Annual Report 2007 - Financials

Gross Margin

Gross margins by revenue classification were as follows:


	Year Ended December 31,
(in millions)	2007		2006		2005
Total Gross margin	40.3	%	40.6	%	41.2	%
Sales	35.9	%	35.7	%	36.6	%
Service, outsourcing and rentals	42.7	%	43.0	%	43.3	%
Finance income	61.6	%	63.7	%	62.7	%

2007 Total Gross margin was down slightly as compared to 2006 as cost improvements were offset by price and product mix.

Sales gross margin increased 0.2-percentage points primarily as cost improvements and other variances more than offset the 2.0-percentage point impact of price declines.
Service, outsourcing and rentals margin decreased 0.3-percentage points as cost improvements and other variances did not fully offset price declines and unfavorable product mix of approximately 2.0-percentage points.
Financing income margin declined 2.1-percentage points reflecting additional interest expense due to higher interest rates. Equipment financing interest is determined based on an estimated cost of funds, applied against an estimated level of debt required to fund our net finance receivables on a 7 to 1 debt to equity leverage ratio (refer to Note 11 – Debt in the Consolidated Financial Statements for further information).

2006 Total Gross margin decreased by 0.6-percentage points from 2005 due to product mix. Price declines of 1.4-percentage points were offset by productivity improvements and other variances of 1.4-percentage points.

Sales gross margin decreased 0.9-percentage points from 2005 as price declines of 2.1-percentage points exceeded the combined impacts of productivity improvements, product mix and other variances of 1.2-percentage points.
Service, outsourcing and rentals margin decreased 0.3-percentage points from 2005 as product mix decline of 1.3-percentage points exceeded the impact of productivity improvements, price and other variances of 1.0-percentage points.
Financing income margin increased 1.0-percentage points due to changes in interest costs specific to equipment financing.

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


(in millions)	Year Ended December 31,									Change
	2007			2006			2005			2007			2006
Total R,D&E expenses	$	912		$	922		$	943		$	10		$	(21	)
R,D&E % Revenue		5.3	%		5.8	%		6.0	%		(0.5	)pts		(0.2	)pts

2007 R,D&E of $912 million decreased $10 million from 2006. We expect our 2008 R,D&E spending to approximate 5% to 5.5% of total revenue.

R&D of $764 million increased $3 million from 2006. We invest in technological development, particularly in color, and believe our R&D spending is sufficient to remain technologically competitive. Our R&D is strategically coordinated with that of Fuji Xerox, which invested $672 million and $660 million in R&D in 2007 and 2006, respectively.
Sustaining engineering costs of $148 million were $13 lower than 2006 due primarily to lower spending related to environmental compliance activities and maturing product platforms in the Production segment.
R,D&E as a percentage of revenue declined 0.5-percentage points as we leveraged our current R,D&E investments to support GIS operations.

2006 R,D&E of $922 million decreased $21 million from 2005 reflecting lower environmental compliance spending.

R&D of $761 million increased $6 million from 2005 reflecting higher expenditures in the Production and Office segments primarily related to expected 2007 product launches.
Sustaining engineering costs of $161 million decreased $27 million from 2005, reflecting lower spending related to environmental compliance activities and maturing product platforms.

Selling, Administrative and General Expenses (“SAG”)


	Year Ended December 31,									Amount Change
	2007			2006			2005			2007			2006
Total SAG expenses	$	4,312		$	4,008		$	4,110		$	304		$	(102	)
SAG as a % of revenue		25.0	%		25.2	%		26.2	%		(0.2	)pts		(1.0	)pts

2007 SAG expenses of $4,312 million were higher than 2006, including a $141 million negative impact from currency. The SAG expense increase was the result of the following:

$93 million increase in selling expenses primarily reflecting the negative impact from currency and the inclusion of GIS. This increase was partially offset by lower costs reflecting the benefits from the 2006 restructuring programs intended to realign our sales infrastructure.
$164 million increase in general and administrative (“G&A”) expenses primarily from the inclusion of GIS, unfavorable currency and information technology investments.
$47 million increase in bad debt expense primarily as a result of an increase in reserves for several customers in Europe as well as a 2006 reduction in expense due to adjustments to the reserves to reflect improvement in write-offs and aging.

