Xerox Holdings Corporation (XRX) Q4 2005 Earnings Report, Transcript and Summary

During this meeting, Ms. Mulcahy and Mr. Zimmerman will make comments that constitute forward-looking statements. This presentation contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements reflect management's current beliefs and expectations, and are subject to a number of factors that may cause actual results to differ materially. Information concerning these factors is included in the company's third-quarter 2005 Form 10-Q filed with the SEC. The Company assumes no obligation to update any forward-looking statements as a result of new information or future events or developments. At this time, I would like to turn the meeting over to Ms. Mulcahy. Ms. Mulcahy, you may begin. Anne Mulcahy, Chairman & Chief Executive Officer: Thank you, Rachel. And thanks everyone for joining us today. If you'll turn to slide 4, we'll provide you a summary of our Q4 results. So, EPS was $0.27 per share meeting our earnings expectations with operational improvements and growth in key segments of our business, especially color. As expected, the $0.27 includes $0.05 of restructuring. Net income for the quarter was up 18% from Q4 2004. Another proof point of our commitment to expand the earnings and deliver value for our shareholders. Currency did have an impact on revenue in the quarter. Total revenue was down 2%, but up 1% on a constant currency basis. Equipment sales were lower than expected. During the quarter, we saw more significant shift in product mix, with stronger sales of lower-priced systems. At the same time, install activity accelerated, which fuels future postsale revenue. In fact, we continue to see steady improvement in postsale, with postsale up 1% in the second half to constant currency. So we're confident that the short-term impact on equipment sales will not limit our ability to deliver long-term gains…

Hi. Good morning. Can you just -- I'll hit the share repurchase question first, because it was a lot faster than we'd anticipated. How quickly do you think you'll run through the incremental 500, and I guess you've got about 70 million left? So 570 million you have right now.

Good morning, Shannon. I would say that, we've put the window at 6 to 12 months, because we think that it won't be quite as -- at quite the pace of the last share repurchase announcement. But still on a timely basis. Larry?

Yes. What we're trying to do is align our share repurchase along with our cash flow. So as cash flow continues to do really well, we will accelerate, and do -- keep the pace with that.

Okay. And that's a good lead into my next question, which is, Larry, can you give us any puts or takes we should keep in mind in first quarter for cash flow, inventory, seeing seasonality, et cetera, we should think about as we forecast cash flow for first quarter?

Well, normally cash flow in the first quarter is not a particularly high number. You know, we kind of built as we go through the year, and I don't think we're going to see significant inventory or AR improvements in the first quarter. So, I don't think -- I think it's a low mark of the full year cash flow.

Okay. And then the final question is with regard to your pension contribution. I know you don't know exactly, but just wanted to confirm. Your comments were basically, you don't see a change from about the 300 -- well you did 388 last year, but around 350 million maybe for '06?

Yes. With just putting a qualifier that there's legislation. I don't think I have to say more than that. But there's legislation going on. I'm not confident I know which way it will end up. If you look at what's been worked on so far, you would not see a dramatic change in our contribution, one way or the other.

Okay. And actually I have one more question, and then I promise to give up. The postsale revenue, I think it will sort of probably bounce along, in sort of flat to up a little bit, just like it bounced along flat to down a little bit for a few quarters. Is there anything that is out there that might make it kick-start a little bit faster on the upside?

Yes. I might -- obviously there's a lot of dynamics that go into postsale. The most significant negative impact is the pace of analog reduction, and we've seen that be pretty constant. So I'd say the real catalyst for postsale growth will be color growth and services contract impacts. As the services business builds momentum, clearly it will have an impact on postsale growth, a positive impact.

Okay. Thank you.

Thank you.

Thank you ma’am. Our next question comes from the line of Ben Reitzes with UBS.

Yes, hi. Good morning. Thanks.

Hi, Ben.

Hi. Anne, what are you thinking now for the revenue growth for 2006 after coming in a little short this quarter?

