avatar IBM World Trade Corporation Manufacturing

Pages

  • Page 1

    Dear IBM Investor: I am happy to report to you on a very strong year for our company. In my letter last year, I said that we believed we had positioned ourselves to capture the most attractive growth and profit opportunities in our industry. In 2006 we did just that, setting new records in profit, earnings per share and cash performance. What our numbers do not reveal — and what is perhaps IBM’s most notable accomplishment during this period — is that we achieved these results while fundamentally reshaping our company. Whether you look at our technology, strategy, business model, processes or culture, IBM is a very different enterprise today than it was at the beginning of the decade. We have prepared the company for growth and leadership in a radically different future — while continuing to deliver steady results.


  • Page 2


  • Page 3

    Chairman’s Letter IBM had a strong year in 2006. Revenue as reported was $91.4 billion, up 4 percent , excluding PCs from our 2005 results. Pretax earnings from continuing operations were $13.3 billion, an increase of 9 percent . Diluted earnings per share from continuing operations were $6.06, up 23 percent, marking 16 straight quarters of growth. IBM has consistently generated return on invested capital significantly above the average for the S&P 500 over the past several years, and we did so again in 2006, with ROIC of 34 percent , excluding our Global Financing business. IBM’s gross profit margin rose for the third consecutive of cash and marketable securities. And of course, stronger year — to 41.9 percent, an increase of 1.8 points in 2006, up earnings and cash give us more flexibility to increase returns more than five points since 2003. Our pretax income margin to you and to invest in future sources of growth. rose to 14.6 percent, an increase of 1.2 points. Both margins Our net 2006 cash investment of $3.8 billion for are at their highest in the past 10 years. Significantly, as 13 acquisitions — nine of them in key strategic areas of I will discuss, they were achieved primarily by remixing our software — was up $2.3 billion year to year. After investing business to higher-value segments and by driving efficiency $ 6.1 billion in R&D and $ 4.7 billion in net capital through global integration. expenditures, we were able to return a record of nearly In many respects, IBM is a “higher-torque” engine today. $9.8 billion to you — $8.1 billion through share repurchase With revenue growth that matches our segments of the and $1.7 billion through dividends — or more than 100 percent industry, we have been able to generate strong profit and of our net earnings. In April 2006 we announced a 50-percent cash. In 2006 we generated net cash from operations, increase in our quarterly dividend, the largest percentage excluding a year-to-year change in Global Financing increase in IBM history and the 362nd consecutive dividend receivables, of $15.3 billion — an increase of $ 2.2 billion paid by IBM. This was the 11th year in a row in which we from last year and our highest on record. In addition, net have increased our dividend. Our balance sheet remains cash generated from every dollar of revenue has increased strong, and the company is well positioned to take advantage 18 percent since 2003. IBM ended 2006 with $10.7 billion of new strategic opportunities. 1


  • Page 4

    Chairman’s Letter STRATEGIC CHOICES of each client, it cannot be done in the lab or on the In order to understand how we achieved these results, plant floor, and it certainly can’t be done in headquarters. I think it is helpful to look back to the major strategic choices It has meant an ongoing effort to change our processes we made several years ago. They were by no means obvious and structures to push decision making close to the at the time, and most IT companies chose different paths. marketplace — what we internally call “lowering the But as we entered the new century, we were convinced that center of gravity” of IBM. three developments would be of paramount importance to IBM and our clients: 3. We believed that globalization would fundamentally change business. Because of free trade policies, the 1. We believed that our clients would place a premium Internet and the emergence of highly skilled populations, on innovation. What technology company doesn’t we believed that globalization would arrive in full force — say it’s all about innovation? But if you really take this and with it the reality that anyone could capitalize on seriously, then you have to commit your company to expertise and market conditions everywhere in the world. continuous adaptation and change. Such is the nature of We believed this opportunity would soon become an our industry, and many IT companies learn that lesson economic imperative: Businesses, institutions, industries the hard way. Today, it’s clear that computing is radically and societies would need to adapt to the changing changing — from the data center and the network to environment. One important aspect of this was a change the proliferation of technology into the home, appliances, in the form of the corporation itself. The “multinational” vehicles and the infrastructure of the planet. And it’s of the 20 th century was evolving into a new kind of equally clear that businesses and institutions worldwide institution, the globally integrated enterprise — which now look to innovation as their key to competitive locates its operations and functions anywhere in the differentiation and growth. world based on the right cost, the right skills and the To capture the most valuable opportunities, we’ve right business environment. We committed ourselves to had to change our mix of products, services, skills and becoming a model of this new form, and we have begun technologies. This is why we’ve exited businesses like transforming IBM’s operations accordingly, tapping into PCs and hard disk drives, and why, through a combination skills and expertise available all over the world and of internal R&D shifts and acquisitions, we have integrating our operations globally. We have also begun substantially strengthened our position in emerging, a promising dialogue with our clients and with government, higher-value spaces, such as service-oriented architecture business and academic leaders around the world to (SOA), information on demand, business process services explore the potential of global integration for economic and open, modular systems for businesses of all sizes. and societal progress. 2. We believed that both our industry and our clients As a result of these strategic choices and actions, IBM’s would seek to reintegrate. But it would not be integration business model today is not only more aligned with our clients’ as in the past — product bundling, “turnkey” solutions needs, but is also a stronger engine of financial performance. or consolidation of industry segments. Instead, businesses That was evident in 2006. Our innovation-driven strategy would increasingly seek to integrate advanced technology and financial model are also putting us in a favorable with their business processes and operations, even their position relative to our competitors within each area of our core business model. Why? Because this kind of integration business mix. would make them both more productive and more innovative. It would give them differentiation and com- BUSINESS MIX AND RESULTS petitive advantages they could not get from off-the-shelf Some of IBM’s competitors — those who are not as focused, technology and solutions. Conceptually, this is an ideal do not have the financial capacity to invest, or are trying role for IBM to play — the “innovators’ innovator.” But to straddle commodity and higher-value businesses — are since this kind of integration requires intimate knowledge struggling to deal with the changes underway today. As we 2 2006 Annual Report


