EX-13 9 dex13.htm REGISTRANT'S 2010 ANNUAL REPORTS TO SHAREHOLDERS Registrant's 2010 Annual Reports to Shareholders

EXHIBIT 13

ANNUAL REPORT

TABLE OF CONTENTS

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

    1   

Executive Overview

    1   

Financial Overview

    2   

Currency Impacts

    3   

Summary Results

    4   

Application of Critical Accounting Policies

    6   

Operations Review of Segment Revenue and Operating Profit

    11   

Costs, Expenses and Other Income

    15   

Gross Margin

    15   

Research, Development and Engineering Expenses

    16   

Selling, Administrative and General Expenses

    16   

Summary of Costs and Expenses

    17   

Restructuring and Asset Impairment Charges

    18   

Acquisition-Related Costs

    19   

Amortization of Intangible Assets

    19   

Worldwide Employment

    19   

Other Expenses, Net

    19   

Income Taxes

    21   

Equity in Net Income of Unconsolidated Affiliates

    22   

Recent Accounting Pronouncements

    22   

Capital Resources and Liquidity

    22   

Cash Flow Analysis

    22   

ACS Acquisition

    24   

Financing Activities, Credit Facility and Capital Markets

    25   

Liquidity and Financial Flexibility

    27   

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

    28   

Off-Balance Sheet Arrangements

    30   

Financial Risk Management

    30   

Non-GAAP Financial Measures

    31   

Forward-Looking Statements

    35   

Audited Consolidated Financial Statements

 

Consolidated Statements of Income

    36   

Consolidated Balance Sheets

    37   

Consolidated Statements of Cash Flows

    38   

Consolidated Statements of Shareholders’ Equity

    39   

 

Xerox 2010 Annual Report  i


Notes to the Consolidated Financial Statements

     40   

    1. Summary of Significant Accounting Policies

     40   

    2. Segment Reporting

     51   

    3. Acquisitions

     53   

    4. Receivables, Net

     58   

    5. Inventories and Equipment on Operating Leases, Net

     64   

    6. Land, Buildings and Equipment, Net

     65   

    7. Investments in Affiliates, at Equity

     66   

    8. Goodwill and Intangible Assets, Net

     67   

    9. Restructuring and Asset Impairment Charges

     69   

  10. Supplementary Financial Information

     71   

  11. Debt

     72   

  12. Liability to Subsidiary Trust Issuing Preferred Securities

     75   

  13. Financial Instruments

     75   

  14. Fair Value of Financial Assets and Liabilities

     80   

  15. Employee Benefit Plans

     81   

  16. Income and Other Taxes

     89   

  17. Contingencies

     93   

  18. Preferred Stock

     97   

  19. Shareholders’ Equity

     97   

  20. Earnings per Share

     102   

Reports of Management

     103   

Report of Independent Registered Public Accounting Firm

     104   

Quarterly Results of Operations

     105   

Five Years in Review

     106   

Performance Graph

     107   

Corporate Information

     107   

 

Xerox 2010 Annual Report  ii


Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Xerox Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes.

Throughout this document, references to “we,” “our,” the “Company” and “Xerox” refer to Xerox Corporation and its subsidiaries. References to “Xerox Corporation” refer to the stand-alone parent company and do not include its subsidiaries.

Executive Overview

We are a $22 billion leading global enterprise for business process and document management. We provide the industry’s broadest portfolio of document systems and services for businesses of any size. This includes printers, multifunction devices, production publishing systems, managed print services (“MPS”) and related software. We also offer financing, service and supplies, as part of our document technology offerings. In 2010, we acquired Affiliated Computer Services, Inc. (“ACS”). Through ACS we offer extensive business process outsourcing and information technology outsourcing services, including data processing, HR benefits management, finance support and customer relationship management services for commercial and government organizations worldwide. We operate in a market that is estimated to be $500 billion. We have 136,500 employees and serve customers in more than 160 countries. Approximately 36 percent of our revenue is generated from customers outside the U.S.

We organize our business around two segments: Technology and Services.

 

 

Our Technology segment comprises our business of providing customers with document technology and related supplies, technical service and equipment financing. Our product categories within this segment include entry, mid-range and high-end products.

 

Our Services segment is comprised of our business process outsourcing, information technology outsourcing and document outsourcing services. Because we participate in all three of these lines of business, we are uniquely positioned in the industry, and we believe this allows us to provide a differentiated solution and deliver greater value to our customers.

The fundamentals of our business rest upon an annuity model that drives significant recurring revenue and cash generation. Over 80 percent of our 2010 total revenue was annuity based revenue that includes contracted services, equipment maintenance and consumable supplies, among other elements. Some of the key indicators of annuity revenue growth include:

 

 

The number of page-producing machines-in-the-field (“MIF”), which is impacted by equipment installations.

 

Page volume and the mix of color pages, as color pages generate more revenue per page than black-and-white.

 

Services signings growth, which reflects the year-over-year increase in estimated future revenues from contracts signed during the period as measured on a trailing twelve month basis.

 

Services pipeline growth, which measures the year-over-year increase in new business opportunities.

Subsequent to the acquisition of ACS, we acquired three additional service companies further expanding our BPO capabilities.

 

 

In July 2010, we acquired ExcellerateHRO, LLP (“EHRO”), a global benefits administration and relocation services provider.

 

In October 2010, we acquired TMS Health (“TMS”), a U.S. based teleservices company that provides customer care services to the pharmaceutical, biotech and healthcare industries.

 

In November 2010, we acquired Spur Information Solutions (“Spur”), one of the United Kingdom’s leading providers of computer software used for parking enforcement.

Additionally, in 2010 we acquired two companies to further expand our distribution capacity.

 

Xerox 2010 Annual Report  1


 

In January 2010, we acquired Irish Business Systems Limited (“IBS”) to expand our reach into the small and mid-size business market in Ireland.

 

In September 2010, we acquired Georgia Duplicating Products (“Georgia”), an office equipment supplier.

Financial Overview

During 2010, despite the continued economic weakness we began to see improvement in our markets. Results remained strong in our developing markets countries as well as in the small to mid-size business market. We began to see increased demand and usage activity in large enterprise customers particularly in the fourth quarter 2010. We closed 2010 with strong revenue growth, operating margin expansion and excellent cash generation, reflecting the strength of our business model and the benefits of our expanded technology and service offerings.

The following is a summary of key 2010 highlights:

 

 

Exceeded on earnings and cash generation commitments

 

Strong services performance, realizing benefits from the ACS acquisition

 

Technology revenue and activity growth; innovative products launched in key segments

 

Disciplined cost and expense management yielding operating margin improvement

We completed the acquisition of ACS on February 5, 2010, and their results subsequent to that date are included in our results. Total revenue of $21.6 billion in 2010 increased 43% from the prior year primarily as a result of the ACS acquisition. Currency had a negligible impact on 2010 total revenues. In order to provide a clearer comparison of our results to the prior year, we are also providing a discussion and analysis on a pro-forma basis, where we include ACS’s 2009 estimated results from February 6 through December 31 in our historical 2009 results(1). On a pro-forma(1) basis, total revenue increased 3% in 2010, including a negligible impact from currency.

2010 Annuity Revenue(2) increased 53% from the prior year, or 1% on a pro-forma(1) basis. Currency had a 1-percentage point unfavorable impact on pro-forma annuity revenue. 2010 Equipment Revenue increased 9% from the prior year, including a 1-percentage point negative impact from currency.

Net income attributable to Xerox for 2010 was $606 million and included $690 million of after-tax costs and expenses related to restructuring, intangibles amortization, acquisition-related costs and other discrete and unusual items. Net income attributable to Xerox for 2009 was $485 million and included $128 million of similar after-tax costs and expenses.

Cash flow from operations was $2.7 billion for 2010 primarily as a result of increased earnings and working capital cash generation. Cash used in investing activities of $2.2 billion primarily reflects the net cash consideration of $1.5 billion for the ACS acquisition. Cash used in financing activities was $3.1 billion, primarily reflecting the repayment of ACS’s debt of $1.7 billion as well as net payments on other debt during 2010 including the early redemption of $660 million of debt.

Our 2011 priorities include:

 

 

Strengthening our leadership in Technology through competitively advantaged products and increased distribution

 

Accelerating our services business - capture significant BPO opportunity and continue improvements in ITO and document outsourcing

 

Continued cost and expense discipline to enable operating margin expansion

 

Drive cash flow, reduce debt and return cash to shareholders

 

Xerox 2010 Annual Report  2


Our 2011 balance sheet and cash flow strategy includes: sustaining our working capital improvements; continued reductions in non-financing debt; leveraging of our financing assets (finance receivables and equipment on operating leases); achieving an optimal cost of capital; and effectively deploying cash to maximize shareholder value through share repurchase, acquisitions and dividends.

In addition, as a result of providing lease equipment financing to our customers, we expect to continue to make investments in lease contracts (finance receivables and equipment on operating leases). Since we maintain a certain level of debt to support this investment, we expect to continue to leverage this investment in 2011 (see “Customer Financing Activities” for additional information).

 

(1) The pro-forma information included within this MD&A is different than the pro-forma information provided in Note 3 – Acquisitions. The pro-forma information included in Note 3 presents the combined results for 2010 and 2009 as if the acquisition was completed January 1st of each respective year. See the “Non-GAAP Financial Measures” section for a further explanation and discussion of this non-GAAP measure.
(2) Annuity revenue = Service, outsourcing and rentals + Supplies, paper and other sales + Finance income.

Currency Impacts

To understand the trends in our business, we believe that it is helpful to analyze the impact of changes in the translation of foreign currencies into U.S. Dollars on revenues and expenses. We refer to this analysis as “currency impact” or “the impact from currency”. This impact is calculated by translating current period activity in local currency using the comparable prior year period’s currency translation rate. This impact is calculated for all countries where the functional currency is the local country currency. Revenues and expenses from our developing market countries (Latin America, Brazil, the Middle East, India, Eurasia and Central-Eastern Europe) are analyzed at actual exchange rates for all periods presented, since these countries generally have unpredictable currency and inflationary environments, and our operations in these countries have historically implemented pricing actions to recover the impact of inflation and devaluation. We do not hedge the translation effect of revenues or expenses denominated in currencies where the local currency is the functional currency.

Approximately 36% of our consolidated revenues are derived from operations outside of the United States where the U.S. Dollar is not the functional currency. When compared with the average of the major European currencies and Canadian Dollar on a revenue-weighted basis, the U.S. Dollar was 2% stronger in 2010 and 7% stronger in 2009, each compared to the prior year. As a result, the foreign currency translation impact on revenue was negligible in 2010 and a 3% detriment in 2009.

Refer to “Gross Margin” section for additional information regarding the impact of currency on our product costs.

 

Xerox 2010 Annual Report  3


Summary Results

Revenue

Revenues for the three years ended December 31, 2010 were as follows:

 

    Revenues     Percent Change     Pro-forma(3)
Change
    Percent of Total Revenue  

(in millions)

  2010     2009     2008     2010     2009     2010     2010     2009     2008  

Revenue:

                 

Equipment sales

  $ 3,857      $ 3,550      $ 4,679        9     (24 )%      9     18     24     26

Supplies, paper and other

    3,377        3,096        3,646        9     (15 )%      4     15     20     21
                                                     

Sales

    7,234        6,646        8,325        9     (20 )%      7     33     44     47

Service, outsourcing and rentals

    13,739        7,820        8,485        76     (8 )%      1     64     51     48

Finance income

    660        713        798        (7)     (11 )%      (7 )%      3     5     5
                                                     

Total Revenues

  $   21,633      $   15,179      $   17,608        43 %      (14 )%      3 %      100 %      100 %      100 % 
                                                     

Segments:

                 

Technology

  $ 10,349      $ 10,067      $ 11,714        3     (14 )%      3     48     66     66

Services

    9,637        3,476        3,828        177     (9 )%      3     44     23     22

Other

    1,647        1,636        2,066        1     (21 )%      1     8     11     12
                                                     

Total Revenues

  $ 21,633      $ 15,179      $ 17,608        43 %      (14 )%      3 %      100 %      100 %      100 % 
                                                     

Memo:

                 

Annuity Revenue (1)

  $ 17,776      $ 11,629      $ 12,929        53     (10 )%      1     82     77     73

Color (2)

  $ 6,397      $ 5,972      $ 6,669        7     (10 )%      7     30     39     38

Revenue 2010

Total revenues increased 43% compared to the prior year. Our consolidated 2010 results include ACS results subsequent to February 5, 2010, the effective date of the acquisition. On a pro-forma (3) basis total revenue grew 3%. Currency had a negligible impact on total revenues during 2010. Total revenues included the following:

 

53% increase in annuity revenue (1), or 1% on a pro-forma (3) basis, with a 1-percentage point negative impact from currency. The components of annuity revenue were as follows:

   

Service, outsourcing and rentals revenue of $13,739 million increased 76%, or 1% on a pro-forma (3) basis, and included a negligible impact from currency. The increase was driven by Business Process Outsourcing (“BPO”) revenue that partially offset the declines in technical service revenue which were driven by a continued but stabilizing decline in pages. Total digital pages declined 4% while color pages increased 9%. During 2010 digital MIF increased by 1% and color MIF increased by 15%.

   

Supplies, paper, and other sales of $3,377 million increased 9%, or 4% on a pro-forma (3) basis, with a 1-percentage point negative impact from currency. Growth in supplies revenues were partially offset by a decline in paper sales.

 

9% increase in equipment sales revenue, including a 1-percentage point negative impact from currency. Growth in install activity was partially offset by price declines of approximately 5% and mix.

 

7% increase in color revenue (2), including a 1-percentage point negative impact from currency reflecting:

   

5% increase in color annuity revenue, including a 1-percentage point negative impact from currency. The increase was driven by higher printer supplies sales and higher page volumes.

   

12% increase in color equipment sales revenue, including a 2-percentage point negative impact from currency. The increase was driven by higher installs of new products.

   

9% growth in color pages(4). Color pages (4) represented 23% of total pages in 2010 while color MIF represented 31% of total MIF.

 

Xerox 2010 Annual Report  4


Revenue 2009

Revenue decreased 14% compared to the prior year, including a 3-percentage point negative impact from currency. Although moderating in the fourth quarter 2009, worldwide economic weakness negatively impacted our major market segments during the year. Total revenues included the following:

 

10% decrease in annuity revenue(1) including a 3-percentage point negative impact from currency. The components of the annuity revenue decreased as follows:

   

8% decrease in service, outsourcing and rentals revenue to $7,820 million reflecting a 3-percentage point negative impact from currency and an overall decline in page volume. Total digital pages declined 6% despite an increase in color pages of 10%. Additionally, during 2009 digital MIF increased by 2% and color MIF increased by 21%.

   

Supplies, paper, and other sales of $3,096 million decreased 15% due primarily to currency, which had a 2-percentage point negative impact, and declines in channel supplies purchases, including lower purchases within developing markets, and lower paper sales.

 

24% decrease in equipment sales revenue, including a 1-percentage point negative impact from currency. The overall decline in install activity was the primary driver along with price declines of approximately 5%.

 

10% decrease in color revenue (2) including a 2-percentage point negative impact from currency reflecting:

   

5% decrease in color annuity revenue including a 3-percentage point negative impact from currency. The decline was partially driven by lower channel color printer supplies purchases. Color represented 40% and 37% of annuity revenue in 2009 and 2008, respectively.

   

22% decrease in color equipment sales revenue including a 2-percentage point negative impact from currency and lower installs driven by the impact of the economic environment. Color sales represented 53% and 50% of total equipment sales in 2009 and 2008.

   

10% growth in color pages(4). Color pages (4) represented 21% and 18% of total pages in 2009 and 2008, respectively.

Net Income

Net income and diluted earnings per share, as well as the adjustments to net income (5) for the three years ended December 31, 2010 were as follows:

 

     2010      2009      2008  

(in millions, except per-share amounts)

   Net Income      EPS      Net Income      EPS      Net Income     EPS  

As Reported

   $ 606       $ 0.43       $   485       $   0.55       $ 230      $   0.26   

Adjustments:

                

Xerox and Fuji Xerox restructuring charges

     355         0.26         41         0.05         308        0.34   

Acquisition-related costs

     58         0.04         49         0.06                  

Amortization of intangible assets

     194         0.14         38         0.04         35        0.04   

ACS shareholders litigation settlement

     36         0.03                                  

Venezuela devaluation costs

     21         0.02                                  

Medicare subsidy tax law change

     16         0.01                                  

Provision for litigation matters

                                     491        0.54   

Equipment write-off

                                     24        0.03   

Loss on early extinguishment of debt

     10         0.01                                  

Settlement of unrecognized tax benefits

                                     (41     (0.05
                                                    

As Adjusted(5)

   $   1,296       $ 0.94       $ 613       $ 0.70       $   1,047      $ 1.16   
                                                    

Weighted average shares for reported EPS

  

     1,351            880           895   

Weighted average shares for adjusted EPS

  

     1,378            880           897   

Average shares for the calculation of adjusted EPS for 2010 of 1,378 million include a pro-rata portion of 27 million shares associated with the Series A convertible preferred stock and therefore the 2010 dividends of $21 million are excluded. In addition, average shares for the calculation of adjusted EPS for both 2010 and 2008 include 2 million shares associated with other convertible securities. We evaluate the dilutive effect of our convertible securities on an “if-converted” basis. Refer to Note 20 – Earnings Per Share in the Consolidated Financial Statements for additional information.