Well, I think that -- and I said that we're confident that 3% is still a very reasonable expectation at constant currency. I think what we have seen is, if you look at Q4, we clearly drove very strong activity. We were aggressive in the marketplace, which we wanted to do. Placements for us is obviously the engine of the future. So we wanted to gain share, we wanted to drive big activity, particularly with some of the new products. But we did, through the impact from price pressures and mix pressures in the quarter. The other thing was is that the impact of operating leases was a little bit larger than we probably anticipated, at a point and a half of impact on the equipment sale line. But, that's our strategy. It's money in the bank. Annuity contracts are absolutely a great business for us, good margins, and a really healthy way for us to drive the annuity business. So all in all, the drivers were very positive. Although when you added it all up on the mix and the price side, equipment sale was a little bit lower than anticipated. But we got a good trend going in postsale, we've got a good trend going in DMO. The color growth has stayed very robust. And services momentum is clearly building. So all in all, we're quite confident about the commitment we've made on 3%. It may be a little bit less equipment sale, and a little bit more postsale, in terms of delivering that 3%. But we are quite confident about the flow-through from the activity and the performance of Q4.

Just to put it like in a different light. You've said in your presentation that color has a clear benefit on the top and bottom line. And obviously, you're delivering in color. But something -- we're not obviously seeing the leverage on the top line or the bottom line. I mean obviously a lower tax rate helped quite a bit in the quarter. So we're not -- I don't -- what is the big offset? Like, what is the -- is it Nuvera? Is it the offset of the DocuTechs? Or is there -- how would you kind of -- if something was holding back the leverage in the quarter, and what we might see turn going forward, am I looking at it in the right way? Like, is color going to eventually offset the weakness in the high-end black and white? Or how would you kind of couch the leverage we're going to see in the future in that regard?

So Ben I would say color's already offsetting any weakness in the postsale production part of the business. I think the growth opportunity really comes from two things. one is the Light Lens impact declining, and then the scaling of Nuvera, which clearly will be a strong impact on both top and bottom line. And we've been clear that we're thrilled with our light production results. We expect those to continue. But the Heartland production publishing business will be helped significantly as we bring on the enhanced features of Nuvera, which are happening in the first half of the year. The other dynamic that happens is on the color side. We're very pleased with color activity growth, and color production activity growth in pages. But it's still what we would call is not a fully mature business, in terms of critical amount of installs, which drive better economics and efficiencies. So the more color that goes in, the more profitable it becomes. And therefore, a much richer, if you will, impact overall. So there's an investment strategy here on color that we're ramping up and we'll get the full benefit on down the road. So I think those dynamics are the ones that you have to watch, and that is the continued pace and growth of color, and clearly the return of production publishing. By the way, we had a very strong, decent DocuTech performance in Q4. So even in the absence of Nuvera, we had flat performance on production publishing, which was an improving trend. So I think it's going in the right direction, but those would be the elements I'd point to.

Okay. Thanks a lot, Anne.

Thank you, Ben.

Thank you. Our next question comes from the line of Matt Troy with Citigroup.

Good morning.

Hi, Matt.

I had a question on DMO. Specifically, you referenced that you were pleased with the momentum there, and certainly that was part of the story in the back half of '05.

Yes.

Certain leverage potential, but I'm just looking at the revenue numbers. They've improved sequentially through the year.

Yes.

Well, operating income was up year-over-year in DMO.

I'm talking sequentially.

Sequentially. And what I would say, is that a lot of the revenue growth in developing markets comes from, particularly, the indirect distribution part of the business, which is low-end printers, low-end multifunction. So the strength of that business does put pressure overall on the operating margin of DMO. But that's part of our model for DMO, as well, in the sense that our expectation is they're going to be an engine of growth. And clearly that's right now being driven by Eastern Europe and overall, it's going to be a win. If you look year-over-year at operating margins in DMO, it improved 2 full points. And we expect significant improvement year-over-year from 2005 to 2006 as this model gets stronger. So, the quarters can have some anomalies in it. But overall, you should see operating margin improvement in 2006 out of DMO.

