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    20 0 4 IBM A NNUA L REPO R T 2004 international business machines


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    chairman’s letter Dear IBM Investor: Last year, I told you that IBM was in the process of becoming a very different company. I said that we had achieved a new degree of clarity about our business model — innovation for the enterprise — and that this was driving change in every aspect of the corporation. And I described the deeper level of this reexamination — our collective work to redefine IBM’s core values. Now it’s a year later, and I want to tell you about the progress $12.9 billion in cash available for investment and distribution we have made. IBM today is stronger and more focused than to shareholders. Of that, $3.7 billion went for net capital it has been in years. The path we set for ourselves several expenditures and $1.7 billion for acquisitions that strength- years ago is yielding results — in terms of an improved compet- ened our capabilities. itive position, an enhanced capacity to innovate, and a greater We were able to return a record $8.3 billion to investors — ability to deliver results to our clients and to you, our owners. $7.1 billion through share repurchase and $1.2 billion through Our task now comes down to execution. At a recent dividends. We ended the year in a strong cash position, meeting with IBM’s senior leaders, I said that 2005 is the year with $10.6 billion, including marketable securities. In 2004, of “small s and big E”: less focus on strategic development, our return on invested capital increased to 29 percent , maximum push on execution. This is the appropriate emphasis excluding our Global Financing business and a one-time for our company today, because most of the major strategic pension settlement charge.* pieces are now in place for IBM to become the leader of a rapidly changing information technology industry. Samuel J. Palmisano A good year CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER I want to explain to you what we did last year to turn strategy and vision into results. Your company turned in another good year in 2004. We continued to execute our business plan effectively, producing share gains in key markets, increasing revenue and growing both earnings and earnings per share. Our results from continuing operations saw record revenue of $96.3 billion, an increase of 8 percent; earnings of $8.4 billion, an increase of 11 percent; and diluted earnings per share of $4.94, an increase of 14 percent. One of the strengths of our business model, from a financial point of view, is the amount of cash we generate. After committing $5.7 billion to R&D in 2004, we had 01


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    chairman’s letter We were able to achieve these results because of our • We grew and expanded our business in the world’s hyper- performance in the marketplace. growth markets. We have learned over many years that the best way to pursue opportunities in emerging markets is to • IBM Global Services is the leading IT services company in make investments and build relationships for the long haul, the world, with more than twice the revenue of our nearest to become part of the local economy and to help advance rival. We are ranked number one in IT outsourcing, application the society’s broader goals. We are doing that in China, management and e-business hosting. In 2004, Global Services India, Brazil and Russia — and it’s yielding good results. IBM’s revenue grew 8 percent to $46.2 billion, driven by continued business in these four key emerging markets grew more than growth in Strategic Outsourcing, as well as revenue increases 25 percent in 2004, to more than $4 billion. in Integrated Technology Services and Business Consulting Services (led by strong growth in Business Transformation The year had its share of challenges, and some parts of Outsourcing). Although signings and backlog declined in the business fell short. But overall, it was a solid year for the 2004, Global Services improved its rate of revenue growth in IBM company. The results confirm that we are in the right every quarter, excluding the benefit of currency, due to the businesses and the right segments of the industry. improving yield of our backlog and current signings. A transaction and a transformation • Our software revenue totaled $15.1 billion, an increase Of course, just as significant as the segments we are in are of 5 percent. We gained share in key segments and held our those we are not. The industry’s contraction in recent years leading share position in middleware overall. WebSphere has forced IT companies to choose between being high- grew 14 percent, Rational 15 percent and Tivoli 15 percent. value innovation players or high-volume distributors of other • We continue as number one in the world in servers, with people’s intellectual capital. Companies that are caught zSeries, pSeries and xSeries each increasing its share position in the middle run the risk of being hammered from both in 2004. IBM is the market leader in the super-hot category of below and above. blade servers, with revenue growing more than 150 percent As I described to you last year, we’ve made our choice: IBM for the year. Industry analyst IDC estimates that by 2008 is an innovation company. Of course, declaring something like one of every four servers will be a blade. We had challenging that is easy. It has taken a great deal of discipline to execute. product transitions in storage systems and iSeries, which For instance, over the past several years, while we increased hurt us. Personal computer revenue growth was strong for our presence in software, consulting and infrastructure serv- the year. Technology OEM growth was good, and we continue ices, we exited or reduced our presence in commoditizing to see yield improvements in our semiconductor operation. businesses like hard disk drives, memory chips and network- Overall, our hardware revenue was $31.2 billion, an increase ing hardware. And most notably, this past December we of 10 percent. announced our agreement for Lenovo, China’s computer leader, to acquire IBM’s Personal Computing Division. • Revenue in all of IBM’s industry sectors — which is the way These kinds of decisions are hard for many companies — we serve our largest clients globally — grew for the full year, indeed, some won’t make them — because it means parting led by the financial services, communications and distribution with business models and technologies that were once their sectors. We continued our strong growth in sales to small and crown jewels. In our own case, IBM invented the hard disk drive medium-size businesses, which grew by 8 percent. and DRAM chip, and we set the standard in PCs back in 1981. 02


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    chairman’s letter We take enormous pride in these achievements. But if you “Understanding Our Company: An IBM Prospectus,” which intend to remain the innovation leader, you commit yourself accompanies this year’s annual report. I encourage you to continuous reinvention. You’ve got to do the hard work, to take a look at it. I think it will help explain how we see the every day, to discover and develop new capabilities — and world, and how that is driving our actions. new ways of working — that will keep you moving forward. The new Lenovo will be the world’s third-largest PC busi- The meaning of 2004 ness. It will have greater global reach and greater economies Several major shifts — in business models, in technology of scale, and we will continue to work together to deliver and in how they together are reshaping our industry — have world-class PC solutions in the marketplace. There’s no doubt driven everything we’ve done at IBM over the past four in my mind that this was the best path forward for our years. They continued to do so in 2004. personal computer business. For IBM, our PC transaction — perhaps the most widely 1. Because clients now demand that information technology commented-upon event of the year for us — was certainly be intimately integrated with their business operations, we have a milestone. But not, I would argue, for the reasons many reshaped IBM’s business skills, assets and delivery capability. believe. We could simply have sold our PC business. Instead, what we did was to reposition both that business This has involved everything from our acquisition of and IBM itself in ways that help each and that align with PricewaterhouseCoopers Consulting in 2002, to the launch the future trajectory of the IT market. This deal crystallizes, of multiple industry- and process-specific practices and lines of business. Some people may see this simply as IBM bulking as well as any single event could, the nature of our business up in services. It is true that we needed to add a lot of deep model, strategy and marketplace position today: business expertise — and we will continue to strengthen our IBM is an enterprise-focused company. It is not hand here. But clients want more than the consultant’s strategic our strength or intention to participate directly in advice, the systems integrator’s skills or the IT outsourcer’s consumer markets. scale. They want new business designs, enabled by technol- ogy, that give them some quantifiable competitive advantage. We are all about innovation. We are best at creating They want new options and alternatives, not only in how and delivering differentiating value to our clients. they manage IT, but in how they conceptualize and manage We are a global business. Much more than marketing their companies. products and services around the world, this means This is what we mean by On Demand Business. CEOs establishing deep roots locally and leveraging our might not use that exact term (yet), but a more responsive, multinational presence for operational advantage. virtually integrated company is increasingly what they are asking us to help them build. Companies like eBay, Bank To explain our perspective on both the IT industry and IBM’s of America and METRO Group, and institutions like Miami- transformation lies beyond the scope of an annual report. Dade County and the new Museum of Modern Art are, to However, I do believe it is vital for anyone with an interest one degree or another, on demand enterprises. in IBM to understand this long-term view and what lies I want to highlight one aspect of On Demand Business, behind it — not a mere cyclical change, but a major structural because it represents a very large new market opportunity for shift in our industry. That is why we created the document us. We call it Business Performance Transformation Services 03


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    chairman’s letter (BPTS), and industry analyst IDC sizes it at about $1.4 trillion — Consider: 32,768 Power processors are at the heart of our as large as the existing global IT industry. We peg the part of Blue Gene supercomputer, which last year set a new record — BPTS that IBM is addressing at about $500 billion. more than 70 trillion calculations per second. Yet variations As its name suggests, BPTS involves helping clients opti- of Power chips are also the foundation for our pSeries and mize their operations through new business designs and iSeries, and are used in our blade servers, our storage systems processes, and, in some cases, turning over those operations and an expanding array of devices — network routers, mobile to expert partners to manage. As you can imagine, this is a devices, game consoles — designed by our OEM partners. very different type of services business—one that is increasingly Built on a Power core, the Cell processor — a “supercomputer “asset-based.” It requires deep knowledge of business on a chip”— was developed along with Sony and Toshiba processes like logistics, supply chain and human resource for broadband, high-definition uses. management, and relies heavily on automated processes Increasing the uses of the Power family is important for and intellectual capital, not mere labor arbitrage. IBM, because it gives us the advantages of a high-performance In 2004, we extended our capabilities in BPTS, making processor and high-volume economics. This is one reason substantial investments in four areas — Business Transformation we’ve opened Power’s technical specifications through our Outsourcing, Engineering and Technology Services, Strategy and Change Consulting, and Business Performance Manage- revenue from continuing income from continuing ment Software. We generated more than $3 billion in revenue operations operations in these four areas — up about 45 percent over the previous year. And our software and services groups are working (IN BILLIONS OF DOLLARS) (IN BILLIONS OF DOLLARS) together to build out an infrastructure that fuses business transformation with information technology — what is called services-oriented architecture — to support our evolution to an asset-based services business. 96.3 8.4 2. Because we saw that computing was undergoing a fundamental 8.1 7.9 shift, we developed the architecture and technologies for the 7.6 On Demand Operating Environment, based on open standards. 89.1 The new computing architecture is based on a truly networked 5.3 world and the emergence of open standards — for the first 85.1 time in our industry’s history — as well as some exciting new 83.1 technologies and new ways of accessing and managing IT. 81.2 It builds on our strengths in enterprise computing, core technology and software. One of our most important core technologies is our Power microprocessor family. What’s significant about Power is not just that it’s fast and packs a lot of punch (plenty of 00 01 02 03 04 00 01 02 03 04 microprocessors do). Power is highly customizable. 04


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    chairman’s letter Power Everywhere and Power.org initiatives. We are building 3. These two elements of on demand — new business models and a broader ecosystem of innovation around Power, reflecting a new computing infrastructure — are now coming together in the fact that innovation today is an increasingly collaborative ways that will redefine the industry and play to IBM’s strengths. process — and not only in software. All of these changes — businesses we’ve exited, those we’ve And speaking of software, through steady internal entered, our increased investments, the technologies development and select acquisitions over the past several and practices we’ve invented — were undertaken not simply years, IBM has become the leader in enterprise-class to assemble a portfolio, even a portfolio of high-value busi- middleware, which helps companies integrate and manage nesses, but to do something with them. Namely, we aim to their operations. An important differentiator for our give our clients capabilities they cannot get either from software business is that it is entirely built on open standards, another company or even a collection of other companies. supporting a wide variety of hardware platforms and This is why we’ve worked hard to forge connections applications. This gives our clients flexibility and choice, between our services and software businesses, our semi- and makes it easy for them to integrate their infrastructure conductor unit and our server and storage units, between and business operations. IBM Research and every other part of the company, and between IBM and an increasing variety of business partners. earnings per share cash available for IBM’s strategy is less about going to market with a more investment and distribution complete array of capabilities than it is about leveraging to shareholders those capabilities to create new intellectual capital for clients. (IN DOLLARS, ASSUMING DILUTION FROM CONTINUING OPERATIONS) (IN BILLIONS OF DOLLARS) Priorities going forward As we move ahead in 2005, we are guided by the same priorities that have shaped our progress thus far. we will make on demand business a fuller reality for clients. 4.94 12.7 12.9 The concept is no longer in dispute. Enterprises are achieving 4.59 12.0 4.32 4.34 11.3 tangible benefits from being on demand—and are increasingly 10.5 embracing its long-term strategic promise for competitive advantage. We will work with a growing roster of clients who 3.07 want to become on demand enterprises, and we will continue to build out the technologies and services for the On Demand Operating Environment. we will continue to deepen ibm’s capabilities as a company built on innovation. This is our business model and has been since the company’s inception. It has shaped our transforma- tion over the past several years, and it continues to shape 00 01 02 03 04 00 01 02 03 04 the evolution of our workforce strategy, management systems, economics and client relationships. 05


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    chairman’s letter FINANCIAL HIGHLIGHTS International Business Machines Corporation and Subsidiary Companies (Dollars in millions except per share amounts) FOR THE YEAR 2004 2003 AT YEAR END 2004 2003 Revenue $««96,293 $««89,131 Cash, cash equivalents and Income from continuing operations 8,448 7,613 marketable securities $««10,570 $««««7,647 Loss from discontinued operations 18 30 Total assets 109,183 104,457 Working capital 7,172 7,039* * Net income 8,430 7,583 Total debt 22,927 23,632 Earnings/(loss) per share Stockholders’ equity 29,747 27,864 of common stock: Assuming dilution: Common shares outstanding (in millions) 1,646 1,695 Continuing operations 4.94 4.34 Market capitalization 162,223 157,047 Discontinued operations (0.01) (0.02) Stock price per common share 98.58 92.68 Number of employees in IBM/ Total 4.93 4.32 wholly owned subsidiaries 329,001 319,273 Basic: ** Reclassified to conform with 2004 presentation. Continuing operations 5.04 4.42 Discontinued operations (0.01) (0.02) Total 5.03 4.40 Net cash provided by operating activities from continuing operations 15,406 14,569 Investment in plant, rental machines and other property 4,368 4,393 Cash dividends paid on common stock 1,174 1,085 Per share of common stock 0.70 0.63 06


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    chairman’s letter we will focus in 2005 on execution. This is that “big E” inhibit us from collaborating, innovating and contributing to message I gave to IBM’s leaders at the beginning of this year. IBM’s growth. All of our strategic work over the past four years has given These and dozens of other ideas are now in various us considerable capabilities to seize the growth and profit stages of implementation, and I am confident that they will opportunities I’ve described. Now, we have to improve our make a material difference to IBM. Our values are also being ability to integrate all of this capability for our clients. turned into actions every day in countless other ways: how In other words, we need to become even more of an we work with our clients and colleagues; the actions of IBM’s On Demand Business ourselves. And a big part of that is crisis response team after the Asian tsunami disaster; or the what I call “lowering the center of gravity” of our company. progress of the World Community Grid — harnessing vast, For us, this is neither conventional decentralization nor simple unused computational power to help cure disease and forecast delegation. It means shifting resources closer to the point of natural disasters. contact with the client, creating enterprise-wide processes From the point of view of a CEO, perhaps the best aspect that are commonly shared, and establishing truly global of this entire process has been the broad platform it creates operations that capitalize on the talent and scale now available to drive change. When your primary organizational challenge in every part of the world. is one of execution, there is nothing more encouraging than Every time we have simplified the company and pushed the knowledge that your organization’s direction and sense authority and resources closer to where the day-to-day of mission come not out of some threat or crisis, but from the action is, we’ve seen great results — with clients (because we aspirations of your own workforce. For 329,000 IBMers — and are easier to do business with), in our cost structure (because you can count me among them — what drives us every day is we eliminate unnecessary layers), in revenue growth (because a determination to make IBM the great company we all want we differentiate ourselves from the competition) and in how and expect it to be. individual IBMers feel about their company. Last year, I told you about the online “jam” in which IBMers collectively defined our values for the first time in nearly a century. I told you what an outpouring of passion, imagination and pride that was. Well, even more impressive was the follow-up jam Samuel J. Palmisano CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER we held last fall. This time, we asked IBMers to contribute ideas to make our values a day-to-day reality in the com- pany. Participation was extraordinary — more than 57,000 IBMers contributed more than 32,000 comments and ideas — and the ideas were concrete, practical and focused on execution. The top-rated ideas range from back-office integration supporting the development and marketing of integrated solutions; to helping first-line managers by giving them more authority over budgets and freeing up their time to * IBM’s Form 8-K dated January 18, 2005 (Attachment III) contains devote to their people; to clearing away the barriers that information about return on invested capital. 07


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    ibm annual report 2004 FINANCIAL REPORT International Business Machines Corporation and Subsidiary Companies REPORT OF MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 09 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a Significant Accounting Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM . . . . . . . . . . . 10 b Accounting Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 c Acquisitions/Divestitures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 MANAGEMENT DISCUSSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 d Financial Instruments (excluding derivatives). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Road Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 e Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Management Discussion Snapshot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 f Financing Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Description of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 g Plant, Rental Machines and Other Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Year in Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 h Investments and Sundry Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Prior Year in Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 i Intangible Assets Including Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Looking Forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 j Sale and Securitization of Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Employees and Related Workforce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 k Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Global Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 l Derivatives and Hedging Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 CONSOLIDATED FINANCIAL STATEMENTS m Other Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 n Stockholders’ Equity Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Financial Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 o Contingencies and Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 p Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 q Advertising and Promotional Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 r Research, Development and Engineering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 s 2002 Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 t Earnings Per Share of Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 u Rental Expense and Lease Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 v Stock-Based Compensation Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 w Retirement-Related Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 x Segment Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 FIVE-YEAR COMPARISON OF SELECTED FINANCIAL DATA . . . . . . . . . . . . . . . . . . . . . . . . . 92 SELECTED QUARTERLY DATA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 BOARD OF DIRECTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 BOARD OF DIRECTORS AND SENIOR EXECUTIVE OFFICERS . . . . . . . . . . . . . . . . . . . . . . 95 STOCKHOLDER INFORMATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 08


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    REPORT OF MANAGEMENT ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies management responsibility for financial information The company’s internal control over financial reporting includes those policies and Responsibility for the integrity and objectivity of the financial information presented in this procedures that (i) pertain to the maintenance of records that, in reasonable detail, accu- Annual Report rests with IBM management. The accompanying financial statements have rately and fairly reflect the transactions and dispositions of the assets of the company; (ii) been prepared in accordance with accounting principles generally accepted in the United provide reasonable assurance that transactions are recorded as necessary to permit prepa- States of America, applying certain estimates and judgments as required. ration of financial statements in accordance with accounting principles generally accepted IBM maintains an effective internal control structure. It consists, in part, of organizational in the United States of America, and that receipts and expenditures of the company are arrangements with clearly defined lines of responsibility and delegation of authority, and being made only in accordance with authorizations of management and directors of the comprehensive systems and control procedures. An important element of the control company; and (iii) provide reasonable assurance regarding prevention or timely detection environment is an ongoing internal audit program. Our system contains self-monitoring of unauthorized acquisition, use, or disposition of the company’s assets that could have a mechanisms, and actions are taken to correct deficiencies as they are identified. material effect on the financial statements. To assure the effective administration of internal controls, we carefully select and train Because of its inherent limitations, internal control over financial reporting may not our employees, develop and disseminate written policies and procedures, provide appro- prevent or detect misstatements. Also, projections of any evaluation of effectiveness to priate communication channels, and foster an environment conducive to the effective future periods are subject to the risk that controls may become inadequate because of functioning of controls. We believe that it is essential for the company to conduct its business changes in conditions, or that the degree of compliance with the policies or procedures affairs in accordance with the highest ethical standards, as set forth in the IBM Business may deteriorate. Conduct Guidelines. These guidelines, translated into numerous languages, are distributed Management conducted an evaluation of the effectiveness of internal control over to employees throughout the world, and reemphasized through internal programs to financial reporting based on the framework in Internal Control — Integrated Framework assure that they are understood and followed. issued by the Committee of Sponsoring Organizations of the Treadway Commission. PricewaterhouseCoopers LLP, an independent registered public accounting firm, is Based on this evaluation, management concluded that the company’s internal control over retained to audit IBM’s consolidated financial statements and management’s assessment of financial reporting was effective as of December 31, 2004. Management’s assessment of the the effectiveness of the company’s internal control over financial reporting. Its accompany- effectiveness of the company’s internal control over financial reporting as of December 31, ing report is based on audits conducted in accordance with the standards of the Public 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public Company Accounting Oversight Board (United States). accounting firm, as stated in their report which is included herein. The Audit Committee of the Board of Directors is composed solely of independent, non-management directors, and is responsible for recommending to the Board the independent registered public accounting firm to be retained for the coming year, sub- ject to stockholder ratification. The Audit Committee meets periodically and privately with the independent registered public accounting firm, with the company’s internal auditors, as well as with IBM management, to review accounting, auditing, internal con- trol structure and financial reporting matters. Samuel J. Palmisano Mark Loughridge CHAIRMAN, PRESIDENT AND SENIOR VICE PRESIDENT CHIEF EXECUTIVE OFFICER CHIEF FINANCIAL OFFICER management’s report on internal control over financial reporting FEBRUARY 22, 2005 FEBRUARY 22, 2005 Management is responsible for establishing and maintaining adequate internal control over financial reporting of the company. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. 09


