10-Q 1 0001.txt QUARTERLY REPORT ON FORM 10-Q FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to___________ Commission File Number 1-4471 XEROX CORPORATION (Exact Name of Registrant as specified in its charter) New York 16-0468020 _ (State or other jurisdiction (IRS Employer Identification No.) of incorporation or organization) P.O. Box 1600 Stamford, Connecticut 06904-1600 (Address of principal executive offices) (Zip Code) (203) 968-3000 _ (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at October 31, 2000 Common Stock 667,442,866 shares This document consists of 50 pages. Forward-Looking Statements From time to time the Registrant (or the "Company") and its representatives may provide information, whether orally or in writing, which are deemed to be "forward-looking" within the meaning of the Private Securities Litigation Reform Act of 1995 ("Litigation Reform Act"). These forward-looking statements and other information relating to the Company are based on the beliefs of management as well as assumptions made by and information currently available to management. The words "anticipate," "believe," "estimate," "expect," "intend," "will," and similar expressions, as they relate to the Company or the Company's management, are intended to identify forward-looking statements. Such statements reflect the current views of the Registrant with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated or expected. The Registrant does not intend to update these forward-looking statements. In accordance with the provisions of the Litigation Reform Act we are making investors aware that such "forward-looking" statements, because they relate to future events, are by their very nature subject to many important factors which could cause actual results to differ materially from those contained in the "forward-looking" statements. Such factors include but are not limited to the following: Competition - the Registrant operates in an environment of significant competition, driven by rapid technological advances and the demands of customers to become more efficient. There are a number of companies worldwide with significant financial resources which compete with the Registrant to provide document processing products and services in each of the markets served by the Registrant, some of whom operate on a global basis. The Registrant's success in its future performance is largely dependent upon its ability to compete successfully in its currently-served markets and to expand into additional market segments. Transition to Digital - presently black and white light-lens copiers represent approximately 25% of the Registrant's revenues. This segment of the general office market is mature with anticipated declining industry revenues as the market transitions to digital technology. Some of the Registrant's new digital products replace or compete with the Registrant's current light-lens equipment. Changes in the mix of products from light-lens to digital, and the pace of that change as well as competitive developments could cause actual results to vary from those expected. Pricing - the Registrant's ability to succeed is dependent upon its ability to obtain adequate pricing for its products and services which provide a reasonable return to shareholders. Depending on competitive market factors, future prices the Registrant can obtain for its products and services may vary from historical levels. In addition, pricing actions to offset currency devaluations may not prove sufficient to offset further devaluations or may not hold in the face of customer resistance and/or competition. Financing Business - a portion of the Registrant's profits arise from the financing of its customers' purchases of the Registrant's equipment. On average, 75 to 80 percent of equipment sales are financed through the Registrant. The Registrant's ability to provide such financing at competitive rates and realize profitable spreads is highly dependent upon its own costs of borrowing which, in turn, depend upon its credit ratings. There is no assurance that the company's credit ratings can be maintained and/or access to the credit markets can be assured. A downgrade or lowering in such ratings could restrict access to the credit markets, would reduce the profitability of such financing business, and/or reduce the volume of financing business done. In connection with our recently announced turnaround plan, the Company is exploring alternatives to providing financing to our customers using third parties. Productivity - the Registrant's ability to sustain and improve its profit margins is largely dependent on its ability to maintain an efficient, cost- effective operation. Productivity improvements through process reengineering, design efficiency and supplier cost improvements are required to offset labor cost inflation and potential materials cost changes and competitive price pressures. The Registrant's productivity will also be affected by the results of the Company's recently announced turnaround plan. The Registrant is in the process of finalizing plans designed to reduce costs by $1.0 billion annually. International Operations - the Registrant derives approximately half its revenue from operations outside of the United States. In addition, the Registrant manufactures many of its products and/or their components outside the United States. The Registrant's future revenue, cost and profit results could be affected by a number of factors, including changes in foreign currency exchange rates, changes in economic conditions from country to country, changes in a country's political conditions, trade protection measures, licensing requirements and local tax issues. New Products/Research and Development - the process of developing new high technology products and solutions is inherently complex and uncertain. It requires accurate anticipation of customers' changing needs and emerging technological trends. The Registrant must then make long-term investments and commit significant resources before knowing whether these investments will eventually result in products that achieve customer acceptance and generate the revenues required to provide anticipated returns from these investments. Restructuring - the Registrant's ability to ultimately reduce pre-tax annual expenditures by approximately $1.4 billion, before reinvestments, is dependent upon its ability to successfully implement the 1998 and 2000 restructuring programs including the elimination of 14,200 net jobs worldwide (9,000 under 1998 program, 5,200 under 2000 program), the closing and consolidation of facilities and the successful implementation of process and systems changes. Revenue Growth - the Registrant's ability to attain a consistent trend of revenue growth over the intermediate to longer term is largely dependent upon expansion of its equipment sales worldwide which in turn are dependent upon the ability to finance internally or through a third party the customer's purchases of the Registrant's products. The ability to achieve equipment sales growth is subject to the successful implementation of our initiatives to provide industry-oriented global solutions for major customers and expansion of our distribution channels in the face of global competition and pricing pressures. Our inability to attain a consistent trend of revenue growth could materially affect the trend of our actual results. Liquidity - the Registrant's liquidity is currently provided through its own cash generation from operations, various financing strategies, including securitizations, and utilization of its $7 billion Revolving Credit Agreement with a large group of banks which is available through October, 2002. The Registrant has embarked upon a process of selling certain assets with the objective of generating proceeds for the purpose of retiring outstanding debt. Thus, the Registrant's liquidity is dependent upon its ability to successfully generate positive cash flow from operations, continuation of securitizations and other financing alternatives, and completion of asset sales Xerox Corporation Form 10-Q September 30, 2000 Table of Contents Page Part I - Financial Information Item 1. Financial Statements Consolidated Statements of Income 5 Consolidated Balance Sheets 6 Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition Document Processing 25 Discontinued Operations 35 Capital Resources and Liquidity 36 Risk Management 41 Supplemental Revenue Discussion 43 Item 3. Quantitative and Qualitative Disclosure about Market Risk 45 Part II - Other Information Item 1. Legal Proceedings 46 Item 2. Changes in Securities 46 Item 6. Exhibits and Reports on Form 8-K 46 Signatures 48 Exhibit Index Computation of Net Income per Common Share 49 Computation of Ratio of Earnings to Fixed Charges 50 $7 Billion Revolving Credit Agreement Dated October 22, 1997 (filed in electronic form only) Financial Data Schedule (filed in electronic form only) For additional information about The Document Company Xerox, please visit our Web site at www.xerox.com/investor PART I - FINANCIAL INFORMATION Item 1 Xerox Corporation Consolidated Statements of Income (Unaudited) Three months ended Nine months ended September 30, September 30, (In millions, except per-share data) 2000 1999 2000 1999 Revenues Sales $ 2,375 $ 2,463 $ 7,192 $ 7,144 Service, outsourcing, financing and rentals 2,087 2,164 6,389 6,645 Total Revenues 4,462 4,627 13,581 13,789 Costs and Expenses Cost of sales 1,509 1,385 4,266 3,899 Cost of service, outsourcing, financing and rentals 1,316 1,238 3,902 3,708 Inventory charges - - 119 - Research and development expenses 272 230 776 737 Selling, administrative and general expenses 1,379 1,208 3,947 3,631 Restructuring charge and asset impairments - - 504 - Mexico provision 55 - 170 - Gain on affiliate's sale of stock - - (21) - Purchased in-process research and development - - 27 - Other, net 127 61 276 182 Total Costs and Expenses 4,658 4,122 13,966 12,157 Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities' Interests (196) 505 (385) 1,632 Income taxes (benefits) (29) 157 (93) 506 Equity in net income of unconsolidated affiliates (10) (5) (60) (39) Minorities' interests in earnings of subsidiaries 10 14 33 35 Net Income (Loss) $ (167) $ 339 $ (265) $ 1,130 Basic Earnings (Loss) per Share $ (0.26) $ 0.50 $(0.44) $ 1.66 Diluted Earnings (Loss) per Share $ (0.26) $ 0.47 $(0.44) $ 1.55 See accompanying notes. Xerox Corporation Consolidated Balance Sheets September 30, December 31, (In millions, except share data in thousands) 2000 1999 Assets (Unaudited) Cash $ 154 $ 126 Accounts receivable, net 2,422 2,622 Finance receivables, net 4,909 5,115 Inventories 3,108 2,961 Deferred taxes and other current assets 1,552 1,230 Total Current Assets 12,145 12,054 Finance receivables due after one year, net 8,155 8,203 Land, buildings and equipment, net 2,499 2,456 Investments in affiliates, at equity 1,582 1,615 Goodwill, net 1,628 1,724 Intangible and other assets 2,481 1,701 Investment in discontinued operations 793 1,130 Total Assets $ 29,283 $ 28,883 Liabilities and Equity Short-term debt and current portion of long-term debt $ 4,015 $ 3,957 Accounts payable 997 1,016 Accrued compensation and benefit costs 589 715 Unearned income 232 186 Other current liabilities 1,689 2,163 Total Current Liabilities 7,522 8,037 Long-term debt 13,132 10,994 Postretirement medical benefits 1,183 1,133 Deferred taxes and other liabilities 2,223 2,245 Discontinued operations liabilities - policyholders' deposits and other 50 428 Deferred ESOP benefits (299) (299) Minorities' interests in equity of subsidiaries 124 127 Company-obligated, mandatorily redeemable preferred securities of subsidiary trust holding solely subordinated debentures of the Company 638 638 Preferred stock 659 669 Common shareholders' equity 4,051 4,911 Total Liabilities and Equity $ 29,283 $ 28,883 Shares of common stock issued and outstanding 667,005 665,156 See accompanying notes. Xerox Corporation Consolidated Statements of Cash Flows (Unaudited) Nine months ended September 30 (In millions) 2000 1999 Cash Flows from Operating Activities Net Income (Loss) $ (265) $ 1,130 Adjustments required to reconcile income to cash flows from operating activities: Depreciation and amortization 824 659 Provisions for doubtful accounts 316 205 Restructuring and other charges 623 - Mexico provision 170 - Gain on affiliate's sale of stock (21) - Gain on divestitures (63) - Purchased in-process research and development 27 - Provision for postretirement medical benefits, net of payments 34 31 Cash payments for the 1998 restructuring (153) (339) Cash payments for the 2000 restructuring (69) - Minorities' interests in earnings of subsidiaries 33 35 Undistributed equity in income of affiliated companies (20) (39) Increase in inventories (217) (60) Increase in on-lease equipment (483) (249) Increase in finance receivables (736) (901) Proceeds from securitization of finance receivables - 1,150 Increase in accounts receivable (249) (497) Proceeds from securitization of accounts receivable 315 - Decrease in accounts payable and accrued compensation and benefit costs (126) (411) Net change in current and deferred income taxes (491) 197 Change in other current and noncurrent liabilities (242) (188) Other, net (278) (432) Total (1,071) 291 Cash Flows from Investing Activities Cost of additions to land, buildings and equipment (324) (393) Proceeds from sales of land, buildings and equipment 80 29 Proceeds from divestitures 90 - Acquisitions, net of cash acquired (873) (107) Other, net - (24) Total (1,027) (495) Cash Flows from Financing Activities Net change in debt 2,208 565 Proceeds from secured borrowing 411 - Dividends on common and preferred stock (441) (439) Proceeds from sales of common stock 22 125 Proceeds from(settlements of)equity put options 24 (5) Dividends to minority shareholders (5) (29) Total 2,219 217 Effect of Exchange Rate Changes on Cash (1) (9) Cash Provided by Continuing Operations 120 4 Cash Provided (Used) by Discontinued Operations (92) 23 Increase in Cash 28 27 Cash at Beginning of Period 126 79 Cash at End of Period $ 154 $ 106 See accompanying notes 1. The unaudited consolidated interim financial statements presented herein have been prepared by Xerox Corporation ("the Company") in accordance with the accounting policies described in its 1999 Annual Report to Shareholders and should be read in conjunction with the notes thereto. