Exhibit (iii) - -------------------------------------------------------------------------------- ================================================================================ Management's Discussion and Analysis ================================================================================ Year ended December 31, 1997 Overview Pitney Bowes Inc. (the company) continues to build on the core activities that support its strong competitive position. We concentrate on products and services that enable us to be the provider of informed mail and messaging management. The company operates within three industry segments: business equipment, business services, and commercial and industrial financing. Business equipment consists of four product, supplies and service classes: mailing systems, copier systems, facsimile systems and related financing. The products are sold, rented or financed by the company, while supplies and services are sold. The financial services operations provide lease financing and other credit options for the company's products in the U.S., Canada, the U.K., Germany, France, Norway, Ireland and Australia. Business services consists of facilities management and mortgage servicing. Facilities management services are provided for a variety of business support and processing functions. Mortgage servicing provides billing, collecting and processing services for major investors in residential first mortgages. The commercial and industrial financing segment, which is shifting its strategic focus to fee-based financial services, provides large-ticket financing programs covering a broad range of products and other financial services to the commercial and industrial markets in the U.S. It also provides small-ticket lease financing services to small and medium-sized businesses throughout the U.S., marketing exclusively through a nationwide network of brokers and independent lessors. Results of Continuing Operations 1997 Compared to 1996 In 1997, revenue increased 6%, operating profit grew 18%, income from continuing operations grew 12% and diluted earnings per share from continuing operations increased 15% to $1.80 compared with $1.56 for 1996. Revenue growth was 8%, after adjusting for the impacts of previously announced strategic actions in Australia, asset sale activity and the strategic shift of the external large-ticket business to more fee-based income sources. - -------------------------------------------------------------------------------- Diluted Earnings Per Share from Continuing Operations [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Dollars ------- 1995 .............................................................. 1.34 1996 .............................................................. 1.56 1997 .............................................................. 1.80 - -------------------------------------------------------------------------------- The revenue increase came primarily from growth in the business equipment and business services segments of 7% and 16%, respectively, over 1996. Volume increases in our U.S. Mailing Systems, Production Mail, U.S. Copier Systems, worldwide Facsimile Systems, facilities management and mortgage servicing businesses were the principal cause of the revenue growth. The impact of prices and exchange rates was minimal. The revenue increase was partially offset by an 8% decline in revenue in the commercial and industrial financing segment. Within this segment, external large-ticket revenue declined 17% due to our strategy to reduce our external assets and shift to more fee-based revenue streams. The reduction of external large-ticket assets included the effect of the agreement with GATX Capital, more fully discussed under Other Matters. External small-ticket revenue grew 2% on increased volume. Excluding the impact of planned asset sales, revenue in the commercial and industrial financing segment would have declined by 2%. Approximately 75% of our total revenue in 1997 and 1996 is recurring revenue, which we believe is a continuing good indicator of potential repeat business. - -------------------------------------------------------------------------------- Revenue [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Dollars in millions ------------------- 1995 Sales .................................................... 1,546 Rentals & Financing ...................................... 1,575 Support Services ......................................... 433 1996 Sales .................................................... 1,675 Rentals & Financing ...................................... 1,718 Support Services ......................................... 466 1997 Sales .................................................... 1,834 Rentals & Financing ...................................... 1,783 Support Services ......................................... 484 - -------------------------------------------------------------------------------- Operating profit grew 18% over the prior year compared with growth of 9% in 1996, continuing to reflect our strong emphasis on reducing costs and controlling operating expenses in all our businesses. Another measure of our success in controlling costs and expenses in 1997 and 1996 was that growth in operating profit, excluding the 1996 charge for exiting the Australian copier business, continued to significantly outpace revenue growth. Operating profit grew 22% in the business equipment segment, 27% in the business services segment and declined 14% in the commercial and industrial financing segment. Excluding the 1996 charge for exiting the Australian copier 17 - -------------------------------------------------------------------------------- business, operating profit growth would have been 13%, with the business equipment segment operating profit growth at 16%. The operating profit growth in the business equipment segment came from strong performances by U.S. Mailing Systems, worldwide Facsimile Systems and U.S. Copier Systems. Our mortgage servicing business, Atlantic Mortgage and Investment Corporation, contributed to the operating profit growth in the business services segment. In the commercial and industrial financing segment, the operating profit declined due to a planned reduction in the company's large-ticket external portfolio. Operating profit in this segment included the impacts of a charge for costs and asset valuation related to the agreement announced in August 1997 with GATX Capital (see Other Matters) and external large-ticket and small-ticket asset sales in 1996. Excluding these items, operating profit in the commercial and industrial financing segment would have increased 9%. Sales revenue increased 9% in 1997 due mainly to strong equipment sales in U.S. Mailing Systems and U.S. Copier Systems, higher supplies revenue at Facsimile Systems and increased sales of facilities management services. The increase in U.S. Mailing Systems' revenue is due mainly to customers' conversion to more advanced technologies, with feature-rich products and services driven by meter migration (see Regulatory Matters). The increase in U.S. Copier Systems was due to solid equipment sales paced by the introduction of six new products, the phased rollout of the color and digital copier systems and the introduction of the Smart Image RIP(TM) controllers that allow a color copier to function as a high-quality color printer. Buyers Laboratory named the Pitney Bowes copier line as "Line of the Year" with a record seven Pitney Bowes copiers named "Picks of the Year," the most by any copier vendor in the history of the award. The award is based on factors that are critical to customer productivity, satisfaction and value such as reliability, copy quality and ease of use. Facsimile Systems' sales revenue increased due to higher supplies revenue resulting from strong demand for plain paper cartridges. Increased sales of facilities management services were due primarily to the continued expansion of our commercial contract base. In total, Financial Services financed 36% and 39% of all sales in 1997 and 1996, respectively. This decrease is due mainly to the impact of increased sales revenue from our facilities management business which does not use traditional financing services used by our other businesses. Rentals and financing revenue increased 4% from 1996. Rentals revenue increased 5% from 1996 due mainly to rapid growth in the base of electronic and digital meters. This resulted from the conversion of U.S. Mailing Systems' customers to more advanced technology and new distribution channels such as the availability of the digital desktop Personal Post Office(TM) meter via the Internet and selected retail outlets specializing in business supplies. By the end of 1997, 75% of the company's U.S. meter base was made up of electronic and digital meters, with approximately 25% made up of advanced technology digital meters. As planned and in line with the United States Postal Service (USPS) guidelines, we no longer place mechanical meters and the company has reduced the percentage of mechanical meters in service to 25% of its U.S. meter population. Rentals revenue in 1997 no longer included the administrative revenue associated with the trust fund, because the USPS took control of the fund in 1996. Double-digit contributions to rentals revenue growth came from our U.S. and U.K. facsimile businesses, driven by an increased rental base of advanced products introduced in 1997, such as model 9830, selected as the "Best Plain Paper Fax Machine" by the American Facsimile Association, and model 9910. Financing revenue, adjusted for planned asset sales, grew 7% in 1997 on increased volume of leases of Pitney Bowes products and new product offerings such as Purchase Power(SM). Including the impact of asset sales, which generated more revenue in 1996 than in 1997, financing revenue grew 3% in 1997. Support services revenue in 1996 included service revenue from the Australian copier business. Adjusting for this discontinued revenue, support services would have increased 5%, led by healthy increases in on-site service contracts at Production Mail and chargeable service calls in the U.K. U.S. Mailing Systems, U.S. Copier Systems and Software Solutions also contributed to the growth. Without adjusting for the discontinued Australian revenue, support services revenue increased 4%. Cost of sales decreased to 59% of sales revenue compared to 61% a year earlier. This improvement was driven by lower product costs, increased sales of high margin supplies and the effect of a stronger dollar on equipment purchases. The improvement was achieved despite the offsetting effect of increased revenue and costs of the lower-margin facilities management business, where most of its expenses are included in cost of sales. Cost of rentals and financing remained flat, at 31% of related revenues for 1997. This ratio remained unchanged despite the lower costs in 1996 as a result of not placing mechanical meters and the additional depreciation expense in 1997 from increased placements of electronic and digital meters. Cost of rentals and financing in 1997 also includes the charge for costs and asset valuation related to the agreement with GATX Capital (see Other Matters). Selling, service and administrative expenses were 33% of revenue in 1997 compared with 35% in 1996. The ratio in 1996 included the impact of a $30 million charge resulting from the company's decision to exit the Australian copier business. Excluding this charge, the ratio in 1996 would have been 34%. Improvement in this ratio is due primarily to our continued emphasis on controlling operating expenses while growing revenue. This was our fifth consecutive year of an improving expense-to-revenue ratio, after adjusting for the charge described above. 18 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Selling, Service and Administrative Rate - -------------------------(excluding 1996 Australian charge) [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Percentage of revenue --------------------- 1995 .................................................... 34.6% 1996 .................................................... 33.9% 1997 .................................................... 33.4% - -------------------------------------------------------------------------------- Research and development expenses increased 9% in 1997. This increase demonstrates the company's continued commitment to developing new technologies across all our product lines. Specifically, the increase relates to the development of new digital meters, advanced technology mailing and inserting machines and software products. Net interest expense increased 2% due mainly to higher average borrowings during 1997 to fund the company's stock repurchase program. Future changes in interest rates could affect our borrowing strategies. We manage our interest rate risk, most of which is in financial services, with a balanced mix of debt maturities, variable and fixed rate debt and interest rate swap agreements. Our variable and fixed rate debt mix, after adjusting for the effect of interest rate swaps, was 48% and 52%, respectively, at December 31, 1997. As more fully discussed in the Liquidity and Capital Resources section, the company and its finance subsidiary issued additional debt in January 1998. Including this debt, our variable and fixed rate debt mix at December 31, 1997 would have been 38% and 62%, respectively. - -------------------------------------------------------------------------------- Continuing Operations Margin [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Percentage ---------- 1995 ............................................................... 11.5% 1996 ............................................................... 12.2% 1997 ............................................................... 12.8% - -------------------------------------------------------------------------------- The effective tax rate was 34.5% for 1997 compared with 31.4% for 1996. The tax benefit associated with the company's actions in Australia and the related write-off of our Australian investment was primarily responsible for the low rate in 1996. Excluding this benefit, the 1996 effective tax rate would have been 34.3%. Income from continuing operations and diluted earnings per share increased 12% and 15%, respectively, in 1997. The reason for the increase in diluted earnings per share outpacing the increase in net income was the company's share repurchase program, under which 17.9 million shares, 6% of the average common and potential common shares outstanding in 1996, were repurchased in 1997. Income from continuing operations as a percentage of revenue increased to 12.8% in 1997 from 12.2% in 1996. - -------------------------------------------------------------------------------- Income from Continuing Operations [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] Dollars in millions ------------------- 1995 ...................................................... 408 1996 ...................................................... 469 1997 ...................................................... 526 - -------------------------------------------------------------------------------- Results of Continuing Operations 1996 Compared to 1995 In 1996, revenue increased 9%, income from continuing operations grew 15% and diluted earnings per share from continuing operations increased 16% to $1.56 compared to $1.34 for 1995. Revenue growth came primarily from increased sales of facilities management services, production mail and high-end mailing equipment and was principally volume-driven, while prices and exchange rates remained relatively unchanged from 1995. This growth was achieved despite lower revenue in Canada, where a new management team was put in place to focus on profitable growth. Approximately 75% of our total revenue in 1996 was recurring revenue, which we believe is a good indicator of potential repeat business. The 15% growth in income from continuing operations was possible because of continued emphasis on programs to increase efficiency and reduce operating expenses, despite the fact that more revenues were coming from the lower-margin business services sector. The fact that growth in income from continuing operations significantly outpaced revenue growth is a measure of the success of our emphasis on operating efficiencies. 