  • Page 5

    Samuel J. Palmisano — Chairman, President and Chief Executive Officer 3


  • Page 6

    Chairman’s Letter have learned, it’s better to be in businesses that are truly strength in application servers and business integration. differentiating in the eyes of the client than to go simply for Rational software tools grew 4 percent, and Tivoli size, volume and thin margins — where the client doesn’t 26 percent. Our Lotus division — which introduced receive unique value, and the investor doesn’t benefit. well-received Web 2.0-enabled collaboration tools for This is why we have entered new, more attractive spaces, the enterprise in early 2007 — grew 12 percent. We will through acquisition and by redirecting our R&D investments. be expanding our software offerings in 2007 to move Let me describe how these shifts are impacting each of beyond one-on-one and team collaboration — introducing our major businesses. tools that build communities of expertise. • Software: In the world of software, we are witnessing • global Services: The global services industry is being a shift toward new architectures and the componentization reshaped by two trends. The first is the emergence of a of applications. This new model, inherently networked new services model, based on the integration of software and based upon open standards, enables different and services, and the breaking-up of formerly monolithic business designs and the horizontal integration of business business processes into components that can be delivered processes. Within the enterprise, its main impact is over the Web. IBM Global Services is leading the industry occurring at the level of middleware. Because we began in the development of business componentization years ago to build a position as the worldwide leader in and the technology enablement of business processes. middleware, IBM is now uniquely able to capitalize on it. The second trend is a shift to smaller deals of shorter IBM’s software segment revenues totaled $18.2 billion duration, higher profitability and more industry-specific in 2006, an increase of 8 percent. Software generated focus. While our transition to this model experienced some 40 percent of IBM’s segment pretax profits. We are hiccups initially, we are making steady progress and saw recognized as the industry leader in SOA . The information solid growth in short-term signings in 2006. on demand practice we launched in 2006, grouped IBM remains the leading IT services company in the under Information Management, grew 68 percent. Our world, with more than twice the revenue of our nearest acquisition of companies such as FileNet, MRO and rival. Revenues from our two Global Services segments Micromuse enhanced our growth in information and in 2006 totaled $48.3 billion, an increase of 2 percent. systems management. Our industry-leading WebSphere Services’ share of IBM’s segment pretax profits increased family grew 23 percent for the year, with particular to 37 percent. Revenues from the Global Technology results from continuing operations revenue income (Dollars in billions) (Dollars in billions) $100 $10 96.3 89.1 91.1 91.4 8 9.4 80 81.2 8.0 7.5 60 6 6.6 40 4 4.2 20 2 0 0 02 03 04 05 06 02 03 04 05 06 2005 performance includes results from four months of the IBM PC business, which was divested on April 30, 2005.  2006 Annual Report


  • Page 7

    Services segment totaled $32.3 billion, an increase of innovation and gloBal integration 3 percent. Revenues from the Global Business Services IBM’s lines of business work together in a model defined segment were essentially flat at $16 billion, but by innovation and global integration, the twin imperatives improvements in utilization, pricing, contract management that we believe are reshaping business and society in the and delivery optimization enabled it to grow its pretax 21st century. This ability to both innovate and integrate — margin by 2.7 points, to 9.8 percent, excluding 2005 and do so in ways that are truly global — is unique to IBM, special actions. IBM Global Services is ranked as the and sets us apart from our competition. number one or number two service provider in consulting, Last year was in many ways the culmination of our systems integration, maintenance, Web hosting, application repositioning of IBM as an innovation company. Its most services and data center outsourcing. With a strong visible manifestation was our marketing and communications finish to the year — the fourth quarter, with nearly campaign around the theme, “What makes you special?” $18 billion in signings, was our largest since the second Of course, marketing campaigns by themselves are of little quarter of 2002 — we ended 2006 with an estimated importance — unless they persuade the world of an underlying backlog of $116 billion. reality that is substantial and meaningful. Ours did, supported by a long list of clients whose innovation potential • Systems and technology: IBM is the world leader we have unleashed through unique solutions. It was also in servers, and is leading a number of key changes in supported by the continued preeminence of IBM’s research the industry, including shifts to multicore microprocessors, and development capabilities, reflected in our 14 th straight to high-end virtualized systems, and to the new category year of earning by far the most U.S. patents of any company of modular systems known as blades. In 2006 we rolled in the world. out systems based on the new generation of our Our ability to deliver differentiating innovation to our Power Architecture family, POWER 5+; introduced clients is being greatly enhanced by IBM’s global integration — the System z Business Class mainframe, targeting which is simultaneously giving us better economics and smaller firms; and extended our virtualization and deeper capabilities, while eliminating enormous redundancies energy management capabilities. that were built up over 50 years as a multinational. IBM Our systems and technology business extended operates in 170 countries, with about 65 percent of our its industry leadership in 2006, with segment revenues employees outside the U.S., including 30 percent in Asia of $22 billion, an increase of 5 percent. Global Financing Pacific. Our non-U.S. operations generate about 60 percent segment revenues totaled $2.4 billion, a decrease of of IBM’s revenue. 2 percent. Our System z mainframes had a strong year, IBM’s research and software development have long growing 8 percent and marking their sixth consecutive been globally integrated. The company’s R&D system assigns quarter of increased shipments of MIPS (millions of work among our 20,000-plus software developers in 61 labs instructions per second). Our system storage business in 15 countries, and 3,000 scientists and technologists in was up 6 percent for the year, and our microelectronics IBM Research centers in the U. S., China, Israel, Switzerland, business continued to grow, increasing 22 percent for Japan and India, based on areas of unique expertise. the year, thanks to our position as the technology In 2006 we expanded our global delivery centers, where engine for all three major gaming platforms. Systems talented IBMers support the full range of our clients’ and Technology Group and Global Financing accounted applications and business transformation initiatives. We added for 23 percent of IBM’s segment pretax profit in 2006. thousands of skilled people and improved our capabilities in India, Brazil and Argentina, as well as Eastern Europe The hard work we’ve done to remix our businesses to lead and multiple other locations in Asia. We have moved in these emergent, higher-profit spaces is now showing up in our global procurement mission to China and many of the our earnings and gross profit margins. But a changed business services that support our external and internal Websites mix is not the only factor causing IBM’s strong performance. to places like Brazil and Ireland. Our financing back office is in Rio de Janeiro. These IBMers are not leading teams 


  • Page 8

    Generating Higher Value at IBM 1. Several years ago, we saw change coming. Value was shifting in the IT industry, driven by a new • Companies were seeking to integrate advanced computing paradigm, new client needs and the rising tide technology with their business processes and operations, of globalization . not primarily to reduce costs, but to enable innovation • Change in computing architecture was rippling across and growth . the data center and the network, to a proliferation • Enterprises and institutions were looking to tap into of technology infused into all aspects of work and life . skills and expertise available all over the world and to integrate their operations globally . 2. We remixed our businesses, to move to the emerging higher-value spaces. We exited commoditizing businesses like PCs and hard 2006 Segment Pretax SYSTEMS disk drives, and strengthened our position in areas like Income Mix AND FINANCING service-oriented architecture (SOA), information on demand, business process services and open, modular systems for 23% businesses of all sizes . This has changed our business mix SERVICES 37% toward higher-value segments of the industry . 40% SOFTWARE 3. And we decided to become a globally integrated enterprise, in order to improve IBM’s overall productivity and to participate in the world’s growth markets. IBM operates in 170 countries, with about 65 percent of our employees Over the next four years, IBM expects outside the U .S ., including 30 percent in Asia Pacific . Our non-U .S . operations the IT markets in Brazil, China, India generate about 60 percent of IBM’s revenue . and Russia to grow revenue at more than two times the worldwide rate, 2006 Employee Population 2006 Revenue creating a market opportunity by Geographic Region by Geographic Region of more than $150 billion by 2010 . (Excludes OEM) EUROPE, EUROPE, 2006 IBM Revenue Growth MIDDLE EAST MIDDLE EAST (Excludes PCs) AND AFRICA AND AFRICA ASIA PACIFIC ASIA PACIFIC Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19% 25% 35% 20% China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16% 30% India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38% Russia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21% 45% 45% Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21% AMERICAS AMERICAS 6 2006 Annual Report