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) which are necessary for a fair statement of operating results for the interim periods presented have been made. Prior years' financial statements have been restated to reflect certain reclassifications to conform with the 2000 presentation. The impact of these changes is not material and did not affect net income. References herein to "we" or "our" refer to Xerox and consolidated subsidiaries unless the context specifically requires otherwise. 2. Accounts receivable Sale Agreement In September 2000, the Company entered into an agreement to sell, on an ongoing basis, a defined pool of accounts receivable to a wholly-owned qualifying bankruptcy-remote special purpose entity. The special purpose entity, in turn, sells participating interests in such accounts receivable to financial institutions up to a maximum amount of $400 million. Under the terms of the agreement, new receivables are added to the pool as collections reduce previously sold accounts receivable. The Company continues to service these receivables on behalf of the special purpose entity and receives a servicing fee. As of September 30, 2000, $315 million in proceeds were received from the securitization of accounts receivable under this agreement. The proceeds were used to reduce outstanding debt and are reflected as an operating cash flow in the consolidated statement of cash flows. The earnings impact related to the receivables sold and securitized under this agreement was not material. 3. Finance receivable Secured Borrowing: In September 2000, the Company transferred $457 million of finance receivables to a wholly-owned qualifying bankruptcy- remote special purpose entity for cash proceeds of $411 million. The difference of $46 million between the amount transferred and the proceeds represents the Company's retained interest in these finance receivables. The Company and the financial institutions which provided the funding for the special purpose entity's payment for the transfer of the receivables, through the purchase of participating interests, intend the transfer to be a "true sale at law" and have received an opinion to that effect from the Company's outside legal counsel. However, the agreement includes a repurchase option and therefore the proceeds of $411 million received from the financial institutions were accounted for as a secured borrowing in accordance with the provisions of SFAS No. 125 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". The balance of the receivables transferred was $457 million at September 30, 2000 and continues to be included in Finance receivables, net in the Consolidated Balance Sheet. 4. Inventories consist of (in millions): September 30, December 31, 2000 1999 Finished products $ 1,878 $ 1,800 Work in process 162 122 Raw materials and supplies 378 363 Sub-total 2,418 2,285 Equipment on operating leases, net 690 676 Total $ 3,108 $ 2,961 5. On March 31, 2000, we announced details of a worldwide restructuring program designed to enhance shareholder value, spur growth and strengthen the company's competitive position in the digital marketplace primarily through cost and expense reductions. In connection with this program, in the first quarter of 2000 we recorded a pre-tax provision of $625 million ($444 million after taxes and including our $18 million share of a restructuring charge recorded by Fuji Xerox, an unconsolidated affiliate). The $625 million pre-tax charge includes severance costs related to the elimination of 5,200 positions worldwide. Approximately 65 percent of the positions eliminated are in the U.S., 20 percent are in Europe, and the remainder are predominantly in Latin America. The employment reductions are wide-ranging, impacting all levels and business groups. None of the reductions will reduce sales coverage or affect direct research and development. The charge also includes $71 million related to facility closings and other asset write-offs and $119 million for inventory charges, which were recorded as a component of cost of revenues. For facility fixed assets classified as assets to be disposed of, the impairment loss recognized is based on the fair value less cost to sell, with fair value based on estimates of existing market prices for similar assets. The inventory charges relate primarily to the consolidation of distribution centers and warehouses and the exit from certain product lines. The $625 million pre-tax charge was reduced by $2 million in the second quarter due to a change in estimate. The restructuring is expected to be completed in early 2001. Key initiatives of the restructuring, which will result in charges for severance and exit activities, include the following: 1) Sharpening the company's focus on cost, quality and delivery in manufacturing by reducing the production infrastructure and moving certain product lines to regions where they are in the greatest customer demand. 2) Driving greater efficiency in logistics and supply chain operations through the consolidation of distribution centers and warehouses, reducing costs and improving inventory turns. 3) Enhancing customer service delivery by deploying technology and executing process changes to reduce costs. 4) Implementing an average 10 percent reduction in the number of middle and upper managers across the various Xerox businesses in the United States, with similar reductions in other geographic areas. 5) Eliminating redundancies in support functions by moving to a shared service model for marketing, human resources and finance. 6) Outsourcing work in areas not related to the company's core business operations and where there is economic advantage. 7) Accelerating the integration of business functions in General Markets Operations to achieve benchmark expenses and processes for indirect sales channels. 8) Implementing a wide-ranging series of initiatives across Developing Markets Operations (DMO) geographies to improve productivity and cost levels. 9) Leveraging Web-based technology to simplify and streamline processes across internal business operations, and extending to vendor and customer relationships. The following table summarizes the status of the restructuring reserve (in millions): Charges September 30, Total Against 2000 Cash Charges: Reserve Reserve Balance Severance and related costs $384 $ 59 $325 Lease cancellation and other costs 49/1/ 10 39 Sub-total 433 69 364 Non-cash Charges: Asset impairment 71 71 - Inventory charges 119 119 - Sub-total 190 190 - Currency Impact - 10 (10) Total $623 $269 $354/2/ /1/ Includes $2 million reduction recorded in second quarter 2000. /2/ Of this amount, $265 is included in Other current liabilities. Included in the charge of $49 million is $32 million of various contractual commitments, other than facility occupancy leases, that will be terminated early as a result of the restructuring. The commitments include cancellation of supply contracts and outsourced vendor contracts. Also included are approximately $17 million of charges related to lease cancellation costs which are mainly for the consolidation of distribution centers and warehouses located primarily in the U.S. Included in the charge of $71 million was: $44 million for machinery and tooling for products that were discontinued or alternatively sourced; $7 million for leasehold improvements at facilities that will be closed; and $20 million of sundry surplus assets, individually insignificant, from various parts of our business. These assets were primarily located in the U.S. and the related product lines generated an immaterial amount of revenue. Approximately $100 million of the $119 million of inventory charges related to excess inventory in many product lines created by the consolidation of distribution centers and warehouses. The remainder was related to the exit from certain product lines, including approximately $15 million of electrostatic machines in our wide format printing business due to a transition to ink jet products. As of September 30, 2000, approximately 1,200 employees have left the Company under the 2000 restructuring program. There have been no material changes to the program since its announcement, and the remaining reserve relates to cash expenditures to be incurred primarily during the remainder of 2000 and early 2001. 6. In April 1998, in connection with a restructuring program the Company recorded a pre-tax charge of $1,644 million. The charge was composed of: Cash Charges: Severance and related costs $1,017 Lease cancellation and other costs 198 Sub-total 1,215 Non-cash Charges: Asset impairment 316 Inventory charges 113 Sub-total 429 Total $1,644 Included in the cash charges were $91 million and $107 million of lease cancellation costs and of various other contractual decommitments, respectively. These premises were vacated at various dates in 1998 and 1999, and by the end of 1999 the majority of the premises were vacated. The remaining facilities are expected to be vacated by early 2001. Delays in vacating these facilities were primarily due to: delays in terminating employees in European countries as a result of local labor laws, strong unions and workers councils and socialist governments in some countries; and delays in implementing key system enablers in Europe. The other costs totaling $107 million are comprised of various contractual decommitments, other than facility occupancy leases, that are being terminated early as a result of the restructuring. The decommitments, related to information management contracts and outsourced vendor contracts, are in the form of either penalties associated with the early termination of the contract or contractual obligations for which we will not generate future economic benefit. The non-cash portion of this restructuring program included $316 million of asset impairments and $113 million of inventory charges recorded as cost of revenues. The $316 million asset charge included $156 million for facilities abandonment and $160 million for other asset write-offs. The facilities abandonment charge affects assets located in numerous locations in the U.S. and Europe and is comprised of the following: $54 million primarily for machinery and tooling for light-lens products that have been discontinued as a result of the restructuring; $40 million for a major training facility to be disposed as training will transition to more localized processes and $62 million for other facilities and leasehold improvements at locations to be abandoned as part of the restructuring. Other assets written off are primarily comprised of capitalized internal use software and information management infrastructure totaling $124 million that are being abandoned as part of our closed facilities or as a result of the overhauling of internal processes. The remainder of $36 million is comprised of sundry surplus assets, individually insignificant, from various parts of our business. In general, the aforementioned assets were either abandoned or scrapped and therefore written down to zero and removed from service at the time the restructuring charge was recorded. These assets were not previously considered impaired, as they were expected to generate cash flow sufficient to recover their carrying value based on the Company's previous business strategies. The majority of the assets were not utilized after they were written off. For those assets that we continued to use, we had the ability to remove these assets from operations at the time of the restructuring. The $113 million of inventory charges relate to certain light- lens products that were scrapped as a result of our decision to accelerate the transition to digital products and excess spare parts that were scrapped as a result of our decision to centralize certain parts depots. The 1998 Restructuring included provisions for consolidation of 56 European customer support centers into one facility and implementing a shared services organization for back-office operations in Ireland. As of September 30, 2000, the remaining reserve balance for the 1998 restructuring program is $185 million. Approximately $160 million of the remaining reserve is for severance and related costs with approximately $30 million designated for salary continuance payments due to employees who have already been terminated. The 1998 restructuring program called for the termination of 12,700 employees of which 11,400 have left the Company as of September 30, 2000. Approximately $130 million of the severance reserve relates to the 1,300 employees remaining to be terminated, most of whom are employed in our European operations. The remaining reserve of $25 million primarily relates to the run off of lease cancellation payments. We expect the remaining reserve to be fully encumbered by the end of 2000. 