low end of the range versus the high end of the range. That's why these product launches are so significant that we just announced because they are the next generation of three to five which clearly will drive more momentum in the marketplace. So that first office mono category is probably the largest contributor to the overall mix pressure.

The second is our outstanding performance in low-end office color printing. I think we talked about 169% growth that clearly that is the lowest margin -- equipment margin segment that we participate in. That's really not a problem because the long-term impacts of the -- on post sale from the consumables is something we'll take any day of the week. But within a 90-day period of time that kind of extraordinary performance in low-end color printing does put pressure on the equipment margin.

And the third area is really the strength of light production with the 4110 performance versus the higher end of the production publishing segment which is represented by Nuvera, Jay. And although we're seeing an improving trend there, it's been a little bit slower than we anticipated but we know that that improving trend will continue for the balance of the year.

So we are confident that we've got the actions aligned in terms of product launches to improve gross margin and our restructuring actions are primarily focused on margin improvement based upon the targeted areas that we're looking at. So yes, we believe we can improve them. This has been certainly a continuing issue for us which is why we took the actions when we did. But we're confident that we can improve them and we've basically adjusted our range of gross margins for the balance of the year based upon the first-half performance.

With sector revenue, the 3% outlook for the second half of the year is better than you did in the first half, but it's probably less than some of us might have anticipated. How would you rank the various influences of overall market demand, particularly in commercial and graphic arts and office markets versus mix, versus availability?

Let's talk about market demand. We're very bullish on market demand. We had double-digit activity increases across the board this quarter and we expect that clearly to be a driver of growth in the second half of the year with a much stronger product portfolio. So we're really not concerned about market demand. Certainly, although we're focused on improving mix, we know that activity, particularly in segments one and two and color printing, will continue so we're going to continue to have a lot of growth coming from the lower end of some of the product ranges.

I would say that the biggest perhaps -- or the most depressing element, if you will, on overall revenue growth for the second half is actually more the impact of currency than it is anything else, Jay, and that's really more of a Q4 phenomenon than a Q3 phenomenon. But we've looked really carefully at what our opportunities for growth are and feel quite confident we can deliver the growth we've outlooked even with kind of a little bit of a headwind situation from currency in Q4.

Lastly, Larry, do you have a GAAP operating cash flow forecast for the year? You did 627 through the first half. What do you think the total number might turn out to be for the year?

I think we're just going to stay with our billion to 1.5 billion, Jay.

Thank you very much.

Ben Reitzes, UBS.

A couple things. One is actually interest income. If I see this right, Larry, you have interest income of 88 million, up from 18 in the prior quarter. The other expense line contributed $0.05 more than I had in my model of positive. I was just wondering what's going on there. You mentioned it in your comments, but if you could just clarify is this kind of interest income level sustainable? And then, what happened in one quarter to make the interest income go up so much again? And if you could explain that, and then I have a follow-up on the top line.

As I showed, Ben, on the P&L chart when we took out the tax benefit, a significant portion of that interest income is associated with the benefits from the tax settlement here. So that really isn't a year-to-year improvement that we have in our $0.20. So it's part of one of those -- that first column of the settlement. So that settlement of 343 million is split between discontinued operations, ongoing operations and interest income on the settlement amounts.

Okay. So we take that out (multiple speakers).

Yes, you take that out.

So what's the number we should be modeling going forward? Just comparable to this first quarter?

Yes.

Okay. Sorry about that. Now, with regard to the fourth quarter year-end you talked about currency. And with regard to that, I guess we're calculating about a 2 -- over 2 points at current rates of potential currency headwind. Could you talk about what your bottom-line impact is? The way I look at it is $0.03 lower earnings for the second quarter and then about $0.04 lower earnings than we expected for the third. So then in order to get to the low end of the guidance we still have to get $0.03+ back in the fourth quarter with raised outlook for that one. So if currency is going to be a 2+ point hit to the top line, what is it to the bottom line at current rates?

Ben, let me just talk about -- I mean your assessment is pretty correct in terms of obviously the implications for Q4. We look at currency being probably overall about 1.5 points in Q4 versus your 2 point piece of it. But I think the real drivers and what we want to focus on in terms of why Q4 is such an opportunity for us really comes from three areas. One is that DMO performance -- clearly the compare is highly leveraged in Q4 in terms of the opportunity for DMO to make a significant contribution. The second is to have the whole product portfolio available in Q4 with all of the new product introductions flowing through. And the third opportunity is restructuring flow-through which certainly begins in Q3 but we just announced it.

