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    2005 Annual Report


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    Dear IBM Investor, In my letters to you over the past several years, I have described IBM’s view of how the information technology industry is being radically reshaped by developments in technology, its application in business and the onrush of globalization. I have also reported on the actions we have taken to capitalize on these shifts and to position our company for long-term prosperity. AS A RESULT OF THESE ACTIONS, IBM has emerged After investing $5.8 billion in R&D, $3.5 billion from this period a very different company. We are in net capital expenditures and $1.5 billion for acqui- much more focused on the high-value segments of sitions, we ended the year with $13.7 billion of cash, our industry, better balanced, more productive and including marketable securities. Over the past several more profitable than just a few years ago. Our solid years, IBM has consistently generated return on results in 2005 are a consequence of this reposition- invested capital significantly above the average for the ing, and of the innovation and marketplace execution S&P 500, and we did so again in 2005, with ROIC of more than 329,000 IBMers around the world. of 24 percent, excluding Global Financing and non- Our revenue in 2005 was $88.3 billion, up recurring items. We were able to return a record 3 percent, without our divested personal computer of nearly $9 billion to you — $7.7 billion through business. Revenue as reported was $91.1 billion, share repurchase and $1.2 billion through dividends. down 5 percent. Pre-tax earnings from continuing After lots of hard work to remix our portfolio of operations were $12.2 billion, an increase of 15 per- businesses and to improve IBM’s overall competi- cent; and diluted earnings per share were $4.91, tiveness, I believe the headwinds we faced entering up 12 percent. Excluding non-recurring items, our the decade are largely behind us. In this letter, earnings per share increased 18 percent, to $5.32. I will describe the performance of IBM’s three major Particularly noteworthy was a rise of 3.2 points in businesses. I will also describe why I believe that IBM’s gross profit margin, to 40.1 percent. our business model, based on the twin pillars of _1


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    Samuel J. Palmisano Chairman, President and Chief Executive Officer 2_


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    integration and innovation, and underpinned by a since the fourth quarter of 1998. pSeries UNIX strong financial footing, is unique — and why we are servers had a strong year, growing 15 percent, with strongly positioned to capture the most attractive double-digit growth in all geographies. We believe growth and profit opportunities in the years ahead. this was the fourth straight year of improvement in pSeries’ market position. We expect to maintain Leadership Businesses and Leadership Results our leadership in the fast-growing Blade server Our results in 2005 were achieved through the business, with a 2005 growth rate of 65 percent. In marketplace performance of our major businesses — addition, our system storage business was up 15 per- Systems and Technology, Software, and Services. cent for the year, driven by our mainstay disk Let me describe that performance briefly for each. and tape products. And our emerging technologies also gained momentum, such as storage virtualiza- SYSTEMS AND TECHNOLOGY: Our company’s tion, which added 1,700 clients. technology strength is the result of long-term Led by our sweep of the three major gaming investments we’ve made over many years, invest- platforms, IBM’s microelectronics business achieved ments that are now bearing fruit. Last year, IBM’s 16 percent growth. Revenue from our 300-millimeter Systems and Technology business extended its indus- wafer products grew strongly in 2005 — including try leadership, enhancing its competitive standing more than 250 percent growth in the fourth quarter. and staking out advantageous positions in growth Engineering & Technology Services grew 39 percent markets of the future. Since 2000, IBM’s total for the year. The Cell Broadband Engine, our share of the server market has grown 9.5 points in revolutionary microprocessor developed through annual revenue, according to industry analyst IDC. a unique technology collaboration with Sony and Our Systems and Technology revenues in 2005 Toshiba, is bringing the capabilities of supercomputer- were up 5 percent. In the fourth quarter, shipments level simulation to multiple arenas, including con- of MIPS (millions of instructions per second) sumer electronics, healthcare and defense. Recently for our zSeries mainframes grew 28 percent year- we combined a number of these engineering and to-year — our largest quarter of MIPS shipments on technology operations into a new unit, Technology record, leading to our highest mainframe revenue Collaboration Solutions, to bring greater focus and Results from continuing operations Revenue Income Earnings per share — Net cash from operating (Dollars in billions) (Dollars in billions) assuming dilution activities, excluding Global (In dollars) Financing receivables (Dollars in billions) $100_ 8.0 4.91 96.3 $8_ 7.5 $5_ $15_ 89.1 91.1 4.39 83.1 81.2 6.9 6.6 12.6 12.9 13.1 80_ 4_ 3.94 3.76 12_ 11.7 6_ 10.5 60_ 3_ 9_ 4.2 4_ 2.43 40_ 2_ 6_ 2_ 20_ 1_ 3_ 0_ 0_ 0_ 0_ 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 2005 performance includes results from four months of the IBM PC business, which was divested on April 30, 2005. _3


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    resources to the opportunities we see in collaborative investment in a new “information on demand” innovation. There is large and growing demand practice we announced this February, including across engineering-intensive industries — from auto- advanced tools and 10,000 additional practitioners motive and aerospace to telecommunications and located in centers of excellence around the world. medical equipment — to leverage the technologies Our Rational software tools grew 4 percent for the and research prowess of partners. This is not year, and Tivoli 11 percent — including 24 percent outsourced R&D, but true shoulder-to-shoulder growth for Tivoli storage software, as clients collaboration. The ability to extend IBM’s legendary continued their strong adoption of our virtualization technology strengths to clients to accelerate their technologies. In addition, our 2005 acquisitions own product and service R&D is a powerful proposi- of companies such as Ascential, Bowstreet, SRD tion that no one in our industry can easily match. and DWL have strengthened our hand in other high-growth areas, including business integration SOFTWARE: Software revenues totaled $15.8 billion and Web-enabled software. in 2005, an increase of 4 percent. We believe we improved our competitive position in all five of our GLOBAL SERVICES: IBM Global Services remains key middleware brands. Indeed, 2005 marked a the leading IT services company in the world, with milestone for our software business. As I’ve reported more than twice the revenue of our nearest rival. to you for several years, we have been focusing our We are ranked as the number-one service provider internal software R&D and acquisition efforts on the in IT outsourcing, Web hosting and consulting high-growth middleware segment of the software & systems integration. Revenues from Global opportunity. Last year, for the first time, more than Services in 2005 totaled $47.4 billion, an increase of half of our software revenue came from strategic 2 percent. Our backlog is estimated at $111 billion, middleware products vs. the slower growth host or the same as a year ago. legacy platforms. We’ve been seeing a transition in services over In software, as in systems, the technology bets we the past few years, a shift to smaller deals of shorter made several years ago are paying off. Companies are duration. These are good opportunities — if you seeking to dissolve barriers that impede the flow of can recalibrate your sales model to capture them in information within the enterprise by deploying open, addition to the traditional “mega-deals.” And the standards-based middleware to integrate their IT sys- profitability of these kinds of deals is very attractive, tems and to maximize digital assets in all their forms. if your global cost structure is competitive. We had There is a significant shift underway in the world of to address both our sales model and services cost software toward what is called service-oriented archi- structure last year, and we did so. We also took other tecture (SOA), which allows companies to be much actions to strengthen our services business — shifting more flexible and responsive. As the worldwide thousands of employees into global delivery centers; leader in middleware, IBM is in a strong position to rebalancing our Integrated Technology Services capitalize on the SOA market, which some analysts portfolio; and doubling the resources dedicated to expect to more than double, to $143 billion, by 2008. integrated solutions, which we expect will account Our WebSphere middleware family grew 10 per- for 70 percent of the total IT opportunity by 2008. cent in 2005, with particular strength in Application These changes give us a platform for increasing Servers and Portals, which grew 15 percent and growth in 2006. 12 percent, respectively. Information management I want to call out in particular our continuing software grew 8 percent, fueled by our content progress in the high-growth market we call Business management and information integration products — a Performance Transformation Services. This is where set of offerings that we are enhancing with a $1 billion 4_ Chairman’s Letter


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    Moving to a high-value model IBM’s Segment Pre-Tax Systems and Financing World leader in server sales. IBM has improved its server market position Income in 2005 was by 9.5 points since 2000. Blade server revenue grew by 65 percent in 2005. balanced among its three IBM leads in supercomputers, with 219 of the top 500 systems — including primary businesses. number one (BlueGene/L) and five of the top ten. Software Pre-Tax Income 2005* World leader in middleware and the second-largest software business overall. SYSTEMS IBM is the market leader in information management software, all application AND FINANCING integration and middleware categories; instant messaging software for SOFTWARE corporations; portal software; and systems management and systems 28% 37% operations software. 35% Services World leader in IT services and consulting. IBM has approximately 198,000 SERVICES services professionals globally. Offerings include datacenter outsourcing, business transformation services, consulting, systems integration, application management services, infrastructure and system maintenance and Web * Excludes 2Q restructuring charges and PCs. hosting. IBM Global Services signings grew 9 percent in 2005. Software includes Enterprise Investments. The company has steadily shifted its business mix toward more profitable, innovation-based segments. Business Revenue Mix Transaction Revenue Mix Profitability The company’s business mix has IBM uses the cash from its reliable As a result of these shifts, the shifted away from commoditizing seg- annuity businesses to fund investment company has improved its gross ments, such as PCs, hard disk drives in high-value integrated solutions: profit margins over the past five and DRAMs, and toward higher value offerings that integrate services years. IBM’s margin is the highest businesses: transactional, which and technology to solve a business it has been since 1996. provide near-term income; and or infrastructure problem. Clients annuity, which provide predictable, increasingly seek solutions rather than long-term income, supplying capital to “point-product” purchases of particular invest in future growth. technologies and products. 1996 1996 Gross Profit Margin ANNUITY SOLUTIONS TRANSACTIONAL 50%_ POINT 40.1% PRODUCTS COMMODITY 40%_ 37.9% 36.6% 36.5% 36.9% Today * Today * ANNUITY TRANSACTIONAL SOLUTIONS 30%_ POINT PRODUCTS 20%_ 01 02 03 04 05 COMMODITY * Post PC divestiture _5


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    Capturing growth opportunities and increasing efficiency IBM continually identifies and seizes future high-growth opportunities. Emerging Countries Emerging Business IBM continues to extend its reach into high-growth markets around Transformation Opportunities the world. In 2005, excluding PCs, the company grew in: • Business Performance Transformation Services: an estimated $500 billion market for transforming operations such as Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . 29% supply chain management, engineering and design services, China . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9% human resource management and customer care. IBM’s BPTS revenue was $4 billion in 2005, up 28 percent. India . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59% • Service-Oriented Architecture (SOA): Based on industry stan- dards and Web services software, SOA is an important new Russia . . . . . . . . . . . . . . . . . . . . . . . . . . 29% way for businesses to share and integrate previously fragmented data and business processes. IBM is the leading SOA provider, with nearly 500 certified partners around the world. Emerging Customer Sets Emerging Technology Opportunities • Technology Collaboration Solutions: This new unit consolidates In 2005, excluding PCs, IBM achieved strong growth in such key sectors as: many of IBM’s technology strengths and extends them to clients to accelerate their own product and service R&D. The Engineering & Technology Services unit grew revenue Healthcare . . . . . . . . . . . . . . . . . . . . . . . 20% 39 percent in 2005. Travel & Transportation . . . . . . . . . . . . . 16% • Advanced Microprocessor Technology: IBM’s revenue from advanced semiconductors for consumer electronics, Consumer Products. . . . . . . . . . . . . . . . 11% telecommunications, healthcare and other industries grew Small & Medium-sized Business . . . . . . 6% by 16 percent in 2005, driven by improved manufacturing yields for game processors. IBM is integrating all its capabilities for its clients. Global Integration A Flatter Organization Greater Organizational IBM is integrating its businesses into a IBM is pushing decision-making closer Efficiency single global system — increasing flexibility, to the client, and lowering the company’s The steps described here have improved creating a more complete view of opera- “center of gravity.” IBM’s cost structure and organizational tions and identifying new sources of talent • Sales support centers: Piloted success- efficiency. and skills. This system features: fully in Europe, these “deal hubs” help • Reduced costs: Areas such as procure- • Global delivery centers: The company sales teams by coordinating technical ment, hardware, IT equipment and shifted more than 18,000 employees into support, pricing, legal and quality connectivity have contributed to the these in 2005. assurance. In 2006 the company will overall margin improvement and enabled • Globally integrated manufacturing: deploy deal hubs in Asia/Pacific and greater competitiveness in key markets. Nine plants have been integrated into a North and South America. IBM is applying these supply chain single flexible network capable of sharing • Restructured operations in Europe: IBM principles to its services business. workloads across clients, products moved most client-facing leaders closer • Decreased inventory: Inventory levels and geographies. to their customers in 2005. were reduced by more than $250 million • Globally integrated corporate functions: • New lead-management process: The in 2005, adjusted for the sale of the These include legal, human resources, On Target system — which generated PC business. finance, information technology and more than $100 million in incremental • Speedier procurement: Over the past real estate site operations. revenue as a limited pilot in 2005 — decade the time to process a purchase • Global skills marketplace: IBM’s helps sellers identify and prioritize order has decreased from one month Professional Marketplace system lets potential clients. It will be expanded to to a few hours. IBM consulting partners manage 15 countries in 2006. skills globally. It indexes the skills of 68,000 professionals worldwide. 6_ Chairman’s Letter


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    we apply our technology prowess and economies of necessary as never before, for companies that hope scale to running and transforming business processes to remain competitive. After decades of new tech- for our clients — from supply chain, to human nology invention, we are entering a phase familiar resources, to logistics and more. Our BPTS revenue to economic historians who study technological increased 28 percent in 2005, to $4 billion. We have revolutions. This is when new technologies get more than tripled our resources focused on BPTS infused into every aspect of business and society. since early 2004. Several of our 16 acquisitions And this is when lasting value is created and real in 2005 were aimed at strengthening our BPTS money gets made. Increasingly today, it’s playing capabilities in such areas as healthcare, the order- out on a global stage — and that, in turn, is driving to-cash cycle and “applications on demand” for a new model of the corporation itself. We’re small and medium businesses. We’re increasing shifting away from the 20th century multinational investments in engineering collaboration. And and toward a new way to integrate the components we recently created a new unit to consolidate and of business activity on a global basis. We call this accelerate our efforts in business transformation the “globally integrated enterprise.” outsourcing, including a promising opportunity to deliver more standardized business processing Those who succeed in this new era will seize upon services, mainly to smaller enterprises. innovation and integration to differentiate themselves from their rivals — including the new ones that will Integrate to Innovate arise continually from all corners of an increasingly Each of our three major businesses is a multi-faceted interconnected planet. leader in its own right. But they are not standalone We’ve been talking for several years about the entities. They work together in a model defined by bifurcation of our industry and the fundamental integration and innovation — the imperatives that we choice that companies in IT have to make between believe are increasingly shaping business and society two radically different business models. One of those in the 21st century. This ability to integrate and is to compete on low price in rapidly commoditizing innovate is unique to IBM, and sets us apart from segments. These types of businesses focus on revenue our competition. growth, but their models, based on commodity products and services, inherently do not produce • Innovation is increasingly what businesses and superior profit margins. The other is to compete institutions of all kinds seek, in response to by creating unique, differentiating value through a “flattening” world of ever-more intense and global innovation. As you know, we have chosen to be competition. That sounds simple enough — but the provider of high-value, innovative solutions. it’s not just about building a “better mousetrap.” But candidly, we were not well positioned to be a The kind of innovation companies need today goes high-value leader as recently as a few years ago. beyond products or services, involving all aspects We were weighed down by commoditizing business of the enterprise — from business processes and lines with eroding profit margins. models to management systems, culture and policies. Today, we have succeeded in moving almost entirely Accomplishing this kind of systemic innovation out of commoditizing areas. In addition, we have requires a unique blend of business and technology, shifted our transaction mix more toward higher value and a deep understanding of the new tools, tech- solutions and away from individual product sales. In niques and capabilities that have come of age today. large measure as a result of those changes, our gross • Integration of technology with business design is profit margin is the best it’s been since 1996, and the now possible as never before — and therefore is company is much better balanced in terms of profit _7


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    contribution. When you exclude second-quarter To that end, we have prepared a companion restructuring charges and PCs, about 37 percent of document to this annual report, describing some of our profit last year was from software, including the powerful tools, techniques and new models that enterprise investments; about 28 percent from systems are available and affordable for innovators today. and financing; and about 35 percent from services. It’s a Great Time To Be an Innovator also contains the stories of IBM clients who are using these new An Innovation Company capabilities to enhance their own unique strengths If you understand the broad economic and societal and thus achieve differentiation and competitive changes taking place, the transformation of our advantage. I think you’ll find it informative, and I company to capitalize on them and the resulting mix hope it stimulates ideas about how your own organi- of our business, it should be apparent that IBM in zation or community could benefit from the new 2006 is neither a “computer company” nor a “services possibilities for innovation. company.” We are not even “an IT company.” IBM today, perhaps more than any time in our history, is An Integrated Company an innovation company. We have a distinctive point For IBM, the key to capturing all this value we’re of view on how innovation is changing, and creating through innovation is to integrate it for our a unique set of capabilities to enable our clients clients. Operationally, that raises two key questions: to capture its benefits. In a word, we are their Where is it best for that integration to occur, and innovation partner. We make them innovative — around what? the innovators’ innovator, if you will. I believe the right place to integrate IBM is close You’d never see this, though, if you only looked to the action — which is why we’ve been working through the lens of the IT industry’s traditional hard to “lower the center of gravity” of our company. segmentation: hardware, software, services and their Starting in Europe, for instance, we implemented many product-specific subsets. Further, that view a new management system in 2005 that flattened doesn’t just obscure the picture of IBM; it also distorts the organizational structure and moved more client- the reality of how technology is acquired and used facing leaders out into local markets — the biggest by businesses today. Companies, governmental such change there in nearly half a century. It used agencies, educational and healthcare organizations to be that 44 percent of executives were in head- and other enterprises and institutions everywhere quarters offices; now, 84 percent of them are working are faced with opportunities and threats, and in in-country. In addition, we have tripled the number response they need to innovate. That’s the industry of people working in or serving emerging markets we are part of, and those are the marketplace realities such as China, India, Brazil and Russia — where everyone in it needs to address. together our business grew 23 percent last year, For IBMers, this deeper notion of innovation is excluding PCs. what we mean when we talk about “innovation that At the same time, we have shifted pricing authority matters”— one of three core values we collectively down to the country level. We also created “deal defined for our company three years ago in one of hubs” to give our teams a single point of contact our all-company jams. IBMers around the world are for sales support and other client services. They’ve tremendously excited about the possibilities being been an immediate success. Win rates are up unlocked by this broad and ambitious notion of across the board — with double-digit increases in the innovation. And we’re eager to share our point of countries of Europe where we piloted the hubs. We view with clients, partners and our thousands of will roll out new deal hubs in the Americas, Asia, collaborators across business, government, education Australia and additional parts of Europe in the and every area of society. first half of this year. 8_ Chairman’s Letter


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    When it comes to the second question — on what trajectory, because we’re at the forefront of creating basis are we integrating? — the answer lies in our both. We are rapidly becoming a model of global core values. For the IBMers who shaped these values, integration — leveraging economies of scale and they are much more than vague aspirations. They expertise for the benefit of our clients and our own are, in fact, a set of decision-making criteria that operational effectiveness. And while many companies guide how we organize and run the company. consult or offer piece-part technologies and services, A little more than a year ago, tens of thousands of we are distinct in our ability to integrate the right IBMers came together to turn our values into technologies, expertise and partnerships in ways dozens of specific actions and changes — many of that enable our clients to be truly special. which we implemented in 2005. I’ve described some “Innovation that matters” is, finally, central to of them, such as the deal hubs, in this letter. IBM’s identity — to why our employees choose us; These steps to transform our company were why our partners and clients look to collaborate crucial, and that work will never stop. But being a with us; and why you, our owners, invest in us. And values-managed company applies at the top, as well. interestingly, this same vision is showing up more That’s why, at the beginning of this year, I decided and more these days among companies, governments, to disband the senior leadership structure that had educators, healthcare practitioners and communities been in place in IBM for more than a decade, around the world. and to replace it with one based on simpler, clearer For IBM, this is gratifying, and hopeful. As we criteria for our top positions. enter a promising new era, I am proud of the world- First, we formed a new group of IBM’s senior- wide IBM team for bringing us to this point — and most leaders who will be accountable for the I am grateful to you, our shareholders, for your performance and execution of our business. Second, support as we have repositioned the company to be we created a broader group that will focus specifically the innovation leader. I and my colleagues are on integrating IBM on the basis of our values. Both delighted and challenged by the prospect of advancing groups met for the first time about a month ago this work, and by what, together with our clients, to discuss how to bring to bear all of IBM’s capability our partners and you, we can do to lead it. to drive marketplace results. I know from the team’s energy and commitment that this move was the right thing to do. Innovation that Matters These days, you’d have to look long and hard to Samuel J. Palmisano find a company that doesn’t say it is committed to Chairman, President and Chief Executive Officer innovation. But innovation of the sort I’ve discussed here — the kind that’s grounded in the integration of business and technology, that draws on multi-faceted collaboration and that functions in a truly global way — is devilishly hard. For all the reasons I’ve shared with you in this letter, I believe that IBM has an unmatched ability to deliver this sort of innovation. We are the only company that couples broad expertise across The selected references in this letter to the company’s financial results: (1) excluding the effects of industries and business processes with deep technol- the divestiture of the company’s PC business, (2) excluding non-recurring items, (3) excluding the Global Financing Business and (4) at constant currency are non-GAAP financial measures and are ogy capability. We have a unique understanding made to facilitate a comparative view of the company's ongoing operational performance. See the company’s Form 8-K dated January 17, 2006, Attachments II and III, for additional information on of information technology’s potential and future the use of these non-GAAP financial measures. _9


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    Financial Highlights (Dollars in millions except per share amounts) FOR THE YEAR 2005 2004 Revenue $«««91,134 $«««96,293 Income from continuing operations $«««««7,994 $«««««7,497 Loss from discontinued operations (24) (18) Income before cumulative effect of change in accounting principle 7,970 7,479 Cumulative effect of change in accounting principle** (36) — Net income $«««««7,934 $«««««7,479 Earnings/(loss) per share of common stock: Assuming dilution: Continuing operations $«««««««4.91 $«««««««4.39 Discontinued operations (0.01) (0.01) Before cumulative effect of change in accounting principle 4.90 4.38 Cumulative effect of change in accounting principle** (0.02) — Total $«««««««4.87* $«««««««4.38 Basic: Continuing operations $«««««««4.99 $«««««««4.48 Discontinued operations (0.02) (0.01) Before cumulative effect of change in accounting principle 4.98* 4.47 Cumulative effect of change in accounting principle** (0.02) — Total $«««««««4.96 $«««««««4.47 Net cash provided by operating activities from continuing operations $«««14,914 $«««15,349 Capital expenditures, net 3,527 3,745 Share repurchase 7,739 7,145 Cash dividends paid on common stock 1,250 1,174 Per share of common stock 0.78 0.70 AT YEAR END 2005 2004 Cash, cash equivalents and marketable securities $«««13,686 $«««10,570 Total assets 105,748 111,003 Working capital 10,509 7,357 Total debt 22,641 22,927 Stockholders’ equity 33,098 31,688 Common shares outstanding (in millions) 1,574 1,646 Market capitalization $«129,381 $«162,223 Stock price per common share $«««««82.20 $«««««98.58 Number of employees in IBM/wholly owned subsidiaries 329,373 329,001 * Does not total due to rounding. ** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information. 10_