2006 SAG expenses of $4,008 million decreased from 2005 as a result of the following:

$58 million reduction in selling expenses, including lower marketing spending and headcount reductions.
$59 million reduction in G&A expenses as a result of continued expense management initiatives, including benefits from restructuring.
The above reductions were partially offset by a $15 million increase in bad debt expense.

Bad debt expense included in SAG was $134 million, $87 million and $72 million in 2007, 2006 and 2005, respectively. Both 2005 and, to a lesser extent, 2006 reflect the benefits associated with recoveries and adjustments to the reserves as the result of improvements in write-offs and aging. This favorable trend in write-offs, receivables aging and collections continues to be reflected in our current year bad debt expense. Bad debt expense as a percent of total revenue was 0.8%, 0.5% and 0.5% for 2007, 2006 and 2005, respectively. At December 31, 2007, bad debt reserves, as a percentage of receivables, were comparable to year end 2006.

Restructuring and Asset Impairment Charges

For the three years ended December 31, 2007, 2006 and 2005 we recorded restructuring and asset impairment (credits)/charges of $(6) million, $385 million and $366 million, respectively. Restructuring activity was minimal in 2007 and the related credit of $6 million primarily reflects changes in estimates for prior years’ severance costs. 2006 net charges of $318 million related to headcount reductions of approximately 3,400 employees in North America and Europe. Lease termination and asset impairment net charges of $67 million primarily reflected the relocation of certain manufacturing operations and the exit from certain leased and owned facilities. 2005 net charges of $350 million related to the elimination of 3,900 employees worldwide and the remaining $16 million of net charges related to asset impairments and lease cancellations. The remaining restructuring reserve balance as of December 31, 2007, for all programs was $109 million. Refer to Note 9 – Restructuring and Asset Impairment Charges in the Consolidated Financial Statements for further information regarding our restructuring programs.

Worldwide Employment

Worldwide employment of 57,400 as of December 31, 2007 increased approximately 3,700 from December 31, 2006, primarily reflecting the addition of GIS personnel and the hiring of former contract employees in certain Latin American subsidiaries, partially offset by reductions from the 2006 restructuring programs. Worldwide employment was approximately 53,700 and 55,200 at December 31, 2006 and 2005, respectively.

Other Expenses, Net

Other expenses, net for the three years ended December 31, 2007 consisted of the following:


	Year Ended December 31,
(in millions)	2007			2006			2005
Non-financing interest expense	$	263		$	239		$	231
Interest income		(55	)		(69	)		(138	)
Gain on sales of businesses and assets		(7	)		(44	)		(97	)
Currency losses, net		8			39			5
Amortization of intangible assets		42			41			38
Legal matters		(6	)		89			115
Minorities’ interests in earnings of subsidiaries		30			22			15
Loss on extinguishment of debt		–			15			–
All other expenses, net		20			4			55
Total Other expenses, net	$	295		$	336		$	224

Non-financing interest expense: In 2007 non-financing interest expense increased primarily due to higher average debt balances as well as higher rates. In 2006 non-financing interest expense increased due to higher interest rates partially offset by lower average debt balances.

Interest income: Interest income is derived primarily from our invested cash and cash equivalent balances. The decline in interest income in 2007 was primarily due to lower average cash balances partially offset by higher rates. The decline in 2006 was primarily because 2005 included $57 million of interest income associated with the 2005 settlement of the 1996-1998 IRS audit as well as lower average cash balances partially offset by higher rates of return.

Gain on sales of businesses and assets: 2006 gain on sales of businesses and assets primarily consisted of the following:

$15 million on the sale of our Corporate headquarters.
$11 million on the sale of a manufacturing facility.
$10 million receipt from escrow of additional proceeds related to our 2005 sale of Integic.

In 2005, gain on sales of businesses and assets primarily consist of the $93 million gain on the sale of Integic.

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

In 2007, 2006 and 2005 currency losses totaled $8 million, $39 million and $5 million, respectively. The 2006 increase in currency losses primarily reflected the mark-to-market of derivative contracts which are economically hedging anticipated foreign currency denominated payments. The mark-to-market losses were primarily due to the strengthening of the Euro against other currencies, in particular the Canadian Dollar, U.S. Dollar and Japanese Yen, as compared to the weakening Euro in 2005.

