全錄公司 (XRX) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Xerox Corporation third-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 Xerox investor website at www.Xerox.com/investor.

At the request of Xerox Corporation, today's meeting will be tape recorded. Taping and rebroadcasting of this call are prohibited 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 current beliefs and expectations and are subject to risks, uncertainties, and assumptions. Should one or more of these risks, 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 second-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. Ms. Mulcahy, you may begin.

Thank you so much and good morning. Thanks for joining us today. If you will turn to slide 4, we will provide a summary of our Q3 results. We are quite pleased with the results. It's another quarter of improved performance that delivered on our commitments. We met expectations by delivering revenue growth and earnings expansion. It's progress we feel good about, and we are confident that momentum from Q3 will accelerate in the fourth quarter.

So third-quarter earnings per share were $0.05 on a GAAP basis. This includes a $0.12 impact from previously disclosed charges as well as a $0.01 restructuring charge. So excluding these items, EPS was $0.18 per share. So let me give you some highlights. Total revenue was up 1%, driven by 2% equipment sale growth and 1% growth in post sale revenue.

Our investments in color are paying off. Color revenue was up 22%, primarily due to strong sales of our iGen3 Digital Production Press and the new DocuColor multifunction system. Our focus on cost and expense management strengthened the bottom line. We reduced SAG by 25 million; it's down 1 point as a percent of revenue. While gross margin is down 1 point year-over-year, it improved sequentially, reflecting the initial benefits of our restructuring actions.

The balance sheet remains healthy, with operating cash flow of 162 million and 1.6 billion in cash and short-term investments. At the same time we reduced year-over-year debt by 3.3 billion. With that, we are in a strong financial position to launch today a 500 million share repurchase program, certainly a milestone in our continuing progress to increase shareholder value.

So Larry will walk you through the financial statements, but first I would like to spend a few minutes on revenue and installs. Of course before we take your questions, I will wrap up with thoughts on Q4.

So if you turn to slide 5, here is a look at our revenue trends. You will see that there was no benefit from currency on total revenue this quarter and that the revenue results are trending positively. The sale of new technology boosted equipment sales, up 2% in the quarter. As you know, we launched a host of new products during the quarter, and we're seeing a ramping effect from these launches, with equipment sales picking up 5% in September.

In fact, there have been a number of large fleet deals in the last few months, including one for Dow Chemical to upgrade their global infrastructure with 3,500 Xerox multifunction systems that will allow Dow greater capability, reliability, and cost savings. OfficeMax is installing 650 Xerox CopyCentres and 600 DocuColor systems to launch self-service color copying and full-service color copying and printing at their retail outlets.

As you know, sales of our digital systems flow through to boost annuity revenue, driving top-line gains. With about 70% of our revenue from post sale, this is an important proof point of the success of our growth strategy. We saw improved performance this quarter, 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.

Total revenue in the quarter was up 1%, again, with no benefit of currency. We do expect some headwind from currency in Q4, on current spot rates about 2 points, which has an impact on our full-year revenue expectations. New products will continue to lift equipment sales, and we expect post sale trend to stay on track. But considering the negative effect from currency, we believe full-year revenue growth will be about 1%.

Color is a significant driver of this growth and helps to offset declines in black and white office and publishing. We have created the industry's broadest portfolio of color systems for production and office environments of any size, and the payoff is in the pages. So let's take a closer look, if you turn to slide 6.

We often say it is all about the pages. Here is why. Look at the trends in growing our color equipment sales, how these sales flow through to boost annuity revenue and the steady increase in color pages. Consider that color revenue per page is about five times greater than digital black and white. It is clear that color provide significant leverage for our top-line growth.

In Q3, equipment sales from color were up 31%, and revenue from color post sale grew 18%. This growth is absolutely changing the profile of our revenue picture, with color now representing 30% of our total revenue. That is up 10 points from two years ago. The number of Xerox pages printed on color devices continues to increase at a steady rate. It is now at 7%, nearly double from two years ago, yet with opportunities to grow considerably ahead of us.

The success of our award-winning color portfolio is fueling this page growth. From developing the best technology to reaching different markets through a broad portfolio, we absolutely lead in this space. It is a fabulous business model, an attractive market, a competitive advantage, and it's delivering solid returns.

If you would turn to slide 7. In our production business, color was again a highlight, with sales of the Xerox iGen3 fueling a 21% increase in production color revenue. Production digital grew 3% in Q3. Total production revenue was down 1%, with equipment sale growth only partially offsetting a decline in production post sale and financing revenue. Activity was strong, with installs of production color systems up 5%, fueling a 39% increase in production color pages.