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    Report of Financials INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Report of Management 12 Notes to Consolidated Financial Statements Report of Independent Registered A Significant Accounting Policies 54 Public Accounting Firm 13 B Accounting Changes 61 C Acquisitions/Divestitures 63 Management Discussion D Financial Instruments (excluding derivatives) 67 Road Map 14 E Inventories 68 Forward-Looking and Cautionary Statements 15 F Financing Receivables 68 Management Discussion Snapshot 15 G Plant, Rental Machines and Other Property 68 Description of Business 17 H Investments and Sundry Assets 68 Year in Review 22 I Intangible Assets Including Goodwill 68 Prior Year in Review 34 J Securitization of Receivables 70 Looking Forward 36 K Borrowings 70 Employees and Related Workforce 43 L Derivatives and Hedging Transactions 71 Global Financing 43 M Other Liabilities 74 N Stockholders’ Equity Activity 75 Consolidated Financial Statements O Contingencies and Commitments 76 Earnings 48 P Taxes 79 Financial Position 49 Q Research, Development and Engineering 80 Cash Flows 50 R 2005 Actions 80 Stockholders’ Equity 51 S Earnings Per Share of Common Stock 82 T Rental Expense and Lease Commitments 83 U Stock-Based Compensation 83 V Retirement-Related Benefits 85 W Segment Information 95 X Subsequent Events 100 Five-Year Comparison of Selected Financial Data 101 Selected Quarterly Data 102 Board of Directors and Senior Executive Officers 103 Stockholder Information 104 _11


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    Report of Management INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Management Responsibility for The company’s internal control over financial reporting Financial Information includes those policies and procedures that (i) pertain to the Responsibility for the integrity and objectivity of the financial maintenance of records that, in reasonable detail, accurately information presented in this Annual Report rests with IBM man- and fairly reflect the transactions and dispositions of the assets agement. The accompanying financial statements have been of the company; (ii) provide reasonable assurance that transac- prepared in accordance with accounting principles generally tions are recorded as necessary to permit preparation of financial accepted in the United States of America, applying certain esti- statements in accordance with accounting principles generally mates and judgments as required. accepted in the United States of America, and that receipts and IBM maintains an effective internal control structure. It con- expenditures of the company are being made only in accordance sists, in part, of organizational arrangements with clearly defined with authorizations of management and directors of the company; lines of responsibility and delegation of authority, and compre- and (iii) provide reasonable assurance regarding prevention or hensive systems and control procedures. An important element timely detection of unauthorized acquisition, use, or disposition of of the control environment is an ongoing internal audit program. the company’s assets that could have a material effect on the Our system also contains self-monitoring mechanisms, and financial statements. actions are taken to correct deficiencies as they are identified. Because of its inherent limitations, internal control over To assure the effective administration of internal controls, financial reporting may not prevent or detect misstatements. we carefully select and train our employees, develop and dis- Also, projections of any evaluation of effectiveness to future peri- seminate written policies and procedures, provide appropriate ods are subject to the risk that controls may become inadequate communication channels, and foster an environment conducive because of changes in conditions, or that the degree of compli- to the effective functioning of controls. We believe that it is ance with the policies or procedures may deteriorate. essential for the company to conduct its business affairs in Management conducted an evaluation of the effectiveness accordance with the highest ethical standards, as set forth in the of internal control over financial reporting based on the frame- IBM Business Conduct Guidelines. These guidelines, translated work in Internal Control—Integrated Framework issued by the into numerous languages, are distributed to employees through- Committee of Sponsoring Organizations of the Treadway out the world, and reemphasized through internal programs to Commission (COSO). Based on this evaluation, management assure that they are understood and followed. concluded that the company’s internal control over financial PricewaterhouseCoopers LLP, an independent registered reporting was effective as of December 31, 2005. Management’s public accounting firm, is retained to audit IBM’s Consolidated assessment of the effectiveness of the company’s internal con- Financial Statements and management’s assessment of the trol over financial reporting as of December 31, 2005 has been effectiveness of the internal control over financial reporting. Its audited by PricewaterhouseCoopers LLP, an independent reg- accompanying report is based on audits conducted in accor- istered public accounting firm, as stated in their report which is dance with the standards of the Public Company Accounting included herein. Oversight Board (United States). 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 SAMUEL J. PALMISANO year, subject to stockholder ratification. The Audit Committee Chairman of the Board, meets periodically and privately with the independent registered President and Chief Executive Officer public accounting firm, with the company’s internal auditors, as February 28, 2006 well as with IBM management, to review accounting, auditing, internal control structure and financial reporting matters. Management’s Report on Internal Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting of the company. MARK LOUGHRIDGE Internal control over financial reporting is a process designed to Senior Vice President, provide reasonable assurance regarding the reliability of finan- Chief Financial Officer cial reporting and the preparation of financial statements for February 28, 2006 external purposes in accordance with accounting principles generally accepted in the United States of America. 12_ Report of Management


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    Report of Independent Registered Public Accounting Firm INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF Control-Integrated Framework issued by the Committee of INTERNATIONAL BUSINESS MACHINES CORPORATION : Sponsoring Organizations of the Treadway Commission We have completed integrated audits of International Business (COSO), is fairly stated, in all material respects, based on those Machines Corporation’s 2005 and 2004 Consolidated Financial criteria. Furthermore, in our opinion, the Company maintained, Statements and of its internal control over financial reporting as in all material respects, effective internal control over financial of December 31, 2005 and an audit of its 2003 Consolidated reporting as of December 31, 2005, based on criteria estab- Financial Statements in accordance with the standards of the lished in Internal Control-Integrated Framework issued by the Public Company Accounting Oversight Board (United States). COSO. The Company’s management is responsible for main- Our opinions, based on our audits and the report of other audi- taining effective internal control over financial reporting and for tors, are presented below. its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on Consolidated Financial Statements management’s assessment and on the effectiveness of the In our opinion, based on our audits and the report of other audi- Company’s internal control over financial reporting based on our tors, the accompanying Consolidated Financial Statements audit. We conducted our audit of internal control over financial appearing on pages 48 through 100 present fairly, in all material reporting in accordance with the standards of the Public respects, the financial position of International Business Company Accounting Oversight Board (United States). Those Machines Corporation and its subsidiary companies at standards require that we plan and perform the audit to obtain December 31, 2005 and 2004, and the results of their operations reasonable assurance about whether effective internal control and their cash flows for each of the three years in the period over financial reporting was maintained in all material respects. ended December 31, 2005 in conformity with accounting princi- An audit of internal control over financial reporting includes ples generally accepted in the United States of America. These obtaining an understanding of internal control over financial financial statements are the responsibility of the Company’s man- reporting, evaluating management’s assessment, testing and agement. Our responsibility is to express an opinion on these evaluating the design and operating effectiveness of internal financial statements based on our audits. We did not audit the control, and performing such other procedures as we consider financial statements of the Company’s Business Consulting necessary in the circumstances. We believe that our audit pro- Services Reporting Unit (which includes the consulting practice vides a reasonable basis for our opinions. acquired from us) for the years ended December 31, 2004 and A company’s internal control over financial reporting is a 2003, which statements reflect total revenues of 14.3 percent and process designed to provide reasonable assurance regarding the 14.5 percent of the related consolidated totals in the years ended reliability of financial reporting and the preparation of financial December 31, 2004 and 2003, respectively. Those statements statements for external purposes in accordance with generally were audited by other auditors whose report thereon has been accepted accounting principles. A company’s internal control furnished to us, and our opinion expressed herein, insofar as it over financial reporting includes those policies and procedures relates to the amounts included for the Company’s Business that (i) pertain to the maintenance of records that, in reasonable Consulting Services Reporting Unit, is based solely on the report detail, accurately and fairly reflect the transactions and disposi- of the other auditors. We conducted our audits of these state- tions of the assets of the company; (ii) provide reasonable assur- ments in accordance with the standards of the Public Company ance that transactions are recorded as necessary to permit Accounting Oversight Board (United States). Those standards preparation of financial statements in accordance with generally require that we plan and perform the audit to obtain reasonable accepted accounting principles, and that receipts and expendi- assurance about whether the financial statements are free of tures of the company are being made only in accordance with material misstatement. An audit of financial statements includes authorizations of management and directors of the company; examining, on a test basis, evidence supporting the amounts and (iii) provide reasonable assurance regarding prevention or and disclosures in the financial statements, assessing the timely detection of unauthorized acquisition, use, or disposition accounting principles used and significant estimates made by of the company’s assets that could have a material effect on the management, and evaluating the overall financial statement financial statements. presentation. We believe that our audits and the report of other Because of its inherent limitations, internal control over finan- auditors provide a reasonable basis for our opinion. cial reporting may not prevent or detect misstatements. Also, As discussed in notes A and U to the financial statements, projections of any evaluation of effectiveness to future periods the Company changed the manner in which it accounts for are subject to the risk that controls may become inadequate stock-based awards exchanged for employee services as of because of changes in conditions, or that the degree of compli- January 1, 2005. ance with the policies or procedures may deteriorate. Internal Control Over Financial Reporting Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over PRICEWATERHOUSECOOPERS LLP Financial Reporting appearing on page 12, that the Company maintained effective internal control over financial reporting as New York, New York of December 31, 2005 based on criteria established in Internal February 28, 2006 _13


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Road Map across its portfolio to create solution offerings for its global client-base, driving profit and cash growth over the long term. The financial section of the International Business Machines Corporation (IBM and/or the company) 2005 Annual Report, Transparency consisting of this Management Discussion, the Consolidated Transparency is a primary goal of successful financial reporting. Financial Statements that follow and the notes related thereto, The following are the key elements you will find in this year’s comprises 89 pages of information. This Road Map is designed Annual Report. to provide you with some perspective regarding the information • The company, in accordance with Section 404 of the contained in the financial section. Sarbanes-Oxley Act of 2002, conducted an evaluation of its internal control over financial reporting and concluded that IBM’s Business Model the internal control over financial reporting was effective as The company’s business model is built to support two principal of December 31, 2005. goals: helping clients succeed in delivering business value by becoming more efficient and competitive through the use of • The Management Discussion is designed to provide readers business insight and information technology (IT) solutions; and with a view of the company’s results and certain factors that providing long-term value to shareholders. In support of these may affect future prospects from the perspective of the com- objectives, the business model has been developed over time pany’s management. Within the “Management Discussion through strategic investments in services and technologies that Snapshot,” on pages 15 to 17 the key messages and details have the best long-term growth and profitability prospects will give readers the ability to quickly assess the most impor- based on the value they deliver to clients. In addition, the com- tant drivers of performance within this brief overview. pany is committed to its employees and the communities in • The Management Discussion reflects the company’s continued which it operates. and improving strength in providing client- and industry-spe- The model is designed to allow for flexibility and periodic cific solutions utilizing the broad capabilities of its portfolio. rebalancing. In 2005, 16 acquisitions were completed, primarily The sections on “Description of the Business” on page 17, in software and services, at an aggregate cost of approximately “Results of Continuing Operations” on page 22, “Financial $2 billion, and the company completed the sale of its Personal Position” on page 30, and “Looking Forward” on page 36, Computing business to Lenovo Group Limited (Lenovo). are all written from the perspective of the consolidated entity. The company’s portfolio of capabilities ranges from services Detailed analysis for each of the company’s segments is also that include Business Performance Transformation Services to included and appears on pages 27 to 30. software, hardware, fundamental research, financing and the • Global Financing is a business segment within the company component technologies used to build larger systems. These that is measured as if it were a standalone entity. A separate capabilities are combined to provide business insight and solu- “Global Financing” section beginning on page 43 is not tions in the enterprise computing space. included in the consolidated perspective that is referred to In terms of financial performance, the company has contin- above. This section is separately presented given this seg- ued to focus on its participation in the high-growth, high-profit ment’s unique impact on the company’s financial condition segments of the IT industry that will enable the company to and leverage. deliver consistently strong earnings, high returns on invested • The company divested its Personal Computing business capital and excellent cash flows. The company’s business to Lenovo on April 30, 2005. The details of this significant model is based on a balanced portfolio of services, systems and transaction are discussed in note C, “Acquisitions/ technology and software maintaining a broad range of capabili- Divestitures,” on pages 66 and 67. As a result of this divesti- ties that will allow the company to compete effectively and grow ture, the company’s reported financial results include four in key markets even during changing economic environments. months of activity for the Personal Computing business in This strategy results in less volatile returns overall, as the portfo- 2005 as compared to 12 months in 2004. This lack of compa- lio has an effective segmentation of businesses that drive trans- rable periods has a material impact on the company’s actional revenue and profits, as well as businesses that drive reported revenue results. Therefore, in the Management annuity-based revenue and profits. The strength of the business Discussion, within the “Year in Review” section on pages 22 model is not any single component—it is the company’s ability to to 25, the company has presented an analysis of revenue generate consistent financial performance with balanced contri- both on an as-reported basis and on a basis that excludes butions across the portfolio. the revenues from the divested Personal Computing business In terms of marketplace performance—i.e., the ability to from both the 2005 and 2004 periods. The company believes deliver client value — it is important to understand that the funda- that the analysis that excludes the Personal Computing mental strength of this business model is not found in the breadth revenues is a better indicator of the company’s operational of the portfolio alone, but in the way the company creates busi- revenue performance in 2005 as compared to 2004. ness solutions from among its capabilities and relationships. Strategically, the company has exited commoditized busi- • The selected reference to constant currency in the nesses, increased its concentration in higher-value businesses Management Discussion is made so that the financial and created a more balanced portfolio. The company integrates results can be viewed without the impacts of changing 14_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES foreign currency exchange rates and therefore facilitates a Forward-Looking and Cautionary Statements comparative view of business growth. The percentages Certain statements contained in this Annual Report may consti- reported in the financial tables throughout the Management tute forward-looking statements within the meaning of the Private Discussion are calculated from the underlying whole-dollar Securities Litigation Reform Act of 1995. These statements numbers. See “Currency Rate Fluctuations” on page 42 for involve a number of risks, uncertainties and other factors that additional information. could cause actual results to be materially different, as dis- Helpful Hints cussed more fully elsewhere in this Annual Report and in the ORGANIZATION OF INFORMATION company’s filings with the SEC, including the company’s 2005 • This Management Discussion section provides the reader of Form 10-K filed on February 28, 2006. the financial statements with a narrative on the company’s financial results. It contains the results of operations for each segment of the business, followed by a description of the Management Discussion Snapshot company’s financial position, as well as certain employee (Dollars and shares in millions except per share amounts) data. It is useful to read the Management Discussion in con- YR. TO YR. PERCENT/ junction with note W, “Segment Information,” on pages 95 MARGIN through 99. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE • Pages 48 through 53 include the Consolidated Financial Revenue $««91,134 $««96,293 (5.4) % * Statements. These statements provide an overview of the Gross profit margin «40.1% «36.9% 3.2 pts. company’s income and cash flow performance and its finan- Total expense and cial position. other income $««24,306 $««24,900 (2.4) % • The notes follow the Consolidated Financial Statements. Total expense and other Among other things, the notes contain the company’s income to revenue ratio «26.7% «25.9% 0.8 pts. accounting policies (pages 54 to 61), detailed information on Income from continuing specific items within the financial statements, certain contin- operations before gencies and commitments (pages 76 through 78), and the income taxes $««12,226 $««10,669 14.6% results of each IBM segment (pages 95 through 99). Provision for income taxes $««««4,232 $««««3,172 33.4% Income from continuing 2004 Annual Report operations $««««7,994 $««««7,497 6.6% Effective January 1, 2005, the company adopted the provisions of Earnings per share of Statement of Financial Accounting Standards (SFAS) No. 123(R), common stock: “Share-Based Payment,” (“SFAS 123(R)”). The company elected Assuming dilution: to adopt the modified retrospective application method provided Continuing operations $««««««4.91 $««««««4.39 11.8% by SFAS 123(R). This method permits the restatement of historical Discontinued operations «(0.01) (0.01) 45.0% financial statement amounts. See note A, “Significant Accounting Cumulative effect Policies,” on pages 58 and 59 and note U, “Stock-Based of change in Compensation,” on pages 83 to 85 for additional information. accounting principle++ «(0.02) «— NM In addition, as a result of the divestiture of the Personal Total $««««««4.87 + $««««««4.38 11.2% Computing business in 2005, the company revised its operating segments in the second quarter. See note W, “Segment Weighted-average shares Information,” on page 95 for additional information. Accordingly, outstanding: as a result of these actions, the company filed a restated 2004 Diluted «1,627.6 «1,707.2 (4.7) % Annual Report with the Securities and Exchange Commission Assets** «$105,748 «$111,003 (4.7) % (SEC) on Form 8-K on July 27, 2005. Liabilities** «$««72,650 «$««79,315 (8.4) % Equity** «$««33,098 «$««31,688 4.4% Discontinued Operations * (5.8) percent adjusted for currency. On December 31, 2002, the company sold its hard disk drive ** At December 31 (HDD) business to Hitachi, Ltd. (Hitachi). The HDD business + Does not total due to rounding. was accounted for as a discontinued operation under generally ++Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting accepted accounting principles (GAAP) which requires that the Changes,” on pages 61 and 62 for additional information. income statement and cash flow information be reformatted to NM—Not Meaningful separate the divested business from the company’s continuing operations. See page 36 for additional information. Continuing Operations In 2005, the company delivered solid growth in earnings and cash generation—balanced across its portfolio—and executed a series of actions to improve productivity and to reallocate resources to the faster growing areas of the business. _15


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The company’s reported results include the Personal • Repatriation of $9.5 billion of foreign earnings under the Computing business for four months in 2005 versus 12 months American Jobs Creation Act of 2004 improving the com- in 2004. pany’s geographic liquidity position Total revenue, as reported, declined 5.4 percent versus • Further extension of the company’s commitment to innova- 2004; excluding the Personal Computing business external rev- tion and open standards enue from both years, total revenue increased 3.2 percent (2.8 percent adjusted for currency). Pre-tax income from continuing The consolidated gross profit margin increased 3.2 points operations grew 14.6 percent, while diluted earnings per share to 40.1 percent versus 2004. An improvement in the Hardware from continuing operations increased 11.8 percent compared to margin (5.6 points) contributed 1.9 points to the overall margin 2004. Net cash provided by operating activities was $14,914 mil- improvement. This increase was primarily driven by the sale of lion. The company’s financial performance in 2005 was driven the company’s Personal Computing business in the second by a combination of segment performance, portfolio actions and quarter of 2005. In addition, the Global Services margin execution of the company’s productivity initiatives. improved 1.7 points versus 2004 to 25.9 percent. This increase The increase in revenue, excluding the Personal Computing was driven by several factors: the restructuring actions taken in business, in 2005 as compared to 2004 was primarily due to: the second quarter of 2005 to improve cost competitiveness; improved utilization levels; and a better overall contract profile. • Improving demand in the hardware business driven The Software margin increased slightly and the Enterprise by pSeries and xSeries server products, as well as Investments/Other margin improved 6.3 points in 2005 to 46.5 Storage products, Microelectronics and Engineering and percent, but these increases only slightly improved the overall Technology Services company margin. The Global Financing margin declined 5.2 • Improved demand in the software business, driven by key points versus 2004 to 54.7 percent primarily driven by a mix branded middleware products towards lower margin remarketing sales and increased interest • Continued growth in emerging countries (up 23 percent) cost. This decline had an immaterial impact on the company’s and in Business Performance Transformation Services (up overall margin due to the size of the segment. 28 percent) Total expense and other income declined 2.4 percent in 2005 versus 2004. The decline was primarily due to the gain The increase in income from continuing operations in 2005 associated with the sale of the company’s Personal Computing as compared to 2004 was primarily due to: business, a gain from a legal settlement with Microsoft, partially • Moderate revenue growth in the Hardware and Software seg- offset by the incremental restructuring charges recorded in the ments as discussed above second quarter. Overall, retirement-related plan costs increased $993 million • Execution of the company’s restructuring and productivity versus 2004, impacting both gross margin and expense. See initiatives, primarily focused on Global Services note V, “Retirement-Related Benefits” on pages 85 to 95 and • Improved demand and continued operational improvement “Retirement-Related Benefits” on page 27 for additional informa- in the Microelectronics business tion. In addition, stock-based compensation expense decreased In addition to improved earnings, in 2005, the company exe- $543 million versus 2004, impacting both gross margin and cuted a series of important actions that benefited the company’s expense. See “Stock-Based Compensation,” on pages 26 and performance in the current year and strengthened its capabili- 27 for additional information. ties going forward. These actions included: The provision for income taxes resulted in an effective tax rate of 34.6 percent for 2005, compared with the 2004 effective • Completion of the divestiture of the Personal Computing tax rate of 29.7 percent. The 4.9 point increase in the effective business to Lenovo tax rate in 2005 was primarily due to the third-quarter tax charge • Continuation of investment in acquisitions to strengthen the associated with the repatriation under the American Jobs company’s on demand capabilities; in 2005, the company Creation Act of 2004. See note P, “Taxes,” on page 80 for addi- completed 16 acquisitions at a cost of approximately $2 billion tional information concerning this repatriation tax charge. • Implementation of a large restructuring action to improve the With regard to the decrease in total Assets, the impact of company’s cost competitiveness currency was approximately $5.7 billion. Other asset changes primarily consisted of an increase in Cash and cash equivalents, • Change of the company’s operating model in Europe—shift- an increase in Goodwill associated with 2005 acquisitions and ing resources and decision-making closer to the clients increased Prepaid pension assets. These increases were par- • Redesign of the company’s U.S. pension plan, as well as tak- tially offset by lower financing receivables and lower deferred ing actions in other countries; over the longer term, these tax assets. actions will reduce volatility and provide a more competitive The decrease in total Liabilities was primarily driven by the cost structure impact of currency, approximately $4.1 billion. In addition, 16_ Management Discussion