Amortization of intangible assets: 2007 amortization of intangible assets expense of $42 million reflects amortization expense of $16 million associated with intangible assets acquired as part of our acquisition of GIS, partially offset by reduced amortization from prior years due to the full amortization of certain intangible assets from previous acquisitions.

Legal matters: In 2006 legal matters expenses consisted of the following:

$68 million for probable losses on Brazilian labor-related contingencies – see Note 16 – Contingencies in the Consolidated Financial Statements for additional details.
$33 million associated with probable losses from various legal matters partially offset by $12 million of proceeds from the Palm litigation matter. The $11 million remaining proceeds from the Palm litigation is associated with a license and recorded in sales as licensing revenue.

In 2005, legal matters expenses consisted of the following:

$102 million, including $13 million for interest expense, related to the MPI arbitration panel ruling.
$13 million related to all other legal matters, primarily reflecting charges for probable losses on cases that had not yet been resolved.

Refer to Note 16 – Contingencies in the Consolidated Financial Statements for additional information regarding litigation against the Company.

Loss on extinguishment of debt: 2006 loss of $15 million includes the $13 million write-off of unamortized deferred debt issuance costs associated with the termination of a previous credit facility and a $2 million loss associated with the repayment of the mortgage in connection with the sale of our Corporate headquarters in Stamford, Connecticut.

All other expenses, net: In 2006 all other expenses, net decreased due to the absence of the following 2005 items:

$15 million for property damage and impaired receivables losses sustained from Hurricane Katrina.
$26 million charge related to the European Union Waste Directive.

Income Taxes


	Year Ended December 31,
(in millions)	2007			2006			2005
Pre-tax income	$	1,438		$	808		$	830
Income tax expenses (benefits)		400			(288	)		(5	)
Effective tax rate		27.8	%		(35.6	)%		(0.6	)%

The 2007 effective tax rate of 27.8% was lower than the U.S. statutory rate primarily reflecting tax benefits from the geographical mix of income and the related effective tax rates in those jurisdictions and the utilization of foreign tax credits as well as the resolution of other tax matters. These benefits were partially offset by changes in tax law.

The 2006 effective tax rate of (35.6%) was lower than the U.S. statutory rate primarily due to:

Tax benefits of $518 million from the resolution of tax issues associated with the 1999-2003 IRS audits and other domestic and foreign tax audits.
Tax benefits of $19 million as a result of tax law changes and tax treaty changes.
$11 million from the reversal of a valuation allowance on deferred tax assets associated with foreign net operating loss carryforwards.
The geographical mix of income and related effective tax rates in those jurisdictions.
These benefits were partially offset by losses in certain jurisdictions where we are not providing tax benefits and continue to maintain deferred tax valuation allowances.

The 2005 effective tax rate of (0.6)% was lower than the U.S. statutory tax rate primarily due to:

Tax benefits of $253 million, associated with the finalization of the 1996-1998 IRS audit.
Tax benefits of $42 million primarily from the realization of foreign tax credits offset by the geographical mix of income and the related tax rates in those jurisdictions.
Tax benefits of $31 million from the reversal of a valuation allowance on deferred tax assets associated with foreign net operating loss carryforwards. This reversal followed a re-evaluation of their future realization resulting from a refinancing of a foreign operation.
These impacts were partially offset by losses in certain jurisdictions where we are not providing tax benefits and continue to maintain deferred tax valuation allowances.

Our effective tax rate will change based on nonrecurring events as well as recurring factors including the geographical mix of income before taxes and the related tax rates in those jurisdictions and available foreign tax credits. In addition, our effective tax rate will change based on discrete or other nonrecurring events (such as audit settlements) that may not be predictable. We anticipate that our effective tax rate for 2008 will approximate 30%, excluding the effect of any discrete items.

Equity in Net Income of Unconsolidated Affiliates

2007 equity in net income of unconsolidated affiliates of $97 million is principally related to our 25% share of Fuji Xerox (“FX”) income. The $17 million reduction from 2006 is primarily due to $30 million in our after-tax share of FX restructuring charges.

Income from Discontinued Operations

As disclosed in Note 15 – Income and Other Taxes in the Consolidated Financial Statements, in June 2005 the 1996-1998 Internal Revenue Service (“IRS”) audit was finalized. Of the total tax benefits realized, $53 million was attributed to our discontinued operations.

Recent Accounting Pronouncements

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