19 - -------------------------------------------------------------------------------- Sales revenue increased 8% from the prior year, 10% if the comparison excludes the approximately $30 million in upgrade revenue generated by the first-quarter 1995 USPS rate change. Facilities management led the company with a 17% sales increase, as it continued to expand its commercial market contract base. Sales of digital, software-based equipment were strong, with notable increases in production mail, high-end mailing and copier placements. In total, financial services financed 39% of all sales in 1996 and 1995. Our facilities management business does not require the same traditional financing services used by the other parts of the company, and its growth impacts this percentage. Rentals and financing revenue increased 9% from 1995. Rentals revenue increased 6% from 1995. The company voluntarily halted mechanical meter placements in early 1996 to comply with USPS pending guidelines on moving to electronic and digital meters. This caused a slight decline in the 1996 installed U.S. meter base. However, we expect rapid growth in the base of electronic and digital meters to continue for the next few years, as these products attract new categories of customers worldwide, including the small office/home office (SOHO) market segment. Since the introduction of PostPerfect(TM) in 1995, the company's first digital meter and the subsequent introduction of the Personal Post Office(TM) meter in October 1996, more than 100,000 digital meters have been placed in service. During 1996, the USPS took control of the postal payment trust fund. This significantly lowered the administrative revenue included in this category during 1996 and lowered the growth in rentals revenue. In December 1997, the company filed suit against the USPS charging that, in taking control of the trust fund, the USPS unlawfully used its regulatory power to misappropriate revenues which compensated the company for development, maintenance, and administration of its Postage By Phone(R) system. Financing revenue increased 15% in 1996. Increased volume in Pitney Bowes product leases and small-ticket leases to credit-worthy businesses drove this growth. A strategic shift to concentrate on fee-based income contributed as well, though gains were offset by a planned reduction in the external large-ticket financing business. Excluding the impact of external financial asset sales, revenue growth would have been 10%. Support service revenue grew 7%, driven by volume growth in equipment maintenance contracts, manned on-site production mail service contracts and chargeable service calls. The ratio of cost of sales to sales revenue grew .3 percentage points due to the change in sales revenue mix toward the lower-margin facilities management business, which includes most of its expenses in cost of sales. The revenue mix impact was balanced by lower product costs, increased sales of higher-margin feature-rich products and the effect of a stronger U.S. dollar on equipment purchases. The 1995 ratio also benefited from the lower costs associated with the revenue related to the USPS rate change in the first quarter of 1995. The ratio of cost of rentals and financing to the related revenue increased 1.4 percentage points to 30.8% in 1996. This is due to the effect of the sale of external finance assets and a change in revenue mix. Excluding asset sales, this ratio would have increased .8 percentage points. The strong growth in the mortgage servicing and brokered small-ticket external leasing businesses, both of which include a majority of their expenses in the cost of financing, also increased this ratio. The ratio of selling, service and administrative expenses to revenue remained relatively unchanged from 1995 at 34.7% despite a $30 million charge (writing off the remaining goodwill and other related expenses) resulting from the company's decision to exit the Australian copier business and downsize its Australian facsimile business. This will enable the company's Australian operations to concentrate on the more profitable mailing and high-end facsimile businesses. This charge was almost completely offset by associated tax benefits and had a minimal impact on the results for the year. Without this charge, selling, service and administrative expenses would have been reduced to 33.9% of 1996 revenues. Changes in the revenue mix helped to reduce this ratio. Various reengineering programs within the company have resulted in operating efficiencies and controlling costs, all of which have lowered the worldwide expense ratio. Research and development expenses in 1996 matched the previous year, demonstrating the company's commitment to providing the global marketplace with a continuous stream of innovative, high-quality products and services such as the PostPerfect(TM) meter and the Personal Post Office(TM) meter. Development spending is expected to increase in the future, as we invest in the new software and digital products demanded by the marketplace. Net interest expense decreased 10% as a result of lower interest rates and lower average debt. Overall, borrowing levels remained steady with those in the latter half of 1995. Financial services did borrow more to support more Pitney Bowes product placements and small-ticket external leases. Future changes in interest rates could affect our borrowing strategies. We manage our interest rate risk, most of which is in financial services, with a balanced mix of debt maturities, variable and fixed rate debt and interest rate swap agreements. Our variable and fixed rate debt mix, after adjusting for the effect of interest rate swaps, was 41% and 59%, respectively, at December 31, 1996. Operating profit, excluding the Australian charge, grew 14% with 11% coming from the business equipment segment, 31% from the business services segment and 26% from the commercial and industrial financing segment. Including the Australian charge, overall operating profit increased 9% with business equipment contributing a 6% increase. The operating profit growth in the business equipment segment came from strong performances by mailing and facsimile globally, and the copier business in the U.S. All businesses contributed to the operating profit growth in the business services segment. 20 - -------------------------------------------------------------------------------- In the commercial and industrial financing segment, operating profit growth was helped by a decreasing interest rate environment and from the asset sales described earlier. The effective tax rate for 1996, including the tax benefits associated with the company's actions in Australia and the related write-off of its Australian investment, was 31.4%. Excluding such benefits, the effective tax rates for 1996 and 1995 were 34.3% and 34.1%, respectively. Income from continuing operations grew 15% for all of 1996. Strong growth in income from worldwide mailing and facsimile systems as well as good results from all other businesses led to the overall increase. Other Matters On August 21, 1997, the company announced that it had entered into an agreement with GATX Capital Corporation (GATX Capital), a subsidiary of GATX Corporation, which when completed, will reduce the company's external large-ticket finance portfolio by approximately $1.1 billion. This represented approximately 50% of the company's external large-ticket portfolio and reflects the company's ongoing strategy of focusing on fee- and service-based revenue rather than asset-based income. Under the terms of the agreement, the company transferred external large-ticket finance assets through a sale to GATX Capital and an equity investment in a limited liability company owned by GATX Capital and the company. At December 31, 1997, the company had received approximately $800 million of the approximately $900 million in cash it expects to receive. The company will also retain approximately $200 million of equity investment in a limited liability company along with GATX Capital. On June 29, 1995, the company sold Monarch Marking Systems, Inc. (Monarch) for approximately $127 million in cash to a new company jointly formed by Paxar Corporation and Odyssey Partners, L.P. On August 11, 1995, the company sold Dictaphone Corporation (Dictaphone) for approximately $450 million in cash to an affiliate of Stonington Partners, Inc. The sales of Dictaphone and Monarch resulted in gains approximating $155 million, net of approximately $130 million of income taxes. Dictaphone and Monarch have been classified in the Consolidated Statements of Income as discontinued operations; revenue and income from continuing operations exclude the results of Dictaphone and Monarch for all periods presented. See Note 13 to the Consolidated Financial Statements. Accounting Changes In 1996, Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (FAS 125), was issued for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. The company adopted FAS 125 on January 1, 1997. As of December 31, 1997, there was no material impact on the financial statements of the company due to the adoption of this statement. In 1997, the company adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128). Under FAS 128, the company disclosed basic and diluted earnings per share (EPS) on the face of the Consolidated Statements of Income. In addition, a reconciliation of the basic and diluted EPS computation is presented in Note 9 to the Consolidated Financial Statements. In 1997, Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," was issued. It will require the company to disclose, in financial statement format, all non-owner changes in equity. This statement is effective for fiscal years beginning after December 15, 1997 and requires reclassification of prior period financial statements for comparability purposes. The company expects to adopt this statement in 1998. Also in 1997, Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," was issued, effective for fiscal years beginning after December 15, 1997. It establishes standards for reporting information about operating segments in annual financial statements and interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The company expects to adopt this statement beginning with its 1998 consolidated financial statements. Liquidity and Capital Resources Our ratio of current assets to current liabilities improved to .73 to 1 at December 31, 1997 compared to .67 to 1 at December 31, 1996. To control the impact of interest rate swings on our business, we use a balanced mix of debt maturities, variable and fixed rate debt and interest rate swap agreements. In 1997, we entered into interest rate swap agreements, primarily through our financial services business. Swap agreements are used to fix or lower interest rates on commercial loans than we would otherwise have been able to get without the swap. - -------------------------------------------------------------------------------- Current Ratio [THE FOLLOWING TABLE WAS REPRESENTED BY A BAR CHART IN THE PRINTED MATERIAL.] 1995 .............................................................. .60 1996 .............................................................. .67 1997 .............................................................. .73 - -------------------------------------------------------------------------------- 21 - -------------------------------------------------------------------------------- The ratio of total debt to total debt and stockholders' equity was 64.2% at December 31, 1997, versus 60.5% at December 31, 1996, including the preferred stockholders' equity in a subsidiary company as debt. Excluding the preferred stockholders' equity in a subsidiary company from debt, the ratio of total debt to total debt and stockholders' equity was 62.0% at December 31, 1997 versus 59.0% at December 31, 1996. The $663 million repurchase of 17.9 million shares of common stock in 1997 increased this ratio. The company's strong results and proceeds from the sale of external leasing assets and the GATX transaction described previously partially offset the increase in this ratio. As part of the company's non-financial services shelf registrations, a medium-term note facility exists permitting issuance of up to $100 million in debt securities with maturities ranging from more than one year to 30 years of which $32 million remained available at December 31, 1997. We also had an additional $300 million remaining on our non-financial services shelf registration statement filed with the Securities and Exchange Commission (SEC). On January 22, 1998, the company issued notes amounting to $300 million available under this shelf registration. These unsecured notes bear annual interest at 5.95% and mature in February 2005. The notes are redeemable earlier at the company's option. The net proceeds from these notes will be used for general corporate purposes, including the repayment of short-term debt. We intend to file a new non-financial services shelf registration statement with the SEC as soon as possible. Pitney Bowes Credit Corporation (PBCC), a wholly-owned subsidiary of the company, had $250 million of unissued debt securities available under a shelf registration statement filed with the SEC in September 1995. On January 16, 1998, PBCC issued notes amounting to $250 million available under this shelf registration. These unsecured notes bear annual interest at 5.65% and mature in January 2003. The proceeds will be used to meet PBCC's financing needs over the next 12 months. PBCC intends to file a new shelf registration statement with the SEC as soon as possible. In July 1996, PBCC issued $300 million of medium-term notes: $200 million at 6.54% due in July 1999 and $100 million at 6.78% due in July 2001. In September 1996, PBCC issued $200 million of medium-term notes: $100 million at 6.305% due in October 1998 and $100 million at 6.8% due in October 2001. To help us better manage our international cash and investments, in June 1995 and April 1997, Pitney Bowes International Holdings, Inc. (PBIH), a subsidiary of the company, issued $200 million and $100 million, respectively, of variable term, voting preferred stock (par value $.01) representing 25% of the combined voting power of all classes of its outstanding capital stock, to outside institutional investors in a private placement. The remaining 75% of the voting power is held directly or indirectly by Pitney Bowes Inc. The preferred stock is recorded on the Consolidated Balance Sheets as "Preferred Stockholders' Equity in a Subsidiary Company." We used the proceeds of these transactions to pay down short-term debt. We have an obligation to pay cumulative dividends on this preferred stock at rates that are set at auction. The auction periods are generally 49 days, although they may increase in the future. The weighted average dividend rate in 1997 and 1996 was 4.1% and 4.0%, respectively. Dividends are recorded in the Consolidated Statements of Income as minority interest, and are included in selling, service and administrative expenses. At December 31, 1997, the company had unused lines of credit and revolving credit facilities of $1.8 billion (including $1.5 billion at its financial services businesses) in the U.S. and $75.6 million outside the U.S., largely supporting commercial paper debt. We believe our financing needs for the next few years can be met with cash generated internally, money from existing credit agreements, debt issued under new shelf registration statements and existing commercial and medium-term note programs. Information on debt maturities is presented in Note 5 to the Consolidated Financial Statements. Total financial services assets decreased to $5.5 billion at December 31, 1997, down 2.6% from $5.6 billion in 1996. To fund finance assets, borrowings were $3.3 billion in 1997 and $3.6 billion in 1996. Approximately $1.1 billion and $430 million in cash was generated from the sale of finance assets in 1997 and 1996, respectively. We used the money to pay down debt, repurchase shares and fund new business development. In October 1997, the Board of Directors declared a two-for-one split of the company's common stock. The split was effected through a dividend of one share of common stock for each common share outstanding. The company distributed the stock dividend on or about January 16, 1998, for each share held of record at the close of business December 29, 1997. See Note 7 to the Consolidated Financial Statements. We spent $17 million and $45 million in cash in 1996 and 1995, respectively, on severance and benefits to support the company's strategic focus initiative plan that was adopted during 1994. As of December 31, 1996, the company had successfully completed its plan. Market Risk The company is exposed to the impact of interest rate changes and foreign currency fluctuations due to its investing and funding activities and its operations in different foreign currencies. The company's objective in managing its exposure to interest rate changes is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. To achieve its objectives, the company uses a balanced mix of debt maturities and variable and fixed rate debt together with interest rate swaps to fix or lower interest expense. 22 - -------------------------------------------------------------------------------- The company's objective in managing the exposure to foreign currency fluctuations is to reduce the volatility in earnings and cash flow associated with foreign exchange rate changes. Accordingly, the company enters into various contracts, which change in value as foreign exchange rates change, to protect the value of external and intercompany transactions in foreign currencies. The principal currencies hedged are the British pound, Canadian dollar, Japanese yen and Australian dollar. The company employs established policies and procedures governing the use of financial instruments to manage its exposure to such risks. The company does not enter into foreign currency or interest rate transactions for speculative purposes. The gains and losses on these contracts offset changes in the value of the related exposures. The company utilizes a "Value-at-Risk" (VaR) model to determine the maximum potential loss in fair value from changes in market conditions. The VaR model utilizes a "variance/co-variance" approach and assumes normal market conditions, a 95% confidence level and a one-day holding period. The model includes all of the company's debt and all interest rate and foreign exchange derivatives contracts. Anticipated transactions, firm commitments, and receivables and accounts payable denominated in foreign currencies, which certain of these instruments are intended to hedge, were excluded from the model. The VaR model is a risk analysis tool and does not purport to represent actual losses in fair value that will be incurred by the company, nor does it consider the potential effect of favorable changes in market factors. At December 31, 1997, the company's maximum potential one-day loss in fair value of the company's exposure to foreign exchange rates and interest rates, using the variance/co-variance technique described above, was not material. Year 2000 The company is working to resolve the potential impact of the year 2000 on the processing of date-sensitive information by the company's computerized information systems, manufacturing systems and certain products developed by the company. As part of its ongoing investment in advanced information technology, the company's systems and applications acquired in recent years as well as recently developed products are year 2000 compliant. The company has committed internal and external resources to identify systems, applications and products that are not year 2000 compliant, and developed a plan and timetable to address the issues identified, including implementation and testing. The company continuously monitors its progress in ensuring timely resolution of year 2000 issues. A substantial portion of this work is planned to be completed in 1998 with remaining work expected to be completed in 1999. At this time, the company is not aware of any reason or situation that would impede the achievement of its plan and timetable, nor do we anticipate that the cost of addressing this issue will have a material adverse impact on the company's financial position, results of operations or cash flows in future periods. However, the company recognizes its limitations in influencing third-party constituents (i.e., vendors, customers, financial institutions, etc.) and the complexity of the year 2000 issue. As a result, the full impact of the year 2000 issue cannot be determined with complete certainty. Capital Investment During 1997, net investments in fixed assets included net additions of $98 million to property, plant and equipment and $146 million to rental equipment and related inventories compared with $75 million and $200 million, respectively, in 1996. These additions included expenditures for normal plant and manufacturing equipment. In the case of rental equipment, the additions included the production of postage meters and the purchase of facsimile and copier equipment for new placements and upgrade programs. At December 31, 1997, commitments for the acquisition of property, plant and equipment reflected plant and manufacturing equipment improvements as well as rental equipment for new and replacement programs. Legal, Environmental and Regulatory Matters Legal In the course of normal business, the company is occasionally party to lawsuits. These may involve litigation by or against the company relating to, among other things: o contractual rights under vendor, insurance or other contracts o intellectual property or patent rights o equipment, service or payment disputes with customers o disputes with employees We are currently a defendant in a number of lawsuits, none of which should have, in the opinion of management and legal counsel, a material adverse effect on the company's financial position or results of operations. 