7. Common shareholders' equity consists of (in millions): September 30, December 31, 2000 1999 Common stock $ 669 $ 667 Additional paid-in-capital 1,665 1,539 Retained earnings 3,792 4,501 Accumulated other comprehensive income /1/ (2,075) (1,796) Total $ 4,051 $ 4,911 /1/ Accumulated other comprehensive income at September 30, 2000 is composed of cumulative translation $(2,055), minimum pension liability of $(33), and unrealized gains on marketable securities of $13. Comprehensive income (loss) for the three months and nine months ended September 30, 2000 and 1999 is as follows (in millions): Three months ended Nine months ended September 30, September 30, 2000 1999 2000 1999 Net income (loss) $ (167) $ 339 $ (265) $1,130 Translation adjustments (160) (75) (292) (1,051) Unrealized gains on marketable Securities - - 14 - Comprehensive income (loss) $ (327) $ 264 $ (543) $ 79 8. A summary of interest expense follows: Three months ended Nine months ended September 30, September 30, 2000 1999 2000 1999 Financing interest $ 153 $ 142 $ 450 $ 416 Non-financing interest 112 59 289 190 Total interest expense $ 265 $ 201 $ 739 $ 606 9. Segment Reporting In the first quarter of 2000, we completed the realignment of our operations to better align the company to serve its diverse customers/distribution channels and to provide an industry- oriented focus for global document services and solutions. As a result of this realignment, our reportable segments have been revised accordingly and are as follows: Industry Solutions, General Markets and Developing Markets. The Industry Solutions operating segment (ISO) covers the direct sales and service organizations in North America and Europe. It is organized around key industries and focused on providing our largest customers with document solutions consisting of hardware, software and services, including document outsourcing, systems integration and document consulting. The General Markets operating segment (GMO) includes sales agents in North America, concessionaires in Europe and our Channels Group which includes retailers and resellers. It is responsible for increasing penetration of the general market space, including small office solutions, products for networked work group environments and personal/home office products. In addition, it has responsibility for product development and acquisition for its markets, providing customer- and channel-ready products and solutions. The Developing Markets operating segment (DMO) includes operations in Latin America, China, Russia, India, the Middle East and Africa. It takes advantage of growth opportunities in emerging markets/countries around the world, building on the leadership Xerox has already established in a number of those markets. Other businesses include several units, none of which met the thresholds for separate segment reporting. The revenues included in this group are primarily from Xerox Supplies Group (XSG) and Xerox Engineering Systems (XES). All corporate expenses, including interest, have been allocated to the operating segments. Operating segment profit or loss information for the three months ended September 30, 2000 and 1999 is as follows (in millions): Industry General Developing Other Solutions Markets Markets Businesses Total 2000 Revenue from external customers $ 2,213 $1,206 $ 678 $ 365 $ 4,462 Intercompany revenues 8 33 - (41) - Total segment revenues $ 2,221 $1,239 $ 678 $ 324 $ 4,462 Segment profit/(loss)/1/ $ (80) $ (58) $ (72) $ 14 $ (196) 1999 Revenue from external customers $ 2,361 $1,127 $ 671 $ 468 $ 4,627 Intercompany revenues 7 31 - (38) - Total segment revenues $ 2,368 $1,158 $ 671 $ 430 $ 4,627 Segment profit $ 331 $ 48 $ 69 $ 57 $ 505 Operating segment profit or loss information for the nine months ended September 30, 2000 and 1999 is as follows (in millions): Industry General Developing Other Solutions Markets Markets Businesses Total 2000 Revenue from external customers $ 6,691 $3,766 $1,980 $1,144 $13,581 Intercompany revenues 31 167 - (198) - Total segment revenues $ 6,722 $3,933 $1,980 $ 946 $13,581 Segment profit/(loss)/1/ $ 215 $ (22) $(106) $ 178 $ 265 1999 Revenue from external customers $ 7,124 $3,385 $1,909 $1,371 $13,789 Intercompany revenues 26 73 - (99) - Total segment revenues $ 7,150 $3,458 $1,909 $1,272 $13,789 Segment profit $ 1,106 $ 194 $ 192 $ 140 $ 1,632 /1/ The following is a reconciliation of segment profit to total Company Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities' Interest: Three months ended Nine months ended September 30, September 30, 2000 2000 Total segment profit $(196) $ 265 2000 Restructuring: Inventory charges - (119) Restructuring charge and asset impairments - - (504) (623) CPID purchased in-process R&D - (27) Income (Loss) before Income Taxes (Benefits), Equity Income and Minorities' Interests $(196) $(385) 10. Acquisitions On January 1, 2000, we and Fuji Xerox completed the acquisition of the Color Printing and Imaging Division of Tektronix, Inc. (CPID). The aggregate consideration paid of $925 million in cash, which includes $73 million paid directly by Fuji Xerox, is subject to certain post-closing adjustments. CPID manufactures and sells color printers, ink and related products, and supplies. The acquisition was accounted for in accordance with the purchase method of accounting. The operating results of CPID have been included in the consolidated statement of income since January 1, 2000. The excess of cash paid over the fair value of net assets acquired has been allocated to identifiable intangible assets and goodwill. An independent appraiser, using a discounted cash flow approach, valued the identifiable intangible assets. The value of the identifiable intangible assets includes $27 million for acquired in-process research and development which was written off in the first quarter of 2000. This charge represents the fair value of certain acquired research and development projects that were determined not to have reached technological feasibility as of the date of the acquisition. We determined the amount of the purchase price to be allocated to in-process research and development, based on the methodology that focused on the after-tax cash flows attributable to the in-process products combined with the consideration of the stage of completion of the individual research and development project at the date of acquisition. The remaining excess of the purchase price was allocated to other identifiable intangible assets and goodwill. Identifiable intangible assets included in the valuation, exclusive of intangible assets acquired by Fuji Xerox, were the installed customer base ($209 million), the distribution network ($123 million), the existing technology ($103 million), the workforce ($71 million), and trademarks ($23 million). These identifiable assets are included in the Intangibles and other assets in the Consolidated Balance Sheet. The remaining excess has been assigned to goodwill. Other identifiable intangible assets and goodwill are being amortized on a straight-line basis over their estimated useful lives which range from 7 to 25 years. The valuation of the identifiable intangible assets, referred to above, is based on studies and valuations which have been finalized. However the final goodwill amount may be affected by any post-closing adjustments which could potentially reduce the purchase price. 11. Divestitures In April 2000, the Company sold a 25 percent ownership interest in its wholly-owned subsidiary, ContentGuard, to Microsoft, Inc. for $50 million and recognized a pre-tax gain of $23 million, which is included in Other, net. An additional pre-tax gain of $27 million was deferred and is included in Unearned income in the Consolidated Balance Sheet. In connection with the sale, ContentGuard also received $40 million from Microsoft for a non- exclusive license of its patents and other intellectual property and a $25 million advance against future royalty income from Microsoft on sales of products incorporating ContentGuard's technology. The license payment is being amortized over the life of the license agreement of 10 years and the royalty advance will be recognized in income as earned. In June 2000, the Company completed the sale of its U.S. and Canadian commodity paper business, including an exclusive license for the Xerox brand, to Georgia Pacific and recorded a pre-tax gain of approximately $40 million which is included in Other, net. In addition to the proceeds from the sale of the business, the Company will receive royalty payments on future sales of Xerox branded commodity paper by Georgia Pacific and will earn commissions on Xerox originated sales of commodity paper as an agent for Georgia Pacific. The U.S. and Canadian commodity paper business had annual sales of approximately $275 million of our $1.0 billion total worldwide paper sales in 1999. 12. Mexico Provision For the nine months ended September 30, 2000, the Company recorded a pre-tax provision of $170 million ($120 million after taxes) related to its previously announced issues in Mexico. A portion of this provision includes an amount which would ordinarily represent a charge for uncollectable accounts that would be included in Selling, administrative, and general expenses. This amount is presently not determinable. The provision relates to establishing reserves for uncollectable long-term receivables, recording liabilities for amounts due to concessionaires and, to a lesser extent, for adjustments related to contracts that did not fully meet the requirements to be recorded as sales-type leases. No further provisions are expected. The investigation of this matter by the Audit Committee of our Board of Directors, with the assistance of outside advisors, is presently being finalized. In response to these issues, the Company has taken the following actions - a number of senior local managers in Mexico were held accountable and removed from the Company; a new general manager was appointed in Mexico with a strong financial background; the Audit Committee of the Board of Directors has launched an independent investigation into the Mexican operation and an extensive review of the Company's worldwide internal controls was initiated to ensure that the issues identified in Mexico are not present elsewhere. In June 2000, the Company was advised that the Securities and Exchange Commission (SEC) had entered an order of a formal, non- public investigation into our accounting and financial reporting practices in Mexico. We are cooperating fully with the SEC. 13. Litigation On March 10, 1994, a lawsuit was filed in the United States District Court for the District of Kansas by two independent service organizations (ISOs) in Kansas City and St. Louis and their parent company. Subsequently, a single corporate entity, CSU, L.L.C. (CSU), was substituted for the three affiliated companies. CSU claimed damages predominately resulting from the Company's alleged refusal to sell parts for high-volume copiers and printers to CSU prior to 1994. The Company's policies and practices with respect to the sale of parts to ISOs were at issue in an antitrust class action in Texas, which was settled by the Company during 1994. Claims for individual lost profits of ISOs who were not named parties, such as CSU, were not included in that class action. The Company asserted counter-claims against CSU alleging patent and copyright infringement relating to the copying of diagnostic software and service manuals. On April 8, 1997, the District Court granted partial summary judgment in favor of the Company on CSU's antitrust claims, ruling that the Company's unilateral refusal to sell or license its patented parts cannot give rise to antitrust liability. On January 8, 1999, the Court dismissed with prejudice all of CSU's antitrust claims. The District Court also granted summary judgment in favor of the Company on its patent infringement claim, leaving open with respect to patent infringement only the issues of willfulness and the amount of damages, and granted partial summary judgment in favor of the Company with respect to some of its claims of copyright infringement. A judgment in the amount of $1 million was entered in favor of the Company and against CSU on the copyright infringement counterclaim. On February 16, 2000, the United States Court of Appeals for the Federal Circuit affirmed the judgment of the District Court dismissing CSU's antitrust claims and on July 11, 2000 CSU petitioned the Supreme Court for a writ of certiorari to review the Appeals Court's judgment. On April 11, 1996, an action was commenced by Accuscan Corp. (Accuscan), in the United States District Court for the Southern District of New York, against the Company seeking unspecified damages for infringement of a patent of Accuscan which expired in 1993. The suit, as amended, was directed to facsimile and certain other products containing scanning