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    REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies To the Stockholders and Board of Directors of International Business Machines Corporation: reporting as of December 31, 2004, based on criteria established in Internal Control- We have completed an integrated audit of International Business Machines Corporation’s Integrated Framework issued by the COSO. The company’s management is responsible 2004 consolidated financial statements and of its internal control over financial reporting for maintaining effective internal control over financial reporting and for its assessment of as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements the effectiveness of internal control over financial reporting. Our responsibility is to express in accordance with the standards of the Public Company Accounting Oversight Board opinions on management’s assessment and on the effectiveness of the company’s internal (United States). Our opinions, based on our audits and the reports of other auditors, are control over financial reporting based on our audit. We did not examine the effectiveness presented below. of the controls over the initiation and recording of revenue transactions and the recording of direct costs at the company’s Business Consulting Services Reporting Unit as of Decem- consolidated financial statements ber 31, 2004. The effectiveness of those controls was examined by other auditors whose In our opinion, based on our audits and the report of other auditors, the accompanying report has been furnished to us, and our opinions expressed herein, insofar as they relate consolidated financial statements appearing on pages 40 through 91 present fairly, in all to the effectiveness of those controls, are based solely on the report of the other auditors. material respects, the financial position of International Business Machines Corporation and We conducted our audit of internal control over financial reporting in accordance with the its subsidiary companies at December 31, 2004 and 2003, and the results of their opera- standards of the Public Company Accounting Oversight Board (United States). Those stan- tions and their cash flows for each of the three years in the period ended December 31, dards require that we plan and perform the audit to obtain reasonable assurance about 2004 in conformity with accounting principles generally accepted in the United States of whether effective internal control over financial reporting was maintained in all material America. These financial statements are the responsibility of the company’s management. respects. An audit of internal control over financial reporting includes obtaining an under- Our responsibility is to express an opinion on these financial statements based on our standing of internal control over financial reporting, evaluating management’s assessment, audits. We did not audit the financial statements of the company’s Business Consulting testing and evaluating the design and operating effectiveness of internal control, and per- Services Reporting Unit (which includes the consulting practice acquired from us as dis- forming such other procedures as we consider necessary in the circumstances. We believe cussed in note c) for the years ended December 31, 2004, December 31, 2003 and the that our audit and the report of the other auditors provide a reasonable basis for our opinions. three months ended December 31, 2002, which statements reflect total revenues of 14.3 A company’s internal control over financial reporting is a process designed to provide percent, 14.5 percent and 4.3 percent of the related consolidated totals in the years ended reasonable assurance regarding the reliability of financial reporting and the preparation of December 31, 2004, 2003 and 2002, respectively. Those statements were audited by other financial statements for external purposes in accordance with generally accepted account- auditors whose report thereon has been furnished to us, and our opinion expressed herein, ing principles. A company’s internal control over financial reporting includes those policies insofar as it relates to the amounts included for the company’s Business Consulting and procedures that (i) pertain to the maintenance of records that, in reasonable detail, Services Reporting Unit, is based solely on the report of the other auditors. We conducted accurately and fairly reflect the transactions and dispositions of the assets of the company; our audits of these statements in accordance with the standards of the Public Company (ii) provide reasonable assurance that transactions are recorded as necessary to permit Accounting Oversight Board (United States). Those standards require that we plan and preparation of financial statements in accordance with generally accepted accounting perform the audit to obtain reasonable assurance about whether the financial statements principles, and that receipts and expenditures of the company are being made only in are free of material misstatement. An audit of financial statements includes examining, on accordance with authorizations of management and directors of the company; and (iii) a test basis, evidence supporting the amounts and disclosures in the financial statements, provide reasonable assurance regarding prevention or timely detection of unauthorized assessing the accounting principles used and significant estimates made by management, acquisition, use, or disposition of the company’s assets that could have a material effect on and evaluating the overall financial statement presentation. We believe that our audits and the financial statements. the report of other auditors provide a reasonable basis for our opinion. Because of its inherent limitations, internal control over financial reporting may not internal control over financial reporting prevent or detect misstatements. Also, projections of any evaluation of effectiveness to Also, in our opinion, based on our audit and the report of other auditors, management’s future periods are subject to the risk that controls may become inadequate because of assessment, included in Management’s Report on Internal Control over Financial Reporting changes in conditions, or that the degree of compliance with the policies or procedures appearing on page 9, that the company maintained effective internal control over financial may deteriorate. reporting as of December 31, 2004 based on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those PricewaterhouseCoopers LLP criteria. Furthermore, in our opinion, based on our audit and the report of other auditors, NEW YORK, NEW YORK the company maintained, in all material respects, effective internal control over financial FEBRUARY 22, 2005 10


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Road Map • In 2004, the company, in accordance with Section 404 of the Sarbanes-Oxley Act of The financial section of the International Business Machines Corporation (IBM and/or the 2002, conducted an evaluation of its internal control over financial reporting and company) 2004 Annual Report, consisting of this Management Discussion, the Consoli- concluded that the internal control over financial reporting was effective as of dated Financial Statements that follow and the notes related thereto, comprises 83 pages December 31, 2004. of information. This Road Map is designed to provide you with some perspective regard- • The Management Discussion is designed to provide readers with a view of the com- ing the information contained in the financial section and a few helpful hints for reading pany’s results and certain factors that may affect future prospects from the perspective the document. of the company’s management. Within the Management Discussion Snapshot, the key messages and details will give readers the ability to quickly assess the most ibm’s business model important drivers of performance within this brief overview. The company’s business model is built to support two principal goals: helping clients suc- • The Management Discussion reflects the company’s continued and improving strength ceed in delivering business value by becoming more efficient and competitive through in providing broad client solutions, as opposed to a “piece parts” conglomeration of the use of business insight and information technology (IT) solutions; and providing long- many hardware, software and services businesses. The Description of the Business on term value to shareholders. In support of these objectives, the business model has been page 13, Results of Continuing Operations on page 17, Financial Position on page developed over time through strategic investments in services and technologies that have 23, and Looking Forward on page 28 sections, all are written from the perspective the best long-term growth and profitability prospects based on the value they deliver to of the consolidated entity. Detailed analysis for each of the company’s segments is clients. In addition, the company is committed to its employees and the communities in also included and appears on pages 21 to 23. which it operates. The model is designed to allow for flexibility and periodic rebalancing. In 2004, • Global Financing is a business segment within the company that is managed on an 14 acquisitions were completed, all in software and services, at an aggregate cost of over arm’s-length basis and measured as if it were a standalone entity. A separate Global $2 billion, and in the fourth quarter the company announced the agreement to sell its Financing section beginning on page 35 is not included in the consolidated perspec- Personal Computing Division, a unit of the Personal Systems Group. tive that is referred to above. This section is separately presented given this segment’s The company’s portfolio of capabilities ranges from services that include business unique impact on the company’s financial condition and leverage. performance transformation services to software, hardware, fundamental research, financ- • The selected reference to constant currency in the Management Discussion is made ing and the component technologies used to build larger systems. These capabilities are so that the financial results can be viewed without the impacts of changing foreign combined to provide business insight and solutions in the enterprise computing space. currency exchange rates and therefore facilitates a comparative view of business In terms of financial performance, over the last two years, the company has increased growth. The percentages reported in the financial tables throughout the Management its participation in the high-growth areas of its industry, while at the same time maintaining Discussion are calculated from the underlying whole-dollar numbers. See “Currency a breadth of capabilities that has allowed it to gain share in key markets during changing Rate Fluctuations” on page 33 for additional information. economic environments. In general, this strategy results in less volatile returns overall, because each individual capability has unique financial attributes. Some involve contractual helpful hints long-term cash and income streams while others involve cyclical transaction-based sales. Organization of Information The annuity-like business delivers incremental growth with a high degree of stability and • This Management Discussion section provides the reader of the financial statements provides substantial cash. New engagements deliver more significant revenue growth and with a narrative on the company’s financial results. It contains the results of operations require a level of investment to generate success. for each segment of the business, followed by a description of the company’s finan- In terms of marketplace performance — i.e., the ability to deliver client value — it is cial position, as well as certain employee data. It is useful to read the Management important to understand that the fundamental strength of this business model is not found Discussion in conjunction with note x, “Segment Information,” on pages 87 through 91. in the breadth of the portfolio alone, but in the way the company creates business solu- • Pages 40 through 48 include the Consolidated Financial Statements. These statements tions from among its capabilities and relationships. provide an overview of the company’s income and cash flow performance and its financial position. transparency Transparency is a primary goal of successful financial reporting. The following are the key • The notes follow the Consolidated Financial Statements. Among other things, the notes elements you will find in this year’s Annual Report. contain the company’s accounting policies (pages 49 to 55), detailed information on specific items within the financial statements, certain contingencies and commit- ments (pages 69 to 71), and the results of each IBM segment (pages 87 through 91). 11


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies subsequent event continuing operations Subsequent to the company’s press release and Form 8-K filing on January 18, 2005, In 2004, the company demonstrated that it could extend its leadership in a growth environ- announcing 2004 fourth quarter and full year financial results, the company conducted a ment. The company delivered revenue growth of 8.0 percent and diluted earnings per review of agreements for sales of third-party hardware in Japan. As a result of this review, share growth of 13.8 percent. The increase in the company’s Income from continuing the company determined that certain IBM Japan employees acted improperly and incon- operations and diluted earnings per share from continuing operations as compared to sistently with the company’s policies and practices. The company is taking appropriate 2003 was primarily due to: disciplinary action. • Improving demand associated with the moderate expansion of the economy and Therefore, the company has reduced full year Global Services revenue and cost by continued market share gains for zSeries and xSeries server products $260 million. The previously announced 2004 fourth quarter financial results included $50 million of this adjustment. The additional $210 million adjustment is considered a • Continued operational improvements in the Microelectronics business Type 1 subsequent event under generally accepted accounting principles (GAAP) and • Continued demand growth in emerging countries must be reflected in the company’s 2004 financial statements. As a result, the company has • Favorable impact of currency translation reduced Global Services revenue and cost by $75 million, $55 million, and $80 million in the first, second and third quarters of 2004, respectively. The increase in revenue in 2004 as compared to 2003 was primarily due to: There was no reduction made to the company’s gross profit dollars, income from • Improved demand in Global Services and key industry sectors continuing operations or cash flows. • Improving demand associated with the moderate expansion of the economy and Discontinued Operations continued market share gains for zSeries, xSeries and pSeries server products, as On December 31, 2002, the company sold its hard disk drive (HDD) business to Hitachi, well as increased revenue for personal computers Ltd. (Hitachi). The HDD business was accounted for as a discontinued operation under • Continued demand growth in emerging countries (up over 25 percent) and in Business GAAP which requires that the income statement and cash flow information be reformatted Performance Transformation Services (up approximately 45 percent) to separate the divested business from the company’s continuing operations. See pages • Favorable impact of currency translation 60 and 61 for additional information. With regard to the way that management reviews the business, as-reported and constant currency revenue trends were positive for all of the company’s segments (except Global Management Discussion Snapshot Financing), geographies and industry sectors. See pages 17 and 18 for the summary trend (Dollars and shares in millions except per share amounts) rates on an as-reported and constant currency basis, as well as information for each segment Yr. to Yr. on pages 21 to 23. Percent/ Margin The consolidated gross profit margin was relatively flat versus 2003, increasing 0.4 FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change points. An improvement in Hardware margins (1.8 points) contributed 0.5 points to the Revenue $÷«96,293 $«««89,131 8.0% * overall margin improvement. In addition, Global Financing margin improved 4.2 points Gross profit margin 37.4% 37.0% 0.4 pts. compared to 2003, however, this improvement had an immaterial impact on the com- Total expense and other income $÷«24,004 $«÷22,144 8.4% pany’s overall margin due to the size of the segment. These improvements were partially Total expense and other income to revenue ratio 24.9% 24.8% 0.1 pts. offset by Global Services and Software — while margins in these segments were generally Provision for income taxes $÷÷«3,580 $÷÷«3,261 9.8% flat year-to-year, the mix of these segments slightly impacted the overall company margin. Income from continuing operations $÷÷«8,448 $÷÷«7,613 11.0% Total expense and other income increased in 2004 versus 2003 due primarily to Earnings per share from continuing operations: increased retirement-related plan costs, including the $320 million charge due to the par- Diluted $«««««««4.94 $«««««««4.34 13.8% tial settlement of certain legal claims against the company’s IBM Personal Pension Plan Basic $«««««««5.04 $«««««««4.42 14.0% (PPP), and unfavorable currency translation. Weighted-average shares outstanding: Diluted 1,708.9 1,756.1 (2.7) % Overall, retirement-related plan costs increased $1,082 million versus 2003, impacting Basic 1,675.0 1,721.6 (2.7) % both gross margin and expense. See note w, “Retirement-Related Benefits” on pages 78 Assets ** $«109,183 $«104,457 4.5% through 86 for additional information. Liabilities ** $«««79,436 $÷«76,593 3.7% The provision for income taxes resulted in an effective tax rate of 29.8 percent for Equity ** $«««29,747 $÷«27,864 6.8% 2004, compared with the 2003 effective tax rate of 30.0 percent. The 0.2 point decrease in the effective tax rate in 2004 was primarily due to the tax effect of the settlement of certain * 3.4 percent adjusting for currency 12 ** At December 31 pension claims in the third quarter of 2004 (highlighted above).


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies With regard to Assets, approximately $3.6 billion of the increase relates to the impact investment in such an infrastructure provides both superior returns and maximum freedom of currency translation. The remaining increase primarily consists of an increase in Cash and of interoperability and action. Standards have become a core element of IBM’s overall cash equivalents, an increase in Goodwill associated with recent acquisitions and increased strategy and impact all of our unit strategies. Prepaid pension assets. The increases were partially offset by lower financing receivables The shift to standards-based technologies has been bolstered significantly in recent and lower deferred tax assets. years by the rapid growth of the “open source” software movement, a result of large-scale For additional information, see the Year in Review section on pages 17 to 26. collaboration among members of the worldwide developer and business communities. Global Financing debt decreased, but the company’s Global Financing debt-to-equity Examples include the Linux operating system, the Eclipse computing platform and the ratio remained flat at 6.9 to 1 and within the company’s targeted range. Java programming language. Global Services signings were $43 billion in 2004 as compared to $55 billion in 2003. IBM’s clients include many different kinds of enterprises, from sole proprietorships to The Global Services backlog is estimated to be $111 billion at December 31, 2004 versus the world’s largest organizations, governments and companies representing every major $120 billion at December 31, 2003. For additional information, see Global Services Signings industry and endeavor. Over the last decade, IBM has exited or greatly de-emphasized its on page 29. involvement in consumer markets and divested itself of other noncore businesses to con- Looking forward, the company’s longer-term financial model targets earnings per centrate on the enterprise market. In IBM’s view, opportunities in the enterprise market are share to grow at a low double-digit rate with revenue growth in the mid-to-high single superior — representing approximately two-thirds of the IT industry’s revenue. As a result, digits, continued productivity driven margin improvement, and effective capital deploy- IBM has made acquisitions and invested in emerging business opportunities important to ment for acquisitions and common stock repurchase. The company’s ability to meet these its enterprise clients. Many of these investments have grown into multibillion dollar busi- objectives depends on a number of factors, including those outlined on page 17 and on nesses in their own right, and are now contributing to IBM’s growth. pages 69 to 71. The majority of the company’s enterprise business, which excludes the company’s original equipment manufacturer (OEM) technology business, occurs in industries that are broadly grouped into six sectors around which the company’s go-to-market strategies, Description of Business and sales and distribution activities are organized: Please refer to IBM’s Annual Report on Form 10-K filed on February 24, 2005, with the • Financial Services: Banking, Financial Markets, Insurance Securities and Exchange Commission (SEC) for a more detailed version of this Description • Public: Education, Government, Healthcare, Life Sciences of Business, especially the detailed “Significant Factors Affecting IBM’s Business” section. • Industrial: Aerospace, Automotive, Defense, Chemical and Petroleum, Electronics IBM is an innovation-based business serving the needs of enterprises and institutions • Distribution: Consumer Products, Retail, Travel, Transportation worldwide. It defines innovation as the intersection of business insight and technological invention. IBM seeks to deliver client success — in whatever ways its clients define success — • Communications: Telecommunications, Media and Entertainment, Energy and Utilities by giving them differentiating capabilities that provide unique competitive advantage. • Small and Medium Business: Mainly companies with less than 1,000 employees By helping its clients redesign their business processes and organizational structure, the it industry and ibm’s strategy enabled by new operating environments, IBM helps them to become on demand busi- IBM operates in the IT industry, which comprises three principal categories: nesses. IBM defines an on demand business as an enterprise whose business processes are responsive to any demand, opportunity or threat; integrated end-to-end across the • Business Value company; and capable of integrating fluidly across extended business ecosystems of part- • Infrastructure Value ners, suppliers and clients. • Component Value IBM first described this new model and set of capabilities in 2002, believing they IBM has realized and continues to see a shift in revenue and profit growth from Component represent the current evolution of information technology architectures and of business Value to Infrastructure Value and Business Value, where revenue and profit potential are and institutional models. IBM calls this architecture the On Demand Operating thought to be greatest in the years ahead. Environment: an infrastructure based on industry-wide standards (commonly referred to as “open standards”), rather than on proprietary technologies. In IBM’s view, an enterprise’s 13