Installs of production monochrome systems were up 21%, the benefit of continued success with our 4110 light production system. Although the market is flat to modestly declining in black and white publishing, we are gaining share.

Last month's Print 05 show was an opportunity to showcase our all-digital suite of systems, and it stood apart from competitors as the broadest, most advanced digital printing technology in the industry. It not only attracted a lot of visitors but generated significant leads and revenue. At the show we also launched the production version of the 50-page per minute DocuColor 240/250 digital printer copier, yet another addition to our highly successful DocuColor family.

So if you turn to slide 8, our office business. Total revenue was up 2% in the quarter, with digital revenue growing 4%. Revenue from office color grew 23%. Installs of color multifunction devices were up 56% largely due to demand for the office version of the DocuColor 240/250. Strong growth in office color printing continued in Q3, driven by laser printers, including a benefit from our OEM business as well Phaser solid ink printers. In fact, Staples recently purchased more than 1200 Phaser solid ink color printers for each of its stores.

So all of this activity contributed to page growth. In Q3, office color pages continued to trend favorably, up 29%. In office digital black and white, installs were up 21% with significant activity growth in segments 1 and 2. Segment 1 alone was up 45%. In segments 2 through 5 we are starting to see the ramp of 18 new office products launched in June. Order taking on most of the products began in late July in North America and in early September in Europe. So while we started to see the benefit of these products in September, we expect sales of these systems will boost equipment revenue in Q4.

There are three key drivers of our wins in the office market. First, we've got the broadest portfolio of technology in color and black and white, stand-alone devices to scalable multifunction systems, and offerings that serve the needs of businesses small to large. Second, we're expanding our sales channel to include more resellers and sales agents, extending our reach through two-tier distribution and capturing market opportunity in small and medium-size businesses.

Third, the strength of our relationships in large enterprises leads to services-driven technology wins. Our competitive advantage is helping them simplify their workflow, reduce document costs, and streamline document-intensive processes. Much of this business is translating into a 20% annual increase in signings of total services contracts.

For example, EMC has engaged Xerox to manage its output infrastructure, everything from fax copying, asset management, supplies, help desk, and user training. The five-year deal should result in a savings of about 30% to 40% for EMC and in a significant annuity stream for Xerox. Through an extensive managed services contract, more than 70 Xerox people are now on site at Toyota's U.S. sales headquarters to handle records retention, mail room, and document services.

So if you turn to slide 9, in our developing markets operations we continue to see improved performance, especially in Russia and Central and Eastern Europe, where the growth trends remain exceptionally strong. We're seeing steady improvement in Latin America, which is in line with our expectations as the two-tiered distribution model begins to lift results. So we are executing on a proven strategy, building a stable and efficient distribution capacity for both office and production, while improving the productivity of the infrastructure to support this model.

We expect the positive trends we're seeing this quarter will continue, and we are closely managing every aspect of this business model transition. So now I'd like to turn it over to Larry to review the financials. And as I said I will be back to wrap up and take your questions as well. Larry?

Thank you, Anne, and good morning. We delivered another solid quarter of performance in third quarter. Strong product activity, total revenue growth, and, most important, annuity post sale revenue growth. Through focused cost and expense management we improved the bottom line and expanded earnings. Our balance sheet is strong, driven by continued cash flow performance, lower debt, and improved leverage.

Today we announced a share repurchase program, evidence of the strength of our financial position and our commitment to providing increased returns for our shareholders. We fully expect that the trends you see today will continue. These are the proof points that our business model is delivering value for our stakeholders.

Let's take a look at the numbers, slide 11. Revenue trends continue to be a positive story. Our targeted growth areas grew 3%, driven by the very strong install activity that Anne discussed. As you know, this strong activity leads to post sale annuity growth. We're beginning to see that flow through now. In addition, color revenue grew 22%, a leading indicator for future annuity growth as color pages drive significantly more post sale revenue and profit. Currently, color represents only 7% of our total pages.

Value-added services shows a year-over-year revenue decline of 14%. This does not reflect the total revenue from our services business. As Anne mentioned, we're actually seeing more and more services contracts integrated into our managed services business. Managed services revenue is included within the digital office and digital production growth areas. Our total services signings continue to grow at a rate in excess of 20% annually. To better quantify the success of our services business, we are looking at alternative measurements that will more effectively convey this performance.

DMO continues on a positive trend as Eastern and Central Europe and Eurasia grow substantially and Latin America shows improvement. Light lens and SOHO continue to decline at a high percentage rate, but is now just 3% of the total revenue, down from 6% last year. All this leads into the post sale story; here is a closer look, slide 12.