So much more of an impact in Q4 than Q3. So as we look at the Q3, Q4 scenario, there is no question that the drivers for Q4 performance are very strong and therefore will leverage Q4 performance more than it has in a traditional year.

I guess the way to clarify it, though, would be if you have 1.5 points or two points or 1.5 on the top line it's less than that on the bottom line?

Yes.

Because you have costs over there.

A lot less. Absolutely.

Okay. Sorry, one last thing. iGen you said is strong, but obviously wasn't enough to offset on the gross margin line some of the shifts going on at the high-end black and white. I mean, just in terms of contribution margin and/or gross margin, when do you think iGen gets big enough to like offset this shift? I mean, just qualitatively if there's anything -- obviously part of the story here is that high-end color is going to offset some of the trends in the slower growing areas. So when does it get big enough to really move the needle on the margin side so that you can absorb these kind of hits?

Well, certainly the ramp up of iGen this year is going to reflect significant improvement by the end of this year on margin and, I mean, you can't forget then -- we sometimes focus on equipment margin, but that's 25% of our revenue, 75% of our revenue is in post sale. The average iGen is still delivering 400,000 color pages per month. We've gotten multiple installations now. We've got 60 installations with multiple iGens in customers. So the implications for iGen clearly are significant with regard to margin improvements, but the impact on post sale with the kind of revenues that it's driving is, I think, the most exciting part of the iGen performance.

Okay, thanks a lot.

Matthew Troy, Smith Barney.

I wanted to follow-up on margin, specifically operating margin in the production segment. If I think about that category, post sale and other revenues drive roughly two-thirds of the category. Yet if I look at it, those revenues were flat year-over-year and operating margins declined from about 11% to about 7%. I'm just wondering, there are two metrics there, one would be a decline in mix shift and hardware sales, others would be potentially some pricing vulnerability on the consumable side, neither of which I would have thought would have had a 4 point impact on operating margin. Could you just talk to what was specifically driving that in production?

It really is mix. You're right; pricing is clearly not an impact whatsoever. This is the dynamic of light production and basically 4110 performance has been so strong and the light production margins are lower. I also think that when you look at -- and we've been trying to really deliver a message that when you look at operating margins by segment, 90 days has a lot of anomalies in it. If you look at the first-half operating margin in the production business it's actually about a point off, not 4 points off. So we do see this normalizing and clearly getting better as we proceed through the year. But I think in the first half it's not all that significant and the total causal here really is the mix shift to 4110.

Okay. Second question would be on the expanded channel distribution on the office side, I believe you guys opened up segment one and two outside of your dedicated direct sales force in '04. My sense is that's starting to see traction in '05. Can you give us an update on how that's going, what percent of your sales are flowing through the expanded channels now and is that having any impact on margins?

I think we're really pleased and it's not just segment one and two but it's also OEM activity and other sources of distribution that are really driving a lot of the growth in the low-end products. But I actually believe that it's really just starting to ramp up. It's really just been a couple of quarters where we've had segment one and two products available through indirect channels. But they love it. It's their highest source of growth and they're anxious to take whatever we can give them in terms of those categories.

But I also wouldn't forget from a printer perspective the growth that we're getting from our OEM business as well driving a lot of that. But overall I would say pleased and I still think the mass growth opportunity is still in front of us with regard to the multifunction products being distributed through the two-tier channels.

One product just to take note of which has been a barnburner is our 2424. That's that color multifunction solid ink product that we launched in March. And that 69% growth you saw in office color multifunction, a large part of that was due to the 2424 which is clearly being distributed through those indirect channels.

Last question if I could, Fuji Xerox -- I haven't heard too much about that in the call. I looked at your equity net income of unconsolidated affiliates and it's the lowest it's been in at least 1.5 years. I know that's a somewhat lumpy category, but could you just put some color onto perhaps why that number was a little over than we were expecting?

Yes, it's actually more of a timing. We're pretty pleased I mean with Fuji Xerox's performance. We were just over there for a week doing both product reviews and operational reviews. And I think you'll continue to see very much of a steady flow of income from Fuji Xerox. So we're not at all concerned about a little bit of a decline this quarter.

Is it more a timing issue?

Yes, definitely.

Alright. Thanks, guys.

Jack Kelly, Goldman Sachs.

Anne, could you just give us a little more color? You had in an answer to a previous question about gross margins mentioned three factors and one was a shift from office mono to segments one and two from three to five. What's driving that? And I guess the thrust of the question is if that persists for whatever reasons are we then into another restructuring charge six months down the road? How much -- I know it's a tough question -- how much have you kind of built-in in terms of restructuring for this new product mix? I guess the first question is why is it happening.