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Business Value Infrastructure Value The company helps its clients transform their businesses and gain competitive advantage Infrastructure Value includes systems, such as high-volume servers; middleware software by applying its skills and experience to business performance challenges specific to the that can interconnect disparate operating systems and applications with data; storage client’s industry or across industries and processes. The company enters into long-term networks; and devices. It also refers to such services as infrastructure management — relationships and creates solutions for clients, driving on demand business innovation, on its whether on the client’s premises or managed remotely at IBM’s own facilities — and consult- own or in partnership with other companies. The company draws upon its broad product ing about how to improve and strengthen the infrastructure and realize greater return on and service offerings, including Business Consulting Services, IBM Research, industry-leading investment in it. Central to IBM’s approach for building value in the infrastructure category middleware, and its deep experience in systems and technology design. is its support of open standards and its active promotion of Linux and other open source CA PA B I L I T I E S platforms, which help IBM’s clients control costs and allow them to benefit from the latest Business Consulting Services ( BCS ). Delivery of value to clients through consulting services advances created by development communities around the world. IBM’s strategic objective for client relationship management, financial management, human capital, business strategy is to deliver open and integrated offerings and expand partnerships. and change, and supply chain management, as well as application innovation and the trans- CA PA B I L I T I E S formation of business processes and operations. (Global Services) Application Management Services. Application development, management, maintenance Business Performance Management ( BPM ). Enables companies to visualize end-to-end and support services for packaged software, as well as custom and legacy applications. processes across business and IT systems, analyze execution in real time against goals, and (Global Services) make adjustments as needed. IBM offers consulting, services and middleware to simulate Commercial financing. Short-term inventory and accounts receivable financing to dealers and monitor business processes, and provides customers with real-time analysis of the and remarketers of IT products. (Global Financing) underlying IT systems carrying out those processes. (Software) DB 2 information management software. Advanced database and content management soft- Business Transformation Outsourcing ( BTO ). Delivers improved business results to clients ware solutions that enable clients to leverage information on demand. (Software) through the continual strategic change and the operation and transformation of the client’s e-business Hosting Services. Solutions for the management of clients’ Web-based infrastruc- business processes, applications and infrastructure. (Global Services) ture and business applications, as well as a growing portfolio of industry-specific independ- Center for Business Optimization ( CBO ). Helps clients continually optimize their business ent software vendor (ISV) solutions that are delivered as a service. (Global Services) performance by drawing upon massive amounts of real-time data, advanced analytical Integrated Technology Services ( ITS ). Design, implementation and maintenance of clients’ methods, business expertise and deep computing power. (Global Services) technology infrastructures. (Global Services) Customer Financing. Lease and loan financing to external and internal clients for terms gen- Lotus software. Collaboration and messaging software that allows a company’s employees, erally between two and five years. (Global Financing) clients, vendors and partners to engage in real-time and asynchronous communication and Engineering & Technology Services ( E&TS ). System and component design services, strate- knowledge management. (Software) gic outsourcing of clients’ design teams, and technology and manufacturing consulting Personal computers. Notebook and desktop computers featuring ThinkVantage Technolo- services. (Systems and Technology Group) gies that provide enterprises and end users with increased productivity and cost-effectiveness. On Demand Innovation Services ( ODIS ). IBM Research scientists work with BCS consultants (Personal Systems Group) to analyze and solve clients’ most intractable business challenges. ODIS offers a number of Printing Systems. Production print solutions, on demand print-related solutions, enterprise cross-industry micropractices with deep expertise including mobile enablement and infor- workgroup print technologies, and print management software and services. (Personal mation mining. (Global Services and IBM Research) Systems Group) Software and services to meet industry-specific needs. Solutions and applications built on an Rational software. Integrated tools designed to improve an organization’s software devel- on demand, standards-based infrastructure to transform a process that is unique to specific opment processes and capabilities. (Software) industries. (Multiple IBM segments) Remarketing. The sale and lease of used equipment (primarily sourced from the conclusion Business Performance Transformation Services ( BPTS ). Helps clients transform their spend- of lease transactions) to new or existing clients. (Global Financing) ing on business processes, namely Selling, General and Administrative and Research and Development. BPTS requires advanced technology and deep expertise in industry and/or Retail Store Solutions. Point-of-sale retail checkout equipment, software and solutions. specific functions like Human Resources (HR), logistics, payroll, sales, customer services and (Personal Systems Group) procurement, to result in holistic improvement for the performance and success of a busi- Servers. IBM eServer systems using IBM operating systems (zSeries and iSeries), as well as ness, including efficiency of individual processes and their combined effort. BPTS solutions AIX, the IBM UNIX operating system (pSeries) and the Microsoft Windows operating system are delivered to clients by several of the company’s business areas: BTO, E&TS, Strategy and (xSeries). All servers can also run Linux, a key open source operating system. (Systems and Change Consulting and BPM. (Multiple IBM segments) Technology Group and Software) 14


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Storage. Data storage products, including disk, tape and storage area networks. (Systems Personal Systems Group includes sales of personal computers, business and computing and Technology Group) solutions for retail stores and advanced printing capabilities for large enterprise clients Strategic Outsourcing Services ( SO ). Competitive cost advantages through the outsourcing and small and medium-sized businesses. In December 2004, it was announced that of processes and operations. (Global Services) Lenovo Group Limited, the largest information technology company in China, will acquire Tivoli software. Software for infrastructure management, including security, change, config- IBM’s Personal Computing Division. This transaction is expected to close in the second uration, job scheduling, storage capability, performance and availability. (Software) quarter of 2005. WebSphere software. Management of a wide variety of business processes using open Software consists primarily of middleware and operating systems software. Middleware standards to interconnect applications, data and operating systems. (Software) software enables clients to integrate systems, processes and applications across their Component Value enterprises. Middleware is designed to be the underlying support for applications provided Component Value includes advanced semiconductor development and manufacturing for by independent software vendors (ISVs), who build industry- or process-specific applica- IBM’s server and storage offerings, and services, technology and licenses provided to OEMs tions according to open industry standards. Operating systems are the engines that run that create and market products requiring advanced chips and other core technology computers. Approximately 40 percent of external Software revenue relates to one-time elements. IBM leverages components for infrastructure value, while continuing to partici- charge (OTC) arrangements, whereby the client pays one up-front payment for a lifetime pate in selected markets, focusing on key industry partners. license. The remaining annuity revenue consists of both maintenance revenue sold with OTC arrangements, as well as revenue from software sold on a monthly license charge CA PA B I L I T I E S Application Specific Integrated Circuit ( ASICs). Manufacturing of customized semiconductor (MLC) arrangement. Typically, arrangements for the sale of OTC software include one year products for clients. (Systems and Technology Group) of maintenance. The client can also purchase ongoing maintenance after the first year, which includes product upgrades and technical support. Advanced Foundry. Integrated supply chain services and a full suite of semiconductor manu- facturing services using either a client’s or IBM’s design. (Systems and Technology Group) Global Financing is described on pages 35 to 39. Standard products and custom microprocessors. Semiconductors designed and manufactured primarily based upon IBM’s PowerPC architecture. (Systems and Technology Group) Enterprise Investments develops and provides industry-specific IT solutions supporting the Hardware, Software and Global Services segments of the company. Primary product lines business segments include product life cycle management software and document processing technologies. Organizationally, the company’s major operations comprise a Global Services segment; a Product life cycle management software primarily serves the Industrial sector and helps Systems and Technology Group; a Personal Systems Group; a Software segment; a Global clients manage the development and manufacturing of their products. Document Financing segment; and an Enterprise Investments segment. processor products service the Financial Services sector and include products that enable electronic banking. Global Services is a critical component of the company’s strategy of providing insight and solutions to clients. While solutions often include industry-leading IBM software and hard- ibm worldwide organizations ware, other suppliers’ products are also used if a client solution requires it. Global Services The following three company-wide organizations play key roles in IBM’s delivery of value outsourcing contracts as well as BCS contracts range from less than one year to ten years. to its clients: Systems and Technology Group provides IBM’s clients with business solutions requiring • Sales & Distribution Organization and related sales channels advanced computing power and storage capabilities. More than half of the Systems and • Research, Development and Intellectual Property Technology Group’s eServer and Storage Systems sales transactions are through business • Integrated Supply Chain partners; approximately 40 percent are direct to end-user clients, more than half of which are through the Web at ibm.com. In addition, the group provides leading semiconductor technology and products, packaging solutions and engineering technology services to OEM clients (approximately 14 percent of Systems and Technology Group revenue) and for IBM’s own advanced technology needs. While appropriately not reported as external revenue, hardware is also deployed to support Global Services solutions. 15


  • Page 18

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Sales & Distribution Organization In addition to these IP income sources, the company also generates value from its With a comprehensive knowledge of IBM’s business and infrastructure solutions, as well as the patent portfolio through cross-licensing arrangements and IP licensed in divestiture individual products, technologies and services offered by IBM and its network of business transactions. The value of these other two sources is not readily apparent in the financial partners, the company’s global team of account representatives and solutions professionals results and Consolidated Statement of Earnings, because income on cross-licensing gain a deep understanding of each client’s organizational, infrastructure and industry-specific arrangements is recorded only to the extent that cash is received. The value received by needs to determine the best approach for addressing the client’s critical business and IT IBM for IP involving the sale of a business is included in the overall gain or loss from the challenges. These professionals work in integrated teams with IBM consultants and technol- divestiture, not in the separately displayed IP income amounts in financial results and ogy representatives, combining their deep skills and expertise to deliver high-value solutions. Consolidated Statement of Earnings. In January 2005, IBM announced that it would pledge 500 of its patents for use by the I N T E R N A L R O U T E S -TO - M A R K E T open computing community, representing a major shift in the way IBM manages and Global Services consultants focused on selling end-to-end solutions for large, complex deploys its intellectual property portfolio. IBM’s intent is to help form an industry-wide business challenges. “patent commons,” in which patents are used to establish a platform for further innovation Hardware and software brand specialists selling IBM products as parts of discrete technology in areas of broad interest to information technology developers and users. The pledge is decisions, typically to “self-integrating” IT departments. applicable to any individual, community or company working on or using software that ibm.com Online and telephone sales and assistance operations handle basic commodity meets the Open Source Initiative (OSI) definition of open source software. transactions for large enterprises and small-to-medium businesses. Integrated Supply Chain B U S I N E S S PA RT N E R S R O U T E S -TO - M A R K E T Just as IBM works to transform its clients’ supply chains for greater efficiency and respon- Global/major independent software vendors (ISVs). ISVs deliver business process or industry- siveness to market conditions, IBM has undertaken a large-scale initiative to recast its own specific applications and, in doing so, often influence the sale of IBM hardware, middleware integrated supply chain as an on demand business operation, turning what had previously and services. been an expense to be managed into a strategic advantage for the company and, ultimately, improved delivery and outcomes for its clients. IBM spends approximately $41 billion Global/major systems integrators (SIs). SIs identify business problems and design solutions annually through its supply chain, procuring materials and services around the world. The when Global Services is not the preferred systems integrator; they also sell computing company’s supply, manufacturing and distribution operations are integrated in one oper- infrastructures from IBM and its competitors. ating unit that has reduced inventories, improved response to marketplace opportunities Regional ISVs and SIs. SIs identify the business problems, and ISVs deliver business process and external risks and converted fixed to variable costs. Simplifying and streamlining or industry-specific applications to medium-sized and large businesses requiring IBM internal operations has improved sales force productivity and processes and thereby the computing infrastructure offerings. experiences of the company’s clients when working with IBM. Because some of the cost Solutions providers, resellers and distributors. Resellers sell IBM platforms and value-added savings this unit generates are passed along to clients, they will not always result in a visible services as part of a discrete technology platform decision to clients wanting third- gross margin improvement in the company’s Consolidated Statement of Earnings. While party assistance. these efforts are largely concerned with product manufacturing and delivery, IBM is also applying supply chain principles to service delivery across its solutions and services Research, Development and Intellectual Property lines of business. To accomplish this, IBM is creating a new labor resource management IBM’s research and development (R&D) operations differentiate IBM from its competitors. IBM system — based on a uniform taxonomy of skills — that will enable the organization to more annually spends approximately $5 – 6 billion for R&D, including capitalized software costs, efficiently match its labor resources to the needs of IBM clients, deploy the right expertise focusing its investments in high-growth opportunities. As a result of innovations in these quickly, and create a better short-term and long-term balance of labor supply and and other areas, IBM was once again awarded more U.S. patents in 2004 than any other demand by comparing the demands of the market against the database of available skills. company. This marks the 12th year in a row that IBM achieved this distinction. In addition to its own manufacturing operations, the company uses a number of con- In addition to producing world-class hardware and software products, IBM innovations tract manufacturing (CM) companies around the world to manufacture IBM-designed are a major differentiator in providing solutions for the company’s clients through its products. The use of CM companies is intended to generate cost efficiencies and reduce growing services activities. The company’s investments in R&D also result in intellectual time-to-market for certain IBM products. Some of the company’s relationships with CM property (IP) income. Some of IBM’s technological breakthroughs are used exclusively in companies are exclusive. The company has key relationships with Sanmina-SCI for the IBM products, while others are used by the company’s licensees for their products when manufacture of some Intel-based products and with Solectron for a significant portion of that new technology is not strategic to IBM’s business goals. A third group is both used the manufacturing operations of Global Asset Recovery Services — an operation of Global internally and licensed externally. 16 Financing that restores end-of-lease personal computers and other IT equipment for resale.


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies key business drivers client’s internal systems, applications and processes remains a monumental and expensive The following are some of the key drivers of the company’s business. task. The broad-based acceptance of open standards — rather than closed, proprietary architectures — also allows the computing infrastructure to more easily absorb (and thus Economic Environment and Corporate IT Spending Budgets benefit from) new technical innovations. IBM is committed to fostering open standards If overall demand for hardware, software and services changes, whether due to general because they are vital to the On Demand Operating Environment, and because their economic conditions or a shift in corporate buying patterns, sales performance could be acceptance will expand growth opportunities across the entire business services and IT impacted. IBM’s diverse portfolio of products and offerings is designed to gain market industry. There are a number of competitors in the IT industry with significant resources share in strong and weak economic climates. The company accomplishes this by not only and investments who are committed to closed and proprietary platforms as a way to lock having a mix of offerings with long-term cash and income streams as well as cyclical trans- customers into a particular architecture. This competition will result in increased pricing action-based sales, but also by continually developing competitive products and solutions pressure and/or IP claims and proceedings. IBM’s support of open standards is evidenced and effectively managing a skilled resource base. IBM continues to transform itself to take by the enabling of its products to support open standards such as Linux, and the develop- advantage of shifting demand trends, focusing on client or industry-specific solutions, ment of Rational software development tools, which can be used to develop and upgrade business performance and open standards. any other company’s software products. Internal Business Transformation and Efficiency Initiatives Emerging Business Opportunities IBM continues to drive greater productivity and cost savings as it transforms itself into an The company is continuing to refocus its business on the higher value segments of enter- on demand enterprise. This includes the internal supply chain initiatives discussed above, prise computing — providing technology and transformation services to clients’ businesses. as well as driving collaboration across the IBM enterprise to stimulate innovation and drive Consistent with that focus, the company continues to significantly invest in Emerging growth. Transformation efforts are improving the company’s management of its costs Business Opportunities, as a way to drive revenue growth and market share gain. Areas of worldwide: rebalancing of skills, optimizing its workforce to drive growth, keeping the com- investment include strategic acquisitions, primarily in software and services, information- pany’s compensation programs competitive, and creating a cost-efficient and cutting-edge based medicine, on demand retail, sensor and actuator solutions, Business Performance IT infrastructure to support its transformation. IBM is extending its supply chain initiatives Transformation Services, key technologies (POWER5 and POWERBlade) and emerging to labor costs and other internal processes. Continued success in this area will impact the growth countries such as China, Russia, India and Brazil. company’s cost structure improvements, as well as the amount of competitive leverage it can apply by passing savings along to clients. Innovation Initiatives Year in Review IBM invests for new and innovative capabilities, products and services. IBM has been moving results of continuing operations away from commoditized categories of the IT industry and into areas in which it can differ- Revenue entiate itself through innovation and by leveraging its investments in R&D. Examples (Dollars in millions) include IBM’s leadership position in the design and fabrication of ASICs; the design of Yr. to Yr. smaller, faster and energy-efficient semiconductor devices; the design of “grid” comput- Percent Yr. to Yr. Change ing networks that allow computers to share processing power; the transformation and Percent Constant FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Currency integration of business processes; and the company’s efforts to advance open technology standards and to engage with governments, academia, think tanks and nongovernmental Statement of Earnings organizations on emerging trends in technology, society and culture. In the highly compet- Revenue Presentation: itive IT industry, with large diversified competitors as well as smaller and nimble single- Global Services $«46,213 $«42,635 8.4% 3.1% technology competitors, IBM’s ability to continue its cutting-edge innovation is critical to Hardware 31,154 28,239 10.3 6.5 maintaining and increasing market share. IBM is managing this risk by more closely linking Software 15,094 14,311 5.5 0.6 its R&D organization to industry-specific and client-specific needs, as discussed in Global Financing 2,608 2,826 (7.7) (11.5) Description of Business — IBM Worldwide Organizations. Enterprise Investments/Other 1,224 1,120 9.3 5.2 Open Standards Total $«96,293 $«89,131 8.0% 3.4% The broad adoption of open standards is essential to the computing model for an on demand business and is a significant driver of collaborative innovation across all industries. Without interoperability among all manner of computing platforms, the integration of any 17


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) Revenue across all geographies increased in 2004 when compared to 2003. In the Yr. to Yr. Americas, U.S. (6 percent) and Canada (9 percent) revenue grew as did Latin America Percent Yr. to Yr. Change (12 percent), notably Brazil, which grew at 15 percent. Percent Constant Within Europe/Middle East /Africa, Eastern Europe, the Nordic countries, Spain (7 per- FOR THE YEAR ENDED DECEMBER 31: 2004 2003* Change Currency cent) and France (3 percent) had revenue growth, while the U.K. (2 percent), Germany Industry Sector: (3 percent) and Italy (8 percent) declined after adjusting for currency. Asia Pacific had Financial Services $«24,339 $«22,274 9.3% 4.0% strong growth in 2004, led by China, which grew at 25 percent, and the ASEAN region Public 14,758 13,917 6.0 2.0 (17 percent), while Japan, which is about 60 percent of Asia Pacific’s revenue, also had Industrial 12,582 11,850 6.2 1.1 growth of 5 percent. Collectively, as a result of the company’s targeted investments, the Distribution 8,767 8,157 7.5 3.1 emerging countries of China, Russia (75 percent), India (45 percent) and Brazil had revenue Communications 8,859 8,026 10.4 6.0 growth over 25 percent in 2004 to over $4.0 billion in revenue. Small & Medium 21,162 19,537 8.3 3.2 OEM revenue increased in 2004 versus 2003 due primarily to continued strong OEM 2,885 2,634 9.6 9.3 growth in the company’s Engineering & Technology Services business and improved Other 2,941 2,736 7.5 3.1 operational performance in the Microelectronics business. Total $«96,293 $«89,131 8.0% 3.4% The increase in Global Services revenue was driven by SO as it continued its steady growth. BCS and ITS revenue also increased. Maintenance revenue increased due to the * Reclassified to conform with 2004 presentation. favorable impact of currency movements. In addition, significant progress was made in the company’s relatively new BPTS offer- (Dollars in millions) ings (see page 14) where revenue grew approximately 45 percent. Yr. to Yr. Percent In Hardware, Systems and Technology Group, revenue increased as zSeries servers, Yr. to Yr. Change xSeries servers, pSeries servers and Engineering & Technology Services increased. zSeries’ Percent Constant FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Currency strong performance resulted from clients adding new workload to the mainframe as they build their on demand infrastructures. xSeries had strong growth, driven by its leadership Geographies: in Blades. pSeries server revenue increased as the company’s POWER5 technology was Americas $«40,064 $«38,078 5.2% 4.5% well received by customers in 2004. Demand for the company’s Engineering & Technology Europe/Middle East/Africa 32,068 29,102 10.2 0.8 services continued to be strong. Storage Systems revenue increased due to greater Asia Pacific 21,276 19,317 10.1 4.2 demand for external midrange disk and tape products, offset by decreases in high-end OEM 2,885 2,634 9.6 9.3 disk products. Microelectronics revenue increased due primarily to improved yields and Total $«96,293 $«89,131 8.0% 3.4% increased output in the 300 millimeter factory. iSeries server revenue declined as the transition to POWER5 technology is taking longer than previous cycles. Revenue from all industry sectors increased in 2004 when compared to 2003, reflecting Personal Systems Group revenue increased in 2004, driven by strong performance the company’s broad capabilities and industry-specific solutions which combine technol- worldwide by the company’s ThinkPad mobile computers. Retail Store Solutions also ogy and high value services to solve a client’s business or IT problems. These solutions also delivered strong revenue growth in 2004 due to continued demand for its products as provide for a longer-term relationship with the client, rather than a transaction-oriented well as the acquisition of Productivity Solutions Inc. in November 2003. sale. The Financial Services sector revenue growth was led by financial markets (15 per- Software revenue increased due to improved demand for Data Management products, cent), banking (9 percent) and insurance (8 percent). The Communications sector had Tivoli software products, the WebSphere family of products and Rational products. strong revenue growth in Telecommunications (15 percent), while the Distribution sector Operating Systems revenue increased slightly primarily due to favorable currency translation. was led by the retail industry (12 percent). The Small & Medium business sector increased The decline in Global Financing revenue in 2004 versus 2003 was primarily driven by as the company continued to roll out new products under the Express label that are lower used equipment sales. See pages 35 to 39 for additional information regarding designed and priced specifically for customers in the 100 to 1,000 employee segment. Global Financing results. 18