functions and sought damages for sales between 1990 and 1993. On April 1, 1998, the jury entered a verdict in favor of Accuscan for $40 million. However, on September 14, 1998, the Court granted the Company's motion for a new trial on damages. The trial ended on October 25, 1999 with a jury verdict of $10 million. The Company's motion to set aside the verdict or, in the alternative, to grant a new trial was denied by the Court. The Company is appealing to the Court of Appeals for the Federal Circuit. Accuscan is appealing the new trial grant which reduced the verdict from $40 million and seeking a reversal of the jury's finding of no willful infringement. We are in the midst of the briefing schedule at the Court of Appeals. A consolidated lawsuit was filed in the United States District Court for the Western District of Texas. It was a consolidation of two previously separate lawsuits, one of which had been filed in the United States District Court for the District of New Jersey and had been transferred to Texas, and the other which was commenced in Texas. Plaintiffs in both cases claimed that the withdrawal of Crum & Forster Holdings, Inc. (a former subsidiary of ours) (C&F) from the Xerox Corporation Employee Stock Ownership Plan (ESOP) constituted a wrongful termination under the Employee Retirement Income Security Act (ERISA). Both cases were also brought as purported class actions. The complaints in the two cases asserted different legal theories for recovery. In one case damages of $250 million were alleged and in the other case damages were unspecified. On October 4, 2000, the Court granted Xerox's motion for summary judgment and dismissed the case in its entirety. The plaintiffs may still attempt to appeal the court's ruling. Xerox will vigorously defend any such appeal. On June 24, 1999, Xerox Corporation was served with a summons and complaint filed in the Superior Court of the State of California for the County of Los Angeles. The complaint was filed on behalf of 681 individual plaintiffs claiming damages as a result of Xerox's alleged disposal and/or release of hazardous substances into the soil, air and groundwater. On July 22, 1999 and on April 12, 2000,respectively, two additional complaints were filed in the same Court, which have not yet been served on Xerox. These separate actions are on behalf of an additional 80 plaintiffs and 140 plaintiffs, respectively, with the same claims for damages as the June, 1999 action. Plaintiffs in all three cases further allege that they have been exposed to such hazardous substances by inhalation, ingestion and dermal contact, including but not limited to hazardous substances contained within the municipal drinking water supplied by the City of Pomona and the Southern California Water Company. Plaintiffs' claims against Xerox include personal injury, wrongful death (claimed in the first two complaints), property damage, negligence, trespass, nuisance, fraudulent concealment, absolute liability for ultra-hazardous activities, civil conspiracy, battery and violation of the California Unfair Trade Practices Act. Damages are unspecified. We deny any liability for the plaintiffs' alleged damages and intend to vigorously defend these actions. Xerox has not answered or appeared in any of the cases because all three have either been stayed by stipulation of the parties or order of the court. Plaintiffs are currently seeking to have the three cases coordinated with a number of other unrelated groundwater cases pending in Southern California. Xerox is opposing coordination of the cases. On December 9, 1999, a complaint was filed in the United States District Court for the District of Connecticut in an action entitled Giarraputo, et al. vs. Xerox Corporation, Barry Romeril, Paul Allaire and Richard Thoman which purports to be a class action on behalf of the named plaintiff and all other purchasers of Common Stock of the Registrant between January 25, 1999 and October 7, 1999 (Class Period). On December 13, 1999, an amended complaint was filed adding an additional named plaintiff, extending the Class Period through December 10, 1999, and expanding the class to include individuals who purchased call options or sold put options. The amended complaint alleges that pursuant to the Securities Exchange Act of 1934, as amended, each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of the Company's Common Stock during the Class Period by disseminating materially false and misleading statements and/or concealing material facts. The amended complaint further alleges that the alleged scheme: (i) deceived the investing public regarding the economic capabilities, sales proficiencies, growth, operations and the intrinsic value of the Company's Common Stock; (ii) allowed several corporate insiders, such as the named individual defendants, to sell shares of privately held Common Stock of the Company while in possession of materially adverse, non-public information; and (iii) caused the individual plaintiffs and the other members of the purported class to purchase Common Stock of the Company at inflated prices. The amended complaint seeks unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all defendants, jointly and severally, for all damages sustained as a result of defendants' alleged wrongdoing, including interest thereon, together with reasonable costs and expenses incurred in the action, including counsel fees and expert fees. Several additional class action complaints alleging the same or substantially similar claims were filed in the same Court. On March 14, 2000, the Court issued an order consolidating all of these related cases into a single action captioned In re Xerox Corporation Securities Litigation, and appointing lead plaintiffs, and lead and liaison counsel. On April 28, 2000 plaintiffs filed an amended consolidated class action complaint on behalf of a redefined class consisting of themselves and all other purchasers of Common Stock of Registrant during the period between October 22, 1998 through October 7, 1999. On June 12, 2000, the individual named defendants and Xerox Corporation made a motion to dismiss the amended consolidated class action complaint for failure to meet the pleading requirements of the Private Securities Litigation Reform Act. Plaintiffs filed an opposition to the motion on July 13, 2000. The motion is pending. The named individual defendants and we deny any wrongdoing and intend to vigorously defend the action. On July 5, 2000, a shareholder derivative action was commenced in the Supreme Court of the State of New York, County of New York on behalf of Registrant against all current members of the Board of Directors (with the exception of Anne M. Mulcahy) (collectively, the "Individual Defendants"), and Registrant, as a nominal defendant. Plaintiff claims breach of fiduciary duties related to certain of the accounts receivable related to Registrant's operations in Mexico. The complaint alleges that the Individual Defendants breached their fiduciary duties by, among other things, permitting wrongful business practices to occur, inadequately supervising and failing to instruct employees and managers of Registrant and taking no steps to institute appropriate legal action against those responsible for unspecified wrongful conduct. Plaintiff claims that Registrant has suffered unspecified damages but which are "expected to exceed tens of millions of dollars", and seeks judgment, among other things, requiring the Individual Defendants to pay to Registrant the amounts by which Registrant has been damaged by reason of their breach of their fiduciary duties and/or to the extent they have been unjustly enriched and to institute and enforce appropriate procedural safeguards to prevent the alleged wrongdoing. On October 5, 2000, the Individual Defendants and Xerox Corporation made a motion to dismiss the complaint for failure to make a pre-suit demand upon the Board and for failure to state a claim for breach of fiduciary duty. The motion is pending. The Individual Defendants deny the wrongdoing alleged in the complaint and intend to vigorously defend the action. On August 24, 2000, an action was commenced in the United States District Court for the District of Connecticut against the Company, KPMG, LLP ("KPMG"), and Paul A. Allaire, G. Richard Thoman, Anne M. Mulcahy and Barry D. Romeril ("Individual Defendants"). The action purports to be a class action on behalf of the named plaintiff and all purchasers of Common Stock of the Company during the period from January 25, 2000 and July 27, 2000 ("Class"). Among other things, the complaint alleges that each of the Company, KPMG and the Individual Defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Securities and Exchange Commission Rule 10b-5 thereunder, by participating in a fraudulent scheme that operated as a fraud and deceit on purchasers of the Company's Common Stock by disseminating materially false and misleading statements and/or concealing material adverse facts relating to the Company's Mexican operations. The complaint alleges that this scheme deceived the investing public regarding the true state of the Company's financial condition and caused the named plaintiff and other members of the alleged Class to purchase the Company's Common Stock at artificially inflated prices. The complaint seeks unspecified compensatory damages in favor of the named plaintiff and the other members of the alleged Class against the Company, KPMG and the Individual Defendants, jointly and severally, including interest thereon, together with reasonable costs and expenses, including counsel fees and expert fees. Several additional class action complaints alleging the same or substantially similar claims were filed in the same Court. The Individual Defendants and we deny any wrongdoing alleged in the complaint and intend to vigorously defend the action. 14. Subsequent Events During the third quarter we recorded the receipt of a premium of approximately $24 million on the sale of equity put options. This premium was recorded as an addition to Common shareholders' equity. In October 2000, the holder of these equity put options exercised their option for early termination and settlement. The cost of this settlement to the Company was approximately $92 million for 7.5 million shares with an average strike price of $18.98 per share. This transaction will be recorded as a reduction of Common shareholders' equity during the fourth quarter of 2000. These transactions, therefore, have resulted in a net cash usage of $68 million. On October 24, 2000, we announced a turnaround program, in which we outlined a wide- ranging plan to sell assets, cut costs and strengthen our strategic core. Additionally, we are exploring alternatives to provide financing for customers in a manner that does not involve the Xerox balance sheet, and over time will provide financing to our customers using third parties. We are actively engaged in discussions to sell certain assets, including: our operations in China, a portion of the 50 percent ownership in Fuji Xerox, Xerox Engineering Systems, and our interests in spin-off companies such as ContentGuard and Inxight. We are in discussions with a number of parties to make a significant equity investment in our inkjet business, we are exploring a joint venture with non-competitive partners for our Palo Alto Research Center, and we are considering outsourcing or selling certain manufacturing operations. Furthermore, we are in discussion to form a strategic alliance for our European paper business and commercializing our non-core technology assets through partnerships with venture capital investors. It is expected that in most cases asset sales will result in a gain. Regarding the cost reductions, we are in the process of finalizing plans designed to reduce costs by $1.0 billion annually, the majority of which will affect 2001. The actions include: - reallocating resources from headquarter operations to the field, eliminating duplicative industry-and-product organizations and, in certain developing market countries, moving to a distributor-based product-sales approach, - reducing more than $200 million in manufacturing and supply chain costs, - reducing service costs through greater emphasis on remote diagnostics and third-party service providers, and by moving activities into the operating companies to eliminate a worldwide service staff organization, - reducing infrastructure and overhead across corporate headquarters, manufacturing and research and development, - re-allocating research and development efforts to underpin growth opportunities in solutions and color, working more closely with Fuji Xerox to eliminate R&D redundancies and scrutinizing all programs based on their affordability and future profitability. No provisions have been recorded relating to possible employee separation as our plans have not been finalized. Item 2 Xerox Corporation Management's Discussion and Analysis of Results of Operations and Financial Condition Document Processing Summary Total 2000 third quarter revenues declined 4 percent to $4.5 billion compared with $4.6 billion in the 1999 third quarter. Excluding adverse currency translation, pre-currency revenues declined 1 percent. Excluding the beneficial impact of the January 1, 2000 acquisition of the Tektronix, Inc. Color Printing and Imaging Division (CPID), pre-currency revenues declined 4 percent. The 2000 third quarter loss reflected the revenue decline as well as a significant operating margin decline. Equity income from Fuji Xerox improved in the 2000 third quarter. Including an additional $55 million pre-tax provision ($41 million after taxes) related to the company's previously announced issues in Mexico, the net loss was $167 million in the 2000 third quarter. No further provisions for this issue are expected. Excluding the Mexico provision, the third quarter 2000 net loss was $126 million compared with net income of $339 million in the 1999 third quarter. Total revenues in the first nine months of 2000 were $13.6 billion which was a decline of 2 percent compared with $13.8 billion in the first nine months of 1999. Excluding adverse currency translation, pre-currency revenues increased 1 percent. Excluding the beneficial impact of the CPID acquisition, pre- currency revenues declined 2 percent. Year to date 2000 revenues included an increase of approximately $40 million associated with excellent growth in licensing patents from our intellectual property portfolio and selling standalone software. Including the effect of special items, we had a net loss of $265 million in the first nine months of 2000. Excluding special items, net income in the first nine months of 2000 declined 72 percent to $315 million from $1,130 million in the first nine months of 1999. Special items included the following after-tax charges - $443 million in connection with the 2000 restructuring program (including our $18 million share of a separate Fuji Xerox restructuring charge), $17 million for acquired in-process research and development associated with the CPID acquisition and $120 million for the Mexico provision. The decline in net income reflects the significant gross margin deterioration and higher SAG in the first nine months of 2000. Diluted earnings/(loss) per share: Including the 6 cent provision arising from the independent investigation of our Mexico operations, our loss per share was $0.26 in the 2000 third quarter. Excluding this provision, the third quarter 2000 loss per share was $0.20 compared with $0.47 earnings per share in the 1999 third quarter. The catch-up impact of an effective tax rate increase adversely affected our results by an estimated 6 cents and unfavorable third quarter year-over- year currency adversely affected our results by an estimated 5 cents. The CPID acquisition was non-dilutive on third quarter 2000 earnings as the expected synergies we are capturing from the integration are offsetting the higher goodwill and interest expense. Including special items, the diluted loss per share was $0.44 for the first nine months of 2000. Excluding special items, diluted earnings per share declined 72 percent to $0.43 in the first nine months of 2000 from $1.55 in the first nine months of 1999. Unfavorable year-over-year currency adversely impacted the first nine months earnings by approximately 14 cents. The following table summarizes net income (loss) and diluted earnings (loss) per share (EPS) for the third quarter and first nine months of 2000: (in millions, except per-share data) Three months ended Nine months ended September, 30 September, 30 2000 1999 2000 1999 Income before special items $ (128) $ 339 $ 315 $1,130 Restructuring and IPRD charges 2 - (460) - Mexico Provision (41) - (120) - Net Income (Loss) $ (167) $ 339 $ (265) $1,130 EPS: Income before special items $(0.20) $0.47 $ 0.43 $ 1.55 Restructuring and IPRD charges - - (0.69) - Mexico Provision (0.06) - (0.18) - Diluted EPS $(0.26) $0.47 $ (0.44) $ 1.55 Pre-Currency Growth To understand the trends in the business, we believe that it is helpful to adjust revenue and expense growth (except for ratios) to exclude the impact of changes in the translation of European and Canadian currencies into U.S. dollars. We refer to this adjusted growth as "pre-currency growth." A substantial portion of our consolidated revenues is 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 and Canadian currencies on a revenue-weighted basis, the U.S. dollar was approximately 11 percent stronger in the 2000 third quarter than in the 1999 third quarter. As a result, currency translation had an unfavorable impact of approximately three percentage points on revenue growth for both the quarter and year-to-date. Revenues Revenue By Segment Revenues and revenue growth rates by segment are as follows: Memo: 3Q 2000 Pre-Currency 1999 Revenue Growth Revenue Full Year Post Pre Growth Revenues Revenues Currency Currency Q1 Q2 Total Revenues $19.2 $4.5 (4)% (1)% 6% (1)% Industry Solutions Ops. 10.0 2.2 (6) (3) - (5) General Markets Ops. 4.7 1.2 7 10 19 14 Developing Markets Ops. 2.7 0.7 1 2 15 (2) Other Businesses 1.8 0.4 (22) (19) (4) (16) Memo: Fuji Xerox 7.8 1.9 4 1 2 7 YTD 2000 . Revenue Growth . Post Pre Revenues Currency Currency Total Revenues $13.6 (2)% 1% Industry Solutions Ops. 6.7 (6) (3) General Markets Ops. 3.8 11 14 Developing Markets Ops. 2.0 4 4 Other Businesses 1.1 (17) (13) Memo: Fuji Xerox 6.2 14 3 Dollars are in billions. Industry Solutions Operations (ISO) covers the direct sales and service organizations in North America and Europe. Revenues declined 6 percent (3 percent pre-currency) in the 2000 third quarter. Open sales territories and lower sales productivity as a result of less experienced sales people following higher sales turnover levels in the early part of this year were compounded by persistent U.S. customer administration issues at a time when competitive product capabilities have strengthened. Pricing pressure increased in certain products including monochrome digital multi-function products and DocuTech in the U.S. and monochrome production products in Europe. Revenues in the 2000 third quarter declined in the U.S., France, Germany and Canada, and reflected good growth in the U.K. ISO revenues declined 6 percent (3 percent pre-currency) in the first nine months of 2000 due to the continued sales force and U.S. customer administration issues and intensified competitive and pricing pressures. General Markets Operations (GMO) includes sales agents in North America, concessionaires in Europe and our Channels Group which includes retailers and resellers. General Markets Operations revenues grew 7 percent (10 percent pre-currency) in the 2000 third quarter from the 1999 third quarter including the CPID acquisition. Excluding CPID, General Markets pre-currency revenues declined 5 percent in the 2000 third quarter. European concessionaires had strong growth while revenues from North American sales agents declined modestly. Excellent Channels office color network printer and inkjet revenue growth was somewhat offset by small office/home office monochrome printer and copier declines. Initial shipments of our new DocuPrint M series family of inkjet printers, resulting from our alliance with Sharp Corporation and Fuji Xerox, began in the third quarter. GMO revenues increased 11 percent (14 percent pre-currency) in the first nine months of 2000 including the favorable impact from the CPID acquisition. Excluding CPID, pre-currency revenues were flat for the first nine months of 2000, driven by flat revenues in North American sales agents. Developing Markets Operations (DMO) includes operations in Latin America, China, Russia, India, the Middle East and Africa. Third quarter 2000 revenue growth was strong in Brazil reflecting the improving economic environment and activity growth. China and the Middle East and Africa had excellent revenue growth in the third quarter and Russia had strong revenue growth. Revenue declined in Argentina as well as a number of other Latin American countries and in Mexico as this operation recovers from the previously discussed operational issues. DMO revenues increased 4 percent (4 percent pre-currency) in the first nine months of 2000 reflecting excellent revenue growth in China and the Middle East and Africa, strong growth in India, and modest growth in Brazil, while revenue declined in Argentina and Mexico. The Company's Latin America operations in general, and Brazil in particular, are subject to volatile economies and currency fluctuations. Our Brazilian operations currently represent approximately 5 percent of total revenues, and as such, will continue to have an impact on the Company's results of operations. Historically, the Brazilian operations have managed to offset the impact of devaluation through pricing actions and reductions in its cost base and accordingly have successfully managed their operations so as to moderate the effects of these economic events. To date, the recovery in Brazil has not fully returned to pre-1999 levels. Fuji Xerox Co., Ltd., an unconsolidated entity jointly owned by Xerox Limited and Fuji Photo Film Company Limited, develops, manufactures and distributes document processing products in Japan, Australia, New Zealand, and other areas of the Pacific Rim. Fuji Xerox revenues grew 4 percent (1 percent pre-currency) in the 2000 third quarter reflecting flat revenues in Japan and good revenue growth in Fuji Xerox' other Asia Pacific territories. Fuji Xerox revenues grew 14 percent (3 percent pre-currency) in the first nine months of 2000 reflecting modest revenue growth in Japan and good revenue growth in Fuji Xerox' other Asia Pacific territories. Key Ratios and Expenses The trend in key ratios was as follows: 1999 2000 . Q1 Q2 Q3 Q4 FY Q1 Q2 Q3 YTD Gross Margin 45.9% 45.3% 43.3% 41.8% 44.0% 42.0%* 40.8% 36.7% 39.9%* SAG % Revenue 27.2 25.8 26.1 27.8 26.8 27.8 28.5 30.9 29.1 * Excludes inventory charges associated with the 2000 restructuring program. If included, the Gross Margin in Q1 and YTD would have been 39.3% and 39.0%, respectively. 1999 third quarter gross margin, SAG and R&D benefited from significant reversals of first half 1999 provisions for overall incentive compensation expense. As a result, the 2000 year over year unfavorable gross margin and spending comparisons are accentuated. The gross margin declined by 6.6 percentage points in the 2000 third quarter from the 1999 third quarter, or 6.5 percentage points excluding CPID. Approximately two-thirds of the gross margin decline was the result of weak activity, including DocuTech and Production Printing equipment sales, and unfavorable product mix. In addition, unfavorable transaction currency and competitive pricing pressures were only partially offset by manufacturing and other productivity improvements. Gross margin declined by 5.0 percentage points in the first nine months of 2000 from the first nine months of 1999 or 4.7 percentage points excluding CPID. The decline reflects weak DocuTech and Production Printing equipment sales, competitive price pressure and unfavorable currency. In addition, gross margin was adversely impacted by unfavorable product mix and lower service gross margins, as service revenue declines have not yet been accompanied by corresponding cost reductions. Gross margin in the first quarter of 2000 benefited from increased licensing and stand-alone software revenues associated with the licensing of a number of patents from our intellectual property portfolio. Selling, administrative and general expenses (SAG) grew 14 percent in the 2000 third quarter. Excluding the favorable effect of currency, SAG grew 18 percent, or 15 percent excluding CPID. SAG includes $138 million and $316 million in bad debt provisions in the 2000 third quarter and year-to-date which is $54 million higher than the 1999 third quarter, and $108 million higher than year-to-date 1999. The main drivers of the increase in bad debts for both the quarter and year-to-date are primarily in the U.S. as we continue to resolve aged billing and receivables issues. SAG growth also includes increased sales payline and incentive compensation partially offset by the impact of increased open sales territories; significant transition costs associated with the implementation of our European shared services organization; the continuing persistent impact of the U.S. customer administration issues and significant marketing, advertising and promotional investments for our major inkjet printer initiative. In the 2000 third quarter, SAG represented 30.9 percent of revenue compared with 26.1 percent of revenue in the 1999 third quarter. Year-to-date, SAG represented 29.1 percent of revenue compared with 26.3 percent of revenue in 1999. Research and development (R&D) expense grew 18 percent in the 2000 third quarter, or 13 percent excluding CPID, reflecting increased program spending. We continue to invest in technological development to maintain our position in the rapidly changing document processing market with an added focus on increasing the effectiveness and value of that investment. R&D expense grew 5 percent for the first nine months of 2000, as compared to 1999. Xerox R&D remains technologically competitive and is strategically coordinated with Fuji Xerox. Worldwide employment declined by 300 in the 2000 third quarter to 96,000 as a result of 900 employees leaving the company under the 1998 and 2000 worldwide restructuring programs partially offset by the net hiring of 600 employees, primarily for the company's growing document outsourcing business. Worldwide employment increased by 1,400 in the first nine months of 2000 as a result of our acquisition of CPID with 2,200 employees and a net