Okay. We've done a ton of analysis on this both from a market perspective as well as business analysis and I think the office market has been -- become very conducive to new product launches driving growth and our segment three to five haven't had really that burst, if you will, of new product introductions in a while. And therefore we saw really decisions tailing off in three to five versus the amount of activity we were seeing in segments one and two. So it's not as much the major enterprise clients that are substituting segment one and two products because a lot of that's coming through indirect channels. It's more that we just haven't seen the same amount of activity happening in those clients.

Bringing out these new products, which clearly have higher gross margins but also have more efficient price points and footprints, really does create a decision point for those clients and we believe we will see activity in segments three to five get better with the introduction of these three to five product launches. So yes, we're certainly optimistic that the mix will get better but I think it's also important that we're playing this game from both sides. We're going to do everything to ensure that the mix gets better, but we're also taking very aggressive actions on the cost competitive side.

And to your second point, we're putting cost restructuring actions in anticipating if it didn't get better what we have to do to improve the overall competitiveness of the category. The vast majority of the restructuring is going to service and manufacturing which does impact gross margin. And although we won't see a big impact in Q3, we think Q4 we'll see a significant impact in terms of the flow-through of those restructuring actions. So we're being a little bit aggressive on the restructuring side, but we want to make sure that this is not a reoccurring issue.

And the lack of activity on your customers in three to five or that segment of their needs, you don't think that is being answered by other competitors or other products, etc.? I mean they're doing something I would think.

I would say that it is not. Our share has been pretty either steady or flat, if you will, in the office mono section. In segments one and two we have been gaining share. In the higher end of it the market was down 5%. We were down more than the market, Jack, there but the market was also down and because we're such a big player I think it does drive the overall market conditions. So there is no question that three to five has been our weak spot, that clearly, the market was down as well and we really got to demonstrate that we can grow in that market with the new product launches.

Just a second last question, DMO margins, can you give us a sense, Anne, where they maybe were overall and how Latin America compared with the overall DMO?

Our expectation is that DMO operating margin continues to improve. You saw it improve in Q2. You'll continue to see that trend. Over time, we expect DMO to be operating at the company average in terms of where it its operating margin is. This year the drag on it will be Brazil. Basically the rest of DMO will be pretty close to the operating average of the company and we expect that they should clearly get there with the kind of actions that we are taking in Brazil, but it will be lagging slightly because of the impact of Brazil.

Carol Sabbagha, Lehman Brothers.

To follow up on mix versus price you talked a little bit about the office why think it's not really pricing it's more of a product mix issue. Can you talk about production, why you believe that customers trading down is kind of not a permanent thing more a reflection of pricing? And that Nuvera, I mean it's been out for quite a while, at least some portions of it, and we have kept it -- every quarter we say it's going to do a little bit better later on in the year. Why do think that that's going to improve significantly in the second half?

What we are finding, Carol, is that we are not substituting, if you will, the light production units for the heavy-duty production publishing applications. We're quite frankly winning share in the light production segments. And I think it is more incremental opportunity than it is substitutional. We look at the pricing scenario really carefully. We would characterize the pricing in the production environment as being about 5% investment and quite frankly that's more driven by color than it is black and white. Black and white has been very stable for us.

Nuvera has clearly started slower than we would have anticipated. Part of it is staggered functionality and we are continuing to address that with functionality announcements through the balance of this year and into '06 on things like feeding and finishing that will help us really deliver everything the market is looking for on Nuvera. So the opportunity to quite frankly open up the market opportunity through increased functionality is part of what has been holding back Nuvera in the marketplace and we are addressing it with enhancements as quickly as we possibly can.

So clearly this is light production versus heavy publishing mix. It is not price driven. And we actually have done pretty well in the overall DocuTech arena over the last few quarters. But there's no question that the improvement in Nuvera performance will be the single biggest factor in improving the margins in production.

Going back for one second to mix in the office, is the H-P introduction -- I'm going to get the number wrong -- 43 something kind of at their low end MSP device, is that impacting the market in terms of customers are now trading down because that's an option?

Yes, it's the 4345 and it's an A4 device -- you know, a higher speed A4 device versus the traditional A3 device. And we clearly are watching it. We'll also be participating in that category as well, but to date we've not seen any significant impact on market share in the office category from that product, Carol. So we're watching it closely and clearly we're prepared to compete but not to date.