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies The following table presents each segment’s revenue as a percentage of the com- Expense pany’s total: (Dollars in millions) Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Global Services 48.0% 47.8% Total expense and other income $«24,004 $«22,144 8.4% Hardware 32.3 31.7 Expense to Revenue (E/R) 24.9% 24.8% 0.1 pts. Software 15.7 16.1 Global Financing 2.7 3.2 Total expense and other income increased 8.4 percent (5.4 percent adjusting for currency) Enterprise Investments/Other 1.3 1.2 in 2004 versus 2003. The increase was primarily due to higher retirement-related plan Total 100.0% 100.0% costs, Research, development and engineering expense and the effect of currency trans- lation on expense. For additional information regarding the increase in Total expense and See segment discussion on pages 21 to 23 for further details on year-to-year revenue other income, see the following analyses by category: changes by brand. Selling, General and Administrative (SG&A) (Dollars in millions) Gross Profit Yr. to Yr. Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003* Change FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Selling, general and administrative expense: Gross Profit Margin: Selling, general and administrative — base $«17,584 $«15,787 11.4% Global Services 25.1% 25.2% (0.1) pts. Advertising and promotional expense 1,335 1,406 (5.1) Hardware 29.6 27.8 1.8 Workforce reductions — ongoing 332 454 (26.9) Software 87.3 86.5 0.8 Bad debt expense 133 205 (35.3) Global Financing 60.0 55.8 4.2 Enterprise Investments/Other 40.3 43.4 (3.1) Total $«19,384 $«17,852 8.6% Total 37.4% 37.0% 0.4 pts. * Reclassified to conform with 2004 presentation. The modest decline in Global Services gross profit margin was due to continued invest- Total SG&A expense increased 8.6 percent (5.1 percent adjusting for currency). The ment in on demand infrastructure and business transformation capabilities, and less increase was primarily driven by increased expense for retirement-related plan costs of contribution from the higher margin Maintenance business. approximately $515 million, which included a one-time charge of $320 million related to The increase in Hardware margins was primarily due to yield improvements in the the partial settlement of certain legal claims against the company’s PPP (see pages 20 and Microelectronics business and margin improvements in zSeries servers, xSeries servers, 21 for further information on retirement-related benefits), unfavorable currency translation storage products and personal computers, as well as the impact of certain hedging trans- of $626 million, and provisions for certain litigation-related expenses of $125 million in actions (see “Anticipated Royalties and Cost Transactions” on page 66). 2004. These increases were partially offset by lower workforce reductions and lower The Software margin increased due to growth in software revenue, as well as produc- Advertising and promotional expense. The amount of Workforce reductions — ongoing will tivity improvements in the company’s support and distribution models. vary from year to year depending upon the required skills, competitive environment and The increase in the Global Financing margin was primarily driven by a mix change economic conditions. In addition, Bad debt expense declined primarily due to lower reserve towards higher margin financing revenue and away from lower margin used equipment requirements associated with the improvement in economic conditions and improved sales and improved margins from financing revenue. credit quality, as well as the lower asset base of the Global Financing receivables portfolio The cost savings generated by the company’s supply chain initiatives also contributed (see page 37). to the company’s overall margin improvement, but as discussed on page 16, the company has passed a portion of the savings to clients to improve competitive leadership and gain market share in key industry sectors. In addition, an increase in retirement-related plan costs of approximately $490 million compared to 2003 impacted overall segment margins. See segment discussion on pages 21 to 23 for further details on gross profit. 19


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies OT H E R ( I N CO M E ) A N D E X P E N S E I N T E L L E CT UA L P R O P E RTY A N D C U STO M D E V E LO P M E N T I N CO M E (Dollars in millions) (Dollars in millions) Yr. to Yr. Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Other (income) and expense: Intellectual property and custom Foreign currency transaction losses $«381 $«411 (7.5) % development income: Interest income (180) (152) 18.9 Sales and other transfers of intellectual property $÷÷466 $««««562 (17.1) % Net realized gains on sales of securities and Licensing/royalty-based fees 393 338 16.3 other investments (59) (54) 9.0 Custom development income 310 268 15.7 Writedowns of impaired investment assets 20 50 (59.6) Total $«1,169 $«1,168 0.2% Net realized (gains)/losses from certain real estate activities (71) 16 NM Intellectual property and custom development income was flat in 2004 versus 2003. The 2002 actions* 42 2 NM timing and amount of Sales and other transfers of IP may vary significantly from period to Other (156) (35) NM period depending upon the timing of divestitures, industry consolidation, economic con- Total $««(23) $«238 NM ditions and the timing of new patents and know-how development. * See note s, “2002 Actions” on pages 73 through 76. I N T E R E ST E X P E N S E NM — Not Meaningful (Dollars in millions) Yr. to Yr. Other (income) and expense was income of $23 million in 2004 versus expense of $238 mil- FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change lion in 2003. The improvement was primarily driven by increased gains from various asset Interest expense: sales including certain real estate transactions in 2004 versus 2003, additional Interest Total $«139 $«145 (4.6) % income generated by the company in 2004 and other nonrecurring gains/settlements increasing in 2004 when compared to 2003. The Foreign currency transaction losses relate primarily to losses on certain hedge contracts offset by gains on the settlement of foreign Interest expense is presented in Cost of Global Financing in the Consolidated Statement currency receivables and payables. See pages 33 and 34 for additional discussion of of Earnings only if the related external borrowings are to support the Global Financing currency impacts on the company’s financial results. external business. See page 38 for additional information regarding Global Financing debt and interest expense. R E S E A R C H , D E V E LO P M E N T A N D E N G I N E E R I N G (Dollars in millions) Retirement-Related Benefits Yr. to Yr. The following table provides the total pre-tax cost for all retirement-related plans. Cost FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change amounts are included as an addition to the company’s cost and expense amounts in the Research, development and engineering: Consolidated Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) relating to Total $«5,673 $«5,077 11.7% the job function of the individuals participating in the plans. (Dollars in millions) The increase in Research, development and engineering (RD&E) expense in 2004 versus Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change 2003 was primarily the result of increased spending in middleware software including new acquisitions (approximately $240 million). In addition, RD&E expense increased due to Retirement-related plans cost: spending related to the POWER5 technology initiatives (approximately $140 million), Defined benefit and contribution pension increased spending on new storage products (approximately $50 million), and higher plans cost $«1,072 $«««27 NM retirement-related plan costs (approximately $77 million). Nonpension postretirement benefits costs 372 335 11.0% Total $«1,444 $«362 NM NM — Not Meaningful 20


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Overall, retirement-related plan costs increased $1,082 million versus 2003. On Global Services December 31, 2003, the company lowered its PPP discount rate from 6.75 percent to (Dollars in millions) 6.0 percent which increased pre-tax cost and expense by almost $200 million in 2004. In Yr. to Yr. addition, the 2004 results include a charge of $320 million due to the partial settlement of FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change certain legal claims against the company’s PPP. The 2004 results were also affected by Global Services Revenue: $«46,213 $«42,635 8.4% changes in the market value of plan assets as well as similar trends in the company’s other Strategic Outsourcing $«19,309 $«17,124 12.8% defined benefits pension plans that contributed to the increase in costs. See note w, Business Consulting Services 13,767 12,955 6.3 “Retirement-Related Benefits” on pages 78 through 86 for additional information. The Integrated Technology Services 7,441 7,099 4.8 year-to-year increase impacted gross margin, SG&A and RD&E by approximately $490 mil- Maintenance 5,696 5,457 4.4 lion, $515 million and $77 million, respectively. Provision for Income Taxes Global Services revenue increased 8.4 percent (3.1 percent adjusted for currency). SO The provision for income taxes resulted in an effective tax rate of 29.8 percent for 2004, continued to demonstrate its competitive advantage in delivering on demand solutions by compared with the 2003 effective tax rate of 30.0 percent. The 0.2 point decrease in the leveraging its business transformational skills and its scale during 2004. Each geography effective tax rate in 2004 was primarily due to the tax effect of the settlement of certain continued year-to-year growth, with seven consecutive quarters of double-digit growth in pension claims in the third quarter of 2004. Europe/Middle East /Africa, excluding currency benefits. Within SO, e-business Hosting Services, an offering that provides Web infrastructure and application management as Weighted-Average Common Shares an Internet based service, continued its pattern of revenue growth. ITS revenue, which Yr. to Yr. excludes Maintenance, increased driven by growth in Business Continuity and Recovery FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Services of 29 percent, partially offset by the revenue reduction for sales of third-party Earnings per share from continuing operations: hardware in Japan. (See page 12, “Subsequent Event” for additional information.) BCS Assuming dilution $«««««4.94 $«««««4.34 13.8% revenue increased driven by strong growth in BTO. BCS continued to improve its revenue Basic 5.04 4.42 14.0 growth rate at constant currency in every quarter of the year. Maintenance revenue Weighted-average shares outstanding (in millions): increased primarily driven by favorable impacts of currency movements. Assuming dilution 1,708.9 1,756.1 (2.7) % Basic 1,675.0 1,721.6 (2.7) (Dollars in millions) Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change The average number of common shares outstanding assuming dilution was lower by 47.2 mil- Global Services: lion shares in 2004 versus 2003. The decrease was primarily the result of the company’s Gross profit $«11,576 $«10,732 7.9% common share repurchase program. See note n, “Stockholders’ Equity Activity,” on page Gross profit margin 25.1% 25.2% (0.1) pts. 69 for additional information regarding the common share activities. Also see note t, “Earnings Per Share of Common Stock,” on page 77. The Global Services gross profit dollars increased primarily due to the corresponding segment details increase in revenue. The gross profit margin declined due to investment in on demand infra- The following is an analysis of the 2004 versus 2003 external segment results. The analysis structure and business transformation capabilities, as well as a lower mix of Maintenance of 2003 versus 2002 external segment results is on pages 26 to 28. revenue (12 percent in 2004 versus 13 percent in 2003), which has a higher gross profit margin than the other categories of Global Services revenue. These declines were partially offset by improved profitability in BCS driven by improved utilization, reduced overhead structure and an improved labor mix. 21


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Hardware Storage Systems revenue increased slightly due to increased demand for external (Dollars in millions) midrange disk (13 percent) and tape products (9 percent). These increases were partially Yr. to Yr. offset by decreases in high-end disk products (18 percent) as clients anticipated the ship- FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change ment of the company’s new POWER5 high-end storage product which will ship in the first Hardware Revenue: $«30,710 $«27,856 10.2% quarter of 2005. Engineering & Technology Services had strong revenue growth due to Systems and Technology Group $«17,916 $«16,469 8.8% increased design and technical services contracts and Microelectronics revenue increased zSeries 14.9 modestly as yields in the 300 millimeter plant improved. iSeries (17.2) Personal Systems Group revenue increased 12.4 percent (8.3 percent adjusting for pSeries 7.3 currency). The increase was driven by strong performance worldwide by the company’s xSeries 22.8 ThinkPad mobile computer (22 percent). Desktop personal computer revenue increased Storage Systems 1.6 (4 percent) in 2004 when compared to 2003 due primarily to favorable currency move- Microelectronics 0.6 ments. Retail Store Solutions revenue increased due to strong demand for the company’s Engineering & Technology Services 93.4 products and the acquisition of Productivity Solutions Inc. in November 2003. This acqui- Personal Systems Group 12,794 11,387 12.4 sition drove 6.9 points of the unit’s revenue growth in 2004. Printer Systems maintenance Personal Computers 14.4 revenue declined due to lower annuity-based revenue on a declining installed base. Retail Store Solutions 17.6 (Dollars in millions) Printer Systems (7.6) Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Systems and Technology Group revenue increased 8.8 percent (5.2 percent adjusting for Hardware: currency). zSeries revenue increased due to clients continuing to add new workloads on the Gross profit $«9,552 $«8,461 12.9% zSeries platform as they build their on demand infrastructures, as well as taking advantage Gross profit margin 31.1% 30.4% 0.7 pts. of the capabilities of the z990 server for consolidation. Mainframes remain the platform of choice for hosting mission-critical transactions as well as for consolidation and infrastruc- Hardware gross profit dollars and gross profit margin increased in 2004 versus 2003. The ture simplification. The total delivery of zSeries computing power as measured in MIPS increase in gross profit dollars was primarily driven by the increase in Hardware revenue. (millions of instructions per second) increased 33 percent in 2004 versus 2003, offsetting The increase in the overall hardware margin was driven by several factors. Improved yields price declines of 23 percent per MIPS. xSeries server revenue increased (24 percent) due and lower unit costs in the Microelectronics business contributed 0.8 points of the increase. to strong growth in both high-end and 1 & 2 Way Servers. xSeries-related BladeCenter In addition, margin improvements in zSeries, xSeries and Storage Systems contributed 0.5 revenue had strong growth, up over 150 percent, as the company is leading and shaping points, 0.2 points and 0.1 point, respectively, to the overall margin improvement. These the blade market. In the fourth quarter of 2004, the company saw strong demand for improvements were partially offset by lower margins in iSeries, pSeries, Retail Store the new POWERBlade, which can run Windows, Linux and AIX on different servers in the Solutions and Printer Systems, which impacted the overall margin by 0.8 points, 0.3 points, BladeCenter. pSeries server revenue increased reflecting clients very strong acceptance of 0.1 point and 0.1 point, respectively. the POWER5 systems. The new pSeries high-end system started shipping in November Differences between the hardware segment gross profit margin and gross profit dollar 2004, marking the completion of a top to bottom refresh of the pSeries server product line amounts above and the amounts reported on page 19 (and derived from page 40) prima- in just three months. iSeries server revenue declined driven by lower sales as the transition rily relate to the impact of certain hedging transactions (see “Anticipated Royalties and to POWER5 is taking longer than in previous cycles, as customers must transition their Cost Transactions” on page 66). The recorded amounts for such impact are considered operating environment to the new level. unallocated corporate amounts for purposes of measuring the segment’s gross margin performance and therefore are not included in the segment results above. 22


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Software The increase in the Software gross profit dollars and gross profit margin was primarily (Dollars in millions) driven by growth in software revenue due to favorable currency movements, as well as Yr. to Yr. productivity improvements in the company’s support and distribution models. FOR THE YEAR ENDED DECEMBER 31: 2004 2003* Change Global Financing Software Revenue: $«15,094 $«14,311 5.5% See pages 35 and 36 for a discussion of Global Financing’s revenue and gross profit. Middleware $«11,963 $«11,240 6.4% WebSphere family 14.2 Enterprise Investments Data Management 6.6 Revenue from Enterprise Investments increased 10.8 percent (4.2 percent adjusted for Lotus 2.7 currency). Revenue for product life-cycle management software increased primarily in the Tivoli 15.0 automotive and aerospace industries, partially offset by lower hardware revenue (48 per- Rational 15.5 cent), primarily for document processors. Gross profit dollars increased 12.4 percent and Other middleware 1.8 gross profit margins increased 0.6 points to 44.2 percent in 2004 versus 2003. The increase Operating systems 2,474 2,452 0.9 in gross profit dollars was primarily driven by the increase in revenue. The gross profit Other 657 619 6.1 margin increase was primarily driven by higher life-cycle management software margins driving 0.8 points of the increase, partially offset by lower margins on document processors * Reclassified to conform with 2004 presentation. due to discounting, which impacted the overall margin by 0.2 points. Software revenue increased 5.5 percent (0.6 percent adjusted for currency). Middleware financial position revenue increased 6.4 percent (1.5 percent adjusted for currency). The WebSphere family Dynamics of software offerings revenue increased 14 percent with growth in business integration The assets and debt associated with the company’s Global Financing business are a sig- software (14 percent), WebSphere Portal software (12 percent) and application servers nificant part of the company’s financial condition. Accordingly, although the financial (20 percent). Data Management revenue increased 7 percent with growth of 12 percent in position amounts appearing below and on pages 24 and 25 are the company’s consolidated DB2 Database software on both the host (13 percent) and distributed platforms (11 per- amounts including Global Financing, to the extent the Global Financing business is a major cent), DB2 Tools (8 percent), and distributed enterprise content management software driver of the consolidated financial position, reference in the narrative section will be made (23 percent). Rational software revenue increased (15 percent) with growth across all prod- to the separate Global Financing section in this Management Discussion on pages 35 to uct areas. Tivoli software revenue increased (15 percent), aided by the Candle acquisition, 39. The amounts appearing in the separate Global Financing section are supplementary which was completed in the second quarter of 2004. Tivoli systems management, storage data presented to facilitate an understanding of the company’s Global Financing business. and security software all had revenue growth in 2004 versus 2003. Lotus software revenue Working Capital increased 3 percent and Other Foundation middleware products revenue also increased (Dollars in millions) 2 percent due to favorable currency movements. AT DECEMBER 31: 2004 2003* Operating system software increased due to growth in xSeries and pSeries, which cor- relates to the increases in the related server brands. zSeries operating system revenue Current assets $«46,970 $«44,662 declined 1 percent despite the growth in related hardware volumes due to ongoing soft- Current liabilities 39,798 37,623 ware price performance delivered to enterprise clients. iSeries operating system software Working capital $«««7,172 $«««7,039 declined 6 percent in line with related hardware volumes. Overall, operating systems Current ratio 1.18:1 1.19:1 software revenue increased primarily as a result of favorable currency movements. * Reclassified to conform with 2004 presentation. (Dollars in millions) Yr. to Yr. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 Change Current assets increased $2,308 million driven by an increase of $2,923 million in Cash and cash equivalents and Marketable securities. Also, Inventories increased $374 million Software: primarily driven by new product transitions and increased capacity in the 300 millimeter Gross profit $«13,175 $«12,384 6.4% semiconductor fab. These increases were partially offset by an overall decrease in the Gross profit margin 87.3% 86.5% 0.8 pts. company’s current receivables of $787 million. The current receivables net decrease was 23