This slide as well as the next slide are fundamental to the understanding the basis of our model, which is a post sale annuity growth model. On a constant currency basis, our post sale and financing annuity grew 1% in the third quarter. Within this, digital grew 5% and consistently has been in the 5% to 6% range over the last two years. This is the driver behind our annuity growth and will only be helped by, number one, color leverage; our growth in DMO; services-led and operating leases; and growth in our financing business as our finance receivable portfolio begins to grow again.

In addition, the declining impact of light lens and SOHO will continue; and the growth in digital, services, DMO, and financing will flow through to total revenue. Here is a closer look at the decline of light lens and SOHO, slide 13. Light lens was 210 million in the third quarter of 2004, which was a decline of 157 million from the same quarter in 2003. This represented a 6-point negative impact on the total post sale revenue growth.

In third quarter of this year, the decline was 84 million or a 3-point negative impact to total post sale revenue growth. Just extrapolate the impact moving forward to 1 to 1.5-point impact, or 50 million. The growth areas consistently grow and light lens becomes de minimus. We have all but completed the transition to a total digital portfolio. Our annuity will drive stability and growth as we move forward.

Now let's take a look at the P&L, slide 14. To provide clarity we added a couple of columns that highlight restructuring, litigation and hurricane losses, as well as the impact of the EU directive and accounting change, all circled in red. Reported earnings were $0.05 per share. There were two accounting-related charges in the quarter. The charge associated with the EU directive was recorded to other net and was 26 million, or 18 million after tax. The cumulative accounting change, which has its own line, was 8 million after tax. Both items resulted in a $0.03 per share impact.

The next column highlights the litigation charge and loss from Hurricane Katrina of 122 million before tax and a $17 million restructuring charge, together a 99 million after-tax effect or $0.10 per share. So adjusted P&L sums to $0.18 per share.

Key points in our adjusted P&L are gross profit margin of 41.3, a positive trend from last quarter. Expenses were significantly down year-over-year, as we deliver productivity which will support or model going forward. As we told you in 2Q, we are now reporting sustaining engineering costs related to our products within RD&E, which was 6.4% of revenue in the quarter. These costs were previously reported in cost of sales. Expense declines in SAG of 25 million, driven by 23 million in G&A reductions, and reflects improvement of 1 point over last year. In addition, nonfinancing interest expense was down 36 million over last year.

So in summary on the P&L, all the fundamentals are in line. We had both equipment sales and annuity revenue growth. We managed our expenses and gross profit margin to deliver on our model. And we expanded our earnings to deliver shareholder value.

Let's go to cash, slide 16. We had 162 million of cash from operations, including a 200 million investment in inventory to build up from fourth-quarter activity. We contributed 50 million to our UK pension and saw some growth in accounts receivable, which we will address going forward. Year-to-date, our cash from operations is 789 million, moving toward our 1 to 1.5 billion expectation for the full year.

We paid down 700 million of debt, 524 million of secured debt, taking secured debt down 1.2 billion year-to-date. Cash and short-term investments balance is approximately 1.6 billion.

Slide 17. Here is a look at the key points on the balance sheet. 3.3 billion debt reduction from last year, including 1.2 billion reduction in secured debt. We now have 7.5 billion in debt versus 7.8 billion in finance receivables. With the 7.1 debt-to-capital ratio within our financing business, approximately 6.8 billion of the total 7.5 billion of debt is associated with our financing activity, a marked improvement in leverage and secured debt.

So in wrapping up, I believe we made significant progress in all areas of our business. Revenue, post sale annuity, sequential improvement in gross profit margin, cost and expense management, increased earnings, as well as a strong balance sheet that we will use to deliver increased returns to shareholders through a share repurchase program. For the last three years we have consistently delivered strong operating cash flow, reduction in debt and leverage, and significant cash on hand. We are now well positioned to begin a share repurchase program and intend to buy back $500 million in stock over the next 12 months.

Our financial goals remain the same and are aligned with our overall growth strategy. Returning to investment-grade continues to be a priority. At the same time, we will leverage our financial position to evaluate acquisitions opportunistically, and we will ensure that all our actions, like the stock buyback program, deliver increased value to our stakeholders. We are confident that our capital structure, cash flow, and business performance support these goals and keep us on a firm financial footing. Thanks and now back to Anne.

Thanks, Larry. I am now on slide 18. We have been consistent in saying that our performance this year will ramp up in the second half, especially considering the launch of 43 new products year-to-date. Our Q3 results set the stage for continued revenue momentum, especially if the post sale trend continues to improve on a constant currency basis. At the same time, we will see the flowthrough from our restructuring actions strengthening the bottom line.