Is it fair to say the majority of that opportunity is coming from the Latin American operation, still?

Well, I think the opportunity for improvement is more significant. We've got a -- right now Eastern Europe, Eurasia, is doing fabulously and we expect that to continue. The -- yes. The opportunity for improvement is clearly going to come from Latin American operations.

Okay. And second question, echoing on some of the earlier inquiries, on the postsale story. I mean, you guys have been talking about that for a couple quarters now. The numbers, sequentially, are improved. But it's flat in the fourth quarter, not gangbusters. I'm wondering if you look at by segment, the performance of the install base, if you could maybe just walk us through. Is that hitting your expectations by segment? And is there opportunity to potentially lower cost per page to fuel more activity through the install base?

row:

Right.

Office digital grew at 8%, production digital grew at 9%, the color MIF grew at 31%, driving total digital placements in the field growing at 8%. So, it's kind of a science, and the fact is, is that with strong activity rates, good retention rates, which drives higher populations in the field, the flow-through is absolutely going to happen. And that's why when it comes to postsale, we can look at it with a high degree of confidence as to how this model works. And all the indications with regard to pages, populations, and row activity are very, very positive.

And just on that last point that I asked. Is there a crossover point where the install base hit sufficient density where you can lower your price per page, and maybe stoke a little bit more activity, or we're not close to that yet?

Well, we actually did a little bit of that in Q4, I would say. And that's why perhaps the equipment revenue was a little bit disappointing in terms of even what we expected. But we did it in 2 areas. We did it with our new black and white introductions in segments 3 to 5 because we wanted to get out there and really gain share and be competitive on the black and white business. And the second area is we continue to be very aggressive in color printing, particularly solid ink, which certainly is not attractive on the equipment sales price side, but is extraordinarily attractive downstream. So some of the equipment sale performance in Q4 was an attempt to invest in driving even more significant activity that will flow through to postsale in 2006.

All right. Thanks for the detail, Anne.

Okay. Thanks, Matt.

Thank you sir. Our next question comes from the line of Caroline Sabbagha with Lehman Brothers.

Thanks very much. Anne, just going back to equipment sales on the -- in the quarter. You said it disappointed. Clearly, the low end did well, but something in the high end must have disappointed you. Which areas would you point to on that front? And in looking at '06, you suggested that equipment sales may not be what you expected it to be in November. I think at that time you gave expectations of 2 to 6% on constant currency.

Yes.

Where would you -- what do you think that range looks like, and would you still expect equipment sales on -- given what you saw on the fourth quarter, to be up next year on a constant currency? And then 1 more follow-up after that, please.

Okay. So let's just talk about some of the dynamics on equipment sale and, you -- clearly on a constant currency basis, actually production did quite well and was growing on a constant currency basis. I think if there was any disappointment there, it was one that we expected, which is we don't have the full impact yet of Nuvera. But light production was gang busters, thrilled with the 240/250, and thrilled with iGen, in terms of performance, and DocuColor continued to perform strong. So all in all, I don't think we would say that production was a disappointment. In office, I think we saw a couple of things that did suppress what we might have expected in equipment sales. One is I think big-time price pressures in office color printing, some of which we drove with solid ink. We kind of lapped ourselves on the OEM business in Q4, so that it was not a source of growth, and actually was no -- didn't provide any growth for us in Q4. Obviously that comes in at very low margin, so it's not a big deal as it relates to profit. And I think that our aggressive posturing in the marketplace in segments 3 to 5 did dampen if you will, the revenue story coming out of black and white office digital. So I would look at it and say office was really impacted more than production on the equipment sale side. The other thing was that point and a half I talked about from operating leases, came from a strength in our office services deals, which clearly had the impact on the office business. So I would look at it and say, aggressive pricing in office, by the way, which we drove, and also the office services impact in office as well as the fact that OEM -- our OEM business provided no growth really, year-over-year, in terms of the growth it had provided in previous quarters. And in terms of our expectations, I think we're still within the range on equipment sales, Carol. We're not going to be out of the range by any means. I think we just are at the lower end of the range, versus the higher end of the range on equipment sale. And I think that on the postsale side, we'll do better than we anticipated, still feeling confident about the 3% growth in constant currency.