23 - -------------------------------------------------------------------------------- Environmental The company is subject to federal, state and local laws and regulations relating to the environment and is currently named as a member of various groups of potentially responsible parties in administrative or court proceedings. As we previously announced, in 1996 the Environmental Protection Agency (EPA) issued an administrative order directing us to be part of a soil cleanup program at the Sarney Farm site in Amenia, New York. The site was operated as a landfill between the years 1968 and 1970 by parties unrelated to the company, and wastes from a number of industrial sources were disposed there. We do not concede liability for the condition of the site, but are working with the EPA to identify, and then seek reimbursement from, other potentially responsible parties. We estimate the total cost of our remediation effort to be in the range of $3 million to $5 million for the soil remediation program. The administrative and court proceedings referred to above are in different states. It is impossible for us to estimate with any certainty the total cost of remediating, the timing or extent of remedial actions which may be required by governmental authorities, or the amount of liability, if any, we might have. If and when it is possible to make a reasonable estimate of our liability in any of these matters, we will make financial provision as appropriate. Based on the facts we presently know, we believe that the outcome of any current proceeding will not have a material adverse effect on our financial condition or results of operations. Regulation In June 1995, the USPS finalized and issued regulations governing the manufacture, distribution and use of postage meters. These regulations cover four general categories: meter security, administrative controls, Computerized Meter Resetting Systems and other issues. The company continues to comply with these regulations in its ongoing postage meter operations. In May 1996, the USPS issued a proposed schedule for the phaseout of mechanical meters in the U.S. Between May 1996 and March 1997 the company worked with the USPS to negotiate a revised mechanical meter migration schedule which better reflected the needs of existing mechanical meter users and minimized any potential negative financial impact on the company. The final schedule agreed to with the USPS is as follows: o as of June 1, 1996, new placements of mechanical meters would no longer be permitted; replacements of mechanical meters previously licensed to customers would be permitted prior to the applicable suspension date for that category of mechanical meter o as of March 1, 1997, use of mechanical meters by persons or firms who process mail for a fee would be suspended and would have to be removed from service o as of December 31, 1998, use of mechanical meters that interface with mail machines or processors ("systems meters") would be suspended and would have to be removed from service o as of March 1, 1999, use of all other mechanical meters ("stand-alone meters") would be suspended and have to be removed from service Based on the foregoing schedule, the company believes that the phaseout of mechanical meters will not cause a material adverse financial impact on the company. As a result of the company's aggressive efforts to meet the USPS mechanical meter migration schedule combined with the company's ongoing and continuing investment in advanced postage evidencing technologies, mechanical meters represent 25% of the company's installed U.S. meter base at December 31, 1997, compared with 40% at December 31, 1996. At December 31, 1997, 75% of the company's installed U.S. meter base is electronic or digital, compared to 60% at December 31, 1996. In May 1995, the USPS publicly announced its concept of its Information Based Indicia Program (IBIP) for future postage evidencing devices. As initially stated by the USPS, the purpose of the program was to develop a new standard for future digital postage evidencing devices which significantly enhanced postal revenue security and supported expanded USPS value-added services to mailers. The program would consist of the development of four separate specifications: o the Indicium specification--the technical specifications for the indicium to be printed o a Postal Security Device specification--the technical specification for the device that would contain the accounting and security features of the system o a Host specification o a Vendor Infrastructure specification In July 1996, the USPS published for public comment draft specifications for the Indicium, Postal Security Device and Host specifications. The company submitted extensive comments to these specifications in November 1996. Revised specifications were then published in 1997 which incorporated many of the changes recommended by the company in its prior comments, including the recommendation that IBIP apply only to the personal computer (PC) environment and not apply at the present time to other digital postage evidencing systems. The company submitted comments to these revised specifications. Also, in March 1997 the USPS published for public comment the Vendor Infrastructure specification to which the company responded on June 27, 1997. As of December 31, 1997, the USPS had not yet finalized the four IBIP specifications; however, the company has developed a PC product which satisfies the proposed IBIP specifications. This product is currently undergoing testing by the USPS and is expected to be ready for market when final approval of the specifications is issued. 24 - -------------------------------------------------------------------------------- Effects of Inflation and Foreign Exchange Inflation, although moderate in recent years, continues to affect worldwide economies and the way companies operate. It increases labor costs and operating expenses, and raises costs associated with replacement of fixed assets such as rental equipment. Despite these growing costs and the USPS meter migration initiatives, the company has generally been able to maintain profit margins through productivity and efficiency improvements, continual review of both manufacturing capacity and operating expense levels, and, to an extent, price increases. Although not affecting income, deferred translation gains and (losses) amounted to $(32) million, $16 million and $(5) million in 1997, 1996 and 1995, respectively. In 1997, the translation loss resulted from the strengthening of the U.S. dollar against most other currencies except for the pound sterling. In 1996, the translation gains resulted primarily from the strengthening of the pound sterling and the Canadian dollar. In 1995, translation losses resulted primarily from the weakening of the pound sterling. The results of the company's international operations are subject to currency fluctuations, and we enter into foreign exchange contracts (for purposes other than trading) primarily to minimize our risk of loss from such fluctuations. Exchange rates can impact settlement of our intercompany receivables and payables that result from transfers of finished goods inventories between our affiliates in different countries, and intercompany loans. At December 31, 1997, the company had approximately $290.8 million of foreign exchange contracts outstanding, most of which mature in 1998, to buy or sell various currencies. Risks arise from the possible non-performance by counterparties in meeting the terms of their contracts and from movements in securities values, interest and/or exchange rates. However, the company does not anticipate non-performance by the counterparties as they are composed of a number of major international financial institutions. Maximum risk of loss on these contracts is limited to the amount of the difference between the spot rate at the date of the contract delivery and the contracted rate. Dividend Policy The company's Board of Directors has a policy to pay a cash dividend on common stock each quarter when feasible. In setting dividend payments, the board considers the dividend rate in relation to the company's recent and projected earnings and its capital investment opportunities and requirements. The company has paid a dividend each year since 1934. Forward-Looking Statements The company wants to caution readers that any forward-looking statements (those which talk about the company's or management's current expectations as to the future) in this Annual Report or made by the company management involve risks and uncertainties which may change based on various important factors. Some of the factors which could cause future financial performance to differ materially from the expectations as expressed in any forward-looking statement made by or on behalf of the company include: o changes in postal regulations o timely development and acceptance of new products o success in gaining product approval in new markets where regulatory approval is required o successful entry into new markets o mailers' utilization of alternative means of communication or competitors' products o our success at managing customer credit risk 25 - -------------------------------------------------------------------------------- ================================================================================ Summary of Selected Financial Data ================================================================================ (Dollars in thousands, except per share data) Years ended December 31 ------------------------------------------------------------------------------- 1997 1996 1995 1994 1993 - ----------------------------------------------------------------------------------------------------------------------------------- Total revenue $4,100,464 $3,858,579 $3,554,754 $3,270,613 $3,000,386 Costs and expenses 3,297,366 3,174,196 2,935,823 2,729,472 2,501,526 Nonrecurring items, net -- -- -- (25,366) -- - ----------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations before income taxes 803,098 684,383 618,931 566,507 498,860 Provision for income taxes 277,071 214,970 211,222 218,077 193,166 - ----------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 526,027 469,413 407,709 348,430 305,694 Discontinued operations -- -- 175,431 45,161 47,495 Effect of accounting changes -- -- -- (119,532) -- - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 526,027 $ 469,413 $ 583,140 $ 274,059 $ 353,189 =================================================================================================================================== Basic earnings per share: Continuing operations $1.82 $1.57 $1.35 $1.11 $.97 Discontinued operations -- -- .58 .15 .15 Effect of accounting changes -- -- -- (.38) -- - ----------------------------------------------------------------------------------------------------------------------------------- Net income $1.82 $1.57 $1.93 $.88 $1.12 =================================================================================================================================== Diluted earnings per share: Continuing operations $1.80 $1.56 $1.34 $1.10 $.96 Discontinued operations -- -- .57 .15 .15 Effect of accounting changes -- -- -- (.38) -- - ----------------------------------------------------------------------------------------------------------------------------------- Net income $1.80 $1.56 $1.91 $.87 $1.11 =================================================================================================================================== Total dividends on common, preference and preferred stock $231,392 $206,115 $181,657 $162,714 $142,142 Dividends per share of common stock $.80 $.69 $.60 $.52 $.45 Average common and potential common shares outstanding 292,517,116 301,303,356 304,739,952 315,485,784 318,784,232 Balance sheet at December 31 Total assets $7,893,389 $8,155,722 $7,844,648 $7,399,720 $6,793,816 Long-term debt $1,068,395 $1,300,434 $1,048,515 $779,217 $847,316 Capital lease obligations $10,142 $12,631 $14,241 $23,147 $29,462 Stockholders' equity $1,872,577 $2,239,046 $2,071,100 $1,745,069 $1,871,595 Book value per common share $6.69 $7.56 $6.90 $5.76 $5.91 Ratios Profit margin -- continuing operations: Pretax earnings 19.6% 17.7% 17.4% 17.3% 16.6% After-tax earnings 12.8% 12.2% 11.5% 10.7% 10.2% Return on stockholders' equity -- before accounting changes 28.1% 21.0% 28.2% 22.6% 18.9% Debt to total capital 64.2% 60.5% 62.2% 66.3% 61.3% Other Common stockholders of record 31,092 32,258 32,859 31,226 31,189 Total employees 29,901 28,625 27,723 32,792 32,539 Postage meters in service in the U.S., U.K. and Canada 1,561,668 1,494,157 1,517,806 1,480,692 1,445,689 See notes, pages 31 through 46 26 - -------------------------------------------------------------------------------- ================================================================================ Consolidated Statements of Income ================================================================================ (Dollars in thousands, except per share data) Years ended December 31 ------------------------------------------------------ 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------------------------- Revenue from: Sales $1,834,057 $1,675,090 $1,546,393 Rentals and financing 1,782,851 1,717,738 1,575,094 Support services 483,556 465,751 433,267 - ----------------------------------------------------------------------------------------------------------------------------------- Total revenue 4,100,464 3,858,579 3,554,754 - ----------------------------------------------------------------------------------------------------------------------------------- Costs and expenses: Cost of sales 1,081,537 1,025,250 941,124 Cost of rentals and financing 557,769 529,740 463,601 Selling, service and administrative 1,367,862 1,340,276 1,230,671 Research and development 89,463 81,726 81,800 Interest expense 209,194 203,877 226,110 Interest income (8,459) (6,673) (7,483) - ----------------------------------------------------------------------------------------------------------------------------------- Total costs and expenses 3,297,366 3,174,196 2,935,823 - ----------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations before income taxes 803,098 684,383 618,931 Provision for income taxes 277,071 214,970 211,222 - ----------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 526,027 469,413 407,709 Income, net of income tax, from discontinued operations -- -- 21,483 Net gains on sale of discontinued operations -- -- 153,948 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 526,027 $ 469,413 $ 583,140 =================================================================================================================================== Basic earnings per share: Income from continuing operations $1.82 $1.57 $1.35 Discontinued operations -- -- .58 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $1.82 $1.57 $1.93 =================================================================================================================================== Diluted earnings per share: Income from continuing operations $1.80 $1.56 $1.34 Discontinued operations -- -- .57 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $1.80 $1.56 $1.91 =================================================================================================================================== See notes, pages 31 through 46 27 - -------------------------------------------------------------------------------- ================================================================================ Consolidated Balance Sheets ================================================================================ (Dollars in thousands, except per share data) December 31 ------------------------------ 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------------- Assets Current assets: Cash and cash equivalents $ 137,073 $ 135,271 Short-term investments, at cost which approximates market 1,722 1,500 Accounts receivable, less allowances: 1997, $21,129; 1996, $16,160 348,792 340,730 Finance receivables, less allowances: 1997, $54,170; 1996, $40,176 1,546,542 1,339,286 Inventories 249,207 281,942 Other