So for Q4, we expect to deliver earnings in the range of $0.25 to $0.29 per share including additional restructuring charges of $0.05 per share; or $0.30 to $0.34 per share excluding the restructuring charges of $0.05 per share.

In closing, the growth strategy is working, with the key revenue trends moving in the right direction. Our leadership in color is fuelling today's equipment sales and boosting our annuity revenue, driving total revenue growth. Leading with services adds to this rich annuity stream. In large enterprises around the world we are winning more and more services business. It contributes to equipment sales and flows through to post sale.

Our focus on cost competitiveness keeps strengthening overall operational performance, and today's share repurchase announcement speaks to the strength of our financial results. We're keeping up our sharp focus on execution, and we are delivering on our commitments. We believe our efforts this year will again yield double-digit earnings growth. So thank you so much for your attention. Now Larry and I would be pleased to take your questions.

(OPERATOR INSTRUCTIONS) Jay Vleeschhouwer with Merrill Lynch.

The first question I would like to ask, Anne, is how you might further gain operational improvement and keep the gross margin in line. Specifically, could you foresee further leveraging the manufacturing outsourcing on either the office or production side, to continue to improve the product cost competitiveness?

The second question is, you mentioned that you had been adding for the office market additional indirect sales capacity. Is that process done? Is there more capacity you can or should add on the office side? For that matter, could you foresee adding direct or indirect sales capacity as well for production?

Okay, so let me talk about operational improvements. You specifically mentioned manufacturing outsourcing, Jay. I think we have continued to take advantage of our external relationships for manufacturing outsourcing. So though, although we may not be moving, for example, our high-end production business, we continue to extend that relationship in terms of anything they can do more efficiently than we can, we have taken advantage of it.

I would say our three biggest opportunities for ongoing improvement really lie in our RD&A, where we continue to optimize on the platform productivity approach, both for engines as well as controllers. Service productivity, really taking advantage of digital economics; I mean the fact that we are almost a complete digital Company right now is really a big deal in terms of our ability to capture service productivity.

And finally, supply chain productivity, because as we do engage more indirect channels, we are able to kind of adjust our own internal infrastructure and take advantage of that. All of that is really supported by our lean Six Sigma efforts and the thousands of trained resources we have in the Company that manage productivity projects. So I think we are really in great shape, with a very targeted focus on improved productivity that has just become a way of life in this Company.

On the capacity and distribution side, there is no question that we continue not only to add new channels, but we also are adding new products to our indirect channels as well. So for example, multifunction products like the 2424, the solid ink multifunction device, is being distributed through indirect channels. So it is not just new channel partners, but it is incremental sources of revenue for those channel partners we already have.

On the direct side, our focus is really about building up our capacity on services-led; making sure that we have the vertical expertise to support the opportunities in the marketplace. So some that is additional direct capacity, and some of it is kind of substitutional as the portfolio changes to be more services-led.

So bottom line is, I think we still believe we have got opportunities in SAG while we continue to refine and improve distribution. But I think if you looked at our distribution system today in our industry, there is nobody with a broader set of channels engaged than Xerox.

Lastly, could you comment on what you are seeing in specific verticals, graphic arts, commercial printing, government, and the like? That would be helpful as well. Thanks.

Okay. Let me start with graphic arts. I think we are pretty bullish on graphic arts. When you talk about the growth in color production pages, a lot of that is coming from the graphic arts marketplace and specifically the commercial print marketplace. We are very pleased with the progress that iGen is delivering, and that is primarily still a graphic arts presence. Probably 70/30.

You know, we have got 80 customers with multiple iGens. We have 70 iGen customers that are doing over 1 million pages per month on iGen. That has really been the heartland, if you will, for production color digital growth. So that is showing very much in terms of the graphic arts marketplace.

We are also seeing some very specific opportunities I think in verticals through our services-led business. I would highlight legal, in terms of highly paper-intensive, litigation support driving some of our services opportunities. Also, I think we continue to do very well in healthcare on services-led opportunities. So, good progress there.

Public sector I would say has been kind of a very steady performing sector for us. We are really just starting to crack the code on some of our services-led opportunities for public sector. We have highlighted some of the things we have been doing for cities, like City of Newark. Sheriffs' departments, a lot of public sector opportunities that really have been kind of first adapters, if you will, for some of the more innovative infrastructure approaches.

So overall, I would not highlight any particular weak sector, Jay. I think I probably would focus on the strength of graphic arts from a production color perspective as being the headline.