  • Page 26

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies a combination of several factors: a decline of $1,782 million in Short-term financing The decrease in cash used in financing activities of $179 million was attributable to receivables as collections exceeded new originations; an increase in Other accounts less net debt payments of $2,454 million, partially offset by higher net payments for receivable of $499 million as a long-term receivable related to the sale of the HDD business common stock activity of $2,186 million, and higher dividend payments of $89 million. is now reflected as current; and an increase in Notes and accounts receivable — trade of Within debt, on a net basis, $1,027 million of cash was used to pay off debt in 2004 versus $496 million as a result of favorable currency movements. $3,481 million in 2003. The net cash payments of $1,027 million in 2004 were made up Current liabilities increased $2,175 million primarily due to a $1,453 million increase of $4,538 million of cash payments to settle debt, partially offset by $2,438 million of in Short-term debt, a $984 million increase in Accounts payable, and a $683 million proceeds from new debt and $1,073 million from an increase in short-term borrowings. increase in Deferred income driven by Global Services business growth in 2004. These The higher payments for common stock were driven by increases of approximately increases were partially offset by a decrease of $747 million in Taxes payable primarily due $2,802 million in cash payments to repurchase stock which was partially offset by increases to the Internal Revenue Service (IRS) settlement described in note p, “Taxes” on page 73, of $616 million in cash received for stock issued associated with the company’s stock and $331 million in Other accrued expenses and liabilities primarily due to decreases of option plan and employee stock purchase plan. approximately $160 million in restructuring accruals. Non-current Assets and Liabilities Cash Flow (Dollars in millions) The company’s cash flows from operating, investing and financing activities, as reflected in Yr. to Yr. DECEMBER 31: 2004 2003* Change the Consolidated Statement of Cash Flows on pages 44 and 45, are summarized in the table below. These amounts include the cash flows associated with the company’s Global Non-current assets $«62,213 $«59,795 4.0% Financing business. See pages 35 to 39. Long-term debt 14,828 16,986 (12.7) (Dollars in millions) Non-current liabilities (excluding debt) 24,810 21,984 12.9 FOR THE YEAR ENDED DECEMBER 31: 2004 2003 * Reclassified to conform with 2004 presentation. Net cash provided by/(used in) continuing operations: Operating activities $«15,406 $«14,569 The increase in Non-current assets of $2,418 million was driven by several factors: an Investing activities (5,346) (5,122) increase of $1,968 million in Prepaid pension assets (see note w, “Retirement-Related Financing activities (7,619) (7,798) Benefits,” on pages 78 through 86); an increase of $1,516 million in Goodwill, driven by Effect of exchange rate changes on cash and cash equivalents 405 421 acquisitions; and an increase of $486 million in Plant, rental machines and other property — Net cash used in discontinued operations* (83) (162) net, driven by currency. These increases were partially offset by a decrease of $1,826 mil- lion in Investments and sundry assets due to a decrease of $1,264 million in deferred tax Net change in cash and cash equivalents $«««2,763 $«««1,908 assets primarily due to the IRS settlement (see note p, “Taxes” on page 73) and $647 million * Does not include approximately $97 million in 2003 of net proceeds from the sale of the HDD business. Such proceeds in non-current derivatives due primarily to the reclassification of derivative instruments. are included in Net cash provided by Investing activities in the table above. Long-term debt declined $2,158 million primarily due to the transfer of long-term bonds to short-term debt as these items approach maturity. Net cash provided from operating activities for the year ended December 31, 2004 Other non-current liabilities increased $2,826 million primarily due to a $1,632 million increased $837 million as compared to 2003. This increase was driven primarily by increase in Retirement and nonpension postretirement benefit obligations, a $380 million increased income from continuing operations ($835 million), the cash generated by the increase in Deferred income, a $317 million increase in Derivative liabilities and a $138 change in Global Financing receivables ($582 million) and lower restructuring payments million increase in warranty accruals. The increase in the Retirement and nonpension ($462 million). These increases were partially offset by additional pension funding world- postretirement benefit obligations was primarily attributable to the required accounting wide in 2004 of $1.2 billion. for the unfunded status of the non-U.S. pension plans as described on page 83, as well as Net investing activities increased by $224 million on a year-to-year basis. Net capital pension costs and approximately $544 million due to foreign currencies. The increase in spending decreased $190 million on a year-to-year basis. The primary drivers to the reduc- Deferred income was driven by Global Services resulting from new contracts with long- tion in net capital spending were increased cash from equipment sales of $272 million term components. The increase in Derivative liabilities was primarily attributable to the reflecting the cash investments of the company’s Microelectronics business strategic impact of foreign currencies in combination with extending beyond one year the hedging partners, as well as a $25 million decrease in the company’s internal spending on plant, of anticipated royalties and cost transactions during 2004 (see note l, “Derivatives and rental machines and other property. This cash savings was partially offset by an increase of Hedging Transactions” on pages 65 to 67). The increase in warranty accruals was primarily $107 million in capitalized software development. related to personal computers resulting from increased volumes. 24


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Debt consolidated fourth quarter results The company’s funding requirements are continually monitored and strategies are executed (Dollars and shares in millions except per share amounts) to manage the company’s overall asset and liability profile. Additionally, the company Yr. to Yr. maintains sufficient flexibility to access global funding sources as needed. FOR FOURTH QUARTER: 2004 2003 Change (Dollars in millions) Revenue $«27,671 $«25,913 6.8% * AT DECEMBER 31: 2004 2003 Gross profit margin 39.2% 38.4% 0.8 pts. Total expense and other income $«««6,488 $«««6,097 6.4% Total company debt $«22,927 $«23,632 Total expense and other income-to-revenue ratio 23.4% 23.5% (0.1) pts. Non-Global Financing debt * ««««««607 «««368 Provision for income taxes $«««1,309 $«««1,162 12.7% Non-Global Financing debt/capitalization 2.2% 1.5% Income from continuing operations $«««3,055 $«««2,716 12.5% * Non-Global Financing debt is the company’s total external debt less the Global Financing debt described in the Global Earnings per share from continuing operations: Financing balance sheet on page 36. Assuming dilution $÷÷«1.81 $«««««1.56 16.0% Basic $÷÷«1.84 $÷÷«1.59 15.7% Non-Global Financing debt increased $239 million and the debt-to-capital ratio at Weighted-average shares outstanding: December 31, 2004 was well within acceptable levels at 2.2 percent. Assuming dilution 1,691.6 1,745.7 (3.1) % Equity Basic 1,659.0 1,708.5 (2.9) % (Dollars in millions) * 2.7 percent increase adjusting for currency Yr. to Yr. AT DECEMBER 31: 2004 2003 Change Continuing Operations Stockholders’ equity: The increase in the company’s fourth quarter 2004 Income from continuing operations and Total $«29,747 $«27,864 6.8% diluted earnings per share from continuing operations as compared to the fourth quarter of 2003 was due to: The company’s total consolidated Stockholders’ equity increased $1,883 million during • The increased demand for the company’s offerings associated with moderate 2004 primarily due to an increase in the company’s retained earnings driven by net expansion of the economy, as well as the company’s continued market share gains income, partially offset by the company’s ongoing stock repurchase program and higher • Favorable impact of currency translation partly offset by related hedging activity dividend payments. The following is an analysis of the external segment results. Off-Balance Sheet Arrangements The company, in the ordinary course of business, entered into off-balance sheet arrange- Global Services revenue increased 10.1 percent (5.7 percent adjusting for currency). SO ments as defined by the Securities and Exchange Commission (SEC) Financial Reporting revenue increased 12 percent as each geography had year-to-year revenue growth. ITS Release 67 (FRR-67), “Disclosure in Management’s Discussion and Analysis about Off- revenue increased 8 percent helped by continued growth in Business Continuity and Balance Sheet Arrangements and Aggregate Contractual Obligations,” including: certain Recovery Services. BCS revenue increased 12 percent year-to-year, with double-digit guarantees, indemnifications and retained interests in assets transferred to an unconsoli- growth in both the Americas and Asia Pacific and high single-digit growth in EMEA. dated entity for securitization purposes. The company achieved Global Services signings of $12.7 billion, including 13 signings None of these off-balance sheet arrangements either has, or is reasonably likely to over $100 million. have, a material current or future effect on financial condition, changes in financial condi- The company’s Systems & Technology Group revenue grew 4.9 percent (1.3 percent tion, revenues or expenses, results of operations, liquidity, capital expenditures or capital adjusting for currency). xSeries server revenue increased 25 percent year-to-year driven by resources. See page 31 for the company’s contractual obligations. solid performance in both high-end and 1 & 2 Way servers. The IBM Blade servers continued See note o, “Contingencies and Commitments,” on page 71, for detailed information their strong growth in the fourth quarter of 2004. pSeries revenue increased 15 percent about the company’s guarantees on certain loans and financial commitments, indemnifi- year-to-year in the fourth quarter, reflecting very strong client acceptance of the POWER5 cation arrangements and note j, “Sale and Securitization of Receivables” on page 64 for systems technology. OEM grew 10 percent year-to-year in the fourth quarter driven by detailed information regarding loans receivable securitization program. improved yields in the 300 millimeter line where output grew 40 percent versus the third quarter and Engineering & Technology Services business revenue grew at 61 per- cent year-to-year. These increases were partially offset by lower zSeries server revenue of 25


  • Page 28

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies 4 percent on MIPS growth of 6 percent in the fourth quarter of 2004. iSeries server revenue Share repurchases totaled approximately $2.9 billion in the fourth quarter. The declined 9 percent year-to-year, however, strong customer acceptance of the refreshed weighted-average number of diluted common shares outstanding in the quarter was POWER5 iSeries drove sequential revenue growth. Storage Products revenue declined 1,691.6 million compared with 1,745.7 million in the 2003 fourth quarter, lower by 54.1 11 percent year-to-year. Total Disk products declined 15 percent as the company transi- million shares. The decreased amount of shares was driven primarily by the company’s tions to new products. ongoing common share repurchase program. Personal Systems Group revenue increased 1.8 percent (declined 1.7 percent adjusting The company generated slightly lower cash flows from operations in the 2004 fourth for currency) driven by increased ThinkPad mobile computers. The company experienced quarter as compared to the 2003 fourth quarter primarily due to higher pension funding some disruption due to the Lenovo agreement, which was announced in the seasonally driven by the $700 million funding of the PPP and approximately $500 million funding of strongest month of the year. non-U.S. plans. The company also had an increase in acquisitions (primarily the Maersk Software revenue increased 7.0 percent (2.9 percent adjusting for currency). The Data/DMdata acquisition in the fourth quarter of 2004) compared to the same period of WebSphere family of software products grew 18 percent for the quarter. Application servers 2003. Finally, the company repurchased $2,932 million in shares during the 2004 fourth grew 33 percent following the October announcement of a new release that provided quarter compared with $3,069 million in shares repurchased during the 2003 fourth quarter. improved security and integration of Web Services. Business Integration products grew 17 percent. Rational revenue grew 8 percent in the quarter, with growth across all product areas. Data Management software grew 8 percent as DB2 database software grew 15 percent, Prior Year in Review driven by double-digit growth in both host and distributed platforms and distributed enter- (Dollars and shares in millions except per share amounts) prise content management software grew 31 percent. Tivoli software increased 25 percent, Yr. to Yr. as Systems Management software grew 31 percent, storage software increased 19 percent FOR THE YEAR ENDED DECEMBER 31: 2003 2002 Change and security software increased 9 percent. Lotus software increased 5 percent as Domino Revenue $«««89,131 $«81,186 9.8% * products grew 2 percent for the quarter driven by the Notes messaging products. Other Gross profit margin 37.0% 37.3% (0.3) pts. Foundation middleware products declined 2 percent for the quarter. Total expense and other income $÷«22,144 $«22,760 (2.7) % Global Financing revenue declined 10.4 percent (13.5 percent adjusting for currency) Total expense and other income-to-revenue ratio 24.8% 28.0% (3.2) pts. driven primarily by a decline in used equipment sales. Provision for income taxes $«÷÷3,261 $«««2,190 48.9% The company’s gross profit margin increased 0.8 percentage points to 39.2 percent. Income from continuing operations $÷÷«7,613 $«««5,334 42.7% The Hardware gross profit margin improved 2 percentage points with improving margins Earnings per share from continuing operations: in most product areas. Global Financing gross profit margin improved 7.5 percentage Assuming dilution $÷÷÷«4.34 $«««««3.07 41.4% points to 59.7 percent primarily driven by improved used equipment sales and financing Basic $÷÷÷«4.42 $÷÷«3.13 41.2% margins and an improvement in mix toward higher margin financing revenue. Global Discontinued operations: Services and Software gross profit margin improved slightly year-over-year. Loss $÷÷÷÷««30 $«««1,755 NM Total expense and other income increased 6.4 percent in the fourth quarter and rev- Diluted earnings per share $÷÷««(0.02) $««««(1.01) NM enue increased 6.8 percent resulting in the total expense-to-revenue ratio improvement of Basic earnings per share $«÷÷«(0.02) $««««(1.03) NM 0.1 point to 23.4 percent. Retirement-related plan expenses increased $150 million year- Weighted-average shares outstanding: to-year and were partially offset by lower workforce rebalancing expense of $75 million. Assuming dilution 1,756.1 1,730.9 1.5% RD&E expense increased 8.2 percent or $112 million, driven by increased spending in the Basic 1,721.6 1,703.2 1.1% Software and the Systems and Technology Group segments. In addition, the company Assets** $«104,457 $«96,484 8.3% recorded a provision for litigation-related expenses of $125 million in SG&A and the Liabilities** $«÷76,593 $«73,702 3.9% effects of currency was an addition to expense of approximately $150 million in the fourth Equity ** $«÷27,864 $«22,782 22.3% quarter of 2004. The company’s 2004 fourth quarter effective tax rate was 30.0 percent, the same as 2003. * 2.8 percent at constant currency ** at December 31 NM — Not Meaningful 26


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies continuing operations Global Services The increase in the company’s 2003 Income from continuing operations and diluted Global Services revenue increased 17.3 percent (9.3 percent at constant currency) in 2003 earnings per share from continuing operations as compared to 2002 was due to: versus 2002. SO revenue increased 14.2 percent in 2003 primarily driven by new signings. • The results of the company’s productivity and efficiency initiatives, including the SO continued to demonstrate its competitive advantage in delivering on demand solutions benefits from the 2002 Microelectronics and productivity restructuring actions by leveraging its business transformation skills and its scale during 2003. e-business Hosting Services, an offering that provides Web infrastructure and application manage- • Stronger demand associated with the improving economy (especially during the ment as an Internet-based service, continued its strong pattern of revenue growth. BCS fourth quarter) and continued market share gains revenue increased 37.5 percent in 2003 due to the acquisition of PwCC in the fourth quarter • The charges recorded in 2002 for the 2002 actions (See note s, “2002 Actions” on of 2002. ITS revenue increased 3.3 percent due to the favorable impact of currency move- pages 73 through 76 for additional information.) ments. During 2003, the company changed its reporting for certain OEM hardware sales • Favorable impact of currency translation, partly offset by related hedging activities to the company’s clients from gross to net revenue treatment based upon a review of the terms of these sales. The company determined that the agent-like characteristics of The increase in revenue in 2003 as compared to 2002 was due to: these transactions were more appropriately recorded on a net revenue basis. Due to the • Stronger demand associated with the improving economy (especially during the amounts involved, the prior year amounts were not adjusted. As a result of this change in fourth quarter) and continued market share gains 2003, revenue and costs for ITS were lower by $279 million in 2003 as compared to 2002, • The impact of the fourth quarter 2002 acquisition of PricewaterhouseCoopers’ con- partially offsetting the currency impact discussed above. This change had no impact on sulting business (PwCC) and the first quarter 2003 acquisition of Rational, partially the company’s gross profit dollars, net income or cash flows. The company signed $55 bil- offset by decreases in revenue due to Systems and Technology Group divestitures lion of services contracts in 2003, an increase of $2 billion versus 2002. The estimated services backlog at December 31, 2003, was $120 billion. • The favorable impact of currency translation, which contributed 7.0 points of the 9.8 percent revenue increase Hardware Segments Systems and Technology Group revenue increased 1.7 percent (decreased 4.2 percent at Revenue for all industry sectors increased in 2003 on an as-reported basis, which has constant currency) in 2003 versus 2002. xSeries server products revenue increased 16.8 per- been reclassified to conform with the 2004 presentation. The Financial Services sector cent due to growth in sales of high-volume servers supported by strong growth in blades. (12.5 percent), Public sector (14.3 percent), and Industrial sector (14.8 percent) were The pSeries server revenues increased 12.5 percent due to strong demand for the 64-bit among the strongest, with continued growth (12.5 percent) in the Small & Medium POWER systems across both the low-end and high-end server offerings. Revenue from the Business sector. These results reflect the company’s go-to-market strategy of designing zSeries servers increased 7.4 percent. The total delivery of zSeries computing power as industry-specific solutions. measured in MIPS increased more than 28 percent in 2003 as compared to 2002. This Full-year geographic revenue increased across all geographies. In the Americas increase was offset by lower average price per MIPS in 2003 of 19 percent versus 2002. revenue increased 5 percent. U.S. (3 percent) and Canada (13 percent) revenue grew as Revenue from the iSeries servers increased in all four quarters of 2003 when compared to did Latin America (6 percent), notably in Brazil (26 percent). In Europe/Middle East/Africa, 2002. Storage Systems revenue increased 9.8 percent due to growth in external disk and revenue increased 20 percent and was highest in the U.K. (17 percent), Central Europe and tape products. Middle East and Africa. In Asia Pacific revenue increased 13 percent, while 2003 revenue Microelectronics revenue declined 31.6 percent in 2003 versus 2002 driven by actions for Japan, which is about 60 percent of the region’s revenue, increased 7 percent com- taken in 2002 to refocus and redirect its business to high-end foundry, ASICs and standard pared with 2002. Australia/New Zealand (32 percent) also achieved strong performance products. These actions included the divestiture of multiple non-core businesses. There within Asia Pacific. was also sluggish demand from certain OEM clients that contributed to this decline. While OEM revenue, representing three percent of the company’s revenue, declined, Personal Systems Group revenue increased 3.1 percent (down 2.5 percent at constant the decline was smaller than the prior year decline. The year-to-year percent change in currency) in 2003 versus 2002. Revenue from mobile personal computers increased revenue (a decline of 21.4 percent) reflects, in large part, the company’s exit from its inter- (10.9 percent) due to strong demand and was offset by lower desktop personal computer connect products business in 2002, as well as sluggish demand from certain OEM clients. revenue (4.0 percent). The decreased desktop revenue primarily reflects the fact that The following is an analysis of external segment results. increased volume gains were not enough to offset a reduction in price due to decreasing commodity costs. 27


  • Page 30

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Software With regard to Assets, approximately $7 billion of the increase relates to the impact of Software revenue increased 9.4 percent (1.9 percent at constant currency) in 2003 versus currency translation. The remaining increase primarily consists of an increase in Goodwill 2002, driven by Middleware software products. The WebSphere family of software offer- of $2.8 billion associated with recent acquisitions, increased pension assets of $2.4 billion, ings revenue increased 11.8 percent as clients continued to focus on the higher function as well as strong cash performance. The increase in cash during 2003 was due to the com- products that integrate Web-based applications, including advanced collaboration tech- bination of stronger operating results and lower pension funding. The company reduced nology, on a user’s desktop. The lower-function WebSphere application server continued non-Global Financing debt in 2003 as a result of strong cash flows from operations. Global to commoditize. Improved demand was also noted for Data Management DB2 database Financing debt also decreased, but the company’s Global Financing debt-to-equity ratio software. Revenue from Tivoli products increased 12.0 percent as clients continue to real- remained flat at 6.9 to 1 and within the company’s target range. ize the on demand attributes of Tivoli products, enabling businesses to securely automate The ratio of unguaranteed residual value as a percentage of the related original many of their processes and gain operational efficiencies. Operating system software amount financed declined 0.3 point to 3.6 percent at December 31, 2003, as compared revenue increased 6.2 percent due to the favorable impacts of currency movements. to December 31, 2002, due to an increase in the percentage of leases that contain bargain Offsetting these increases were lower demand for DB2 tools, Lotus advanced collabora- purchase options. tion software, and Other middleware software. A new Lotus messaging platform became generally available during the 2003 fourth quarter and helped to drive momentum in the discontinued operations Lotus Notes family of products towards the end of 2003. Overall, the increase in total On December 31, 2002, the company sold its HDD business to Hitachi for approximately Software revenue was mainly due to the acquisition of Rational in the first quarter of 2003. $2 billion. The majority of the cash was received with the remaining payment due in When compared to the separately reported 2002 external revenue amounts for Rational, December 2005. The HDD business was accounted for as a discontinued operation its revenue increased approximately 6 percent in 2003. whereby the results of operations and cash flows were removed from the company’s results from continuing operations for all periods presented. Global Financing The company incurred a loss from discontinued operations of $1,755 million in 2002, See pages 35 to 39 for prior year review of Global Financing. net of tax. The loss in 2002 was due to (amounts are net-of-tax): Enterprise Investments • Loss on operational results ($620 million) Revenue from Enterprise Investments increased 4.2 percent (down 5.1 percent at constant • Loss on sale ($382 million) currency) in 2003 versus 2002. The decline was attributable to demand for product life- • Certain actions taken by the company in the second and fourth quarters of 2002 cycle management software in the European market, especially in the automotive and ($508 million) related to the HDD business aerospace industries. The company’s gross profit margins remained relatively flat. Increases in margins for • Inventory write-offs resulting from a strategic decision to cease reworking and selling Hardware of 0.7 point resulting from the ongoing benefits from the company’s integrated efforts for some of the older HDD products after the announcement of the divesti- supply chain initiatives and Software of 2.1 points resulting from favorable currency trans- ture plans ($245 million) lation were offset by decreases in Global Services margins of 1.1 points driven primarily by investment costs on the early stages of an SO contract and the company’s changing mix of revenue toward BCS. Looking Forward As discussed above, there were several charges in 2002 that impacted the year-to- The following key drivers impacting the company’s business are discussed on page 17: year expense comparison. These items contributed 2.8 points of the improvement in the • Economic environment and corporate IT spending budgets Total expense and other income-to-revenue ratio. The remaining improvement was prima- • Internal business transformation and efficiency initiatives rily due to the results of productivity and efficiency initiatives offset by an increase in retire- ment-related plans cost. • Innovation initiatives The company’s effective tax rate increased from 29.1 percent in 2002 to 30.0 percent • Open standards in 2003. This increase was primarily due to a less favorable mix of geographic income and • Emerging business opportunities the absence of the tax benefit associated with the Microelectronics actions taken in the second quarter of 2002. 28


