By William Trent, CFA of Stock Market Beat

When we recently criticized Xerox (XRX) for it’s practice of taking restructuring charges in each of the last seven years while suggesting investors treat them as one-time events, a company representative noted that “First Call estimate for Xerox’s Q4 earnings was 37 cents. That number did not include restructuring. While Xerox provided guidance on restructuring for Q4, analysts posted an adjusted EPS number that excluded any impact from restructuring. Compared to First Call and Xerox’s own Q4 guidance, Xerox did exceed expectations for the quarter at 38 cents adjusted EPS.”

Our response:

Xerox guided to first-quarter 2007 earnings between $0.21 and $0.23, right in line with the 22-cent consensus. We’re sure they will report at least $0.22. The real surprise would be if they did it on an unadjusted basis.

Money News:- Xerox Cuts Outlook on Restructuring – AOL Money & Finance

Xerox Corp. late Monday slashed its profit outlook for the first quarter because the copy machine maker said a partner company will record accounting charges as part of a plan to cut costs.The Stamford, Conn.-based company has a 25 percent stake in Fuji Xerox Co., a partnership that markets Xerox products in Japan and other countries in the Pacific Rim.

Xerox said in a Securities and Exchange Commission filing late Monday Fuji Xerox plans to record accounting charges against earnings as part of a restructuring program to rein in costs and become more productive and competitive.

While Xerox reiterated its outlook for the year of $1.12 to $1.16 per share, the company cut its first-quarter profit target by 3 cents per share to a range of 18 cents to 20 cents per share.

We applaud Xerox for actually taking the numbers down to reflect this new charge. We hope they also insist that analysts do the same thing when reporting their estimates to First Call. However, our guess is that when it comes time for the earnings report all eyes will be on the number excluding this charge.

Speaking of this charge, Xerox’ participation in the Fuji Xerox JV is accounted for using what is known as the equity method. According to the company’s latest 10K, “Equity in net income of unconsolidated affiliates of $114 million, principally related to our 25% share of Fuji Xerox income, which increased by $16 million in 2006 as compared to 2005, primarily due to improved operational performance.” In both 2005 and 2006 the Fuji Xerox venture contributed nearly 10% of the net income reported by Xerox, without muddying up the “revenue” or “expense” lines.

It is a simple adjustment, however, to see how net margin would be affected by looking at only the operations for which Xerox fully reports results. All that is needed is to subtract “equity in net income of unconsolidated affiliates” from net income, which we do in the table below.

As expected, net margin is lower when you take out portions that are treated as 100% profit (all costs are off the financial statements.) There is also a smaller improvement in margin (130 basis points rather than the 140 reported) in 2006, but a larger one in 2005 when adjusted numbers are used. In addition, the growth in net income is higher in both periods when using the adjusted number. Overall, this analysis tells us that the company’s non-JV business was starting in worse condition that was apparent, but showed more significant improvement relative to taking the numbers at face value.
By understanding how the accounting requirements as well as any management discretion used when applying them, investors can piece together more of the puzzle.

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