  • Page 18

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Accounts payable declined approximately $1.1 billion due to the focusing on high-value innovation-based solutions and services divestiture of the Personal Computing business. Total debt of while consistently generating high returns on invested capital for $22.6 billion decreased $0.3 billion versus 2004. its shareholders. The company utilizes its entire portfolio—hard- Global Services signings were $47 billion in 2005 as com- ware, software, services, technology and research—to maintain pared to $43 billion in 2004. The Global Services backlog is esti- its leadership. With those broad capabilities to enable enterprise mated to be $111 billion at December 31, 2005, flat versus innovation, the expertise and diversity of its global workforce December 31, 2004. For additional information, see “Global and its large network of suppliers and business partners, IBM Services Signings” on page 28. considers itself well-positioned to capitalize on the opportunities For additional information, see the “Year in Review” section represented by the needs of its clients and current trends in on pages 22 through 33. economics and society. IBM believes these trends will have Looking forward, the company’s longer-term financial major effects on business, government, education, healthcare, model targets double-digit earnings per share growth through a transportation and most other fields of endeavor. These develop- combination of revenue growth, productivity-driven margin ments include, in part: the globalization of capabilities, skills, improvement and effective capital deployment for acquisitions and markets; the increasingly interconnected nature of compa- and returns to shareholders through dividends and common nies, industries and even economies; the growing influence of stock repurchases. The company’s ability to meet these objec- open-standards and open-source software; the rise in collabo- tives depends on a number of factors, including those outlined rative models of creation and development; the maturation and on page 21 and on pages 76 to 78. availability of semiconductor and wireless chip technology; the use of service-oriented architectures and Web services in soft- ware development; the growing number of service providers for Description of Business a wider range of traditional and emerging business processes Please refer to IBM’s Annual Report on Form 10-K filed on February and functions; and the advances made by IBM and others in 28, 2006, with the SEC for a more detailed version of this increasing computational speed, capacity and access. Description of Business, especially Item 1A entitled “Risk Factors.” To capitalize on the opportunities presented by these and IBM is an innovation company, serving the needs of enter- other developments, and to avoid commoditization of its portfo- prises and institutions worldwide. IBM seeks to deliver clients lio, IBM regularly reviews its businesses and invests in those that success by enabling their own capacity to innovate, so that they represent strategic growth opportunities, reallocating resources may differentiate their organizations to create a unique compet- as needed; it acquires businesses that contribute strategically itive advantage. to its portfolio; it exits or divests itself of businesses that no To help its clients achieve growth, productivity, efficiency, longer support its strategy for innovation and higher value; and and the realization of greater value through innovation, IBM it seeks to improve productivity and drive efficiencies by inte- draws upon the world’s leading systems, software and services grating its global operations. capabilities to turn enterprises of all sizes, in every major indus- IBM’s strategic priorities for 2006 include: try, into on demand businesses. An on demand business is an enterprise that is integrated end-to-end, and, with its business • Capitalizing on technological, business and social trends and ecosystems of partners, suppliers and clients, is able to manage the need of enterprises to innovate in addressing those trends; that extended network dynamically to address new opportuni- • Maintaining market-share leadership in systems, middle- ties, respond to changes in demand or threats to its business, ware software and services, as a platform to drive growth; enhance flexibility, speed execution and ultimately achieve prof- • Focusing investment and resources on emerging growth itable growth. areas, including Business Performance Transformation In IBM’s view, being on demand is the most comprehensive Services and emerging countries; way to enable a company to innovate—and thus differentiate • Continuing the global integration of IBM, driving productivity itself—consistently over time. IBM views enterprise innovation gains and higher value in service delivery; not only in terms of products and services, but across all dimen- sions of a business: its business processes, business model, • Furthering IBM’s leadership in innovation initiatives, including management systems, culture and role in society. advanced semiconductor design and development, collab- orative intellectual capital, business process expertise and IBM’s Strategy integration, and advanced systems for supercomputing IBM’s strategy is to pursue an innovation agenda with its clients, capability—including mainframes and “grid” networks; partners and in other relationships, and to continue refining its • Acquiring businesses that contribute strategically to its port- portfolio to achieve higher value. Through its understanding of folio, and exiting businesses that no longer support its strat- where technology, client requirements and global business are egy for innovation and higher value. headed, the company continually makes strategic decisions to maintain its leadership of this rapidly changing business by _17


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES IBM’s Capabilities RATIONAL SOFTWARE. Integrated tools designed to improve an To execute its strategy, IBM’s business comprises three princi- organization’s software development processes and capabilities. pal business segments: Software for infrastructure management, T IVO L I S O F T WA R E . • Systems and Financing including security, change, configuration, job scheduling, storage capability, performance and availability. • Software • Services WEBSPHERE SOFTWARE. Management of a wide variety of busi- ness processes using open standards to interconnect applica- SYSTEMS AND FINANCING tions, data and operating systems. SYSTEMS: Servers. IBM systems using IBM operating systems (zSeries and SERVICES iSeries), as well as AIX, the IBM UNIX operating system BUSINESS PERFORMANCE TRANSFORMATION SERVICES (BPTS). Helps (pSeries) and the Microsoft Windows operating system clients transform their spending on business processes, namely (xSeries). All servers can also run Linux, a key open source Selling, General and Administrative, and Research and operating system. Development. BPTS requires advanced technology and deep expertise in industry and/or specific functions like human Storage. Data storage products, including disk, tape, optical resources, logistics, payroll, sales, customer services and pro- and storage area networks. curement, to result in holistic improvement for the performance Advanced Foundry. Integrated supply chain services and a full and success of a business, including efficiency of individual suite of semiconductor manufacturing services using either a processes and their combined effort. BPTS solutions are client’s or IBM’s design. delivered to clients by several of the company’s business areas: Business Transformation Outsourcing, Engineering and Application Specific Integrated Circuit (ASICs). Manufacturing of Technology Services, Strategy and Change Consulting and customized semiconductor products for clients. Business Performance Management. (Revenue reported in var- Standard products and custom microprocessors. Semiconductors ious segments.) designed and manufactured primarily based upon IBM’s BUSINESS TRANSFORMATION OUTSOURCING (BTO). Delivers improved PowerPC architecture. business results to clients through the continual strategic Printing Systems. Production print solutions, on demand print- change and the operation and transformation of the client’s related solutions, enterprise workgroup print technologies, print business processes, applications and infrastructure. management software, services and maintenance. ENGINEERING & TECHNOLOGY SERVICES (E&TS). System and com- Retail Store Solutions. Point-of-sale retail checkout systems, soft- ponent design services, strategic outsourcing of clients’ design ware and solutions. teams, and technology and manufacturing consulting services. (Revenue reported as Hardware segment.) FINANCING: BUSINESS CONSULTING SERVICES (BCS). Delivery of value to clients Commercial financing. Short-term inventory and accounts receivable financing to dealers and remarketers of IT products. through consulting services for client relationship manage- (Revenue reported as Global Financing.) ment, financial management, human capital, business strategy and change, and supply-chain management, as well as appli- Client financing. Lease and loan financing to external and inter- cation innovation and the transformation of business processes nal clients for terms generally between two and seven years. and operations. (Revenue reported as Global Financing.) BUSINESS PERFORMANCE MANAGEMENT (BPM). Enables companies Remarketing. The sale and lease of used equipment (primarily to visualize end-to-end processes across business and IT sys- sourced from the conclusion of lease transactions) to new or tems, analyze execution in real time against goals, and make existing clients. (Revenue reported as Global Financing.) adjustments as needed. IBM offers consulting, services and middleware to simulate and monitor business processes, and SOFTWARE provides clients with real-time analysis of the underlying IT DB2 INFORMATION MANAGEMENT SOFTWARE. Advanced database systems carrying out those processes. (Revenue reported as and content management software solutions that enable clients to Software segment.) leverage information on demand. CENTER FOR BUSINESS OPTIMIZATION (CBO). Helps clients continu- LOTUS SOFTWARE. Collaboration and messaging software that ally optimize their business performance by drawing upon mas- allows a company’s employees, clients, vendors and partners to sive amounts of real-time data, advanced analytical methods, engage in real-time and asynchronous communication and business expertise and deep computing power. knowledge management. 18_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES ON DEMAND INNOVATION SERVICES (ODIS). IBM Research scientists applications according to open industry standards. Operating work with BCS consultants to analyze and solve clients’ most systems are the engines that run computers. Approximately 45 intractable business challenges. ODIS offers a number of cross- percent of external Software revenue relates to one-time industry micropractices with deep expertise including mobile charge (OTC) arrangements, whereby the client pays one up- enablement and information mining. front payment for a perpetual license. The remaining annuity- based revenue consists of both maintenance revenue sold STRATEGIC OUTSOURCING SERVICES (SO). Comprehensive IT serv- with OTC arrangements, as well as revenue from software sold ices integrated with business insight working with clients to on a monthly license charge (MLC) arrangement. Typically, reduce costs and improve productivity through the outsourcing arrangements for the sale of OTC software include one year of of processes and operations. maintenance. The client can also purchase ongoing mainte- INTEGRATED TECHNOLOGY SERVICES (ITS). Design, implementation nance after the first year, which includes product upgrades and maintenance of clients’ technology infrastructures. and technical support. APPLICATION MANAGEMENT SERVICES. Application development, GLOBAL FINANCING is described on pages 43 through 47. management, maintenance and support services for packaged ENTERPRISE INVESTMENTS develops and provides industry- software, as well as custom and legacy applications. specific IT solutions supporting the Hardware, Software and e -BUSINESS HOSTING SERVICES. Solutions for the management of Global Services segments of the company. Primary product clients’ Web-based infrastructure and business applications, as lines include product life cycle management software and doc- well as a growing portfolio of industry-specific independent soft- ument processing technologies. Product life cycle management ware vendor (ISV) solutions that are delivered as a service. software primarily serves the Industrial sector and helps clients manage the development and manufacturing of their products. Business Segments Document processor products service the Financial Services Organizationally, the company’s major operations comprise a sector and include products that enable electronic banking. Global Services segment; a Systems and Technology Group; a Software segment; a Global Financing segment; and an IBM Worldwide Organizations Enterprise Investments segment. The following three company-wide organizations play key roles in IBM’s delivery of value to its clients: GLOBAL SERVICES is a critical component of the company’s strategy of providing insight and solutions to clients. While solu- • Sales & Distribution Organization and related sales channels tions often include industry-leading IBM software and hardware, • Research, Development and Intellectual Property other suppliers’ products are also used if a client solution • Integrated Supply Chain requires it. Contracts for IBM services—commonly referred to as “signings”—can range from less than one year to ten years. SALES & DISTRIBUTION ORGANIZATION Businesses generating short-term signings include ITS and the With a comprehensive knowledge of IBM’s business and infra- commercial content of Consulting and Systems Integration structure solutions, as well as the products, technologies and (C&SI). Long-term businesses include SO, BTO, and the federal services IBM and its Business Partners offer, the company’s content of C&SI. global client teams gain a deep understanding of each client’s organizational, infrastructure and industry-specific needs to SYSTEMS AND TECHNOLOGY GROUP provides IBM’s clients determine the best approach for addressing their critical business with business solutions requiring advanced computing power and IT challenges. These professionals work in integrated teams and storage capabilities. Approximately 60 percent of the with IBM consultants and technology representatives, combining Systems and Technology Group’s server and storage sales their deep skills and expertise to deliver high-value solutions that transactions are through business partners; approximately 40 address clients’ pain points and innovational aspirations. percent are direct to end-user clients, more than half of which The majority of IBM’s business, excluding the company’s are through the Web at ibm.com. In addition, the group pro- original equipment manufacturer (OEM) technology business, vides leading semiconductor technology and products, pack- occurs in industries that are broadly grouped into six sectors. aging solutions and engineering technology services to clients The company’s go-to-market strategies and sales and distribu- and for IBM’s own advanced technology needs. While appro- tion activities are organized around these sectors: priately not reported as external revenue, hardware is also deployed to support services solutions. • Financial Services: Banking, Financial Markets, Insurance SOFTWARE consists primarily of middleware and operating sys- • Public: Education, Government, Healthcare and Life Sciences tems software. Middleware software enables clients to integrate • Industrial: Aerospace and Defense, Automotive, Chemical systems, processes and applications across their enterprises. and Petroleum, Electronics Middleware is designed to be the underlying support for appli- cations provided by ISVs, who build industry- or process-specific _19


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES • Distribution: Consumer Products, Retail, Travel, Transportation new technology is not strategic to IBM’s business goals. A third • Communications: Telecommunications, Media and Entertain- group is both used internally and licensed externally. ment, Energy and Utilities In addition to these IP income sources, the company also generates value from its patent portfolio through cross-licensing • Small and Medium Business: Mainly companies with less arrangements and IP licensed in divestiture transactions. The than 1,000 employees value of these other two sources is not readily apparent in the INTERNAL ROUTES-TO-MARKET financial results and Consolidated Statement of Earnings, Services consultants focused on selling end-to-end solutions for because income on cross-licensing arrangements is recorded large, complex business challenges. only to the extent that cash is received. The value received by IBM for IP involving the sale of a business is included in the over- Hardware and software brand specialists S elling IBM products as all gain or loss from the divestiture, not in the separately dis- parts of discrete technology decisions, and focusing on mid- played IP income amounts in financial results and Consolidated sized clients interested in purchasing “turnkey” solutions, such Statement of Earnings. as those in the IBM Express Portfolio. INTEGRATED SUPPLY CHAIN ibm.com provides fast, easy access to IBM’s product and busi- Just as IBM works to transform its clients’ supply chains for ness expertise via the Web and telephone. Identifies business greater efficiency and responsiveness to market conditions, the opportunities for all of IBM’s routes to market and provides company continues to see business value as it establishes its online and telephone sales of standard hardware, software, globally integrated supply chain as an on demand business, services and financing for all size companies. transforming this function into a strategic advantage for the BUSINESS PARTNERS ROUTES-TO-MARKET company and, ultimately, improved delivery and outcomes for Global/major independent software vendors. ISVs deliver business its clients. Leveraging this experience, in June 2005, IBM process or industry-specific applications and, in doing so, often launched its supply-chain business transformation outsourcing influence the sale of IBM hardware, middleware and services. service to optimize and help run clients’ end-to-end supply chain processes, from procurement to logistics. Global/major systems integrators (SIS). SIS identify business IBM spends approximately $38 billion annually through its problems and design solutions when IBM Global services is not supply chain, procuring materials and services around the the preferred systems integrator; they also sell computing infra- world. The company’s supply, manufacturing and logistics and structures from IBM and its competitors. customer fulfillment operations are integrated in one operating Regional ISVs and SIS. SIS identify the business problems, and unit that has reduced inventories, improved response to market- ISVs deliver business process or industry-specific applications place opportunities and external risks and converted fixed to to medium-sized and large businesses requiring IBM computing variable costs. Simplifying and streamlining internal processes infrastructure offerings. has improved operations and sales force productivity and processes and thereby the experiences of the company’s Solutions providers, resellers and distributors. Resellers sell IBM clients when working with IBM. Because some of the cost sav- platforms and value-added services as part of a discrete technol- ings this unit generates are passed along to clients, they will not ogy platform decision to clients wanting third-party assistance. always result in a visible gross margin improvement in the com- RESEARCH , DEVELOPMENT AND INTELLECTUAL PROPERTY pany’s Consolidated Statement of Earnings. While these efforts are largely concerned with product manufacturing and delivery, IBM’s research and development (R&D) operations differentiate IBM is also applying supply-chain principles to service delivery IBM from its competitors. IBM annually spends approximately across its solutions and services lines of business. $5–$6 billion for R&D, including capitalized software costs, focus- In addition to its own manufacturing operations, the com- ing its investments in high-growth opportunities. As a result pany uses a number of contract manufacturing (CM) companies of innovations in these and other areas, IBM was once again around the world to manufacture IBM-designed products. The awarded more U.S. patents in 2005 than any other company. This use of CM companies is intended to generate cost efficiencies marks the 13th year in a row that IBM achieved this distinction. and reduce time-to-market for certain IBM products. Some of In addition to producing world-class hardware and software the company’s relationships with CM companies are exclusive. products, IBM innovations are a major differentiator in providing The company has key relationships with Sanmina-SCI for the solutions for the company’s clients through its growing services manufacture of some Intel-based products and with Solectron activities. The company’s investments in R&D also result in intel- for a significant portion of the manufacturing operations of lectual property (IP) income. Some of IBM’s technological break- throughs are used exclusively in IBM products, while others are used by the company’s licensees for their products when that 20_ Management Discussion


  • Page 22

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Global Asset Recovery Services—an operation of Global clients differentiate themselves for competitive advantage, IBM Financing that restores end-of-lease personal computers and has been moving away from commoditized categories of the IT other IT equipment for resale. industry and into areas in which it can differentiate itself through innovation and by leveraging its investments in R&D. Examples Key Business Drivers include IBM’s leadership position in the design and fabrication of The following are some of the key drivers of the com- ASICs; the design of smaller, faster and energy-efficient semicon- pany’s business. ductor devices; the design of “grid” computing networks that ECONOMIC ENVIRONMENT AND CORPORATE allow computers to share processing power; the transformation SPENDING BUDGETS and integration of business processes; and the company’s efforts to advance open technology standards and to engage with gov- If overall demand for systems, software and services changes, ernments, academia, think tanks and nongovernmental organiza- whether due to general economic conditions or a shift in corpo- tions on emerging trends in technology, society and culture. In the rate buying patterns, sales performance could be impacted. highly competitive IT industry, with large diversified competitors, IBM’s diverse portfolio of products and offerings is designed to as well as smaller and nimble single-technology competitors, gain market share in strong and weak economic climates. The IBM’s ability to continue its cutting-edge innovation is critical to company accomplishes this by not only having a mix of offerings maintaining and increasing market share. IBM is managing this with long-term cash and income streams, as well as cyclical risk by more closely linking its R&D organizations to industry-spe- transaction-based sales, but also by continually developing cific and client-specific needs, as discussed in “Description of competitive products and solutions and effectively managing Business—IBM Worldwide Organizations” on pages 19 to 21. a skilled resource base. IBM continues to transform itself to take advantage of shifting demand trends, focusing on client- OPEN STANDARDS or industry-specific solutions, business performance and The broad adoption of open standards is essential to the com- open standards. puting model for an on demand business and is a significant INTERNAL BUSINESS TRANSFORMATION AND driver of collaborative innovation across all industries. Without GLOBAL INTEGRATION INITIATIVES interoperability among all manner of computing platforms, the integration of any client’s internal systems, applications and IBM continues to drive greater productivity, flexibility and cost processes remains a monumental and expensive task. The savings by transforming and globally integrating its own busi- broad-based acceptance of open standards—rather than ness processes and functions. In 2005, the company realigned closed, proprietary architectures—also allows the computing its operations and organizational structure in Europe to give infrastructure to more easily absorb (and thus benefit from) new sales and delivery teams greater authority, accountability and technical innovations. IBM is committed to fostering open stan- flexibility to make decisions and to execute more effectively on dards because they are vital to the On Demand Operating behalf of our clients. Additionally, in 2005, many of the com- Environment, and because their acceptance will expand growth pany’s corporate functions—such as Legal, Finance, Human opportunities across the entire business services and IT indus- Resources, Information Technology, and Real Estate Site try. There are a number of competitors in the IT industry with sig- Operations—which had been previously replicated for many of nificant resources and investments who are committed to closed the individual countries where IBM operates were integrated so and proprietary platforms as a way to lock clients into a particu- that they could be managed and their resources optimized on a lar architecture. This competition will result in increased pricing global scale. In addition to eliminating redundancies and over- pressure and/or IP claims and proceedings. IBM’s support of head structures to drive productivity, this integration improved open standards is evidenced by the enabling of its products to IBM’s capacity to innovate by providing greater clarity of key pri- support open standards such as Linux, and the development of orities around shared goals and objectives and led to a sharper Rational software development tools, which can be used to focus for the company on learning, development and knowl- develop and upgrade other companies’ software products. edge sharing. INVESTING IN GROWTH OPPORTUNITIES INNOVATION INITIATIVES The company is continuing to refocus its business on the higher IBM invests to improve its ability to help its clients innovate. value segments of enterprise computing—providing technology Investment may occur in the research and development of new and transformation services to clients’ businesses. Consistent products and services, as well as in the establishment of new col- with that focus, the company continues to significantly invest in laborative and co-creation relationships with developers, other growth opportunities as a way to drive revenue growth and mar- companies, and other institutions. To deliver value that helps ket share gains. Areas of investment include strategic acquisi- tions, primarily in software and services, focused client- and industry-specific solutions, BPTS, key technologies and emerg- ing growth countries such as China, Russia, India and Brazil. _21


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Year in Review Results of Continuing Operations REVENUE (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE CURRENCY Statement of Earnings Revenue Presentation: Global Services $«47,357 $«46,213 2.5% 2.1%% Hardware 24,314 31,154 (22.0) (22.2) Software 15,753 15,094 4.4 3.7 Global Financing 2,407 2,608 (7.7) (8.4) Enterprise Investments/Other 1,303 1,224 6.5 7.0 Total $«91,134 $«96,293 (5.4) % (5.8) % (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004* CHANGE CURRENCY Industry Sector: Financial Services $«24,059 $«24,479 (1.7) % (1.8) % Public 14,020 14,769 (5.1) (5.5) Industrial 11,666 12,610 (7.5) (7.7) Distribution 8,844 8,831 0.1 (0.2) Communications 8,589 8,888 (3.4) (3.8) Small & Medium 17,969 20,793 (13.6) (13.7) OEM 3,271 2,885 13.4 13.4 Other 2,716 3,038 (10.6) (16.8) Total $«91,134 $«96,293 (5.4) % (5.8) % * Reclassified to conform with 2005 presentation. (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE CURRENCY Geographies: Americas $«38,817 $«40,064 (3.1) % (4.4) % Europe/Middle East/Africa 30,428 32,068 (5.1) (4.1) Asia Pacific 18,618 21,276 (12.5) (12.7) OEM 3,271 2,885 13.4 13.4 Total $«91,134 $«96,293 (5.4) % (5.8)) % On April 30, 2005, the company sold its Personal Computing incomparable periods for which the Personal Computing busi- business. Accordingly, the company’s reported revenue results ness results are included in the as-reported results. The company include four months of revenue for the company’s Personal believes that a more appropriate discussion is one that excludes Computing business in 2005 versus 12 months in 2004. The the revenue results of the Personal Computing business in both company has presented a discussion on changes in reported 2005 and 2004 because it presents results on a comparable revenues along with a discussion of revenue results excluding basis and provides a more meaningful discussion which the divested Personal Computing business. A significant driver focuses on the company’s ongoing operational performance. of the changes in revenues, on an as-reported basis, is the Such discussion is presented on pages 24 and 25. 22_ Management Discussion