 

Xerox 2010 Annual Report  5


 

(1) Annuity revenue equals Service, outsourcing and rentals plus Supplies, paper and other sales plus Finance income.
(2) Color revenues represent a subset of total revenue and excludes the impact of GIS’s revenues.
(3) Growth on a pro-forma basis reflects the inclusion of ACS’s adjusted results from February 6 through December 31, 2009. Refer to the “Non-GAAP Financial Measures” section for an explanation of this non-GAAP financial measure.
(4) Pages include estimates for developing markets, GIS and printers.
(5) Refer to the “Non-GAAP Financial Measures” section for an explanation of this non-GAAP financial measure.

Application of Critical Accounting Policies

In preparing our Consolidated Financial Statements and accounting for the underlying transactions and balances, we apply various accounting policies. Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures included herein with the Audit Committee of the Board of Directors. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management’s judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates could have reasonably been used, we disclosed the impact of these different estimates on our operations. In certain instances, like revenue recognition for leases, the accounting rules are prescriptive; therefore, it would not have been possible to reasonably use different estimates. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period.

Specific risks associated with these critical accounting policies are discussed throughout the MD&A, where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, refer to Note 1 - Summary of Significant Accounting Policies, in the Consolidated Financial Statements.

Revenue Recognition for Leases

Our accounting for leases involves specific determinations under applicable lease accounting standards. These determinations affect the timing of revenue recognition for our equipment. If a lease qualifies as a sales-type capital lease, equipment revenue is recognized as sale revenue upon delivery or installation of the equipment as opposed to ratably over the lease term. The critical elements that we consider with respect to our lease accounting are the determination of the economic life and the fair value of equipment, including the residual value. For purposes of determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is five years since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases are for original terms longer than five years. There is no significant after-market for our used equipment. We believe five years is representative of the period during which the equipment is expected to be economically usable, with normal service, for the purpose for which it is intended.

Revenue Recognition for Bundled Lease Arrangements

We sell our products and services under bundled lease arrangements, which typically include equipment, service, supplies and financing components for which the customer pays a single negotiated monthly fixed price for all elements over the contractual lease term. Approximately 40% of our equipment sales revenue is related to sales made under bundled lease arrangements. Typically these arrangements include an incremental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price per page. Revenues under these arrangements are allocated, considering the relative fair values of the lease and non-lease deliverables included in the bundled arrangement, based upon the estimated fair values of each element. Lease deliverables include maintenance and executory costs, equipment and financing, while non-lease deliverables generally consist of supplies and non-maintenance services. The allocation for lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon. These elements are generally recognized over the term of the lease as services revenue. The remaining amounts are allocated to the equipment and financing elements, which are subjected to the accounting estimates noted above under “Revenue Recognition for Leases.” We perform analyses of available verifiable objective evidence of equipment fair value based on cash selling prices during the applicable period. The cash selling prices are compared to the range of values included in our lease accounting systems. The range of cash selling prices must be reasonably consistent with the lease selling prices, taking into account residual values, in order for us to determine that such lease prices are indicative of fair value.

 

Xerox 2010 Annual Report  6


Our pricing interest rates, which are used in determining customer payments, are developed based upon a variety of factors including local prevailing rates in the marketplace and the customer’s credit history, industry and credit class. We reassess our pricing interest rates quarterly based on changes in the local prevailing rates in the marketplace. These interest rates have generally been adjusted if the rates vary by twenty-five basis points or more, cumulatively, from the last rate in effect. The pricing interest rates generally equal the implicit rates within the leases, as corroborated by our comparisons of cash to lease selling prices.

Revenue Recognition for Services – Percentage-of-Completion

A significant portion of our services revenue is recognized based on objective criteria that do not require significant estimates or uncertainties. For example, transaction volume, time and materials and cost reimbursable arrangements are based on specific, objective criteria under the contracts. Accordingly, revenues recognized under these contracts do not require the use of significant estimates that are susceptible to change. However, revenue recognized using the percentage-of-completion accounting method does require the use of estimates and judgment as discussed below. During 2010, we recognized approximately $270 million of revenue using the percentage-of-completion accounting method.

Revenues on certain fixed price contracts where we provide information technology system development and implementation services are recognized using the percentage-of-completion approach. Revenue is recognized over the contract term based on the percentage of development and implementation services that are provided during the period compared with the total estimated development and implementation services to be provided over the entire contract. These contracts require that we perform significant, extensive and complex design, development, modification and implementation activities for our clients’ systems. Performance will often extend over long periods, and our right to receive future payment depends on our future performance in accordance with the agreement.

The percentage-of-completion methodology involves recognizing probable and reasonably estimable revenue using the percentage of services completed, on a current cumulative cost to estimated total cost basis, using a reasonably consistent profit margin over the period. Due to the longer term nature of these projects, developing the estimates of costs often requires significant judgment. Factors that must be considered in estimating the progress of work completed and ultimate cost of the projects include, but are not limited to, the availability of labor and labor productivity, the nature and complexity of the work to be performed and the impact of delayed performance. If changes occur in delivery, productivity or other factors used in developing the estimates of costs or revenues, we revise our cost and revenue estimates, which may result in increases or decreases in revenues and costs. Such revisions are reflected in income in the period in which the facts that give rise to that revision become known. If at any time these estimates indicate the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately in cost. We perform ongoing profitability analyses of our services contracts in order to determine whether the latest estimates require updating.

Allowance for Doubtful Accounts and Credit Losses

We perform ongoing credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience adjusted for current conditions. We cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past.

 

Xerox 2010 Annual Report  7


Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and financial health of specific customers. We recorded bad debt provisions of $188 million, $291 million and $188 million in SAG expenses in our Consolidated Statements of Income for the years ended December 31, 2010, 2009 and 2008, respectively.

Historically, the majority of the bad debt provision related to our finance receivables portfolio. This provision is inherently more difficult to estimate than the provision for trade accounts receivable because the underlying lease portfolio has an average maturity, at any time, of approximately two to three years and contains past due billed amounts, as well as unbilled amounts. The estimated credit quality of any given customer and class of customer or geographic location can significantly change during the life of the portfolio. We consider all available information in our quarterly assessments of the adequacy of the provision for doubtful accounts.

Bad debt provisions decreased by $103 million in 2010 and reserves as a percentage of trade and finance receivables decreased to 3.3% at December 31, 2010 as compared to 4.1% at December 31, 2009 and 3.4% at December 31, 2008. The decline in 2010 reflects the improving trend in write-off’s over the past year as well as the acquisition of ACS. We continue to assess our receivable portfolio in light of the current economic environment and its impact on our estimation of the adequacy of the allowance for doubtful accounts. Refer to Note 4 – Receivables in the Consolidated Financial Statements for additional information.

As discussed above, in preparing our Consolidated Financial Statements for the three years ended December 31, 2010, we estimated our provision for doubtful accounts based on historical experience and customer-specific collection issues. This methodology was consistently applied for all periods presented. During the five year period ended December 31, 2010, our reserve for doubtful accounts ranged from 3.0% to 4.1% of gross receivables. Holding all assumptions constant, a 1-percentage point increase or decrease in the reserve from the December 31, 2010 rate of 3.3% would change the 2010 provision by approximately $98 million.

Pension and Retiree Health Benefit Plan Assumptions

We sponsor defined benefit pension plans in various forms in several countries covering employees who meet eligibility requirements. Retiree health benefit plans cover U.S. and Canadian employees for retirement medical costs. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and retiree health benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases and mortality. Differences between these assumptions and actual experiences are reported as net actuarial gains and losses and are subject to amortization to net periodic benefit cost generally over the average remaining service lives of the employees participating in the plans.

Cumulative actuarial losses for our defined benefit pension plans of $1.9 billion as of December 31, 2010 were essentially unchanged from December 31, 2009. Positive returns on plan assets in 2010 as compared to expected returns offset a decrease in discount rates. The total actuarial loss will be amortized over future periods, subject to offsetting gains or losses that will impact the future amortization amounts.

We used a weighted average expected rate of return on plan assets of 7.3% for 2010, 7.4% for 2009 and 7.6% for 2008, on a worldwide basis. During 2010, the actual return on plan assets was $846 million, reflecting an improvement in the equity markets during the year. When estimating the 2011 expected rate of return, in addition to assessing recent performance, we considered the historical returns earned on plan assets, the rates of return expected in the future and our investment strategy and asset mix with respect to the plans’ funds. The weighted average expected rate of return on plan assets we will use in 2011 is 7.2%.

For purposes of determining the expected return on plan assets, we use a calculated value approach to determine the value of the pension plan assets, rather than a fair market value approach. The primary difference between these two methods relates to a systematic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that can result from using the fair market value approach. The difference between the actual return on plan assets and the expected return on plan assets is added to, or subtracted from, any cumulative differences from prior years. This amount is a component of the net actuarial gain or loss.

 

Xerox 2010 Annual Report  8


Another significant assumption affecting our pension and retiree health benefit obligations and the net periodic benefit cost is the rate that we use to discount our future anticipated benefit obligations. The discount rate reflects the current rate at which the benefit liabilities could be effectively settled considering the timing of expected payments for plan participants. In estimating this rate, we consider rates of return on high quality fixed-income investments included in published bond indices, adjusted to eliminate the effects of call provisions and differences in the timing and amounts of cash outflows related to the bonds. In the U.S. and the U.K., which comprise approximately 75% of our projected benefit obligations, we consider the Moody’s Aa Corporate Bond Index and the International Index Company’s iBoxx Sterling Corporate AA Cash Bond Index, respectively, in the determination of the appropriate discount rate assumptions. The weighted average discount rate we used to measure our pension obligations as of December 31, 2010 and to calculate our 2011 expense was 5.2%, which is lower than 5.7% that was used to calculate our 2010 expense. The weighted average discount rate we used to measure our retiree health obligation as of December 31, 2010 and to calculate our 2011 expense was 4.9%, which is lower than 5.4% that was used to calculate our 2010 expense.

On a consolidated basis, we recognized net periodic pension cost of $355 million, $270 million and $254 million for the years ended December 31, 2010, 2009 and 2008, respectively. The costs associated with our defined contribution plans, which are included in net periodic pension cost, were $51 million, $38 million and $80 million for the years ended December 31, 2010, 2009 and 2008, respectively. The increase in 2010 was primarily due to our partial resumption of the 401(k) match in the U.S. On a consolidated basis, we recognized net retiree health benefit cost of $32 million, $26 million and $77 million for the years ended December 31, 2010, 2009 and 2008, respectively.

Assuming settlement losses in 2011 are consistent with 2010, our 2011 net periodic defined benefit pension cost is expected to be approximately $30 million lower than 2010, primarily driven by the U.S. as a result of a reduction in the amortization of actuarial losses and an increase in expected asset returns from higher asset values and expected contributions to the plan. Our 2011 retiree health benefit cost is expected to be approximately $17 million lower than 2010, primarily as a result of amendments to the U.S. plan in 2010.

Benefit plan costs are included in several income statement components based on the related underlying employee costs. Pension and retiree health benefit plan assumptions are included in Note 15 – Employee Benefit Plans in the Consolidated Financial Statements. Holding all other assumptions constant, a 0.25% increase or decrease in the discount rate would change the 2011 projected net periodic pension cost by $17 million. Likewise, a 0.25% increase or decrease in the expected return on plan assets would change the 2011 projected net periodic pension cost by $17 million.

Income Taxes and Tax Valuation Allowances

We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We follow very specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded in our Consolidated Balance Sheets and provide valuation allowances as required. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. If we continue to operate at a loss in certain jurisdictions or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a significant portion of our deferred tax assets resulting in a substantial increase in our effective tax rate and a material adverse impact on our operating results. Conversely, if and when our operations in some jurisdictions become sufficiently profitable to recover previously reserved deferred tax assets, we would reduce all or a portion of the applicable valuation allowance in the period when such determination is made. This would result in an increase to reported earnings in such period. Adjustments to our valuation allowance, through charges (credits) to income tax expense, were $22 million, $(11) million and $17 million for the years ended December 31, 2010, 2009 and 2008, respectively. There were other (decreases) increases to our valuation allowance, including the effects of currency, of $11 million, $55 million and $(136) million for the years ended December 31, 2010, 2009 and 2008, respectively. These did not affect income tax expense in total as there was a corresponding adjustment to deferred tax assets or other comprehensive income. Gross deferred tax assets of $3.8 billion and $3.7 billion had valuation allowances of $735 million and $672 million at December 31, 2010 and 2009, respectively.

 

Xerox 2010 Annual Report  9


We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax expense based upon our assessment of the more-likely-than-not outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results. Our ongoing assessments of the more-likely-than-not outcomes of the examinations and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results.

We file income tax returns in the U.S. Federal jurisdiction and in various foreign jurisdictions. In the U.S, with the exception of ACS, we are no longer subject to U.S. Federal income tax examinations for years before 2007. ACS is no longer subject to such examination for years before 2004. With respect to our major foreign jurisdictions, we are no longer subject to tax examinations by tax authorities for years before 2000.

Legal Contingencies

We are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and ERISA, as discussed in Note 17 – Contingencies in the Consolidated Financial Statements. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with outside counsel handling our defense in these matters, which involves an analysis of potential results, assuming a combination of litigation and settlement strategies. Should developments in any of these matters cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

Business Combinations and Goodwill

The application of the purchase method of accounting for business combinations requires the use of significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed in order to properly allocate purchase price consideration between assets that are depreciated and amortized from goodwill. Our estimates of the fair values of assets and liabilities acquired are based upon assumptions believed to be reasonable, and when appropriate, include assistance from independent third-party appraisal firms.

As a result of our acquisition of ACS, as well as other acquisitions including GIS, we have a significant amount of goodwill. Goodwill is tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units and determination of the fair value of each reporting unit. We estimate the fair value of each reporting unit using a discounted cash flow methodology. This requires significant judgment including: estimation of future cash flows, which is dependent on internal forecasts; estimation of the long-term rate of growth for our business; the useful life over which cash flows will occur; determination of our weighted average cost of capital for purposes of establishing a discount rate; and consideration of relevant market data.

Our annual impairment test of goodwill is performed in the fourth quarter of each year. The estimated fair values of our reporting units were based on discounted cash flow models derived from internal earnings forecasts and assumptions. The assumptions and estimates used in those valuations considered the current economic environment. In performing our 2010 impairment test, the following were the overall composite assumptions regarding revenue and expense growth, which formed the basis for estimating future cash flows used in the discounted cash flow model: (1) revenue growth 3-5%; (2) gross margin 33-35%; (3) RD&E 3%; (4) SAG 19-20%; and (5) return on sales 10-12%. We believe these assumptions are appropriate because they are consistent with historical results (inclusive of ACS), generally consistent with our forecasted long-term business model and give appropriate consideration to the current economic environment.

 

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Based on these valuations, we determined that the fair values of our reporting units exceeded their carrying values and no goodwill impairment charge was required during the fourth quarter 2010.

Refer to Note 1 – Summary of Significant Accounting Policies – “Goodwill and Intangible Assets” for additional information regarding our goodwill impairment testing, as well as Note 8 – Goodwill and Intangible Assets, Net in the Consolidated Financial Statements for additional information regarding goodwill by operating segment.

Operations Review of Segment Revenue and Operating Profit

Our reportable segments are consistent with how we manage the business and view the markets we serve. Our reportable segments are Technology, Services and Other.

2010 Segment Reporting Change

In 2010, as a result of our acquisition of ACS, we realigned our internal financial reporting structure and began reporting our financial performance based on two primary segments – Technology and Services. The Technology segment represents the combination of our former Production and Office segments excluding the document outsourcing business. The Services segment represents the combination of our document outsourcing business, which includes Xerox’s historic business process services, and ACS’s business process outsourcing and information technology outsourcing businesses. We believe this realignment improves our view of the expanded markets we now serve and will help us to better manage our business which is primarily centered around equipment systems and outsourcing services. Our Technology segment operations involve the sale and support of a broad range of document systems from entry level to the high-end. Our Services segment operations involve delivery of a broad range of outsourcing services including document, business processing and IT. Our 2009 and 2008 segment disclosures have been restated to reflect our new 2010 internal reporting structure. Refer to Note 2 – Segment Reporting, in the Consolidated Financial Statements for further description of these segments.

Revenues by segment for the three years ended December 31, 2010 were as follows:

 

(in millions)

   Total Revenue      Segment Profit (Loss)     Segment Margin  

2010

       

Technology

   $   10,349       $   1,085        10.5

Services

     9,637         1,132        11.7

Other

     1,647         (342     (20.8 )% 
                         

Total

   $ 21,633       $ 1,875        8.7 % 
                         

2009

       

Technology

   $ 10,067       $ 949        9.4

Services

     3,476         231        6.6

Other

     1,636         (342     (20.9 )% 
                         

Total

   $ 15,179       $ 838        5.5 % 
                         

2009 Pro-forma(1)

       

Technology

   $ 10,067       $ 949        9.4

Services

     9,379         1,008        10.7

Other

     1,636         (447     (27.3 )% 
                         

Total

   $ 21,082       $ 1,510        7.2 % 
                         

2008

       

Technology

   $ 11,714       $ 1,288        11.0

Services

     3,828         302        7.9

Other

     2,066         (245     (11.9 )% 
                         

Total

   $ 17,608       $ 1,345        7.6
                         

 

(1) Results include ACS’s 2009 estimated results February 6 through December 31. Refer to the “Non-GAAP Financial Measures” section for an explanation of this non-GAAP financial measure.