Okay. Perfect. And then the follow-up question is, there seems to be this mix shift downwards across the board and it seems it's been happening relatively all year.

Right.

Would you say that that trading down dynamic is more of an industry dynamic, or something more specific to Xerox and the product introductions you've had? And if it's an industry dynamic, what do you think the factors are, and does it anniversary out at some point in time?

Well, I think the -- we would say that we're calling it an industry dynamic, and we're going with it, and we're going to perform really going with the fact that there is a trend downwards. We do think it's driven in the office by segments 1 and 2. There's no question that there's a movement to a more distributed approach that has put pressure on the higher segments of the office. And in production, the light production strength is clearly there to stay. We intend to capitalize on it, and certainly grow as fast or faster than the market exhibited by our repositioning on the number 1 market share across the world in light production. I think the flip side of that is really the color story, which obviously is providing probably more growth than we would have anticipated, but on a much smaller percentage of the base. And therefore, we do believe that going forward that we can deliver growth by the strength of activity, and the leveraging of the color business. But we think that there's an industry trend here that we're going to work with and clearly optimize going forward.

Great. Thank you very much.

Thanks, Carol.

Thank you ma’am. Our next question comes from the line of Jack Kelly with Goldman Sachs.

Good morning.

Good morning, Jack.

Anne, could you discuss the 13% decline in operating profits in the production segment? In the press release you -- one of the comments that was made was there was a mix shift, which has been discussed already, which negatively impacted margins. But that wouldn't necessarily explain an absolute decline. It could, but might not. So if you could just give us a little color on that.

Okay. So there was a decline in the operating margin for production and I would actually point to 2 specific areas that are responsible. 1 is a lot more color coming in. We talked about kind of the maturity curve on color, so you have a lot more color coming in at lower margins. All of which improve in 2006. So it's not a constant impact. And the other piece is the very high performance in light production, offset by not having the strength of the full Nuvera compliment in place. So those two clearly did have an impact overall on the operating margin of production. I would point out, Jack, that was almost entirely offset by strength in office. And that the total operating margin, if you look at segment profit, was up 1.7 points for the Company. We were at 10.5% versus 8.8 the year before. So the operating segment profit, although down in production, was more than offset by the rest of the Company which really shows the strength of the core business flow-through there. So we believe that, and we're anticipating that we're going to improve the production margin going forward, and we're going to maintain the good trends we have in DMO and office, as it relates to operating segment profit.

So the swing in profitability in margins in production '06 over '05, would be replacing some of that high-end business, which you lost in '05. Is that -- because the color probably will continue to be -- whatever impact it had in '05, it probably would have a similar impact in '06.

Well, I think actually color margins are going to get better, just because of the critical mass of installs. When you look at the base of DocuColor installs we have and (inaudible) installs out right now, the economics are -- there is an improving, certainly within the year in 2005 and they're just going to get better. So color will have a positive impact. But it's not so much the loss of production, it's the fact that we've got the strength of light production against the absence of new Nuvera placements. And Nuvera really, with its full enhanced finishing, is designed to really do the -- attack the offset market, book publishing market, the one-on-one market. So it's the absence of that, more than it is the actual losses in the production side of the house.

Okay. And then in terms of the '06 forecasts where you kind of shifted to the higher end. On the sales side, revenue side doesn't sound like things have changed, maybe there's a little mix change between postsale and equipment.

Yes.

Does the upward shift or bias just reflect the lower tax rate, Anne? Going from I guess 36 to 37, which you guys had built in to the 34?