current assets and prepayments 180,179 123,337 - ----------------------------------------------------------------------------------------------------------------------------------- Total current assets 2,463,515 2,222,066 Property, plant and equipment, net 497,261 486,029 Rental equipment and related inventories, net 788,035 815,306 Property leased under capital leases, net 4,396 5,848 Long-term finance receivables, less allowances: 1997, $78,138; 1996, $73,561 2,581,349 3,450,231 Investment in leveraged leases 727,783 633,682 Goodwill, net of amortization: 1997, $40,912; 1996, $34,372 203,419 205,802 Other assets 627,631 336,758 - ----------------------------------------------------------------------------------------------------------------------------------- Total assets $ 7,893,389 $ 8,155,722 =================================================================================================================================== Liabilities and stockholders' equity Current liabilities: Accounts payable and accrued liabilities $ 878,759 $ 849,789 Income taxes payable 147,921 212,155 Notes payable and current portion of long-term obligations 1,982,988 1,911,481 Advance billings 363,565 331,864 - ----------------------------------------------------------------------------------------------------------------------------------- Total current liabilities 3,373,233 3,305,289 Deferred taxes on income 905,768 720,840 Long-term debt 1,068,395 1,300,434 Other noncurrent liabilities 373,416 390,113 - ----------------------------------------------------------------------------------------------------------------------------------- Total liabilities 5,720,812 5,716,676 - ----------------------------------------------------------------------------------------------------------------------------------- Preferred stockholders' equity in a subsidiary company 300,000 200,000 Stockholders' equity: Cumulative preferred stock, $50 par value, 4% convertible 39 46 Cumulative preference stock, no par value, $2.12 convertible 2,220 2,369 Common stock, $1 par value (480,000,000 shares authorized; 323,337,912 shares issued) 323,338 323,338 Capital in excess of par value 28,028 30,260 Retained earnings 2,744,929 2,450,294 Cumulative translation adjustments (63,348) (31,297) Treasury stock, at cost (43,664,034 shares) (1,162,629) (535,964) - ----------------------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 1,872,577 2,239,046 - ----------------------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 7,893,389 $ 8,155,722 =================================================================================================================================== See notes, pages 31 through 46 28 - -------------------------------------------------------------------------------- ================================================================================ Consolidated Statements of Cash Flows ================================================================================ (Dollars in thousands) Years ended December 31 ------------------------------------- 1997 1996(a) 1995(a) - --------------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 526,027 $ 469,413 $ 583,140 Net gains on sale of discontinued operations -- -- (153,948) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 300,086 278,168 271,648 Net change in the strategic focus initiative -- (16,826) (45,078) Increase in deferred taxes on income 185,524 106,298 148,828 Change in assets and liabilities: Accounts receivable (11,295) 49,187 (18,696) Sales-type lease receivables (192,365) (225,565) (146,010) Inventories 30,526 35,256 9,788 Other current assets and prepayments (58,135) (14,467) (7,519) Accounts payable and accrued liabilities 33,622 43,125 28,517 Income taxes payable (62,910) (21,281) (96,436) Advance billings 33,607 16,715 22,637 Other, net (81,274) (28,543) (20,391) - --------------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 703,413 691,480 576,480 - --------------------------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Short-term investments (388) 548 (2,553) Net investment in fixed assets (244,065) (271,972) (337,718) Net investment in direct-finance lease receivables 672,148 50,494 (316,343) Investment in leveraged leases (95,600) (63,320) (141,898) Investment in mortgage servicing rights (105,955) (50,407) (63,533) Proceeds from sales of subsidiaries -- -- 577,000 Other investing activities 432 (9,493) (4,415) - --------------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 226,572 (344,150) (289,460) - --------------------------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Increase (decrease) in notes payable 89,536 (467,838) (432,418) Proceeds from long-term obligations -- 500,000 275,000 Principal payments on long-term obligations (256,326) (12,181) (66,734) Proceeds from issuance of stock 33,396 31,201 26,999 Stock repurchases (662,758) (144,475) (98,038) Proceeds from preferred stock issued by a subsidiary 100,000 -- 200,000 Dividends paid (231,392) (206,115) (181,657) - --------------------------------------------------------------------------------------------------------------------------------- Net cash used in financing activities (927,544) (299,408) (276,848) - --------------------------------------------------------------------------------------------------------------------------------- Effect of exchange rate changes on cash (639) 1,997 74 - --------------------------------------------------------------------------------------------------------------------------------- Increase in cash and cash equivalents 1,802 49,919 10,246 Cash and cash equivalents at beginning of year 135,271 85,352 75,106 - --------------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 137,073 $ 135,271 $ 85,352 ================================================================================================================================= Interest paid $ 203,870 $ 204,596 $ 228,460 ================================================================================================================================= Income taxes paid, net $ 159,854 $ 111,176 $ 163,745 ================================================================================================================================= (a) Certain prior year amounts have been reclassified to conform with the 1997 presentation. See notes, pages 31 through 46 29 - -------------------------------------------------------------------------------- ================================================================================ Consolidated Statements of Stockholders' Equity ================================================================================ (Dollars in thousands, except per share data) Capital in Cumulative Treasury Preferred Preference Common excess of Retained translation stock, stock stock stock par value earnings adjustments at cost - ----------------------------------------------------------------------------------------------------------------------------------- Balance, January 1, 1995 $48 $2,790 $323,338 $35,200 $1,785,513 $(41,617) $ (360,203) Net income 583,140 Cash dividends: Preferred ($2.00 per share) (1) Preference ($2.12 per share) (261) Common ($.60 per share) (181,395) Issuances under dividend reinvestment and stock plans (4,047) 30,594 Conversions to common stock (1) (243) (2,267) 2,511 Repurchase of common stock (98,038) Translation adjustments (5,374) Tax credits relating to stock options 1,413 - ----------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1995 47 2,547 323,338 30,299 2,186,996 (46,991) (425,136) Net income 469,413 Cash dividends: Preferred ($2.00 per share) (1) Preference ($2.12 per share) (194) Common ($.69 per share) (205,920) Issuances under dividend reinvestment and stock plans (2,441) 31,649 Conversions to common stock (1) (178) (1,819) 1,998 Repurchase of common stock (144,475) Translation adjustments 15,694 Tax credits relating to stock options 4,221 - ----------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1996 46 2,369 323,338 30,260 2,450,294 (31,297) (535,964) Net income 526,027 Cash dividends: Preferred ($2.00 per share) (1) Preference ($2.12 per share) (179) Common ($.80 per share) (231,212) Issuances under dividend reinvestment and stock plans (2,741) 33,997 Conversions to common stock (7) (149) (1,940) 2,096 Repurchase of common stock (662,758) Translation adjustments (32,051) Tax credits relating to stock options 2,449 - ----------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1997 $39 $2,220 $323,338 $28,028 $2,744,929 $(63,348) $(1,162,629) =================================================================================================================================== See notes, pages 31 through 46 30 - -------------------------------------------------------------------------------- ================================================================================ Notes to Consolidated Financial Statements ================================================================================ (Dollars in thousands, except per share data or as otherwise indicated) 1. Summary of significant accounting policies Consolidation The consolidated financial statements include the accounts of Pitney Bowes Inc. and all of its subsidiaries (the company). All significant intercompany transactions have been eliminated. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash equivalents, short-term investments and accounts receivable Cash equivalents include short-term, highly liquid investments with a maturity of three months or less from the date of acquisition. The company places its temporary cash and short-term investments with financial institutions and limits the amount of credit exposure with any one financial institution. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of customers and relatively small account balances within the majority of the company's customer base, and their dispersion across different businesses and geographic areas. Inventory valuation Inventories are valued at the lower of cost or market. Cost is determined on the last-in, first-out (LIFO) basis for most U.S. inventories, and on the first-in, first-out (FIFO) basis for most non-U.S. inventories. Fixed assets and depreciation Property, plant and equipment are stated at cost and depreciated principally using the straight-line method over appropriate periods: machinery and equipment principally three to 15 years and buildings up to 50 years. Major improvements which add to productive capacity or extend the life of an asset are capitalized while repairs and maintenance are charged to expense as incurred. Rental equipment is depreciated on the straight-line method over appropriate periods, principally three to ten years. Other depreciable assets are depreciated using either the straight-line method or accelerated methods. Properties leased under capital leases are amortized on a straight-line basis over the primary lease terms. Rental arrangements and advance billings The company rents equipment to its customers, primarily postage meters and mailing, shipping, copier and facsimile systems under short-term rental agreements, generally for periods of three months to three years. Charges for equipment rental and maintenance contracts are billed in advance; the related revenue is included in advance billings and taken into income as earned. Asset valuation The company periodically reviews the fair value of long-lived assets and capitalized mortgage servicing rights for impairment. Financing transactions At the time a finance transaction is consummated, the company's finance operations record the gross finance receivable, unearned income and the estimated residual value of leased equipment. Unearned income represents the excess of the gross finance receivable plus the estimated residual value over the cost of equipment or contract acquired. Unearned income is recognized as financing income using the interest method over the term of the transaction and is included in rentals and financing revenue in the Consolidated Statements of Income. Initial direct costs incurred in consummating a transaction are accounted for as part of the investment in a lease and amortized to income using the interest method over the term of the lease. In establishing the provision for credit losses, the company has successfully utilized an asset-based percentage. This percentage varies depending on the nature of the asset, recent historical experience, vendor recourse, management judgment and the credit rating of the respective customer. The company evaluates the collectibility of its net investment in finance receivables based upon its loss experience and assessment of prospective risk, and does so through ongoing reviews of its exposures to net asset impairment. The carrying value of its net investment in finance receivables is adjusted to the estimated collectible amount through adjustments to the allowance for credit losses. Finance receivables are charged to the allowance for credit losses after collection efforts are exhausted and the account is deemed uncollectible. The company's general policy is to discontinue income recognition for finance receivables contractually past due for over 90 to 120 days depending on the nature of the transaction. Resumption of income recognition occurs when payments reduce the account to 60 days or less past due. However, large-ticket external transactions are reviewed on an individual basis. Income recognition is normally discontinued as soon as it is apparent that the obligor will not be making payments in accordance with lease terms and resumed after the company has sufficient experience on resumption of payments to be satisfied that such payments will continue in accordance with the original or restructured contract terms. The company has, from time to time, sold selected finance assets. The company follows Statement of Financial Accounting Standards (FAS) No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," when accounting for its sale of finance assets. All assets obtained or liabilities incurred in consideration are recognized as proceeds of the sale and any gain or loss on the sale is recognized in earnings. The company's investment in leveraged leases consists of rentals receivable net of principal and interest on the related nonrecourse debt, estimated residual value of the leased property and unearned 31 - -------------------------------------------------------------------------------- income. The unearned income is recognized as leveraged lease revenue in income from investments over the lease term. Goodwill Goodwill represents the excess of cost over the value of net tangible assets acquired in business combinations and is amortized using the straight-line method over appropriate periods, principally 40 years. The recoverability of goodwill is assessed by determining whether the unamortized balance can be recovered from expected future cash flows from the applicable operation. Revenue Sales revenue is primarily recognized when a product is shipped. Costs and expenses Operating expenses of field sales and service offices are included in selling, service and administrative expenses because no meaningful allocation of such expenses to cost of sales, rentals and financing or support services is practicable. Income taxes The deferred tax provision is determined under the liability method. Deferred tax assets and liabilities are recognized based on differences between the book and tax bases of assets and liabilities using currently enacted tax rates. The provision for income taxes is the sum of the amount of income tax paid or payable for the year as determined by applying the provisions of enacted tax laws to the taxable income for that year and the net change during the year in the company's deferred tax assets and liabilities. Deferred taxes on income result principally from expenses not currently recognized for tax purposes, the excess of tax over book depreciation, recognition of lease income and gross profits on sales to finance subsidiaries. For tax purposes, income from leases is recognized under the operating method and represents the difference between gross rentals billed and depreciation expense. It has not been necessary to provide for income taxes on $385 million of cumulative undistributed earnings of subsidiaries outside the U.S. These earnings will be either indefinitely reinvested or remitted substantially free of additional tax. Determination of the liability that would result in the event all of these earnings were remitted to the U.S. is not practicable. It is estimated, however, that withholding taxes on such remittances would approximate $12 million. Nonpension postretirement benefits and postemployment benefits The company provides certain health care and life insurance benefits to eligible retirees and their dependents. The cost of these benefits are recognized over the period the employee provides credited service to the company. Substantially all of the company's U.S. and Canadian employees become eligible for retiree health care benefits after reaching age 55 and with the completion of the required service period. Postemployment benefits include primarily company-provided medical benefits to disabled employees and company-provided life insurance as well as other disability- and death-related benefits to former or inactive employees, their beneficiaries and covered dependents. It is the company's practice to fund amounts for these nonpension postretirement and postemployment benefits as incurred. Earnings per share In December 1997, the company adopted FAS No. 128, "Earnings per Share." Under FAS No. 128, basic earnings per share is based on the weighted average number of common shares outstanding during the year, whereas diluted earnings per share also gives effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares include preference stock, preferred stock and stock option and purchase plan shares. Postage deposits The company's U.S. customers using the Pitney Bowes Postage By Phone(R) meter setting system, a computerized system developed by the company for the resetting of postage meters via telephone, can elect to make deposits directly with the United States Postal Service (USPS) to cover expected postage usage. Such customers can also elect, for a fee, to have the company pay the postage to the USPS under a revolving credit product called Purchase Power(SM). The company earns income on balances from customers who elect to use our credit facilities. Resetting fees received by the company are not affected by the customers' choice of payment method. Foreign exchange Assets and liabilities of subsidiaries operating outside the U.S. are translated at rates in effect at the end of the period, and revenues and expenses are translated at average rates during the period. Net deferred translation gains and losses are accumulated in stockholders' equity. The company enters into foreign exchange contracts for purposes other than trading primarily to minimize its risk of loss from exchange rate fluctuations on the settlement of intercompany receivables and payables arising in connection with transfers of finished goods inventories between affiliates and certain intercompany loans. Gains and losses on foreign exchange contracts entered into as hedges are deferred and recognized as part of the cost of the underlying transaction. At December 31, 1997, the company had approximately $290.8 million of foreign exchange contracts outstanding, most of which mature in 1998, to buy or sell various currencies. Risks arise from the possible non-performance by counterparties in meeting the terms of their contracts and from movements in securities values, interest and/or exchange rates. However, the company does not anticipate non-performance by the counterparties as they are composed of a number of major international financial institutions. Maximum risk 32 - -------------------------------------------------------------------------------- of loss on these contracts is limited to the amount of the difference between the spot rate at the date of the contract delivery and the contracted rate. Foreign currency transaction gains and (losses) net of tax were $.5 million, $(.5) million and $1.6 million in 1997, 1996 and 1995, respectively. 