 

Xerox 2010 Annual Report  11


Technology

Our technology segment includes the sale of document systems and supplies, provision of technical service and financing of products.

 

    Year Ended December 31,      Percent Change  

(in millions)

  2010      2009      2008      2010     2009  

Equipment sales

  $ 3,404       $ 3,137       $ 4,079         9     (23 )% 

Post sale revenues (1)

    6,945         6,930         7,635             (9 )% 
                              

Total Revenue

  $   10,349       $   10,067       $   11,714         3     (14 )% 
                              

 

(1) Post sale revenue does not include outsourcing revenue which is reported in our Services segment.

Revenue 2010

Technology revenue of $10,349 million increased 3%, including a negligible impact from currency and reflected solid install and related equipment revenue growth including the launch of 21 new products in 2010. Total revenues included the following:

 

9% increase in equipment sales revenue, with a 1-percentage point negative impact from currency, driven primarily by install growth across all color product categories.

 

Post sale revenue was flat compared to prior year, with a 1-percentage point negative impact from currency, as increased supplies sales were offset by lower service revenues reflecting decreased but stabilizing page volumes.

 

Technology revenue mix was 22% entry, 56% mid-range and 22% high-end.

Segment Profit 2010

Technology segment profit of $1,085 million increased $136 million from 2009, reflecting an increase in gross profit due to higher revenues, lower bad debt expense as well as cost and expense savings from restructuring actions.

Installs 2010

Entry

 

46% increase in installs of A4 black-and white multifunction devices driven by growth in developing markets and indirect channels.

 

39% increase in installs of A4 color multifunction devices driven by demand for new products.

 

4% increase in installs of color printers.

Mid-range

 

4% increase in installs of mid-range black-and-white devices.

 

27% increase in installs of mid-range color devices primarily driven by demand for new products, such as the Xerox Color 550/560, WorkCentre® 7545/7556 and WorkCentre® 7120/7700, and the continued strong demand for the ColorQubeTM.

High-end

 

8% decrease in installs of high-end black-and-white systems, reflecting declines across most product areas.

 

26% increase in installs of high-end color systems, reflecting strong demand for the recently launched Xerox Color 800 and 1000.

Install activity percentages include installations for document outsourcing and the Xerox-branded product shipments to GIS. Descriptions of “Entry,” “Mid-range,” and “High-end” can be found in Note 2 – Segment Reporting in the Consolidated Financial Statements.

 

Xerox 2010 Annual Report  12


Revenue 2009

Technology revenue of $10,067 million decreased 14%, including a 3-percentage point negative impact from currency. Total revenue included the following:

 

23% decrease in equipment sales revenue, with a 2-percentage point negative impact from currency. The decline reflects lower installs driven by the weak economic environment during the year and delays in customer spending on technology.

 

9% decrease in post sale revenue, with a 3-percentage point negative impact from currency, reflecting lower page volumes and supplies primarily as a result of the weak economic environment.

 

Technology revenue mix was 21% entry, 56% mid-range and 23% high-end.

Segment Profit 2009

Technology profit of $949 million decreased $339 million from 2008. The decrease is primarily the result of lower gross profit reflecting decreased revenue partially offset by lower costs and expenses reflecting the benefits from restructuring and favorable currency.

Installs 2009

Entry

 

40% decrease in installs of A4 black-and white multifunction devices primarily reflecting lower activity in developing markets.

 

22% decrease in installs of A4 color multifunction devices driven by lower overall demand.

 

34% decrease in installs of color printers due to lower demand and lower sales to OEM partners.

Mid-range

 

31% decrease in installs of mid-range black-and-white devices.

 

19% decrease in installs of mid-range color devices driven by lower overall demand which more than offset the impact of new products including the ColorQube and a mid-range version of the Xerox® 700.

High-end

 

29% decrease in installs of high-end black-and-white systems reflecting declines in all product areas.

 

37% decrease in installs of high-end color systems as entry production color declines were partially offset by increased iGen4 installs.

Services

Our Services segment comprises three service offerings: Business Process Outsourcing (“BPO”), Document Outsourcing (“DO”) and Information Technology Outsourcing (“ITO”).

Services total revenue and segment profit for the year ended December 31, 2010 increased 177% and 390%, respectively, primarily due to the inclusion of ACS. Since these comparisons are not meaningful, results for the Services segment are primarily discussed on a pro-forma basis, with ACS’s 2009 estimated results from February 6 through December 31 included in our historical 2009 results (See “Non-GAAP Financial Measures” section for discussion of this non-GAAP measure).

Revenue 2010

Services revenue of $9,637 million increased 177%, or 3% on a pro-forma(1 ) basis, including a negligible impact from currency.

 

BPO delivered pro-forma(1) revenue growth of 8% and represented 53% of total services revenue. BPO growth was driven by healthcare services, customer care, transportation solutions, healthcare payer services and 2010 acquisitions.

 

DO revenue decreased 3%, including a negligible impact from currency, and represented 34% of total services revenue. The decrease primarily reflects the continued impact of the weak economy on usage levels and renewal rates.

 

ITO revenue was flat on a pro-forma(1) basis and represented 13% of total services revenue.

Segment Profit 2010

Services operating profit of $1,132 million increased $901 million or $124 million on a pro-forma(1) basis from 2009, driven primarily by BPO growth and lower G&A expenses.

 

Xerox 2010 Annual Report  13


Metrics

Pipeline

Our BPO and ITO revenue pipeline including synergy opportunities grew 25% over the fourth quarter 2009. The sales pipeline includes the Total Contract Value (“TCV”) of new business opportunities that could potentially be contracted within the next six months and excludes business opportunities with estimated annual recurring revenue in excess of $100 million. The DO sales pipeline grew approximately 17% over the fourth quarter 2009. The DO sales pipeline includes all active deals with $10 million or greater in TCV.

Signings

Signings (“Signings”) are defined as estimated future revenues from contracts signed during the period, including renewals of existing contracts. Services signings were an estimated $14.6 billion in TCV in 2010 and increased 13% as compared to the comparable prior year period. TCV represents estimated total revenue for future contracts for pipeline or signed contracts for signings as applicable.

Signings were as follows:

 

(in billions)

   Year Ended December 31, 2010  

BPO

   $   10.0   

DO

     3.3   

ITO

     1.3   
        

Total Signings

   $ 14.6   
        

Signings growth was driven by strong signings in both our BPO and DO businesses. In 2010 we signed significant new business in the following areas:

 

 

Child support payment processing

 

Commercial healthcare

 

Customer care

 

Electronic payment cards

 

Enterprise print services

 

Government healthcare

 

Telecom and hardware services

 

Transportation

Revenue 2009

Services revenue of $3,476 million decreased 9% including a 2-percentage point negative impact from currency. Services revenue for 2009 and 2008 primarily reflects revenue from DO services. The decrease in revenue is primarily due to lower usage primarily in black-and-white devices.

Segment Profit 2009

Services operating profit of $231 million decreased $71 million from 2008. The decrease was primarily due to lower gross profit reflecting a decrease in revenues partially offset by lower cost and expenses reflecting benefits from restructuring and favorable currency.

Other

Revenue 2010

Other revenue of $1,647 million increased 1%, including a negligible impact from currency. Increases in GIS’s network integration and electronic presentation systems and Wide Format sales offset a decline in paper sales. Paper comprised approximately 58% of the Other segment revenue.

 

Xerox 2010 Annual Report  14


Segment Loss 2010

Other segment loss of $342 million was flat with 2009 as higher gross profit reflecting an increase in gross margins from the mix of revenues was partially offset by higher interest expense associated with funding for the ACS acquisition.

Revenue 2009

Other revenue of $1,636 million decreased 21%, including a 2-percentage point negative impact from currency, primarily driven by declines in revenue from paper, wide format systems and licensing and royalty arrangements. Paper comprised approximately 60% of the Other segment revenue.

Segment Loss 2009

Other operating loss of $342 million increased $97 million from 2008, primarily due to lower revenue, as well as lower interest and equity income.

 

(1) Refer to the “Non-GAAP Financial Measures” section for an explanation of the Pro-forma non-GAAP financial measure.

Costs, Expenses and Other Income

Gross Margin

Gross margins by revenue classification were as follows:

 

     Year Ended December 31,     Change      Pro-forma(1)
Change
 
     2010     2009     2008     2010      2009      2010  

Sales

     34.5     33.9     33.7     0.6pts         0.2pts         1.1pts   

Service, outsourcing and rentals

     33.1     42.6     41.9     (9.5)pts         0.7pts         (0.7)pts   

Finance income

     62.7     62.0     61.8     0.7pts         0.2pts         0.7pts   

Total Gross Margin

     34.4     39.7     38.9     (5.3)pts         0.8pts         (0.2)pts   

Gross Margin 2010

The 2010 total gross margin decreased 5.3-percentage points, and service, outsourcing and rentals gross margin decreased 9.5-percentage points, on an actual basis primarily due to the ACS acquisition. ACS, as a services based company, had a lower gross margin as compared to a technology based company, which typified Xerox before the acquisition. Since actual comparisons are not meaningful, gross margins for these two categories are primarily discussed below on a pro-forma basis with ACS’s 2009 estimated results from February 6 through December 31 included in our historical 2009 results (See “Non-GAAP Financial Measures” section for a further discussion of this non-GAAP measure).

 

 

Total gross margin decreased 5.3-percentage points or 0.2-percentage points on a pro-forma(1) basis, as compared to 2009. The decline was primarily due to the unfavorable impact of year-over-year transaction currency.

 

Sales gross margin increased 0.6-percentage points or 1.1-percentage points on a pro-forma(1) basis, as compared to 2009. Cost improvements and positive mix more than offset a 0.5-percentage point adverse impact from transaction currency and price declines of about 1-percentage points.

 

Service, outsourcing and rentals gross margin decreased 9.5-percentage points or 0.7-percentage points on a pro-forma(1) basis, as compared to 2009 as price declines and the higher rate of growth in lower margin BPO revenue were only partially offset by cost improvements.

 

Financing income gross margin of 62.7% remained comparable to 2009.

Since a large portion of our inventory is procured from Japan, the strengthening of the Yen versus the U.S. Dollar and Euro in 2010 and 2009 has significantly impacted our product costs. In 2010, the Yen strengthened approximately 6% against the U.S. Dollar and 10% against the Euro as compared to 2009. In 2009, the Yen strengthened approximately 10% against the U.S. Dollar and 15% against the Euro as compared to 2008. We expect product costs and gross margins to continue to be negatively impacted in 2011, particularly in the first half, if Yen exchange rates remain at January 2011 levels.

 

(1) Refer to the “Non-GAAP Financial Measures” section for an explanation of the Pro-forma non-GAAP financial measure.

 

Xerox 2010 Annual Report  15


Gross Margin 2009

 

Total gross margin increased 0.8-percentage points compared to 2008 primarily driven by cost improvements, enabled by restructuring and our cost actions, which were partially offset by the 0.5-percentage point unfavorable impact of transaction currency, primarily the Yen, and price declines of 1.0-percentage points.

 

Sales gross margin increased 0.2-percentage points primarily due to the cost improvements and the positive mix of revenues partially offset by the adverse impact of transaction currency on our inventory purchases of 1.0-percentage point and price declines of 1.2-percentage points.

 

 

Service, outsourcing and rentals margin increased 0.7-percentage points primarily due to the positive impact from the reduction in costs driven by our restructuring and cost actions of 1.5-percentage points. These cost improvements more than offset the approximate 0.9-percentage points impact of pricing.

 

Financing income margin of 62% remained comparable to 2008.

Research, Development and Engineering Expenses (“RD&E”)

We invest in technological research and development, particularly in color, software and services. We believe our R&D spending is sufficient to remain technologically competitive. Our R&D is strategically coordinated with that of Fuji Xerox.

 

     Year Ended December 31,     Change     Pro-forma(1)
Change
 

(in millions)

   2010     2009     2008     2010     2009     2010  

R&D

   $   653      $   713      $   750      $ (60   $ (37   $ (60

Sustaining Engineering

     128        127        134        1        (7     1   
                                                

Total RD&E Expenses

   $ 781      $ 840      $ 884      $ (59   $ (44   $ (59
                                                

RD&E % Revenue

     3.6     5.5     5.0     (1.9)pts        0.5pts        (0.4)pts   

R&D Investment by Fuji Xerox(2 )

   $ 821      $ 796      $ 788      $ 25      $ 8        n/a   

 

(1) Refer to the “Non-GAAP Financial Measures” section for an explanation of the Pro-forma non-GAAP financial measure.
(2) Increase in Fuji Xerox R&D was primarily due to changes in foreign exchange rates.

RD&E 2010: The decrease in RD&E spending for 2010 primarily reflects the savings from restructuring and productivity improvements.

RD&E 2009: The decrease in RD&E spending for 2009 reflects our restructuring and cost actions which consolidated the development and engineering infrastructures within our Technology segment.

Selling, Administrative and General Expenses (“SAG”)

 

     Year Ended December 31,     Change     Pro-forma(1)
Change
 

(in millions)

   2010     2009     2008     2010     2009     2010  

Total SAG

   $   4,594      $   4,149      $   4,534      $ 445      $ (385   $ (57

SAG as a % of revenue

     21.2     27.3     25.7     (6.1)pts        1.6pts        (0.9)pts   

Bad Debt Expense

   $ 188      $ 291      $ 188      $ (103   $ 103      $ (108

Bad Debt as a % of revenue

     0.9     1.9     1.1     (1.0)pts        0.8pts        (0.5)pts   

 

(1) Refer to the “Non-GAAP Financial Measures” section for an explanation of the Pro-forma non-GAAP financial measure.

SAG 2010

SAG as a percent of revenue decreased 6.1-percentage points on an actual basis primarily due to the ACS acquisition. ACS, as a typical service based company, had lower SAG as a percent of revenue as compared to a technology based company, which typified Xerox before the acquisition. Since actual comparisons are not meaningful, SAG is primarily discussed on a pro-forma basis, with ACS’s 2009 estimated results from February 6 through December 31 included in our historical 2009 results (See “Non-GAAP Financial Measures” section for additional discussion of this non-GAAP measure).

 

Xerox 2010 Annual Report  16


SAG of $4,594 million was $445 million higher than 2009, or $57 million lower on a pro-forma (1) basis, including a negligible impact from currency. The pro-forma(1) SAG decrease reflects the following:

 

$137 million increase in selling expenses, reflecting increased demand generation and brand advertising and higher commissions partially offset by restructuring savings and productivity improvements.

 

$86 million decrease in general and administrative expenses, reflecting benefits from restructuring and operational improvements.

 

$108 million decrease in bad debt expense, reflecting an improving write-off trend.

SAG 2009

SAG of $4,149 million was $385 million lower than 2008, including a $126 million benefit from currency. The SAG decrease was the result of the following:

 

$311 million decrease in selling expenses, reflecting favorable currency; benefits from restructuring, an overall reduction in marketing spend and lower commissions.

 

$177 million decrease in general and administrative expenses, reflecting favorable currency and benefits from restructuring and cost actions partially offset by higher compensation accruals.

 

$103 million increase in bad debt expense, reflecting increased write-offs in North America and Europe.

Summary Costs and Expenses

The following is a summary of key metrics used to assess our performance:

 

     Year Ended December 31,     Change      Pro-forma(1)
Change
 

(in millions)

   2010     2009     2008     2010      2009      2010  

Total Gross Margin

     34.4     39.7     38.9     (5.3)pts         0.8pts         (0.2)pts   

RD&E % of revenue

     3.6     5.5     5.0     (1.9)pts         0.5pts         (0.4)pts   

SAG % of revenue

     21.2     27.3     25.7     (6.1)pts         1.6pts         (0.9)pts   

Operating Margin(1)

     9.6     6.8     8.4     2.8pts         (1.6)pts         1.0pts   

Pre-tax income (loss) margin

     3.8     4.1     (0.4 )%      (0.3)pts         4.5pts         (2.2)pts   

 

(1) See the “Non-GAAP Measures” section for additional information.

As previously noted, the acquisition of ACS increased the proportion of revenues from Services. Consistent with Services companies, this portion of our operations has a lower gross margin than our Technology segment, but also has both, lower SAG and R&D as a percent of revenue. Accordingly, in 2010 we began to assess our performance using an operating margin metric, which neutralizes this mix differential. Operating margin is an internal measurement metric and represents gross margin minus RD&E percentage of revenue and SAG percentage of revenue. (Refer to the “Non-GAAP Financial Measures” section for further information and the reconciliation of operating margin to pre-tax income (loss) margin).

During 2010, operating margin increased 2.8-percentage points or 1.0-percentage-points on a pro-forma (1) basis, as compared to 2009. The improvement reflects strong revenue growth and continued disciplined cost and expense management. During 2009, operating margin decreased 1.6-percentage points largely due to lower revenue as a result of the worldwide recession as well as the negative effects of currency on our product costs, which were only partially offset by savings from prior year restructuring actions.

 

Xerox 2010 Annual Report17


Restructuring and Asset Impairment Charges

2010 Activity

During 2010 we recorded $483 million of net restructuring and asset impairment charges which included the following:

 

$470 million of severance costs related to headcount reductions of approximately 9,000 employees. The costs associated with these actions applied about equally to North America and Europe, with approximately 20% related to our developing market countries. Approximately 50% of the costs were focused on gross margin improvements, 40% on SAG and 10% on the optimization of RD&E investments and impacted the following functional areas:

   

Services

   

Supply chain and manufacturing

   

Back office administration

   

Development and engineering

 

$28 million for lease termination costs primarily reflecting the continued rationalization and optimization of our worldwide operating locations, including consolidations with ACS.

