Stock-Based Compensation

(share data in thousands)

We have a long-term incentive plan whereby eligible employees may be granted restricted stock units (RSUs), performance shares (PSs) and/or stock options (SOs). We grant stock-based compensation awards in order to continue to attract and retain qualified employees and to better align employees' interests with those of our shareholders. Each of these awards is subject to settlement with newly issued shares of our common stock.

Stock-based compensation expense was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Stock-based compensation expense, pre-tax	$	15	$	14	$	44	$	39
Income tax benefit recognized in earnings	4		5		11		15

The following is a summary of changes to our program design and performance metrics effective for our April 2018 grant and grants thereafter under our new program, as approved by our board of directors (the "Board"). The Board also approved a change in the timing of our annual grant of awards from July to April, to better align our grant date with other annual incentive compensation payments and the underlying performance period related to PSs. We grant RSUs and PSs to officers, selected executives and middle managers, and SOs to officers and selected executives only.

Restricted Stock Units

Compensation expense for RSUs is based upon the grant date market price and is recognized on a straight-line basis over a three-year graded-vesting period, based on management's estimate of the number of shares expected to vest. RSUs vest on a graded schedule as follows: 25% after one year of service, 25% after two years of service, and 50% after three years of service from the date of grant. Prior to the April 2018 grant, RSUs vested on a three-year cliff basis from the date of grant. Shares awarded to employees who are retirement-eligible at the date of grant, become retirement-eligible during the vesting period, or are terminated not-for-cause (e.g. as part of a restructuring initiative), vest based on service provided from the date of grant to the date of separation on a pro-rata share of each individual graded-vesting tranche. Shares granted through September 30, 2018 under our new program were 1,130, with a corresponding weighted average grant date fair value of $27.61 per share.

Performance Shares

In connection with the April 2018 grant, the Board approved the following changes to the PS performance goals: the Earnings Per Share (EPS) metric was replaced with a Total Shareholder Return (TSR) metric and the Cash Flow from Operations metric was replaced with a Free Cash Flow metric. The Board retained the Revenue metric as a performance goal as well as the three-year performance period for all measures. The performance metrics are equally weighted; accordingly, each PS grant is two-thirds performance based (revenue and free cash flow) and one-third market-based (TSR). The performance goals are independent of each other and depending on the achievement of these metrics, a recipient of a PS award is entitled to receive a number of shares equal to a percentage, ranging from 0% to 200% of the PS award granted. PSs retain the three-year cliff vesting from the date of grant.

Performance-Based Component

PSs vest contingent upon meeting pre-determined cumulative goals for revenue and free cash flow. The fair value of the performance-based component of our PSs is based upon the grant-date market price. Compensation expense is recognized on a straight-line basis over the vesting period, based on management's estimate of the number of shares expected to vest. If the cumulative three-year actual results exceed the stated targets, all plan participants have the potential to earn additional shares of common stock up to a maximum overachievement of 100% of the original grant. If the stated targets are not met, any recognized compensation cost would be reversed. Shares granted through September 30, 2018 under our new program were 693, with a corresponding weighted average grant date fair value of $27.88 per share.

As a result of the change in management in the second quarter 2018, the Board is currently reviewing this plan and has not finalized the performance measures and corresponding weightings and therefore the plan remains discretionary as of the third quarter 2018. Since final performance measures have not been approved as of September 30, 2018, the criteria needed to establish a grant date has not been met and therefore the fair value of the April 2018 grant will continue to be revalued based on the period end stock price for each subsequent reporting period until the grant date criteria has been met.

Market-Based Component

The TSR metric is based on the percentage change in the Company’s stock price plus the dividends paid over the three-year measurement period. Payout for this portion of the PS will be determined based on Xerox’s percentage change compared to the shareholder returns of the peer group of companies approved by the compensation committee of the Board (as disclosed in the 2018 annual proxy statement). Since the TSR portion of the PS award represents a market condition, a Monte Carlo simulation was used to determine the grant-date fair value. A summary of the key valuation input assumptions used in the Monte Carlo simulation relative to PS awards granted were as follows:



	Program to Date September 30, 2018
Term	3 years
Risk-free interest rate⁽¹⁾	2.39		%
Dividend yield⁽²⁾	3.24		%
Xerox’s historical volatility⁽³⁾	29.12		%
Weighted average fair value⁽⁴⁾	$	32.03

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(1)	The risk-free interest rate was based on the zero-coupon U.S. Treasury yield curve from the valuation date, with a maturity matched to the TSR performance period.


(2)	The dividend yield was calculated as the expected quarterly dividend divided by Xerox’s three-month average stock price as of the valuation date.


(3)	Xerox’s historical volatility is calculated from daily stock returns over a three-year look-back term from the valuation date.


(4)	The weighted average of fair values used to record compensation expense as determined by the Monte Carlo simulation.

Our TSR compared to the peer group TSR will determine the payout as follows:



Percentile	Payout as a Percent of Target⁽¹⁾
80^th and above	200	%
50^th	100	%
25^th	35	%
Below 25^th	0	%

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(1)	For performance between the levels described above, the degree of vesting is interpolated on a linear basis.

Compensation expense is recognized on a straight-line basis over the vesting period based on the fair value determined by the Monte Carlo simulation and, except in cases of employee forfeiture, cannot be reversed regardless of performance. Shares granted through September 30, 2018 under our new program were 346.

Stock Options

The Board also approved the granting of SOs as part of the 2018 plan design. Except for the conversion of options relating to our acquisition of Affiliated Computer Systems in 2010, we have not issued any SOs since 2004. Compensation expense associated with SOs is based upon the grant date fair value determined by utilizing the Black-Scholes (BS) option-pricing model and is recorded on a straight-line basis over a three-year graded-vesting period, based on management's estimate of the number of SOs expected to vest. SOs vest on a graded schedule as follows: 25% after one year of service, 25% after two years of service, and 50% after three years of service from the date of grant. Similar to RSUs, SOs awarded to employees who are retirement-eligible at the date of grant, become retirement-eligible during the vesting period, or are terminated not-for-cause, vest based on service provided from the date of grant to separation, on a pro-rata share of each individual vesting tranche.

The weighted average assumptions used in the BS option-pricing model relative to SO awards were as follows:



	Program to Date September 30, 2018
Expected term⁽¹⁾	6.13 years
Expected volatility⁽²⁾	27.25		%
Expected dividend yield⁽³⁾	3.25		%
Risk-free interest rate⁽⁴⁾	2.63		%
Weighted average fair value⁽⁵⁾	$	5.71

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(1)	Since these SO grants are effectively part of a new program, the expected term was calculated using the "Simplified Method” under the SEC guidance based on the SOs vesting schedule and contractual term. We did not have sufficient historical exercise data to provide a reasonable basis to estimate an expected term.


(2)	The expected volatility was calculated based on a combination of Xerox's term-matched historical volatility and implied volatility from traded options.


(3)	The dividend yield was calculated as the expected quarterly dividend divided by Xerox’s three-month average stock price as of the grant date.


(4)	The risk-free interest rate was based on the zero-coupon U.S. Treasury yield curve with a maturity matched to the expected term of the SOs.


(5)	The weighted average of fair values used to record compensation expense as determined by the BS option-pricing model.

SOs granted through September 30, 2018 under our new program were 1,379.

Note: Management’s estimate of the number of shares expected to vest at the time of grant reflects an estimate for forfeitures based on our historical forfeiture rate to date. Should actual forfeitures differ from management’s estimate, the activity will be reflected in a subsequent period.