hiring of 1,800 employees, primarily in the second quarter and for the Company's fast-growing document outsourcing business, partially offset by 2,600 employees leaving the company under the 1998 and 2000 worldwide restructuring programs. Gain on affiliate's sale of stock of $21 million, which was recorded in the first quarter of 2000, reflects our proportionate share of the increase in equity of Scansoft Inc. resulting from Scansoft's issuance of stock in connection with an acquisition. This gain is partially offset by a $5 million charge, in the first quarter, reflecting our share of Scansoft's write-off of in-process research and development associated with this acquisition, which is included in Equity in net income of unconsolidated affiliates. Scansoft, an equity affiliate, is a developer of digital imaging software that enables users to leverage the power of their scanners, digital cameras, and other electronic devices. The $66 million increase in Other, net, from the 1999 third quarter largely reflects increased non-financing interest expense and goodwill and other identifiable intangibles amortization associated with the January, 2000 CPID acquisition as well as increased non-financing interest expense associated with higher interest rates and higher debt levels. Total non-financing interest expense was $112 million in the 2000 third quarter which is $53 million higher than the 1999 third quarter. In the 2000 third quarter we recorded $28 million of increased interest income on tax audit settlements which on a year-over-year basis is largely offset by the 1999 third quarter gain of $20 million on the sale of our remaining interest in Documentum, Inc. For the first nine months of 2000, Other, net increased $94 million as the asset gains, described below, and the increased interest income on tax audit settlements were more than offset by increased non-financing interest expense and goodwill and other identifiable intangibles amortization associated with the CPID acquisition as well as increased non-financing interest expense associated with higher interest rates and higher debt levels. Total year-to-date non-financing interest expense was $289 million which is $99 million higher than the 1999 year-to-date. In April 2000, the Company sold a 25 percent ownership interest in its wholly-owned subsidiary, ContentGuard, to Microsoft, Inc. and recognized a pre-tax gain of $23 million which is included in Other, net. In connection with the sale, ContentGuard also received $40 million from Microsoft for a non-exclusive license of its patents and other intellectual property. This payment is being amortized over the life of the license agreement of 10 years. In addition, ContentGuard will receive future royalty income from Microsoft on sales of Microsoft products incorporating ContentGuard's technology. In June 2000, the Company completed the sale of its U.S. and Canadian commodity paper business, including an exclusive license for the Xerox brand, to Georgia Pacific and recorded a pre-tax gain of approximately $40 million which is included in Other, net. In addition to the proceeds from the sale of the business, the Company will receive royalty payments on future sales of Xerox branded commodity paper by Georgia Pacific and will earn commissions on Xerox originated sales of commodity paper as an agent for Georgia Pacific. The U.S. and Canadian commodity paper business had annual sales of approximately $275 million of our $1.0 billion total worldwide paper sales in 1999. Although future revenue is expected to be lower as a result of the sale, operating income should remain essentially unchanged as a result of payments received under the royalty/agent elements of the agreement. We expect a cash flow benefit as the existing working capital is reduced. During the third quarter, the Company recorded an additional pre- tax provision of $55 million ($41 million after taxes or $0.06 per share) related to collection issues on long-term receivables resulting from imprudent business practices associated with the previously announced issues in Mexico. In the second quarter, the Company recorded a pre-tax provision of $115 million ($78 million after taxes or $0.11 per share). A portion of these provisions includes an amount which would ordinarily represent a charge for uncollectable accounts that would be included in Selling, administrative, and general expenses. This amount is presently not determinable. Over a period of years, several senior managers in Mexico had collaborated to circumvent Xerox accounting policies and administrative procedures. The charges related to provisions for uncollectable long-term receivables, the recording of liabilities for amounts due to concessionaires and to a lesser extent for contracts that did not fully meet the requirements to be recorded as sales-type leases. No further provisions are expected. The investigation of this matter by the Audit Committee of our Board of Directors, with the assistance of outside advisors, is presently being finalized. In response to these issues, the Company has taken the following actions - a number of senior local managers in Mexico were held accountable and removed from the Company; a new general manager was appointed in Mexico with a strong financial background; the Audit Committee of the Board of Directors has launched an independent investigation into the Mexican operation and an extensive review of the Company's worldwide internal controls was initiated to ensure that the issues identified in Mexico are not present elsewhere. The Company was advised in June, 2000 that the U.S. Securities and Exchange Commission (SEC) had entered an order of a formal, non-public investigation into our accounting and financial reporting practices in Mexico. We are cooperating fully with the SEC. Income Taxes, Equity in Net Income of Unconsolidated Affiliates and Minorities' Interests in Earnings of Subsidiaries Income (Loss) before income taxes was a loss of $196 million in the 2000 third quarter including the Mexico provision. Excluding the Mexico provision, the loss before income taxes was $141 million in the 2000 third quarter compared with income of $505 million in the 1999 third quarter. Including the effect of special items, the loss before income taxes was $385 million in the first nine months of 2000. Excluding special items, income before income taxes in the first nine months of 2000 declined 73 percent to $435 million from $1,632 million in the first nine months of 1999. Special items include the following on a pre-tax basis - a charge of $623 million in connection with the 2000 restructuring program, a $27 million charge for acquired in-process research and development associated with the CPID acquisition and a $170 million provision for Mexico. The effective tax rate, including the tax benefit on the Mexico provision, was 14.8 percent in the 2000 third quarter and 24.2 percent for the first nine months of 2000. Excluding the tax benefit of the Mexico provision, the 2000 third quarter rate was 10.6 percent and 20.0 percent for the first nine months of 2000. The 1999 third quarter, 1999 full year and the underlying 2000 first half tax rate was 31.0 percent. We expect the underlying 2000 full year tax rate to be similar to the underlying year-to- date rate of 38.0 percent. The adjustment in the underlying tax rate from 31.0 percent to 38.0 percent that was applied to the first half income reduced the 2000 third quarter tax benefit and increased the net loss by $38 million or 6 cents per share. The increase in the effective tax rate is due primarily to a lower tax rate on losses in Europe compared with expected profits. Equity in net income of unconsolidated affiliates is principally our 50 percent share of Fuji Xerox income. Total equity in net income increased by $5 million in the 2000 third quarter and $21 million for the first nine months of 2000 reflecting improved Fuji Xerox business results and favorable currency translation. Fuji Xerox revenues of $1.9 billion in the 2000 third quarter increased 4 percent compared with the 1999 third quarter, including the favorable impact of currency translation resulting primarily from the strengthening yen compared with the U.S. dollar. Pre-currency revenue growth was 1 percent. Net income of $30 million in the 2000 third quarter increased 51 percent from the 1999 third quarter driven by the higher revenues, higher gross margin due primarily to manufacturing cost productivity, a lower statutory tax rate and favorable currency. Fuji Xerox revenues of $6.2 billion in the first nine months of 2000 increased 14 percent compared with the same period in 1999 including the favorable impact of currency translation. Pre- currency revenue growth was 3 percent. Net income of $167 million in the first nine months of 2000 increased from the prior year due to improved business results and favorable currency. On March 31, 2000 we announced details of a worldwide restructuring program designed to enhance shareholder value, spur growth and strengthen the company's competitive position in the digital marketplace primarily through cost and expense reductions. In connection with this program, in the first quarter of 2000 we recorded a pre-tax provision of $625 million ($444 million after taxes including our $18 million share of the Fuji Xerox restructuring charge). The resulting pre-tax provision of $625 million includes severance costs related to the elimination of 5,200 positions, net worldwide through a combination of voluntary programs and layoffs. The charge also includes $190 million related to facility closings and other asset write-offs such as scrapping certain inventory. The $625 million pre-tax charge was reduced by $2 million in the second quarter due to a change in estimate. The pre-tax savings from this restructuring plan, net of implementation costs, are expected to be approximately $95 million in 2000 and an incremental $300 million in 2001. These savings are not expected to be reinvested. Approximately 60 percent of the savings are expected in SAG with the balance in other activities. With respect to the headcount reductions we expect that approximately 3,400 positions will be eliminated by the end of 2000 and the balance in early 2001. As of September 30, 2000, approximately 1,200 employees had left the company under the program, and termination benefits of $59 million have been charged to the reserve. Asset impairment, inventory charges and other charges of $71 million, $119 million and $10 million, respectively, have also been charged against the restructuring reserve. The 2000 restructuring reserve balance at September 30, 2000 totaled $354 million which relates to cash expenditures to be incurred primarily during the remainder of 2000 and early 2001. Additional details regarding the initiatives and status of the 2000 restructuring reserve are included in Note 5 of the "Notes to Consolidated Financial Statements" of this Quarterly Report on Form 10-Q. In April 1998, we announced a worldwide restructuring program. In connection with this program, we recorded a second quarter 1998 pre-tax provision of $1,644 million ($1,107 million after taxes including our $18 million share of a restructuring charge recorded by Fuji Xerox). The program includes employment reductions, the closing and consolidation of facilities, and the write-down of certain assets. As of September 30, 2000, approximately 11,400 employees had left the company under the 1998 restructuring program. The majority of the reserve balance of $185 million at September 30, 2000 relates to expenditures to be incurred primarily during 2000 for the completion of certain European initiatives and continued payments associated with the severance and lease cancellation initiatives already implemented. We expect the remaining reserve to be fully encumbered by the end of 2000. The status of the 1998 restructuring reserve is included in Note 6 of the "Notes to Consolidated Financial Statements" of this Quarterly Report on Form 10-Q. On January 1, 2000 we completed the acquisition of the Tektronix, Inc. Color Printing and Imaging Division (CPID) for $925 million in cash including $73 million paid by Fuji Xerox for the Asia Pacific operations of CPID. This transaction resulted in goodwill and other identifiable intangible assets of approximately $637 million, which will be amortized over their useful lives, ranging from 7 to 25 years. In addition, we recognized a $27 million pre-tax charge in the 2000 first quarter for acquired in-process research and development associated with this acquisition. New Accounting Standards. In 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No.133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires companies to recognize all derivatives as assets or liabilities measured at their fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. We will adopt SFAS No. 133, as amended, beginning January 1, 2001. We do not expect this Statement to have a material impact on our consolidated financial statements. Discontinued Operations - Insurance and Other The net investment in our discontinued businesses which includes Insurance and Other Discontinued Businesses totaled $743 million at September 30, 2000 compared with $702 million at December 31, 1999. The increase in the first nine months of 2000 was primarily caused by the scheduled