  • Page 24

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES As-reported revenues across all industry sectors declined, (10 percent adjusted for currency), the U.K. declined 1 percent except for the Distribution sector, which was essentially flat, due (flat adjusted for currency) and Spain declined 1 percent (flat to the sale of the company’s Personal Computing business. The adjusted for currency). Financial Services revenue decrease was driven by Financial Japan, which represents about 60 percent of the Asia Pacific Markets (12.2 percent) partially offset by increases in Insurance revenue base, declined 13 percent (11 percent adjusted for cur- (1.9 percent) and Banking (0.5 percent). The Public sector rev- rency) in 2005 versus 2004. In addition, ASEAN revenue declined enue decline was driven by Education (31.0 percent), Life 3 percent (3 percent adjusted for currency) and China declined Sciences (19.1 percent) and Government (2.0 percent), partially 19 percent (20 percent adjusted for currency), while India revenue offset by increased revenue in Healthcare (13.1 percent). The increased 10 percent (8 percent adjusted for currency). Distribution sector revenue increase was driven by Travel and The company continued to invest in growth initiatives in its Transportation (11.0 percent) and Consumer Products (2.6 per- emerging countries. Revenue growth in these emerging countries cent), partially offset by lower revenue in Retail Industry (7.5 per- is driven by client investment to build out their infrastructures, cent). The decrease in Communications sector revenue was especially in the Financial Services sector. Overall revenue in driven by Media and Entertainment (11.5 percent), Utilities (5.4 these countries declined 2 percent (9 percent adjusted for cur- percent) and Telecommunications (1.1 percent). rency). The declines were driven by the sale of the company’s America’s revenue decline was driven by the sale of the Personal Computing business. China declined 19 percent company’s Personal Computing business. The U.S. declined 5 (20 percent adjusted for currency), while Brazil’s revenue grew percent, while Canada increased 5 percent (declined 3 percent 21 percent (1 percent adjusted for currency), India’s revenue adjusted for currency) and Latin America increased 8 percent grew 10 percent (8 percent adjusted for currency) and Russia’s (declined 2 percent adjusted for currency). revenue increased 2 percent (2 percent adjusted for currency). Revenue in Europe declined across most major countries OEM revenue increased in 2005 versus 2004 primarily due driven by the sale of the company’s Personal Computing busi- to improved manufacturing yields for game processors driven ness. Of the major countries, Germany declined 12 percent by the ramp up of production for these processors in the second (11 percent adjusted for currency), France declined 7 percent half of 2005. In addition, E&TS revenue continued to show (6 percent adjusted for currency), Italy declined 11 percent strong revenue growth. REVENUE EXCLUDING DIVESTED PERSONAL COMPUTING BUSINESS REVENUE (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE CURRENCY Statement of Earnings Revenue Presentation: Global Services $«47,357 $«46,213 2.5% 2.1% Hardware 21,439 20,417 5.0 4.9 Software 15,753 15,094 4.4 3.7 Global Financing 2,407 2,608 (7.7) (8.4) Enterprise Investments/Other 1,303 1,224 6.5 7.0 Total $«88,259 $«85,556 3.2% 2.8%% (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE CURRENCY Industry Sector: Financial Services $«23,789 $«23,393 1.7% 1.7%% Public 13,556 12,858 5.4 5.0 Industrial 11,437 11,702 (2.3) (2.4) Distribution 8,722 8,309 5.0 4.7 Communications 8,458 8,391 0.8 0.5 Small & Medium 16,387 15,393 6.5 6.4 OEM 3,271 2,885 13.4 13.4 Other 2,639 2,625 0.5 (6.6) Total $«88,259 $«85,556 3.2% 2.8%% _23


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE CURRENCY Geographies: Americas $«37,725 $«35,904 5.1% 3.7% Europe/Middle East/Africa 29,549 28,889 2.3 3.6 Asia Pacific 17,714 17,878 (0.9) (1.1) OEM 3,271 2,885 13.4 13.4 Total $«88,259 $«85,556 3.2% 2.8%% Revenue from Small & Medium Business increased 6.5 percent The company continued to invest in growth initiatives in its in 2005 versus 2004. The Small & Medium Business increase emerging countries. Revenue growth in these emerging countries was led by the Americas, where clients continued to focus on is driven by client investment to build out their infrastructures, cost, efficiency and business value in their IT decisions. Clients especially in the Financial Services sector. Overall revenue in value the IBM solutions, including the Express offerings that the these countries grew 23 percent (14 percent adjusted for cur- company takes to market through its strong network of business rency) in 2005 versus 2004 without the Personal Computing busi- partners and ISVs. The Financial Services revenue increase was ness. Russia grew 29 percent (29 percent adjusted for currency); driven by Banking (3.8 percent) and Insurance (7.3 percent) as India was up 59 percent (55 percent adjusted for currency); these clients continue to focus on back office efficiencies. These Brazil increased 29 percent (7 percent adjusted for currency) increases were partially offset by lower revenue from Financial and China was up 9 percent (8 percent adjusted for currency). Markets (10.5 percent). The Public sector revenue increase was The company expects to continue to shift investment to these primarily driven by Healthcare (19.7 percent) as the company areas to address these important markets. launched new solutions to improve healthcare productivity, qual- OEM revenue increased in 2005 versus 2004 primarily due ity and lower costs, increasing growth at both new and existing to improved manufacturing yields for game processors driven accounts and Government (4.5 percent). The Distribution sector by the ramp up of production for these processors in the second revenue increase was driven by Travel and Transportation (16.2 half of 2005. In addition, E&TS revenue continued to show percent) and Consumer Products (11.4 percent), partially offset strong revenue growth. by a decline in Retail (4.5 percent). Communications sector rev- The increase in Global Services revenue was primarily driven enue increased slightly driven by Telecommunications (2.6 per- by BCS and SO, however all Global Services categories had cent), partially offset by declines in Media & Entertainment (6.5 revenue growth versus 2004. Global Services signings were $47.1 percent) and Utilities (0.5 percent). billion in 2005, an increase of 9.5 percent versus 2004. The com- America’s performance, adjusted for currency, was driven by pany continued to have strong revenue growth in its businesses revenue growth across all key brands and regions. The U.S. grew that address the BPTS opportunity, up 28 percent versus 2004. 3 percent, Canada grew 7 percent and Latin America grew 11 per- Overall, Hardware revenue declined as reported in 2005 cent in 2005 versus 2004. Overall demand remains positive, as compared to 2004 due to the divestiture of the Personal clients invest to improve the competitiveness of their infrastructure Computing business. Systems and Technology Group revenue and provide differentiated advantage in the marketplace. increased as pSeries servers, xSeries servers, iSeries servers, Revenue performance in Europe was mixed. Of the major Storage Systems, Microelectronics and E&TS had revenue countries, without the benefit of currency, the U.K., France and growth versus 2004. pSeries revenue increased as clients Spain increased 7 percent, 2 percent and 5 percent, respec- continued to recognize the strength and leadership of the tively, while Germany and Italy declined 6 percent and 7 percent, POWER5+ architecture. xSeries servers revenue was driven by respectively, in an environment that continues to be challenging. the company’s strong momentum in Blades. iSeries revenue The company successfully executed its restructuring actions, and grew slightly and was affected in the fourth quarter as demand its new operating model, with a more streamlined management fell off as clients anticipated the first quarter 2006 announce- system, is now in place. These changes will allow the company ment of the new POWER5+ based product. Storage Systems to compete more effectively in these markets. revenue growth was driven by Total Disk products, as enterprise Asia Pacific had the weakest results of the major geogra- and mid-range disk products both had strong revenue growth. phies in 2005. Japan, which represents about 60 percent of the Tape products revenue also increased in 2005 versus 2004. Asia Pacific revenue base, declined 5 percent adjusted for cur- Microelectronics revenue increased due to improved manufac- rency in 2005 versus 2004. The company continues to drive turing yields and volumes for game processors. E&TS revenue actions to improve execution, and expects improved revenue continued to be strong in 2005 versus 2004. These increases performance in 2006. Mitigating the declines in Japan, China were partially offset by declines in zSeries server revenue, Retail revenue grew 8 percent and ASEAN revenue grew 20 percent Stores Solutions and Printer Systems. Although zSeries server with strong results, led by India (55 percent). 24_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES revenue declined, MIPS (millions of instructions per second) vol- margin improvement and permitted the company to improve umes increased 7 percent in 2005 versus 2004. price competitiveness in key markets. In addition, an increase in Personal Computing Division revenue decreased as a result retirement-related plan costs of approximately $648 million par- of the company divesting its Personal Computing business tially offset by a decrease in stock-based compensation costs of to Lenovo. The 2005 results have four months of revenue versus approximately $133 million compared to 2004 also impacted 12 months of revenue in 2004. See note C, “Acquisitions/ overall segment margins. See “Segment Details” discussion on Divestitures,” on pages 66 to 67 for additional information. pages 27 to 30 for further details on gross profit. Software revenue increased in 2005 versus 2004 driven by EXPENSE growth in the company’s key branded Middleware offerings, par- tially offset by lower Operating Systems revenue. The Middleware (Dollars in millions) revenue growth was driven by Tivoli software offerings, the YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE WebSphere family of products and Lotus software offerings. Global Financing revenue declined due to a continued Total expense and decline in the income-generating asset base and yields. See other income $«24,306 $«24,900 (2.4) % pages 43 through 47 for additional information regarding Expense to Revenue (E/R) 26.7% 25.9% 0.8 pts. Global Financing. The following table presents each revenue category as a Total expense and other income decreased 2.4 percent (2.9 per- percentage of the company’s total: cent adjusted for currency) in 2005 versus 2004. Overall, the decrease was primarily due to the gain associated with the FOR THE YEAR ENDED DECEMBER 31: 2005 2004 divestiture of the Personal Computing business ($1,108 million), Global Services 52.0% 48.0% a gain from a legal settlement with Microsoft ($775 million) par- Hardware 26.7 32.3 tially offset by incremental restructuring charges ($1,706 million) Software 17.3 15.7 recorded in the second quarter of 2005. The expense-to-revenue Global Financing 2.6 2.7 ratio increased 0.8 points to 26.7 percent in 2005, as revenue Enterprise Investments/Other 1.4 1.3 declined 5.4 percent and expense declined 2.4 percent in 2005 versus 2004. For additional information regarding the decrease Total 100.0% 100.0% in Total expense and other income, see the following analyses by category: GROSS PROFIT SELLING, GENERAL AND ADMINISTRATIVE (SG&A) YR. TO YR. (Dollars in millions) FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004* CHANGE Gross Profit Margin: Global Services 25.9% 24.2% 1.7 pts. Selling, general and Hardware 35.1 29.5 5.6 administrative expense: Software 87.5 87.2 0.3 Selling, general and Global Financing 54.7 59.9 (5.2) administrative—base $«16,845 $«16,690 0.9% Enterprise Investments/Other 46.5 40.2 6.3 Advertising and Total 40.1% 36.9% 3.2 pts. promotional expense 1,284 1,335 (3.8) Workforce reductions—ongoing 289 397 (27.2) Restructuring 1,475 — NM The increase in Global Services gross profit margin was prima- Retirement-related expense 846 610 38.7 rily due to benefits from the restructuring actions taken in the Stock-based compensation 606 914 (33.7) second quarter of 2005, improved utilization/productivity and a Bad debt expense (31) 133 (123.3) better overall contract profile. The increase in Hardware margin was primarily due to the divestiture of the Personal Computing Total $«21,314 $«20,079 6.1% business (which had a lower gross profit margin than the other * Reclassified to conform with 2005 presentation. hardware businesses) in the second quarter of 2005. This sale NM—Not Meaningful contributed 3.8 points to the increase in the 2005 margin. Microelectronics’ margins increased due to improving yields. Total SG&A expense increased 6.1 percent (5.7 percent The decrease in Global Financing gross profit margin was adjusted for currency). The increase was primarily driven by the driven by declining financing margins primarily due to the restructuring charges recorded in the second quarter of 2005. changing interest rate environment and a mix towards lower See note R, “2005 Actions” on pages 80 and 81 for additional margin remarketing sales. information. In addition, retirement-related expenses increased The cost savings generated by the company’s continuing in 2005. See the “Retirement-Related Benefits” caption on page focus on supply-chain initiatives also contributed to the overall 27 for additional information. These increases were partially off- set by lower operational expenses as a result of the restructuring _25


  • Page 27

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES actions and the Personal Computing business divestiture, The decline in Research, development and engineering (RD&E) lower stock-based compensation expense (see “Stock-Based was driven by the sale of the company’s Personal Computing Compensation” caption below for additional information) and business in the second quarter of 2005 ($93 million) and lower lower ongoing workforce reductions. In addition, Bad debt spending in Microelectronics ($93 million) and Software ($25 expense declined primarily due to decreased specific reserve million). These decreases were partially offset by increased requirements, an overall reduction in the financing asset portfo- spending in Systems and Technology for server products ($171 lio (see Global Financing Receivables and Allowances on page million). Included in RD&E expense was increased retirement- 45 for additional information), the improvement in economic related expense of $95 million and a decrease of $94 million for conditions and improved credit quality. stock-based compensation expense in 2005 versus 2004. OTHER (INCOME) AND EXPENSE INTELLECTUAL PROPERTY AND CUSTOM DEVELOPMENT INCOME (Dollars in millions) (Dollars in millions) YR. TO YR. YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004* CHANGE FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE Other (income) and expense: Intellectual property and Foreign currency custom development income: transaction losses $«««««170 $««381 (55.4) % Sales and other transfers Interest income (307) (180) 70.6 of intellectual property $«236 $««««466 (49.4) % Net realized gains on sales of Licensing/royalty-based fees 367 393 (6.6) securities and other investments (111) (59) 88.1 Custom development income 345 310 11.3 Net realized (gains)/losses from Total «$«948 $«1,169 (19.0) % certain real estate activities (179) (71) 152.1 Restructuring 231 — NM The decrease in Sales and other transfers of intellectual prop- Lenovo/Microsoft gains (1,883) — NM erty was primarily due to Applied Micro Circuits Corporation’s Other (43) (94) (54.3) (AMCC) acquisition of the company’s IP associated with its Total $«(2,122) $«««(23) NM embedded PowerPC 4xx standard products for $208 million in * Reclassified to conform with 2005 presentation. 2004. The timing and amount of Sales and other transfers of IP NM—Not Meaningful may vary significantly from period to period depending upon timing of divestitures, industry consolidation, economic condi- Other (income) and expense was income of $2,122 million and tions and the timing of new patents and know-how development. $23 million in 2005 and 2004, respectively. The increase was pri- INTEREST EXPENSE marily driven by the gain on the sale of the company’s Personal (Dollars in millions) Computing business. The pre-tax gain associated with this transaction was $1,108 million. See note C, “Acquisitions/ YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE Divestitures” on pages 66 to 67 for additional information. In addition, the company settled certain antitrust issues with the Interest expense: Microsoft Corporation and the gain from this settlement was $775 Total $«220 $«139 58.6%% million; additional Interest income generated by the company in 2005; and lower foreign currency transaction losses which relate The increase in Interest expense was primarily driven by higher to losses on certain hedge contracts offset by settlement of for- average non-Global Financing debt and higher effective interest eign currency receivables and payables. See “Currency Rate rates in 2005 versus 2004. Interest expense is presented in Cost of Fluctuations,” on page 42 for additional discussion of currency Global Financing in the Consolidated Statement of Earnings only if impacts on the company’s financial results. The company also the related external borrowings are to support the Global had additional gains from the sale of certain real estate transac- Financing external business. See pages 46 and 47 for additional tions in 2005 versus 2004. These gains were partially offset by information regarding Global Financing debt and interest expense. real-estate related restructuring charges recorded in the second quarter of 2005. See note R, “2005 Actions” on pages 80 and 81 STOCK - BASED COMPENSATION for additional information. Total pre-tax stock-based compensation expense of $1,035 mil- lion decreased $543 million compared to 2004. This decrease RESEARCH, DEVELOPMENT AND ENGINEERING was principally the result of changes in the company’s equity pro- (Dollars in millions) grams, primarily driven by: (1) a reduction in the level and fair YR. TO YR. value of stock option grants ($306 million) and (2) changes to the FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE terms of the company’s employee stock purchase plan, which Research, development rendered it non-compensatory in the second quarter of 2005 in and engineering: accordance with the provisions of SFAS 123(R) ($186 million). The Total $«5,842 $«5,874 (0.6) % year-to-year reductions in pre-tax compensation expense were reflected in the following categories: Cost ($133 million); Selling, 26_ Management Discussion


  • Page 28

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES general and administrative expense ($308 million); Research, WEIGHTED - AVERAGE COMMON SHARES development and engineering expense ($94 million); and, Other (income) and expense ($8 million). See note U, “Stock-Based YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE Compensation,” on pages 83 to 85 for additional information. Earnings per share of RETIREMENT- RELATED BENEFITS common stock: The following table provides the total pre-tax cost for all retire- Assuming dilution: ment-related plans. Cost amounts are included as an addition to Continuing operations $«««««4.91 $«««««4.39 11.8% the company’s cost and expense amounts in the Consolidated Discontinued operations «(0.01) «(0.01) 45.0 Statement of Earnings within the caption (e.g., Cost, SG&A, Cumulative effect RD&E) relating to the job function of the individuals participating of change in in the plans. accounting principle** «(0.02) «««««— NM (Dollars in millions) Total $«««««4.87* $«««««4.38 11.2% YR. TO YR. Basic: FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE Continuing operations $«««««4.99 $«««««4.48 11.4% Retirement-related plans cost: Discontinued operations «(0.02) «(0.01) 44.6 Defined benefit and contribution Cumulative effect pension plans cost $«2,058 $«1,072 92.0%% of change in Nonpension postretirement accounting principle** «(0.02) ««««— NM plans costs 379 372 1.9 Total $«««««4.96* $«««««4.47 11.0% Total $«2,437 $«1,444 68.8% Weighted-average shares outstanding (in millions): Overall, retirement-related plan costs increased $993 million ver- Assuming dilution «1,627.6 ««««1,707.2 (4.7) % sus 2004. The 2005 increase was driven by the amortization of Basic 1,600.6 1,675.0 (4.4) deferred charges, as well as changes in the discount rates, a key * Does not total due to rounding. assumption underlying the valuation of the plans. During 2005, ** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting the company recognized approximately $1,100 million of previ- Changes,” on pages 61 and 62 for additional information. ously deferred actuarial losses (as a result of the amortization of NM—Not Meaningful assumption changes) which contributed approximately $700 mil- lion of the increase in retirement-related expense in 2005. In addi- The average number of common shares outstanding assuming tion, on December 31, 2004, the company lowered the discount dilution was lower by 79.6 million shares in 2005 versus 2004. rate assumption in a number of countries which increased pre-tax The decrease was primarily the result of the company’s common expense by approximately $300 million in 2005. Additionally, share repurchase program. See note N, “Stockholders’ Equity during 2005, the company recorded a curtailment charge of $267 Activity,” on pages 75 and 76 for additional information regard- million in the fourth quarter as a result of U.S. pension plan ing the common share activities. Also see note S, “Earnings Per amendments, as well as a $65 million charge in the second quar- Share of Common Stock,” on page 82. ter related to the restructuring actions. Offsetting the year-to-year Segment Details effects of these one-time charges recorded in 2005 was a one- The following is an analysis of the 2005 versus 2004 external time charge of $320 million recorded in 2004 for the partial settle- segment results. The analysis of 2004 versus 2003 external seg- ment of certain legal claims against the U.S. pension plan. ment results is on pages 34 to 36. The $993 million year-to-year increase impacted Cost, SG&A, RD&E and Other (income) and expense by approximately GLOBAL SERVICES $648 million, $236 million, $95 million and $14 million, respec- (Dollars in millions) tively. See note V, “Retirement-Related Benefits,” on pages 85 to YR. TO YR. 95 for a detailed discussion of the company’s benefit plans FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE including a description of the plans, accounting policies, plan Global Services revenue: $«47,357 $«46,213 2.5% financial information and assumptions. Strategic Outsourcing $«19,766 $«19,309 2.4% INCOME TAXES Business Consulting Services 14,185 13,767 3.0 The provision for income taxes resulted in an effective tax rate of Integrated Technology Services 7,538 7,441 1.3 34.6 percent for 2005, compared with the 2004 effective tax rate Maintenance 5,868 5,696 3.0 of 29.7 percent. The 4.9 point increase in the effective tax rate in 2005 was primarily due to the third-quarter 2005 tax charge asso- Global Services revenue increased 2.5 percent (2.1 percent ciated with the repatriation of $9.5 billion under the American adjusted for currency) in 2005 versus 2004. Although SO rev- Jobs Creation Act of 2004. See note P, “Taxes,” on page 80 for enue continued to grow, it experienced a slowdown in its revenue additional information concerning this repatriation tax charge. _27


  • Page 29

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES growth rate due to the impact of high levels of backlog erosion year. In addition, since Global Services is primarily a resource- experienced in 2004 and the cumulative effect of lower signings, based business, the resulting Global Services margins were starting in 2004 through the first quarter of 2005. SO revenue impacted more by pension expense increases, partially miti- growth was driven by the Americas (2 percent) and EMEA (6 per- gated by lower stock-based compensation expense. cent), with a decline year to year in Asia Pacific (2 percent). GLOBAL SERVICES SIGNINGS BCS revenue increased in 2005 versus 2004 led by growth (Dollars in millions) in the Americas (7 percent) and EMEA (5 percent), partially off- set by declines in Asia Pacific (6 percent). BCS signings were FOR THE YEAR ENDED DECEMBER 31: 2005 2004 2003 up 19 percent over last year, with Consulting and Systems Longer-term* $«27,180 $«22,857 $«34,608 Integration up 3 percent and Business Transformation Shorter-term* 19,901 20,146 20,854 Outsourcing up 126 percent. The company’s Consulting and Total $«47,081 $«43,003 $«55,462 Systems Integration business had many areas of growth, with * Longer-term signings include SO and BTO contracts, as well as the U.S. federal strong performance in the Strategy and Change and Supply government contracts within BCS. Shorter-term signings include ITS and all other Chain Management practices. This overall growth was mitigated BCS contracts. These amounts have been adjusted to exclude the impact of year- by weakness year to year in Japan, Germany, and the com- to-year currency changes. pany’s Federal Business in the U.S. However, across all prac- tices, the company drove improved resource utilization and In 2005, total Global Services signings increased 9 percent year pricing trends remained stable to improving. The company is to year, driven by a 19 percent increase in longer-term signings, taking actions to improve its growth in Consulting and Systems while shorter-term signings were essentially flat. Integration. The company is increasing the level of dedicated Global Services signings are management’s initial estimate of sales resources to drive its Business and Web Services and the value of a client’s commitment under a Global Services System Oriented Architecture (SOA) solutions, further investing contract. Signings are used by management to assess period in resources to address mid-market opportunities, increasing performance of Global Services management. There are no third- the level of brand resources in Asia Pacific and leveraging its party standards or requirements governing the calculation of global end-to-end design, build, and run capabilities. signings. The calculation used by management involves esti- The company’s BTO business continued its strong year-to- mates and judgments to gauge the extent of a client’s commit- year growth. BTO is an important offering to address the BPTS ment, including the type and duration of the agreement, and opportunity. Other elements include the Strategy and Change the presence of termination charges or wind-down costs. For practice, E&TS, and Business Performance Software. For the year, example, for longer-term contracts that require significant up-front BPTS revenue was $4 billion, up 28 percent year to year. investment by the company, the portions of these contracts that ITS signings were down 7 percent in 2005 versus 2004. The are counted as a signing are those periods in which there is a ITS business is more dependent upon short-term signings for significant economic impact on the client if the commitment is not revenue growth and signings declines in the third and fourth achieved, usually through a termination charge or the client incur- quarter impacted the overall revenue growth rate for 2005. The ring significant wind-down costs as a result of the termination. For company began to rebalance its ITS offerings portfolio and shift shorter-term contracts that do not require significant up-front its business development and delivery capabilities and skills to investments, a signing is usually equal to the full contract value. higher growth areas in the third quarter of 2005. The initial port- Signings includes SO, BCS and ITS contracts. Contract folio rebalancing work is completed. The company is adding extensions and increases in scope are treated as signings only business development skills and the sales coverage model has to the extent of the incremental new value. Maintenance is not been aligned to the revised portfolio. included in signings as maintenance contracts tend to be more steady-state, where revenues equal renewals, and therefore, (Dollars in millions) the company does not think they are as useful a predictor of YR. TO YR. future performance. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE Backlog includes SO, BCS, ITS, and Maintenance. Backlog Global Services: is intended to be a statement of overall work under contract and Gross profit $«12,287 $«11,175 9.9% therefore does include Maintenance. Backlog estimates are Gross profit margin 25.9% 24.2% 1.7 pts. subject to change and are affected by several factors, including terminations, changes in the scope of contracts, periodic reval- Global Services gross profit dollars increased primarily due to idations, adjustments for revenue not materialized and currency the corresponding increase in revenue and improved gross assumptions used to approximate constant currency. profit margins across all categories of Global Services. The Contract portfolios purchased in an acquisition are treated gross profit margin improvement was primarily due to benefits as positive backlog adjustments provided those contracts meet from the second-quarter 2005 restructuring and productivity ini- the company’s requirements for initial signings. A new signing tiatives (see note R, “2005 Actions,” on pages 80 and 81 for will be recognized if a new services agreement is signed inci- additional information), improved utilization levels, primarily dental or coincident to an acquisition. within BCS, and a better overall contract profile versus the prior 28_ Management Discussion