 

$19 million loss associated with the sale of our Venezuelan subsidiary. The loss primarily reflects the write-off our Venezuelan net assets including working capital and long-lived assets. We will continue to sell equipment, parts and supplies to the acquiring company through a distribution arrangement but will no longer have any direct or local operations in Venezuela. The sale of our operations and change in business model follows a decision by management in the fourth quarter 2010 to reduce the Company’s future exposure and risk associated with operating in this unpredictable economy.

The above charges were partially offset by $41 million of net reversals for changes in estimated reserves from prior period initiatives.

We expect 2011 pre-tax savings of approximately $270 million from our 2010 restructuring actions and approximately $475 million of annualized savings once all actions are fully implemented.

2009 Activity

Restructuring activity was minimal in 2009, and the related charges primarily reflected changes in estimates in severance costs from previously recorded actions.

2008 Activity

During 2008, we recorded $357 million of net restructuring charges predominantly consisting of severance and costs related to the elimination of approximately 4,900 positions primarily in North America and Europe. Focus areas for these actions include the following:

 

Improving efficiency and effectiveness of infrastructure including: marketing, finance, human resources and training;

 

Capturing efficiencies in technical services, managed services and supply chain and manufacturing infrastructure; and

 

Optimizing product development and engineering resources.

In addition, related to these activities, we also recorded lease cancellation and other costs of $19 million and asset impairment charges of $53 million. The lease termination and asset impairment charges primarily related to: (i) the relocation of certain manufacturing operations including the closing of our toner plant in Oklahoma City and the consolidation of our manufacturing operations in Ireland; and (ii) the exit from certain leased and owned facilities as a result of the actions noted above.

Restructuring Summary

The restructuring reserve balance as of December 31, 2010, for all programs was $323 million, of which approximately $309 million is expected to be spent over the next twelve months. Refer to Note 9 – Restructuring and Asset Impairment Charges in the Consolidated Financial Statements for additional information regarding our restructuring programs.

 

Xerox 2010 Annual Report  18


Acquisition-Related Costs

Costs of $77 million were incurred during 2010 in connection with our acquisition of ACS. These costs include $53 million of transaction costs, which represent external costs directly related to completing the acquisition of ACS and primarily include expenditures for investment banking, legal, accounting and other similar services. Legal costs include costs associated with the ACS shareholders litigation which was settled in 2010. The remainder of the acquisition-related costs represents external incremental costs directly related to the integration of ACS and Xerox. These costs include expenditures for consulting, systems integration, corporate communication services and the consolidation of facilities as well as the expense associated with the performance shares that were granted to ACS management in connection with existing change-in-control agreements.

Costs of $72 million were incurred during 2009, in connection with our acquisition of ACS. $58 million of the costs relate to the write-off of fees associated with the Bridge Loan Facility commitment which was terminated as a result of securing permanent financing to fund the acquisition. The remainder of the costs represents transaction costs such as banking, legal and accounting fees, as well as some pre-integration costs such as external consulting services.

Amortization of Intangible Assets

During 2010, we recorded $312 million for the amortization of intangibles assets, which was $252 million higher than 2009. The increase primarily reflects the amortization of intangibles associated with our acquisition of ACS. Refer to Note 3 – Acquisitions in the Consolidated Financial Statements for additional information regarding the ACS acquisition.

Amortization of intangibles was $60 million in 2009 which was an increase of $6 million over 2008 primarily as a result of the full-year amortization of the assets acquired as part of our acquisitions in 2008.

Worldwide Employment

Worldwide employment of 136,500 as of December 31, 2010 increased approximately 83,000 from December 31, 2009, primarily due to the additional headcount related to the ACS acquisition partially offset by restructuring reductions. Worldwide employment was approximately 53,600 and 57,100 at December 31, 2009 and 2008, respectively.

Other Expenses, Net

Other expenses, net for the three years ended December 31, 2010 were as follows:

 

(in millions)

         2010                 2009                 2008        

Non-financing interest expense

   $   346      $ 256      $ 262   

Interest income

     (19     (21     (35

Gain on sales of businesses and assets

     (18     (16     (21

Currency losses, net

     11        26        34   

ACS shareholders litigation settlement

     36                 

Litigation matters

     (4     9        781   

Loss on early extinguishment of debt

     15                 

All Other expenses, net

     22        31        12   
                        

Total Other Expenses, Net

   $ 389      $     285      $     1,033   
                        

 

Xerox 2010 Annual Report  19


Non-financing interest expense: 2010 non-financing interest expense of $346 million increased $90 million from 2009 due to higher average debt balances, primarily resulting from the funding of the ACS acquisition, partially offset by the early extinguishment of certain debt instruments as well as the scheduled repayments of other debt.

In 2009 non-financing interest expense decreased compared to 2008, as interest expense associated with our $2.0 billion Senior Note offering for the funding of the ACS acquisition was more than offset by lower interest rates on the remaining debt.

Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances. The decline in interest income in 2010 and 2009 was primarily due to lower average cash balances and rates of return.

Gain on sales of businesses and assets: Gains on sales of business and assets primarily consisted of the sales of certain surplus facilities in Latin America.

Currency losses, net: Currency losses primarily result from the re-measurement of foreign currency-denominated assets and liabilities, the cost of hedging foreign currency-denominated assets and liabilities, the mark-to-market of foreign exchange contracts utilized to hedge those foreign currency-denominated assets and liabilities and the mark-to-market impact of hedges of anticipated transactions, primarily future inventory purchases, for those that we do not apply cash flow hedge accounting treatment.

The 2010 net currency losses were primarily due to the currency devaluation in Venezuela. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the U.S. Dollar for a majority of our products. As a result of this devaluation, we recorded a currency loss of $21 million in the first quarter of 2010 for the re-measurement of our net Bolivar-denominated monetary assets. This loss was partially offset by a cumulative translation gain of $6 million that was recognized upon the repatriation of cash and liquidation of a foreign subsidiary.

The 2009 net currency losses were primarily due to the significant movement in exchange rates among the U.S. Dollar, Euro and Yen in the first quarter of 2009, as well as the increased cost of hedging, particularly in developing markets.

The 2008 currency losses were primarily due to net re-measurement losses associated with our Yen-denominated payables, foreign currency-denominated assets and liabilities in our developing markets and the cost of hedging. The currency losses on Yen-denominated payables were largely limited to the first quarter 2008 as a result of the significant and rapid weakening of the U.S. Dollar and Euro versus the Yen.

ACS Shareholders’ Litigation Settlement: Represents litigation expense of $36 million for the settlement of claims by ACS shareholders arising from our acquisition of ACS. The total settlement for all defendants was approximately $69 million, with Xerox paying approximately $36 million net of insurance proceeds.

Litigation matters: The 2010 and 2009 amounts for litigation matters primarily relate to changes in estimated probable losses for various legal matters.

In 2008 legal matters consisted of the following:

 

 

$721 million reflecting provisions for the $670 million court approved settlement of Carlson v. Xerox Corporation and other pending securities-related cases, net of insurance recoveries.

 

$36 million for probable losses on Brazilian labor-related contingencies. Following an assessment of the most recent trend in the outcomes of these matters, we reassessed the probable estimated loss and, as a result, recorded an additional reserve of $36 million in the fourth quarter of 2008.

 

$24 million associated with probable losses from various other legal matters.

Refer to Note 17 – Contingencies in the Consolidated Financial Statements for additional information regarding litigation against the Company.

 

Xerox 2010 Annual Report  20


All other expenses, net: All Other expenses in 2010 decreased primarily due to lower interest expense on the Brazil tax and labor contingencies.

All Other expenses, net in 2009 were $19 million higher than 2008, primarily due to fees associated with the sale of receivables, as well as an increase in interest expense related to Brazil tax and labor contingencies.

Income Taxes

 

    Year Ended December 31,  
    2010     2009     2008  

(in millions)

  Pre-Tax
Income
    Income
Tax
Expense
    Effective
Tax Rate
    Pre-Tax
Income
    Income
Tax
Expense
    Effective
Tax Rate
    Pre-Tax
Income
    Income
Tax
Expense
    Effective
Tax Rate
 

Reported

  $ 815      $   256        31.4   $ 627      $ 152        24.2   $ (79   $ (231     292.4

Adjustments:

                 

Xerox restructuring charge(1 )

    483        166          (8     (3       426        134     

Acquisition-related costs

    77        19          72        23                     

Amortization of intangible assets

    312        118          60        22          54        19     

Venezuela devaluation costs

    21                                            

Medicare subsidy tax law change

           (16                                  

Equipment write-off

                                    39        15     

Provision for securities litigation

                                    774        283     

ACS shareholders’ litigation settlement

    36                                            

Loss on early extinguishment of debt

    15        5                                 41     
                                                                       

Adjusted(2)

  $   1,759      $ 548        31.2   $   751      $   194        25.8   $   1,214      $   261        21.5
                                                                       

The 2010 effective tax rate was 31.4%, or 31.2%(2) on an adjusted basis, which was lower than the U.S. statutory rate primarily due to the geographical mix of income before taxes and the related effective tax rates in those jurisdictions as well as the U.S. tax impacts on certain foreign income and tax law changes.

The 2009 effective tax rate was 24.2%, or 25.8%(2) on an adjusted basis, which was lower than the U.S. statutory tax rate primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions and the settlement of certain previously unrecognized tax benefits partially offset by a reduction in the utilization of foreign tax credits.

The 2008 effective tax rate was 292.4%, or 21.5%(2) on an adjusted basis, which was lower than the U.S. statutory tax rate primarily reflecting the benefit to taxes from the geographical mix of income before taxes and the related effective tax rates in those jurisdictions, the utilization of foreign tax credits and tax law changes.

Our effective tax rate will change based on nonrecurring events as well as recurring factors including the geographical mix of income before taxes and the related effective tax rates in those jurisdictions and the U.S. tax impacts on certain foreign income. In addition, our effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be predictable. We anticipate that our effective tax rate for 2011 will be approximately 31%, excluding the effects of any discrete events.

Refer to Note 16 – Income and Other Taxes in the Consolidated Financial Statements for additional information.

 

Xerox 2010 Annual Report  21


 

(1) Income tax benefit from restructuring in 2010 includes a $19 million benefit from the sale of our Venezuelan operations.
(2) See the “Non-GAAP Measures” section for additional information.

Equity in Net Income of Unconsolidated Affiliates

 

     Year Ended December 31,  

(in millions)

   2010      2009      2008  

Total equity in net income of unconsolidated affiliates

   $ 78       $ 41       $ 113   

Fuji Xerox after-tax restructuring costs(1)

     38         46         16   

 

(1) Represents our 25% share of Fuji Xerox after-tax restructuring costs. Amounts are included in Total equity in net income of unconsolidated affiliates.

Equity in net income of unconsolidated affiliates primarily reflects our 25% share in Fuji Xerox.

The 2010 increase of $37 million from 2009 was primarily due to an increase in Fuji Xerox’s net income, which was primarily driven by higher revenue and cost improvements, as well as lower restructuring costs.

The 2009 decrease of $72 million from 2008 was primarily due to Fuji Xerox’s lower net income, which was negatively impacted by the weakness in the worldwide economy, as well as $46 million related to our share of Fuji Xerox after-tax restructuring costs.

Recent Accounting Pronouncements

Refer to Note 1 – Summary of Significant Accounting Policies in the Consolidated Financial Statements for a description of recent accounting pronouncements including the respective dates of adoption and the effects on results of operations and financial condition.

Capital Resources and Liquidity

Cash Flow Analysis

The following summarizes our cash flows for the three years ended December 31, 2010, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements:

 

     Year Ended December 31,     Change  

(in millions)

   2010     2009     2008     2010     2009  

Net cash provided by operating activities

   $ 2,726      $   2,208      $ 939      $ 518      $ 1,269   

Net cash used in investing activities

     (2,178     (343     (441     (1,835     98   

Net cash (used in) provided by financing activities

     (3,116     692        (311     (3,808     1,003   

Effect of exchange rate changes on cash and cash equivalents

     (20     13        (57     (33     70   
                                        

(Decrease) increase in cash and cash equivalents

       (2,588     2,570        130        (5,158     2,440   

Cash and cash equivalents at beginning of year

     3,799        1,229        1,099        2,570        130   
                                        

Cash and Cash Equivalents at End of Year

   $ 1,211      $ 3,799      $   1,229      $   (2,588   $   2,570   
                                        

 

Xerox 2010 Annual Report  22


Cash Flows from Operating Activities

Net cash provided by operating activities was $2,726 million for the year ended December 31, 2010 and includes $113 million of cash outflows for acquisition related expenditures. The $518 million increase in cash from 2009 was primarily due to the following:

 

$1,173 million increase in pre-tax income before depreciation and amortization, stock-based compensation, litigation, restructuring and the Venezuelan currency devaluation.

 

$458 million increase due to higher accounts payable and accrued compensation primarily related to higher inventory purchases and the timing of accounts payable payments as well as increased compensation, benefit and other accruals.

 

$141 million increase primarily from the early termination of certain interest rate swaps.

 

$57 million increase due to lower restructuring payments.

 

$470 million decrease as a result of higher inventory levels reflecting increased activity.

 

$367 million decrease due to an increase in accounts receivable, net of collections of deferred proceeds from the sale of receivables, primarily as a result of higher revenues and a lower impact from receivable sales.

 

$216 million decrease as a result of up-front costs and other customer related spending associated with our services contracts.

 

$140 million decrease due to higher finance receivables of $119 million and equipment on operating leases of $21 million both reflective of increased equipment placements.

 

$115 million decrease primarily due to higher contributions to our U.S. pension plans. No contributions were made in 2009 to our U.S. pension plans due to the availability of prior years’ credit balances.

Net cash provided by operating activities was $2,208 million for the year ended December 31, 2009. The $1,269 million increase in cash from 2008 was primarily due to the following:

 

$587 million increase due to the absence of payments for securities-related litigation settlements.

 

$433 million increase as a result of lower inventory levels reflecting aggressive supply chain actions in light of lower sales volume.

 

$410 million increase from accounts receivables reflecting the benefits from sales of accounts receivables, lower revenue and strong collection effectiveness.

 

$177 million increase due to lower contributions to our defined pension benefit plans. The lower contributions are primarily in the U.S., as no contributions were required due to the availability of prior years’ credit balances.

 

$116 million increase due to lower net tax payments.

 

$84 million increase due to higher net run-off of finance receivables.

 

$64 million increase due to lower placements of equipment on operating leases, reflecting lower install activity.

 

$440 million decrease in pre-tax income before litigation, restructuring and acquisition costs.

 

$139 million decrease due to higher restructuring payments related to prior years’ actions.

 

$54 million decrease due to lower accounts payable and accrued compensation, primarily related to lower purchases and the timing of payments to suppliers.

Cash Flows from Investing Activities

Net cash used in investing activities was $2,178 million for the year ended December 31, 2010. The $1,835 million increase in the use of cash from 2009 was primarily due to the following:

 

$1,571 million increase primarily due to the acquisitions of ACS for $1,495 million, EHRO for $125 million, TMS Health for $48 million, IBS for $29 million, Georgia for $21 million and Spur for $12 million.

 

$326 million increase due to higher capital expenditures (including internal use software) primarily as a result of the inclusion of ACS in 2010.

 

$35 million decrease due to higher cash proceeds from asset sales.

Net cash used in investing activities was $343 million for the year ended December 31, 2009. The $98 million decrease in the use of cash from 2008 was primarily due to the following:

 

$142 million decrease due to lower capital expenditures (including internal use software), reflecting very stringent spending controls.

 

$21 million increase due to lower cash proceeds from asset sales.

 

Xerox 2010 Annual Report  23


Cash Flows from Financing Activities

Net cash used in financing activities was $3,116 million for the year ended December 31, 2010. The $3,808 million decrease in cash from 2009 was primarily due to the following:

 

$3,980 million decrease due to net debt activity. 2010 includes the repayments of $1,733 million of ACS’s debt on the acquisition date, $950 million of Senior Notes, $550 million early redemption of the 2013 Senior Notes, net payments of $110 million on other debt and $14 million of debt issuance costs for the bridge loan facility commitment, which was terminated in 2009. These payments were offset by net proceeds of $300 million from Commercial Paper issued under a program we initiated during the fourth quarter 2010. 2009 reflects the repayment of $1,029 million for Senior Notes due in 2009, net payments of $448 million for Zero Coupon Notes, net payments of $246 million on the Credit Facility, net payments of $35 million primarily for foreign short-term borrowings and $44 million of debt issuance costs for the Bridge Loan Facility commitment which was terminated. These payments were partially offset by net proceeds of $2,725 million from the issuance of Senior Notes in May and December 2009.

 

$66 million decrease, reflecting dividends on an increased number of outstanding shares as a result of the acquisition of ACS.

 

$182 million increase due to proceeds from the issuance of common stock primarily as a result of the exercise of stock options issued under the former ACS plans as well as the exercise of stock options from several expiring grants.

 

$58 million increase from lower net repayments on secured debt.

