Xerox: New Lease on Life

The copy machine maker has survived a SEC investigation and billion-dollar restatements, and attention is finally shifting from its problems to its...
Craig SchneiderOctober 24, 2003

Revenue recognition has long been a hot topic for the Securities and Exchange Commission — all the more reason to learn from Xerox Corp.’s protracted affair with the agency.

The SEC began its investigation into Xerox in June 2000; in April 2002 it charged the company with fraud. The commission alleged that Xerox management accelerated the revenue recognition of leasing equipment over a four-year period by more than $3 billion, and inflated pre-tax earnings by $1.5 billion, to meet or exceed Wall Street expectations and hide its true operating performance.

Xerox settled the charges, agreeing to a $10 million fine — at the time the largest civil penalty against a public company for financial reporting violations — as well as a restatement of its financials from 1997 through 2000 and an adjustment of previously announced 2001 results. The company, in classic SEC form, did not have to admit or deny any wrongdoing in the settlement.

After the settlement, Xerox chairman and CEO Anne Mulcahy, who was named president a month before the SEC launched its investigation and stepped up to the helm in August 2001, talked of moving forward with her turnaround initiatives for improving the health of the business. “Xerox is best served by putting these issues with the SEC behind us,” she said in a statement at the time.

Revenue: Back to the Future

It took some time, however, to emerge from beneath the accounting scandal. In June 2002, Xerox restated $6.4 billion of equipment sales from 1997 through 2001 — twice the SEC’s estimate in its claim — and reduced earnings by $1.4 billion for that period.

The company said that of the total restatement, $5.1 billion in revenue was allocated among service, rental, outsourcing, and financing revenue streams over the five years, while $1.9 billion in revenue was recognized in 2002 and beyond.

The restatement came just days after WorldCom admitted it had improperly accounted for $3.9 billion in expenses, so a mass exodus from the stock was to be somewhat expected. Xerox even defended itself from those claiming it might be the next Enron. As many an executive and corporate spokesperson explained, the company’s accounting woes were tied not to phony revenue or fictitious transactions, but rather to the timing and allocation of real revenue — specifically, the lease revenue in equipment, service, and finance revenue steams.

As one former equity analyst described the scandal, Xerox was “robbing the future to pay for the present.” After the restatement, the revenue didn’t disappear; it shifted back to future periods beginning in 2002. Some critics have gone so far as to say that during the company’s recovery, the accounting change actually helped it to report higher-than-expected numbers.

Long before the settlement and restatement, Xerox rid itself of the executives that, according to the SEC, had participated in a scheme to defraud investors by using accounting devices to meet short-term goals. The SEC charged six in all, including former CFO Barry Romeril and CEO Paul Allaire, with using improper accounting to increase equipment revenue and inflate earnings.

In July 2002, the individuals settled the civil suit with a $22 million payment that included penalties and forfeiture of profits. No one was required to admit or deny wrongdoing. Romeril was barred for life from being the director or officer of a public company and from practicing as an accountant before the SEC.

More Profits, Less Debt

Mulcahy has been credited with spearheading the company’s turnaround, which included a return to profitability after some two years of losses. In addition to moving the business to higher-margin products, she laid off 30 percent of the workforce and outsourced functions including the internal audit.

As of June 30, 2003, Xerox’s total debt stood at $14.4 billion, compared with $19.3 billion at year-end 2000. The company’s cash reserves, just $132 million at the end of 1999, had risen to $1.75 billion by 2000. As of June 30 of this year, the company held $2.28 billion in cash and cash equivalents.

Indeed, things are looking up for Xerox these days. On June 25, Xerox completed a $3.6 billion recapitalization, reflecting strong investor confidence and demand for Xerox. The recapitalization includes public offerings of common stock, mandatory convertible preferred stock, and senior unsecured notes, as well as a new $1 billion credit facility. Shares, which had fallen to an all-time low of $4.20 on October 2002, stood at about $10 a year later.