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies With respect to the economic environment, while it is always difficult to predict future as a signing are those periods in which there is a significant economic impact on the client economic trends, in 2004 the economic environment improved — shifting from a period of if the commitment is not achieved, usually through a termination charge or the customer recovery to moderate expansion. Going forward, we anticipate moderate growth for the incurring significant wind-down costs as a result of the termination. For shorter-term con- traditional IT industry. Several factors — including increasing complexity and globalization — tracts that do not require significant up-front investments, a signing is usually equal to the are driving clients to transform their businesses. The year-to-year and sequential quarterly full contract value. growth trend comparisons achieved by the company are indicators of this improvement. Signings includes SO, BCS and ITS contracts. Contract extensions and increases in With respect to business transformation and the continual conversion of the company scope are treated as signings only to the extent of the incremental new value. Maintenance into an on demand business, the company’s supply chain initiatives are expected to allow is not included in signings as maintenance contracts tend to be more steady-state, where continued flexibility to drive additional competitive advantages. The company will con- revenues equal renewals, and therefore, the company does not think they are as useful a tinue to focus on increased productivity and efficiency to accelerate the globalization and predictor of future performance. transformation of its global business model. Backlog includes SO, BCS, ITS and Maintenance. Backlog is intended to be a statement Finally, with respect to technology, in 2004 the company has again been awarded of overall work under contract and therefore does include Maintenance. Backlog estimates more U.S. patents than any other company for the twelfth year in a row. The company con- are subject to change and are affected by several factors, including terminations, changes tinues to focus internal development investments on high-growth opportunities and to in scope of contracts (mainly long-term contracts), periodic revalidations, and currency broaden its ability to deliver industry- and client-specific solutions. assumptions used to approximate constant currency. From a client-set perspective, the strong momentum in 2004 with respect to the Small Contract portfolios purchased in an acquisition are treated as positive backlog adjust- & Medium Business sector should continue. We anticipate continued growth in the ments provided those contracts meet the company’s requirements for initial signings. A Communications, Distribution and Public sectors, however, the Financial Services sector new signing will be recognized if a new services agreement is signed incidental or coinci- growth may moderate. dent to an acquisition. The company also will selectively pursue acquisitions, primarily in the Global Services Although signings and backlog declined in 2004, Global Services improved its year- and Software segments, where it believes these acquisitions will expand its portfolio to to-year revenue growth rate — excluding the benefit of currency — on a sequential basis in meet clients’ needs. 2004. This increase in Global Services growth rate is due to the improving yield of its back- log and current signings. The average duration of new contracts has shortened, and the Global Services Signings company continues to drive additional revenue from its contract base through volumes (Dollars in millions) and scope expansion. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 2002 The combination in 2004 of the company’s Systems Group and Technology Group will Longer-term* $«22,857 $«34,608 $«33,068 continue to benefit the company’s ability to integrate key semiconductor and other core Shorter-term* 20,146 20,854 20,020 technology innovations into solutions for clients. The company continues to leverage its eServer zSeries mainframe technology investments across its server and storage portfolio. Total $«43,003 $«55,462 $«53,088 The ability to share elements of this technology such as security, automation, and virtual- * Longer-term contracts are generally 7 to 10 years in length and represent SO and longer-term business transforma- ization, with the more commoditized platforms is a key competitive advantage for IBM. tion contracts as well as those BCS contracts with the U.S. federal government and its agencies. Shorter-term are con- tracts generally 3 to 9 months in length and represent the remaining BCS and ITS contracts. These amounts have been Given the commoditized nature of the personal computer industry and the company’s adjusted to exclude the impact of year-to-year currency changes. announced agreement to sell its Personal Computing Division, its first half results may be more volatile than in the company’s other businesses. The company plans to take the nec- Global Services signings are management’s initial estimate of the value of a client’s com- essary actions to mitigate those impacts. The divestiture is expected to close in the second mitment under a Global Services contract. Signings are used by management to assess quarter of 2005. period performance of Global Services management. There are no third-party standards The key to the company’s growth in Software will be clients’ continued adoption of its or requirements governing the calculation of signings. The calculation used by manage- on demand solutions. The key differentiating factor for the company is the strength and ment involves estimates and judgments to gauge the extent of a client’s commitment, breadth of its middleware portfolio. Software is a key component of on demand solutions, including the type and duration of the agreement, and the presence of termination and the company will continue to invest in this strategic area and strengthen its portfolio charges or wind-down costs. For example, for longer-term contracts that require signifi- through acquisitions. In addition, the company will continue to build a strong partner cant up-front investment by the company, the portions of these contracts that are counted ecosystem to drive growth. 29


  • Page 32

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Given the declining interest rate environment, the company reduced its discount rate Cash Flow and Liquidity Trends assumption for the PPP by 25 basis points to 5.75 percent on December 31, 2004. The (Dollars in billions) company will keep the expected long-term return on PPP assets at 8 percent. The actual AT DECEMBER 31: 2004 2003 2002 2001 2000 return on PPP plan assets in 2004 was 13 percent. With similar overall trends in these Net cash from operating activities $«15.4 $«14.6 $«13.8 $«14.0 $«««8.8 assumptions worldwide, as well as the impact of the recent years’ changes in the market Cash and marketable securities 10.6 7.6 6.0 6.4 3.7 value of plan assets, the year-to-year impact from retirement related plans on pre-tax Size of global credit facilities 10.0 10.0 12.0 12.0 10.0 income in 2005 will be approximately $1.0 billion higher as compared to 2004, excluding Trade receivables securitization facility 0.5 — — — — the 2004 one-time charge of $320 million related to the partial settlement of certain legal claims against the PPP. The amount of IP and custom development income has been declining in recent The major rating agencies’ ratings on the company’s debt securities at December 31, 2004 years. Although it was flat in 2004, the overall declining trend may continue as the com- appear in the table below and remain unchanged over the past five years. The company pany does not expect it to be a contributor to growth. The overall level of IP is dependent has no contractual arrangements that, in the event of a change in credit rating, would on several factors: divestitures, industry consolidation, economic conditions and the tim- result in a material adverse effect on its financial position or liquidity. ing of new patent development. Standard Moody’s In the normal course of business, the company expects that its effective tax rate will and Investors Fitch Poor’s Service Ratings approximate 30 percent. The rate will change year-to-year based on nonrecurring events (such as the tax effect of the pension claims settlement in 2004 or a possible repatriation Senior long-term debt A+ A1 AA- charge in 2005 as described in note p, “Taxes” on page 73) as well as recurring factors Commercial paper A-1 Prime-1 f-1+ including the geographic mix of income before taxes, the timing and amount of foreign dividends, state and local taxes, and the interaction of various global tax strategies. The company prepares its Consolidated Statement of Cash Flows in accordance with Statement of Financial Accounting Standards (SFAS) No. 95, “Statement of Cash Flows,” on american jobs creation act of 2004 pages 44 and 45 and highlights causes and events underlying sources and uses of cash in In 2001, the World Trade Organization (WTO) determined that tax provisions of the FSC that format on page 24. For purposes of running its business, the company manages, Repeal and Extraterritorial Income (ETI) Exclusion Act of 2000 constituted an export subsidy monitors and analyzes cash flows in a different format. prohibited by the WTO Agreement on Subsidies and Countervailing Measures Agreement. As discussed on page 35, one of the company’s two primary objectives of its Global As a result, the U.S. enacted the American Jobs Creation Act of 2004 (the “Act”) in October Financing business is to generate strong return-on-equity. Increasing receivables is the 2004. The Act repeals the ETI export subsidy for transactions after 2004 with two years of basis for growth in a financing business. Accordingly, management considers Global transition relief (2005 – 2006). The Act also provides a nine-percent deduction for income Financing receivables as a profit-generating investment — not as working capital that from qualified domestic production activities which will be phased in over 2005– 2010. should be minimized for efficiency. After classifying the Cash from/(for) Global Financing While the net impact of certain legislative provisions has not been fully evaluated, the receivables as an investment, the remaining net cash flow is viewed by the company as the company does not expect this legislation to affect its ongoing effective tax rate for 2005 Cash available for investment and for distribution to shareholders. With respect to the or 2006. company’s cash flow analysis for internal management purposes, Global Financing Also, the Act includes a temporary incentive for the company to repatriate earnings accounts receivables are combined with Global Financing debt to represent the Net accumulated outside the U.S. The current status of the company’s evaluation and potential Global Financing receivables (a profit-generating investment). impacts are discussed in note p, “Taxes,” on page 73. Over the past five years, the company generated over $59.4 billion in Cash available liquidity and capital resources for investment and for distribution to shareholders. As a result, during the period the The company generates strong cash flow from operations, providing a source of funds company invested in $21.4 billion of net capital expenditures, invested $8.0 billion in ranging between $8.8 billion and $15.4 billion per year over the past five years. The com- strategic acquisitions, received $1.4 billion from divestitures and returned $33.0 billion to pany provides for additional liquidity through several sources — a sizable cash balance, shareholders through dividends and share repurchases. The amount of prospective access to global funding sources, a committed global credit facility and in 2004, the com- Returns to shareholders in the form of dividends and share repurchases will vary based pany converted a receivables securitization facility from an “uncommitted” to a “commit- upon several factors including affordability, namely each year’s operating results, capital ted” facility, adding an additional source of liquidity. (See note j, “Sale and Securitization expenditures, research and development, and acquisitions, as well as the factors discussed of Receivables” on page 64 for additional information.) The table below provides a sum- in the following table. mary of these major sources of liquidity as of the end of fiscal years 2000 through 2004. 30


  • Page 33

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies The company’s Board of Directors meets quarterly to approve the dividend payment. Contractual Obligations The company announced a dividend payment of $0.18 per common share, payable (Dollars in millions) March 10, 2005, which is the company’s 357th consecutive quarterly payment. The com- Total pany expects to fund the quarterly dividend payments through cash from operations. Contractual Payments Due In Payment The table below represents the way in which management reviews its cash flow as Stream 2005 2006-07 2008-09 After 2009 described above. Long-term debt obligations $«17,664 $«3,175 $«4,396 $«2,614 $÷«7,479 (Dollars in billions) Capital (Finance) lease obligations 56 46 8 1 1 Operating lease obligations 6,607 1,383 2,210 1,603 1,411 FOR THE YEAR ENDED DECEMBER 31: 2004 2003 2002 2001 2000 Purchase obligations 2,268 919 828 479 42 Net cash from operating activities Other long-term liabilities: (comprised of): $«15.4 $«14.6 $«13.8 $«14.0 $««8.8 Minimum pension funding Cash from/(for) Global Financing (mandated) * 2,384 361 1,175 848 — accounts receivable $«««2.5 $«««1.9 $«««3.3 $«««2.0 $«(2.5) Executive compensation 782 95 121 141 425 Cash available for investment and Environmental liabilities 246 28 25 23 170 for distribution to shareholders 12.9 12.7 10.5 12.0 11.3 Long-term termination benefits 2,406 344 483 334 1,245 Net Global Financing receivables 0.7 (0.7) 0.2 0.9 (0.6) Other 457 80 166 136 75 Net capital expenditures (3.7) (3.9) (4.6) (4.9) (4.3) Total $«32,870 $«6,431 $«9,412 $«6,179 $«10,848 Net divestitures/(acquisitions) (1.7) (1.7) (2.0) (0.9) (0.3) Returns to shareholders (8.3) (5.4) (5.2) (6.5) (7.6) * These amounts represent future pension contributions that are mandated by local regulations or statute for retirees receiving pension benefits. They are all associated with non-U.S. pension plans. The projected payments beyond 2009 Other 2.9 0.9 0.2 2.2 — are not currently determinable. See note w, “Retirement-related Benefits,” on pages 78 through 86 for additional infor- mation on the non-U.S. plans’ investment strategies and expected contributions. Net change in cash and cash equivalents $«««2.8 $«««1.9 $««(0.9) $«««2.8 $«(1.5) Purchase obligations include all commitments to purchase goods or services of either a fixed or minimum quantity that meet any of the following criteria: (1) they are non-cancelable, Events that could temporarily change the historical cash flow dynamics discussed on page (2) the company would incur a penalty if the agreement was canceled, or (3) the company 30 include unexpected adverse impacts from litigation or future pension funding during must make specified minimum payments even if it does not take delivery of the contracted periods of severe and prolonged downturn in the capital markets. Whether any litigation products or services (“take-or-pay”). If the obligation to purchase goods or services is non- has such an adverse impact will depend on a number of variables, which are more completely cancelable, the entire value of the contract is included in the above table. If the obligation described on page 71. With respect to pension funding, on January 19, 2005 the company is cancelable, but the company would incur a penalty if canceled, the dollar amount of the contributed $1.7 billion to the qualified portion of the company’s PPP. This contribution penalty is included as a purchase obligation. Contracted minimum amounts specified in fulfilled a number of short-term and long-term strategic objectives. This contribution take-or-pay contracts are also included in the above table as they represent the portion of reduces the probability of large future U.S. pension contributions by building a funding each contract that is a firm commitment. buffer above the current liability level. In addition, it positions the company to further In the ordinary course of business, the company enters into contracts that specify reduce volatility in pension contributions and earnings over the long term. Finally, the that the company will purchase all or a portion of its requirements of a specific product, company will benefit from the return on these additional pension assets in 2005. The commodity, or service from a supplier or vendor. These contracts are generally entered increase in pension income produced from this funding will partially offset the impact of into in order to secure pricing or other negotiated terms. They do not specify fixed or year-end 2004 pension assumptions changes. minimum quantities to be purchased and, therefore, the company does not consider The company is not quantifying any further impact from pension funding because it is them to be purchase obligations. not possible to predict future movements in the capital markets. However, for 2005, if actual returns on plan assets for the PPP were less than 1 percent, the PPP’s accumulated benefit obligation (ABO) would be greater than its Plan assets (assuming no other assump- tion change). As discussed on page 83, such a situation may result in a further voluntary contribution of cash or stock to the PPP or a charge to stockholders’ equity. 31


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    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies critical accounting estimates To the extent the outlook for long-term returns changes such that management The application of GAAP involves the exercise of varying degrees of judgment. While the changes its expected long-term return on plan assets assumption, each 50 basis point resulting accounting estimates will, by definition, not always precisely equal the related increase or decrease in the expected long-term return on PPP plan assets assumption will actual results, eight of these estimates involve more judgment than others. Two of these have an estimated increase or decrease, respectively, of $229 million on the following year’s estimates are the allowance for uncollectible financing receivables and the fair value of pre-tax net periodic pension income (based upon the PPP’s plan assets at December 31, lease residual values. See page 39 for a discussion of these estimates. The others are dis- 2004 and the January 2005 contribution of $1.7 billion discussed further on page 84). cussed below. Another key management assumption is the discount rate. See page 83 for informa- The sensitivity analyses used below are not meant to provide a reader with manage- tion regarding the discount rate assumption. Changes in the discount rate assumptions ment’s predictions of the variability of the estimates used. Rather, the sensitivity levels will impact the interest cost component of the net periodic pension income calculation selected (e.g., 5 percent, 10 percent, etc.) are included to allow users of the Annual Report and due to the fact that the ABO is calculated on a net present value basis, changes in the to understand a general-direction cause and effect of changes in the estimates. discount rate assumption will also impact the current ABO. An increase in the ABO caused by a decrease in the discount rate may result in a voluntary contribution to a pension plan. Useful Lives of Microelectronics Plant and Equipment As discussed on page 30, the company reduced the discount rate assumption for the The company determines the estimated useful lives and related depreciation charges for PPP by 25 basis points to 5.75 percent on December 31, 2004. This change will increase its plants and equipment. For Microelectronics, this estimate is based on projected tech- pre-tax cost and expense in 2005 by $90 million. Had the discount rate assumption for the nology, process and product life cycles that could change significantly due to technical PPP increased by 25 basis points on December 31, 2004, pre-tax cost and expense would innovations and competitor actions in response to relatively severe industry cycles. To the have decreased by $91 million in 2005. As mentioned above, changes in the discount rate extent actual useful lives are less than previously estimated lives, the company will increase assumption will impact the ABO which in turn, may impact the company’s funding decisions its depreciation charge or will write-off or writedown technically obsolete or non-strategic if the ABO exceeds plan assets. In order to analyze the sensitivity of discount rate move- assets that have been abandoned or sold. ments, each 25 basis point increase or decrease in the interest rate will cause a correspon- The company estimates useful lives of its Microelectronics equipment by reference to ding decrease or increase, respectively, in the PPP’s ABO of an estimated $1.1 billion based the current and projected dynamics in the semiconductor industry, product/process life upon December 31, 2004 data. Page 82 presents the PPP’s ABO (after the reduction in cycles and anticipated competitor actions. discount rate discussed above) and plan assets as of December 31, 2004. To the extent that Microelectronics actual useful lives differ from management’s estimates Impacts of these types of changes on the pension plans in other countries will vary by 10 percent, consolidated net income would be an estimated $62 million higher/lower depending upon the status of each respective plan. based upon 2004 results, depending upon whether the actual lives were longer/shorter, respectively, than the estimates. To the extent that the actual lives were shorter by 10 per- Costs to Complete Service Contracts cent, it is estimated that there would have also been a lower-of-cost-or-market inventory The company enters into numerous service contracts through its SO and BCS businesses. charge of less than $5 million. SO contracts range for periods up to ten years and BCS contracts can be for several years. During the contractual period, revenue, cost and profits may be impacted by estimates of Pension Assumptions the ultimate profitability of each contract, especially contracts for which the company uses The expected long-term return on plan assets is used in calculating the net periodic pension the percentage-of-completion method of accounting. See page 50 for the company’s serv- (income)/cost. See page 83 for information regarding the expected long-term return on ices revenue recognition accounting policies. If at any time, these estimates indicate the plan assets assumption. The differences between the actual return on plan assets and contract will be unprofitable, the entire estimated loss for the remainder of the contract is expected long-term return on plan assets are recognized in the calculation of net periodic recorded immediately. pension (income)/cost over five years. The company performs ongoing profitability analyses of its services contracts in order As described on page 83, if the fair value of the pension plan’s assets is below the to determine whether the latest estimates require updating. Key factors reviewed by the plan’s ABO, the company will be required to record a minimum liability. In some situations, company to estimate the future costs to complete each contract are future labor costs and the pension asset must be partially reversed through a charge to stockholders’ equity. productivity efficiencies. The company may voluntarily make contributions or be required, by law, to make contri- butions to the pension plans. Actual results that differ from the estimates may result in more or less future company funding into the pension plans than is planned by manage- ment. See page 31 for additional information and near-term sensitivities of actual returns on funding decisions. 32