Thank you, Anne.

Ben Reitzes with UBS.

Could you talk about your restructuring, just in a little more detail? What exactly is going into these restructuring actions that we have been seeing over the past few quarters, and the $0.05 in the next one? Then are they done in '05? Do we see them in '06? In particular, just what in headcount is going on as well? Like which types of positions? Then I just have a follow-up on that.

Okay, this is the -- we kind of outlooked this restructuring when we outlooked back in second quarter what we expected for balance of year. Actually the implementation of this restructuring is very consistent with the guidance that we provided then.

We kind of split it into a 60% focus on kind of the service productivity side, which is gross margin impact, and 40% on SAG infrastructure. Not selling; as a matter-of-fact, we are investing in selling. But coming through really in G&A productivity.

And we are really pleased this quarter as we look at our progress in SAG. The $25 million of SAG improvement did not come from bad debt or from selling; it really came from G&A infrastructure, which are improvements in things like IT infrastructure, supply chain, support, second-tier functions, but not from direct resources.

So we would expect that the $0.05 that we are projecting for fourth quarter would really follow that path and continue down the focus on service productivity and SAG kind of infrastructure costs. That is very much aligned with the goals we have for SAG and gross margin improvement.

So it's very targeted. We are obviously getting in front of a curve and building in some flexibility for us, as we think about 2006, then, in terms of creating a little buffer on the service productivity side. So we don't expect and do not anticipate certainly major restructuring at this time. We would look at it and say it would be opportunistic; it would be business model driven; but nothing in a major way that we would anticipate today.

Okay. Just with regard to color, it looks like the 240 and 250 are really strong in the midrange. Could you just talk about the sustainability of that? In the fourth quarter, it would seem like if those areas in the midrange color, mid to higher end range of color, should be very strong. Could you let us know about '06 sustainability there? Are there even more new products coming in that range? Or does this lineup you have now probably power you through?

So I couldn't be more thrilled with the performance of the 240/250. It is off to a totally fabulous start, and I anticipate that continuing to -- that momentum to continue. The power of the 240/250 is it kind of addresses that seam between office and production. It is really a gap we had in the past, and we're filling that gap. So the great news about it is that it's not coming off the backs of production color. It is really an opportunity for us to get pages that were going to the competition. So we are really pleased with 240/250.

As a matter-of-fact, during Print 05 we announced actually taking that product to the production marketplace with three kind of graphic arts front ends. So we will just start to exploit the opportunity now in the graphic arts marketplace with the 240/250 engine. So a lot more to come on that one. I mean, I think that the opportunity and statistics around color are so compelling. When you look at page growth in the office of 29%, page growth in production of 39%, great revenue per page. Only 7% of the pages being color; 93% to go. It is just a fabulous story, and I think we are really well positioned with the product lineup we have today.

In many ways the 240/250 was filling the only real gap we had in our color lineup from the desktop up through iGen. We're going to continue to build on that line, Ben. Our deal is we have got a pipeline of innovation, and you will continue to see enhancements and products from this Company going forward. So this is not by any means the end of the story.

That seems like the sweet spot. I appreciate the color. One last quick thing for Larry and then I am done. Cash flow, Larry, if I take out finance receivables, was below EPS or at least operating EPS by quite a bit. Does it snap back in the fourth quarter big-time because of the inventory phenomenon? Or just any color there would be appreciated.

Yes, I think the third quarter is characterized by our inventory investment. If you look at last year, it wasn't quite as much but we did make an inventory investment. And if you looked at last year's fourth quarter, that number came down proportionally; and we expect the same thing to happen. We also expect improvement in accounts receivable in the fourth quarter. I think in total, we expect it to be a very good cash flow quarter.

Jim still seems to be doing a pretty good job there in AR.

He's our man in AR.

That's right. All right. Take care, guys.

Shannon Cross, Cross Research.

Can you talk a little bit about production margins? They were sort of flat to down slightly from last quarter. Obviously the mix issue is going on. But can you give us an idea on how we should look for that to improve? Obviously restructuring should play in there. But anything else you can provide?

Yes, I think it's always important on the margin side, most of the margin pressures come from the equipment side versus the post sales side. So it really is -- mix is the largest driver of that. The main causal is the strength of light production; 4110 has continued to exceed our expectations and really be a home run in the marketplace, but it clearly does not have as high a margin as the traditional high-end production publishing devices do.

A couple of other factors as well. Our color performance in production is very, very strong. In this case, it is still a maturing, if you will, post sale margin. Because until you get the levels of installs out there, your economics around service and clearly the labor economics around that are not as attractive as they are. But that is an improving proposition; because obviously, we are really moving forward very nicely in terms of the critical mass of color installs.