Net cash provided by financing activities was $692 million for the year ended December 31, 2009. The $1,003 million increase in cash from 2008 was primarily due to the following:

 

$812 million increase because no purchases were made under our share repurchase program in 2009.

 

$170 million increase from lower net repayments on secured debt.

 

$21 million increase due to lower share repurchases related to employee withholding taxes on stock-based compensation vesting.

 

$3 million decrease due to lower net debt proceeds. 2009 reflects the repayment of $1,029 million for Senior Notes due in 2009, net payments of $448 million for Zero Coupon Notes, net payments of $246 million on the Credit Facility, net payments of $35 million primarily for foreign short-term borrowings and $44 million of debt issuance costs for the Bridge Loan Facility commitment which was terminated. These payments were partially offset by net proceeds of $2,725 million from the issuance of Senior Notes in May and December 2009. 2008 reflects the issuance of $1.4 billion in Senior Notes, $250 million in Zero Coupon Notes and net payments of $354 million on the Credit Facility and $370 million on other debt.

ACS Acquisition

On February 5, 2010 we acquired all of the outstanding equity of ACS in a cash-and-stock transaction valued at approximately $6.2 billion, net of cash acquired. The consideration transferred to acquire ACS was as follows:

 

(in millions)

   February 5,
2010
 

Xerox common stock issued

   $   4,149   

Cash consideration, net of cash acquired

     1,495   

Value of exchanged stock options

     168   

Series A convertible preferred stock

     349   
        

Net Consideration – Cash and Non-cash

   $ 6,161   
        

In addition, we also repaid $1.7 billion of ACS’s debt at acquisition and assumed an additional $0.6 billion.

Refer to Note 3 – Acquisitions, in the Consolidated Financial Statements for additional information regarding the ACS acquisition.

 

Xerox 2010 Annual Report  24


Financing Activities, Credit Facility and Capital Markets

Customer Financing Activities

We provide lease equipment financing to the majority of our customers primarily in our Technology segment. Our lease contracts permit customers to pay for equipment over time rather than at the date of installation. Our investment in these contracts is reflected in Total finance assets, net. We currently fund our customer financing activity through cash generated from operations, cash on hand, borrowings under bank credit facilities and proceeds from capital markets offerings.

We have arrangements in certain international countries and domestically through GIS, where third-party financial institutions independently provide lease financing, on a non-recourse basis to Xerox, directly to our customers. In these arrangements, we sell and transfer title of the equipment to these financial institutions. Generally, we have no continuing ownership rights in the equipment subsequent to its sale; therefore, the unrelated third-party finance receivable and debt are not included in our Consolidated Financial Statements.

The following represents our investment in lease contracts as of December 31:

 

(in millions)

   2010      2009  

Total Finance receivables, net (1)

   $   6,620       $   7,027   

Equipment on operating leases, net

     530         551   
                 

Total Finance Assets, net

   $ 7,150       $ 7,578   
                 

 

(1) Includes (i) billed portion of finance receivables, net, (ii) finance receivables, net and (iii) finance receivables due after one year, net as included in the Consolidated Balance Sheets as of December 31, 2010 and 2009.

$134 million of the $428 million decrease in Total finance assets, net is due to currency.

We maintain a certain level of debt, referred to as financing debt, in order to support our investment in our lease contracts. We maintain an assumed 7:1 leverage ratio of debt to equity as compared to our finance assets for this financing aspect of our business. Based on this leverage, the following represents the breakdown of Total debt between financing debt and core debt as of December 31:

 

(in millions)

   2010      2009  

Financing debt (1)

   $   6,256       $   6,631   

Core debt

     2,351         2,633   
                 

Total Debt

   $ 8,607       $ 9,264   
                 

 

(1) Financing debt includes $5,793 million and $6,149 million as of December 2010 and 2009, respectively, of debt associated with Total finance receivables, net and is the basis for our calculation of “equipment financing interest” expense. The remainder of the financing debt is associated with Equipment on operating leases.

The following summarizes our debt as of December 31:

 

(in millions)

   2010     2009  

Principal debt balance(1)

   $ 8,380      $   9,122   

Net unamortized discount

     (1     (11

Fair value adjustments

     228        153   
                

Total Debt

     8,607        9,264   

Less: Current maturities and short-term debt(1 )

       (1,370     (988
                

Total Long-term Debt(1)

   $ 7,237      $ 8,276   
                

 

(1) December 31, 2010 includes Commercial Paper of $300 million.

 

Xerox 2010 Annual Report  25


Sales of Accounts Receivable

We have facilities in the U.S., Canada and several countries in Europe that enable us to sell to third-parties, on an on-going basis, certain accounts receivable without recourse. The accounts receivables sold are generally short-term trade receivables with payment due dates of less than 60 days. Accounts receivable sales were as follows:

 

    Year Ended December 31,  

(in millions)

  2010     2009     2008  

Accounts receivable sales

  $   2,374      $   1,566      $   717   

Deferred proceeds

    307                 

Fees associated with sales

    15        13        4   

Estimated increase on operating cash flows(1)

    106        309        51   

 

(1) Represents the difference between current and prior year fourth quarter accounts receivable sales adjusted for the effects of: (i) the deferred proceeds, (ii) collections prior to the end of the year and (iii) currency.

Refer to Note 4 – Receivables, Net in the Consolidated Financial Statements for additional information.

Financial Instruments

Refer to Note 13 – Financial Instruments in the Consolidated Financial Statements for additional information regarding our derivative financial instruments.

Share Repurchase Programs

Refer to Note 19 – Shareholders’ Equity – “Treasury Stock” in the Consolidated Financial Statements for additional information regarding our share repurchase programs.

Dividends

The Board of Directors declared aggregate dividends of $243 million and $152 million on common stock in 2010 and 2009, respectively. The increase in 2010 is primarily due to the common stock issued in connection with the ACS acquisition.

The Board of Directors declared aggregate dividends of $21 million on the Series A Convertible Preferred Stock in 2010. The preferred shares were issued in connection with the acquisition of ACS.

Refer to Note 3 – Acquisitions, in the Consolidated Financial Statements for additional information regarding the ACS acquisition.

Capital Market Activity

In 2010, we redeemed our $550 million 7.625% Senior Notes due in 2013. We incurred a loss on extinguishment of approximately $15 million, representing the call premium of approximately $7 million, as well as the write-off of unamortized debt costs of $8 million.

Refer to Note 11 – Debt in the Consolidated Financial Statements for additional information regarding 2010 Debt activity.

 

Xerox 2010 Annual Report  26


Liquidity and Financial Flexibility

We manage our worldwide liquidity using internal cash management practices, which are subject to (1) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (2) the legal requirements of the agreements to which we are a party and (3) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services.

Our liquidity is a function of our ability to successfully generate cash flows from a combination of efficient operations and access to capital markets. Our ability to maintain positive liquidity going forward depends on our ability to continue to generate cash from operations and access to financial markets, both of which are subject to general economic, financial, competitive, legislative, regulatory and other market factors that are beyond our control.

The following is a discussion of our liquidity position as of December 31, 2010:

 

 

Total cash and cash equivalents was $1.2 billion and there were no outstanding borrowings or letters of credit under our $2 billion Credit Facility. The Credit Facility provides backup for our Commercial Paper (“CP”) borrowings which amounted to $300 million at December 31, 2010.

 

In October 2010, Xerox’s Board of Directors authorized the company to issue Commercial Paper (“CP”), a liquidity vehicle that the Company has not used for several years. Aggregate CP and Credit Facility borrowings may not exceed $2 billion outstanding at any time. Under the company's private placement CP program as of December 31, 2010, we could issue CP up to a maximum amount of $1 billion. In February 2011 this amount was increased to $2 billion to be consistent with the Board authorization.

 

Over the past three years we have consistently delivered strong cash flow from operations, driven by the strength of our annuity-based revenue model. Cash flows from operations were $2,726 million, $2,208 million and $939 million for the years ended December 31, 2010, 2009 and 2008, respectively. Cash flows from operations in 2008 included $615 million in net payments for securities litigation.

 

Our principal debt maturities are in line with historical and projected cash flows and are spread over the next ten years as follows and includes $300 million of Commercial Paper in 2011 (in millions):

 

Year

   Amount  

2011

   $   1,370   

2012

     1,126   

2013

     412   

2014

     771   

2015

     1,251   

2016

     950   

2017

     501   

2018

     1,001   

2019

     650   

2020 and thereafter

     348   
        

Total Debt

   $ 8,380   
        

Loan Covenants and Compliance

At December 31, 2010, we were in full compliance with the covenants and other provisions of our Credit Facility and Senior Notes. We have the right to prepay outstanding loans or to terminate the Credit Facility without penalty. Failure to comply with material provisions or covenants of the Credit Facility and Senior Notes could have a material adverse effect on our liquidity and operations and our ability to continue to fund our customers’ purchase of Xerox equipment.

 

Xerox 2010 Annual Report  27


Refer to Note 11 – Debt in the Consolidated Financial Statements for additional information regarding debt arrangements.

Contractual Cash Obligations and Other Commercial Commitments and Contingencies

At December 31, 2010, we had the following contractual cash obligations and other commercial commitments and contingencies:

 

(in millions)

  2011     2012     2013     2014     2015     Thereafter  

Total debt, including capital lease obligations (1)

  $ 1,370      $ 1,126      $ 412      $ 771      $ 1,251      $ 3,450   

Minimum operating lease commitments (2)

    669        486        337        171        118        106   

Liability to subsidiary trust issuing preferred securities (3)

                                       650   

Defined benefit pension plans

    500                                      

Retiree health payments

    87        86        85        85        84        396   

Estimated Purchase Commitments:

           

Flextronics (4)

    670                                      

Fuji Xerox (5)

    2,100                                      

HPES Contracts (6)

    69        23        6                        

Other IM service contracts(7)

    150        140        122        89        12        36   

Other (8)

    7        7        1                        

Other Commitments(9):

           

Surety Bonds

    636        20        7        1        1        1   

Letters of Credit

    96        15               4               155   
                                               

Total

  $   6,354      $   1,903      $   970      $   1,121      $   1,466      $   4,794   
                                               

 

(1) Refer to Note 11 - Debt in the Consolidated Financial Statements for additional information and interest payments related to total debt. Amounts above include principal portion only and $300 million of Commercial Paper in 2011.
(2) Refer to Note 6 - Land, Buildings and Equipment, Net in the Consolidated Financial Statements for additional information related to minimum operating lease commitments.
(3) Refer to Note 12 - Liability to Subsidiary Trust Issuing Preferred Securities in the Consolidated Financial Statements for additional information and interest payments (amounts above include principal portion only).
(4) Flextronics: We outsource certain manufacturing activities to Flextronics and are currently in the first of two one-year extensions of the Master Supply Agreement. The term of this agreement is three years, with two additional one year extension periods. The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment.
(5) Fuji Xerox: The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment.
(6) HPES contract: We have an information management contract with HP Enterprise Services (“HPES”) legal successor to Electronic Data Systems Corp. through March 2014. Services to be provided under this contract include support for European mainframe system processing, as well as workplace, service desk, voice and data network management. Although the HPES contract runs through March 2014, we may choose to transfer some of the services to internal Xerox providers before the HPES contract ends. There are no minimum payments required under this contract. The amounts disclosed in the table reflect our estimate of minimum payments for the periods shown. We can terminate the contract for convenience by providing sixty day’s prior notice without paying a termination fee. Should we terminate the contract for convenience, we have an option to purchase the assets placed in service under the HPES contract.
(7) IM (“Information Management”) services: During 2010 and 2009, we terminated certain information management services provided under the HPES contract. Terminated services were either discontinued or we entered into new agreements for similar services with other providers. Services provided under these contracts include mainframe application processing, development and support; and mid-range applications processing and support. The contracts have various terms through 2015. Some of the contracts require minimum payments and require early termination penalties. The amounts disclosed in the table reflect our estimate of minimum payments.
(8) Other purchase commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts.
(9) Certain contracts, primarily governmental, require surety bonds or letters of credit as guarantee of performance. Generally these commitments have one year terms which are typically renewed annually. Refer to Note 17—Contingencies in the Consolidated Financial Statements for additional information.

 

Xerox 2010 Annual Report  28


Pension and Other Post-retirement Benefit Plans

We sponsor defined benefit pension plans and retiree health plans that require periodic cash contributions. Our 2010 contributions for these plans were $237 million for our defined benefit pension plans and $92 million for our retiree health plans. In 2011 we expect, based on current actuarial calculations, to make contributions of approximately $500 million to our worldwide defined benefit pension plans and approximately $90 million to our retiree health benefit plans. Contributions to our defined benefit pension plans have increased from the prior year due to a decrease in the discount rate, prior years’ investment performance as well as the requirement in the U.S. to make quarterly contributions for the current plan year. Contributions in subsequent years will depend on a number of factors, including the investment performance of plan assets and discount rates as well as potential legislative and plan changes. We currently expect contributions to our defined benefit pension plans to decline in years subsequent to 2011.

Our retiree health benefit plans are non-funded and are almost entirely related to domestic operations. Cash contributions are made each year to cover medical claims costs incurred during the year. The amounts reported in the above table as retiree health payments represent our estimate of future benefit payments.

Fuji Xerox

We purchased products, including parts and supplies, from Fuji Xerox totaling $2.1 billion, $1.6 billion and $2.1 billion in 2010, 2009 and 2008, respectively. Our purchase commitments with Fuji Xerox are entered into in the normal course of business and typically have a lead time of three months. Related party transactions with Fuji Xerox are discussed in Note 7 – Investments in Affiliates, at Equity in the Consolidated Financial Statements.

Brazil Tax and Labor Contingencies

Our Brazilian operations are involved in various litigation matters and have received or been the subject of numerous governmental assessments related to indirect and other taxes, as well as disputes associated with former employees and contract labor. The tax matters, which comprise a significant portion of the total contingencies, principally relate to claims for taxes on the internal transfer of inventory, municipal service taxes on rentals and gross revenue taxes. We are disputing these tax matters and intend to vigorously defend our positions. Based on the opinion of legal counsel and current reserves for those matters deemed probable of loss, we do not believe that the ultimate resolution of these matters will materially impact our results of operations, financial position or cash flows. The labor matters principally relate to claims made by former employees and contract labor for the equivalent payment of all social security and other related labor benefits, as well as consequential tax claims, as if they were regular employees. As of December 31, 2010, the total amounts related to the unreserved portion of the tax and labor contingencies, inclusive of any related interest, amounted to approximately $1,274 million, with the increase from the December 31, 2009 balance of $1,225 million primarily related to currency and current year interest indexation partially offset by matters that have been closed. With respect to the unreserved balance of $1,274 million, the majority has been assessed by management as being remote as to the likelihood of ultimately resulting in a loss to the Company. In connection with the above proceedings, customary local regulations may require us to make escrow cash deposits or post other security of up to half of the total amount in dispute. As of December 31, 2010 we had $276 million of escrow cash deposits for matters we are disputing and there are liens on certain Brazilian assets with a net book value of $19 million and additional letters of credit of approximately $160 million. Generally, any escrowed amounts would be refundable and any liens would be removed to the extent the matters are resolved in our favor. We routinely assess these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable.

Other Contingencies and Commitments

As more fully discussed in Note 17 – Contingencies in the Consolidated Financial Statements, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning securities law, intellectual property law, environmental law, employment law and the Employee Retirement Income Security Act. In addition, guarantees, indemnifications and claims may arise during the ordinary course of business from relationships with suppliers, customers and nonconsolidated affiliates. Nonperformance under a contract including a guarantee, indemnification or claim could trigger an obligation of the Company.

 

Xerox 2010 Annual Report  29


We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. Should developments in any of these areas cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs.

Unrecognized Tax Benefits

As of December 31, 2010, we had $186 million of unrecognized tax benefits. This represents the tax benefits associated with various tax positions taken, or expected to be taken, on domestic and international tax returns that have not been recognized in our financial statements due to uncertainty regarding their resolution. The resolution or settlement of these tax positions with the taxing authorities is at various stages and therefore we are unable to make a reliable estimate of the eventual cash flows by period that may be required to settle these matters. In addition, certain of these matters may not require cash settlement due to the existence of credit and net operating loss carryforwards, as well as other offsets, including the indirect benefit from other taxing jurisdictions that may be available.

Off-Balance Sheet Arrangements

Although we rarely utilize off-balance sheet arrangements in our operations, we enter into operating leases in the normal course of business. The nature of these lease arrangements is discussed in Note 6 – Land, Buildings and Equipment, Net in the Consolidated Financial Statements. In addition, we have facilities in the U.S., Canada and several countries in Europe that enable us to sell to third-parties, on an on-going basis, certain accounts receivable without recourse. Refer to Note 4 – Receivables, Net in the Consolidated Financial Statements for further additional information.

See the table above for the Company’s contractual cash obligations and other commercial commitments and Note 17 – Contingencies in the Consolidated Financial Statements for additional information regarding our guarantees, indemnifications and warranty liabilities.

Financial Risk Management

We are exposed to market risk from foreign currency exchange rates and interest rates, which could affect operating results, financial position and cash flows. We manage our exposure to these market risks through our regular operating and financing activities and, when appropriate, through the use of derivative financial instruments. We utilized derivative financial instruments to hedge economic exposures, as well as reduce earnings and cash flow volatility resulting from shifts in market rates.

Recent market events have not caused us to materially modify or change our financial risk management strategies with respect to our exposures to interest rate and foreign currency risk. Refer to Note 13 – Financial Instruments in the Consolidated Financial Statements for additional discussion on our financial risk management.