  • Page 9

    4. As a result, IBM is a higher-performing enterprise today than it was a decade ago. Our business model is more aligned with our clients’ needs and generates better earnings, profits and cash. We have achieved record profit . . . record earnings per share . . . The company’s gross profit margin and pretax Pretax earnings from continuing operations were income margin are the highest they have been in $13 .3 billion, an increase of 9 percent . Diluted earnings the past 10 years . per share were $6 .06, up 23 percent, marking 16 straight quarters of growth . Margins Earnings Per Share (From continuing operations) GROSS PROFIT 50% MARGIN $7 41.9 40.1 6 40% 36.6 36.5 36.9 6.06 5 30% 4.91 4 PRETAX INCOME 4.39 MARGIN 3.76 20% 3 13.4 14.6 10.6 11.1 2 2.43 10% 7.2 1 0% 0 02 03 04 05 06 02 03 04 05 06 . . . and record cash performance. 5. And that has enabled us to invest in Cash generated from every dollar of revenue has increased 18 percent since 2003 . future sources of growth and provide record return to investors . . . Net Cash from Operations, Excluding Global Financing Receivables (Dollars in billions) Primary Uses of Cash Over the Past Five Years (Dollars in billions) $18 $80 70 16 70 Returned to Shareholders 14 15.3 60 SHARE REPURCHASES 50 12 12.9 13.1 12.6 40 10 DIVIDENDS 10.5 30 Reinvested 8 20 NET CAPITAL EXPENDITURES 6 10 STRATEGIC ACQUISITIONS 0 4 2 . . . while continuing to invest in R&D — more than $28 billion over the 0 02 03 04 05 06 past five years. 7


  • Page 10

    Chairman’s Letter focused on China or India or Brazil or Ireland. They are capabilities might be applied to urgent needs — from the leading integrated global operations. environment, to healthcare, to small global business, to the In addition to integrating the entire company globally, emergence of a “3-D Internet”— and how those possibilities we are investing to extend our leadership within the might spawn new high-growth businesses. fastest-growing markets. We have tripled the number of We have assigned senior business owners to develop people working in or serving markets such as China, India, 10 of the most promising ideas, and we’ve stripped away Brazil and Russia in the past four years. Our business there, process so they can move quickly. We also gave them a pool excluding PCs, grew 21 percent last year. Over the next of $100 million in development funds to get them started. four years, we expect these markets to grow at more than The important point in this is that when you commit yourself two times the worldwide rate, with an opportunity of more to innovation that matters, you free up talented people than $150 billion by 2010. to try new things — new approaches, new partnerships, new In the May / June 2006 issue of the public policy journal markets. That is, you ask them to think. Foreign Affairs, I described our point of view on the globally To capture some of the essential elements of IBM’s integrated enterprise, and this idea has struck a chord with way of working, collaborating and approaching problems, many leaders around the world. We are now working we have created a companion piece for this year’s annual actively across IBM’s broad ecosystem to explore the report. It is entitled, appropriately enough, THINK. For promise — and challenges — of this new model. We believe all IBM investors — and for anyone who is considering a it offers hope for a new kind of globalization, one that not relationship with our company, either as a client, a partner, only generates vast new opportunity, but that also vastly an employee, or a neighbor — an understanding of what expands the chances for all people on the planet to share in it. makes IBM tick is essential in gauging our prospects for the century ahead. A DISTINCTIVE WAY OF THINKING As we enter this new era of technology, business and To many of us, IBM’s transformation of the past few years, global society, I am proud of the worldwide IBM team for while dramatic, has not felt unfamiliar. For me and others bringing us to this point, and I am grateful to you, our in my generation, the experience has not been one of shareholders, for your support in our journey. I hope and entering uncharted waters, but of returning to a pace of trust that you are pleased with how your company is change, a level of impact and a type of thinking that drew growing and evolving. My colleagues and I are excited by us to this company in the first place. And its origins go the possibilities for how, together with our clients, our back a long way. partners and you, we can bring this remarkable enterprise For nearly a century, businesses, institutions and into its next phase of leadership and discovery. individuals have sought a relationship with IBM because of this company’s unique ability to conceptualize opportunities, to analyze developments and to reimagine how the world could work. For nearly a century, literally millions of women and men have been drawn here to be part of an Samuel J. Palmisano enterprise that above all grounded itself in lasting values, Chairman, President and Chief Executive Officer and that valued, above all, the capacity of its people to think. Today, those values and that kind of thinking are deepening and taking on more and more exciting new forms. One example in 2006 was InnovationJam — an open brainstorming event on IBM’s worldwide intranet that engaged more than The selected references in this letter to the company’s financial results: (1) excluding the effects of the divestiture 150,000 IBMers, their family members, IBM clients and of the company’s PC business, (2) excluding non-recurring items, and (3) excluding the Global Financing business are non-GAAP financial measures, as is the reference to return on invested capital (ROIC), and these partners from business and academia. We shared a few of references are made to facilitate a comparative view of the company’s ongoing operational performance. Additional information on the use of these non-GAAP financial measures is provided in the company’s Form 8-K submitted our “crown jewels,” some of the latest technologies from to the SEC on January 18, 2007 (Attachment II — Non-GAAP Supplementary Materials) and in the company’s 2006 Annual Report (Management Discussion and Analysis — Year in Review and Looking Forward — Liquidity IBM’s labs. Then, together, we explored how these new and Capital Resources). 8 2006 Annual Report


  • Page 11

    What does it take to change the way the world works? www.ibm.com/ibm/think 9


  • Page 12

    Financial highlightS international BuSineSS MachineS corPoration and SuBSidiarY coMPanieS (Dollars in millions except per share amounts) FOR THE YEAR 2006 2005 Revenue $ 91,424 $ 91,134 Income from continuing operations $ 9,416 $ 7,994 Income/(loss) from discontinued operations 76 (24) Income before cumulative effect of change in accounting principle 9,492 7,970 Cumulative effect of change in accounting principle** — (36) Net income $ 9,492 $ 7,934 Earnings/(loss) per share of common stock: Assuming dilution: Continuing operations $ 6.06 $ 4.91 Discontinued operations 0.05 (0.01) Before cumulative effect of change in accounting principle 6.11 4.90 Cumulative effect of change in accounting principle** — (0.02) Total $ 6.11 $ 4.87* Basic: Continuing operations $ 6.15 $ 4.99 Discontinued operations 0.05 (0.02) Before cumulative effect of change in accounting principle 6.20 4.98* Cumulative effect of change in accounting principle** — (0.02) Total $ 6.20 $ 4.96 Net cash provided by operating activities from continuing operations $ 15,019 $ 14,914 Capital expenditures, net 4,737 3,527 Share repurchase 8,084 7,739 Cash dividends paid on common stock 1,683 1,250 Per share of common stock 1.10 0.78 AT YEAR END 2006 2005 Cash, cash equivalents and marketable securities $ 10,657 $ 13,686 Total assets 103,234 105,748 Working capital 4,569 10,509 Total debt 22,682 22,641 Stockholders’ equity 28,506 33,098 Common shares outstanding (in millions) 1,506 1,574 Market capitalization $146,355 $129,381 Stock price per common share $ 97.15 $ 82.20 Number of employees in IBM/wholly owned subsidiaries 355,766 329,373 * Does not total due to rounding. ** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on page 72 for additional information. 0 2006 Annual Report