  • Page 30

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES HARDWARE Microelectronics revenue increased due to improved man- (Dollars in millions) ufacturing yields and volumes for game processors. The fourth quarter of 2005 was the first full quarter of production for these YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE processors. Partially offsetting this increase was a softening of demand for some of the company’s older technology. E&TS rev- Hardware revenue: $«23,857 $«30,710 (22.3) % enue continued to show strong growth as it represents a unique Systems and Technology opportunity for the company to leverage its deep capabilities, Group $«20,981 $«19,973 5.0% expertise and assets in engineering design to benefit client zSeries (7.6) engineering and R&D processes. E&TS is a key component of iSeries 0.8 the company’s businesses that address the BPTS opportunity. pSeries 14.6 Retail Stores Solutions revenue decreased primarily due to xSeries 5.9 a number of large transactions in 2004 and demand from these Storage Systems 15.3 clients declined in 2005. Printer Systems revenue decreased Microelectronics 15.6 due primarily to lower hardware and maintenance sales. Engineering & Personal Computing Division revenue decreased as a result Technology Services 39.2 of the company divesting its Personal Computing business to Retail Store Solutions (23.0) Lenovo on April 30, 2005. The 2005 results have four months of Printer Systems (8.6) revenue versus 12 months in 2004. See note C, “Acquisitions/ Personal Computing Division 2,876 10,737 NM Divestitures,” on pages 66 and 67 for additional information. NM—Not Meaningful (Dollars in millions) Systems and Technology Group revenue increased 5.0 percent YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE (5 percent adjusted for currency) in 2005 versus 2004. pSeries server revenue increased with double digit growth in all geogra- Hardware: phies as clients continue to recognize the strength and leader- Gross profit $«8,718 $«9,505 (8.3) % ship of the POWER architecture. In early October, the company Gross profit margin 36.5% 31.0% 5.5 pts. announced a new POWER5+ processor that includes the indus- try’s first Quad Core Module, which puts four processor cores on The decrease in gross profit dollars for 2005 versus 2004 was a single piece of ceramic. Additional new pSeries products will primarily due to the sale of the company’s Personal Computing be delivered in 2006. The company expects to gain share in the business. The increase in gross profit margin was also primarily UNIX market when the 2005 external results are reported. due to the divestiture of the Personal Computing business iSeries server revenue increased driven by broad demand for (which had a lower gross profit margin than the other hardware the company’s POWER5 based offerings. Demand in the fourth products) in the second quarter of 2005. This divestiture con- quarter of 2005 fell off as clients anticipated the first-quarter tributed 3.8 points of the improvement in the Hardware margin. 2006 announcement of the new POWER5+ based products. In Systems and Technology Group gross profit margins 2005, iSeries added over 2,500 new clients, reflecting a contin- declined 1.2 points to 40.4 percent in 2005 versus 2004. ued commitment to the platform from ISVs, resellers and clients. Microelectronics margins improved and contributed 0.6 points Within xSeries, server revenue increased 7 percent despite of improvement as manufacturing yields and volumes increased strong competitive pressures driving lower prices, particularly in on game processors. In addition, margin improvements in Europe and Asia. The company’s momentum in Blades remains pSeries contributed 0.5 points to the overall margin. These strong with revenue growth of 65 percent in 2005 versus 2004. improvements were more than offset by lower margins in The company expects to maintain its market leadership position Storage Systems which impacted the overall margin by 1.1 points in Bladecenter. Although zSeries server revenue declined ver- primarily due to intensified competition resulting in product dis- sus 2004, MIPS volumes grew 7 percent in 2005. The MIPS counting and the mix to mid-range disk and tape products. In growth was driven by the company’s new System z9 which addition, zSeries, xSeries and iSeries servers had lower margins began shipping in late September 2005. The zSeries clients which impacted the overall margin by 0.8 points, 0.2 points and continue to add new workloads to this platform as they build 0.2 points, respectively. their on demand infrastructure. These new workloads have Differences between the Hardware segment gross profit accelerated Java and Linux adoption on the zSeries platform. margin and gross profit dollar amounts above and the amounts TotalStorage revenue growth was driven by Total disk rev- reported on page 25 (and derived from page 48) primarily relate enue growth of 19 percent, while tape grew 9 percent in 2005 to the impact of certain hedging transactions (see “Anticipated versus 2004. Within External disk, mid-range disk and enterprise Royalties and Cost Transactions” on page 72). The recorded products both had strong revenue growth of approximately 24 amounts for these transactions are considered unallocated cor- percent in 2005 versus 2004. The company believes it gained porate amounts for purposes of measuring the segment’s gross market share in external disk and extended its market leadership margin performance and therefore are not included in the seg- in tape. ment results above. _29


  • Page 31

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SOFTWARE (Dollars in millions) (Dollars in millions) YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2005 2004* CHANGE Software: Software revenue: $«15,753 $«15,094 4.4% Gross profit $«13,781 $«13,161 4.7% Gross profit margin 87.5% 87.2% 0.3 pts. Middleware $«12,552 $«11,968 4.9% WebSphere family 10.2 Information Management 8.2 The increase in the Software gross profit dollars and gross profit Lotus 9.7 margin was primarily driven by growth in Software revenue and Tivoli 11.5 reduced external royalty costs. Rational 3.6 GLOBAL FINANCING Other middleware (1.4) See page 44 for a discussion of Global Financing’s revenue and Operating systems 2,426 2,474 (2.0) gross profit. Other 775 652 18.8 * Reclassified to conform with 2005 presentation. ENTERPRISE INVESTMENTS Revenue from Enterprise Investments increased 1.9 percent to Software revenue increased 4.4 percent (3.7 percent adjusted $1,203 million (1.6 percent adjusted for currency) in 2005 versus for currency) in 2005 versus 2004 as the software market 2004. The revenue increase was attributable to higher product remains highly competitive. The company believes it gained life-cycle management software revenue primarily for Industrial market share in all five key middleware brands in 2005 and held (5 percent) and Small & Medium Business clients (2 percent). market share in total Middleware. Gross profit dollars increased 8.0 percent to $563 million in The WebSphere family of products revenue increased with 2005 versus 2004. The gross profit margin increased 2.6 points growth in WebSphere Application Servers (15 percent) and to 46.8 percent in 2005 versus 2004. The increase in gross profit WebSphere Portals (12 percent) software versus 2004. The dollars and gross profit margin in 2005 was primarily driven by WebSphere family provides the foundation technologies for the increased product life-cycle management software revenue. clients implementing business processes and applications in a Financial Position Services Oriented Architecture (SOA). As clients’ interest in SOA DYNAMICS has increased, so has the demand for highly scalable, robust infrastructure platforms, such as WebSphere. The assets and debt associated with the company’s Global Information Management software revenue increased Financing business are a significant part of the company’s finan- driven by growth in content management and information inte- cial position. The financial position amounts appearing below and gration product sets. on pages 31 and 32 are the company’s consolidated amounts Lotus software revenue increased as clients continue to including Global Financing. However, to the extent the Global demonstrate strong response to the Domino Version 7 product Financing business is a major driver of the consolidated financial line, as well as very high interest in Workplace software. position, this narrative section will refer to the separate Global Workplace software more than doubled its revenue in 2005 ver- Financing section in this Management Discussion on pages 43 sus 2004. through 47. The amounts appearing in the separate Global Tivoli software revenue increased with strong growth in stor- Financing section are supplementary data presented to facilitate age software as clients’ adoption of the company’s virtualization an understanding of the company’s Global Financing business. technologies continued to gain traction. Tivoli systems manage- WORKING CAPITAL ment and security software offerings also had good revenue (Dollars in millions) growth in 2005 versus 2004. The security products revenue was AT DECEMBER 31: 2005 2004 driven by the company’s new SOA Security offerings which were well received in the second half of 2005. Current assets $«45,661 $«47,143 Rational software revenue increased in 2005 versus 2004, Current liabilities 35,152 39,786 however, late in the fourth quarter of 2005, client buying defer- Working capital $«10,509 $«««7,357 rals prevented stronger performance. Current ratio 1.30 1.18 Revenue from Other middleware products, including host software products such as compilers, certain tools and Other Storage and Printer software declined versus 2004. Current assets decreased $1,482 million due to declines of Operating Systems software revenue declined in 2005 ver- $3,708 million in short-term receivables primarily driven by sus 2004, primarily due to lower zSeries and pSeries revenue, declines of: $1,100 million in financing receivables as collections partially offset by increased iSeries and xSeries revenue. exceeded new originations, approximately $300 million in trade receivables due to the divestiture of the Personal Computing business, approximately $375 million in non-client receivables 30_ Management Discussion


  • Page 32

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES primarily driven by the final payment received from Hitachi for received from Hitachi for the purchase of the HDD business the purchase of the HDD business, and $1,637 million due to the (approximately $268 million); a $218 million decline in net capi- effects of currency; and a decrease of $475 million in inventories tal spending and $256 million in lower cash spending for acqui- primarily driven by the Personal Computing divestiture and sitions; however, the company did expend $1,482 million in net reductions in the Systems and Technology Group server brands. cash on acquisitions in 2005. These declines were partially These declines were partially offset by the $3,116 million increase offset by a $458 million increase in marketable securities and (approximately $3,905 million before negative currency impact other investments. of $789 million) in Cash and cash equivalents and Marketable The decrease in net cash used in financing activities of $415 securities (see the Cash Flow analysis below). million was primarily the result of an increase in net cash inflows Current liabilities decreased $4,634 million primarily due to related to debt of approximately $1,636 million, partially offset by declines of: $2,095 million in Accounts payable of which approx- higher net payments for common stock activity of $1,145 million imately $1,100 million was due to the Personal Computing and higher dividend payments of $76 million. Within total debt, divestiture and $332 million due to the effects of currency; on a net basis, in 2005, the company had $609 million in net $1,303 million in other accruals driven primarily by a decline cash proceeds from new debt versus $1,027 million used to in derivative liabilities due to year-to-year changes in foreign retire debt in 2004. The net cash proceeds of $609 million in currency rates; and $883 million in Short-term debt primarily due 2005 comprise $4,363 million of cash proceeds from new debt to the settlement of $2,300 million in commercial paper debt, partially offset by $3,522 million of cash payments to settle debt partially offset by new debt issuances of approximately $1,500 and by $232 million in short-term repayments. The higher pay- million to facilitate foreign earnings repatriation actions. ments for common stock were driven by increases of approxi- mately $594 million in cash payments to repurchase stock and CASH FLOW decreases of approximately $551 million in cash received for The company’s cash flow from operating, investing and financ- stock issued under the company’s stock option plan and ing activities, as reflected in the Consolidated Statement of Cash employee stock purchase plan. Flows on page 50, are summarized in the table below. These amounts include the cash flows associated with the company’s NON - CURRENT ASSETS AND LIABILITIES Global Financing business. See pages 43 through 47. (Dollars in millions) AT DECEMBER 31: 2005 2004 (Dollars in millions) FOR THE YEAR ENDED DECEMBER 31: 2005 2004 Non-current assets $«60,087 $«63,860 Long-term debt $«15,425 $«14,828 Net cash provided by/(used in) Non-current liabilities (excluding debt) $«22,073 $«24,701 continuing operations: Operating activities $«14,914 $«15,349 Investing activities (4,423) (5,346) The decrease in Non-current assets of $3,773 million was prima- Financing activities (7,147) (7,562) rily driven by declines of: $2,141 million in Investments and Effect of exchange rate changes sundry assets; $1,419 million in Plant, rental machines, and other on cash and cash equivalents (789) 405 property-net which was driven by the effects of currency Net cash used in discontinued (approximately $562 million) and asset sales; and $1,322 million operations* (40) (83) in Long-term financing receivables (see page 45). The decline in Investments and sundry assets was mainly due to a $2,839 Net change in cash and million decrease ($252 million due to the effects of currency) in cash equivalents $«««2,515 $«««2,763 deferred tax assets driven by the utilization of income tax credit * Does not include $319 million in 2005 of net proceeds from the sale of the HDD carryforwards and U.S. and non-U.S. pension activity, partially business. $51 million is included in Operating activities from continuing operations and $268 million is included in Investing activities from continuing operations. offset by increases of $314 million in deferred transition costs driven by growth in services arrangements with clients, $155 mil- Net cash from operating activities for the year ended December lion in alliance investments primarily due to the company’s 31, 2005 decreased $435 million as compared to 2004. The equity interest in Lenovo, and $112 million in non-current deriva- decrease was primarily driven by an increase in restructuring tive assets due to the appreciation of the U.S. dollar against cer- payments of $1,012 million and an increase in pension funding in tain foreign currencies. These declines were partially offset by the United States of approximately $1,015 million, partially offset increases of $1,004 million in Goodwill driven by the company’s by the $775 million legal settlement payment from Microsoft and acquisitions and $231 million (approximately $1,220 million $493 million due to improved management of inventory primarily before negative currency impact of $989 million) in Prepaid pen- in the Systems and Technology Group. sion assets due primarily to the $1,700 million funding of the IBM Net cash used in investing activities decreased $923 million Personal Pension Plan (PPP) in the first quarter of 2005. on a year-to-year basis driven by: a $907 million improvement in Long-term debt increased $597 million due to new debt divestiture-related cash due to the divestiture of the Personal issuances. The company continually monitors its liquidity profile Computing business and disposition of a portion of Lenovo and interest rates, and manages its short- and long-term debt shares (approximately $662 million) and the final net payment portfolios accordingly. _31


  • Page 33

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Other non-current liabilities decreased $2,628 million due to financial commitments and indemnification arrangements. The decreases of $2,104 million in Retirement and nonpension company does not have retained interests in assets transferred postretirement obligations of which approximately $1,137 million to unconsolidated entities (see note J, “Securitization of was due to the effects of currency and the remaining $967 mil- Receivables,” on page 70) or other material off-balance sheet lion was attributable to the favorable funded status of primarily interests or instruments. non-U.S. pension plans as discussed on page 93; and $524 mil- lion in other accruals primarily due to the effects of currency. Consolidated Fourth-Quarter Results (Dollars and shares in millions except per share amounts) DEBT YR. TO YR. The company’s funding requirements are continually monitored FOR FOURTH QUARTER: 2005 2004 CHANGE and strategies are executed to manage the company’s overall Revenue $«24,427 $«27,671 (11.7) % * asset and liability profile. Additionally, the company maintains Gross profit margin «44.1% «38.8% 5.3 pts. sufficient flexibility to access global funding sources as needed. Total expense and other income $«««6,197 $«««6,690 (7.4) % (Dollars in millions) Total expense and other AT DECEMBER 31: 2005 2004 income-to-revenue ratio 25.4% 24.2% 1.2 pts. Total company debt $«22,641 $«22,927 Income from continuing Non-Global Financing debt* $«««2,142 $««««««607 operations before income taxes $«««4,568 $«««4,048 12.8%% Non-Global Financing debt/ Provision for income taxes $«««1,348 $«««1,206 11.6%% capitalization 6.7% 2.1% Income from continuing * Non-Global Financing debt is the company’s total external debt less the Global operations $«««3,220 $«««2,842 13.3% Financing debt described in the Global Financing balance sheet on page 44. Income/(loss) from discontinued operations $««««««««««3 $«««««««(15) NM Non-Global Financing debt increased $1,535 million and the Cumulative effect of change debt-to-capital ratio at December 31, 2005 was within accept- in accounting principle** $«««««««(36) $««««««««— NM able levels at 6.7 percent. Non-Global Financing debt increased Earnings per share of versus 2004 primarily to facilitate the company’s repatriation common stock: actions under the American Jobs Creation Act of 2004. The Assuming dilution: increase relates to short-term debt issuances. Continuing operations $«««««2.01 $«««««1.68 19.6% Discontinued operations ««««««««— «« (0.01) NM EQUITY Cumulative effect (Dollars in millions) of change in AT DECEMBER 31: 2005 2004 accounting principle** «««(0.02) «««««««— NM Stockholders’ equity: Total $«««««1.99 $«««««1.67 19.2% Total $«33,098 $«31,688 Weighted-average shares outstanding: The company’s total consolidated Stockholders’ equity increased Assuming dilution 1,604.8 1,692.1 (5.2) % $1,410 million during 2005 primarily due to an increase in the * (8.5) percent adjusted for currency. company’s retained earnings driven by net income, partially off- ** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting set by the company’s ongoing stock repurchase program and Changes,” on pages 61 and 62 for additional information. higher dividend payments. NM—Not Meaningful OFF - BALANCE SHEET ARRANGEMENTS CONTINUING OPERATIONS In the ordinary course of business, the company entered into off- In the fourth quarter, the company increased Income from contin- balance sheet arrangements as defined by the SEC Financial uing operations by $378 million or 13.3 percent versus the fourth Reporting Release 67 (FRR-67), “Disclosure in Management’s quarter of 2004. Diluted earnings per share from continuing oper- Discussion and Analysis about Off-Balance Sheet Arrangements ations of $2.01 increased 19.6 percent versus the prior year. and Aggregate Contractual Obligations.” The company’s performance in the fourth quarter was None of these off-balance sheet arrangements either has, or driven by several factors: is reasonably likely to have, a material current or future effect on financial condition, changes in financial condition, revenues or • Strong results in the hardware business, driven by Storage expenses, results of operations, liquidity, capital expenditures or products, Microelectronics and zSeries and pSeries servers. capital resources. See page 39 for the company’s contractual obli- • Increased demand for the company’s key branded middleware gations and note O, “Contingencies and Commitments,” on page software products and improved profitability in that segment. 78, for detailed information about the company’s guarantees, 32_ Management Discussion


  • Page 34

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES • Improved margins in Global Services driven primarily by 4.5 percent, driven by the company’s content management and benefits from the company’s restructuring, productivity information integration product sets. Lotus revenue grew 1.6 initiatives and a better overall contract profile. percent and Tivoli revenue increased 2.9 percent driven by a 17 percent growth in the brand’s storage software products. Total revenue in the fourth quarter declined 11.7 percent as Rational software revenue declined 2.0 percent—performance reported (8.5 percent decline adjusted for currency). The com- was good in Asia Pacific and Europe, but some clients delayed pany’s revenue profile was significantly impacted by the divesti- buying decisions in the Americas. In addition to the revenue ture of the Personal Computing business in the second quarter of growth in the company’s key branded middleware, described 2005—excluding the Personal Computing business, the com- above, the profitability of the software business improved as pany’s fourth-quarter 2004 total revenue was $24,703 million. well, with the segment’s pre-tax margin growing by 5.7 points in When compared to this revised amount, total revenue in the the fourth quarter versus 2004. fourth-quarter 2005 decreased 1.1 percent (increased 2.5 percent Global Financing revenue declined 8.0 percent (5.6 percent adjusted for currency) driven by a decline in Global Services. adjusted for currency) driven primarily by lower client financing The following is an analysis of the external segment results. revenue due to a declining asset base, as well as lower external Global Services revenue decreased 4.9 percent (0.9 per- used equipment sales. cent adjusted for currency). The decline was driven primarily by The company’s total gross profit margin increased 5.3 points weakness in short-term signings and a decrease in SO revenue. in the fourth-quarter 2005 compared to the fourth-quarter 2004, Short-term signings were down 4 percent and flat in the fourth which included the divested Personal Computing business. quarter and third quarter of 2005, respectively, when compared Excluding the Personal Computing business, the fourth-quarter with the same periods in 2004. Total SO signings declined 32 2004 gross profit margin was 41.9 percent, making the current percent this quarter and revenue was down 5.3 percent. SO rev- quarter’s margin a 2.2 point improvement on a comparable basis. enue continues to be impacted by the high levels of backlog Total expense and other income decreased 7.4 percent erosion experienced in 2004 and the cumulative effect of lower compared to the prior-year period. Selling, general and admin- signings starting in 2004 through the first quarter of 2005. ITS istrative expense decreased 3.4 percent year to year, driven pri- revenue, excluding Maintenance, was down 5.4 percent and marily by the divestiture of the Personal Computing business signings also declined this quarter by 10 percent. BCS revenue and the company’s restructuring actions, offset by a $267 million decreased 6.1 percent driven by declines in Asia Pacific and curtailment charge related to the announced changes in the Italy, while revenue in the Americas grew versus 2004. BCS company’s U.S. defined benefit pension plans. RD&E expense signings increased by 23 percent, driven by the Americas and decreased 3.6 percent, while Intellectual property and custom Europe, with significant growth (144 percent) in long-term development income also decreased 23.7 percent year to year. Business Transformation Outsourcing signings. Profitability Other (income) and expense was $334 million of income in the improved in Global Services as both gross margin (3.1 points) fourth quarter of 2005 versus $4 million of income in the same and segment pre-tax (2.4 points) margin increased versus the period last year. This improvement was driven by gains on cer- fourth quarter of 2004. Margin improvements were primarily tain real estate transactions (increase of $160 million) and the driven by the company’s second-quarter restructuring actions, favorable impact of hedging programs (up approximately $150 improved resource utilization and a better contract profile. million) versus the fourth quarter of 2004. Global Services signings for the quarter were $11.5 billion. The company’s effective tax rate in the fourth-quarter 2005 Systems and Technology Group revenue grew 6.3 percent was 29.5 percent compared with 29.8 percent in the fourth quar- (9.8 percent adjusted for currency). zSeries server revenue ter of 2004. The nonrecurring pension curtailment charge increased 5.5 percent, with strong MIPs growth of 28 percent reduced the fourth-quarter 2005 effective tax rate by 0.5 points. year to year. zSeries growth continues to be driven by new work- In the fourth quarter, the company recorded a $36 million loads, such as Linux and Java. iSeries server revenue declined charge, net of tax, to reflect the cumulative effect of a change 18.2 percent as clients anticipated the early 2006 announcement in accounting principle related to the adoption of FASB of new POWER5+ products. pSeries server revenue grew 3.9 Interpretation No. 47. See note B, “Accounting Changes,” on percent, driven by that brand’s POWER5+ product line refresh pages 61 and 62 for additional information. which began in the fourth quarter. xSeries servers grew volumes Share repurchases totaled approximately $1.0 billion in the 13 percent, however, revenue was flat due to competitive pricing fourth quarter. The weighted-average number of diluted com- pressures. Blade Center product revenue grew 41.4 percent in mon shares outstanding in the fourth-quarter 2005 was 1,604.8 the quarter. Storage products had a strong quarter with revenue million compared with 1,692.1 million in the same period of 2004. growth of 23.6 percent, driven by Total disk (32.2 percent) prod- The company generated an increase of $1,395 million in ucts. Microelectronics OEM revenue grew 48.1 percent year to cash flow provided by operating activities. This increase reflects year as 300-millimeter-based products, driven by game proces- the effects of prior-year funding of the U.S. pension plan ($700 sors, grew over 250 percent versus the fourth quarter 2004. million) and improved inventory management ($327 million). Software revenue increased 0.3 percent (3.3 percent Also, net cash used in financing activities decreased signifi- adjusted for currency). The WebSphere family of products grew cantly—$2,417 million—primarily driven by a reduction in share 3.6 percent, while Information Management software increased repurchases in the quarter versus the fourth-quarter 2004. _33