The third thing I would say is we did see some price pressure, a little bit more than we have seen in the past. I think we generally talk somewhere around 5%. I would characterize it more in the 5% to 10%, and we drove a little bit of that. We really had a DocuTech performance in the quarter, and we are continuing with some incentives to ensure that we have good share performance on the production publishing side. So we actually drove a little bit of the price pressure in the quarter on the production publishing side with some incentives around DocuTech.

So all of that adds up to certainly an improving trend as we install more color, as mix gets better, but we did see some pressures there in the third quarter.

Okay, thank you. Can you just talk a little bit, Anne, about your strategy with regards to the OEM business? Now you are 25%, 26% of the color laser market. How we should think about that over the next couple of years, and what the opportunities are there, both -- actually in color laser, for your solid ink as well as the Dell relationship.

I think we are pleased, actually. Our branded business for color printers grew this quarter, so we clearly have a strong and very robust color printer business, particularly solid ink, which we don't OEM, and also some of the higher-end color laser products, which really are the sweet spot for our own branded distribution.

We see the OEM opportunity here as being dedicated to small and medium-size businesses with the very low end of color printing, where we know we are not the distribution channel of choice there. Therefore it is an opportunity for us to grow share, get better economics, and not, quite frankly, be substitutional in terms of where we are strong in terms of channel relationships and enterprise-level customers.

So I think we're going to continue to make good business judgment about where OEM is a good complementary strategy for us, and improves efficiencies of scale, and is strong in channels that are not our strength, and give us good returns. But this will be guided by good business financial judgment in terms of the returns to the business.

So you will avoid the Lexmark issue, I suppose.

I guess that is what I am saying.

Okay, thank you very much.

Jack Kelly with Goldman Sachs.

Anne, just coming back to production for a minute, I guess good explanation of why the margins went down, the mix and price. But in terms of absolute profits -- and maybe Larry can help; maybe there's some restructuring in here. But the 33% drop in operating profit in production, could you give us some maybe more detail on that?

Then secondly, looking at margins for all four of your groups -- production, office, DMO, and other -- and maybe if you could just share with us, looking out over the next year or so, where do you think margins could go from where they are currently?

Let me begin. There is no other factor, if you will, in the flowthrough on the production operating profit other than the factors that we talked about. It really is mix driven. It is also, if you will, the factor around the maturity of the color business. The flowthrough from mono is higher, just because it's a mature business. So the strength in color and light production definitely is putting pressure on the operating profit.

The good news is, on the color side it's money in the bank. Because the post sale leverage that it delivers over the long term will flow through to much improved operating margins. But it is really that basic, Jack. It is one that we are going to take a little bit of a hit based upon the strength of color production, but it's absolutely the right thing to do for the long-term health of the business.

We think we can do a better job on the mono side, balancing the install activity between the high end of publishing and the light production. So that is more ours to execute against, versus just the pace of color installs. But that is what it is. There is no major restructuring elements that I would highlight there by any means.

So over the next couple quarters, other things being equal, would you expect that production operating profits may be down? Not down that much, but will continue to decline; is that fair?

I would say I would look at it in terms of sequential opportunity for improvement. So I think on a cumulative basis you're going to start to see improvement on production. Clearly our plan is to actively address the mix issue; as well as the post sale piece just gets better every quarter. So this one is on a positive trend.

Okay.

And you had a second question?

Yes. Just as we looked at -- I know it's tough -- but looking at the other three pieces, office, DMO and other, big improvement in other. DMO big improvement. In the past I think you have talked DMO maybe getting back to corporate margins.

Absolutely. So office is really quite good. It is over 10% in terms of returns, and improved year-over-year. We are very pleased with office, and so we expect office to continue to be a point of strength for us.

DMO we are climbing back up, as you know, to get it at the corporate average. We think you're making good progress there and we will continue to make good progress.

On other, the good news on other is there is interest, positive news there. The only thing I would say is that, overall, some of the smaller businesses that go into other have been improving as well. But overall, other should be a helper, not a hurter.

Just lastly, on Brazil, I guess in terms of DMO it was still down. Is that in line with your expectations, Anne, or did you expect it to turn sooner than it apparently is?

No, I think we are okay with where Brazil is at. It is improving. We did highlight, because we thought it was important for you to know, that certainly Russia and Central and Eastern Europe are the headlines for growth in DMO. But there is absolute improvement both in Latin America and Brazil, and we expect that to continue. It is pretty much at the pace we would have anticipated.