Foreign Exchange Risk Management

Assuming a 10% appreciation or depreciation in foreign currency exchange rates from the quoted foreign currency exchange rates at December 31, 2010, the potential change in the fair value of foreign currency-denominated assets and liabilities in each entity would not be significant because all material currency asset and liability exposures were economically hedged as of December 31, 2010. A 10% appreciation or depreciation of the U.S. Dollar against all currencies from the quoted foreign currency exchange rates at December 31, 2010 would have a $528 million impact on our cumulative translation adjustment portion of equity. The net amount invested in foreign subsidiaries and affiliates, primarily Xerox Limited, Fuji Xerox, Xerox Canada Inc. and Xerox do Brasil, and translated into U.S. Dollars using the year-end exchange rates, was $5.3 billion at December 31, 2010.

 

Xerox 2010 Annual Report  30


Interest Rate Risk Management

The consolidated weighted-average interest rates related to our total debt and liability to subsidiary trust issuing preferred securities for 2010, 2009 and 2008 approximated 5.8%, 6.1%, and 6.6%, respectively. Interest expense includes the impact of our interest rate derivatives.

Virtually all customer-financing assets earn fixed rates of interest. The interest rates on a significant portion of the Company’s term debt are fixed.

As of December 31, 2010, $952 million of our total debt carried variable interest rates, including the effect of pay variable interest rate swaps we use to reduce the effective interest rate on our fixed coupon debt.

The fair market values of our fixed-rate financial instruments are sensitive to changes in interest rates. At December 31, 2010, a 10% change in market interest rates would change the fair values of such financial instruments by approximately $194 million.

Non-GAAP Financial Measures

We have reported our financial results in accordance with generally accepted accounting principles (“GAAP”). Additionally, we have discussed our results using non-GAAP measures.

Management believes that these non-GAAP financial measures provide an additional means of analyzing the current periods’ results against the corresponding prior periods’ results. However, these non-GAAP financial measures should be viewed in addition to, and not as a substitute for, the Company’s reported results prepared in accordance with GAAP. Our non-GAAP financial measures are not meant to be considered in isolation or as a substitute for comparable GAAP measures and should be read only in conjunction with our consolidated financial statements prepared in accordance with GAAP. Our management regularly uses our supplemental non-GAAP financial measures internally to understand, manage and evaluate our business and make operating decisions. These non-GAAP measures are among the primary factors management uses in planning for and forecasting future periods. Compensation of our executives is based in part on the performance of our business based on these non-GAAP measures.

A reconciliation of these non-GAAP financial measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are set forth below.

Adjusted Earnings Measures

To better understand the trends in our business and the impact of the ACS acquisition, we believe it is necessary to adjust the following amounts determined in accordance with GAAP to exclude the effects of the certain items as well as their related income tax effects:

 

 

Net income and Earnings per share (“EPS”),

 

Pre-tax income(loss) margin, and

 

Effective tax rate.

The above have been adjusted for the following items:

 

 

Restructuring and asset impairment charges (including those incurred by Fuji Xerox): Restructuring and asset impairment charges consist of costs primarily related to severance and benefits for employees terminated pursuant to formal restructuring and workforce reduction plans. We exclude these charges because we believe that these historical costs do not reflect expected future operating expenses and do not contribute to a meaningful evaluation of our current or past operating performance. In addition, such charges are inconsistent in amount and frequency. Such charges are expected to yield future benefits and savings with respect to our operational performance.

 

Xerox 2010 Annual Report  31


 

Acquisition-related costs: We incurred significant expenses in connection with our acquisition of ACS which we generally would not have otherwise incurred in the periods presented as a part of our continuing operations. Acquisition-related costs include transaction and integration costs, which represent external incremental costs directly related to completing the acquisition and the integration of ACS and Xerox. We believe it is useful for investors to understand the effects of these costs on our total operating expenses.

 

Amortization of intangible assets: The amortization of intangible assets is driven by our acquisition activity which can vary in size, nature and timing as compared to other companies within our industry and from period to period. Accordingly, due to the incomparability of acquisition activity among companies and from period to period, we believe exclusion of the amortization associated with intangible assets acquired through our acquisitions allows investors to better compare and understand our results. The use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods.

 

Other discrete, unusual or infrequent costs and expenses: In addition, we have also excluded the following items given the discrete, unusual or infrequent nature of these items on our results of operations:

   

2010 (1) loss on early extinguishment of debt; (2) ACS shareholders litigation settlement; (3) Venezuela devaluation and (4) Medicare subsidy tax law change (income tax effect only); and

   

2008 (1) provision for litigation matters; (2) equipment write-off and (3) settlement of unrecognized tax benefits.

We believe the exclusion of these items allows investors to better understand and analyze the results for the period as compared to prior periods as well as expected trends in our business.

See “Net Income” and “Income Taxes” sections in the M,D&A for the reconciliation of these Non-GAAP measures for Net Income / Earnings per share and the Effective tax rate, respectively, to the most directly comparable measures calculated and presented in accordance with GAAP.

The following is a reconciliation of the Non-GAAP measure of Operating margin to Pre-tax income margin, which is the most directly comparable measure calculated and presented in accordance with GAAP.

 

(in millions)

   As Reported
2010
    As Reported
2009
    Pro-forma
2009(1)
    As Reported
2008
    10 vs. 09
Change
    Pro-forma
Change
    09 vs. 08
Change
 

Total Revenues

   $   21,633      $   15,179      $   21,082      $   17,608        43     3     (14 )% 
                                      

Pre-tax Income

     815        627        1,267        (79     30     (36 )%      *   

Adjustments:

              

Xerox restructuring charge

     483        (8     (8     429         

Acquisition-related costs

     77        72        104                

Amortization of intangible assets

     312        60        60        54         

Equipment write-off

                          39         

Other expenses, net(2)

     389        285        382        1,033         
                                      

Adjusted Operating Income

   $ 2,076      $ 1,036      $ 1,805      $ 1,476        100     15     (30 )% 
                                      

Pre-tax Income (Loss) Margin

     3.8     4.1     6.0     (0.4 )%      (0.3) pts        (2.2) pts        4.5 pts   

Adjusted Operating Margin

     9.6     6.8     8.6     8.4     2.8 pts        1.0 pts        (1.6) pts   

 

* Percent change not meaningful.
(1) Pro-forma reflects ACS’s 2009 estimated results from February 6 through December 31 adjusted to reflect fair value adjustments related to property, equipment and computer software as well as customer contract costs. In addition, adjustments were made for deferred revenue, exited businesses, certain non-recurring product sales and other material non-recurring costs associated with the acquisition.
(2) 2008 includes provision for litigation matters of $774 million.

 

Xerox 2010 Annual Report  32


Pro-forma Basis

To better understand the trends in our business, we discuss our 2010 operating results by comparing them against adjusted 2009 results which include ACS historical results for the comparable period. Accordingly, we have included ACS’s 2009 estimated results for the comparable period February 6, 2009 through December 31, 2009 in our reported 2009 results. We refer to comparisons against these adjusted 2009 results as “pro-forma” basis comparisons. ACS 2009 historical results have been adjusted to reflect fair value adjustments related to property, equipment and computer software as well as customer contract costs. In addition, adjustments were made for deferred revenue, exited businesses and other material non-recurring costs associated with the acquisition. We believe comparisons on a pro-forma basis are more meaningful than the actual comparisons given the size and nature of the ACS acquisition. We believe the pro-forma basis comparisons allow investors to have better understanding and additional perspective of the expected trends in our business as well as the impact of the ACS acquisition on the Company’s operations.

A reconciliation of these non-GAAP financial measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are set forth below.

 

Xerox 2010 Annual Report  33


Total Xerox    Year Ended December 31,              

(in millions)

   As Reported
2010
    As Reported
2009
    Pro-forma
2009 (1)
    Change     Pro-forma
Change
 

Revenue:

          

Equipment sales

   $ 3,857      $ 3,550      $ 3,550        9     9

Supplies, paper and other

     3,377        3,096        3,234        9     4
                            

Sales

     7,234        6,646        6,784        9     7

Service, outsourcing and rentals

     13,739        7,820        13,585        76     1

Finance income

     660        713        713        (7 )%      (7 )% 
                            

Total Revenues

   $   21,633      $ 15,179      $ 21,082        43     3
                            

Service, outsourcing and rentals

   $ 13,739      $ 7,820      $ 13,585        76     1

Add: Finance income

     660        713        713       

Add: Supplies, paper and other sales

     3,377        3,096        3,234       
                            

Annuity Revenue

   $ 17,776      $   11,629      $   17,532        53     1
                            

Gross Profit:

          

Sales

   $ 2,493      $ 2,251      $ 2,269       

Service, outsourcing and rentals

     4,544        3,332        4,585       

Finance income

     414        442        442       
                            

Total

   $ 7,451      $ 6,025      $ 7,296       
                            

Gross Margin:

          

Sales

     34.5     33.9     33.4     0.6 pts        1.1 pts   

Service, outsourcing and rentals

     33.1     42.6     33.8     (9.5) pts        (0.7) pts   

Finance income

     62.7     62.0     62.0     0.7 pts        0.7 pts   

Total

     34.4     39.7     34.6     (5.3) pts        (0.2) pts   

RD&E

   $ 781      $ 840      $ 840       

RD&E % Revenue

     3.6     5.5     4.0     (1.9) pts        (0.4) pts   

SAG

   $ 4,594      $ 4,149      $ 4,651       

SAG % Revenue

     21.2     27.3     22.1     (6.1) pts        (0.9) pts   

Services Segment

 

     Year Ended December 31,              

(in millions)

   As Reported
2010
    As Reported
2009
    Pro-forma
2009 (1)
    Change     Pro-forma
Change
 

Document Outsourcing

   $   3,297      $   3,382      $   3,382        (3 )%      (3 )% 

Business Processing Outsourcing

     5,112        94        4,751        *        8

Information Technology Outsourcing

     1,249               1,246        *       

Less: Intra-segment eliminations

     (21                   *        *   
                            

Total Revenue – Services

   $ 9,637      $ 3,476      $ 9,379        177     3
                            

Segment Profit – Services

   $ 1,132      $ 231      $ 1,008        390     12
                            

Segment Margin – Services

     11.7     6.6     10.7     5.1 pts        1.0 pts   
                            
* Percent change not meaningful.

 

(1) Pro-forma reflects ACS’s 2009 estimated results from February 6 through December 31 adjusted to reflect fair value adjustments related to property, equipment and computer software as well as customer contract costs. In addition, adjustments were made for deferred revenue, exited businesses, certain non-recurring product sales and other material non-recurring costs associated with the acquisition.

 

Xerox 2010 Annual Report  34


Forward-Looking Statements

This Annual Report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements. These statements reflect management’s current beliefs, assumptions and expectations and are subject to a number of factors that may cause actual results to differ materially. Information concerning these factors is included in our 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”). We do not intend to update these forward-looking statements, except as required by law.

 

Xerox 2010 Annual Report  35


 

XEROX CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

     Year Ended December 31,  

(in millions, except per-share data)

   2010      2009     2008  

Revenues

       

Sales

   $ 7,234       $ 6,646      $ 8,325   

Service, outsourcing and rentals

     13,739         7,820        8,485   

Finance income

     660         713        798   
                         

Total Revenues

     21,633         15,179        17,608   

Costs and Expenses

       

Cost of sales

     4,741         4,395        5,519   

Cost of service, outsourcing and rentals

     9,195         4,488        4,929   

Equipment financing interest

     246         271        305   

Research, development and engineering expenses

     781         840        884   

Selling, administrative and general expenses

     4,594         4,149        4,534   

Restructuring and asset impairment charges

     483         (8     429   

Acquisition-related costs

     77         72          

Amortization of intangible assets

     312         60        54   

Other expenses, net

     389         285        1,033   
                         

Total Costs and Expenses

       20,818           14,552          17,687   

Income (Loss) before Income Taxes and Equity Income

     815         627        (79

Income tax expense (benefit)

     256         152        (231

Equity in net income of unconsolidated affiliates

     78         41        113   
                         

Net Income

     637         516        265   

Less: Net income attributable to noncontrolling interests

     31         31        35   
                         

Net Income Attributable to Xerox

   $ 606       $ 485      $ 230   
                         

Basic Earnings per Share

   $ 0.44       $ 0.56      $ 0.26   

Diluted Earnings per Share

   $ 0.43       $ 0.55      $ 0.26   

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

Xerox 2010 Annual Report  36


 

XEROX CORPORATION

CONSOLIDATED BALANCE SHEETS

 

     December 31,  

(in millions, except share data in thousands)

   2010     2009  

Assets

    

Cash and cash equivalents

   $ 1,211      $ 3,799   

Accounts receivable, net

     2,826        1,702   

Billed portion of finance receivables, net

     198        226   

Finance receivables, net

     2,287        2,396   

Inventories

     991        900   

Other current assets

     1,126        708   
                

Total current assets

     8,639        9,731   

Finance receivables due after one year, net

     4,135        4,405   

Equipment on operating leases, net

     530        551   

Land, buildings and equipment, net

     1,671        1,309   

Investments in affiliates, at equity

     1,291        1,056   

Intangible assets, net

     3,371        598   

Goodwill

     8,649        3,422   

Deferred tax assets, long-term

     540        1,640   

Other long-term assets

     1,774        1,320   
                

Total Assets

   $ 30,600      $ 24,032   
                

Liabilities and Equity

    

Short-term debt and current portion of long-term debt

   $ 1,370      $ 988   

Accounts payable

     1,968        1,451   

Accrued compensation and benefits costs

     901        695   

Unearned income

     371        201   

Other current liabilities

     1,807        1,126   
                

Total current liabilities

     6,417        4,461   

Long-term debt

     7,237        8,276   

Liability to subsidiary trust issuing preferred securities

     650        649   

Pension and other benefit liabilities

     2,071        1,884   

Post-retirement medical benefits

     920        999   

Other long-term liabilities

     797        572   
                

Total Liabilities

     18,092        16,841   
                

Series A Convertible Preferred Stock

     349         
                

Common stock

     1,398        871   

Additional paid-in capital

     6,580        2,493   

Retained earnings

     6,016        5,674   

Accumulated other comprehensive loss

     (1,988     (1,988
                

Xerox shareholders’ equity

     12,006        7,050   

Noncontrolling interests

     153        141   
                

Total Equity

     12,159        7,191   
                

Total Liabilities and Equity

   $ 30,600      $ 24,032   
                

Shares of common stock issued and outstanding

     1,397,578        869,381   
                

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

Xerox 2010 Annual Report  37


XEROX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,  

(in millions)

   2010     2009     2008  

Cash Flows from Operating Activities:

      

Net income

   $ 637      $ 516      $ 265   

Adjustments required to reconcile net income to cash flows from operating activities:

      

Depreciation and amortization

     1,097        698        669   

Provision for receivables

     180        289        199   

Provision for inventory

     31        52        115   

Deferred tax (benefit) expense

     (2     120        (324

Net gain on sales of businesses and assets

     (18     (16     (21

Undistributed equity in net income of unconsolidated affiliates

     (37     (25     (53

Stock-based compensation

     123        85        85   

Provision for litigation, net

     36               781   

Payments for litigation, net

     (36     (28     (615

Restructuring and asset impairment charges

     483        (8     429   

Payments for restructurings

     (213     (270     (131

Contributions to pension benefit plans

     (237     (122     (299

(Increase) decrease in accounts receivable and billed portion of finance receivables

     (118     467        57   

Collections of deferred proceeds from sales of receivables

     218                 

(Increase) decrease in inventories

     (151     319        (114

Increase in equipment on operating leases

     (288     (267     (331

Decrease in finance receivables

     129        248        164   

(Increase) decrease in other current and long-term assets

     (98     129        (8

Increase in accounts payable and accrued compensation

     615        157        211   

Decrease in other current and long-term liabilities

     (9     (100     (174

Net change in income tax assets and liabilities

     229        (18     (92

Net change in derivative assets and liabilities

     85        (56     230   

Other operating, net

     70        38        (104
                        

Net cash provided by operating activities

     2,726        2,208        939   
                        

Cash Flows from Investing Activities:

      

Cost of additions to land, buildings and equipment

     (355     (95     (206

Proceeds from sales of land, buildings and equipment

     52        17        38   

Cost of additions to internal use software

     (164     (98     (129

Acquisitions, net of cash acquired

     (1,734     (163     (155

Net change in escrow and other restricted investments

     20        (6     8   

Other investing, net

     3        2        3   
                        

Net cash used in investing activities

     (2,178     (343     (441
                        

Cash Flows from Financing Activities:

      

Net proceeds (payments) on secured financings

     1        (57     (227

Net (payments) proceeds on other debt

     (3,057     923        926   

Common stock dividends

     (215     (149     (154

Preferred stock dividends

     (15              

Proceeds from issuances of common stock

     183        1        6   

Excess tax benefits from stock-based compensation

     24               2   

Payments to acquire treasury stock, including fees

                   (812

Repurchases related to stock-based compensation

     (15     (12     (33

Other financing

     (22     (14     (19
                        

Net cash (used in) provided by financing activities

     (3,116     692        (311
                        

Effect of exchange rate changes on cash and cash equivalents

     (20     13        (57
                        

(Decrease) increase in cash and cash equivalents

      (2,588     2,570        130   

Cash and cash equivalents at beginning of year

     3,799        1,229        1,099   
                        

Cash and Cash Equivalents at End of Year

   $ 1,211      $   3,799      $   1,229   
                        

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

Xerox 2010 Annual Report  38


 