  • Page 35

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies To the extent actual estimated completed contract margins on percentage of completion tax liabilities based on estimates of whether additional taxes and interest will be due. To services contracts differ from management’s quarterly estimates by 1 percentage point, the the extent that the final tax outcome of these matters is different than the amounts that company’s consolidated net income would have improved/declined by an estimated were initially recorded, such differences will impact the income tax provision in the period $69 million using 2004 results, depending upon whether the actual results were higher/ in which such determination is made. lower, respectively, than the estimates. This amount excludes any accrual resulting from To the extent that the provision for income taxes increases/decreases by 1 percent contracts in loss positions. For all long-term services contracts that have an estimated of income from continuing operations before income taxes, consolidated income from completed contract profit of 5 percent or less, if actual profits were 5 percentage points continuing operations would have declined/improved by $120 million in 2004. less than expected, the consolidated net income would be reduced by an estimated $85 million. currency rate fluctuations Changes in the relative values of non-U.S. currencies to the U.S. dollar affect the company’s Net Realizable Value and Client Demand results. At December 31, 2004, currency changes resulted in assets and liabilities denom- The company reviews the net realizable value of and demand for its inventory on a quar- inated in local currencies being translated into more dollars than at year-end 2003. The terly basis to ensure recorded inventory is stated at the lower of cost or net realizable value company uses a variety of financial hedging instruments to limit specific currency risks and that obsolete inventory is written off. Inventories at higher risk for writedowns or write- related to financing transactions and other foreign currency-based transactions. Further offs are those in the industries that have lower relative gross margins and that are subject discussion of currency and hedging appears in note l, “Derivatives and Hedging Transac- to a higher likelihood of changes in industry cycles. The semiconductor and personal tions,” on pages 65 to 67. computer businesses are two such industries. The company earned approximately 58 percent of its net income in currencies other Factors that could impact estimated demand and selling prices are the timing and than the U.S. dollar. In general, these currencies appreciated against the U.S. dollar during success of future technological innovations, competitor actions, supplier prices and 2004 so net income in these countries translated into more dollars than they would have economic trends. in 2003. The company also maintains hedging programs to limit the volatility of currency To the extent that semiconductor and personal computer inventory losses differ from impacts on the company’s financial results. These hedging programs limit the impact of management estimates by 5 percent, the company’s consolidated net income in 2004 currency changes on the company’s financial results but do not eliminate them. In addition would have improved/declined by an estimated $42 million using 2004 results, depending to the translation of earnings and the company’s hedging programs, the impact of currency upon whether the actual results were better/worse, respectively, than expected. changes also may affect the company’s pricing and sourcing actions. For example, the Warranty Claims company may procure components and supplies in multiple functional currencies and sell The company generally offers three-year warranties for its personal computer products products and services in other currencies. Therefore, it is impractical to quantify the impact and one-year warranties on most of its other products. The company estimates the amount of currency on these transactions and on consolidated net income. For these reasons, the and cost of future warranty claims for its current period sales. These estimates are used to company believes that extended periods of dollar weakness are positive for net income record accrued warranty costs for current period product shipments. The company uses and extended periods of dollar strength are negative, although the precise impact is diffi- historical warranty claim information as well as recent trends that might suggest that past cult to assess. cost information may differ from future claims. For non-U.S. subsidiaries and branches that operate in U.S. dollars or whose economic Factors that could impact the estimated claim information include the success of the environment is highly inflationary, translation adjustments are reflected in results of opera- company’s productivity and quality initiatives, as well as parts and labor costs. tions, as required by SFAS No. 52, “Foreign Currency Translation.” Generally, the company To the extent that actual claims costs differ from management’s estimates by 5 per- manages currency risk in these entities by linking prices and contracts to U.S. dollars and cent, consolidated net income will have improved/declined by an estimated $32 million in by entering into foreign currency hedge contracts. 2004, depending upon whether the actual claims costs were lower/higher, respectively, market risk than the estimates. In the normal course of business, the financial position of the company is routinely subject Income Taxes to a variety of risks. In addition to the market risk associated with interest rate and currency The company is subject to income taxes in both the U. S. and numerous foreign jurisdic- movements on outstanding debt and non-U.S. dollar denominated assets and liabilities, tions. Significant judgment is required in determining the worldwide provision for income other examples of risk include collectibility of accounts receivable and recoverability of taxes. During the ordinary course of business, there are many transactions and calculations residual values on leased assets. for which the ultimate tax determination is uncertain. As a result, the company recognizes 33


  • Page 36

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies The company regularly assesses these risks and has established policies and business Interest Rate Risk practices to protect against the adverse effects of these and other potential exposures. As At December 31, 2004, a 10 percent decrease in the levels of interest rates with all other a result, the company does not anticipate any material losses from these risks. variables held constant would result in a decrease in the fair market value of the company’s The company’s debt in support of the Global Financing business and the geographic financial instruments of $172 million as compared with a decrease of $170 million at breadth of the company’s operations contains an element of market risk from changes in December 31, 2003. A 10 percent increase in the levels of interest rates with all other vari- interest and currency rates. The company manages this risk, in part, through the use of a ables held constant would result in an increase in the fair value of the company’s financial variety of financial instruments including derivatives, as explained in note l, “Derivatives instruments of $153 million as compared to $152 million at December 31, 2003. Changes and Hedging Transactions,” on pages 65 to 67. in the relative sensitivity of the fair value of the company’s financial instrument portfolio for To meet disclosure requirements, the company performs a sensitivity analysis to deter- these theoretical changes in the level of interest rates are primarily driven by changes in mine the effects that market risk exposures may have on the fair values of the company’s the company’s debt maturity, interest rate profile and amount. debt and other financial instruments. Foreign Currency Exchange Rate Risk The financial instruments that are included in the sensitivity analysis comprise all of the At December 31, 2004, a 10 percent weaker U.S. dollar against foreign currencies, with all company’s cash and cash equivalents, marketable securities, long-term non-lease receiv- other variables held constant, would result in a decrease in the fair value of the company’s ables, investments, long-term and short-term debt and all derivative financial instruments. financial instruments of $692 million as compared with a decrease of $283 million at The company’s portfolio of derivative financial instruments generally includes interest rate December 31, 2003. Conversely, a 10 percent stronger U.S. dollar against foreign curren- swaps, interest rate options, foreign currency swaps, forward contracts and option contracts. cies, with all other variables held constant, would result in an increase in the fair value of To perform the sensitivity analysis, the company assesses the risk of loss in fair values the company’s financial instruments of $679 million compared with $296 million at from the effect of hypothetical changes in interest rates and foreign currency exchange December 31, 2003. In 2004 versus 2003, the reported increase in foreign currency rates on market-sensitive instruments. The market values for interest and foreign currency exchange rate sensitivity was primarily due to an increase in hedges of foreign cash flow. exchange risk are computed based on the present value of future cash flows as affected by the changes in rates that are attributable to the market risk being measured. The discount financing risks rates used for the present value computations were selected based on market interest and See the Global Financing — Description of Business on page 35 for a discussion of the foreign currency exchange rates in effect at December 31, 2004 and 2003. The differences financing risks associated with the company’s Global Financing business and management’s in this comparison are the hypothetical gains or losses associated with each type of risk. goals to mitigate such risks while striving for superior return on Global Financing’s equity. Information provided by the sensitivity analysis does not necessarily represent the actual changes in fair value that the company would incur under normal market conditions because, due to practical limitations, all variables other than the specific market risk factor Employees and Related Workforce are held constant. In addition, the results of the model are constrained by the fact that certain items are specifically excluded from the analysis, while the financial instruments Percentage Changes relating to the financing or hedging of those items are included by definition. Excluded FOR THE YEAR ENDED DECEMBER 31: 2004 2003 2002 2004-03 2003-02 items include leased assets, forecasted foreign currency cash flows and the company’s net investment in foreign operations. As a consequence, reported changes in the values IBM/wholly owned subsidiaries 329,001 319,273 315,889 3.0 1.1 of some of the financial instruments impacting the results of the sensitivity analysis are not Less-than-wholly owned subsidiaries 19,051 18,189 22,282 4.7 (18.4) matched with the offsetting changes in the values of the items that those instruments are Complementary 21,225 17,695 17,250 19.9 2.6 designed to finance or hedge. The results of the sensitivity analysis at December 31, 2004, and December 31, 2003, Employees at IBM and its wholly owned subsidiaries in 2004 increased 9,728 from last are as follows: year. The company continues to invest in Global Services and Software, growth areas of the business, through a combination of hiring and acquisitions. The company also contin- ues to rebalance its workforce to improve IBM’s competitiveness in the marketplace and to withdraw from certain businesses, thereby offsetting some of the growth. 34


  • Page 37

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies In less-than-wholly owned subsidiaries, the number of employees increased from last results of operations year. The increase is primarily in the International Information Products Company, a personal (Dollars in millions) computer-related joint venture in China, which IBM has announced an agreement to sell FOR THE YEAR ENDED DECEMBER 31: 2004 2003 2002 to Lenovo as part of the sale of the Personal Computing Division. External revenue $«2,607 $«2,827 $«3,203 The company’s complementary workforce is an approximation of equivalent full-time Internal revenue 1,287 1,300 939 employees hired under temporary, part-time and limited-term employment arrangements to meet specific business needs in a flexible and cost-effective manner. Total revenue 3,894 4,127 4,142 Cost 1,539 1,846 1,803 Gross profit $«2,355 $«2,281 $«2,339 Global Financing Gross profit margin 60.5% 55.3% 56.5% description of business Pre-tax income $«1,494 $«1,182 $««««955 Global Financing is a business segment within IBM, that is managed on an arm’s-length basis After-tax income* $««««937 $««««766 $««««627 and measured as if it were a standalone entity. Accordingly, the information presented in Return on equity * 28.6% 22.3% 17.2% this section is consistent with this separate company view. The mission of Global Financing is to generate a return on equity. It also facilitates the * See page 39 for the details of the After-tax income and the Return on equity calculation. client’s acquisition of IBM hardware, software and services. Global Financing invests in financing assets, manages the associated risks, and lever- Global Financing revenue declined 5.6 percent in 2004 as compared with 2003. External ages with debt, all with the objective of generating consistently strong returns on equity. revenue decreased 7.8 percent (11.5 percent at constant currency) in 2004 versus 2003 The focus on IBM products and IBM clients mitigates the risks normally associated with a primarily driven by external used equipment sales of $708 million in 2004 versus $928 mil- financing company. Global Financing has the benefit of both a deep knowledge of its lion in 2003, a decrease of 23.7 percent. Global Financing remarkets used equipment, client base and a clear insight into the products that are being leased. This combination primarily resulting from equipment that is returned at end of lease both externally and allows Global Financing to effectively manage two of the major risks (credit and residual internally. Externally remarketed equipment revenue represents sales or leases to clients value) that are normally associated with financing. and resellers. Internally remarketed equipment revenue primarily represents used equip- ment that is sold or leased internally to the Hardware and Global Services segments. The Global Financing comprises three lines of business: Hardware segment will also sell the equipment that it purchases from Global Financing to • Customer financing provides lease and loan financing to end users and internal external customers. Internal revenue decreased 1.0 percent in 2004 versus 2003 driven customers for terms generally between two and five years. Internal financing is pre- by remarketing revenue of $783 million in 2004 versus $828 million in 2003, a decrease dominantly in support of Global Services’ long-term customer service contracts. Global of 5.4 percent, partially offset by commercial financing revenue of $269 million in 2004 Financing also factors a selected portion of the company’s accounts receivable, versus $240 million in 2003, an increase of 12.2 percent. primarily for cash management purposes. All of these internal financing arrangements Global Financing revenue was flat in 2003 as compared with 2002. External revenue are at arm’s-length rates and are based upon market conditions. decreased 11.7 percent (18.0 percent at constant currency) in 2003 versus 2002 driven by financing revenue of $1,896 million in 2003 versus $2,224 million in 2002, a decrease of • Commercial financing provides primarily short-term inventory and accounts receiv- 14.7 percent, due to declining interest rates and a lower average asset base, and external able financing to dealers and remarketers of IT products. used equipment sales of $931 million in 2003 versus $979 million in 2002, a decrease of • Remarketing sells and leases used equipment to new or existing customers. This 4.9 percent. The lower average asset base was primarily due to lower originations in prior equipment is primarily sourced from the conclusion of lease transactions. years. Internal revenue increased 38.4 percent in 2003 versus 2002 driven by internal used In addition to the strength of the economy and its impact on corporate IT budgets, key equipment sales, primarily zSeries. drivers of Global Financing’s results are interest rates and originations. Originations, which determine the asset base of Global Financing’s annuity-like business, are impacted by IBM’s non-Global Financing sales volumes and Global Financing’s participation rates. Participation rates are the propensity of IBM’s clients to finance their purchases through Global Financing in lieu of paying IBM up-front cash or financing through a third party. 35


  • Page 38

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Global Financing gross profit dollars increased 3.2 percent and gross profit margin financial condition increased 5.2 points in 2004 versus 2003. The increase in gross profit dollars was primarily Balance Sheet driven by cost of sales on remarketing equipment of $931 million in 2004 versus $1,168 (Dollars in millions) million in 2003, a decrease of 20.2 percent and borrowing costs of $608 million in 2004 AT DECEMBER 31: 2004 2003 versus $678 million in 2003, a decrease of 10.3 percent related to volumes and the inter- Cash $««««««850 $««««««813 est rate environment during the year, partially offset by the decrease in revenue discussed above. The increase in gross profit margin was driven by improved margins in financing Net investment in sales-type leases 11,141 11,969 and equipment sales, and a mix change toward higher margin financing income and away Equipment under operating leases: from lower margin equipment sales. External customers 1,817 1,707 Global Financing gross profit dollars decreased 2.5 percent and gross profit margin Internal customers (a) (b) 1,906 1,873 declined 1.2 points in 2003 versus 2002. The decrease in gross profit dollars was primarily Customer loans 9,889 10,413 driven by declining interest rates and lower average asset base discussed above, partially Total customer financing assets 24,753 25,962 offset by improved financing margins. The decrease in gross profit margin was driven by Commercial financing receivables 5,710 5,835 a mix change toward lower margin remarketing sales and away from financing income, Intercompany financing receivables (a) (b) 2,172 1,999 partially offset by lower borrowing costs related to the interest rate environment during Other receivables 223 270 the year. Other assets 881 1,037 Global Financing pre-tax income increased 26.4 percent in 2004 versus 2003, com- Total financing assets $«34,589 $«35,916 pared with an increase of 23.8 percent in pre-tax income in 2003 versus 2002. The increase Intercompany payables (a) $«««6,394 $«««6,754 in 2004 was driven by a decrease of $101 million in bad debt expense, a decrease of $23 million in selling, general and administration expenses, a decrease of $100 million in Debt (c) 22,320 23,264 other charges primarily driven by income from internal sales, and the increase in gross Other liabilities 2,620 2,546 profit of $74 million discussed above. The decrease in bad debt expense is reflective of Total financing liabilities 31,334 32,564 the improved general economic environment, improved credit quality of the portfolio, and Total financing equity 3,255 3,352 the declining size of the receivables portfolio. (Also see page 37 for an additional discussion Total financing liabilities and equity $«34,589 $«35,916 of IBM Global Financing Allowance for Doubtful Accounts.) The increase in 2003 versus (a) Amounts eliminated for purposes of IBM’s consolidated results and therefore do not appear on pages 42 and 43. 2002 was driven by a decrease in bad debt expense partially offset by the decrease in (b) These assets, along with all other financing assets in this table, are leveraged using Global Financing debt. gross profit discussed above. The decrease in bad debt expense is reflective of the improved (c) Global Financing debt includes debt of the company and of the Global Financing units that support the Global general economic environment and reduced exposure in specific sectors, particularly the Financing business. Communications sector. The increases in return on equity from 2003 to 2004 and from 2002 to 2003 were also Sources and Uses of Funds due to higher earnings. The primary use of funds in Global Financing is to originate customer and commercial financing assets. Customer financing assets for end users consist primarily of IBM hardware, software and services, but also include non-IBM equipment, software and services to meet IBM clients’ total solutions requirements. Customer financing assets are primarily sales- type, direct financing, and operating leases for equipment as well as loans for hardware, software and services with terms generally for two to five years. Customer financing also includes internal activity as described on page 35. Commercial financing originations arise primarily from inventory and accounts receiv- able financing for dealers and remarketers of IBM and non-IBM products. Payment terms for inventory financing generally range from 30 to 75 days. Payment terms for accounts receivable financing generally range from 30 to 90 days. 36


  • Page 39

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Originations (Dollars in millions) The following are total external and internal financing originations. AT DECEMBER 31: 2004 2003 (Dollars in millions) Gross financing receivables $«26,836 $«28,451 FOR THE YEAR ENDED DECEMBER 31: 2004 2003 2002 Specific allowance for doubtful accounts 654 666 Customer finance: Unallocated allowance for doubtful accounts 127 199 External $«12,433 $«13,279 $«12,845 Total allowance for doubtful accounts 781 865 Internal 1,185 1,150 1,061 Net financing receivables $«26,055 $«27,586 Commercial finance 25,566 24,291 22,546 Allowance for doubtful account coverage 2.9% 3.0% Total $«39,184 $«38,720 $«36,452 Roll-Forward of Financing Receivables Allowance for Doubtful Accounts Cash collections of both customer and commercial financing assets exceeded new financing (Dollars in millions) originations in 2004, which resulted in a net decline in financing assets from December 31, Additions: 2003. The increase in originations in 2004 and 2003 from 2003 and 2002 respectively, was Reserve Bad Debts Dec. 31, due to favorable currency movements offset by a decline in participation rates. The decline Jan. 1, 2004 Used* Expense Other** 2004 in participation rates was in line with industry trends. $«865 $«(237) $«105 $«48 $«781 Cash generated by Global Financing in 2004 was deployed to pay the intercompany * Represents reserved receivables, net of recoveries, that were disposed of during the period. payable and dividends to IBM as well as to reduce debt. ** Primarily represents translation adjustments. Financing Assets by Sector The following are the percentage of external financing assets by industry sector. The percentage of financing receivables reserved decreased from 3.0 percent at December 31, 2003, to 2.9 percent at December 31, 2004 primarily due to the decrease AT DECEMBER 31: 2004 2003 in the unallocated allowance for doubtful accounts. Unallocated reserves decreased 36.2 percent from $199 million at December 31, 2003 to $127 million at December 31, Financial Services 30% 28% 2004 due to the decline in gross financing receivables combined with improved economic Industrial 20 17 conditions and improved credit quality of the portfolio. Specific reserves decreased 1.8 per- Business Partners * 19 18 cent from $666 million at December 31, 2003 to $654 million at December 31, 2004. The Distribution 9 10 decrease in specific reserves was due to the disposition of reserved receivables during Public 9 10 the period combined with lower requirements for additional specific reserves. This Communications 9 11 lower requirement is generally due to improving economic conditions as well as portfolio Other 4 6 management to reduce risk in areas of concern. Total 100% 100% Global Financing’s bad debt expense declined to $105 million for the year ended * Business Partners financing assets represent a portion of commercial financing inventory and accounts receivable December 31, 2004, compared with $206 million for the year ended December 31, 2003. financing for terms generally less than 90 days. The decline was primarily attributed to lower reserve requirements associated with the improvement in economic conditions and improved credit quality of the portfolio in 2004, Financing Receivables and Allowances as compared with 2003, as well as the lower asset base. The following table presents external financing receivables, excluding residual values, and Residual Value the allowance for doubtful accounts. Residual value is a risk unique to the financing business, and management of this risk is dependent upon the ability to accurately project future equipment values. Global Financing has insight into product plans and cycles for the IBM products under lease. Based upon this product information, Global Financing continually monitors projections of future equipment values and compares them with the residual values reflected in the portfolio. See note a, “Significant Accounting Policies” on page 55 for the company’s accounting policy for residual values. 37