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Prior Year in Review of the economy and continued market share gains for zSeries, xSeries and pSeries server products, as well as (Dollars and shares in millions except per share amounts) increased revenue for personal computers YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2004 2003 CHANGE • Continued demand growth in emerging countries (up over 25 percent) and in BPTS (up approximately 45 percent) Revenue $«««96,293 $«««89,131 8.0% * Gross profit margin «36.9% «36.5% 0.4 pts. • Favorable impact of currency translation Total expense and Revenue from all industry sectors increased in 2004 when com- other income $«««24,900 $«««23,130 7.7% pared to 2003, reflecting the company’s broad capabilities and Total expense and other industry-specific solutions which combine technology and high- income-to-revenue ratio 25.9% 26.0% (0.1) % value services to solve a client’s business or IT problems. These Income from continuing solutions also provide for a longer-term relationship with the operations before client, rather than a transaction-oriented sale. The Financial income taxes $«««10,669 $«««««9,417 13.3% Services sector revenue growth of 9.3 percent was led Provision for income taxes $«««««3,172 $«««««2,829 12.1% by Financial Markets (15 percent), Banking (9 percent) and Income from continuing Insurance (8 percent). The Communications sector had revenue operations $«««««7,497 $«««««6,588 13.8% growth of 10.4 percent with growth in Telecommunications (15 Loss from discontinued percent), while the Distribution sector revenue growth was 7.5 operations $««««««««««18 $««««««««««30 (41.3) % percent, led by the Retail Industry (12 percent). The Small & Earnings per share of Medium business sector revenue increased 8.3 percent as the common stock: company continued to roll out new products under the Express Assuming dilution: label that are designed and priced specifically for clients in the Continuing operations $«««««««4.39 $«««««««3.76 16.8% 100 to 1,000 employee segment. Discontinued operations ««««««(0.01) ««««««(0.02) (39.8) % Revenue across all geographies increased in 2004 when Total $«««««««4.38 $«««««««3.74 17.1% compared to 2003. In the Americas, U.S. (6 percent) and Weighted-average shares Canada (9 percent) revenue grew as did Latin America (12 per- outstanding: cent), notably Brazil, which grew at 15 percent. Assuming dilution 1,707.2 1,752.8 (2.6) % Within Europe/Middle East/Africa, Eastern Europe, the Assets** $«111,003 $«106,021 4.7% Nordic countries, Spain (7 percent) and France (3 percent) had Liabilities** $«««79,315 $«««76,490 3.7% revenue growth, while the U.K. (2 percent), Germany (3 percent) Equity** $«««31,688 $«««29,531 7.3% and Italy (8 percent) declined when adjusted for currency. Asia Pacific had strong growth in 2004, led by China, which grew at * 3.4 percent adjusted for currency. 25 percent, and the ASEAN region (17 percent), while Japan, ** At December 31 which is about 60 percent of Asia Pacific’s revenue, also had growth of 5 percent. Collectively, as a result of the company’s Continuing Operations targeted investments, the emerging countries of China, Russia In 2004, the company demonstrated that it could extend its lead- (75 percent), India (45 percent) and Brazil had revenue growth ership in a growth environment. The company delivered revenue over 25 percent in 2004 to over $4.0 billion in revenue. growth of 8.0 percent and diluted earnings per share growth of OEM revenue increased in 2004 versus 2003 due primarily 16.8 percent. The increase in the company’s Income from contin- to continued strong growth in the company’s E&TS business uing operations and diluted earnings per share from continuing and improved operational performance in the Microelectron- operations as compared to 2003 was primarily due to: ics business. • Improving demand associated with the moderate expansion The following is an analysis of external segment results. of the economy and continued market share gains for zSeries GLOBAL SERVICES and xSeries server products Global Services revenue increased 8.4 percent (3.1 percent • Continued operational improvements in the Microelec- adjusted for currency). SO revenue grew 12.8 percent and con- tronics business tinued to demonstrate its competitive advantage in delivering on • Continued demand growth in emerging countries demand solutions by leveraging both its business transforma- • Favorable impact of currency translation tional skills and scale during 2004. Each geography continued year-to-year growth, with seven consecutive quarters of double- The increase in revenue in 2004 as compared to 2003 was pri- digit growth in Europe/Middle East/Africa, excluding currency marily due to: benefits. Within SO, e-business Hosting Services, an offering that • Improved demand in Global Services and key industry sectors provides Web infrastructure and application management as an Internet-based service, continued its pattern of revenue growth. • Improving demand associated with the moderate expansion ITS revenue, which excludes Maintenance, increased 4.8 percent 34_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES driven by growth in Business Continuity and Recovery Services SOFTWARE of 29 percent, partially offset by the reduction for sales of third- Software revenue increased 5.5 percent (0.6 percent adjusted party hardware in Japan. BCS revenue increased 6.3 percent for currency). Middleware revenue increased 6.5 percent (1.5 driven by strong growth in BTO. BCS continued to improve its percent adjusted for currency). The WebSphere family of soft- revenue growth rate when adjusted for currency in every quarter ware offerings revenue increased 14 percent with growth in busi- of the year. Maintenance revenue increased 4.4 percent primarily ness integration software (14 percent), WebSphere Portal soft- driven by favorable impacts of currency movements. ware (12 percent) and application servers (20 percent). Data Management revenue increased 7 percent with growth of 12 HARDWARE percent in DB2 Database software on both the host (13 percent) Systems and Technology Group revenue increased 7.9 percent and distributed platforms (11 percent), DB2 Tools (8 percent), (4.4 percent adjusted for currency). zSeries revenue increased and distributed enterprise content management software (22 14.9 percent due to clients continuing to add new workloads on percent). Rational software revenue increased (16 percent) with the zSeries platform as they build their on demand infrastruc- growth across all product areas. Tivoli software revenue tures, as well as taking advantage of the capabilities of the z990 increased (15 percent), aided by the Candle acquisition, which server for consolidations. Mainframes remain the platform of was completed in the second quarter of 2004. Tivoli systems choice for hosting mission-critical transactions, as well as for management, storage and security software all had revenue consolidations and infrastructure simplification. The total deliv- growth in 2004 versus 2003. Lotus software revenue increased ery of zSeries computing power as measured in MIPS increased 3 percent and Other Foundation middleware products revenue 33 percent in 2004 versus 2003, offsetting price declines of 23 also increased 2 percent due to favorable currency movements. percent per MIP. xSeries server revenue increased (24 percent) Operating system software increased 0.9 percent due to due to strong growth in both high-end and 1&2 Way Servers. growth in xSeries and pSeries, which correlates to the increases xSeries-related Blade-Center revenue had strong growth, up in the related server brands. zSeries operating system revenue over 150 percent, as the company is leading and shaping the declined 1 percent despite the growth in related hardware vol- blade market. In the fourth quarter of 2004, the company saw umes due to ongoing software price performance delivered to strong demand for the new POWERBlade, which can run enterprise clients. iSeries operating system software declined 6 Windows, Linux and AIX on different servers in the BladeCenter. percent in line with related hardware volumes. Overall, operating pSeries server revenue increased 7.3 percent, reflecting clients’ systems software revenue increased primarily as a result of very strong acceptance of the POWER5 systems. The new favorable currency movements. pSeries high-end system started shipping in November 2004, marking the completion of a top-to-bottom refresh of the pSeries GLOBAL FINANCING server product line in just three months. iSeries server revenue See page 44 for a discussion of Global Financing’s revenue and declined driven by lower sales as the transition to POWER5 is gross profit. taking longer than in previous cycles, as clients must transition their operating environment to the new level. ENTERPRISE INVESTMENTS Storage Systems revenue increased 1.6 percent due to Revenue from Enterprise Investments increased 10.7 percent increased demand for external midrange disk (13 percent) and (4.2 percent adjusted for currency). Revenue for product life- tape products (9 percent). These increases were partially offset cycle management software increased primarily in the automo- by decreases in high-end disk products (18 percent) as clients tive and aerospace industries, partially offset by lower hardware anticipated the shipment of the company’s new POWER5 high- revenue (48 percent), primarily for document processors. end storage product which will ship in the first quarter of 2005. Global Services gross profit margin was flat year to year at E&TS had strong revenue growth of 93 percent due to increased 24.2 percent due to continued investment in on demand infra- design and technical services contracts and Microelectronics structure and business transformation capabilities, and less revenue increased modestly (1 percent) as yields in the 300-mil- contribution from the higher margin Maintenance business. limeter plant improved. These declines were offset by improved profitability in BCS Retail Store Solutions revenue increased 17.6 percent due to driven by improved utilization, reduced overhead structure and strong demand for the company’s products and the acquisition an improved labor mix. of Productivity Solutions Inc. in November 2003. This acquisition The increase in Hardware margins of 0.8 points to 31.0 per- drove 6.9 points of the unit’s revenue growth in 2004. Printing cent was primarily due to yield improvements in the Microelec- Systems maintenance revenue declined due to lower annuity- tronics business and margin improvements in zSeries servers, based revenue on a declining installed base. xSeries servers, storage products and personal computers, as Personal Computing Division revenue increased 14.8 per- well as the impact of certain hedging transactions (see cent (10.5 percent adjusted for currency). The increase was “Anticipated Royalties and Cost Transactions” on page 72). driven by strong performance worldwide by the company’s The Software margin at 87.2 percent increased 0.8 points ThinkPad mobile computer (22 percent). Desktop personal due to growth in Software revenue, as well as productivity computer revenue increased (4 percent) in 2004 when com- improvements in the company’s support and distribution models. pared to 2003 due primarily to favorable currency movements. The cost savings generated by the company’s supply-chain _35


  • Page 37

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES initiatives also contributed to the company’s overall margin Discontinued Operations improvement, however, the company has passed a portion of On December 31, 2002, the company sold its HDD business to the savings to clients to improve competitive leadership and Hitachi for approximately $2 billion. The final cash payment of gain market share in key industry sectors. In addition, an increase $399 million was received on December 30, 2005. In addition, in retirement-related plan costs of approximately $490 million the company paid Hitachi $80 million to settle warranty obliga- compared to 2003 impacted overall segment margins. tions during 2005. These transactions were consistent with Total expense and other income increased 7.7 percent (4.8 the company’s previous estimates. The HDD business was percent adjusted for currency) in 2004 versus 2003. accounted for as a discontinued operation whereby the results Total SG&A expense of $20,079 million increased 8.0 per- of operations and cash flows were removed from the company’s cent (4.6 percent adjusted for currency) versus $18,601 million in results from continuing operations for all periods presented. 2003. The increase was primarily driven by increased expense The company incurred a loss from discontinued operations for retirement-related plan costs of approximately $515 million, of $24 million in 2005, $18 million in 2004 and $30 million in which included a one-time charge of $320 million related to the 2003, net of tax. These losses were primarily due to additional partial settlement of certain legal claims against the company’s costs associated with parts warranty as agreed upon by the PPP, unfavorable currency translation of $626 million and provi- company and Hitachi, under the terms of the agreement for the sion for certain litigation-related expenses of $125 million in sale of the HDD business to Hitachi. 2004. These increases were partially offset by lower workforce reductions of $122 million and lower Advertising and promo- tional expense of $71 million. In addition, Bad debt expense Looking Forward declined $72 million due to lower reserve requirements associ- The following key drivers impacting the company’s business are ated with the improvement in economic conditions and discussed on page 21: improved credit quality, as well as the lower asset base of Global Financing’s receivables portfolio. • Economic environment and corporate spending budgets Other (income) and expense was income of $23 million in • Internal business transformation and global integration 2004 versus expense of $238 million in 2003. The improvement initiatives was primarily driven by increased gains from various asset sales • Innovation initiatives including certain real estate transactions ($87 million) in 2004 • Open standards versus 2003, additional Interest income ($28 million) generated by the company in 2004 and other nonrecurring gains/settle- • Investing in growth opportunities ments of $121 million in 2004 compared to 2003. With respect to the economic environment, in 2005 the global Research, development and engineering (RD&E) expense economy slowed modestly following the recovery’s peak a year of $5,874 million increased $560 million or 10.5 percent in 2004 earlier. Looking forward, while uncertainties make it difficult to versus 2003 primarily the result of increased spending in mid- predict future developments, the company anticipates similar dleware software including new acquisitions (approximately moderate growth for the economy and the traditional IT industry. $240 million). In addition, RD&E expense increased due to Several factors-including increasing complexity, globalization spending related to the POWER5 technology initiatives (approx- and the pace of technology change-are driving clients to con- imately $140 million) and higher retirement-related plan costs tinue to transform their businesses. The deeper integration of (approximately $77 million). technology into business models, processes and practices has Intellectual property and custom development income was created new long-term opportunities for the company. IBM is flat in 2004 versus 2003 and Interest expense declined $6 million addressing these opportunities through its BPTS offerings. The versus 2003 primarily due to lower effective interest rates in 2004. company expects continued double-digit revenue growth in The provision for income taxes resulted in an effective tax these offerings in 2006. rate of 29.7 percent for 2004, compared with the 2003 effective With respect to business transformation and the continual tax rate of 30.0 percent. The 0.3 point decrease in the effective conversion of the company into an on demand business, the com- tax rate in 2004 was primarily due to the tax effect of the settle- pany’s supply-chain initiatives are expected to allow continued ment of certain pension claims in the third quarter of 2004. flexibility to drive additional competitive advantages. Also, the With regard to Assets, approximately $3.6 billion of the year- company will leverage the actions taken in 2005 and continue to to-year increase relates to the impact of currency translation. focus on increased productivity and efficiency to accelerate the The remaining increase primarily consists of an increase in Cash globalization and transformation of its global business model. and cash equivalents, an increase in Goodwill associated with Finally, with respect to technology, in 2005 the company has recent acquisitions and increased Prepaid pension assets. The again been awarded more U.S. patents than any other company increases were partially offset by lower financing receivables for the thirteenth year in a row. The company continues to focus and lower deferred tax assets. internal development investments on high-growth opportunities Global Financing debt decreased, but the company’s and to broaden its ability to deliver industry-specific solutions. Global Financing debt-to-equity ratio was 7.0 to 1 for 2004 and 7.1 to 1 for 2003 which is within the company’s targeted range. 36_ Management Discussion


  • Page 38

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES From a client-set perspective, the momentum in 2005 with The company expects 2006 pre-tax retirement-related plan respect to the Small & Medium Business sector should continue. expense to increase approximately $100—$200 million when The company anticipates improved growth in its industry sec- compared to 2005. This expected increase is driven by year-end tors in 2006. 2005 changes in key assumptions used to determine 2006 The company also will continue to selectively pursue acqui- expense (approximately $600 million) and incremental amortiza- sitions, primarily in the Global Services and Software segments, tion expense related to previously deferred losses (approxi- where it believes these acquisitions will expand its portfolio to mately $500 million), offset by expected savings generated from meet clients’ needs. pension plan amendments (approximately $450-$500 million), In 2005, total Global Services signings increased 9 percent better than expected 2005 return on asset performance (approx- year to year, driven by a 19 percent increase in longer-term sign- imately $100 million), as well as the effects of one-time charges ings, while shorter-term signings were essentially flat. Backlog was incurred in 2005 for the fourth-quarter pension curtailment flat versus December 31, 2004, at an estimated $111 billion. The charge ($267 million) and a charge related to the second-quarter company implemented several broad initiatives in the services 2005 restructuring actions ($65 million). business in 2005 including a restructuring action to improve cost Specifically, given the declining interest rate environment, competitiveness, implementation of Professional Marketplace to the company reduced its discount rate assumption for the PPP improve consulting resource utilization, addition of over 15,000 by 25 basis points to 5.5 percent on December 31, 2005. This resources to the Global Resource Delivery Centers and rebalanc- change, along with similar changes to the discount rate for non- ing the Integrated Technology Services portfolio to focus on faster U.S. pension plans are expected to contribute an additional growing opportunities. Global Services pre-tax margin improved $400 million of expense in 2006. In addition, the company in 2005. The company expects to leverage these actions for con- increased the interest crediting rate by 190 basis points to 5.0 tinued improvement in 2006 in both revenue growth rates and percent which will result in an anticipated increase in expense of higher margins. $200 million. The company will keep the expected long-term The company’s Systems & Technology Group develops rate of return on PPP assets at 8 percent. The actual return on leading and often pioneering technologies that can be inte- PPP plan assets in 2005 was 11 percent. grated with software and services to provide client solutions. Pre-tax stock-based compensation expense declined $543 IBM’s BlueGene supercomputer at the Lawrence Livermore million in 2005, as compared to 2004. The company expects National Laboratory earned its designation as the world’s fastest stock-based compensation expense to continue to decline in supercomputer with an astonishing 280-trillion-calculations-per- 2006, when compared to 2005, primarily as a result of changes second performance. In 2005, IBM also won the U.S. National in the company’s equity-based compensation programs. The Medal of Technology in recognition of 40 years of broadly based anticipated decline, however, will not be at a rate consistent with semiconductor innovation. Our latest innovation, the revolution- the decline from 2004 to 2005, given the effect changes in the ary Cell microprocessor—developed in collaboration with Sony company’s employee stock purchase plan had on the 2004 to and Toshiba—boasts a staggering advantage, performing up 2005 expense decrease. to 40 times faster than conventional processors handling graph- The amount of IP and custom development income has been ics-intensive applications in areas like gaming and consumer declining in recent years, down 19 percent in 2005. A moderate electronics, and has potential in adjacent markets like medical declining trend may continue as the company does not expect IP imaging or aerospace and defense. Moving forward, IBM tech- to be a contributor to growth. The overall level of IP is dependent nologies that advantage IBM in the data center systems market on several factors: divestitures, industry consolidation, economic will be leveraged through the Systems & Technology Group’s conditions and the timing of new patent development. new Technology Collaboration Solutions unit to help clients develop their own innovative products and to create incremen- Income Taxes In the normal course of business, the company expects that its tal opportunity for IBM. effective tax rate will approximate 30 percent. The rate will The key to the company’s continued growth in Software will change year to year based on nonrecurring events (such as the be clients’ continued adoption of its on demand solutions. The third-quarter 2005 repatriation charge as described in note P, key differentiating factor for the company is the strength and “Taxes” on page 80), as well as recurring factors including the breadth of its middleware portfolio. Software is a key component geographic mix of income before taxes, the timing and amount of on demand solutions, and the company will continue to invest of foreign dividends, state and local taxes and the interaction of in this strategic area and strengthen its portfolio through acqui- various global tax strategies. sitions. An example is the company’s ability to respond to During the period 2003-2005, the company’s cash tax rate clients’ increasing interest in a SOA with its WebSphere product declined from 18 percent to 16 percent. The company’s cash tax portfolio and key acquisitions, such as DataPower Technology, rate represents the amount of income taxes paid during the year that expand the company’s capabilities to address this opportu- over Income from continuing operations before income taxes. nity. In addition, the company will continue to build a strong partner ecosystem to drive growth. _37