XEROX CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

(in millions)   


Common

Stock(6)

   

Additional

Paid-in

Capital

   

Treasury

Stock (6)

   

Retained

Earnings

    AOCL  (1)    

Xerox

Shareholders’

Equity

   

Non-

controlling

Interests

    Total
Equity
 
                                                        

Balance at December 31, 2007

   $ 920      $ 3,176      $ (31   $ 5,288      $ (765   $ 8,588      $ 103      $ 8,691   
                                  

Net income

                          230               230        35        265   

Translation adjustments

                                   (1,364     (1,364     (3     (1,367

Cumulative effect of change in accounting principles

                          (25            (25            (25

Changes in benefit plans (2)

                                 (286     (286            (286

Other unrealized losses, net

                                 (1     (1            (1
                                  

Comprehensive (Loss) Income

             $ (1,446   $ 32      $ (1,414
                                  

Cash dividends declared - common stock(3)

                          (152            (152            (152

Stock option and incentive plans

     5        55                             60               60   

Payments to acquire treasury stock

                   (812                   (812            (812

Cancellation of treasury stock

     (59     (784     843                                      

Distributions to noncontrolling interests

                                               (15     (15 )
                                                        

Balance at December 31, 2008

   $ 866      $ 2,447      $      $ 5,341      $ (2,416   $ 6,238      $ 120      $ 6,358   
                                  

Net income

                          485               485        31        516   

Translation adjustments

                                 595        595        1        596   

Changes in benefit plans (2)

                                 (169     (169            (169

Other unrealized gains

                                 2       2               2   
                                  

Comprehensive Income

             $ 913      $ 32      $ 945   
                                  

Cash dividends declared - common stock(3)

                          (152            (152            (152

Stock option and incentive plans

     5        67                             72               72   

Tax loss on stock option and incentive plans, net

            (21                          (21            (21

Distributions to noncontrolling interests

                                               (11     (11
                                                        

Balance at December 31, 2009

   $ 871      $ 2,493      $      $ 5,674      $ (1,988   $ 7,050      $ 141      $ 7,191   
                                  

Net income

                          606               606        31        637   

Translation adjustments

                                 (35     (35            (35

Changes in benefit plans (2

                                 23        23               23   

Other unrealized gains, net

                                 12       12               12   
                                  

Comprehensive Income

             $ 606      $ 31      $ 637   
                                  

ACS acquisition (4)

     490        3,825                             4,315               4,315   

Cash dividends declared - common stock(3)

                          (243            (243            (243

Cash dividends declared - preferred stock (5)

                          (21            (21            (21

Stock option and incentive plans

     37        256                             293               293   

Tax benefit on stock option and incentive plans, net

            6                             6               6   

Distributions to noncontrolling interests

                                               (19     (19
                                                        

Balance at December 31, 2010

   $   1,398      $   6,580      $      $   6,016      $ (1,988   $   12,006      $   153      $   12,159   
                                                                

 

(1) Refer to Note 1 “Accumulated Other Comprehensive Loss (AOCL)” section for additional information.
(2) Refer to Note 15 - Employee Benefit Plans for additional information.
(3) Cash dividends declared on common stock of $0.0425 in each of the four quarters in 2008, 2009 and 2010.
(4) Refer to Note 3 – Acquisitions for additional information.
(5) Cash dividends declared on preferred stock of $12.22 per share in the first quarter of 2010 and $20 per share in each of the second, third and fourth quarters of 2010.
(6) Refer to Note 19 – Shareholders’ Equity for rollforward of shares.

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

Xerox 2010 Annual Report  39


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Dollars in millions, except per share data and unless otherwise indicated.

Note 1 – Summary of Significant Accounting Policies

References herein to “we,” “us,” “our,” the “Company,” and Xerox refer to Xerox Corporation and its consolidated subsidiaries unless the context specifically requires otherwise.

Description of Business and Basis of Presentation

We are a $22 billion global enterprise for business process and document management. We provide essential back-office support through our broad portfolio of technology, services and outsourcing offerings. We also offer extensive business process outsourcing and information technology outsourcing services through Affiliated Computer Services, Inc. (“ACS”), which we acquired in February 2010. We develop, manufacture, market, service and finance a complete range of document equipment, software, solutions and services.

Basis of Consolidation

The Consolidated Financial Statements include the accounts of Xerox Corporation and all of our controlled subsidiary companies. All significant intercompany accounts and transactions have been eliminated. Investments in business entities in which we do not have control, but we have the ability to exercise significant influence over operating and financial policies (generally 20% to 50% ownership) are accounted for using the equity method of accounting. Operating results of acquired businesses are included in the Consolidated Statements of Income from the date of acquisition.

We consolidate variable interest entities if we are deemed to be the primary beneficiary of the entity. Operating results for variable interest entities in which we are determined to be the primary beneficiary are included in the Consolidated Statements of Income from the date such determination is made.

For convenience and ease of reference, we refer to the financial statement caption “Income (Loss) before Income Taxes and Equity Income” as “pre-tax income” or “pre-tax loss” throughout the Notes to the Consolidated Financial Statements.

Use of Estimates

The preparation of our Consolidated Financial Statements, in accordance with accounting principles generally accepted in the United States of America, requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are used for, but not limited to: (i) allocation of revenues and fair values in leases and other multiple element arrangements; (ii) accounting for residual values; (iii) economic lives of leased assets; (iv) revenue recognition for services under the percentage-of-completion method; (v) allowance for doubtful accounts; (vi) inventory valuation; (vii) restructuring and related charges; (viii) asset impairments; (ix) depreciable lives of assets; (x) useful lives of intangible assets; (xi) amortization period for customer contract costs (xii) pension and post-retirement benefit plans; (xiii) income tax reserves and valuation allowances; and (xiv) contingency and litigation reserves. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Actual results could differ from those estimates.

 

Xerox 2010 Annual Report  40


The following table summarizes certain significant charges that require management estimates for the three years ended December 31, 2010:

 

     Years Ended December 31,  

Expense/(Income)

   2010      2009      2008  

Restructuring provisions and asset impairments

   $   483       $ (8)       $   429   

Provisions for receivables(1)

     180         289         199   

Provisions for litigation and regulatory matters

     (4)         9         781   

Provisions for obsolete and excess inventory

     31         52         115   

Depreciation and obsolescence of equipment on operating leases

     313         329         298   

Depreciation of buildings and equipment

     379         247         257   

Amortization of internal use software

     70         53         56   

Amortization of product software

     7         5           

Amortization of acquired intangible assets(2 )

     316         64         58   

Amortization of customer contract costs

     12                   

Defined pension benefits – net periodic benefit cost

     304         232         174   

Other post-retirement benefits – net periodic benefit cost

     32         26         77   

Deferred tax asset valuation allowance provisions

     22         (11)         17   

 

(1) Includes net receivable adjustments of $(8), $(2) and $11 for 2010, 2009 and 2008, respectively.
(2) Includes amortization of $4 for patents, which is included in cost of sales for each period presented.

Changes in Estimates

In the ordinary course of accounting for items discussed above, we make changes in estimates as appropriate and as we become aware of circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to the Consolidated Financial Statements.

New Accounting Standards and Accounting Changes

FASB Establishes Accounting Standards Codification™

In 2009, the FASB established the Accounting Standards Codification (“the Codification” or “ASC”) as the official single source of authoritative U.S. generally accepted accounting principles (“GAAP”). All existing accounting standards are superseded. All other accounting guidance not included in the Codification is considered non-authoritative. The Codification also includes all relevant Securities and Exchange Commission (“SEC”) guidance organized using the same topical structure in separate sections within the Codification. The FASB updates the Codification by issuing Accounting Standard Updates (“ASU’s”).

The Codification did not change GAAP, but only the way GAAP is organized and presented. In order to ease the transition to the Codification, we are providing the Codification cross-reference alongside the references to the standards issued and adopted prior to the adoption of the Codification.

Fair Value Accounting

In 2010, the FASB issued ASU No. 2010-06 which amended Fair Value Measurements and Disclosures – Overall (ASC Topic 820-10). This update required a gross presentation of activities within the Level 3 rollforward and added a new requirement to disclose transfers in and out of Level 1 and 2 measurements. The update also clarified the following existing disclosure requirements in ASC 820-10 regarding: i) the level of disaggregation of fair value measurements; and ii) the disclosures regarding inputs and valuation techniques. This update was effective for our fiscal year beginning January 1, 2010 except for the gross presentation of the Level 3 rollforward information, which is effective for our fiscal year beginning January 1, 2011. The principle impact from this update is to expand disclosures regarding our fair value measurements.

 

Xerox 2010 Annual Report  41


In 2009, the FASB issued the following updates that provide additional application guidance and require enhanced disclosures regarding fair value measurements:

 

 

FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (ASC Topic 820-10-65).

 

FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (ASC Topic 320-10-65).

 

FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (ASC Topic 320-10-65).

 

ASU No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820)—Measuring Liabilities at Fair Value.”

We adopted these updates in 2009 and the adoptions did not have a material effect on our financial condition or results of operations.

In 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (ASC Topic 820) which defined fair value, established a market-based framework or hierarchy for measuring fair value and expanded disclosures about fair value measurements. This guidance is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. It did not expand or require any new fair value measures; however the application of this statement may change current practice. We adopted this guidance for financial assets and liabilities effective January 1, 2008 and for non-financial assets and liabilities effective January 1, 2009. The adoption of this guidance, which primarily affected the valuation of our derivative contracts, did not have a material effect on our financial condition or results of operations.

Business Combinations

In 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (ASC Topic 805). This guidance requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose the information needed to evaluate and understand the nature and financial effect of the business combination. We adopted this guidance effective January 1, 2009 and have applied it to all business combinations prospectively from that date. The impact of ASC Topic 805 on our consolidated financial statements depends upon the nature, terms and size of the acquisitions we consummate in the future.

Revenue Recognition

In 2009, the FASB issued the following ASUs:

 

 

ASU No. 2009-13, Revenue Recognition (ASC Topic 605) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. This guidance modified previous requirements by allowing the use of the “best estimate of selling price” in the absence of vendor-specific objective evidence (“VSOE”) or verifiable objective evidence (“VOE”) (now referred to as TPE standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when more objective evidence of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted.

 

 

ASU No. 2009-14, Software (ASC Topic 985) - Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force. This guidance modified the scope of ASC subtopic 985-605 Software-Revenue Recognition to exclude from its requirements (a) non-software components of tangible products and (b) software components of tangible products that are sold, licensed or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality.

 

Xerox 2010 Annual Report  42


We adopted these updates effective for our fiscal year beginning January 1, 2010 and are applying them prospectively from that date for new or materially modified arrangements. The adoption of these updates did not have a material effect on our financial condition or results of operations. See “Summary of Accounting Policies- Revenue recognition – Multiple Element Arrangements” for further information regarding our adoption of ASU No. 2009-13.

With respect to the new software guidance in ASU No. 2009-14, the modification in the scope of the industry-specific software revenue recognition guidance did not result in a change in the recognition of revenue for our equipment and services. Software included within our equipment and services has generally been considered incidental and therefore has been, and will continue to be, accounted for as part of the sale of equipment or services. Most of our equipment have both software and non-software components that function together to deliver the equipment’s essential functionality. The software scope modification is also not expected to change the recognition of revenue for software accessories sold in connection with our equipment or free-standing software sales as these transactions will continue to be accounted for under the industry-specific software revenue recognition guidance as separate software elements. See “Summary of Accounting Policies- Revenue recognition – Software” for further information.

Other Accounting Changes

In 2010, the FASB issued the following codification updates:

 

 

ASU 2010-19 which amended Foreign Currency (ASC Topic 830). The purpose of this update was to codify the SEC staff’s view on certain foreign currency issues related to investments in Venezuela. See “Foreign Currency Translation and Re-measurement” section below for further information regarding our operations in Venezuela.

 

 

ASU 2010-20 which amended Receivables (ASC Topic 310) and requires significantly increased disclosures regarding the credit quality of an entity’s financing receivables and its allowance for credit losses. In addition, this update requires an entity to disclose credit quality indicators past due information, and modifications of its financing receivables. The disclosures are first effective for our 2010 Annual Report. The principal impact from this update was increased disclosures concerning the details of finance receivables and the related provisions and reserves for credit losses. See Note 4 – Receivables, Net for the disclosures required by this update.

In 2009, the FASB issued the following codification updates:

 

 

ASU 2009-16 which amended Transfers and Servicing (ASC Topic 860): Accounting for Transfers of Financial Assets. This update removed the concept of a qualifying special-purpose entity and removed the exception from applying consolidation guidance to these entities. This update also clarified the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. We adopted this update effective for our fiscal year beginning January 1, 2010. Certain accounts receivable sale arrangements were modified in order to qualify for sale accounting under this updated guidance. The adoption of this update did not have a material effect on our financial condition or results of operations.

 

 

ASU 2009-17 which amended Consolidations (ASC Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This update required an analysis to determine whether a variable interest gives the entity a controlling financial interest in a variable interest entity. It also required an ongoing reassessment and eliminates the quantitative approach previously required for determining whether an entity is the primary beneficiary. We adopted this update effective for our fiscal year beginning January 1, 2010 and the adoption did not have a material effect on our financial condition or results of operations.

Since the implementation of the codification, the FASB has issued several ASU’s. Except for the ASU’s discussed above, the remaining ASU’s issued by the FASB entail technical corrections to existing guidance or affect guidance related to unique/infrequent transactions or specialized industries/entities and therefore have minimal, if any, impact on the Company.

 

Xerox 2010 Annual Report  43


Summary of Accounting Policies

Revenue Recognition

We generate revenue through services, the sale and rental of equipment, supplies and income associated with the financing of our equipment sales. Revenue is recognized when earned. More specifically, revenue related to services and sales of our products is recognized as follows:

Equipment: Revenues from the sale of equipment, including those from sales-type leases, are recognized at the time of sale or at the inception of the lease, as appropriate. For equipment sales that require us to install the product at the customer location, revenue is recognized when the equipment has been delivered and installed at the customer location. Sales of customer installable products are recognized upon shipment or receipt by the customer according to the customer’s shipping terms. Revenues from equipment under other leases and similar arrangements are accounted for by the operating lease method and are recognized as earned over the lease term, which is generally on a straight-line basis.

Services: Technical service revenues are derived primarily from maintenance contracts on our equipment sold to customers and are recognized over the term of the contracts. A substantial portion of our products are sold with full service maintenance agreements for which the customer typically pays a base service fee plus a variable amount based on usage. As a consequence, other than the product warranty obligations associated with certain of our low end products, we do not have any significant product warranty obligations, including any obligations under customer satisfaction programs.

Revenues associated with outsourcing services are generally recognized as services are rendered, which is generally on the basis of the number of accounts or transactions processed. Information technology processing revenues are recognized as services are provided to the customer, generally at the contractual selling prices of resources consumed or capacity utilized by our customers. In those service arrangements where final acceptance of a system or solution by the customer is required, revenue is deferred until all acceptance criteria have been met. Revenues on cost reimbursable contracts are recognized by applying an estimated factor to costs as incurred, determined by the contract provisions and prior experience. Revenues on unit-price contracts are recognized at the contractual selling prices as work is completed and accepted by the customer. Revenues on time and material contracts are recognized at the contractual rates as the labor hours and direct expenses are incurred.

In connection with our services arrangements, we incur costs to originate these long-term contracts and to perform the migration, transition and setup activities necessary to enable us to perform under the terms of the arrangement. We capitalize certain incremental direct costs that are related to the contract origination or transition, implementation and setup activities and amortize them over the term of the arrangement. From time to time, we also provide certain inducements to customers in the form of various arrangements, including contractual credits, which are capitalized and amortized as a reduction of revenue over the term of the contract. Customer-related deferred set-up/transition and inducement costs are being amortized over a weighted average period of approximately 8 years. Initial direct costs of an arrangement are capitalized and amortized over the contractual service period.

Long-lived assets used in the fulfillment of the arrangements are capitalized and depreciated over the shorter of their useful life or the term of the contract if an asset is contract specific.

Revenues on certain fixed price contracts where we provide information technology system development and implementation services are recognized over the contract term based on the percentage of development and implementation services that are provided during the period compared with the total estimated development and implementation services to be provided over the entire contract. These services require that we perform significant, extensive and complex design, development, modification or implementation of our customers’ systems. Performance will often extend over long periods, and our right to receive future payment depends on our future performance in accordance with the agreement. During 2010, we recognized approximately $270 of revenue using the percentage-of-completion accounting method.

 

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The percentage-of-completion methodology involves recognizing probable and reasonably estimable revenue using the percentage of services completed, on a current cumulative cost to estimated total cost basis, using a reasonably consistent profit margin over the period. Due to the long-term nature of these projects, developing the estimates of costs often requires significant judgment. Factors that must be considered in estimating the progress of work completed and ultimate cost of the projects include, but are not limited to, the availability of labor and labor productivity, the nature and complexity of the work to be performed and the impact of delayed performance. If changes occur in delivery, productivity or other factors used in developing the estimates of costs or revenues, we revise our cost and revenue estimates, which may result in increases or decreases in revenues and costs, and such revisions are reflected in income in the period in which the facts that give rise to that revision become known.