  • Page 40

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies Sales of equipment, which are primarily sourced from equipment returned at end of Global Financing funds its operations primarily through borrowings using a debt to equity lease, represented 36.6 percent of Global Financing’s revenue in 2004 and 40.5 percent ratio of approximately 7 to 1. The debt is used to fund Global Financing assets. The debt in 2003. The decrease was driven primarily by lower external used equipment sales, due is composed of intercompany loans and external debt. The terms of the intercompany to a decline in sales to business partners. The gross margin on these sales was 34.6 per- loans are set by the company to substantially match the term and currency underlying the cent and 30.2 percent in 2004 and 2003, respectively. The increase in gross margin was receivable. The inter-company loans are based on arm’s-length pricing. The following table primarily due to the improved profitability of internal equipment sales. In addition to sell- illustrates the correlation between Global Financing Assets and Global Financing Debt. ing assets sourced from end of lease, Global Financing optimizes the recovery of residual Both assets and debt are presented in the Global Financing Balance Sheet on page 36. values by leasing used equipment to new customers or extending leasing arrangements with current customers. The following table presents the recorded amount of unguaran- Global Financing Assets and Debt teed residual value for sales-type and operating leases at December 31, 2003 and 2004. (Dollars in millions) In addition, the table presents the residual value as a percentage of the original amount $50 financed, and a run out of the unguaranteed residual value over the remaining lives of these leases at December 31, 2004. In addition to the unguaranteed residual value below, 40 on a limited basis, Global Financing will obtain guarantees of the future value of the equip- ment scheduled to be returned at end of lease. These third-party guarantees are used in 30 the determination of lease classifications for the covered equipment and provide protec- 20 tion against risk of loss arising from declines in equipment values for these assets. The aggregate asset value associated with the guarantees was $700 million and $615 million 10 for financing transactions originated during the years ended December 31, 2004 and 2003, respectively. The associated aggregate guaranteed future value at the scheduled end of lease was $36 million and $26 million for financing transactions originated during 95 96 97 98 99 00 01 02 03 04 the same time periods, respectively. The cost of guarantees was $4.7 million for each year. Global Financing Assets Global Financing Debt Residual Value The company’s Global Financing business provides funding predominantly for the com- (Dollars in millions) pany’s external customers but also provides intercompany financing for the company Total Amortization of 2004 Balance (internal), as described in the “Description of Business” on page 35. As previously stated, 2008 and the company manages and measures Global Financing as if it were a standalone entity 2003 2004 2005 2006 2007 Beyond and accordingly, interest expense relating to debt supporting Global Financing’s external Sales-type leases $««««««845 $««««««836 $«262 $«269 $«248 $«57 customer and internal business is included in the “Global Financing Results of Operations” Operating leases 164 164 78 46 36 4 on page 35 and in note x, “Segment Information,” on pages 87 through 91. Total unguaranteed In the company’s Consolidated Statement of Earnings on pages 40 and 41, however, residual value $«««1,009 $«««1,000 $«340 $«315 $«284 $«61 the interest expense supporting Global Financing’s internal financing to the company is reclassified from Cost of financing to Interest expense. Related original amount financed $«27,820 $«25,982 Liquidity and Capital Resources Percentage 3.6% 3.8% Global Financing is a segment of the company and as such, is supported by the company’s liquidity position and access to capital markets. Cash generated from operations in 2004 Debt was deployed to reduce debt and pay dividends to the company in order to maintain an AT DECEMBER 31: 2004 2003 appropriate debt to equity ratio. Debt to equity ratio 6.9x 6.9x 38


  • Page 41

    MANAGEMENT DISCUSSION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies return on equity To the extent that actual residual value recovery is lower than management’s estimates (Dollars in millions) by 5 percent, Global Financing’s net income would be lower by an estimated $16 million AT DECEMBER 31: 2004 2003 (using 2004 data). If the actual residual value recovery is higher than management’s esti- mates, the increase in net income will be realized at the end of lease when the equipment Numerator: is remarketed. Global Financing after tax income (A)* $÷««937 $««««766 Denominator: market risk Average Global Financing equity (B)** $«3,272 $«3,436 See pages 33 and 34 for discussion of the company’s overall market risk. Global Financing Return on Equity (A) / (B) 28.6% 22.3% looking forward * Calculated based upon an estimated tax rate principally based on Global Financing’s geographic mix of earnings as Given Global Financing’s mission of supporting IBM’s hardware, software and services IBM’s provision for income taxes is determined on a consolidated basis. ** Average of the ending equity for Global Financing for the last five quarters. businesses, originations for both customer and commercial finance businesses will be dependent upon the overall demand for IT hardware, software and services, as well as the customer participation rates. critical accounting estimates Interest rates and the overall economy (including currency fluctuations) will have an As discussed in note a, “Significant Accounting Policies,” on page 49, the application of effect on both revenue and gross profit. The company’s interest rate risk management GAAP involves the exercise of varying degrees of judgment. The following areas require policy, however, combined with the Global Financing funding strategy (see page 38), more judgment relative to the others and relate to Global Financing. Also see “Critical should mitigate gross margin erosion due to changes in interest rates. The company’s Accounting Estimates” on page 32. policy of matching asset and liability positions in foreign currencies will limit the impacts Financing Receivables Reserves of currency fluctuations. Global Financing reviews its financing receivables portfolio at least quarterly in order to The economy could impact the credit quality of the Global Financing receivables port- assess collectibility. A description of the methods used by management to estimate the folio and therefore the level of provision for bad debts. Global Financing will continue to amount of uncollectible receivables is included on page 54. Factors that could result in apply rigorous credit policies in both the origination of new business and the evaluation actual receivable losses that are materially different from the estimated reserve include of the existing portfolio. sharp changes in the economy, or a large change in the health of a particular industry seg- As discussed above, Global Financing has historically been able to manage residual ment that represents a concentration in Global Financing’s receivables portfolio. value risk both through insight into the product cycles as well as through its remarket- To the extent that actual collectibility differs from management’s estimates by 5 per- ing business. cent, Global Financing net income would be higher or lower by an estimated $24 million Global Financing has policies in place to manage each of the key risks involved in (using 2004 data), depending upon whether the actual collectibility was better or worse, financing. These policies, combined with product and customer knowledge, should allow respectively, than the estimates. for the prudent management of the business going forward, even during periods of uncertainty with respect to the economy. Residual Value Residual value represents the estimated fair value of equipment under lease as of the end of the lease. Global Financing estimates the future fair value of residual values by using historical models, the current market for used equipment and forward-looking product Forward-Looking and Cautionary Statements information such as marketing plans and technological innovations. In addition, Global Certain statements contained in this Annual Report may constitute forward-looking state- Financing estimates the fair value by analyzing current market conditions for leasing and ments within the meaning of the Private Securities Litigation Reform Act of 1995. These sales of both new and used equipment. These estimates are periodically reviewed and any statements involve a number of risks, uncertainties and other factors that could cause other than temporary declines in estimated future residual values are recognized upon actual results to be materially different, as discussed more fully elsewhere in this Annual identification. Anticipated increases in future residual value are not recognized until the Report and in the company’s filings with the SEC, including the company’s 2004 Form 10-K equipment is remarketed. Factors that could cause actual results to materially differ from filed on February 24, 2005. the estimates include severe changes in the used equipment market brought on by unforeseen changes in technology innovations and any resulting changes in the useful lives of used equipment. 39


  • Page 42

    CONSOLIDATED STATEMENT OF EARNINGS ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions except per share amounts) FOR THE YEAR ENDED DECEMBER 31: Notes 2004 2003 2002 Revenue: Global Services $«46,213 $«42,635 $«36,360 Hardware 31,154 28,239 27,456 Software 15,094 14,311 13,074 Global Financing 2,608 2,826 3,232 Enterprise Investments/Other 1,224 1,120 1,064 Total Revenue 96,293 89,131 81,186 Cost: Global Services 34,637 31,903 26,812 Hardware 21,929 20,401 20,020 Software 1,919 1,927 2,043 Global Financing 1,045 1,248 1,416 Enterprise Investments/Other 731 634 611 Total Cost 60,261 56,113 50,902 Gross Profit 36,032 33,018 30,284 Expense and Other Income: Selling, general and administrative q 19,384 17,852 18,738 Research, development and engineering r 5,673 5,077 4,750 Intellectual property and custom development income (1,169) (1,168) (1,100) Other (income) and expense (23) 238 227 Interest expense k&l 139 145 145 Total Expense and Other Income 24,004 22,144 22,760 Income from Continuing Operations Before Income Taxes 12,028 10,874 7,524 Provision for income taxes p 3,580 3,261 2,190 Income from Continuing Operations 8,448 7,613 5,334 Discontinued Operations: Loss from discontinued operations c 18 30 1,755 Net Income $«««8,430 $«««7,583 $«««3,579 40


  • Page 43

    CONSOLIDATED STATEMENT OF EARNINGS ibm annual report 2004 (continued) International Business Machines Corporation and Subsidiary Companies (Dollars in millions except per share amounts) FOR THE YEAR ENDED DECEMBER 31: Notes 2004 2003 2002 Earnings/(Loss) per Share of Common Stock: Assuming Dilution: Continuing operations t $«««««4.94 $«««««4.34 $«««««3.07 Discontinued operations t (0.01) (0.02) (1.01) Total t $«««««4.93 $«««««4.32 $«««««2.06 Basic: Continuing operations t $«««««5.04 $«««««4.42 $«««««3.13 Discontinued operations t (0.01) (0.02) (1.03) Total t $«««««5.03 $«««««4.40 $«««««2.10 Weighted-Average Number of Common Shares Outstanding: Assuming dilution 1,708,872,279 1,756,090,689 1,730,941,054 Basic 1,674,959,086 1,721,588,628 1,703,244,345 The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 41


  • Page 44

    CONSOLIDATED STATEMENT OF FINANCIAL POSITION ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) AT DECEMBER 31: Notes 2004 2003* Assets Current assets: Cash and cash equivalents $«««10,053 $«««««7,290 Marketable securities d 517 357 Notes and accounts receivable — trade (net of allowances of $277 in 2004 and $352 in 2003) 10,522 10,026 Short-term financing receivables (net of allowances of $681 in 2004 and $733 in 2003) f 15,801 17,583 Other accounts receivable (net of allowances of $13 in 2004 and $16 in 2003) 1,813 1,314 Inventories e 3,316 2,942 Deferred taxes p 2,229 2,542 Prepaid expenses and other current assets 2,719 2,608 Total current assets 46,970 44,662 Plant, rental machines and other property g 36,385 36,153 Less: Accumulated depreciation g 21,210 21,464 Plant, rental machines and other property — net g 15,175 14,689 Long-term financing receivables f 10,950 10,741 Prepaid pension assets w 20,394 18,426 Investments and sundry assets h 5,468 7,294 Goodwill i 8,437 6,921 Intangible assets — net i 1,789 1,724 Total Assets $«109,183 $«104,457 * Reclassified to conform with 2004 presentation. 42


  • Page 45

    CONSOLIDATED STATEMENT OF FINANCIAL POSITION ibm annual report 2004 (continued) International Business Machines Corporation and Subsidiary Companies (Dollars in millions) AT DECEMBER 31: Notes 2004 2003* Liabilities and Stockholders’ Equity Current liabilities: Taxes p $«««««4,728 $«««««5,475 Short-term debt k&l 8,099 6,646 Accounts payable 9,444 8,460 Compensation and benefits 3,804 3,671 Deferred income 7,175 6,492 Other accrued expenses and liabilities 6,548 6,879 Total current liabilities 39,798 37,623 Long-term debt k&l 14,828 16,986 Retirement and nonpension postretirement benefit obligations w 15,883 14,251 Other liabilities m 8,927 7,733 Total Liabilities 79,436 76,593 Contingencies and commitments o Stockholders’ equity: n Common stock, par value $.20 per share and additional paid-in capital 18,355 16,269 Shares authorized: 4,687,500,000 Shares issued (2004—1,962,687,087; 2003—1,937,393,604) Retained earnings 44,525 37,525 Treasury stock, at cost (shares: 2004—317,094,633; 2003—242,884,969) (31,072) (24,034) Accumulated gains and (losses) not affecting retained earnings (2,061) (1,896) Total Stockholders’ Equity 29,747 27,864 Total Liabilities and Stockholders’ Equity $«109,183 $«104,457 * Reclassified to conform with 2004 presentation. The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 43


  • Page 46

    CONSOLIDATED STATEMENT OF CASH FLOWS ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) FOR THE YEAR ENDED DECEMBER 31: 2004 2003* 2002* Cash Flow from Operating Activities from Continuing Operations: Income from continuing operations $««8,448 $««7,613 $««5,334 Adjustments to reconcile income from continuing operations to cash provided by operating activities: Depreciation 3,959 3,961 3,691 Amortization of intangibles 956 955 802 Deferred income taxes 2,081 1,126 (67) Net gain on assets sales and other (420) (275) (343) Other than temporary declines in securities and other investments 20 50 58 Noncash portion of special actions — — 1,350 Change in operating assets and liabilities, net of acquisitions/divestitures: Receivables 2,613 2,024 4,125 Inventories (291) 293 793 Pension assets (1,284) (1,409) (4,227) Other assets (200) (567) (44) Accounts payable 411 617 (55) Pension liabilities (584) (286) 83 Other liabilities (303) 467 2,288 Net Cash Provided by Operating Activities from Continuing Operations 15,406 14,569 13,788 Cash Flow from Investing Activities from Continuing Operations: Payments for plant, rental machines and other property (4,368) (4,393) (4,753) Proceeds from disposition of plant, rental machines and other property 1,311 1,039 775 Investments in software (688) (581) (597) Purchases of marketable securities and other investments (8,718) (6,471) (1,582) Proceeds from disposition of marketable securities and other investments 8,830 7,023 1,185 Divestiture of businesses 25 97 1,233 Acquisition of businesses (1,738) (1,836) (3,158) Net Cash Used in Investing Activities from Continuing Operations (5,346) (5,122) (6,897) * Reclassified to conform with 2004 presentation. 44


  • Page 47

    CONSOLIDATED STATEMENT OF CASH FLOWS ibm annual report 2004 (continued) International Business Machines Corporation and Subsidiary Companies (Dollars in millions) FOR THE YEAR ENDED DECEMBER 31: 2004 2003* 2002* Cash Flow from Financing Activities from Continuing Operations: Proceeds from new debt 2,438 1,573 6,726 Short-term borrowings/(repayments) less than 90 days — net 1,073 777 (4,087) Payments to settle debt (4,538) (5,831) (5,812) Common stock transactions — net (5,418) (3,232) (3,087) Cash dividends paid (1,174) (1,085) (1,005) Net Cash Used in Financing Activities from Continuing Operations (7,619) (7,798) (7,265) Effect of exchange rate changes on cash and cash equivalents 405 421 148 Net cash used in discontinued operations (83) (162) (722) Net change in cash and cash equivalents 2,763 1,908 (948) Cash and cash equivalents at January 1 7,290 5,382 6,330 Cash and Cash Equivalents at December 31 $«10,053 $«7,290 $«5,382 Supplemental Data: Cash paid during the year: Income taxes $«««1,837 $«1,707 $«1,841 Interest $««««««705 $««««853 $««««831 Noncash Investing and Financing Activities: In 2002, the noncash portion of the purchase price paid to PwCC is a significant noncash investing activity. This transaction is described on pages 59 and 60. * Reclassified to conform with 2004 presentation. The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 45


  • Page 48

    CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) Common Accumulated Stock Gains and and (Losses) Not Additional Affecting Paid-in Retained Treasury Retained Capital Earnings Stock Earnings Total 2002 Stockholders’ equity, January 1, 2002 $«14,248 $«30,142 $«(20,114) $««««(828) $«23,448 Net income plus gains and (losses) not affecting retained earnings: Net income 3,579 $«««3,579 Gains and (losses) not affecting retained earnings (net of tax): Net unrealized losses on SFAS No. 133 cash flow hedge derivatives during 2002 (net of tax benefit of $372) (659) (659) Foreign currency translation adjustments (net of tax benefit of $197) 850 850 Minimum pension liability adjustment (net of tax benefit of $1,574) (2,765) (2,765) Net unrealized losses on marketable securities (net of tax benefit of $8) (16) (16) Total gains and (losses) not affecting retained earnings (2,590) Subtotal: Net income plus gains and (losses) not affecting retained earnings $««««««989 Cash dividends declared — common stock (1,005) (1,005) Common stock issued under employee plans (7,255,995 shares) 440 4 444 Purchases (189,797 shares) and sales (12,873,502 shares) of treasury stock under employee plans — net (475) 1,311 836 Other treasury shares purchased, not retired (48,481,100 shares) (4,212) (4,212)) Treasury shares issued to fund the U.S. pension fund (24,037,354 shares) (576) 2,447 1,871 Shares issued/to be issued in the PwCC acquisition (3,677,213 shares issued) 43 (114) 355 284 Decrease in shares remaining to be issued in acquisition (9) (9) Tax effect — stock transactions 136 136 Stockholders’ equity, December 31, 2002 $«14,858 $«31,555 $«(20,213) $«(3,418) $«22,782 The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 46


  • Page 49

    CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) Common Accumulated Stock Gains and and (Losses) Not Additional Affecting Paid-in Retained Treasury Retained Capital Earnings Stock Earnings Total 2003 Stockholders’ equity, January 1, 2003 $«14,858 $«31,555 $«(20,213) $«(3,418) $«22,782 Net income plus gains and (losses) not affecting retained earnings: Net income 7,583 $«««7,583 Gains and (losses) not affecting retained earnings (net of tax): Net unrealized losses on SFAS No. 133 cash flow hedge derivatives during 2003 (net of tax benefit of $51) (91) (91) Foreign currency translation adjustments (net of tax benefit of $125) 1,768 1,768 Minimum pension liability adjustment (net of tax benefit of $124) (162) (162) Net unrealized gains on marketable securities (net of tax expense of $3) 7 7 Total gains and (losses) not affecting retained earnings 1,522 Subtotal: Net income plus gains and (losses) not affecting retained earnings $«««9,105 Cash dividends declared — common stock (1,085) (1,085) Common stock issued under employee plans (16,445,473 shares) 1,205 (282) 923 Purchases (291,921 shares) and sales (5,992,342 shares) of treasury stock under employee plans — net (246) 582 336 Other treasury shares purchased, not retired (49,994,514 shares) (4,403) (4,403) Shares to be issued in the PwCC acquisition 8 8 Decrease in shares remaining to be issued in acquisition (4) (4) Tax effect — stock transactions 202 202 Stockholders’ equity, December 31, 2003 $«16,269 $«37,525 $«(24,034) $«(1,896) $«27,864 The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 47


  • Page 50

    CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY ibm annual report 2004 International Business Machines Corporation and Subsidiary Companies (Dollars in millions) Common Accumulated Stock Gains and and (Losses) Not Additional Affecting Paid-in Retained Treasury Retained Capital Earnings Stock Earnings Total 2004 Stockholders’ equity, January 1, 2004 $«16,269 $«37,525 $«(24,034) $«(1,896) $«27,864 Net income plus gains and (losses) not affecting retained earnings: Net income 8,430 $«««8,430 Gains and (losses) not affecting retained earnings (net of tax): Net unrealized losses on SFAS No. 133 cash flow hedge derivatives during 2004 (net of tax benefit of $112) (199) (199) Foreign currency translation adjustments (net of tax benefit of $93) 1,055 1,055 Minimum pension liability adjustment (net of tax benefit of $540) (1,066) (1,066) Net unrealized gains on marketable securities (net of tax expense of $30) 45 45 Total gains and (losses) not affecting retained earnings (165) Subtotal: Net income plus gains and (losses) not affecting retained earnings $«««8,265 Cash dividends declared — common stock (1,174) (1,174) Common stock issued under employee plans (25,293,484 shares) 1,815 (129) 1,686 Purchases (422,338 shares) and sales (2,840,648 shares) of treasury stock under employee plans — net (127) 237 110 Other treasury shares purchased, not retired (78,562,974 shares) (7,275) (7,275) Decrease in shares remaining to be issued in acquisition (6) (6) Tax effect — stock transactions 277 277 Stockholders’ equity, December 31, 2004 $«18,355 $«44,525 $«(31,072) $«(2,061) $«29,747 The accompanying notes on pages 49 through 91 are an integral part of the financial statements. 48

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