And on a positive note, just to post sale, it was a little bit better than what we thought. Can you talk about what page volumes are doing and if the significant improvement we saw this quarter versus the run rates are sustainable into the second half of the year?

Yes, by the way, we were really pleased with post sale and, quite frankly, some of the underlying trends in post sale are better than we could have hoped for -- and pages is one of them. Every single category in pages basically got better quarter-to-quarter. We've seen improvement even in the office mono area which had been declining at a more rapid rate. We see great growth in color pages in the office, 26%. Production 38% in color pages. And total color pages -- we had 24% growth in Q1 '05, we've got a 31% in this quarter. And when you look at total digital pages all up all in, it went from a 2% growth in the first quarter to 3% growth in the second quarter.

So these things don't necessarily materialize in 90-days which is really the exciting part of it because page trends were outstanding. And if you look at color, overall the color revenue numbers were terrific and we looked at now the equipment sale color growth of 22% and overall total revenue of 17% as being a huge driver for post sale going forward as well. So pages and color growth are really good I think -- it is like money in the bank in terms of future post sale growth. So yes, we think the indications are excellent for post sale.

Thank you very much.

I think we have time for one more question.

Shannon Cross, Cross Research.

I wanted to follow-up on the restructuring. Can you give us some more details, headcount -- anything you can do? I mean, you said services and manufacturing, are you shifting more to outsourcing? Just provide a few more details on that?

I said the majority of it really impacted gross margin and I'd say somewhere probably around 60% of it really comes from technical service, not services but technical service and manufacturing, the vast majority that being technical service. And it's really the implementation of the flexible service model which means that we will have more flexibility in terms of ramping our service cost with our growth rate and particularly as it relates to the improving reliability of our digital products, the ability to flex our service cost without restructuring going forward is a big deal.

So this really is preparing for the future and creating kind of a flexible buffer for our overall technical service strategy, and that's both in Europe as well as North America. Then manufacturing where it's sort of what I would call refining our capacity and manufacturing a bit. And the rest of it really does come from kind of SAG and infrastructure, not selling because we're making investments in selling, but we are improving things like supply chain and back office opportunities where we think we've got some cost competitive opportunities as well. But I would say the headline really is driven by improvement to gross margin actions, primarily driven with the technical service actions.

The headcount from this restructuring I think is about 2,600. Just to put that in perspective, as I said, the vast majority of it will be done in -- we took in Q2 with the rest of it coming in Q3 and 4, but most of that will be in service headcounts done through a voluntary action that we're completing pretty quickly.

So not much in voluntary at this point?

It's a mix, but the technical service action is primarily a voluntary action and we've done really explicit planning on that one, so there's not a lot of unpredictability left on the technical service side.

Okay. And then in terms of the EPS savings you expect from the 200 million, is there any way to put -- or the gross margin basis point improvement -- any way to put some sort of a parameter around what you're expecting?

Well, I think what we've said is that it will be more Q4 oriented than Q3 oriented and I think you can look at, if you will, some of the improvement in Q4. If you look at the mix between Q3 and Q4, we've really moved out a few cents of earnings to Q4 based upon the flow-through from the restructuring and that's why you see, once again, some of the leverage in Q4 versus Q3. I mean, obviously overall we expect to get the entire 200 million back, but I think you'll see certainly a few cents of that flow through into Q4.

Okay. And then if we could talk a little bit about the growth in color laser and solid ink because obviously those were very, very strong. A way to think about your market share in that segment, especially assuming the OEM business, and then if you wanted to give us any update on the OEM business and whether you'd like to expand that?

So let me talk first of all on the multifunction office color multifunction business. The segment where we introduced the 2424 with the 31 to 40 segment, it actually -- we had 17 points of share growth year-over-year. So obviously had a huge impact on our market share performance in the office multifunction space. So you can kind of see it very visibly in the 31 to 40 segment and that's primarily due to the 2424 announcement.

When we look at color page printers I think you do have to look clearly at the Dell share to really understand the full performance in color printing. Most of our share now is driven by the higher end of the color laser marketplace. And Dell's share, which was up 14 points, obviously a portion of that relates to the OEM activity that's being driven there. So I think, yes, you have to kind of calibrate color page printers share between the OEM business and our direct distribution business to really get a sense of how we're doing in color page printers. We feel good about that business. We're not explicitly talking about extending it at this point in time because I think there's a lot of opportunity still left in those segments for share gain.

Thank you.

Thanks very much, Shannon, and let me thank everybody for your participation this morning, we appreciate it and have a great day. Take care.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude your presentation and you may now disconnect. Have a wonderful day.