  • Page 39

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The cash tax rate differs from the company’s effective tax rate STANDARD MOODY’S due to a number of variables including, but not limited to, certain AND INVESTORS FITCH items of income and expense that are recognized in different POOR’S SERVICE RATINGS years for financial reporting purposes than for income tax pur- Senior long-term debt A+ A1 AA- poses, differences in currency rates used in the translation of the Commercial paper A-1 Prime-1 F1+ non-U.S. income tax provision and income tax payments, and current-year cash tax payments or refunds that are related to The company prepares its Consolidated Statement of Cash prior years. The company anticipates that its cash tax rate will Flows in accordance with SFAS No. 95, “Statement of Cash approximate the upper end of this range for the near term. Flows,” on page 50 and highlights causes and events underly- However, once the company fully utilizes its alternative minimum ing sources and uses of cash in that format on page 31. For pur- tax credits or loss carryforwards, the possibility exists that the poses of running its business, the company manages, monitors cash tax rate could increase. and analyzes cash flows in a different format. Liquidity and Capital Resources As discussed on page 43, one of the company’s two primary The company generates strong cash flow from operations, pro- objectives of its Global Financing business is to generate strong viding a source of funds ranging between $13.7 billion and $15.3 return on equity. Increasing receivables is the basis for growth billion per year over the past five years. The company provides in a financing business. Accordingly, management considers for additional liquidity through several sources; a sizable cash Global Financing receivables as a profit-generating investment- balance, access to global funding sources, a committed global not as working capital that should be minimized for efficiency. credit facility and in 2004, the company converted a receivables After classifying the Global Financing accounts receivables as securitization facility from an “uncommitted” to a “committed” an investment, the remaining net cash flow is viewed by the com- facility, adding an additional source of liquidity. (See note J, pany as the Cash available for investment and for distribution to “Securitization of Receivables” on page 70 for additional informa- shareholders. With respect to the company’s cash flow analysis tion). The table below provides a summary of these major for internal management purposes (see the first table on page sources of liquidity for the years ended December 31, 2001 39), Global Financing accounts receivables are combined with through 2005. Global Financing debt to represent the Net Global Financing debt to accounts receivable (a profit-generating investment). CASH FLOW AND LIQUIDITY TRENDS From the perspective of how management views cash (Dollars in billions) flows, in 2005, net cash from operating activities, excluding 2005 2004 2003 2002 2001 Global Financing receivables, was $13.1 billion, an increase of $0.2 billion compared to 2004. This cash performance was Net cash from driven primarily by the growth in net income from continuing operating activities $«14.9 $«15.3 $«14.5 $«13.8 $«13.7 operations and the company’s continued focus on working cap- Cash and marketable ital and supply-chain management. The company returned over securities $«13.7 $«10.6 $«««7.6 $«««6.0 $«««6.4 100 percent of net income in 2005 to shareholders in dividend Size of global payments and share repurchases. credit facilities $«10.0 $«10.0 $«10.0 $«12.0 $«12.0 Over the past five years, the company generated over $60.8 Trade receivables billion in Cash available for investment and for distribution to securitization facility $«««0.5 $«««0.5 $««««— $««««— $««««— shareholders. As a result, during the period the company invested $20.6 billion of net capital expenditures, invested $9.1 The major rating agencies’ ratings on the company’s debt secu- billion in strategic acquisitions, received $2.2 billion from divesti- rities at December 31, 2005 appear in the following table and re- tures and returned $34.1 billion to shareholders through divi- main unchanged over the past five years. The company has no dends and share repurchases. The amount of prospective contractual arrangements that, in the event of a change in credit Returns to shareholders in the form of dividends and share rating, would result in a material adverse effect on its financial repurchases will vary based upon several factors including position or liquidity. affordability, namely each year’s operating results, capital expenditures, research and development, and acquisitions, as well as the factors discussed immediately following the first table on page 39. The company’s Board of Directors meets quarterly to consider the dividend payment. The company expects to fund dividend payments through cash from operations. 38_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The table below represents the way in which management reviews its cash flow as described on page 38. (Dollars in billions) FOR THE YEAR ENDED DECEMBER 31: 2005 2004 2003 2002 2001 Net cash from operating activities (Continuing Operations): $«14.9 $«15.3 $«14.5 $«13.8 $«13.7 Less: Global Financing accounts receivable 1.8 2.5 1.9 3.3 2.0 Net cash from operating activities (Continuing Operations), excluding Global Financing receivables 13.1 12.9 12.6 10.5 11.7 Investing Activities: Capital expenditures, net (3.5) (3.7) (3.9) (4.6) (4.9) Global Financing accounts receivable 1.8 2.5 1.9 3.3 2.0 Global Financing debt (0.6) (1.7) (2.6) (3.1) (1.1) Net Global Financing debt to accounts receivable 1.3 0.7 (0.7) 0.2 0.9 Acquisitions (1.5) «(1.7) (1.8) (3.2) (0.9) Divestitures 0.9 — 0.1 1.2 — Return to shareholders: Share Repurchase ««(7.7) «(7.1) «««(4.3) ««(4.2) «««(5.3) Dividends (1.2) (1.2) (1.1) (1.0) (1.0) Change in non-Global Financing debt 1.2 0.7 (0.9) (0.1) 0.6 Other ««0.7 «2.5 «««1.9 ««1.4 «««1.4 Discontinued operations — (0.1) (0.2) (0.7) 0.1 Change in cash, cash equivalents and marketable securities ««$«««3.1 «$«««2.9 «««$«««1.7 ««$««(0.4) «««$«««2.7 Table may not add due to rounding. Events that could temporarily change the historical cash flow positions the company to further reduce volatility in pension con- dynamics discussed above include significant changes in oper- tributions and earnings over the long term. ating results, material changes in geographic sources of cash, The company is not quantifying any further impact from pen- unexpected adverse impacts from litigation or future pension sion funding because it is not possible to predict future movements funding during periods of severe and prolonged downturn in the in the capital markets. However, for 2006, if actual returns on plan capital markets. Whether any litigation has such an adverse assets for the PPP were less than 2.3 percent, the PPP’s accumu- impact will depend on a number of variables, which are more lated benefit obligation (ABO) would be greater than its plan assets completely described on page 78. With respect to pension fund- (assuming no other assumption change). As discussed on page ing, on January 19, 2005, the company contributed $1.7 billion to 87, such a situation may result in a further voluntary contribution of the qualified portion of the company’s PPP. This contribution cash or stock to the PPP or a charge to stockholders’ equity. CONTRACTUAL OBLIGATIONS (Dollars in millions) TOTAL PAYMENTS DUE IN CONTRACTUAL PAYMENT STREAM 2006 2007-08 2009-10 AFTER 2010 Long-term debt obligations $«17,745 $«2,906 $«4,174 $«3,752 $«6,913 Capital (finance) lease obligations 452 104 155 141 52 Operating lease obligations 5,780 1,331 2,066 1,369 1,014 Purchase obligations 2,104 809 906 267 122 Other long-term liabilities: Minimum pension funding (mandated)* 3,816 1,818 1,002 996 — Executive compensation 850 115 169 197 369 Environmental liabilities 254 27 29 23 175 Long-term termination benefits 2,378 549 436 308 1,085 Other 332 65 70 44 153 Total $«33,711 $«7,724 $«9,007 $«7,097 $«9,883 * 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 2010 are not currently determinable. See note V, “Retirement-Related Benefits,” on pages 85 to 95 for additional information on the non-U.S. plans’ investment strategies and expected contributions. _39


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Total contractual payments are reported in the second table on income in 2005 would have been an estimated $48 million page 39 excluding the effects of time value and therefore, may higher if the actual lives were longer than the estimates and an not equal the amounts reported in the company’s Consolidated estimated $59 million lower if the actual lives were shorter than Statement of Financial Position. the estimates (based upon 2005 results). Purchase obligations include all commitments to purchase PENSION ASSUMPTIONS goods or services of either a fixed or minimum quantity that meet any of the following criteria: (1) they are noncancelable, (2) the The expected long-term return on plan assets is used in calculat- company would incur a penalty if the agreement was canceled, ing the net periodic pension (income)/cost. See page 92 for infor- or (3) the company must make specified minimum payments mation regarding the expected long-term return on plan assets even if it does not take delivery of the contracted products or assumption. The differences between the actual return on plan services (“take-or-pay”). If the obligation to purchase goods or assets and expected long-term return on plan assets, a compo- services is noncancelable, the entire value of the contract is nent of unrecognized gains/losses, are recognized over the serv- included in the second table on page 39. If the obligation is ice lives of the employees in the plan, provided such amounts cancelable, but the company would incur a penalty if canceled, exceed thresholds which are based upon the obligation or the the dollar amount of the penalty is included as a purchase obli- value of plan assets, as provided by accounting standards. gation. Contracted minimum amounts specified in take-or-pay As described on page 87, if the fair value of the pension contracts are also included in the table as they represent the plan’s assets is below the plan’s ABO, the company will be portion of each contract that is a firm commitment. required to record a minimum liability and a charge to stockhold- In the ordinary course of business, the company enters into ers’ equity. The company may voluntarily make contributions or be contracts that specify that the company will purchase all or a required, by law, to make contributions to the pension plans. portion of its requirements of a specific product, commodity, or Actual results that differ from the estimates may result in more or service from a supplier or vendor. These contracts are generally less future company funding into the pension plans than is entered into in order to secure pricing or other negotiated terms. planned by management. See page 39 for additional information They do not specify fixed or minimum quantities to be pur- and near-term sensitivities of actual returns on funding decisions. chased and, therefore, the company does not consider them to To the extent the outlook for long-term returns changes such be purchase obligations. that management changes its expected long-term return on plan assets assumption, each 50 basis point increase or decrease in Critical Accounting Estimates the expected long-term return on PPP plan assets assumption The application of GAAP involves the exercise of varying degrees will have an estimated increase or decrease, respectively, of of judgment. While the resulting accounting estimates will, by def- $225 million on the following year’s pre-tax net periodic pension inition, not always precisely equal the related actual results, certain income (based upon the PPP’s plan assets at December 31, 2005 estimates involve more judgment than others. Those estimates and assuming no contributions are made in 2006). are described below and on page 47 for Global Financing. Another key management assumption is the discount rate. The sensitivity analyses used below are not meant to pro- See page 91 for information regarding the discount rate vide a reader with management’s predictions of the variability of assumption. Changes in the discount rate assumptions will the estimates used. Rather, the sensitivity levels selected (e.g., impact the interest cost component of the net periodic pension 5 percent, 10 percent, etc.) are included to allow users of the income calculation and due to the fact that the ABO is calcu- Annual Report to understand a general-direction cause and lated on a net present value basis, changes in the discount rate effect of changes in the estimates. assumption will also impact the current ABO. An increase in the ABO caused by a decrease in the discount rate may result in a USEFUL LIVES OF MICROELECTRONICS voluntary contribution to a pension plan. PLANTS AND EQUIPMENT As discussed on page 91, the company reduced the dis- The company determines the estimated useful lives and related count rate assumption for the PPP by 25 basis points to 5.5 per- depreciation charges for its plants and equipment. For Micro- cent on December 31, 2005. This change will increase pre-tax electronics, this estimate is based on projected technology, cost and expense in 2006 by $94 million. Had the discount rate process and product life cycles that could change significantly assumption for the PPP increased by 25 basis points on due to technical innovations and competitor actions in response December 31, 2005, pre-tax cost and expense would decrease to relatively volatile industry cycles. To the extent actual useful by $96 million in 2006. As mentioned above, changes in the dis- lives are less than previously estimated lives, the company will count rate assumption will impact the ABO which, in turn, may increase its depreciation charge or will writeoff or writedown impact the company’s funding decisions if the ABO exceeds technically obsolete or non-strategic assets. plan assets. In order to analyze the sensitivity of discount rate The company estimates useful lives of its Microelectronics movements, each 25 basis point increase or decrease in the equipment by reference to the current and projected dynamics interest rate will cause a corresponding decrease or increase, in the semiconductor industry, product/process life cycles and respectively, in the PPP’s ABO of an estimated $1.2 billion based anticipated competitor actions. upon December 31, 2005 data. Page 90 presents the PPP’s ABO To the extent that Microelectronics’ actual useful lives differ from management’s estimates by 10 percent, consolidated net 40_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES (after the reduction in discount rate discussed on page 40) and period sales and records accrued warranty costs for these plan assets as of December 31, 2005. sales. The company uses historical warranty claim information, Impacts of these types of changes on the pension plans in as well as recent trends that might suggest that past cost infor- other countries will vary depending upon the status of each mation may differ from future claims. respective plan. Factors that could impact the estimated claim information include the success of the company’s productivity and quality COSTS TO COMPLETE SERVICE CONTRACTS initiatives, as well as parts and labor costs. The company enters into numerous service contracts through To the extent that actual future claims costs differ from man- its SO and BCS businesses. SO contracts range for periods agement’s estimates by 5 percent, consolidated net income up to ten years and BCS contracts can be for several years. would have improved/declined by an estimated $26 million in During the contractual period, revenue, cost and profits may be 2005, depending upon whether the actual claims costs were impacted by estimates of the ultimate profitability of each lower/higher, respectively, than the estimates. contract, especially contracts for which the company uses the percentage-of-completion method of accounting. See page 55 INCOME TAXES for the company’s services revenue recognition accounting poli- The company is subject to income taxes in both the U.S. and cies. If at any time these estimates indicate the contract will be numerous foreign jurisdictions. Significant judgments are required unprofitable, the entire estimated loss for the remainder of the in determining the consolidated provision for income taxes. contract is recorded immediately. During the ordinary course of business, there are many The company performs ongoing profitability analyses of its transactions and calculations for which the ultimate tax deter- services contracts in order to determine whether the latest esti- mination is uncertain. As a result, the company recognizes tax mates require updating. Key factors reviewed by the company liabilities based on estimates of whether additional taxes and to estimate the future costs to complete each contract are future interest will be due. These tax liabilities are recognized when, labor costs and productivity efficiencies. despite the company’s belief that its tax return positions are To the extent actual estimated completed contract margins supportable, the company believes that certain positions are on percentage of completion services contracts differ from man- likely to be challenged and may not be fully sustained upon agement’s quarterly estimates by 1 percentage point, the com- review by tax authorities. The company believes that its accru- pany’s consolidated net income would have improved/declined als for tax liabilities are adequate for all open audit years based by an estimated $45 million using 2005 results, depending upon on its assessment of many factors including past experience whether the actual results were higher/lower, respectively, than and interpretations of tax law. This assessment relies on esti- the estimates. This amount excludes any accrual resulting from mates and assumptions and may involve a series of complex contracts in loss positions. For all long-term services contracts judgments about future events. To the extent that the final tax that have an estimated completed contract profit margin of 5 outcome of these matters is different than the amounts percent or less, if actual profits were 5 percentage points less recorded, such differences will impact income tax expense in than expected, consolidated net income would be reduced by the period in which such determination is made. an estimated $135 million. Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In INVENTORY assessing the need for a valuation allowance, management con- The company reviews the market value of and demand for its siders all available evidence including past operating results, inventory on a quarterly basis to ensure recorded inventory is estimates of future taxable income and the feasibility of ongoing stated at the lower of cost or market. Inventories at higher risk for tax planning strategies. In the event that the company changes writedowns or writeoffs are those in the industries that have lower its determination as to the amount of deferred tax assets that can relative gross margins and that are subject to a higher likelihood be realized, the company will adjust its valuation allowance with of changes in industry cycles. The semiconductor business is a corresponding impact to income tax expense in the period in one such industry. which such determination is made. Factors that could impact estimated demand and selling To the extent that the provision for income taxes increases/ prices are the timing and success of future technological innova- decreases by 1 percent of Income from continuing operations tions, competitor actions, supplier prices and economic trends. before income taxes, consolidated income from continuing oper- To the extent that total inventory losses differ from manage- ations would have declined/improved by $122 million in 2005. ment estimates by 5 percent, the company’s consolidated net income in 2005 would have improved/declined by an estimated RESTRUCTURING ACTIONS $22 million using 2005 results, depending upon whether the The company has executed, and may continue to execute, actual results were better/worse, respectively, than expected. restructuring actions which require management to utilize signif- icant estimates related to expenses for severance and other WARRANTY CLAIMS employee separation costs, realizable values of assets made The company offers warranties on most of its products. The com- redundant or obsolete, lease cancellation and other exit costs. If pany estimates the cost of future warranty claims for its current the actual amounts differ from the company’s estimates, the _41


  • Page 43

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES amount of the restructuring charges could be materially derivatives, as explained in note L, “Derivatives and Hedging impacted. See note R, “2005 Actions” on pages 80 and 81 for a Transactions,” on pages 71 to 74. description of restructuring actions. To meet disclosure requirements, the company performs a sensitivity analysis to determine the effects that market risk Currency Rate Fluctuations exposures may have on the fair values of the company’s debt Changes in the relative values of non-U.S. currencies to the U.S. and other financial instruments. dollar affect the company’s results. At December 31, 2005, cur- The financial instruments that are included in the sensitivity rency changes resulted in assets and liabilities denominated in analysis comprise all of the company’s cash and cash equiva- local currencies being translated into fewer dollars than at year- lents, marketable securities, long-term non-lease receivables, end 2004. The company uses a variety of financial hedging investments, long-term and short-term debt and all derivative instruments to limit specific currency risks related to financing financial instruments. The company’s portfolio of derivative transactions and other foreign currency-based transactions. financial instruments generally includes interest rate swaps, for- Further discussion of currency and hedging appears in note L, eign currency swaps, forward contracts and option contracts. “Derivatives and Hedging Transactions,” on pages 71 to 74. To perform the sensitivity analysis, the company assesses The company earned approximately 45 percent of its net the risk of loss in fair values from the effect of hypothetical income in currencies other than the U.S. dollar. The company also changes in interest rates and foreign currency exchange rates maintains hedging programs to limit the volatility of currency on market-sensitive instruments. The market values for interest impacts on the company’s financial results. These hedging pro- and foreign currency exchange risk are computed based on the grams limit the impact of currency changes on the company’s present value of future cash flows as affected by the changes in financial results but do not eliminate them. In addition to the trans- rates that are attributable to the market risk being measured. lation of earnings and the company’s hedging programs, the The discount rates used for the present value computations impact of currency changes also may affect the company’s pric- were selected based on market interest and foreign currency ing and sourcing actions. For example, the company may procure exchange rates in effect at December 31, 2005 and 2004. The components and supplies in multiple functional currencies and differences in this comparison are the hypothetical gains or sell products and services in other currencies. Therefore, it is losses associated with each type of risk. impractical to quantify the impact of currency on these transac- Information provided by the sensitivity analysis does not tions and on consolidated net income. Generally, the company necessarily represent the actual changes in fair value that the believes that extended periods of dollar weakness are positive for company would incur under normal market conditions because, net income and extended periods of dollar strength are negative, due to practical limitations, all variables other than the specific although the precise impact is difficult to assess. market risk factor are held constant. In addition, the results of the For non-U.S. subsidiaries and branches that operate in U.S. model are constrained by the fact that certain items are specifi- dollars or whose economic environment is highly inflationary, cally excluded from the analysis, while the financial instruments translation adjustments are reflected in results of operations, relating to the financing or hedging of those items are included as required by SFAS No. 52, “Foreign Currency Translation.” by definition. Excluded items include leased assets, forecasted Generally, the company manages currency risk in these entities foreign currency cash flows and the company’s net investment by linking prices and contracts to U.S. dollars and by entering in foreign operations. As a consequence, reported changes in into foreign currency hedge contracts. the values of some of the financial instruments impacting the Market Risk results of the sensitivity analysis are not matched with the offset- In the normal course of business, the financial position of the ting changes in the values of the items that those instruments company is routinely subject to a variety of risks. In addition to are designed to finance or hedge. the market risk associated with interest rate and currency move- The results of the sensitivity analysis at December 31, 2005, ments on outstanding debt and non-U.S. dollar denominated and December 31, 2004, are as follows: assets and liabilities, other examples of risk include collectibility INTEREST RATE RISK of accounts receivable and recoverability of residual values on At December 31, 2005, a 10 percent decrease in the levels of leased assets. interest rates with all other variables held constant would result The company regularly assesses these risks and has estab- in an increase in the fair market value of the company’s financial lished policies and business practices to protect against the instruments of $18 million as compared with a decrease of $172 adverse effects of these and other potential exposures. As a million at December 31, 2004. A 10 percent increase in the lev- result, the company does not anticipate any material losses from els of interest rates with all other variables held constant would these risks. result in a decrease in the fair value of the company’s financial The company’s debt in support of the Global Financing instruments of $8 million as compared to an increase of $153 mil- business and the geographic breadth of the company’s opera- lion at December 31, 2004. Changes in the relative sensitivity of tions contain an element of market risk from changes in interest the fair value of the company’s financial instrument portfolio for and currency rates. The company manages this risk, in part, these theoretical changes in the level of interest rates are prima- through the use of a variety of financial instruments including rily driven by changes in the company’s debt maturity, interest rate profile and amount. 42_ Management Discussion


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    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES FOREIGN CURRENCY EXCHANGE RATE RISK value of the company’s financial instruments of $376 million At December 31, 2005, a 10 percent weaker U.S. dollar against compared with $679 million at December 31, 2004. foreign currencies, with all other variables held constant, would Financing risks result in a decrease in the fair value of the company’s financial See the “Global Financing-Description of Business” below for a instruments of $352 million as compared with a decrease of discussion of the financing risks associated with the company’s $692 million at December 31, 2004. Conversely, a 10 percent Global Financing business and management’s actions to miti- stronger U.S. dollar against foreign currencies, with all other gate such risks while striving for consistently strong returns on variables held constant, would result in an increase in the fair Global Financing’s equity. Employees and Related Workforce PERCENTAGE CHANGES FOR THE YEAR ENDED DECEMBER 31: 2005 2004 2003 2005-04 2004-03 IBM/wholly owned subsidiaries 329,373 329,001 319,273 0.1 3.0 Less-than-wholly owned subsidiaries 12,377 19,051 18,189 (35.0) 4.7 Complementary 24,595 21,225 17,695 15.9 19.9 Employees at IBM and its wholly owned subsidiaries in 2005 risks (credit and residual value) that are normally associated were essentially the same level as the prior year. The company with financing. continues to invest in Global Services and Software through a Global Financing comprises three lines of business: combination of hiring and acquisitions. IBM also continues to • Client financing provides lease and loan financing to end rebalance its workforce to improve the company’s competitive- users and internal clients for terms generally between two ness in the marketplace, as well as to withdraw from certain and seven years. Internal financing is predominantly in sup- businesses—notably the divestiture of the Personal Computing port of Global Services’ long-term client service contracts. business in April 2005. Global Financing also factors a selected portion of the com- In less-than-wholly owned subsidiaries, the number of pany’s accounts receivable, primarily for cash management employees decreased from year-end 2004. The decrease is pri- purposes. All of these internal financing arrangements are at marily due to the conversion of the International Information arm’s-length rates and are based upon market conditions. Products Company in China to a wholly-owned unit of IBM’s Personal Computing business that was subsequently sold to • Commercial financing provides primarily short-term inventory Lenovo in 2005. and accounts receivable financing to dealers and remar- The company’s complementary workforce is an approxima- keters of IT products. tion of equivalent full-time employees hired under temporary, • Remarketing sells and leases used equipment to new or part-time and limited-term employment arrangements to meet existing clients both externally and internally. This equipment specific business needs in a flexible and cost-effective manner. is primarily sourced from the conclusion of lease transac- tions. Externally-remarketed equipment revenue represents sales or leases to clients and resellers. Internally-remarketed Global Financing equipment revenue primarily represents used equipment Description of Business that is sold or leased internally to the Hardware and Global Global Financing is a business segment within IBM that is meas- Services segments. The Hardware segment will also sell ured as if it were a standalone entity. Accordingly, the informa- the equipment that it purchases from Global Financing to tion presented in this section is consistent with this separate external clients. company view. The mission of Global Financing is to generate a return on In addition to the strength of the economy and its impact on cor- equity and to facilitate the client’s acquisition of IBM hardware, porate IT budgets, key drivers of Global Financing’s results are software and services. interest rates and originations. Interest rates directly impact Global Financing invests in financing assets, manages the Global Financing’s business by increasing or decreasing both associated risks, and leverages with debt, all with the objective financing revenue and the associated borrowing costs. of generating consistently strong returns on equity. The focus Originations, which determine the asset base of Global on IBM products and IBM clients mitigates the risks normally Financing’s annuity-like business, are impacted by IBM’s non- associated with a financing company. Global Financing has the Global Financing sales volumes and Global Financing’s participa- benefit of both a deep knowledge of its client base and a clear tion rates. Participation rates are the propensity of IBM’s clients to insight into the products that are being leased. This combination finance their purchases through Global Financing in lieu of paying allows Global Financing to effectively manage two of the major IBM up-front cash or financing through a third party. _43