  • Page 13

    REPORT OF FINANCIALS INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES MANAGEMENT DISCUSSION NOTES TO CONSOLIDATED Road Map 12 FINANCIAL STATEMENTS Forward-Looking and Cautionary Statements 13 A Significant Accounting Policies 62 Management Discussion Snapshot 14 B Accounting Changes 71 Description of Business 15 C Acquisitions/Divestitures 73 Year in Review 22 D Financial Instruments (excluding derivatives) 78 Prior Year in Review 37 E Inventories 79 Discontinued Operations 41 F Financing Receivables 79 Other Information 41 G Plant, Rental Machines and Other Property 79 Looking Forward 41 H Investments and Sundry Assets 80 Liquidity and Capital Resources 43 I Intangible Assets Including Goodwill 80 Critical Accounting Estimates 45 J Securitization of Receivables 81 Currency Rate Fluctuations 47 K Borrowings 81 Market Risk 47 L Derivatives and Hedging Transactions 83 Financing Risks 48 M Other Liabilities 87 Employees and Related Workforce 48 N Stockholders’ Equity Activity 88 Global Financing 49 O Contingencies and Commitments 89 P Taxes 92 REPORT OF MANAGEMENT 54 Q Research, Development and Engineering 93 R 2005 Actions 93 REPORT OF INDEPENDENT S Earnings Per Share of Common Stock 95 REGISTERED PUBLIC T Rental Expense and Lease Commitments 96 ACCOUNTING FIRM 55 U Stock-Based Compensation 96 V Retirement-Related Benefits 100 CONSOLIDATED FINANCIAL W Segment Information 111 STATEMENTS X Subsequent Events 115 Earnings 56 Financial Position 57 Cash Flows 58 FIVE-YEAR COMPARISON OF Stockholders’ Equity 59 SELECTED FINANCIAL DATA 116 SELECTED QUARTERLY DATA 117 PERFORMANCE GRAPHS 118 BOARD OF DIRECTORS AND SENIOR EXECUTIVE OFFICERS 120 STOCKHOLDER INFORMATION 121 11


  • Page 14

    ManageMent diScuSSion international BuSineSS MachineS corPoration and SuBSidiarY coMPanieS road MaP tranSParencY the financial section of the international Business Machines transparency is a primary goal of successful financial reporting. the corporation (iBM or the company) 00 annual report, consisting following are the key elements found in this year’s annual report. of this Management Discussion, the Consolidated Financial Statements that follow and the notes related thereto, comprises 108 pages of • The company, in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, conducted an evaluation of its internal control over financial information. This Road Map is designed to provide the reader reporting and concluded that the internal control over financial reporting with some perspective regarding the information contained in the was effective as of December 31, 2006. financial section. • The Management Discussion is designed to provide readers with a view of the company’s results and certain factors that may affect future iBM’S BuSineSS Model prospects from the perspective of the company’s management. Within The company’s business model is built to support two principal goals: the “Management Discussion Snapshot,” on pages 14 to 15, the key helping clients succeed in delivering business value by becoming more messages and details will give readers the ability to quickly assess the innovative, efficient and competitive through the use of business insight most important drivers of performance within this brief overview. and information technology (IT) solutions; and providing long-term value to shareholders. In addition to these goals, the company is com- • The Management Discussion reflects the company’s continued and mitted to its employees and the communities in which it operates. improving strength in providing client- and industry-specific solutions In support of these objectives, the business model has been devel- utilizing its broad capabilities. The sections on “Description of the oped over time through strategic investments in capabilities and Business” on page 15, “Results of Continuing Operations” on page 22, technologies that have the best long-term growth and profitability “Financial Position” on page 32, and “Looking Forward” on page 41, are all written from the perspective of the consolidated entity. Detailed prospects based on the value they deliver to clients. analysis for each of the company’s segments is also included and appears The company’s strategy is to focus on the high-growth, high-value on pages 29 to 32. segments of the IT industry. The company’s broad capabilities include services, software, hardware, fundamental research, financing and the • Global Financing is a business segment within the company that is component technologies used to build larger systems. These global measured as if it were a standalone entity. A separate “Global capabilities are combined to provide business insight and solutions in Financing” section beginning on page 49 is not included in the consoli- the enterprise computing space. dated perspective that is referred to above. This section is separately The business model is flexible, and allows for periodic rebalancing. presented given this segment’s unique impact on the company’s financial In 2006, 13 acquisitions were completed, all focused on expanding the condition and leverage. company’s software and services capabilities, at an aggregate cost of • Effective December 31, 2006, the company adopted the provisions approximately $4.8 billion. In January 2007, the company announced of Statement of Financial Accounting Standards (SFAS) No. 158, its intent to form a joint venture with Ricoh Company based on the “Employer’s Accounting for Defined Benefit Pension and Other company’s Printing Systems business. Postretirement Plans, an amendment to FASB Statements No. 87, The business model, supported by the company’s long-term 88, 106, and 132(R).” SFAS No. 158 requires that the funded status financial model, enables the company to deliver consistently strong of the company’s pension and nonpension postretirement benefit plans earnings, cash flows and high returns on invested capital in changing be recognized as an asset or a liability in the Consolidated Statement of economic environments. Financial Position, the recognition of any changes in that funded status in the year in which the changes occur and the recognition of previously unrecognized gains/(losses), prior service costs/(credits) and transition assets as a component of Accumulated gains and (losses) not affecting retained earnings in the Consolidated Statement of Stockholders’ Equity. The adoption of SFAS No. 158 had a significant non-cash impact on the company’s reported financial position and stockholders’ equity, reduc- Management discussion ........................................................ 12 ing equity by $9.5 billion, net of tax. The adoption of SFAS No. 158 road Map............................................................................. 12 had no impact on the company’s existing debt covenants, credit ratings Forward-Looking and Cautionary statements ..................... 13 Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered Public accounting Firm .... 55 consolidated Statements ....................................................... 56  2006 Annual Report


  • Page 15

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES or financial flexibility. See note V, “Retirement-Related Benefits,” on HELPFUL HINTS pages 100 to 111 for additional information, including the incremental Organization of Information effect on the Consolidated Statement of Financial Position. • This Management Discussion section provides the reader of the • The company divested its Personal Computing business to Lenovo on financial statements with a narrative on the company’s financial April 30, 2005. The details of this significant transaction are discussed results. It contains the results of operations for each segment of in note C, “Acquisitions/Divestitures,” on pages 77 and 78. As a the business, followed by a description of the company’s financial result of this divestiture, the company’s reported financial results do not position, as well as certain employee data. It is useful to read the include any activity in 2006 and include four months of activity for the Management Discussion in conjunction with note W, “Segment Personal Computing Division in 2005 as compared to 12 months in Information,” on pages 111 to 115. 2004. This lack of comparable periods has a material impact on the • Pages 56 through 61 include the Consolidated Financial company’s reported revenue growth. Therefore, in the Management Statements. These statements provide an overview of the company’s Discussion, within the “Year in Review” section on pages 22 to 25 and income and cash flow performance and its financial position. the “Prior Year in Review” section on pages 37 and 38, the company has presented an analysis of revenue both on an as-reported basis • The notes follow the Consolidated Financial Statements. Among and on a basis that excludes the revenue from the divested Personal other things, the notes contain the company’s accounting policies Computing business from both the 2005 and 2004 periods. The com- (pages 62 to 71), acquisitions and divestitures (pages 73 to 78), pany believes that the analysis that excludes the Personal Computing detailed information on specific items within the financial statements, revenue is a better indicator of the company’s operational revenue certain contingencies and commitments (pages 89 to 92), and the performance on an ongoing basis. results of each IBM segment (pages 111 to 115). • IBM made changes to its management system effective as of the first quarter of 2006. In accordance with SFAS No. 131, “Disclosures about DISCONTINUED OPERATIONS Segments of an Enterprise and Related Information,” these changes On December 31, 2002, the company sold its hard disk drive impacted the company’s reportable segments and resulted in the reclassi- (HDD) business to Hitachi, Ltd. (Hitachi). The HDD business was fication of certain revenue and cost within its Consolidated Statement of accounted for as a discontinued operation under generally accepted Earnings from previously reported information. See note W, “Segment accounting principles (GAAP) which requires that the income state- Information,” on page 111 for additional information on the changes in ment and cash flow information be reformatted to separate the reportable segments. These changes did not impact IBM’s total revenue, divested business from the company’s continuing operations. See page cost, expense, net income, earnings per share, Consolidated Statement of 41 for additional information. Financial Position or Consolidated Statement of Cash Flows from pre- viously reported information. The Consolidated Statement of Earnings on page 56 reflects these changes for all periods presented. FORWARD-LOOKING AND • The reference to constant currency in the Management Discussion is CAUTIONARY STATEMENTS made so that certain financial results can be viewed without the impacts Certain statements contained in this Annual Report may constitute of changing foreign currency exchange rates and therefore facilitates a forward-looking statements within the meaning of the Private comparative view of business growth. See “Currency Rate Fluctuations” Securities Litigation Reform Act of 1995. These statements involve a on page 47 for additional information. number of risks, uncertainties and other factors that could cause actual results to be materially different, as discussed more fully else- • Within the financial tables in this Annual Report, certain columns and where in this Annual Report and in the company’s filings with the rows may not add due to the use of rounded numbers for disclosure pur- Securities and Exchange Commission (SEC), including the company’s poses. Percentages reported in the financial tables throughout this Annual 2006 Form 10-K filed on February 27, 2007. Report are calculated from the underlying whole-dollar numbers. 13