Revenues earned in excess of related billings are accrued, whereas billings in excess of revenues earned are deferred until the related services are provided. We recognize revenues for non-refundable, upfront implementation fees on a straight-line basis over the period between the initiations of the ongoing services through the end of the contract term.

Sales to distributors and resellers: We utilize distributors and resellers to sell certain of our products to end-user customers. We refer to our distributor and reseller network as our two-tier distribution model. Sales to distributors and resellers are generally recognized as revenue when products are sold to such distributors and resellers. Distributors and resellers participate in various cooperative marketing and other programs, and we record provisions for these programs as a reduction to revenue when the sales occur. Similarly, we account for our estimates of sales returns and other allowances when the sales occur based on our historical experience.

In certain instances, we may provide lease financing to end-user customers who purchased equipment we sold to distributors or resellers. We compete with other third party leasing companies with respect to the lease financing provided to these end-user customers.

Supplies: Supplies revenue generally is recognized upon shipment or utilization by customers in accordance with the sales terms.

Software: Most of our equipment has both software and non-software components that function together to deliver the equipment’s essential functionality and therefore they are accounted for together as part of the equipment sales or services revenues. Software accessories sold in connection with our equipment sales, as well as free-standing software sales are accounted for as separate deliverables or elements. In most cases, these software products are sold as part of multiple element arrangements and include software maintenance agreements for the delivery of technical service, as well as unspecified upgrades or enhancements on a when-and-if-available basis. In those software accessory and free-standing software arrangements that include more than one element, we allocate the revenue among the elements based on vendor-specific objective evidence (“VSOE”) of fair value. VSOE of fair value is based on the price charged when the deliverable is sold separately by us on a regular basis and not as part of the multiple-element arrangement. Revenue allocated to software is normally recognized upon delivery while revenue allocated to the software maintenance element is recognized ratably over the term of the arrangement.

Leases: The two primary accounting provisions which we use to classify transactions as sales-type or operating leases are: 1) a review of the lease term to determine if it is equal to or greater than 75% of the economic life of the equipment and 2) a review of the present value of the minimum lease payments to determine if they are equal to or greater than 90% of the fair market value of the equipment at the inception of the lease. Our leases in our Latin America operations have historically been recorded as operating leases given the cancellable nature of the contract or because the recoverability of the lease investment is deemed not to be predictable at lease inception.

For purposes of determining the economic life, we consider the most objective measure to be the original contract term, since most equipment is returned by lessees at or near the end of the contracted term. The economic life of most of our products is five years, since this represents the most frequent contractual lease term for our principal products and only a small percentage of our leases have original terms longer than five years. We continually evaluate the economic life of both existing and newly introduced products for purposes of this determination. Residual values, if any, are established at lease inception using estimates of fair value at the end of the lease term.

 

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The vast majority of our leases that qualify as sales-type are non-cancelable and include cancellation penalties approximately equal to the full value of the lease receivables. A portion of our business involves sales to governmental units. Governmental units are those entities that have statutorily defined funding or annual budgets that are determined by their legislative bodies. Certain of our governmental contracts may have cancellation provisions or renewal clauses that are required by law, such as 1) those dependant on fiscal funding outside of a governmental unit’s control, 2) those that can be cancelled if deemed in the best interest of the governmental unit’s taxpayers or 3) those that must be renewed each fiscal year, given limitations that may exist on entering into multi-year contracts that are imposed by statute. In these circumstances, we carefully evaluate these contracts to assess whether cancellation is remote. The evaluation of a lease agreement with a renewal option includes an assessment as to whether the renewal is reasonably assured based on the apparent intent and our experience of such governmental unit. We further ensure that the contract provisions described above are offered only in instances where required by law. Where such contract terms are not legally required, we consider the arrangement to be cancelable and account for the lease as an operating lease.

After the initial lease of equipment to our customers, we may enter subsequent transactions with the same customer whereby we extend the term. Revenue from such lease extensions is typically recognized over the extension period.

Bundled Lease Arrangements: We sell our products and services under bundled lease arrangements, which typically include equipment, service, supplies and financing components for which the customer pays a single negotiated fixed minimum monthly payment for all elements over the contractual lease term. Approximately 40% of our equipment sales revenue is related to sales made under bundled lease arrangements. These arrangements also typically include an incremental, variable component for page volumes in excess of contractual page volume minimums, which are often expressed in terms of price-per-page. The fixed minimum monthly payments are multiplied by the number of months in the contract term to arrive at the total fixed minimum payments that the customer is obligated to make (“fixed payments”) over the lease term. The payments associated with page volumes in excess of the minimums are contingent on whether or not such minimums are exceeded (“contingent payments”). In applying our lease accounting methodology, we only consider the fixed payments for purposes of allocating to the relative fair value elements of the contract. Contingent payments, if any, are recognized as revenue in the period when the customer exceeds the minimum copy volumes specified in the contract. Revenues under bundled arrangements are allocated considering the relative selling prices of the lease and non-lease deliverables included in the bundled arrangement. Lease deliverables include maintenance and executory costs, equipment and financing, while non-lease deliverables generally consist of the supplies and non-maintenance services. The allocation for the lease deliverables begins by allocating revenues to the maintenance and executory costs plus profit thereon. These elements are generally recognized over the term of the lease as service revenue. The remaining amounts are allocated to the equipment and financing elements which are subjected to the accounting estimates noted above under “Leases.”

Multiple Element Arrangements: We enter into the following revenue arrangements that may consist of multiple deliverables:

 

 

Bundled lease arrangements, which typically include both lease deliverables and non-lease deliverables as described above.

 

Sales of equipment with a related full-service maintenance agreement.

 

Contracts for multiple types of outsourcing services, as well as professional and value-added services. For instance, we may contract for an implementation or development project and also provide services to operate the system over a period of time; or we may contract to scan, manage and store customer documents.

If a deliverable in a multiple-element arrangement is subject to specific guidance, such as leased equipment in our bundled lease arrangements (which is subject to specific leasing guidance) or accessory software (which is subject to software revenue recognition guidance), that deliverable is separated from the arrangement based on its relative selling price (the relative selling price method – see below) and accounted for in accordance with such specific guidance. The remaining deliverables in a multiple-element arrangement are accounted for based on the following guidance.

 

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A multiple-element arrangement is separated into more than one unit of accounting if both of the following criteria are met:

 

 

The delivered item(s) has value to the customer on a stand-alone basis; and

 

If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If these criteria are not met, the arrangement is accounted for as one unit of accounting and the recognition of revenue is generally upon delivery/completion or ratably as a single unit of accounting over the contractual service period.

Consideration in a multiple-element arrangement is allocated at the inception of the arrangement to all deliverables on the basis of the relative selling price. When applying the relative selling price method, the selling price for each deliverable is determined using VSOE of the selling price, or TPE of the selling price. If neither VSOE nor TPE of the selling price exists for a deliverable, we will use our best estimate of the selling price for that deliverable.

The new guidance with respect to multiple-element arrangements did not change the allocation of arrangement consideration to the units of accounting or the pattern and timing of revenue recognition for those units. Normally our equipment and services will qualify as separate units of accounting, which are the majority of our multiple-element arrangements. In addition, under previous guidance, consideration for multiple-element arrangements was allocated based on VSOE or TPE, since products and services are generally sold separately or the selling price is determinable based on competitor prices for similar deliverables. As a result, for substantially all of our multiple-element arrangements, we will continue using VSOE or TPE to allocate the arrangement consideration to each respective deliverable.

Although infrequent, under previous guidance with respect to multiple-element arrangements, if we were unable to establish the selling price using VSOE or TPE, arrangement consideration was allocated using the residual method or recognized ratably over the contractual service period. However, since the new guidance allows for the use of our best estimate of the selling price in our allocation of arrangement consideration if VSOE or TPE is not determinable, we now use our best estimate of selling price in those infrequent situations. The objective of using estimated selling price based methodology is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. Accordingly, we determine our best estimate of selling price considering multiple factors including, but not limited to, geographies, market conditions, competitive landscape, internal costs, gross margin objectives and pricing practices. Estimated selling price based methodology generally will apply to an insignificant proportion of our arrangements with multiple deliverables.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand, including money-market funds, and investments with original maturities of three months or less.

Restricted Cash and Investments

As more fully discussed in Note 17 – Contingencies, various litigation matters in Brazil require us to make cash deposits as a condition of continuing the litigation. In addition, several of our secured financing arrangements and other contracts require us to post cash collateral or maintain minimum cash balances in escrow. These cash amounts are classified in our Consolidated Balance Sheets based on when the cash will be contractually or judicially released (refer to Note 10 – Supplementary Financial Information for classification of amounts).

Restricted cash amounts at December 31, 2010 and 2009 were as follows:

 

     2010      2009  

Tax and labor litigation deposits in Brazil

   $   276       $   240   

Escrow and cash collections related to receivable sales

     88         29   

Other restricted cash

     7         20   
                 

Total Restricted Cash and Investments

   $ 371       $ 289   
                 

 

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Inventories

Inventories are carried at the lower of average cost or market. Inventories also include equipment that is returned at the end of the lease term. Returned equipment is recorded at the lower of remaining net book value or salvage value. Salvage value consists of the estimated market value (generally determined based on replacement cost) of the salvageable component parts, which are expected to be used in the remanufacturing process. We regularly review inventory quantities and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand, production requirements and servicing commitments. Several factors may influence the realizability of our inventories, including our decision to exit a product line, technological changes and new product development. The provision for excess and/or obsolete raw materials and equipment inventories is based primarily on near term forecasts of product demand and include consideration of new product introductions, as well as changes in remanufacturing strategies. The provision for excess and/or obsolete service parts inventory is based primarily on projected servicing requirements over the life of the related equipment populations.

Land, Buildings and Equipment and Equipment on Operating Leases

Land, buildings and equipment are recorded at cost. Buildings and equipment are depreciated over their estimated useful lives. Leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life. Equipment on operating leases is depreciated to estimated salvage value over the lease term. Depreciation is computed using the straight-line method. Significant improvements are capitalized and maintenance and repairs are expensed. Refer to Note 5 – Inventories and Equipment on Operating Leases, Net and Note 6 – Land, Buildings and Equipment, Net for further discussion.

Software – Internal Use and Product

We capitalize direct costs associated with developing, purchasing or otherwise acquiring software for internal use and amortize these costs on a straight-line basis over the expected useful life of the software, beginning when the software is implemented (“Internal Use Software”). Costs incurred for upgrades and enhancements that will not result in additional functionality are expensed as incurred. Useful lives of Internal Use Software generally vary from three to ten years.

We also capitalize certain costs related to the development of software solutions to be sold to our customers upon reaching technological feasibility and amortize these costs based on estimated future revenues (“Product Software”). In recognition of the uncertainties involved in estimating revenue, that amortization is not less than straight-line amortization over the software’s remaining estimated economic life. Useful lives of Product Software generally vary from three to ten years. Amounts capitalized for Product Software are included in Cash Flows from Operations.

 

Additions to:    2010      2009      2008  

Internal use software

   $   164       $   98       $   129   

Product software

     70         1         1   

 

     As of December 31,  
Capitalized costs, net:    2010      2009  

Internal use software

   $   468       $   354   

Product software

     145         10   

Goodwill and Other Intangible Assets

Goodwill is tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units and determination of the fair value of each reporting unit. We estimate the fair value of each reporting unit using a discounted cash flow methodology. This requires us to use significant judgment including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, determination of our weighted average cost of capital and relevant market data.

 

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Other intangible assets primarily consist of assets obtained in connection with business acquisitions, including installed customer base and distribution network relationships, patents on existing technology and trademarks. We apply an impairment evaluation whenever events or changes in business circumstances indicate that the carrying value of our intangible assets may not be recoverable. Other intangible assets are amortized on a straight-line basis over their estimated economic lives. We believe that the straight-line method of amortization reflects an appropriate allocation of the cost of the intangible assets to earnings in proportion to the amount of economic benefits obtained annually by the Company. Refer to Note 8 – Goodwill and Intangible Assets, Net for further information.

Impairment of Long-Lived Assets

We review the recoverability of our long-lived assets, including buildings, equipment, internal-use software and other intangible assets, when events or changes in circumstances occur that indicate that the carrying value of the asset may not be recoverable. The assessment of possible impairment is based on our ability to recover the carrying value of the asset from the expected future pre-tax cash flows (undiscounted and without interest charges) of the related operations. If these cash flows are less than the carrying value of such asset, an impairment loss is recognized for the difference between estimated fair value and carrying value. Our primary measure of fair value is based on discounted cash flows.

Treasury Stock

We account for repurchased common stock under the cost method and include such treasury stock as a component of our Common shareholders’ equity. Retirement of Treasury stock is recorded as a reduction of Common stock and Additional paid-in capital at the time such retirement is approved by our Board of Directors.

Research, Development and Engineering (“RD&E”)

Research, development and engineering costs are expensed as incurred. Sustaining engineering costs are incurred with respect to on-going product improvements or environmental compliance after initial product launch. Our RD&E expense for the three years ended December 31, 2010 was as follows:

 

     2010      2009      2008  

R&D

   $   653       $   713       $   750   

Sustaining engineering

     128         127         134   
                          

Total RD&E Expense

   $ 781       $ 840       $ 884   
                          

Restructuring Charges

Costs associated with exit or disposal activities, including lease termination costs and certain employee severance costs associated with restructuring, plant closing or other activity, are recognized when they are incurred. In those geographies where we have either a formal severance plan or a history of consistently providing severance benefits representing a substantive plan, we recognize severance costs when they are both probable and reasonably estimable. Refer to Note 9 – Restructuring and Asset Impairment Charges for further information.

Pension and Post-Retirement Benefit Obligations

We sponsor defined benefit pension plans in various forms in several countries covering employees who meet eligibility requirements. Retiree health benefit plans cover U.S. and Canadian employees for retiree medical costs. We employ a delayed recognition feature in measuring the costs of pension and post-retirement benefit plans. This requires changes in the benefit obligations and changes in the value of assets set aside to meet those obligations to be recognized not as they occur, but systematically and gradually over subsequent periods. All changes are ultimately recognized as components of net periodic benefit cost, except to the extent they may be offset by subsequent changes. At any point, changes that have been identified and quantified but not recognized as components of net periodic benefit cost, are recognized in Accumulated Other Comprehensive Loss, Net of tax.

 

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Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our pension and retiree health benefit plans. These factors include assumptions we make about the discount rate, expected return on plan assets, rate of increase in healthcare costs, the rate of future compensation increases, and mortality. Actual returns on plan assets are not immediately recognized in our income statement, due to the delayed recognition requirement. In calculating the expected return on the plan asset component of our net periodic pension cost, we apply our estimate of the long-term rate of return to the plan assets that support our pension obligations, after deducting assets that are specifically allocated to Transitional Retirement Accounts (which are accounted for based on specific plan terms).

For purposes of determining the expected return on plan assets, we utilize a calculated value approach in determining the value of the pension plan assets, rather than a fair market value approach. The primary difference between the two methods relates to systematic recognition of changes in fair value over time (generally two years) versus immediate recognition of changes in fair value. Our expected rate of return on plan assets is applied to the calculated asset value to determine the amount of the expected return on plan assets to be used in the determination of the net periodic pension cost. The calculated value approach reduces the volatility in net periodic pension cost that would result from using the fair market value approach.

The discount rate is used to present value our future anticipated benefit obligations. In estimating our discount rate, we consider rates of return on high-quality fixed-income investments included in various published bond indexes, adjusted to eliminate the effects of call provisions and differences in the timing and amounts of cash outflows related to the bonds, as well as the expected timing of pension and other benefit payments. In the U.S. and the U.K., which comprise approximately 75% of our projected benefit obligation, we consider the Moody’s Aa Corporate Bond Index and the International Index Company’s iBoxx Sterling Corporate AA Cash Bond Index, respectively, in the determination of the appropriate discount rate assumptions. Refer to Note 15 - Employee Benefit Plans for further information.

Each year, the difference between the actual return on plan assets and the expected return on plan assets, as well as increases or decreases in the benefit obligation as a result of changes in the discount rate are added to or subtracted from any cumulative actuarial gain or loss that arose in prior years. This resultant amount is the net actuarial gain or loss recognized in Accumulated other comprehensive loss and is subject to subsequent amortization to net periodic pension cost in future periods over the remaining service lives of the employees participating in the pension plan.

Foreign Currency Translation and Re-measurement

The functional currency for most foreign operations is the local currency. Net assets are translated at current rates of exchange and income, expense and cash flow items are translated at average exchange rates for the applicable period. The translation adjustments are recorded in Accumulated other comprehensive loss.

The U.S. Dollar is used as the functional currency for certain foreign subsidiaries that conduct their business in U.S. Dollars. A combination of current and historical exchange rates is used in re-measuring the local currency transactions of these subsidiaries and the resulting exchange adjustments are included in income.

Foreign currency losses were $11, $26 and $34 in 2010, 2009 and 2008, respectively, and are included in Other expenses, net in the accompanying Consolidated Statements of Income.

We sold our Venezuelan subsidiary during the fourth quarter of 2010 as part of our restructuring actions – refer to Note 9 – Restructuring and Asset Impairment Charges for further information. Prior to the sale, the U.S. Dollar was the functional currency of our Venezuelan operations. In January 2010, Venezuela announced a devaluation of the Bolivar to an official rate of 4.30 Bolivars to the U.S. Dollar for the majority of our products. As a result of this devaluation, we