Can Xerox Clear Its Jam?


By Olga Kharif In the past two weeks, Xerox has received the most public of thrashings. On Apr. 11, the Securities & Exchange Commission imposed a $10 million fine on the maker of copiers and printers -- its largest ever for a public company -- as a penalty for accounting improprieties that resulted in a "scheme to defraud investors," according to the SEC. The commission also ordered Xerox (XRX) to restate its financials from 1997 to 2000 to correct the improper recognition of $3 billion of revenues and $1.5 billion in pretax earnings.

The Stamford (Conn.) company should have recognized most of the revenues from equipment leases to copy centers over the course of four years, but it recorded them all up-front, the SEC says. With proper accounting, Xerox would have missed analysts' consensus earnings estimates every quarter from mid-1997 to the end of 1999 by an average margin of 22.5%, according to Salomon Smith Barney.

Xerox has neither denied nor admitted to the SEC complaint, in effect pleading "no contest." But investors, understandably, have been down on the company since the investigation was first disclosed in June, 2000, when the stock was trading at around $28 a share. From Apr. 1, 2002, when the SEC charged that Xerox had essentially no earnings growth in the late '90s, the stock has fallen about 13%, to $9.40 from $11.08.

PAYMENTS DUE. Now the big question is: How Xerox will recover? It's possible, but the near-term outlook is grim. Most analysts rate the stock a hold, and the shares are trading below analysts' lowest 12-month target of $11.50. Although the restatement and record fine are manageable, Xerox faces tough hurdles restoring its reputation and its balance sheet -- not to mention the critical challenge of reinvigorating sales in an economy that's still finding its footing. Another possible pitfall: expensive and time-consuming shareholder suits tied to the SEC's findings.

The biggest immediate problem is to refinance $7 billion worth of loans. If Xerox successfully does that and presents its restatements in the next three months, the shares could rise, believes Jonathan Rosenzweig, an analyst with Salomon Smith Barney. Xerox is scheduled to report first-quarter earnings on Apr. 24, so SEC rules prohibit it from public comment about its outlook.

Analysts polled by First Call expect Xerox to lose $72 million, or 1 cent per share, in the first quarter on revenues of $3.9 billion. That compares to a loss of $504 million, or 7 cents a share, on revenues of $4.2 billion in the same period of 2001.

DIRE CONSEQUENCES. In an Apr. 18 filing with the SEC, Xerox said it has made "significant progress" in negotiations with 57 banks related to the $7 billion in loans due in October (an additional $4 billion is due later). Most analysts believe Xerox should be able to get the banks to sign off, and the company expects to finish the refinancing by June.

Still, if Xerox doesn't find rates that offer some financial flexibility, the bank group could declare a payment default. "In such an event, we would be required to consider the full range of strategic measures available to companies in similar circumstances," Xerox said in its filing. "These circumstances [would] raise substantial doubt about our ability to continue as a going concern."

Those are serious words, but Xerox is in a tight spot. To meet the loans' conditions, its net worth -- assets minus debt -- must remain above $1.5 billion. As of Dec. 31, Xerox had a net worth of $2.85 billion, leaving a cushion of $1.3 billion, even after paying the SEC fine and adjusting for the restatement of its results since '97, estimates Rosenzweig. And Xerox says it has $4 billion in cash on hand.

DAMAGED REPUTATION. Why should banks be willing to work with Xerox? "The company you are looking at now is a fundamentally different company" from what it was two years ago, says Shannon Cross, a Merrill Lynch analyst who has a buy rating on the stock. The old Xerox lost many of its salespeople and suffered from several unprofitable businesses. But in 2001, it got rid of money losers, such as the inkjet-printer business, reduced debt, built is its cash position, and began outsourcing another unprofitable business -- equipment financing.

The results can be felt already. Sales reps are staying put, and customers seem to be happier, says Andy Slawetsky, an analyst with office-automation consultancy Industry Analysts and a former Xerox sales rep. "They are starting to lead again," he says.

Even so, Xerox' blue-chip reputation has suffered a severe blow. "They weren't hurting any customers," points out Jack Kelly, an analyst with Goldman Sachs, but shareholder lawsuits alleging fraud are a huge risk. While the SEC ruling will have no legal bearing on these cases, "it likely won't be lost on a judge in the case," says Geoffrey Miller, a professor at the New York University School of Law. And any settlements could dwarf the $10 million fine.

SHIFTED REVENUES. Xerox' liability insurance, covering directors and officers, could help meet some costs. But coverage typically excludes criminal and deliberate actions, and Xerox' insurers are likely to try to deny coverage, says Miller. Xerox won't disclose the amount of insurance it carries. "We are defending the lawsuits vigorously and will continue to do so," wrote a company spokesperson in an e-mail to BusinessWeek Online. "The settlement with the SEC doesn't change that."

Ironically, while Xerox' sales figures for individual years will change as a result of the restatement, the sum of the revenues for all years affected will remain the same, explains Mark Bradshaw, an accounting expert at Harvard Business School. Only the timing of revenue recognition was in question, not the amount. Because Xerox artificially inflated sales and income from 1997 to 1999, the restatement will reduce revenue for those years and boost stated revenues for 2000 and 2001, estimates Rosenzweig.

Moreover, the restatement should also boost the Xerox' 2002 and 2003 revenues, Rosenzweig says. It was still booking revenue up-front in 2000 for typical four-year equipment leases, but that revenue will now be booked over the four-year period, which includes this year and next. Most analysts didn't change their earnings estimates after the SEC fine was announced. Still, sales could dip this year as much as 25% from Xerox' five-year average, due to its narrower roster of businesses and the still-sluggish economy.

"WE'VE DEALT WITH EVERYTHING." Xerox' new line of production printers and office equipment, expected this year, could help. On Apr. 9, the company announced the pricing for its long-awaited DocuColor iGen3 digital press. Later in the year, it'll come out with new digital color printers for offices -- a market expected to grow at a double-digit pace in 2002.

The new printers will "raise the bar for price and performance," says Jennifer Thorwart, an analyst with tech consultancy IDC, helping Xerox better compete against rivals like Hewlett-Packard. Analysts polled by First Call expect Xerox to post $230 net income this year, or 32 cents per share, on revenue of $15.9 billion. That compares to $180 million in 2001, or a loss of 25 cents a share, on revenues of $16.5 billion.

Until Xerox restates its earnings, uncertainty about this year's profits will remain. Nonetheless, investors should feel assured that it has put the accounting problems behind it, according to Charles Niemeier, chief accountant for enforcement at the SEC. "We've dealt with everything we've found," he says.

Xerox will soon hire an independent consultant to review its accounting policies. The SEC fine "was a warning shot," says Miller. It's up to Xerox to make sure it doesn't get any worse. All indications are that it has learned its lesson. If Xerox can get the banks to renegotiate its debt, which analysts say is probable, and impress customers with its new products, investors might have something to look forward to. But no doubt about it, Xerox has a tough row to hoe. Kharif covers the financial markets for BusinessWeek Online from Portland, Ore.


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