  • Page 16

    ManageMent diScuSSion international BuSineSS MachineS corPoration and SuBSidiarY coMPanieS ManageMent diScuSSion SnaPShot continuing oPerationS (Dollars and shares in millions except per share amounts) the company’s 00 performance was the result of a series of YR. TO YR. PERCENT/ actions taken over the last several years to steadily transform the FOR THE YEAR ENDED DECEMBER 31: 2006 2005 MARGIN CHANGE company. The company has divested of businesses that are commod- itizing, while investing in targeted acquisitions to continue to build Revenue $ 91,424 $ 91,134 0.3%* capabilities in higher value areas. The company has also been focused Gross profit margin 41.9% 40.1% 1.8 pts. on increasing productivity, to expand margins and improve efficiency. Total expense and In addition, it has accelerated its move to become a globally inte- other income $ 24,978 $ 24,306 2.8% grated company. These actions have resulted in a more balanced mix Total expense and other of businesses and a stronger, more competitive and sustainable global income to revenue ratio 27.3% 26.7% 0.7 pts. Income from continuing business. The company’s 2006 financial results reflect this improved operations before business model. income taxes $ 13,317 $ 12,226 8.9% The company divested its Personal Computing business on April Provision for income taxes $ 3,901 $ 4,232 (7.8)% 30, 2005. Therefore, the company’s reported results for 2006 do not Income from continuing include any activity for the Personal Computing Division, while the operations $ 9,416 $ 7,994 17.8% results for 2005 include four months of activity. Earnings per share of Total revenue, as reported, increased 0.3 percent versus 2005; common stock: excluding the Personal Computing business external revenue from Assuming dilution: 2005, total 2006 revenue increased 3.6 percent ( 3.2 percent adjusted Continuing operations $ 6.06 $ 4.91 23.4% for currency). Pre-tax income from continuing operations grew 8.9 Discontinued operations 0.05 (0.01) NM percent, while diluted earnings per share from continuing operations Cumulative effect of change in increased 23.4 percent compared to 2005. Income from continuing accounting principle — (0.02) NM operations increased 17.8 percent compared to 2005, benefiting from an improved effective tax rate year to year. Net cash provided by Total $ 6.11 $ 4.87 25.5% operating activities was $15,019 million. Weighted-average shares The increase in revenue, excluding the Personal Computing busi- outstanding: ness, in 2006 as compared to 2005, was primarily due to: Diluted 1,553.5 1,627.6 (4.6)% Assets** $103,234 $105,748 (2.4)% • Improved demand in the software business, driven by Key Branded Liabilities** $ 74,728 $ 72,650 2.9% Middleware products, with positive contributions from key acquisitions; Equity** $ 28,506 $ 33,098 (13.9)% * Flat when adjusted for currency. • Increased demand in the hardware business driven by Microelec- ** At December 31. tronics, System z and Storage; growth in System x and Retail Store NM —Not meaningful Solutions; and • Continued growth in emerging countries (up 21 percent) and solid per- formance in the Americas and Europe/Middle East/Africa geographies. The increase in income from continuing operations before income taxes in 2006 as compared to 2005 was primarily due to: • Revenue growth in the Software segment as discussed above; • Continued execution of the company’s productivity initiatives driving improved Global Services gross margins; and Management discussion ........................................................ 12 road Map............................................................................. 12 • Revenue growth and continued operational improvement in the Forward-Looking and Cautionary statements ..................... 13 Microelectronics business. Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered Public accounting Firm .... 55 consolidated Statements ....................................................... 56  2006 Annual Report


  • Page 17

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The consolidated gross profit margin increased 1.8 points to 41.9 The decrease in Stockholders’ Equity was primarily driven by percent versus 2005. An improvement in the Hardware margin (1.9 retirement-related charges ($7.6 billion) and net common stock trans- points) contributed 0.6 points to the overall margin improvement. actions ($5.4 billion), partially offset by increased Retained earnings This increase was driven by the sale and resulting absence of the ($7.7 billion). The retirement-related driven decrease in Stockholders’ lower margin Personal Computing business. In addition, the Global Equity and the decrease in prepaid pension assets were as a result of Services margin improved 1.5 points versus 2005 to 27.5 percent. the company’s adoption of SFAS No. 158. See note V, “Retirement- This increase was driven by several factors: the restructuring actions Related Benefits,” on pages 100 to 111 for additional information. taken in the second quarter of 2005 to improve cost competitiveness, Global Services signings were $49 billion in 2006 as compared to improved utilization levels and ongoing productivity initiatives. The $47 billion in 2005. The Global Services backlog is estimated to be Software margin increased slightly. The Global Financing margin $116 billion at December 31, 2006, versus $111 billion at December declined 4.4 points versus 2005 to 50.3 percent primarily driven by 31, 2005. higher borrowing costs. This decline had an immaterial impact on For additional information, see the “Year in Review” section on the company’s overall margin due to the size of the segment. pages 22 through 36. Total expense and other income increased 2.8 percent in 2006 Looking forward, the company’s long-term financial model objec- versus 2005. The increase was primarily due to the company’s invest- tive is to generate 10 to 12 percent earnings per share growth over the ments in acquisitions and investments the company is making in its long term through a combination of revenue growth, productivity- software and services businesses and emerging markets. driven margin improvement and effective capital deployment for The provision for income taxes resulted in an effective tax rate of acquisitions and returns to shareholders through dividends and com- 29.3 percent for 2006, compared with the 2005 effective tax rate of mon stock repurchases. The company’s ability to meet these objectives 34.6 percent. The 5.3 point decrease in the 2006 effective tax rate depends on a number of factors, including those outlined on page 21 was primarily attributable to the net effect of several items. In 2006, and on pages 89 to 92. the tax rate was favorably impacted by the absence of the foreign earnings repatriation-related tax charge recorded in the third quarter DESCRIPTION OF BUSINESS of 2005 ( 4.3 points) as well as a benefit from the fourth-quarter 2006 Please refer to IBM’s Annual Report on Form 10-K filed on February 27, settlement of the U.S. federal income tax audit for the years 2001 2007, with the SEC for a more detailed version of this Description of Business, through 2003 ( 3.0 points ). These benefits were partially offset by a especially Item 1A. entitled “Risk Factors.” one-time tax cost associated with the 2006 intercompany transfer of IBM is a globally integrated innovation company, serving the certain intellectual property ( 4.3 points). The remaining items were needs of enterprises and institutions worldwide. The company individually insignificant. seeks to be a partner in its clients’ success by enabling their own Total Assets declined approximately $2.5 billion ($6.2 billion capacity to innovate, so that they may differentiate themselves for adjusted for currency) primarily due to lower prepaid pension assets competitive advantage in a globalized economy. IBM views enterprise ($10.0 billion) and a decrease in Cash and cash equivalents ($4.5 bil- innovation not only in terms of products and services, but across all lion). These decreases were partially offset by increases in Goodwill dimensions of a business: its business processes, business model, man- ($3.4 billion), long-term deferred tax assets ($2.0 billion), Marketable agement systems, culture and role in society. To help clients achieve securities ($1.9 billion), trade receivables ($1.2 billion), financing growth, effectiveness, efficiency and the realization of greater value receivables ($1.8 billion) and Intangible assets ($0.5 billion). through innovation, IBM draws upon the world’s leading systems, The increase in Total Liabilities of $2.1 billion (down $0.4 billion software and services capabilities. adjusted for currency) was primarily driven by Compensation and benefits ($1.3 billion), Deferred income ($1.3 billion) and Accounts payable ($0.6 billion). These increases were partially offset by decreases in long-term deferred tax liabilities ($1.0 billion) and restructuring liabilities ($0.4 billion). Total debt of $22.7 billion was essentially flat versus 2005. 15