funding of reinsurance coverage for certain of the former Talegen Holdings, Inc. companies to Ridge Reinsurance Limited partially offset by proceeds from real estate sales. In July 2000, our OakRe life insurance business entered into an agreement with a subsidiary of the buyer of Xerox Life whereby the subsidiary assumed the remaining reinsurance liabilities associated with the Single Premium Deferred Annuity policies issued by Xerox Life. The agreement results in the completion of the run-off of OakRe. We expect that by the end of the 2000, upon regulatory approval, OakRe will pay a dividend of approximately $80 million, including $60 million of cash and cash equivalents, to Xerox Financial Services, Inc., a wholly owned subsidiary of the Company. The dividend is approximately equal to the remaining carrying value of our investment in OakRe. Capital Resources and Liquidity Historically, the Company's overall funding requirements have been to finance customers' purchases of Xerox equipment and to a lesser extent in recent years to fund working capital requirements. In addition, in 1998 we funded the $413 million acquisition of XLConnect Solutions. In 1999 we funded the acquisition of OmniFax and the increase in our ownership in our joint venture in India for a combined total of $102 million and in 2000 we funded the $852 million acquisition of CPID. The primary sources of funding have been cash flows from operations and borrowings under our commercial paper and term funding programs plus some securitization of finance and trade receivables. Since the beginning of October 2000, the Company has experienced a significant reduction in its ability to access capital markets and uncommitted bank lines of credit. Decisions related to funding of our businesses will remain based on the interest rate environment and capital market conditions as well as our ability to access these markets. Currently, these markets and uncommitted bank lines are largely unavailable to us. As a result, as of October 31, 2000 we had drawn down $5.3 billion under our $7 billion Revolving Credit Agreement dated as of October 27, 1997 with a group of banks (the "Agreement"). These funds were used primarily to pay down commercial paper, medium term notes and similar obligations. We are in compliance with the covenants, terms and conditions in the Agreement, which matures on October 22, 2002, and we expect that the remaining balance of the commitments under the Agreement will be fully available to us to support the Company's business operations going forward. We anticipate that we will require approximately $1.1 billion during the balance of the year to refinance commercial paper, maturing medium term notes and maturing bank obligations. The Company does not have any other material short-term obligations during the balance of the year to be financed through the Agreement unless the Company's debt ratings are further downgraded as discussed below. The Company is implementing several global initiatives to reduce costs and improve operations and sell certain non-core assets that should positively affect the Company's capital resources and liquidity position when completed. These include the implementation of a non-core asset divestiture program, which is expected to generate between $2 billion and $4 billion when completed. In addition, the Company has initiated discussions to change its current method of financing customer purchases of Xerox equipment and to evaluate the sale of all or a portion of the existing finance receivables portfolio, the proceeds of which would be used primarily to reduce debt. The Company has also initiated a worldwide cost reduction program which should result in annualized expense savings of $1 billion when completed. These initiatives are expected to be completed during 2001. We believe that our liquidity is presently sufficient to meet our current and our anticipated needs going forward, subject to timely implementation and execution of the non-core asset sales and the global operating initiatives discussed above. Should the Company not be able to successfully complete these initiatives or non-core asset sales on a timely or satisfactory basis, it will be necessary for the Company to obtain additional sources of funds through other improvements in our operations or through bridge or other financing from third parties. In September 2000, we completed the securitization of certain finance and accounts receivables in the United States as part of our overall funding strategy. Gross proceeds from the finance receivables securitization totaled $411 million. Since this transaction was accounted for as a secured borrowing, the balance sheet continues to reflect the receivables and related debt obligation. Proceeds from the accounts receivable securitization program totaled $315 million and the related amounts were deducted from the balance sheet as a result of the sale. The earnings impact of these transactions was not material. The credit rating agencies that assign ratings to the Company's debt have recently taken various actions including downgrading the Company's senior debt and short-term debt. As of November 13, 2000, Moody's debt ratings were Baa2 and P-2, respectively, and the Company's long-term and short-term ratings were being reviewed for possible downgrade; Fitch debt ratings were BBB- and F3, respectively, and the ratings were on Ratings Watch Negative and Standard and Poors debt ratings were BBB- and A-3, respectively, and the ratings outlook was stable. The recent lowering of the ratings of the Company's debt are expected to result in higher borrowing costs and limited access to the capital markets for the Company going forward. Should the Company be further downgraded by either Moody's or Standard and Poors to non-investment grade status, the counterparties to certain of the Company's derivative agreements may require the Company to repurchase the obligations under such agreements from the counterparties in the approximate aggregate amount of $110 million. In addition, if both credit rating agencies downgrade the Company to non-investment grade status, the Company may be required to repurchase an additional approximate aggregate amount of $130 million. Finally, if either credit rating agency downgrades the Company to a non-investment grade status, the Company may be precluded from making subsequent accounts receivable sales under the Accounts Receivable Sale Agreement (see Note 2 of the "Notes to Consolidated Financial Statements" of this Quarterly Report on Form 10-Q). If this were to occur the majority of the $315 million would require refinancing from another source within two to three months. There is no assurance that the Company's credit ratings will be maintained, the Company's credit ratings will not be downgraded below investment grade, the various counterparties to qualifying derivative agreements would not require the obligations to be repurchased by the Company and/or that the Company will have ready access to the credit markets in the future. Total debt, including ESOP and Discontinued Operations debt not shown separately in our consolidated balance sheets, was $17,197 million at September 30, 2000, reflecting a decline of $360 million from June 30, 2000 (primarily related to completion of our accounts receivable securitization program). Compared with December 31, 1999, total debt increased by $2,196 million. The changes in total indebtedness during the first nine months of 2000 and 1999 are summarized as follows (in millions): 2000 1999 Total debt* as of January 1 $15,001 $15,107 Non-Financing Businesses: Document Processing operations cash usage 1,391 687 Brazil dollar debt reallocation** 15 572 Discontinued businesses*** 92 (109) Non-Financing Businesses 1,498 1,150 Financing Businesses** (282) (1,154) Shareholder dividends 441 439 Acquisitions 873 161 Proceeds from divestitures (90) - All other changes, primarily currency (244) (15) Total debt* as of September 30 $17,197 $15,688 * Includes discontinued operations. ** Includes reallocation from and to our non-financing businesses of a portion of Xerox do Brasil's U.S. dollar denominated debt used to fund customer finance receivables denominated in Brazilian currency. The reallocations were performed consistent with the 8:1 debt to equity guideline used in our customer financing businesses. *** The increase in cash usage primarily reflected a one-time tax payment in 2000 in settlement of prior year tax liability and the reduced net cash proceeds from the sale of assets in 2000 versus 1999. We anticipate that discontinued businesses will generate cash for the balance of the year that will almost fully offset the first nine months usage. In summary, the Company's liquidity is currently provided through various financing strategies including securitizations and utilization of its Revolving Credit Agreement. The Company is also implementing global initiatives to reduce costs and improve operations, negotiating the sale of certain non-core assets, and discussing with third parties possible incremental bridge or other financing facilities. In addition, the Company has initiated discussions to change its current method of financing customer purchases of Xerox equipment and to evaluate the sale of all or a portion of the existing finance receivables portfolio. The adequacy of the Company's continuing liquidity is dependent upon its ability to successfully generate positive cash flow from an appropriate combination of these sources. Document Processing Non-Financing Operations The following table summarizes document processing non-financing operations cash generation and usage for the nine months ended September 30, 2000 and 1999 (in millions): 2000 1999 Income (loss) $ (433) $ 886 Add back special items: Restructuring charge, net 443 - Tektronix IPRD charge, net 17 - Mexico charge, net 120 - Income before special items 147 886 Depreciation* and amortization 824 659 Cash from Operations 971 1,545 Additions to land, buildings and equipment (324) (393) Increase in inventories (217) (60) Increase in on-lease equipment (483) (249) Decrease/(Increase) in accounts receivable 66 (497) Net change in other assets and liabilities (1,182) (694) Sub-total (1,169) (348) Cash payments for 1998 and 2000 restructurings (222) (339) Net Cash Usage $(1,391) $ (687) * Includes on-lease equipment depreciation of $452 and $332 million in the nine months ended September 30, 2000 and 1999, respectively Non-financing operations' net cash usage during the first nine months of 2000 and 1999 totaled $1,391 million and $687 million, respectively. On a year-over-year basis, lower non-financing income was partially offset by higher non-cash on-lease equipment depreciation charges and higher goodwill and intangible asset amortization primarily associated with our January, 2000 CPID acquisition. During the third quarter of 2000 net cash generation totaled $131 million. Additions to land, buildings and equipment primarily include office furniture and fixtures, production tooling and our investments in Ireland, where we are consolidating European customer support centers and investing in inkjet manufacturing. The decline in the first nine months of 2000 versus 1999 is primarily due to lower spending for the Ireland projects. Inventory growth during the first nine months of 2000 was higher than in the first nine months of 1999 due to lower than anticipated equipment sales and some inventory build for new products, primarily the DocuColor 2000 family and Inkjet. On- lease equipment increased by $234 million more than in 1999, before depreciation, reflecting growth in our document outsourcing business and increased customer preference to finance equipment on operating leases. Accounts receivable cash generation improved by $563 million reflecting the $315 million accounts receivable securitization and some improvement in days sales outstanding. The increase in other asset and liability usage is due primarily to lower deferred tax accruals due to lower income as well as higher cash tax payments in 2000 versus 1999. These unfavorable items were partially offset by lower cash payments made under employee compensation plans and payments received in connection with the license and royalty elements of the ContentGuard transaction. Cash payments related to the 1998 restructuring amounted to $153 million and $339 million in first nine months of 2000 and 1999, respectively. The decline reflects the maturity and overall wind-down of the program. Cash payments related to the 2000 restructuring amounted to $69 million. The status of the restructuring reserves is included in Notes 5 and 6 of the "Notes to Consolidated Financial Statements" of this Quarterly Report on Form 10-Q. Financing Businesses Customer financing-related debt declined by $282 million in the first nine months of 2000 and by $1,154 million in the first nine months of 1999. Year-to-date 2000 new business was funded with financing business net income and higher deferred taxes. The 1999 change reflects the impact on our Brazilian finance receivables of the significant first quarter 1999 devaluation of the Brazilian real and the pay-down of debt with the $1,150 million proceeds from the June and September 1999 finance receivable securitizations. For analytical purposes, total equity includes common equity, ESOP preferred stock, mandatorily