  • Page 45

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Results of Operations 2004 versus 2003. The increase in gross profit dollars was pri- (Dollars in millions) marily driven by cost of sales on remarketing equipment of $932 FOR THE YEAR ENDED DECEMBER 31: 2005 2004 2003 million in 2004 versus $1,168 million in 2003, a decrease of 20.3 percent and borrowing costs of $608 million in 2004 versus $678 External revenue $«2,401 $«2,607 $«2,827 million in 2003, a decrease of 10.3 percent related to volumes Internal revenue 1,506 1,287 1,300 and the interest rate environment during the year, partially offset Total revenue 3,907 3,894 4,127 by the decrease in revenue discussed previously. The increase in Cost 1,648 1,540 1,846 gross profit margin was driven by improved margins in financing Gross profit $«2,259 $«2,354 $«2,281 and equipment sales, and a mix change towards higher margin financing income, and away from lower margin equipment sales. Gross profit margin 57.8% 60.5% 55.3% Global Financing pre-tax income increased 8.6 percent in Pre-tax income $«1,583 $«1,458 $«1,152 2005 versus 2004, compared to an increase of 26.6 percent in After-tax income* $«1,032 $««««915 $««««746 2004 versus 2003. The increase in 2005 was driven by a decrease Return on equity* 33.2% 28.6% 22.1% of $140 million in bad debt expense and a decrease of $78 million * See page 47 for the details of the After-tax income and the Return on equity calculation. in SG&A expense, offset by the decrease in gross profit of $95 million discussed previously. The increase in 2004 versus 2003 Total Global Financing revenue increased 0.3 percent in 2005 as was driven by a decrease of $101 million in bad debt expense, a compared to 2004, driven by Internal revenue growth. External decrease of $17 million in SG&A expense, a decrease of $100 mil- revenue decreased 7.9 percent (8.6 percent adjusted for cur- lion in other charges primarily driven by income from internal sales, rency) versus 2004 primarily driven by financing revenue of and the increase in gross profit of $73 million discussed previously. $1,720 million in 2005 versus $1,899 million in 2004, a decrease The decrease in bad debt expense in both 2005 and 2004 is of 9.4 percent, due to lower average asset balances and declin- reflective of the improved general economic environment, ing asset yields. Internal revenue increased 17.0 percent versus improved credit quality of the portfolio, and the declining size of the 2004 driven by used equipment sales of $962 million in 2005 receivables portfolio. (Also see page 45 for an additional discus- versus $716 million in 2004, an increase of 34.4 percent, partially sion of Global Financing Receivables and Allowances.) offset by financing income of $544 million in 2005 versus $571 The increase in return on equity from 2004 to 2005 and 2003 million in 2004, a decrease of 4.7 percent. The increase in used to 2004 was primarily due to higher earnings. equipment sales is due to higher sales to the Hardware segment, as well as early terminations of internal leases and the subse- Financial Condition BALANCE SHEET quent sale of this equipment to Global Services. Total Global Financing revenue declined 5.6 percent in (Dollars in millions) 2004 as compared to 2003. External revenue decreased 7.8 per- AT DECEMBER 31: 2005 2004 cent (11.5 percent adjusted for currency) versus 2003, primarily Cash $«««1,292 $««««««850 driven by external used equipment sales of $708 million in 2004 Net investment in sales-type leases 9,876 11,141 versus $928 million in 2003, a decrease of 23.7 percent. Internal Equipment under operating leases: revenue decreased 1.0 percent in 2004 driven by remarketing External clients 1,847 1,817 revenue of $783 million in 2004 versus $828 million in 2003, a Internal clients(a)(b) 1,788 1,906 decrease of 5.4 percent, partially offset by commercial financing Client loans 8,486 9,889 revenue of $269 million in 2004 versus $240 million in 2003, an increase of 12.2 percent. Total client financing assets 21,997 24,753 Global Financing gross profit dollars decreased $95 million Commercial financing receivables 5,070 5,710 or 4.0 percent and gross profit margin declined 2.7 points in Intercompany financing receivables (a)(b) 1,968 2,172 2005 versus 2004. The decrease in gross profit dollars was pri- Other receivables 127 223 marily driven by the decline in financing revenue discussed Other assets 711 881 above and borrowing costs of $641 million in 2005 versus $608 Total financing assets $«31,165 $«34,589 million in 2004, an increase of 5.5 percent related to the interest Intercompany payables (a) $«««5,262 $«««6,531 rate environment during the year, partially offset by equipment Debt (c) 20,499 22,320 sales gross profit of $637 million in 2005 versus $492 million in Other liabilities 2,348 2,571 2004, an increase of 29.4 percent due to the increase in used equipment sales discussed above. The decrease in gross profit Total financing liabilities 28,109 31,422 margin was driven by a mix change towards lower margin Total financing equity 3,056 3,167 remarketing sales and away from higher margin financing Total financing liabilities and equity $«31,165 $«34,589 income, and lower financing margins due to higher borrowing (a) Amounts eliminated for purposes of IBM’s consolidated results and therefore do costs related to the interest rate environment during the year, not appear on page 49. partially offset by an improvement in equipment sales margins. (b) These assets, along with all other financing assets in this table, are leveraged using Global Financing debt. Global Financing gross profit dollars increased $73 million (c) Global Financing debt includes debt of the company and of the Global Financing or 3.2 percent and gross profit margin increased 5.2 points in units that support the Global Financing business. 44_ Management Discussion


  • Page 46

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SOURCES AND USES OF FUNDS (Dollars in millions) The primary use of funds in Global Financing is to originate AT DECEMBER 31: 2005 2004 client and commercial financing assets. Client financing assets Financial Services 33% 30% for end users consist primarily of IBM hardware, software and Industrial 20 20 services, but also include non-IBM equipment, software and Business Partners* 19 19 services to meet IBM clients’ total solutions requirements. Client Public 10 9 financing assets are primarily sales type, direct financing, and Distribution 8 9 operating leases for equipment, as well as loans for hardware, Communications 6 9 software and services with terms generally for two to seven Other 4 4 years. Global Financing’s client loans are primarily for software Total 100% 100% and services and are unsecured. These loans are subjected to additional credit analysis in order to mitigate the associated risk. * Business Partners’ financing assets represent a portion of commercial financing inventory and accounts receivable financing for terms generally less than 90 days. Unsecured loan agreements include credit protective language, security deposit advances, and dollar limits on how much can GLOBAL FINANCING RECEIVABLES AND ALLOWANCES be financed in order to minimize credit risk. Client financing also includes internal activity as described on page 43. The following table presents external financing receivables, exclud- Commercial financing receivables arise primarily from ing residual values, and the allowance for doubtful accounts. inventory and accounts receivable financing for dealers and (Dollars in millions) remarketers of IBM and non-IBM products. Payment terms for AT DECEMBER 31: 2005 2004 inventory financing generally range from 30 to 75 days. Payment terms for accounts receivable financing generally range from 30 Gross financing receivables $«23,197 $«26,836 to 90 days. These short-term receivables are primarily unse- Specific allowance for doubtful accounts 421 654 cured and are also subject to additional credit actions in order Unallocated allowance for doubtful accounts 84 127 to mitigate the associated risk. Total allowance for doubtful accounts 505 781 ORIGINATIONS Net financing receivables $«22,692 $«26,055 The following are total external and internal financing originations. Allowance for doubtful account coverage 2.2% 2.9% (Dollars in millions) FOR THE YEAR ENDED DECEMBER 31: 2005 2004 2003 ROLL - FORWARD OF FINANCING RECEIVABLES ALLOWANCE Client finance: FOR DOUBTFUL ACCOUNTS External $«12,249 $«12,433 $«13,279 (Dollars in millions) Internal 1,167 1,185 1,150 REDUCTIONS: Commercial finance 27,032 25,566 24,291 RESERVE BAD DEBT DEC. 31, JAN. 1, 2005 USED* EXPENSE OTHER** 2005 Total $«40,448 $«39,184 $«38,720 $«781 $«(183) $«(35) $«(58) $«505 Cash collections of both client and commercial financing assets * Represents reserved receivables, net of recoveries, that were disposed of during exceeded new financing originations in 2005, which resulted in the period. ** Primarily represents translation adjustments. a net decline in financing assets from December 31, 2004. The increases in originations in 2005 and 2004 from 2004 and 2003 respectively, were due to improving volumes in commercial The percentage of financing receivables reserved decreased financing, as well as favorable currency movements offset by a from 2.9 percent at December 31, 2004, to 2.2 percent at decline in participation rates. The decline in participation rates December 31, 2005 primarily due to the decrease in the specific was in line with industry trends. allowance for doubtful accounts. Specific reserves decreased Cash generated by Global Financing in 2005 was deployed 35.6 percent from $654 million at December 31, 2004 to $421 to pay the intercompany payables and dividends to IBM, as well million at December 31, 2005 due to the disposition of reserved as to reduce debt. receivables during the period combined with lower require- ments for additional specific reserves. This lower requirement is FINANCING ASSETS BY SECTOR generally due to a decline in assets and improving economic The following are the percentage of external financing assets by conditions, as well as portfolio management to reduce credit industry sector. risk. Unallocated reserves decreased 33.9 percent from $127 million at December 31, 2004 to $84 million at December 31, 2005 due to the decline in gross financing receivables com- bined with improved economic conditions and improved credit quality of the portfolio. Global Financing’s bad debt expense was a reduction of $35 million for the year ended December 31, _45


  • Page 47

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES 2005, compared with an addition of $105 million for the year sales-type and operating leases at December 31, 2004 and 2005. ended December 31, 2004. The decline was primarily attributed In addition, the table below presents the residual value as a per- to the overall reduction in the financing asset portfolio, as well as centage of the original amount financed, and a run out of when the the improvement in economic conditions and improved credit unguaranteed residual value assigned to equipment on leases at quality of the portfolio in 2005 as compared with 2004. December 31, 2005 is expected to be returned to the company. In addition to the unguaranteed residual value below, on a limited RESIDUAL VALUE basis, Global Financing will obtain guarantees of the future value Residual value is a risk unique to the financing business, and of the equipment to be returned at end of lease. These third-party management of this risk is dependent upon the ability to accu- guarantees are included in minimum lease payments as provided rately project future equipment values at lease inception. Global for by accounting standards in the determination of lease classifi- Financing has insight into product plans and cycles for the IBM cations for the covered equipment and provide protection against products under lease. Based upon this product information, risk of loss arising from declines in equipment values for these Global Financing continually monitors projections of future equip- assets. The residual value guarantee increases the minimum lease ment values and compares them with the residual values reflected payments that are utilized in determining the classification of a in the portfolio. See note A, “Significant Accounting Policies,” on lease as a sales-type lease or an operating lease. Revenue from page 61 for the company’s accounting policy for residual values. a sales-type lease is recorded at the inception of the lease, Global Financing optimizes the recovery of residual values by whereby revenue on an operating lease is recognized over the life selling assets sourced from end of lease, leasing used equipment of the lease. The aggregate asset value associated with the guar- to new clients, or extending lease arrangements with current antees was $651 million and $700 million for financing transac- clients. Sales of equipment, which are primarily sourced from tions originated during the years ended December 31, 2005 and equipment returned at end of lease, represented 42.1 percent of 2004, respectively. In 2005, the residual value guarantee program Global Financing’s revenue in 2005 and 36.6 percent in 2004. The resulted in the company recognizing approximately $543 million increase is driven primarily by higher internal used equipment of revenue that would otherwise have been recognized in future sales, due to higher sales to the Hardware segment, as well as periods as operating lease revenue. If the company had chosen early terminations of internal leases and subsequent sale of equip- to not participate in a residual value program in 2005 and prior ment to Global Services. The gross margin on these sales was 38.7 years, overall revenues would not have been materially affected percent and 34.5 percent in 2005 and 2004, respectively. The due to the relatively constant year-to-year aggregate asset value increase in gross margin was primarily due to the increase in inter- associated with the residual value guarantees. The associated nal equipment sales. In addition to selling assets sourced from aggregate guaranteed future value at the scheduled end of lease end of lease, Global Financing optimizes the recovery of residual was $27 million and $36 million for financing transactions origi- values by leasing used equipment to new clients or extending nated during the same time periods, respectively. The cost of leasing arrangements with current clients. The following table guarantees was $4.3 million for year ended December 31, 2005, presents the recorded amount of unguaranteed residual value for and $5.7 million for year ended December 31, 2004. UNGUARANTEED RESIDUAL VALUE (Dollars in millions) TOTAL RUN OUT OF 2005 BALANCE 2009 AND 2004* 2005 2006 2007 2008 BEYOND Sales-type leases $««««««836 $««««««792 $«238 $«250 $«226 $«««78 Operating leases 197 214 64 73 50 27 Total unguaranteed residual value $«««1,033 $«««1,006 $«302 $«323 $«276 $«105 Related original amount financed $«25,982 $«23,397 Percentage 4.0% 4.3% * Restated to conform with 2005 presentation. DEBT loans are set by the company to substantially match the term and currency underlying the receivable. The intercompany loans are AT DECEMBER 31: 2005 2004 based on arm’s-length pricing. Both assets and debt are pre- Debt-to-equity ratio 6.7x 7.0x sented in the Global Financing Balance Sheet on page 44. The company’s Global Financing business provides fund- Global Financing funds its operations primarily through borrow- ing predominantly for the company’s external clients but also ings using a debt-to-equity ratio of approximately 7 to 1. The debt provides intercompany financing for the company (internal), as is used to fund Global Financing assets and is composed of inter- described in the “Description of Business” on page 43. As pre- company loans and external debt. The terms of the intercompany viously stated, the company measures Global Financing as if it were a standalone entity and accordingly, interest expense 46_ Management Discussion


  • Page 48

    Management Discussion INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES relating to debt supporting Global Financing’s external client operating or sales-type. Global Financing estimates the future and internal business is included in the “Global Financing fair value of leased equipment by using historical models, ana- Results of Operations” on page 44 and in note W, “Segment lyzing the current market for new and used equipment and Information,” on pages 95 through 99. obtaining forward-looking product information such as marketing In the company’s Consolidated Statement of Earnings on plans and technological innovations. Residual value estimates page 48, however, the interest expense supporting Global are periodically reviewed and “other than temporary” declines in Financing’s internal financing to the company is reclassified estimated future residual values are recognized upon identifica- from Cost of financing to Interest expense. tion. Anticipated increases in future residual values are not rec- ognized until the equipment is remarketed. Factors that could LIQUIDITY AND CAPITAL RESOURCES cause actual results to materially differ from the estimates include Global Financing is a segment of the company and as such, is severe changes in the used-equipment market brought on by supported by the company’s liquidity position and access to unforeseen changes in technology innovations and any resulting capital markets. Cash generated from operations in 2005 was changes in the useful lives of used equipment. deployed to reduce debt and pay dividends to the company in To the extent that actual residual value recovery is lower order to maintain an appropriate debt-to-equity ratio. than management’s estimates by 5 percent, Global Financing’s net income would be lower by an estimated $16 million (using Return on Equity 2005 data). If the actual residual value recovery is higher than (Dollars in millions) management’s estimates, the increase in net income will be real- AT DECEMBER 31: 2005 2004 ized at the end of lease when the equipment is remarketed. Numerator: Global Financing after tax income (a)* $«1,032 $««««915 Market Risk Denominator: See pages 42 and 43 for discussion of the company’s overall Average Global Financing equity (b)** $«3,109 $«3,194 market risk. Global Financing Return Looking Forward on Equity (a)/(b) 33.2% 28.6% Given Global Financing’s mission of supporting IBM’s hardware, * Calculated based upon an estimated tax rate principally based on Global software and services businesses, originations for both client Financing’s geographic mix of earnings as IBM’s provision for income taxes is determined on a consolidated basis. and commercial finance businesses will be dependent upon the ** Average of the ending equity for Global Financing for the last five quarters. overall demand for IT hardware, software and services, as well as client participation rates. As a result of the company divesting its Personal Computing Critical Accounting Estimates business to Lenovo in the second quarter, Global Financing will As discussed in note A, “Significant Accounting Policies,” on support Lenovo’s personal computer business through an exclu- page 54, the application of GAAP involves the exercise of varying sive, five-year agreement covering all Global Financing lines of degrees of judgment. The following areas require more judg- business effective May 1, 2005. These participations with Lenovo ment relative to the others and relate to Global Financing. Also will be external revenue to Global Financing. see “Critical Accounting Estimates” on pages 40 to 42. Interest rates and the overall economy (including currency FINANCING RECEIVABLES RESERVES fluctuations) will have an effect on both revenue and gross profit. Global Financing reviews its financing receivables portfolio at The company’s interest rate risk management policy, however, least quarterly in order to assess collectibility. A description of combined with the Global Financing funding strategy (see page the methods used by management to estimate the amount of 46), should mitigate gross margin erosion due to changes in uncollectible receivables is included on page 61. Factors that interest rates. The company’s policy of matching asset and lia- could result in actual receivable losses that are materially differ- bility positions in foreign currencies will limit the impacts of cur- ent from the estimated reserve include sharp changes in the rency fluctuations. economy, or a significant change in the economic health of a The economy could impact the credit quality of the Global particular industry segment that represents a concentration in Financing receivables portfolio and therefore the level of provi- Global Financing’s receivables portfolio. sion for bad debts. Global Financing will continue to apply rigor- To the extent that actual collectibility differs from manage- ous credit policies in both the origination of new business and ment’s estimates by 5 percent, Global Financing net income the evaluation of the existing portfolio. would be higher or lower by an estimated $16 million (using As discussed above, Global Financing has historically been 2005 data), depending upon whether the actual collectibility able to manage residual value risk both through insight into the was better or worse, respectively, than the estimates. product cycles, as well as through its remarketing business. Global Financing has policies in place to manage each of RESIDUAL VALUE the key risks involved in financing. These policies, combined Residual value represents the estimated fair value of equipment with product and client knowledge, should allow for the prudent under lease as of the end of the lease. Residual value estimates management of the business going forward, even during peri- impact the determination of whether a lease is classified as ods of uncertainty with respect to the economy. _47


  • Page 49

    Consolidated Statement of Earnings INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES (Dollars in millions except per share amounts) FOR THE YEAR ENDED DECEMBER 31: NOTES 2005 2004 2003 Revenue: Global Services $«47,357 $«46,213 $«42,635 Hardware 24,314 31,154 28,239 Software 15,753 15,094 14,311 Global Financing 2,407 2,608 2,826 Enterprise Investments/Other 1,303 1,224 1,120 Total Revenue 91,134 96,293 89,131 Cost: Global Services 35,070 35,038 32,304 Hardware 15,771 21,976 20,453 Software 1,972 1,933 1,943 Global Financing 1,091 1,046 1,249 Enterprise Investments/Other 698 731 635 Total Cost 54,602 60,724 56,584 Gross Profit 36,532 35,569 32,547 Expense and Other Income: Selling, general and administrative 21,314 20,079 18,601 Research, development and engineering Q 5,842 5,874 5,314 Intellectual property and custom development income (948) (1,169) (1,168) Other (income) and expense (2,122) (23) 238 Interest expense K&L 220 139 145 Total Expense and Other Income 24,306 24,900 23,130 Income from Continuing Operations Before Income Taxes 12,226 10,669 9,417 Provision for income taxes P 4,232 3,172 2,829 Income from Continuing Operations 7,994 7,497 6,588 Discontinued Operations: Loss from discontinued operations, net of tax (24) (18) (30) Income before cumulative effect of change in accounting principle 7,970 7,479 6,558 Cumulative effect of change in accounting principle, net of tax** B (36) — — Net Income $«««7,934 $«««7,479 $«««6,558 Earnings/(Loss) per Share of Common Stock: Assuming Dilution: Continuing operations s $«««««4.91 $«««««4.39 $«««««3.76 Discontinued operations s (0.01) (0.01) (0.02) Before cumulative effect of change in accounting principle s 4.90 4.38 3.74 Cumulative effect of change in accounting principle** s (0.02) — — Total s $«««««4.87* $«««««4.38 $«««««3.74 Basic: Continuing operations s $«««««4.99 $«««««4.48 $«««««3.83 Discontinued operations s (0.02) (0.01) (0.02) Before cumulative effect of change in accounting principle s 4.98* 4.47 3.81 Cumulative effect of change in accounting principle** s (0.02) — — Total s $«««««4.96 $«««««4.47 $«««««3.81 Weighted-Average Number of Common Shares Outstanding: Assuming dilution 1,627,632,662 1,707,231,708 1,752,847,742 Basic 1,600,591,264 1,674,959,086 1,721,588,628 * Does not total due to rounding. ** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information. The accompanying notes on pages 54 through 100 are an integral part of the financial statements. 48_ Consolidated Statements


  • Page 50

    Consolidated Statement of Financial Position INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES (Dollars in millions except per share amounts) AT DECEMBER 31: NOTES 2005 2004 Assets Current assets: Cash and cash equivalents $«««12,568 $«««10,053 Marketable securities D 1,118 517 Notes and accounts receivable—trade (net of allowances of $267 in 2005 and $277 in 2004) 9,540 10,522 Short-term financing receivables (net of allowances of $422 in 2005 and $681 in 2004) F 13,750 15,801 Other accounts receivable (net of allowances of $7 in 2005 and $13 in 2004) 1,138 1,813 Inventories E 2,841 3,316 Deferred taxes P 1,765 2,413 Prepaid expenses and other current assets 2,941 2,708 Total current assets 45,661 47,143 Plant, rental machines and other property G 34,261 36,385 Less: Accumulated depreciation G 20,505 21,210 Plant, rental machines and other property—net G 13,756 15,175 Long-term financing receivables F 9,628 10,950 Prepaid pension assets V 20,625 20,394 Investments and sundry assets H 4,974 7,115 Goodwill I 9,441 8,437 Intangible assets—net I 1,663 1,789 Total Assets $«105,748 $«111,003 Liabilities and Stockholders’ Equity Current liabilities: Taxes P $«««««4,710 $«««««4,728 Short-term debt K&L 7,216 8,099 Accounts payable 7,349 9,444 Compensation and benefits 3,325 3,804 Deferred income 7,319 7,175 Other accrued expenses and liabilities 5,233 6,536 Total current liabilities 35,152 39,786 Long-term debt K&L 15,425 14,828 Retirement and nonpension postretirement benefit obligations V 13,779 15,883 Other liabilities M 8,294 8,818 Total Liabilities 72,650 79,315 Contingencies and Commitments O Stockholders’ equity: N Common stock, par value $.20 per share and additional paid-in capital 28,926 26,673 Shares authorized: 4,687,500,000 Shares issued (2005—1,981,259,104; 2004—1,962,687,087) Retained earnings 44,734 38,148 Treasury stock, at cost (shares: 2005—407,279,343; 2004—317,094,633) (38,546) (31,072) Accumulated gains and (losses) not affecting retained earnings N (2,016) (2,061) Total Stockholders’ Equity 33,098 31,688 Total Liabilities and Stockholders’ Equity $«105,748 $«111,003 The accompanying notes on pages 54 through 100 are an integral part of the financial statements. _49

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