  • Page 18

    ManageMent diScuSSion international BuSineSS MachineS corPoration and SuBSidiarY coMPanieS iBM’S StrategY the company has divested low growth commoditizing product lines and acquired higher value opportunities to leverage iBM’s infrastructure. IT INDUSTRY LANDSCAPE PRE 2004 2004 2005 2006 Business Value PwCC Daksh Corio Viacore Maersk IT Equitant Infrastructure Value Lotus Logical Networks Healthlink Micromuse Hardware Acquisitions Tivoli Cyanea SRD FileNet Software Services Rational Candle Ascential MRO Informix Trigo Tech DWL CIMS Labs Sector7 Venetica DataPower Language Access360 Schlumberger Isogon Analysis System Collation Unicorn Meiosys REMBO Divestitures Component Value Network HDD BuildForge DRAM EDI Services Webify Displays 4xx Power PC PCs ISS In IBM’s view, the future of business is being shaped by the forces of IBM’s strategic priorities to pursue this vision include: global integration and innovation. They are foundational and inti- mately related to one another. A globally integrated enterprise is a new • offering enterprises in the global economy innovative, high- institutional form that shapes its strategy, management and operations value solutions based on IBM’s ability to integrate technology and globally, based on economics, expertise and open business environ- business model innovation to deliver measurable results for IBM ments. It is optimized for innovation in a worldwide economy and and its clients; society that are increasingly integrated and specialized. IBM’s strategic • leading in the delivery of business value by providing business moves over the past several years—from divestitures and acquisitions, and information technology consulting and implementation ser- to areas of focus for innovation, to the transformation of its core lines vices; building, running and maintaining cross-industry and of business—have been shaped by this vision. industry-specific business process services; leveraging leadership technology and engineering services; and accelerating increased business value through Service Oriented Architectures (SOA) and Information on Demand; • leading in the delivery of advanced infrastructure through enterprise SOA and infrastructure software and services; increased share leadership in servers; driving to leadership in storage; and leading the transition to standardized services offerings; and • Making iBM the premier globally integrated enterprise —lower- ing costs and increasing effectiveness by integrating the company’s decision making at the point of client contact (“lowering IBM’s Management discussion ........................................................ 12 center of gravity”); moving work to where it can best be per- road Map............................................................................. 12 formed; focusing IBM’s resources to create the greatest value; and Forward-Looking and Cautionary statements ..................... 13 excelling in business collaboration. Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered Public accounting Firm .... 55 consolidated Statements ....................................................... 56  2006 Annual Report


  • Page 19

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES ENGINEERING & TECHNOLOGY SERVICES PRINTING RETAIL STORE SOLUTIONS SYSTEMS MICROELECTRONICS COMMERCIAL FINANCING STORAGE CLIENT FINANCING SERVERS SYSTEMS & REMARKETING FINANCING CONSULTING & SYSTEMS INTEGRATION OPERATING SYSTEMS BUSINESS TRANSFORMATION OUTSOURCING INFORMATION MANAGEMENT SOFTWARE SERVICES MAINTENANCE LOTUS STRATEGIC OUTSOURCING RATIONAL TIVOLI INTEGRATED TECHNOLOGY SERVICES WEBSPHERE APPLICATION PRODUCT LIFECYCLE ON DEMAND APPLICATION MANAGEMENT MANAGEMENT SERVICES IBM’S CAPABILITIES Systems and Financing To execute its strategy, IBM’s business comprises three principal SYSTEMS business segments: Servers. IBM systems using IBM operating systems (System z and • Systems and Financing System i), as well as AIX, the IBM UNIX operating system (System p and BladeCenter) and the Microsoft Windows operating system • Software (System x and BladeCenter). All servers can also run Linux, a key • Services open source operating system. Storage. Data storage products, including disk, tape, optical and stor- age area networks (SAN). 17


  • Page 20

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Microelectronics. Semiconductor design and manufacturing of cus- WebSphere Software. Provides the foundation for Web-enabled tomized products including microprocessors, application specific applications and is a key product set in deploying a Service Oriented integrated circuits and standard products for IBM systems and exter- Architecture. Management of a wide variety of business processes nal clients. using open standards to interconnect applications, data and operat- ing systems. Engineering and Technology Services (E&TS). System and compo- nent design services, strategic outsourcing of clients’ design teams, Product Lifecycle Management (PLM). Software that enables clients and technology and manufacturing consulting services. to improve their product development processes and their ability to use product-related information across their businesses. Printing Systems. Production print solutions, on demand print-related solutions, enterprise workgroup print technologies, print management Operating Systems. Software engines that manage the fundamental software, services and maintenance. processes that make computers run. Retail Store Solutions. Point-of-sale retail systems, software and Services solutions. Business Process Services (BPS). A range of offerings from stan- dardized processing platforms and Business Process Outsourcing FINANCING (BPO) through Business Transformation Outsourcing (BTO) that Commercial Financing. Short-term inventory and accounts receiv- delivers improved business results to clients through the strategic able financing to dealers and remarketers of IT products. change and/or operation of the client’s business processes, applications and infrastructure. Client Financing. Lease and loan financing to external and internal clients for terms generally between two and seven years. Consulting and Systems Integration (C&SI). Delivery of value to clients through consulting services for client-relationship manage- Remarketing. The sale and lease of used equipment (primarily sourced ment, financial management, human capital, business strategy and from the conclusion of lease transactions) to new or existing clients. change and supply-chain management. Software Strategic Outsourcing Services (SO). Comprehensive IT services Information Management Software. Advanced database, content integrated with business insight working with clients to reduce management and information integration software that helps compa- costs and improve productivity through the outsourcing of processes nies integrate, manage and gain value from their business information. and operations. Lotus Software. Collaboration, messaging and social networking Integrated Technology Services (ITS). Services offerings that help software that enables businesses to communicate, collaborate and clients access, manage and support their technology infrastructures, increase productivity. through a combination of skilled resources, software and IBM’s knowl- edge of business processes. Rational Software. Software and process automation tools that help clients manage the business process of software and systems delivery. Maintenance. A number of support services from product maintenance through solution support to maintain and improve the availability of Tivoli Software. Software for infrastructure management, including clients’ IT infrastructure. security and storage management that will help organizations better manage their IT infrastructure to more effectively deliver IT services. Application Management Services (AMS). Application develop- ment, management, maintenance and support services for packaged software, as well as custom and legacy applications. Management Discussion ........................................................ 12 Applications on Demand (AoD). Solutions for the management of road Map............................................................................. 12 clients’ Web-based infrastructure and business applications, as well as Forward-Looking and Cautionary statements ..................... 13 a growing portfolio of industry-specific independent software vendor Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 (ISV) solutions that are delivered as a service. Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered public accounting firm .... 55 consolidated statements ....................................................... 56 18 2006 Annual Report