Thank you.

Keith Bachman with Banc of America Securities.

A couple things if I could. Larry, I didn't quite catch what you said about the trajectory of light lens. I was just hoping to get those comments again, on how you think that will track to continue to not be such a negative weight.

Light lens has been consistently going down 45% a quarter. We tried to put on a slide there that the pure arithmetic says that last year it took away 6 points; and this time it took 3 points of growth; and as you look out to next year at the same time, you would be one-half of that at 1.5 point. So at that point it becomes de minimus.

If you have digital growing at 5% or 6%, and now you only have the light lens going down at 1.5%, that is the story of how post sale grows, because you don't have that huge migration to digital. So that was there to just show the arithmetic, that that is how post sale will grow as we go into next year and get the bigger numbers.

Okay, that's helpful. Thank you. On the earnings per share, with some of the charges that you took away to present non-GAAP financials, I would argue that some of those look like, frankly, more operations or more operating impact. But rather than debate whether they should be in or not be in, perhaps I just want to hear your clarification on if I look out a couple quarters, where do you see the differences between the GAAP and the non-GAAP earnings per share?

First of all, I would say that when you look at these items, we actually list them so that you can make your own judgment as to what they are. But we list them whether they are positive or negative.

So second quarter we had a $0.33 gain from a tax law change. We highlighted that and showed how that flows through the bottom line, so that you could really see the business dynamics. That is the whole point of doing it, is so that you can see the hydraulics of how our business is going, compared to these -- what I will call for the moment -- extraordinary items or items that happen.

Unfortunately, in this world right now, you end up with extraordinary items. I can't predict which ones will come in the future. There will be plus ones and there will be minus ones. What I can guarantee you is that we will highlight them and explain to you what they are.

Maybe we will just try to get more granular on the December quarter. The $0.05 in there, that is only for restructuring; there is nothing else in there?

(inaudible) That is what we called -- when we announced this $0.33 gain in the second quarter, we said that there would be an additional $0.01 of restructuring in the third quarter and $0.05 in the fourth quarter. And that is what we are tracking to.

Okay, last one for me.

I think we were pretty explicit about explanations on these charges. This also was an 8-K.

Last one for me, then. On the services, I know it is a fairly small number, but you talked about a better accounting to more represent the business? But just hoping to flesh that a little bit, since it looks like the numbers are negative on what I think is a pretty good opportunity for you.

Maybe, Keith, I can just tell you where we're going to head with that, because more and more of the front-end services, the consulting and the real vert -- you know, specialty services that we do at the front end of a client opportunity are being integrated into our managed services opportunity, in which case that is where they show.

If you looked at our financial reporting, you would see that we have had some nice growth in our services post sale of 2% to 3% in terms of our managed services post sale line, which has been a change of trend and one that is being driven by the fact that these are higher-value services now driving these integrated deals.

So what we thought we would do is perhaps at the investor conference really provide some clarity about how we intend to look at services going forward, so you really get the full picture. I think while we were kind of developing this business and investing in it, we wanted to highlight the consulting investment, which is the front-end driver. But now I think we're at, by the way, a scale and a maturity rate that we can look at our managed services business as a whole. So we will provide you some clarity on that at the investor conference.

Great, I will look forward to it. Thanks Anne.

Matthew Troy with Citigroup.

Question on the buyback. Certainly a pleasant surprise, in that I think it came a little bit earlier than some were expecting. I don't want to look past it; I just want to understand something. In terms of that 500 million number, how should we be thinking about your capital flexibility? Are you limited or in anyway capped right now in terms of either your ability to repurchase shares tied to equity levels? Or is there is further room past the 500 million? Again I don't want to deemphasize that; I just want to understand what kind of flexibility you have.

There is room, a lot of room beyond 500 million.

Okay, okay. Second question would relate to Fuji Xerox. Those numbers consistently sequentially; kind of where we were looking at, but lower against last year's compares. Is that a function of currency? What should we think about the earnings power there below the line?

Actually, Fuji Xerox continues to be a good performer. What you're looking at really was a onetime pension gain this time last year which -- and if you look at that, plus there was a little gain from Integic which is no longer in there, actually the Fuji Xerox performance improved by about $1 million. So Fuji Xerox continues to be a good contributor.

But if I think about it, last year it was running, if you strip of all of the benefits, closer to 30 million. This year it is running closer to 20 million. Is that just currency?