Yes. I think certainly going from 36 to 34 does represent a positive against expectations. I would note that that's still year-over-year, 34% actually provides no leverage in the sense that our tax rate in 2005 was lower than 34. So on a year-over-year basis, actually there's not leverage. But against original expectations, there is. So I think our comment on really guidance at the high end of our range certainly indicates that we have some - not a lot - of positive leverage from tax, and that we are confident about our operational expectations for 2006. And that really comes from the strength of activity and share and color that we've seen in Q4.

Okay. And just finally. The 1.5% drag you mentioned from…

Yes.

The service contracts. I know it's tough, because you don't know the mix of business. But how do you see that trending throughout '06? Would that be less of a drag or more of a drag?

Well, I think it might be more of a drag, in the sense that we expect our services activity to be accelerating and to be gaining momentum. But it's a positive trade-off, Jack.

Right.

Because it's hitting the postsale line which obviously is a higher margin line. So services is part of the strategy to really take advantage of the engine of growth of postsales. So I would expect that if we're as successful as we could be in services, and we are quite confident based upon the pipeline, that you might see even a little bit more of an impact in 2006, as it relates to the equipment sale line. But it's all money in the bank in the postsale line.

Good deal. All right. Thank you.

Thanks, Jack.

Thank you sir. Our next question comes from the line of Bill Shope with JP Morgan.

Okay, great. Thanks. I wanted to dig into postsales a bit more. Obviously, you guys are doing extremely well in color. But could you help me to understand when color starts to actually become a much larger driver of the actual postsales growth revenue? Basically, color's now more than 30% of the total. I would have thought by now your postsales growth overall would have been much higher as a result. Is this more about getting color pages up as a percentage of total, or am I looking at it the wrong way?

Yes, I think when you look at the impact that color's had, I think we talked about the fact that we've had a 5 point -- in terms of the amount of -- the percentage of revenue that color represents, it's a 5 point increase year-over-year, which is pretty significant. But there's no question it's all about pages, okay. You have to look at pages. We talked about it representing 8% of the pages today. And that it's coming up fairly consistently, and the color pages are growing overall at 32% from Q4. And that's been pretty consistent Q3. I think it was 33%, and it's been consistent in office and production. So clearly, it will be a page story that will really leverage the total portfolio for the Company. The revenue already impact-- already shows the impact of the 5 X ratio, if you will, of revenue per page. So it is driving those pages up as quickly as possible that will really cross over in terms of increasing the leverage that color has. So that's what I would use as the single-most important metric in terms of page growth. And that's why we're -- I mean we're thrilled with our activity in Q4. But when you look at where the activity's coming from, I mean just some of the statistics in terms of iGen. We had a 30% activity increase year-over-year in iGen placements, averaging 400,000 pages per month. We have over 100 of those iGens doing a million pages in a single month. So -- and then you look at the thousands of DocuColor installs out there. It's -- I mean from a page leverage story, we are so far ahead of the game in terms of other competitors, that that's annuity. It's pages under contract. Think about it like that. And that's why we're pretty bullish about the fact that color's going to take on greater significance for Xerox than it will for other companies that don't have the kind of page-producing engines out in the field that we do.

Okay. Great. And then a quick question on the OEM business. As you mature through the ramp of the -- that business, are you beginning to see an uptick in the related supply stream? In other words, expect the businesses depressing gross margins in the early stages, are we now approaching a positive inflection point now that we're (inaudible) the initial launches in that relationship?

Yes. I think, as I said, we saw kind of a flat equipment sale impact as we kind of cycled quarter-over-quarter the equipment sale placement side of it. But the profit flow through has been improving. We're pleased with that business. It's been a nice contributor, but this is where -- as nice as the profit increase will be from that, it pales in comparison to the production color business, where the vast majority of pages are produced in the marketplace. So when we look at either our color low-end printing business, including our OEM business, it actually represents a fairly small part of our portfolio, versus some of our competitors. And we think that bodes well for the future, actually.

Okay. Great. Thank you.

Thank you. I think we have time for one last question.

Yes ma’am our final question now will come from the line of Jay Vleeschhouwer, Merrill Lynch.

Thanks. Good morning.