  • Page 21

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES BUSINESS SEGMENTS well as revenue from software sold on a recurring license charge Organizationally, the company’s major operations comprise a arrangement. Typically, arrangements for the sale of OTC software Global Technology Services segment; a Global Business Services seg- include one year of maintenance. The client can also purchase ongoing ment; a Systems and Technology Group segment; a Software segment; maintenance after the first year, which includes product upgrades and and a Global Financing segment. technical support. While not reported as external revenue, software is also deployed to support services solutions. Global Services is a critical component of the company’s strategy of providing insight and solutions to clients. While solutions often Global Financing is described on pages 49 through 53. include industry-leading IBM software and hardware, other suppliers’ products are also used if a client solution requires it. Contracts for IBM WORLDWIDE ORGANIZATIONS IBM services—commonly referred to as “signings”—can range from The following three companywide organizations play key roles in less than one year to over 10 years. Within Global Services there are IBM’s delivery of value to its clients: two reportable segments: Global Technology Services and Global Business Services. • Sales & Distribution Organization and related sales channels • Research, Development and Intellectual Property Global Technology Services (GTS) segment primarily reflects infra- structure services, delivering value through the company’s global • Integrated Supply Chain scale, standardization and automation. It includes outsourcing ser- vices, Integrated Technology Services and Maintenance. Sales & Distribution Organization With a comprehensive knowledge of IBM’s business and infrastructure Global Business Services (GBS) segment primarily reflects profes- solutions, as well as the products, technologies and services IBM and its sional services, delivering business value and innovation to clients business partners offer, the company’s global client teams gain a deep through solutions which leverage industry- and business-process understanding of each client’s organizational, infrastructure and indus- expertise. It includes consulting, systems integration and Application try-specific needs to determine the best approach for addressing their Management Services. critical business and IT challenges. These professionals work in inte- grated teams with IBM consultants and technology representatives, Systems and Technology Group provides IBM’s clients with combining their deep skills and expertise to deliver high-value solutions business solutions requiring advanced computing power and storage that address clients’ pain points and innovational aspirations. capabilities. Approximately 55 percent of the Systems and Technology To facilitate its access to clients and local markets and to improve Group’s server and storage sales transactions are through business productivity, the Sales & Distribution organization utilizes geographic partners; approximately 45 percent are direct to end-user clients, more organizations in the Americas, Europe/Middle East/Africa (EMEA) than half of which are through the Internet at ibm.com. In addition, the and Asia Pacific geographies. This structure enables resources and Group provides leading semiconductor technology and products, pack- decision making to be closer to the clients. aging solutions and engineering technology services to clients and for The majority of IBM’s revenue, excluding the company’s original IBM’s own advanced technology needs. While not reported as external equipment manufacturer ( OEM ) technology business, occurs in revenue, hardware is also deployed to support services solutions. industries that are broadly grouped into six sectors: Software consists primarily of middleware and operating systems • Financial Services: Banking, Financial Markets, Insurance software. Middleware software enables clients to integrate systems, processes and applications across a standard software platform. IBM • Public: Education, Government, Healthcare, Life Sciences middleware is designed to open standards which allows the efficient • Industrial: Aerospace and Defense, Automotive, Chemical and integration of disparate client applications that may have been built Petroleum, Electronics internally, or provided by package software vendors or system integra- • Distribution: Consumer Products, Retail, Travel and Transportation tors. Operating systems are the software engines that run computers. In addition, Software includes Product Lifecycle Management soft- • Communications: Telecommunications, Media and Entertainment, ware which primarily serves the Industrial sector. Approximately 25 Energy and Utilities percent of software transactions are sold through business partners. • Small and Medium Business: Mainly companies with less than Also, 50 percent of external software revenue relates to one-time 1,000 employees charge (OTC) arrangements, whereby the client pays one up-front payment for a perpetual license. The remaining annuity-based revenue consists of both maintenance revenue sold with OTC arrangements, as 19


  • Page 22

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES INTERNAL ROUTES-TO-MARKET of innovations in these and other areas, IBM was once again awarded Services consultants focus on selling end-to-end solutions for large, more U.S. patents in 2006 than any other company. This marks the complex business challenges. 14th year in a row that IBM achieved this distinction. In addition to producing world-class hardware and software Hardware and software brand specialists sell IBM products as parts products, IBM innovations are a major differentiator in providing of discrete technology decisions and as part of broader client solutions. solutions for the company’s clients through its growing services activities. The company’s investments in R&D also result in intellec- ibm.com provides fast, easy access to IBM’s product and business tual property (IP) income of approximately $1 billion annually. Some expertise via the Web and telephone. In addition, ibm.com identifies of IBM’s technological breakthroughs are used exclusively in IBM business opportunities for all of IBM’s routes to market and provides products, while others are licensed and may be used in either/both online and telephone sales of standard hardware, software, services IBM products and/or the products of the licensee. and financing for all-size companies. In addition to these IP income sources, the company also generates value from its patent portfolio through cross-licensing arrangements BUSINESS PARTNERS ROUTES-TO-MARKET and IP licensed in divestiture transactions. The value of these transac- Global/major independent software vendors (ISVs). ISVs deliver tions is not readily apparent in the Consolidated Statement of business-process or industry-specific applications and, in doing so, Earnings, because income on cross-licensing arrangements is recorded often influence the sale of IBM hardware, middleware and services. only to the extent that cash is received. The value received for IP involving the sale of a business is included in the overall gain or loss Global/major systems integrators (SIs). SIs identify business prob- from the divestiture, not in the separately presented IP income lems and design solutions when IBM Global Services is not the amounts on the Consolidated Statement of Earnings. preferred systems integrator; they also sell computing infrastructures from IBM and its competitors. Integrated Supply Chain Just as IBM works to transform its clients’ supply chains for greater Regional ISVs and SIs. SIs identify the business problems, and efficiency and responsiveness to global market conditions, the company ISVs deliver business process or industry-specific applications to continues to derive business value from its own globally integrated sup- medium-sized and large businesses requiring IBM computing infra- ply chain, reinvented as a strategic advantage for the company to create structure offerings. value for clients and shareholders. IBM leverages its supply-chain Solutions providers, resellers and distributors. Resellers sell IBM expertise for clients through its supply-chain business transformation platforms and value-added services as part of a discrete technology outsourcing service to optimize and help run clients’ end-to-end sup- platform decision to clients wanting third-party assistance. ply-chain processes, from procurement to logistics. IBM spends approximately $36 billion annually through its supply Research, Development and Intellectual Property chain, procuring materials and services around the world. The com- IBM’s research and development ( R&D) operations differentiate IBM pany’s supply, manufacturing and logistics and customer fulfillment from its competitors. IBM annually spends approximately $6 billion operations are integrated in one operating unit that has reduced for R&D, focusing its investments in high-growth, high-value oppor- inventories, improved response to marketplace opportunities and tunities. In 2006, the company’s investment in R&D was approximately external risks and converted fixed to variable costs. Simplifying and 15 percent of its combined hardware and software revenue. As a result streamlining internal processes has improved operations, sales force productivity and processes, and these actions have improved client satisfaction when working with the company. Since some of the cost savings this unit generates are passed along to clients, they will not always result in a visible gross margin improvement in the company’s Consolidated Statement of Earnings. IBM is continuing to apply the Management Discussion ........................................................ 12 supply-chain principles of product manufacturing and delivery to road Map............................................................................. 12 service delivery across its solutions and services lines of business. Forward-Looking and Cautionary statements ..................... 13 In addition to its own manufacturing operations, the company Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 uses a number of contract manufacturing (CM) companies around Year in review...................................................................... 22 the world to manufacture IBM-designed products. The use of CM Prior Year in review ............................................................. 37 companies is intended to generate cost efficiencies and reduce time Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 to market for certain IBM products. Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered public accounting firm .... 55 consolidated statements ....................................................... 56 20 2006 Annual Report