No, I think what we're looking at is that there is more than just Fuji Xerox in that line. We look at it pretty carefully. If you look at it, I think the number was like 39 million and 30 -- there was a difference of 39 million; 38 of it was pension gain; and there was 1 million from the Integic gain; and then there was another million then that was a better performance for Fuji Xerox. So it really is operationally doing fine.

Okay. Last question on the Fuji relationship. If I think about the relationship with Enovation, it certainly seems to be gelling. At least from where I sit there booth was full of people looking at your equipment at Print 05. I was wondering if you could just give us an update on that relationship. How happy are you with it? Do you see it changing, or is it where it needs to be right now?

You know, I think we are happy with it, and we are seeing better results from Enovation. One of the things we have learned, particularly as you deal with the commercial print environment, is that it takes time for the learning to take place, for these partnerships to really start to yield results.

So we're starting to see some good results, particularly in entry production color from Enovation, and we think those will continue because the maturity of the sales force is definitely coming up the curve. These are not trivial products to market, and we have been at this one now for about a year with Enovation, and we are definitely seeing a ramp up in their activity. (multiple speakers)

Question on solid ink technology. You had alluded to potentially migrating that technology up the value chain earlier in the year. I was wondering if we can expect in the next couple of months or quarters that migration to appear more visibly. Or is that a back half of the year phenomenon into '06?

We really have not given, Matt, any specifics about the solid ink product line. One of the things we had suggested was that we would go from single function to multifunction. That happened with the 2424. And that we will continue to kind of build off that solid ink product line, eventually getting into certainly higher-end office, low-end production. But that has always been viewed certainly not as short term; more as a long-term approach on the solid ink side.

So it is on plan?

Yes, definitely on our plan, yes.

All right; to be continued. Thanks.

I think we have time for one more question.

Carol Sabbagha with Lehman Brothers.

Just two quick questions, one on pricing. Anne, you touched upon it in production, but it seemed like it got a little bit also in the office. So if you could address it more broadly across the Company; and then what you expect going forward, given what you're seeing in the market.

Okay, I think we saw basically very similar trends, Carol, both in office and production. Interestingly enough, the price pressures were on the mono side than the color side and more on the equipment side than the post sale side. So that kind of characterizes it.

I think we have been saying pretty much we have been staying around the 5% mark. We would characterize this quarter -- it varies product by product -- but 5% to 10% both in office and production. We believe that on the office side, we drove some of that, Carol, with the new line of office mono digital products that we are bringing to market.

So when you look at kind of the Alchemy product, which is the replacement for the 32 to 75-page per minute line, those are being offered at better price points for customers than their previous lines. So we think we are probably out there driving some of the price declines in the office mono space. But we obviously expect to do well on the volume side there, as well as to have better economics on the flowthrough; so that from a profitability perspective, we won't see the same kind of deterioration in profits that we are offering in terms of value proposition to the customer. So that is office.

Then on the high-end side, it really -- by the way, I should say we did see a little bit more competition. What we noticed is that in Q2, some of our competitors lost a lot of share in the mono production side, so we saw a little bit more aggressive pricing on the mono production side in Q3. We have addressed it actually by taking some pricing actions, particularly on the DocuTech line, which is a great face-off to the competitive products. So I think we have got that one pretty well understood.

Okay, one more quick question. On the black and white business equipment sales, if you can -- color was great; but if you back out color, it looks like black and white equipment sales were down 10%, 11% if my math is correct. Can you talk kind of about the major reasons why you think that is? And whether some of those things could reverse out? And looking forward what could be equipment sales in that business? Could it level out, or is the whole market declining a couple of points?

Well, I think we would look and say on the mono side the market is pretty flat in total. We have actually done okay. Our share has either been stable or gained a bit. Gained a lot in some areas, but gained a bit even in some of the key office mono segments. The timing of our product introductions, as you know, really September in Europe for the office mono products, end of July for order taking in North America, so not a full quarter on the office mono side. So we're expecting to gain share in a flat market on the office mono side of it. So we expect office mono trends to get better.

On the high-end of production, we think no matter what we do the 4110 is definitely a homerun and continues to deliver very good results in the marketplace. And that we have got a ramp up clearly with Nuvera as it gains functionality. And we have DocuTech incentives to kind of keep a very strong position as well with still a very successful product in the marketplace. So I think we are well positioned to play effectively in the mono space.

Obviously on the post sale side, that is the light lens impact in terms of the mono space. But on the equipment sale side I think we will see some improvement.

Thank you very much.

Thank you very much, Carol, and thanks, everybody, for your attention today. We really appreciate it. I do want to remind you that we do have our investor conference in New York on November 21. We would hope to see many of you there to join us. So thanks again. Have a great day.

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.