Good morning, Jay.

Before I ask about the equipment and mix issue again, I just want to get your overall view of the end markets, and the health of those. Our economist, anyway, is anticipating some slowdown in the overall U.S. economy, offset, however, by improvements elsewhere, particularly in Japan. And I'm wondering what your thinking is globally. And similarly, if you could comment, as you have before on other calls, on the graphic arts markets, commercial markets, and so on. Then an equipment question.

Okay. So just in terms of global economy, I mean I think we saw some modest improvement, quite frankly, in the U.S. as it relates to our business in Q4. So we actually have seen some improvement there. A lot of good services, contracts and pipeline, as well as good activity. A little bit slower in Europe, but not material in terms of our views. Obviously, incredible health in Eurasia, Eastern Europe, and our Russian markets. We're very, very pleased. Improvement in Latin America. And we do expect to see some positive trends in Japan, and we're quite confident that we'll see good improvement in equity income, certainly in line with the kind of operational improvements you'll see at XC as well. So some positive flow-through on the equity income side from Fuji Xerox. So I'd kind of say nothing dramatic in terms of major changes. A little bit more strength in North America, which is good because it's the biggest operation we have. And graphic arts, very strong, very pleased with what's happening in graphic arts. The big graphic arts customers clearly are taking advantage of digital printing. For us to have 100 customers out there with more than 1 iGen3, I think is a fairly dramatic improvement versus the first half of the year. So pretty pleased overall with the graphic arts environment.

All right. And then the equipment question is -- came up earlier about whether this was an industry dynamic or not. When you look at the data over the course of 2005, there did seem to be some reversion to a higher proportion of higher-speed machines, both copier and printer. If you want to demarcate it between the above 30 and below 30. Over the course of the year, the percentage of units going out is above 30 PPM, for example, did seem to grow. And on the other hand, you're saying that on the low end grew proportionately. So are you just using price more to capture that low-end business where you've typically been not as much exposed as at the high end?

Yes. I mean I think I'll separate it out into black and white and color, Jay, and say in the black and white market, we clearly used price. I should say that we did it intentionally on the segments 3 to 5 because we have new technology with -- where we cannot deteriorate profitability by using better pricing in the 3 to 5 segment. So we were aggressive, and therefore I think that probably was more about us, than it was about anyone else. Segments 1 and 2 are, as you know, very, very competitive segments and clearly we see a continuing competitive thrust in segments 1 and 2. On color, I would say that we are very strong, at the high end of the color office segment, and that's really where we saw just extraordinary activity. I think it was 58% growth in terms of color multifunction, and that's the new 40/50 driving that, Jay, and that is at the high end of the office color segment. So if you think about the 11 to 40 segment, our performance will clearly be leveraged towards the high end of that segment. And I'd say the only other dynamic is -- and it's more about us, than the market, is the -- obviously the production publishing side. I mean, with our share in production publishing, we've sort of defined that market. And therefore without having the full complement of new technology out there, the growth has been slower than it should have been, based upon the Nuvera piece of it. On the other hand, light production's going gangbusters and we're growing faster than the market. So I would say overall, black and white it's industry shift downward and price pressures to really gain share. And on color, I think it's robust, and I think it is more higher end growth than it is lower end growth.

Okay. Got it. Lastly, you said that your total postsale constant currency went from minus 5 in '04 to minus 1 in '05.

Yes.

Could you foresee another, perhaps 4 point positive swing into low double -- low single-digit territory in '06?

Larry just whispered God willing, but I think I would perhaps dampen that expectation and say that the Light Lens base is a lot lower than it was certainly year-over-year, so you will not get the same dramatic turn on the Light Lens side. On the other side you get more color leverage. I think we'll see certainly a nice swing in postsale, but not quite the 4 point swing that we saw year-over-year from 2004 to 2005.

Okay. Thank you very much.

Okay. Thank you, Jay. And let me just add my thanks to all of you. We appreciate your interest, and thank you for your time and participation. Have a great day.

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