Eric Tutterow, a high-yield bond analyst with KDP Investment Advisors, is one analyst encouraged by Xerox’s recent financings. “They have total access to the capital markets,” he says, and because the company can either refinance or issue more stock, “they have a lot of options financially.”

Richard Stice, an equities analyst with Standard & Poor’s, attributes the recent appreciation in Xerox’s share price to the company’s progress in cutting costs, restructuring its sales force, and selling assets. While the SEC’s investigation likely “brought more of the restructuring to the forefront and hastened many of the changes from the strategy standpoint,” he says, “they are basically two separate things.”

Xerox also appears to be making changes to its finance department, whether for Sarbanes-Oxley compliance or as a direct response to its past. The major initiative in the last year has been to realign the global accounting function within the office of the chief accountant, Gary Kabureck.

Xerox is also investing about $10 million to $15 million to update its financial IT systems with IBM, to help ensure greater control as well as timely and precise consolidation of its financial results. The first key component to the upgrade, a new financial consolidation system, is expected to be completed early next year and is being spearheaded by controller Harry Beeth, who left Big Blue last year to join Xerox.

KDP’s Tutterow doubts Xerox will relive its accounting woes under its new leadership. “Anytime the SEC comes in and breathes down your neck, you’re going to make sure your internal controls are impeccable,” he says. “Management is also very forward-looking in the market and has done a good job of refocusing the company on different market segments and moving the company to higher margin products.”

New Board Blood

The California Public Employees’ Retirement System has also been trying to effect change at Xerox. In March 2003, Calpers put the company at the top of its corporate governance focus list, in part for having “one of the most ineffective boards.”

Calpers asked Xerox to take immediate steps to add three independent directors; at the time, the board still comprised the same members who oversaw Xerox during its accounting scandal. Xerox also apparently had a policy that its board members were “‘strongly recommended’ not to communicate directly with institutional investors,” noted Rob Feckner, chairman of the Calpers investment committee. “This is reason enough to ensure that a fresh perspective is added to this board.”

In response, Xerox appointed an independent director, Ann Reese, and said it would add at least one additional independent director by the end of the year. The board, however, remains less amenable to some of Calpers’ other requests, including the separation of the chairman and CEO titles.

While high debt and the SEC investigation have weakened Xerox’s market share, Tutterow doubts that the company’s brand image suffered much in the wake of the accounting scandal. Prospective customers “care a lot less about the corporate image of Xerox and more about the quality of the product,” he says. “From the investor perspective, you are concerned about how [the SEC investigation] will impact earnings going forward, and whether they have the cash flow streams to work through the problems.” Nowadays, he adds, “everyone is really focused on the turnaround and how the restructuring efforts have improved the quality of earnings.”

Investment Grade

Management’s attempt to rebuild investor confidence after the SEC probe suffered a setback when Xerox announced another restatement in December 2002. This time, the company said it had miscalculated interest expense stemming from a debt instrument and a related interest-rate swap agreement. The error caused Xerox to understate interest expense by about $5 million to $6 million after tax, or less than 1 cent per share, in each quarter of 2001 and the first three quarters of 2002.

Stice, who like other analysts was told that the company had put its problems behind it and implemented certain safeguards, remain cautious on the stock because of the surprise. “They’re still not out of the woods yet,” he adds. “It takes awhile to regain credibility.”

Tutterow is decidedly more bullish about Xerox’s prospects. He’s modeling for the company to generate $2.9 billion in cash flow this year and $3 billion in 2004. Much of that is free cash flow because Xerox’s annual interest expense is under $800 million. Considering Xerox’s fairly low capital expenditure, Tutterow expects Xerox to generate between $1.5 billion and $2 billion each year of free cash flow; that figure was $1.93 billion for the trailing twelve months as of June 30.

“They’re on their way, probably on the way back to an investment-grade rating,” Tutterow adds. “It may take some time, but they’ll get there eventually.”