2. Inventories Inventories consist of the following: December 31 1997 1996 - -------------------------------------------------------------------------------- Raw materials and work in process $ 51,429 $ 58,536 Supplies and service parts 93,064 103,182 Finished products 104,714 120,224 - -------------------------------------------------------------------------------- Total $249,207 $281,942 ================================================================================ Had all inventories valued at LIFO been stated at current costs, inventories would have been $33.8 million and $37.3 million higher than reported at December 31, 1997 and 1996, respectively. 3. Fixed assets December 31 1997 1996 - -------------------------------------------------------------------------------- Land $ 34,844 $ 34,859 Buildings 307,341 304,631 Machinery and equipment 778,140 754,011 - -------------------------------------------------------------------------------- 1,120,325 1,093,501 Accumulated depreciation (623,064) (607,472) - -------------------------------------------------------------------------------- Property, plant and equipment, net $ 497,261 $ 486,029 ================================================================================ Rental equipment and related inventories $ 1,577,370 $ 1,634,111 Accumulated depreciation (789,335) (818,805) - -------------------------------------------------------------------------------- Rental equipment and related inventories, net $ 788,035 $ 815,306 ================================================================================ Property leased under capital leases $ 20,507 $ 24,124 Accumulated amortization (16,111) (18,276) - -------------------------------------------------------------------------------- Property leased under capital leases, net $ 4,396 $ 5,848 ================================================================================ 4. Current liabilities Accounts payable and accrued liabilities and notes payable and current portion of long-term obligations are comprised as follows: December 31 1997 1996 - -------------------------------------------------------------------------------- Accounts payable - trade $ 263,416 $ 245,274 Accrued salaries, wages and commissions 106,670 90,452 Accrued pension benefits 84,005 77,323 Accrued nonpension postretirement benefits 15,500 15,500 Accrued postemployment benefits 6,900 6,884 Miscellaneous accounts payable and accrued liabilities 402,268 414,356 - -------------------------------------------------------------------------------- Accounts payable and accrued liabilities $ 878,759 $ 849,789 ================================================================================ Notes payable and overdrafts $1,747,377 $1,656,574 Current portion of long-term debt 234,080 253,190 Current portion of capital lease obligations 1,531 1,717 - -------------------------------------------------------------------------------- Notes payable and current portion of long-term obligations $1,982,988 $1,911,481 ================================================================================ In countries outside the U.S., banks generally lend to non-finance subsidiaries of the company on an overdraft or term-loan basis. These overdraft arrangements and term-loans, for the most part, are extended on an uncommitted basis by banks and do not require compensating balances or commitment fees. Notes payable were issued as commercial paper, loans against bank lines of credit, or to trust departments of banks and others at below prevailing prime rates. Fees paid to maintain lines of credit were $.9 million, $1.5 million and $1.8 million in 1997, 1996 and 1995, respectively. At December 31, 1997, overdrafts outside the U.S. totaled $2.8 million and U.S. notes payable totaled $1.7 billion. Unused credit facilities outside the U.S. totaled $75.6 million at December 31, 1997 of which $31.9 million were for finance operations. In the U.S., the company had unused credit facilities of $1.8 billion at December 31, 1997, largely in support of commercial paper borrowings, of which $1.5 billion were for its finance operations. The weighted average interest rates were 4.8% and 4.9% on notes payable and overdrafts outstanding at December 31, 1997 and 1996, respectively. The company periodically enters into interest rate swap agreements as a means of managing interest rate exposure on both its U.S. and non-U.S. debt. The interest differential to be paid or received is recognized over the life of the agreements as an adjustment to interest expense. The company is exposed to credit 33 - -------------------------------------------------------------------------------- losses in the event of non-performance by swap counterparties to the extent of the differential between the fixed and variable rates; such exposure is considered minimal. The company enters into interest rate swap agreements primarily through its Pitney Bowes Credit Corporation (PBCC) subsidiary. It has been the policy and objective of the company to use a balanced mix of debt maturities, variable and fixed rate debt and interest rate swap agreements to control its sensitivity to interest rate volatility. The company's variable and fixed rate debt mix, after adjusting for the effect of interest rate swap agreements, was 48% and 52%, respectively, at December 31, 1997. The company utilizes interest rate swap agreements when it considers the economic benefits to be favorable. Swap agreements, as noted above, have been principally utilized to fix interest rates on commercial paper and/or obtain a lower cost on debt than would otherwise be available absent the swap. At December 31, 1997, the company had outstanding interest rate swap agreements with notional principal amounts of $268.5 million and terms expiring at various dates from 1999 to 2007. The company exchanged variable commercial paper rates on an equal notional amount of notes payable and overdrafts for fixed rates ranging from 5.9% to 10.75%. 5. Long-term debt December 31 1997 1996 - -------------------------------------------------------------------------------- Non-financial services debt: Due 1998-2003 (3.88% to 5.50%) $ 3,175 $ 3,730 Financial services debt: Senior notes: 5.84% to 6.305% notes due 1998 -- 225,000 6.54% notes due 1999 200,000 200,000 6.06% to 6.11% notes due 2000 50,000 50,000 6.78% to 6.80% notes due 2001 200,000 200,000 6.63% notes due 2002 100,000 100,000 8.80% notes due 2003 150,000 150,000 8.63% notes due 2008 100,000 100,000 9.25% notes due 2008 100,000 100,000 8.55% notes due 2009 150,000 150,000 Canadian dollar notes due 1998-2000 (11.05% to 12.50%) 15,220 21,020 Other -- 684 - -------------------------------------------------------------------------------- Total long-term debt $1,068,395 $1,300,434 ================================================================================ The company has a medium-term note facility which was established as a part of the company's shelf registrations, permitting issuance of up to $100 million in debt securities, of which $32 million remained available at December 31, 1997. Securities issued under this medium-term note facility would have maturities ranging from more than one year up to 30 years. The company also had an additional $300 million remaining on a shelf registration statement filed with the Securities and Exchange Commission (SEC). On January 22, 1998, the company issued notes amounting to $300 million available under this shelf registration. These unsecured notes bear annual interest at 5.95% and mature in February 2005. The notes are redeemable earlier at the company's option. The net proceeds from these notes will be used for general corporate purposes, including the repayment of short-term debt. PBCC had $250 million of unissued debt securities available from a shelf registration statement filed with the SEC in September 1995. On January 16, 1998, PBCC issued notes amounting to $250 million available under this shelf registration. These unsecured notes bear annual interest at 5.65% and mature in January 2003. The proceeds will be used to meet PBCC's financing needs over the next 12 months. The annual maturities of the outstanding debt during each of the next five years are as follows: 1998, $234.1 million; 1999, $204.9 million; 2000, $62.0 million; 2001, $200.7 million and 2002, $100.2 million. Under terms of their senior and subordinated loan agreements, certain of the finance operations are required to maintain earnings before taxes and interest charges at prescribed levels. With respect to such loan agreements, the company will endeavor to have these finance operations maintain compliance with such terms and, under certain loan agreements, is obligated, if necessary, to pay to these finance operations amounts sufficient to maintain a prescribed ratio of earnings available for fixed charges. The company has not been required to make any such payments to maintain earnings available for fixed charges coverage. 6. Preferred stockholders' equity in a subsidiary company Preferred stockholders' equity in a subsidiary company represents 3,000,000 shares of variable term voting preferred stock issued by Pitney Bowes International Holdings, Inc., a subsidiary of the company, which are owned by certain outside institutional investors. These preferred shares are entitled to 25% of the combined voting power of all classes of capital stock. All outstanding common stock of Pitney Bowes International Holdings, Inc., representing the remaining 75% of the combined voting power of all classes of capital stock, is owned directly or indirectly by Pitney Bowes Inc. The preferred stock, $.01 par value, is entitled to cumulative dividends at rates set at auction. The weighted average dividend rate in 1997 and 1996 was 4.1% and 4.0%, respectively. Preferred dividends are reflected as a minority interest in the Consolidated Statements of Income in selling, service and administrative expenses. The preferred stock is subject to mandatory redemption based on certain events, at a redemption price not less than $100 per share, plus the amount of any dividends accrued or in arrears. No dividends were in arrears at December 31, 1997 or 1996. 34 - -------------------------------------------------------------------------------- 7. Capital stock and capital in excess of par value On December 18, 1997, the company's stockholders voted to amend the Restated Certificate of Incorporation to increase the number of authorized common shares from 240,000,000 to 480,000,000 shares and reduce the par value per common share from $2 to $1. This action resulted in a two-for-one split of the company's common stock as previously approved by the Board of Directors. All previously reported common share and per common share data has been restated. At December 31, 1997, 480,000,000 shares of common stock, 600,000 shares of cumulative preferred stock, and 5,000,000 shares of preference stock were authorized, and 279,673,878 shares of common stock (net of 43,664,034 shares of treasury stock), 788 shares of 4% Convertible Cumulative Preferred Stock (4% preferred stock) and 81,975 shares of $2.12 Convertible Preference Stock ($2.12 preference stock) were issued and outstanding. In the future, the Board of Directors can issue the balance of unreserved and unissued preferred stock (599,212 shares) and preference stock (4,918,025 shares). This will determine the dividend rate, terms of redemption, terms of conversion (if any) and other pertinent features. At December 31, 1997, unreserved and unissued common stock (exclusive of treasury stock) amounted to 129,310,772 shares. The 4% preferred stock outstanding, entitled to cumulative dividends at the rate of $2 per year, can be redeemed at the company's option, in whole or in part at any time, at the price of $50 per share, plus dividends accrued to the redemption date. Each share of the 4% preferred stock can be converted into 24.24 shares of common stock, subject to adjustment in certain events. The $2.12 preference stock is entitled to cumulative dividends at the rate of $2.12 per year and can be redeemed at the company's option at the rate of $28 per share. Each share of the $2.12 preference stock can be converted into 16 shares of common stock, subject to adjustment in certain events. At December 31, 1997, a total of 1,330,701 shares of common stock were reserved for issuance upon conversion of the 4% preferred stock (19,101 shares) and $2.12 preference stock (1,311,600 shares). In addition, 2,608,136 shares of common stock were reserved for issuance under the company's dividend reinvestment and other corporate plans. Each share of common stock outstanding has attached one preference share purchase right. Each right entitles each holder to purchase 1/200th of a share of Series A Junior Participating Preference Stock for $97.50 and will expire in February 2006. Following a merger or certain other transactions, the rights will entitle the holder to purchase common stock of the company or the acquirers at a 50% discount. 8. Stock plans The company has the following stock plans which are described below: the U.S. and U.K. Stock Option Plans (ESP), the U.S. and U.K. Employee Stock Purchase Plans (ESPP), and the Directors' Stock Plan. The company adopted FAS No. 123, "Accounting for Stock-Based Compensation," on January 1, 1996. Under FAS No. 123, companies can, but are not required to, elect to recognize compensation expense for all stock-based awards using a fair value methodology. The company has adopted the disclosure-only provisions, as permitted by FAS No. 123. The company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its stock-based plans. Accordingly, no compensation expense has been recognized for the ESP or the ESPP, except for the compensation expense recorded for its performance-based awards under the ESP and the Directors' Stock Plan as discussed herein. If the company had elected to recognize compensation expense based on the fair value method as prescribed by FAS No. 123, net income and earnings per share for the years ended 1997, 1996 and 1995 would have been reduced to the following pro forma amounts: 1997 1996 1995 - -------------------------------------------------------------------------------- Net income As reported $526,027 $469,413 $583,140 Pro forma $523,400 $467,742 $582,510 Basic earnings per share As reported $1.82 $1.57 $1.93 Pro forma $1.81 $1.57 $1.93 Diluted earnings per share As reported $1.80 $1.56 $1.91 Pro forma $1.79 $1.55 $1.91 - -------------------------------------------------------------------------------- In accordance with FAS No. 123, the fair value method of accounting has not been applied to awards granted prior to January 1, 1995. Therefore, the resulting pro forma impact may not be representative of that to be expected in future years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: 1997 1996 1995 - ------------------------------------------------------------------------------- Expected dividend yield 2.0% 2.5% 2.5% Expected stock price volatility 17% 17% 17% Risk-free interest rate 6% 6% 6% Expected life (years) 5 5 5 - ------------------------------------------------------------------------------- Stock Option Plans Under the company's stock option plans, certain officers and employees of the U.S. and the company's participating U.K. subsidiaries are granted options at prices equal to the market value of the company's common shares at the date of grant. Options become exercisable in three equal installments during 35 - -------------------------------------------------------------------------------- the first three years following their grant and expire after ten years. At December 31, 1997, there were 6,314,258 options available for future grants under these plans. The per share weighted average fair value of options granted was $7 in 1997, $5 in 1996 and $4 in 1995. The following table summarizes information about stock option transactions: Per share weighted average exercise Shares price - -------------------------------------------------------------------------------- Options outstanding at January 1, 1995 4,044,772 $15 Granted 1,025,504 $17 