Xerox Has Bigger Worries Than the SEC

The real numbers are weak, and the company must sell Wall Street on a growth plan

Xerox (XRX ) Chairman and CEO Anne M. Mulcahy has been trying hard for months to leave the past behind. In April, Xerox Corp. settled Securities & Exchange Commission charges that from 1997 to 2000 it fraudulently inflated revenues by more than $3 billion and pretax earnings by $1.5 billion. "The SEC matters [are] now behind us," Mulcahy declared.

Then on June 28, Xerox filed its 2001 annual report and with it new numbers for the past five years calculated according to the SEC's demands. The copier maker restated $6.4 billion in revenue--double the sum that the SEC had flagged--and reduced operating income by a staggering 43%. Noting that these changes reflected shifts in the timing of revenue and earnings, not their disappearance, Mulcahy quickly announced once again that Xerox' "new management team has put the past behind us."

But despite Mulcahy's protestations, the past weighs heavily on Xerox. The SEC, which has settled with the company, is still investigating departed executives--including two former CEOs G. Richard Thoman and Paul A. Allaire and former CFO Barry D. Romeril--and Xerox' former auditor, KPMG. Beyond that lies a bigger problem. For the past two years, as management focused on the accounting scandal and a huge debt load, rivals have been stealing Xerox customers at a rapid-fire rate, luring them with improved technology and lower prices. "Xerox lost sight of its competition," says Angele Boyd, a vice-president of IDC, a Framingham (Mass.) research firm.

Wall Street has shown little faith that Xerox has left its problems behind. On revenues of $17 billion for 2001, the company reported a net loss of $71 million. The stock price, meanwhile, has dropped 38% from a 2002 high of $11.45 on Jan. 29, to a recent $7. That's much worse than the 18% slump in the Standard & Poor's 500-stock index over the same period and leaves Xerox at one-tenth of its 1999 high of $64. "There are a lot of investors who have been through some very tough times," says Bill Nygren, manager of the Oakmark Fund, which holds 6.5 million Xerox shares. "If the company's in the headlines in a negative way, they're going to sell."

Two weeks after the restatement was made, in a 1,000-page SEC filing, analysts were still struggling to figure out the implications for future earnings and cash flow. Combined with a heavy debt load, that lack of clarity has made it "hard to get enthusiastic about Xerox," according to Credit Suisse First Boston analyst Gibboney Huske, who rates the stock a "hold."

Stiff competition, fantastic billing screw-ups, and overpriced machines have been problems at Xerox for years. In its April complaint, the SEC accused the company of trying to make up for slipping operating earnings with accounting maneuvers as early as 1997. According to the SEC, for 12 consecutive quarters starting that year, Xerox used accounting tricks to compensate for profit shortfalls. At the time, the company was marketing itself to investors as a growth stock, with a goal of double-digit revenue growth and earnings improvements in the mid-teens, astonishing numbers for the mature copier market.

Today, Xerox has a tamer, though still challenging, goal of 5% annual revenue growth by 2005. But the company is also at a worse competitive disadvantage. In the past three years, its share of the U.S. black-and-white copier market has plunged from 27.5% to 14.9% as value-conscious buyers abandoned high-priced Xerox for Canon and Ricoh. Losing customers is a double whammy for the company, which loses not only new copier sales but also the annuity income from the services and parts it had been supplying on old machines.

At one customer, AlphaGraphics Inc., a chain of franchised print shops based in Salt Lake City, Xerox went from a near-monopoly position in 1995, supplying roughly 90% of the high-speed copiers and printers in AlphaGraphics' 350 locations, to less than 20% in 2000. Instead, AlphaGraphics uses more Canon machines, which print fewer copies per minute but are just as reliable and cost 85% less than Xerox. "They got blown out of the water," says CEO Mike Witte.

Choice business with Coca-Cola Bottling Co. (KO ) and other blue chips, which typically sign multiyear contracts, will be tougher for Xerox to win back from rivals. Today's digital copiers are increasingly connected to corporate computer networks, a process much more involved than plugging in a machine. "The more tightly integrated to the customer we are, the more difficult it gets to replace us," says Dennis Amorosano, director of Canon Inc.'s copier and office systems business.

And Xerox' competitors are not letting up. Ryoichi Bamba, who runs Canon's U.S. office-equipment business, predicts the company's 34% market share will reach 40%.

To fight back, Mulcahy is trying to make Xerox more price-competitive--as she focuses on those sectors with the best growth potential, such as high-end color printing and services. In June, Xerox introduced its next generation of copiers, some of which shoot out more pages per minute at a lower cost than Canon's latest offering. Mulcahy has maintained research and development spending. She says that better color copiers for offices helped the company get to profitability in the second quarter of this year and regain some market share. Xerox also says it has defended and expanded its relationship at big customers including Merck and Unisys and won new ones such as restaurant chain Boston Markets from Canon. "We've been through a turnaround in terms of stabilizing the business model," says Mulcahy, who took the top job last August. "Now, we're really focused on the top line." (For a Q&A with Mulcahy, see "Lessons from a Baptism by Fire".)

Mulcahy is also logging a lot of hours with customers--more than 50% of her time, she estimates. Hired just two years out of college to join Xerox' salesforce 26 years ago, Mulcahy has shown an ability to please customers no matter how irate. In January, AlphaGraphics CEO Witte asked her to fly to South Florida to meet with 70 franchisers. For 2 1/2 hours, Mulcahy stood in the middle of the room fielding questions and complaints about everything from service levels to Xerox' famously troubled billing system. "These people took off the gloves and went after her, and she wasn't afraid to apologize," says Witte. "She is very customer-focused. For Xerox, that's an enormous change." Franchisees gave her points as well for quickly following up on their specific complaints.

She has tried to get the company to follow that example. Faced with what one former executive calls "Xerox' culture of denial," Mulcahy has removed obstructionists and yes-men from her team. With the exception of new Chief Financial Officer Lawrence A. Zimmerman, an IBM veteran, Mulcahy has entirely remade top management by promoting from within, putting a premium on candor. "This is a more outspoken management team," Mulcahy says.

But not everyone has found Mulcahy's Xerox to be sufficiently straightforward. The SEC took the unusual step of publicly lambasting Xerox for failing to cooperate with its two-year investigation of the company. It imposed a $10 million fine, the largest ever for a financial reporting violation. "Given how long it took the Xerox management team to get to the right numbers, only time will tell if top management at Xerox has really changed their culture," says Lynn Turner, a professor at Colorado State University who was chief accountant of the SEC at the time the Xerox investigation was launched.

Mulcahy, who was never personally called on by the SEC and who is not under investigation, says the company has cooperated fully. She is confident that she's the right person to tackle the many challenges still facing Xerox, including an additional $5.8 billion in debt coming due during the next 18 months. "In the past two years, I have probably made tougher decisions than most CEOs," she says. Many more await.

By Nanette Byrnes in Stamford, Conn., with Anthony Bianco

in New York

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