redeemable preferred securities and minorities' interests. The following table summarizes the components and changes in total equity during the first nine months of 2000 and 1999 (in millions): 2000 1999 Minorities' interests $ 127 $ 124 Mandatorily redeemable preferred Securities 638 638 Preferred stock 669 687 Common equity 4,911 4,857 Total equity as of January 1 $6,345 $6,306 Net income (loss) (265) 1,130 Shareholder dividends (441) (439) Exercise of stock options 26 120 Change in minorities' interests (3) (2) Translation adjustments (292) (1,051) All other, net 102 81 Total equity as of September 30 $5,472 $6,145 Minorities' interests $ 124 $ 122 Mandatorily redeemable preferred Securities 638 638 Preferred stock 659 674 Common equity 4,051 4,711 Total equity as of September 30 $5,472 $6,145 Risk Management Xerox is typical of multinational corporations because it is exposed to market risk from changes in foreign currency exchange rates and interest rates that could affect our results of operations and financial condition. We have entered into certain financial instruments to manage interest rate and foreign currency exposures. These instruments are held solely for hedging purposes and include interest rate swap agreements, forward exchange contracts and foreign currency swap agreements. We do not enter into derivative instrument transactions for trading purposes and employ long-standing policies prescribing that derivative instruments are only to be used to achieve a set of very limited objectives. Considering our current situation, there is no assurance we will be able to continue to execute interest rate and foreign currency swap transactions with counterparties. Currency derivatives are primarily arranged in conjunction with underlying transactions that give rise to foreign currency- denominated payables and receivables, for example, an option to buy foreign currency to settle the importation of goods from foreign suppliers, or a forward exchange contract to fix the dollar value of a foreign currency-denominated loan. With regard to interest rate hedging, virtually all customer- financing assets earn fixed rates of interest. Therefore, within industrialized economies, we "lock in" an interest rate spread by arranging fixed-rate liabilities with similar maturities as the underlying assets and fund the assets with liabilities in the same currency. We refer to the effect of these conservative practices as "match funding" customer financing assets. This practice effectively eliminates the risk of a major decline in interest margins during a period of rising interest rates. Conversely, this practice effectively eliminates the opportunity to materially increase margins when interest rates are declining. Pay fixed-rate and receive variable-rate swaps are often used in place of more expensive fixed-rate debt. Additionally, pay variable-rate and receive fixed-rate swaps are used from time to time to transform longer-term fixed-rate debt into variable-rate obligations. The transactions performed within each of these categories enable more cost-effective management of interest rate exposures. The potential risk attendant to this strategy is the non-performance of the swap counterparty. We address this risk by arranging swaps with a diverse group of strong-credit counterparties, regularly monitoring their credit ratings and determining the replacement cost, if any, of existing transactions. Our currency and interest rate hedging are typically unaffected by changes in market conditions as forward contracts, options and swaps are normally held to maturity consistent with our objective to lock in currency rates and interest rate spreads on the underlying transactions. Supplemental Third Quarter Revenue Discussion: Revenue By Major Product Category 1999 2000 . FY Total Q1 Q2 Q3 Q4 FY $* Q1 Q2 Q3 YTD Total Revenues (1)% 4% 2% (3)% -% $19.2 6% (1)% (1)% 1% B&W Office/SOHO (2) 1 - (4) (1) 8.2 (1) (5) (7) (4) B&W Production (2) 2 1 (8) (2) 5.9 (4) (11) (15) (10) Color 8 10 11 1 7 1.9 64 60 74 66 *Revenues are pre-currency except total dollars. Dollars are in billions. Revenues include major product categories only and exclude some small operations. Black & White Office and Small Office/Home Office (SOHO) revenues include our expanding family of Document Centre digital multi- function products, light-lens copiers under 90 pages per minute, our DocuPrint N series of laser printers and digital copiers sold through indirect sales channels, and facsimile products. Revenues declined 7 percent in the 2000 third quarter from the 1999 third quarter including declines in office copying, indirect channels laser printing and copying and facsimile. Office copying revenue declined as equipment sales declined reflecting lower light-lens copier installations and increasing competitive pressures partially offset by higher Document Centre equipment sales. All other revenues include revenues from service, document outsourcing, rentals, supplies and finance income, and represent the revenue stream that follows equipment placement. These office copying third quarter 2000 revenues are essentially unchanged from the 1999 third quarter as increases in Document Centre have offset light lens declines. Black & White Office and SOHO revenues represented 40 percent of third quarter 2000 revenues compared with 43 percent in the 1999 third quarter. Black & White Production revenues include DocuTech, Production Printing, and light-lens copiers over 90 pages per minute. Revenues declined 15 percent in the 2000 third quarter from the 1999 third quarter reflecting very weak equipment sales and a modest decline in all other revenues. DocuTech and production printing revenues declined in the 2000 third quarter, as equipment sales were very weak due to open sales territories and fewer experienced sales people; unfavorable product mix; increased DocuTech competition resulting in increased pricing pressure, more contested sales and elongated sales cycles; and the beginning of the movement of some printing to electronic substitutes. Production light-lens revenues declined significantly in the 2000 third quarter from the 1999 third quarter as the transition to digital products continued. Post equipment install revenues were also adversely affected by equipment sale revenue declines in earlier quarters. Black & White Production revenues represented 26 percent of third quarter 2000 revenues compared with 31 percent in the 1999 third quarter. Color Copying and Printing revenues grew 74 percent in the 2000 third quarter from the 1999 third quarter including the impact of the CPID acquisition. Excluding CPID, color revenues grew 34 percent reflecting a continued significant acceleration from 1999 and first half 2000 trends. Growth reflects the success of our DocuColor 2060 and DocuColor 2045 Digital Color Presses which began shipments in June, 2000 as well as continued excellent placements of the DocuColor 12 and Document Centre ColorSeries 50, the industry's first color-enabled digital multi-function product, which were introduced in the 1999 second half. Inkjet revenue had excellent growth reflecting initial shipments of our new DocuPrint M series of inkjet printers partially offset by lower pricing, as anticipated. Including the CPID acquisition, color revenues represented 16 percent of third quarter 2000 revenues compared with 9 percent in the 1999 third quarter. Revenue By Type The pre-currency growth rates by type of revenue are as follows: 1999 2000 . Q1 Q2 Q3 Q4 FY Q1 Q2 Q3 YTD Equipment Sales (3)% 2% 5% (8)% (2)% 5% (5)% (9)% (4)% All Other Revenues 1 4 - - 1 6 2 4 4 Total Revenues (1)% 4% 2% (3)% -% 6% (1)% (1) 1% Equipment sales declined 9 percent in the 2000 third quarter including the beneficial impact of the CPID acquisition. Excluding CPID, equipment sales declined 13 percent due to weak equipment sales primarily in North America resulting from open sales territories and lower sales productivity as a result of less experienced sales people following higher sales turnover levels in the early part of this year, persistent customer administration issues, intense competition and pricing pressures. Channels equipment sales, excluding CPID, reflected weak small office/home office monochrome laser printer and copier equipment sales. Inkjet equipment sales had excellent growth reflecting initial shipments of our new DocuPrint M series of inkjet printers partially offset by anticipated lower pricing and unfavorable mix. All other revenues, including revenues from service, document outsourcing, rentals, standalone software, supplies, paper and finance income, represent the revenue stream that follows equipment placement. These revenues are primarily a function of our installed population of equipment, usage levels, pricing and interest rates. All other revenues in the 2000 third quarter grew 4 percent compared with the 1999 third quarter. Excluding CPID, all other revenues grew 1 percent. All other revenues benefited from excellent growth in document outsourcing and strong supplies growth from our growing installed population of inkjet and laser printers and copiers sold through indirect channels. Revenues were adversely impacted by lower service revenues reflecting the recent trend of lower equipment sales and continue to be adversely affected by the page volume impact of distributed printing and pages diverted from copiers to printers. Finance income was lower largely due to the unfavorable flow-through impact of the 1999 finance receivables securitizations and the year over year impact of the $11 million gain from the third quarter 1999 securitization as well as lower equipment sales. Document Outsourcing revenues are split between Equipment Sales and all other revenues. Where document outsourcing contracts include revenue accounted for as equipment sales, this revenue is included in Equipment Sales, and all other document outsourcing revenues, including service, equipment rental, supplies, paper, and labor, are included in all other revenues. Document Outsourcing, excluding equipment sales revenue, grew 22 percent in the 2000 third quarter. Item 3. Quantitative and Qualitative Disclosure about Market Risk The information set forth under the caption "Risk Management" on page 40 of this Quarterly Report on Form 10-Q is hereby incorporated by reference in answer to this Item. PART II - OTHER INFORMATION Item 1. Legal Proceedings The information set forth under Note 13 contained in the "Notes to Consolidated Financial Statements" of this Quarterly Report on Form 10-Q is incorporated by reference in answer to this item. Item 2. Changes in Securities During the quarter ended September 30, 2000, Registrant issued the following securities in transactions which were not registered under the Securities Act of 1933, as amended (the Act): (a) Securities Sold: on July 1, 2000, Registrant issued 4,884 shares of Common stock, par value $1 per share. (b) No underwriters participated. The shares were issued to each of the non-employee Directors of Registrant: B.R. Inman, A.A.Johnson, V.E. Jordan, Jr., Y. Kobayashi, H. Kopper, R.S. Larsen, G.J. Mitchell, N.J. Nicholas, Jr., J.E. Pepper, P. F. Russo, M.R. Seger and T.C.Theobald. (c) The shares were issued at a deemed purchase price of $20.75 per share (aggregate price $101,125), based upon the market value on the date of issuance, in payment of the quarterly Directors' fees pursuant to Registrant's Restricted Stock Plan for Directors. (d) Exemption from registration under the Act was claimed based upon Section 4(2) as a sale by an issuer not involving a public offering. Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 3(a)(1) Restated Certificate of Incorporation of Registrant filed by the Department of State of the State of New York on October 29, 1996. Incorporated by reference to Exhibit 3(a)(1) to Registrant's Quarterly Report on Form 10-Q for the Quarter Ended September 30, 1996. Exhibit 3 (b) By-Laws of Registrant, as amended through May 11, 2000. Incorporated by reference to Exhibit 3 (b)to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2000. Exhibit 4(h) $7,000,000,000 Revolving Credit Agreement dated October 22, 1997 among Registrant, Xerox Credit Corporation and certain Overseas Borrowers, as Borrowers, and Various Lenders and Morgan Guaranty Trust Company of New York, The Chase Manhattan Bank, Citibank, N.A. and The First National Bank of Chicago, as Agents" Exhibit 4(i) Instruments with respect to long-term debt where the total amount of securities authorized thereunder does not exceed ten percent of the total assets of the Registrant and its subsidiaries on a consolidated basis have not been filed. The Registrant agrees to furnish to the Commission a copy of each such instrument upon request. Exhibit 11 Computation of Net Income (Loss) per Common Share. Exhibit 12 Computation of Ratio of Earnings to Fixed Charges. Exhibit 27 Financial Data Schedule (in electronic form only). (b) Current reports on Form 8-K dated July 14, 2000 and August 30, 2000 reporting Item 5 "Other Events" were filed during the quarter for which this Quarterly Report is filed. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. XEROX CORPORATION (Registrant) /s/ Gregory B. Tayler _____________________________ Date: November 14, 2000 By Gregory B. Tayler Vice President and Controller (Principal Accounting Officer)