Exercised (649,940) $11 Canceled (59,334) $18 - -------------------------------------------------------------------------------- Options outstanding at December 31, 1995 4,361,002 $16 Granted 805,790 $26 Exercised (702,560) $15 Canceled (86,258) $22 - -------------------------------------------------------------------------------- Options outstanding at December 31, 1996 4,377,974 $18 Granted 1,837,730 $30 Exercised (774,728) $17 Canceled (67,852) $28 - -------------------------------------------------------------------------------- Options outstanding at December 31, 1997 5,373,124 $23 ================================================================================ Options exercisable at December 31, 1995 2,823,052 $15 ================================================================================ Options exercisable at December 31, 1996 2,017,702 $15 ================================================================================ Options exercisable at December 31, 1997 2,703,734 $18 ================================================================================ The following table summarizes information about stock options outstanding at December 31, 1997: Options Outstanding - -------------------------------------------------------------------------------- Weighted Per share Range of average weighted per share remaining average exercise contractual exercise prices Number life price - -------------------------------------------------------------------------------- $9-$20 2,340,638 5.6 years $16 $21-$30 2,862,392 9.2 years $27 $36-$45 170,094 10.0 years $39 - -------------------------------------------------------------------------------- 5,373,124 7.7 years ================================================================================ At December 31, 1997, there were 2,075,066 and 628,668 options exercisable with per share exercise prices ranging from $9 to $20 and $21 to $30, respectively. The per share weighted average exercise prices of these options were $16 and $23, respectively. Beginning in 1997, certain employees eligible for performance-based compensation may defer up to 100% of their annual awards, subject to the terms and conditions of the Pitney Bowes Deferred Incentive Savings Plan. Participants may allocate deferred compensation among specified investment choices, including stock options under the U.S. stock option plan. Stock options acquired under this plan are exercisable three years following their grant and expire after a period not to exceed ten years. At December 31, 1997, there were 90,904 options outstanding under this plan which are included in outstanding options under the company's U.S. stock option plan. The per share weighted average fair value of options granted was $7 in 1997. Certain executives are awarded restricted stock under the company's U.S. stock option plan. Restricted stock awards are subject to both tenure and financial performance over three years. The restrictions on the shares are released, in total or in part, only if the executive is still employed by the company at the end of the performance period and if the performance objectives are achieved. There were no shares awarded in 1997, 100,500 shares awarded in 1996 and 112,600 shares awarded in 1995 at no cost to the executives. The compensation expense for each award is recognized over the performance period. Compensation expense recorded by the company related to these awards was $4.1 million, $2.0 million and $.8 million in 1997, 1996 and 1995, respectively. The per share weighted average fair value of shares awarded was $23 in 1996 and $16 in 1995. Employee Stock Purchase Plans The U.S. ESPP enables substantially all employees to purchase shares of the company's common stock at a discounted offering price. In 1997, the offering price was 90% of the average closing price of the company's common stock on the New York Stock Exchange for the 30 day period preceding the offering date. At no time will the exercise price be less than the lowest price permitted under Section 423 of the Internal Revenue Code. The U.K. ESPP enables eligible employees of the company's participating U.K. subsidiaries to purchase shares of the company's stock at a discounted offering price. In 1997, the offering price was 90% of the average closing price of the company's common stock on the New York Stock Exchange for the three business days preceding the offering date. The company may grant rights to purchase up to 10,626,634 common shares to its regular employees under these plans. The company granted rights to purchase 855,916 shares in 1997, 764,088 shares in 1996, and 852,678 shares in 1995. The per share fair value of rights granted was $4 in 1997, $3 in 1996 and $3 in 1995 for the U.S. ESPP and $9 in 1997, $7 in 1996 and $5 in 1995 for the U.K. ESPP. 36 - -------------------------------------------------------------------------------- Directors' Stock Plan Under this plan, each non-employee director is granted 1,400 shares of restricted common stock annually as part of their compensation. Shares granted at no cost to the directors were 10,900 in 1997, 7,200 in 1996 and 6,400 in 1995. Compensation expense recorded by the company was $370,000, $175,000 and $118,000 for 1997, 1996 and 1995, respectively. The shares carry full voting and dividend rights but may not be transferred or alienated until the later of (1) termination of service as a director, or, if earlier, the date of a change of control, or (2) the expiration of the six month period following the grant of such shares. The per share weighted average fair value of shares granted was $28 in 1997, $19 in 1996 and $14 in 1995. Beginning in 1997, non-employee directors may defer up to 100% of their eligible compensation, subject to the terms and conditions of the Pitney Bowes Deferred Incentive Savings Plan for directors. Participants may allocate deferred compensation among specified investment choices, including the Directors' Stock Plan. Stock options acquired under this plan are exercisable three years following their grant and expire after a period not to exceed ten years. At December 31, 1997, there were 1,994 options outstanding under this plan. The per share weighted average fair value of options granted was $9 in 1997. 9. Earnings per share A reconciliation of the basic and diluted earnings per share computations for income from continuing operations for the years ended December 31, 1997, 1996 and 1995 is as follows: 1997 ----------------------------------- Per Income Shares Share - -------------------------------------------------------------------------------- Income from continuing operations $526,027 Less: Preferred stock dividends (1) Preference stock dividends (179) - -------------------------------------------------------------------------------- Basic earnings per share $525,847 288,782,996 $1.82 - -------------------------------------------------------------------------------- Effect of dilutive securities: Preferred stock 1 21,420 Preference stock 179 1,355,116 Stock options 2,068,442 Employee stock purchase plan shares 289,142 - -------------------------------------------------------------------------------- Diluted earnings per share $526,027 292,517,116 $1.80 ================================================================================ 1996 ----------------------------------- Per Income Shares Share - -------------------------------------------------------------------------------- Income from continuing operations $469,413 Less: Preferred stock dividends (1) Preference stock dividends (194) - -------------------------------------------------------------------------------- Basic earnings per share $469,218 298,233,766 $1.57 - -------------------------------------------------------------------------------- Effect of dilutive securities: Preferred stock 1 22,882 Preference stock 194 1,453,512 Stock options 1,344,634 Employee stock purchase plan shares 248,562 - -------------------------------------------------------------------------------- Diluted earnings per share $469,413 301,303,356 $1.56 ================================================================================ 1995 ----------------------------------- Per Income Shares Share - -------------------------------------------------------------------------------- Income from continuing operations $407,709 Less: Preferred stock dividends (1) Preference stock dividends (261) - -------------------------------------------------------------------------------- Basic earnings per share $407,447 302,280,548 $1.35 - -------------------------------------------------------------------------------- Effect of dilutive securities: Preferred stock 1 23,004 Preference stock 261 1,570,710 Stock options 757,988 Employee stock purchase plan shares 107,702 - -------------------------------------------------------------------------------- Diluted earnings per share $407,709 304,739,952 $1.34 ================================================================================ 37 - -------------------------------------------------------------------------------- 10. Taxes on income Income from continuing operations before income taxes and the provision for income taxes consist of the following: Years ended December 31 --------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------- Income from continuing operations before income taxes: U.S. $ 717,867 $ 656,862 $ 566,806 Outside the U.S. 85,231 27,521 52,125 - ------------------------------------------------------------------------------- Total $ 803,098 $ 684,383 $ 618,931 =============================================================================== Provision for income taxes: U.S. federal: Current $ 117,146 $ 42,257 $ (17,024) Deferred 102,145 111,943 168,297 - ------------------------------------------------------------------------------- 219,291 154,200 151,273 - ------------------------------------------------------------------------------- U.S. state and local: Current 43,159 11,853 13,691 Deferred (7,946) 29,562 26,221 - ------------------------------------------------------------------------------- 35,213 41,415 39,912 - ------------------------------------------------------------------------------- Outside the U.S.: Current 33,596 28,694 28,233 Deferred (11,029) (9,339) (8,196) - ------------------------------------------------------------------------------- 22,567 19,355 20,037 - ------------------------------------------------------------------------------- Total current 193,901 82,804 24,900 Total deferred 83,170 132,166 186,322 - ------------------------------------------------------------------------------- Total $ 277,071 $ 214,970 $ 211,222 =============================================================================== Including discontinued operations, current provisions for 1995 federal, state and local and outside the U.S. would have been $87.6 million, $39.9 million and $41.9 million, respectively. Total tax provision would have been $355.7 million. In 1995 through 1997, the company recognized a reduction in tax expense on account of its investment in a life insurance program. In 1996, the company recognized U.S. tax benefits from the write-off of its Australian investment and from restructuring its Australian operations. A reconciliation of the U.S. federal statutory rate to the company's effective tax rate for continuing operations follows: 1997 1996 1995 - ------------------------------------------------------------------------------ U.S. federal statutory rate 35.0% 35.0% 35.0% State and local income taxes 2.8 3.9 4.2 Australian write-off -- (2.4) -- Life insurance investment (0.7) (1.7) (2.1) Other, net (2.6) (3.4) (3.0) - ------------------------------------------------------------------------------ Effective income tax rate 34.5% 31.4% 34.1% ============================================================================== The effective tax rate for discontinued operations in 1995 differs from the statutory rate due primarily to state and local income taxes and nondeductible goodwill. Deferred tax liabilities and (assets) December 31 1997 1996 - ------------------------------------------------------------------------------- Deferred tax liabilities: Depreciation $ 97,988 $ 72,930 Deferred profit (for tax purposes) on sales to finance subsidiaries 393,645 367,490 Lease revenue and related depreciation 843,422 816,831 Other 109,621 103,471 - ------------------------------------------------------------------------------- Deferred tax liabilities 1,444,676 1,360,722 - ------------------------------------------------------------------------------- Deferred tax assets: Nonpension postretirement benefits (125,377) (130,422) Pension liability (17,351) (17,995) Inventory and equipment capitalization (38,191) (33,145) Net operating loss carryforwards (43,602) (47,481) Alternative minimum tax (AMT) credit carryforwards (27,325) (80,773) Postemployment benefits (18,350) (19,963) Other (181,145) (124,263) Valuation allowance 41,301 46,601 - ------------------------------------------------------------------------------- Deferred tax assets (410,040) (407,441) - ------------------------------------------------------------------------------- Net deferred taxes $ 1,034,636 $ 953,281 =============================================================================== Net deferred taxes includes $128.9 million and $232.4 million for 1997 and 1996, respectively, of current deferred taxes, which are included in income taxes payable in the Consolidated Balance Sheets. The decrease in the deferred tax asset for net operating loss carryforwards and related valuation allowance was due mainly to the decrease in foreign exchange rates, particularly the German mark. The decrease was partially offset by losses incurred by certain foreign subsidiaries. At December 31, 1997 and 1996, approximately $94.5 million and $98.1 million, respectively, of net operating loss carryforwards were available to the company. Most of these losses, as well as the company's alternative minimum tax credit, can be carried forward indefinitely. 38 - -------------------------------------------------------------------------------- 11. Retirement plans The company has several defined benefit and defined contribution pension plans covering substantially all employees worldwide. Benefits are primarily based on employees' compensation and years of service. Company contributions are determined based on the funding requirements of U.S. federal and other governmental laws and regulations. During 1997, the company announced that it amended its U.S. defined benefit pension plan to a pay equity plan for most of its active U.S. employees and enhanced the employer contributions to the U.S. defined contribution plan. The net impact of these changes was a reduction in 1997 U.S. pension plan costs of approximately $15.4 million and a reduction in the projected benefit obligation for the U.S. defined benefit plan of $74.3 million. Total ongoing pension expense amounted to $29.9 million in 1997, $45.6 million in 1996 and $52.2 million in 1995. Net pension expense for defined benefit plans for 1997, 1996 and 1995 included the following components: United States Foreign -------------------------------------- -------------------------------------- 1997 1996 1995 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------------------------- Service cost - benefits earned during period $ 22,780 $ 31,952 $ 33,061 $ 6,771 $ 6,046 $ 5,952 Interest cost on projected benefit obligations 67,111 69,292 68,027 12,515 10,882 10,317 Actual return on plan assets (136,629) (114,641) (124,866) (34,525) (22,512) (17,594) Net amortization and deferral 55,143 44,574 58,831 19,719 9,885 5,237 - ----------------------------------------------------------------------------------------------------------------------------------- Ongoing net periodic defined benefit pension expense 8,405 31,177 35,053 4,480 4,301 3,912 Curtailment (gain) loss charge(a) -- -- (13,974) -- -- 2,921 - ----------------------------------------------------------------------------------------------------------------------------------- Total pension expense $ 8,405 $ 31,177 $ 21,079 $ 4,480 $ 4,301 $ 6,833 =================================================================================================================================== (a) The company merged the pension plans of Monarch Marking Systems, Inc. and Dictaphone Corporation into the Pitney Bowes Retirement Plan. Benefits ceased to be accrued for active employees of Monarch and Dictaphone as of the respective dates of the sale of these companies resulting in a net curtailment gain of approximately $14.0 million. There was a $2.9 million curtailment charge to the Pitney Bowes, Ltd. pension plan due primarily to actions taken by Pitney Bowes, Ltd. The funded status at December 31, 1997 and 1996 for the company's defined benefit plans was: United States Foreign ---------------------------- --------------------------- 1997 1996 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------------- Actuarial present value of: Vested benefits $ 818,931 $ 777,064 $ 150,232 $ 139,300 =================================================================================================================================== Accumulated benefit obligations $ 901,924 $ 858,590 $ 150,471 $ 139,569 =================================================================================================================================== Projected benefit obligations $ 968,950 $ 995,009 $ 179,713 $ 162,613 - ----------------------------------------------------------------------------------------------------------------------------------- Plan assets at fair value, primarily stocks and bonds, adjusted by: 959,632 868,752 209,629 179,040 Unrecognized net (gain) loss (7,854) 49,539 (20,317) (12,983) Unrecognized net asset (9,457) (12,636) (9,283) (11,096) Unamortized prior service costs from plan amendments (49,845) 20,655 5,789 7,316 - ----------------------------------------------------------------------------------------------------------------------------------- 892,476 926,310 185,818 162,277 - ----------------------------------------------------------------------------------------------------------------------------------- Net pension liability (asset) $ 76,474 $ 68,699 $ (6,105) $ 336 =================================================================================================================================== Assumptions for defined benefit plans:(a) Discount rate 7.25% 7.25% 4.0%-7.8% 4.0%-8.5% Rate of increase in future compensation levels 4.25% 4.25% 2.0%-5.0% 2.0%-5.5% Expected long-term rate of return on plan assets 9.50% 9.50% 4.0%-9.0% 4.0%-9.5% (a) Pension costs are determined using assumptions as of the beginning of the year while the funded status of the plans is determined using assumptions as of the end of the year. 39 - -------------------------------------------------------------------------------- 12. Nonpension postretirement benefits Net nonpension postretirement benefit costs consisted of the following components: Years ended December 31 -------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------- Service cost - benefits earned during the period $ 9,688 $ 10,445 $ 8,688 Interest cost on accumulated postretirement benefit obligations 18,770 17,654 18,917 Net deferral and amortization (16,045) (15,946) (17,920) - ------------------------------------------------------------------------------- Net periodic postretirement benefit costs $ 12,413 $ 12,153 $ 9,685 =============================================================================== The company's nonpension postretirement benefit plans are not funded. The status of the plans was as follows: December 31 1997 1996 - -------------------------------------------------------------------------------- Accumulated postretirement benefit obligations: Retirees and dependents $208,368 $206,114 Fully eligible active plan participants 48,570 53,810 Other active plan participants 49,784 44,832 Unrecognized net gain 1,057 2,047 Unrecognized prior service cost 23,141 37,463 - -------------------------------------------------------------------------------- Accrued nonpension postretirement benefits $330,920 $344,266 ================================================================================ The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligations was 7.25% and 8.25% in 1997 and 1996, respectively. This was assumed to gradually decline to 3.75% by the year 2000 and remain at that level thereafter for 1997 and 1996. A one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligations by approximately $13.7 million at December 31, 1997 and the net periodic postretirement health care cost by $1.1 million in 1997. The assumed weighted average discount rate used in determining the accumulated postretirement benefit obligations was 7.25% in 1997 and 1996. During 1997, the company amended its retiree medical program for current and future retirees of Pitney Bowes Management Services who will now have increased participant contributions. 13. Discontinued operations During 1995, the company sold its Monarch Marking Systems, Inc. (Monarch) and Dictaphone Corporation (Dictaphone) subsidiaries. The sales resulted in gains approximating $155 million, net of approximately $130 million of income taxes, from $577 million in proceeds. Dictaphone and Monarch have been classified in the Consolidated Statements of Income as discontinued operations. For the year ended December 31, 1995, Monarch and Dictaphone had revenues of $306 million. Net income was $21.5 million, net of $14.5 million of income taxes in 1995. 14. Commitments, contingencies and regulatory matters The company's finance subsidiaries had no unfunded commitments to extend credit to customers at December 31, 1997. The company evaluates each customer's creditworthiness on a case-by-case basis. Upon extension of credit, the amount and type of collateral obtained, if deemed necessary by the company, is based on management's credit assessment of the customer. Fees received under the agreements are recognized over the commitment period. The maximum risk of loss arises from the possible non-performance of the customer to meet the terms of the credit agreement. As part of the company's review of its exposure to risk, adequate provisions are made for finance assets which may be uncollectible. From time to time, the company is a party to lawsuits that arise in the ordinary course of its business. These lawsuits may involve litigation by or against the company to enforce contractual rights under vendor, insurance, or other contracts; lawsuits relating to intellectual property or patent rights; equipment, service or payment disputes with customers; disputes with employees; or other matters. The company is currently a defendant in a number of lawsuits, none of which should have, in the opinion of management and legal counsel, a material adverse effect on the company's financial position or results of operations. The company is subject to federal, state and local laws and regulations concerning the environment, and is currently participating in administrative or court proceedings as a participant in various groups of potentially responsible parties. As previously announced by the company, in 1996 the Environmental Protection Agency (EPA) issued an administrative order directing the company to be part of a soil cleanup program at the Sarney Farm site in Amenia, New York. The site was operated as a landfill between the years 1968 and 1970 by parties unrelated to the company, and wastes from a number of industrial sources were disposed there. The company does not concede liability for the condition of the site, but is working with the EPA to identify and 40 - -------------------------------------------------------------------------------- then seek reimbursement from other potentially responsible parties. The company estimates that the cost of this remediation effort will range between $3 million and $5 million for the soil remediation program. All of these proceedings are at various stages of activity, and it is impossible to estimate with any certainty the total cost of remediating, the timing and extent of remedial actions which may be required by governmental authorities, or the amount of liability, if any, of the company. If and when it is possible to make a reasonable estimate of the company's liability in any of these matters, we will make financial provision as appropriate. Based on facts presently known, the company does not believe that the outcome of these proceedings will have a material adverse effect on its financial condition. In June 1995, the USPS finalized and issued regulations governing the manufacture, distribution and use of postage meters. These regulations cover four general categories: meter security, administrative controls, Computerized Meter Resetting Systems and other issues. The company continues to comply with these regulations in its ongoing postage meter operations. In May 1996, the USPS issued a proposed schedule for the phaseout of mechanical meters in the U.S. Between May 1996 and March 1997, the company worked with the USPS to negotiate a revised mechanical meter migration schedule which better reflected the needs of existing mechanical meter users and minimized any potential negative financial impact on the company. The final schedule agreed to with the USPS is as follows: (i) as of June 1, 1996, new placements of mechanical meters would no longer be permitted. Replacements of mechanical meters previously licensed to customers would be permitted prior to the applicable suspension date for that category of mechanical meter; (ii) as of March 1, 1997, use of mechanical meters by persons or firms who process mail for a fee would be suspended and would have to be removed from service; (iii) as of December 31, 1998, use of mechanical meters that interface with mail machines or processors ("systems meters") would be suspended and would have to be removed from service; (iv) as of March 1, 1999, use of all other mechanical meters ("stand-alone meters") would be suspended and have to be removed from service. Based on the foregoing schedule, the company believes that the phaseout of mechanical meters will not cause a material adverse financial impact on the company. As a result of the company's aggressive efforts to meet the USPS mechanical meter migration schedule combined with the company's ongoing and continuing investment in advanced postage evidencing technologies, mechanical meters represent 25% of the company's installed U.S. meter base at December 31, 1997, compared with 40% at December 31, 1996. At December 31, 1997, 75% of the company's installed U.S. meter base is electronic or digital, compared to 60% at December 31, 1996. In May 1995, the USPS publicly announced its concept of its Information Based Indicia Program (IBIP) for future postage evidencing devices. As initially stated by the USPS, the purpose of the program was to develop a new standard for future digital postage evidencing devices which significantly enhanced postal revenue security and supported expanded USPS value-added services to mailers. The program would consist of the development of four separate specifications: (i) the Indicium specification--the technical specifications for the indicium to be printed; (ii) a Postal Security Device specification--the technical specification for the device that would contain the accounting and security features of the system; (iii) a Host specification; and (iv) a Vendor Infrastructure specification. In July 1996, the USPS published for public comment draft specifications for the Indicium, Postal Security Device and Host specifications. The company submitted extensive comments to these specifications in November 1996. Revised specifications were then published in 1997 which incorporated many of the changes recommended by the company in its prior comments including the recommendation that IBIP apply only to the personal computer (PC) environment and not apply at the present time to other digital postage evidencing systems. The company submitted comments to these revised specifications. Also, in March 1997 the USPS published for public comment the Vendor Infrastructure specification to which the company responded on June 27, 1997. As of December 31, 1997, the USPS had not yet finalized the four IBIP specifications; however, the company has developed a PC product which satisfies the proposed IBIP specifications. This product is currently undergoing testing by the USPS and is expected to be ready for market introduction when final approval of the specifications is issued. 41 - -------------------------------------------------------------------------------- 15. Leases In addition to factory and office facilities owned, the company leases similar properties, as well as sales and service offices, equipment and other properties, generally under long-term lease agreements extending from three to 25 years. Certain of these leases have been capitalized at the present value of the net minimum lease payments at inception. Amounts included under liabilities represent the present value of remaining lease payments. Future minimum lease payments under both capital and operating leases at December 31, 1997 are as follows: Capital Operating Years ending December 31 leases leases - -------------------------------------------------------------------------------- 1998 $ 3,247 $ 55,869 1999 3,238 41,357 2000 2,880 29,686 2001 2,739 20,348 2002 2,334 13,328 Thereafter 4,046 43,875 - -------------------------------------------------------------------------------- Total minimum lease payments $18,484 $204,463 ======== Less amount representing interest (6,811) - ------------------------------------------------------------ Present value of net minimum lease payments $11,673 ============================================================ Rental expense was $118.2 million, $121.6 million and $129.3 million in 1997, 1996 and 1995, respectively. 16. Financial services The company has several consolidated finance operations which are engaged in lease financing of the company's products in the U.S., Canada, the U.K., Germany, France, Norway, Ireland and Australia, as well as other commercial and industrial transactions in the U.S. On August 21, 1997, the company announced that it had entered into an agreement with GATX Capital Corporation (GATX Capital), a subsidiary of GATX Corporation, which when completed, will reduce the company's external large-ticket finance portfolio by approximately $1.1 billion. This represented approximately 50% of the company's external large-ticket portfolio and reflects the company's ongoing strategy of focusing on fee- and service-based revenue rather than asset-based income. Under the terms of the agreement, the company transferred external large-ticket finance assets through a sale to GATX Capital and an equity investment in a limited liability company owned by GATX Capital and the company. At December 31, 1997, the company had received approximately $800 million of the approximately $900 million in cash it expects to receive. The company will also retain approximately $200 million of equity investment in a limited liability company along with GATX Capital. Condensed financial data for the consolidated finance operations follows: Condensed summary of operations Years ended December 31 1997 1996 1995 - -------------------------------------------------------------------------------- Revenue $789,092 $794,819 $713,909 - -------------------------------------------------------------------------------- Costs and expenses 286,779 294,147 238,457 Interest, net 213,691 216,220 217,499 - -------------------------------------------------------------------------------- Total expenses 500,470 510,367 455,956 - -------------------------------------------------------------------------------- Income before income taxes 288,622 284,452 257,953 Provision for income taxes 82,825 91,638 81,422 - -------------------------------------------------------------------------------- Net income $205,797 $192,814 $176,531 ================================================================================ Condensed balance sheet December 31 1997 1996(a) - ----------------------------------------------------------------------------- Cash and cash equivalents $ 41,637 $ 22,506 Finance receivables, net 1,546,542 1,339,286 Accounts receivable 263,738 -- Other current assets and prepayments 54,753 52,169 - ----------------------------------------------------------------------------- Total current assets 1,906,670 1,413,961 Long-term finance receivables, net 2,581,349 3,450,231 Investment in leveraged leases 727,783 633,682 Other assets 281,244 143,023 - ----------------------------------------------------------------------------- Total assets $5,497,046 $5,640,897 ============================================================================= Accounts payable and accrued liabilities $ 423,462 $ 359,157 Income taxes payable 102,110 156,340 Notes payable and current portion of long-term obligations 1,897,915 2,021,987 - ----------------------------------------------------------------------------- Total current liabilities 2,423,487 2,537,484 - ----------------------------------------------------------------------------- Deferred taxes on income 423,832 330,847 Long-term debt 1,378,827 1,570,549 Other noncurrent liabilities 4,042 4,974 - ----------------------------------------------------------------------------- Total liabilities 4,230,188 4,443,854 - ----------------------------------------------------------------------------- Equity 1,266,858 1,197,043 - ----------------------------------------------------------------------------- Total liabilities and equity $5,497,046 $5,640,897 ============================================================================= (a) Certain prior year amounts have been reclassified to conform with the 1997 presentation. Finance receivables are generally due in monthly, quarterly or semiannual installments over periods ranging from three to 15 years. In addition, 16.5% of the company's net finance assets represent secured commercial and private jet aircraft transactions 42 - -------------------------------------------------------------------------------- with lease terms ranging from three to 25 years. The company considers its credit risk for these leases to be minimal since all aircraft lessees are making payments in accordance with lease agreements. The company believes any potential exposure in aircraft investment is mitigated by the value of the collateral as the company retains a security interest in the leased aircraft. Maturities of gross finance receivables and notes payable for the finance operations are as follows: Gross finance Notes payable and Years ending December 31 receivables subordinated debt - -------------------------------------------------------------------------------- 1998 $1,898,534 $1,897,915 1999 1,095,875 203,615 2000 784,534 61,900 2001 410,173 200,000 2002 157,946 100,000 Thereafter 409,885 813,312 - -------------------------------------------------------------------------------- Total $4,756,947 $3,276,742 ================================================================================ Finance operations' net purchases of Pitney Bowes equipment amounted to $667.3 million, $645.4 million and $618.6 million in 1997, 1996 and 1995, respectively. The components of net finance receivables were as follows: December 31 1997 1996 - ------------------------------------------------------------------------------- Gross finance receivables $ 4,756,947 $ 5,579,517 Residual valuation 527,503 735,978 Initial direct cost deferred 93,438 99,023 Allowance for credit losses (132,308) (113,737) Unearned income (1,117,689) (1,511,264) - ------------------------------------------------------------------------------- Net finance receivables $ 4,127,891 $ 4,789,517 =============================================================================== The company's net investment in leveraged leases is composed of the following elements: December 31 1997 1996 - ------------------------------------------------------------------------------- Net rents receivable $ 810,750 $ 556,058 Unguaranteed residual valuation 609,737 651,385 Unearned income (692,704) (573,761) - ------------------------------------------------------------------------------- Investment in leveraged leases 727,783 633,682 Deferred taxes arising from leveraged leases (300,164) (239,192) - ------------------------------------------------------------------------------- Net investment in leveraged leases $ 427,619 $ 394,490 =============================================================================== Following is a summary of the components of income from leveraged leases: Years ended December 31 1997 1996 1995 - -------------------------------------------------------------------------------- Pretax leveraged lease income $ 6,797 $ 8,497 $11,667 Income tax effect 16,110 6,501 4,408 - -------------------------------------------------------------------------------- Income from leveraged leases $22,907 $14,998 $16,075 ================================================================================ Leveraged lease assets acquired by the company are financed primarily through nonrecourse loans from third-party debt participants. These loans are secured by the lessee's rental obligations and the leased property. Net rents receivable represent gross rents less the principal and interest on the nonrecourse debt obligations. Unguaranteed residual values are principally based on independent appraisals of the values of leased assets remaining at the expiration of the lease. Leveraged lease investments include $289.2 million related to commercial real estate facilities, with original lease terms ranging from five to 25 years. Also included are seven aircraft transactions with major commercial airlines, with a total investment of $293.5 million and original lease terms ranging from 22 to 25 years and transactions involving locomotives, railcars and rail and bus facilities, with a total investment of $145.1 million and original lease terms ranging from 15 to 44 years. The company has sold net finance receivables with varying amounts of recourse in privately placed transactions with third-party investors. The uncollected principal balance of receivables sold and residual guarantee contracts totaled $502.0 million and $328.0 million at December 31, 1997 and 1996, respectively. The maximum risk of loss arises from the possible non-performance of lessees to meet the terms of their contracts and from changes in the value of the underlying equipment. Conversely, these contracts are supported by the underlying equipment value and creditworthiness of customers. As part of the review of its exposure to risk, the company believes adequate provisions have been made for sold receivables which may be uncollectible. The company has invested in various types of equipment under operating leases; the net investment at December 31, 1997 and 1996 was not significant. 43 - -------------------------------------------------------------------------------- 17. Business segment information For a description of the company's segments, see "Overview" on page 17. That information is incorporated herein by reference. The information set forth below should be read in conjunction with such information. Operating profit of each segment is determined by deducting from revenue the related costs and operating expenses directly attributable to the segment. Segment operating profit excludes general corporate expenses, income taxes and net interest other than that related to the financial services businesses. General corporate expenses were $86.6 million in 1997, $79.4 million in 1996 and $63.5 million in 1995. Revenue and operating profit by business segment and geographic area for the years ended 1995 to 1997 were as follows: Revenue ----------------------------------- (in millions) 1997 1996 1995 - ------------------------------------------------------------------------------- Industry segments: Business equipment $ 3,157 $ 2,956 $ 2,799 Business services 557 482 403 Commercial and industrial financing Large-ticket external 195 235 207 Small-ticket external 191 186 146 - ------------------------------------------------------------------------------- 386 421 353 - ------------------------------------------------------------------------------- Total $ 4,100 $ 3,859 $ 3,555 - ------------------------------------------------------------------------------- Geographic areas: United States $ 3,603 $ 3,370 $ 3,108 Outside the United States 651 619 573 Interarea revenue (154) (130) (126) - ------------------------------------------------------------------------------- Total $ 4,100 $ 3,859 $ 3,555 =============================================================================== Operating Profit ------------------------------- (in millions) 1997 1996 1995 - ------------------------------------------------------------------------------- Industry segments: Business equipment(a) $ 755 $ 621 $ 586 Business services 50 40 30 Commercial and industrial financing Large-ticket external 56 62 54 Small-ticket external 19 25 15 - ------------------------------------------------------------------------------- 75 87 69 - ------------------------------------------------------------------------------- Total $ 880 $ 748 $ 685 - ------------------------------------------------------------------------------- Geographic areas: United States $ 800 $ 719 $ 643 Outside the United States(a) 95 38 56 Interarea operating profit (15) (9) (14) - ------------------------------------------------------------------------------- Total $ 880 $ 748 $ 685 =============================================================================== (a) In 1996, excluding the Australian charge of $30 million, the business equipment segment would have been $651 million, and the geographic area outside the United States would have been $68 million. See discussion of selling, service and administrative expenses on page 20. Additional segment information is as follows: Years ended December 31 ------------------------------- (in millions) 1997 1996 1995 - -------------------------------------------------------------------------------- Depreciation and amortization: Business equipment $ 233 $ 220 $ 224 Business services 46 32 23 Commercial and industrial financing Large-ticket external 15 14 13 Small-ticket external 2 1 1 - -------------------------------------------------------------------------------- 17 15 14 - -------------------------------------------------------------------------------- Total $ 296 $ 267 $ 261 ================================================================================ Net additions to property, plant and equipment and rental equipment and related inventories: Business equipment $ 241 $ 258 $ 256 Business services 31 20 7 Commercial and industrial financing Large-ticket external (44) (11) 31 Small-ticket external 9 7 5 - -------------------------------------------------------------------------------- (35) (4) 36 - -------------------------------------------------------------------------------- Total $ 237 $ 274 $ 299 ================================================================================ 44 - -------------------------------------------------------------------------------- Identifiable assets are those used in the company's operations in each segment and exclude cash and cash equivalents and short-term investments. Identifiable assets of geographic areas include intercompany profits on inventory and rental equipment transferred between segments and intercompany accounts. Identifiable assets by business segment and geographic area for the years 1995 to 1997 were as follows: Identifiable Assets -------------------------------- (in millions) 1997 1996 1995 - -------------------------------------------------------------------------------- Industry segments: Business equipment $4,099 $3,776 $3,612 Business services 632 471 374 Commercial and industrial financing Large-ticket external 1,966 2,747 2,868 Small-ticket external 921 874 770 - -------------------------------------------------------------------------------- 2,887 3,621 3,638 - -------------------------------------------------------------------------------- Total $7,618 $7,868 $7,624 ================================================================================ Geographic areas: United States $6,957 $7,188 $6,928 Outside the United States 867 831 828 - -------------------------------------------------------------------------------- Total $7,824 $8,019 $7,756 ================================================================================ A reconciliation of identifiable assets to consolidated assets is as follows: December 31 ------------------------ (in millions) 1997 1996 - ------------------------------------------------------------------------------- Identifiable assets by geographic area $ 7,824 $ 8,019 Interarea profits (12) (18) Intercompany accounts (194) (133) - ------------------------------------------------------------------------------- Identifiable assets by industry segment 7,618 7,868 Cash and cash equivalents and short-term investments 139 137 General corporate assets 136 151 - ------------------------------------------------------------------------------- Consolidated assets $ 7,893 $ 8,156 =============================================================================== 18. Fair value of financial instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash, cash equivalents, short-term investments, accounts receivable, accounts payable and notes payable The carrying amounts approximate fair value because of the short maturity of these instruments. Investment securities The fair value of investment securities is estimated based on quoted market prices, dealer quotes and other estimates. Loans receivable The fair value of loans receivable is estimated based on quoted market prices, dealer quotes or by discounting the future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings. Long-term debt The fair value of long-term debt is estimated based on quoted dealer prices for the same or similar issues. Interest rate swap agreements and foreign currency exchange contracts The fair values of interest rate swaps and foreign currency exchange contracts are obtained from dealer quotes. These values represent the estimated amount the company would receive or pay to terminate agreements taking into consideration current interest rates, the creditworthiness of the counterparties and current foreign currency exchange rates. Residual, conditional commitment and financial guarantee contracts The fair values of residual and conditional commitment guarantee contracts are based on the projected fair market value of the collateral as compared to the guaranteed amount plus a commitment fee generally required by the counterparty assuming the guarantee. The fair value of financial guarantee contracts represents the estimate of expected future losses. Transfer of receivables with recourse The fair value of the recourse liability represents the estimate of expected future losses. The company periodically evaluates the adequacy of reserves and estimates of expected losses; if the resulting evaluation of expected losses differs from the actual reserve, adjustments are made to the reserve. The estimated fair value of the company's financial instruments at December 31, 1997 is as follows: Carrying Fair value(a) value - ------------------------------------------------------------------------------- Investment securities $20,124 $20,015 Loans receivable $357,227 $358,941 Long-term debt $(1,321,497) $(1,396,369) Interest rate swaps $(1,242) $(28,551) Foreign currency exchange contracts $735 $4,542 Residual, conditional commitment and financial guarantee contracts $(6,406) $(7,518) Transfer of receivables with recourse $(8,005) $(8,005) - ------------------------------------------------------------------------------- (a) Carrying value includes accrued interest and deferred fee income. 45 - -------------------------------------------------------------------------------- The estimated fair value of the company's financial instruments at December 31, 1996 is as follows: Carrying Fair value(a) value - ------------------------------------------------------------------------------- Investment securities $2,681 $2,691 Loans receivable $381,790 $365,560 Long-term debt $(1,577,277) $(1,629,527) Interest rate swaps $(1,639) $(27,969) Foreign currency exchange contracts $806 $385 Residual, conditional commitment and financial guarantee contracts $(5,068) $(6,003) Transfer of receivables with recourse $(10,885) $(11,093) - ------------------------------------------------------------------------------- (a) Carrying value includes accrued interest and deferred fee income. 19. Quarterly financial data (unaudited) Summarized quarterly financial data (dollars in millions, except per share data) for 1997 and 1996 follows: Three Months Ended ----------------------------------------- 1997 March 31 June 30 Sept. 30 Dec. 31 - -------------------------------------------------------------------------------- Total revenue $ 961 $1,006 $1,013 $1,120 Cost of sales and rentals and financing $ 381 $ 398 $ 405 $ 455 Net income $ 120 $ 131 $ 128 $ 147 ================================================================================ Basic earnings per share $ .41 $ .45 $ .44 $ .52 ================================================================================ Diluted earnings per share $ .40 $ .45 $ .44 $ .51 ================================================================================ Three Months Ended ----------------------------------------- 1996 March 31 June 30 Sept. 30 Dec. 31 - -------------------------------------------------------------------------------- Total revenue $ 906 $ 943 $ 951 $1,059 Cost of sales and rentals and financing $ 365 $ 373 $ 382 $ 435 Net income $ 106 $ 118 $ 117 $ 128 ================================================================================ Basic earnings per share $ .35 $ .40 $ .39 $ .43 ================================================================================ Diluted earnings per share $ .35 $ .39 $ .39 $ .43 ================================================================================ - -------------------------------------------------------------------------------- Report of Independent Accountants To the Stockholders and Board of Directors of Pitney Bowes Inc.: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Pitney Bowes Inc. and its subsidiaries at December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PRICE WATERHOUSE LLP PRICE WATERHOUSE LLP Stamford, Connecticut January 26, 1998 46 - -------------------------------------------------------------------------------- ================================================================================ Stockholder Information ================================================================================ World Headquarters Pitney Bowes Inc. 1 Elmcroft Rd. Stamford, CT 06926-0700 (203)356-5000 www.pitneybowes.com Annual Meeting Stockholders are cordially invited to attend the 1998 Annual Meeting at 9:30 a.m., Monday, May 11, 1998, at Pitney Bowes World Headquarters in Stamford, Connecticut. A notice of the meeting, proxy statement and proxy will be mailed to each stockholder under separate cover. 10-K Report The Form 10-K report, to be filed by Pitney Bowes with the Securities and Exchange Commission, will provide certain additional information. Stockholders may obtain copies of this report without charge by writing to: MSC 6140 Investor Relations Pitney Bowes Inc. 1 Elmcroft Rd. Stamford, CT 06926-0700 Stock Exchanges Pitney Bowes common stock is traded under the symbol "PBI." The principal market it is listed on is the New York Stock Exchange. The stock is also traded on the Chicago, Philadelphia, Boston, Pacific and Cincinnati stock exchanges. Comments concerning the Annual Report should be sent to: MSC 6309 Director Investor Communications and Advertising Pitney Bowes Inc. 1 Elmcroft Rd. Stamford, CT 06926-0700 For lost securities and certificate replacement: ChaseMellon Shareholder Services LLC Estoppel Department PO Box 3317 South Hackensack, NJ 07606-1917 For change of address, account consolidations, legal transfer inquiries, replacement checks, tax information and other inquiries: ChaseMellon Shareholder Services LLC PO Box 3315 South Hackensack, NJ 07606-1915 For certificate transfers: ChaseMellon Shareholder Services LLC Stock Transfer Department PO Box 3312 South Hackensack, NJ 07606-1912 For dividend reinvestment information: The Chase Manhattan Bank c/o ChaseMellon Shareholder Services LLC PO Box 3336 South Hackensack, NJ 07606-1936 Transfer Agent and Registrar: ChaseMellon Shareholder Services LLC Overpeck Centre 85 Challenger Rd. Ridgefield, NJ 07660 Stockholders may call: ChaseMellon Shareholder Services at (800) 648-8170 or Pitney Bowes Stockholder Services at (203) 351-6088 or (203) 351-7200. Investor Inquiries All investor inquiries about Pitney Bowes should be addressed to: MSC 6140 Investor Relations Pitney Bowes Inc. 1 Elmcroft Rd. Stamford, CT 06926-0700 Stock Information (restated to reflect the stock split) Dividends per common share Quarter 1997 1996 - -------------------------------------------------------------------------------- First $.20 $.1725 Second .20 .1725 Third .20 .1725 Fourth .20 .1725 - -------------------------------------------------------------------------------- Total $.80 $.6900 ================================================================================ Quarterly price ranges of common stock 1997 Quarter High Low - -------------------------------------------------------------------------------- First 31 3/4 26 13/16 Second 37 7/16 27 15/16 Third 42 1/2 35 Fourth 45 3/4 37 7/16 1996 Quarter High Low - -------------------------------------------------------------------------------- First 25 13/16 20 15/16 Second 25 3/4 23 1/4 Third 27 1/4 21 5/8 Fourth 30 11/16 26 1/4 ================================================================================ Trademarks AddressRight, Arrival, Ascent, DirectNet, DocuMatch, ForwardTrak, Fulfillment, Galaxy, Paragon, Personal Post Office, Postage by Phone, PostPerfect, Smart Image RIP and StreamWeaver are trademarks or service marks of Pitney Bowes Inc. Business Rewards, Postal Privilege, Purchase Power and ValueMax are service marks of Pitney Bowes Credit Corporation. OnLine is a trademark of United Parcel Service. 47