  • Page 23

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES KEY BUSINESS DRIVERS Through the Global Innovation Outlook (GIO), IBM has opened The following are some of the key drivers of the company’s business. up its technical and business forecasting processes to include external leaders from business, academia, the public sector, nongovernmental Economic Environment and organizations and other influential constituents of the world com- Corporate Spending Budgets munity. The GIO takes a deep look at some of the most pressing If overall demand for systems, software and services changes, whether issues facing the world and works toward providing solutions to those due to general economic conditions or a shift in corporate buying needs. In 2006, IBM also announced that it will invest $100 million patterns, sales performance could be impacted. IBM’s diverse set of over the next two years to pursue 10 new businesses generated by products and offerings is designed to provide more consistent results InnovationJam, an on-line brainstorming session which brought in both strong and weak economic environments. The company together more than 150,000 people from 104 countries, including accomplishes this by not only having a mix of offerings with long- IBM employees, family members, universities, business partners and term cash and income streams, as well as cyclical transaction-based clients from 67 companies. Over two 72-hour sessions, participants sales, but also by continually developing competitive products and posted more than 46,000 ideas as they explored IBM’s most advanced solutions and effectively managing a skilled resource base. IBM con- research technologies and considered their application to real-world tinues to transform itself to take advantage of shifting demand trends, problems and emerging business opportunities. focusing on client- or industry-specific solutions, business perfor- mance and open standards. Open Standards The broad adoption of open standards is essential to the computing Internal Business Transformation and model for an on demand business and is a significant driver of col- Global Integration Initiatives laborative innovation across all industries. Without interoperability IBM continues to drive greater productivity, flexibility and cost sav- among all manner of computing platforms, the integration of any ings by transforming and globally integrating its own business pro- client’s internal systems, applications and processes remains a monu- cesses and functions. In 2006, the company continued the global mental and expensive task. The broad-based acceptance of open integration of its internal support functions—such as Legal, Finance, standards—rather than closed, proprietary architectures—also allows Human Resources, Information Technology and Real Estate Site the computing infrastructure to more easily absorb (and thus benefit Operations—which had been previously replicated for many of the from) new technical innovations. IBM’s support of open standards is individual countries where IBM operates. In addition to eliminating evidenced by the enabling of its products to support open standards redundancies and overhead structures to drive productivity, this inte- such as Linux, and the development of Rational software development gration has improved IBM’s capacity to innovate by providing greater tools, which can be used to develop and upgrade other companies’ clarity of key priorities around shared goals and objectives and led software products. to a sharper focus for the company on learning, development and knowledge sharing. The company will continue to focus on global Investing in Growth Opportunities integration initiatives to improve productivity in its integrated supply The company is continuing to refocus its business on the higher value chain, service delivery and internal support functions. segments of enterprise computing—providing technology and trans- formation services to clients’ businesses. Consistent with that focus, Innovation Initiatives the company continues to significantly invest in growth opportunities IBM invests to improve its ability to help its clients innovate. as a way to drive revenue growth and market share gains. Areas of Investment may occur in the research and development of new prod- investment include strategic acquisitions, primarily in software and ucts and services, as well as in the establishment of new collaborative services, focused client- and industry-specific solutions, maintaining and co-creation relationships with developers, other companies and technology leadership and emerging growth countries such as China, other institutions. Examples include IBM’s leadership position in the Russia, India and Brazil. design and fabrication of game processors; the design of smaller, faster and energy-efficient semiconductor devices; and the design of “grid” computing networks that allow computers to share processing power. 21


  • Page 24

    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: 2006 2005 CHANGE CURRENCY Statement of Earnings Revenue Presentation: Global Services $48,247 $47,407 1.8% 1.7% Hardware 22,499 24,343 (7.6) (8.3) Software 18,204 16,830 8.2 7.5 Global Financing 2,379 2,407 (1.1) (1.6) Other 94 147 (36.4) (33.4) Total $91,424 $91,134 0.3% (0.0)% (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE CURRENCY Industry Sector: Financial Services $25,181 $24,186 4.1% 3.8% Public 13,401 14,064 (4.7) (5.3) Industrial 11,535 11,699 (1.4) (1.6) Distribution 9,034 8,959 0.8 0.3 Communications 8,679 8,601 0.9 0.6 Small & Medium Business 16,981 17,597 (3.5) (3.8) OEM 3,856 3,271 17.9 17.9 Other 2,756 2,757 (0.1) 0.0 Total $91,424 $91,134 0.3% (0.0)% * Reclassified to conform with 2006 presentation. (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE CURRENCY Geographies: Americas $39,511 $38,817 1.8% 0.8% Europe/Middle East/Africa 30,491 30,428 0.2 (1.1) Asia Pacific 17,566 18,618 (5.7) (3.1) OEM 3,856 3,271 17.9 17.9 Total $91,424 $91,134 0.3% (0.0)% Management Discussion ........................................................ 12 road Map............................................................................. 12 Forward-Looking and Cautionary statements ..................... 13 Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered public accounting firm .... 55 consolidated statements ....................................................... 56 22 2006 Annual Report


  • Page 25

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The company divested its Personal Computing business to Lenovo From a geographic perspective, as-reported revenue performance on April 30, 2005. The details of this significant transaction are dis- was mixed in 2006 compared to 2005, with growth in the Americas cussed in note C, “Acquisitions/Divestitures”, on pages 77 and 78. As and EMEA, being offset by a decrease in Asia Pacific. a result of this divestiture, the company’s reported financial results do Americas’ revenue increased 1.8 percent (1 percent adjusted for not include any activity in 2006 and include four months of activity for currency) in 2006 versus the year-ago period. Revenue increased in all the Personal Computing Division in 2005. This lack of comparable regions with the U.S. up 1.0 percent, Canada 2.4 percent (decreased periods has a material impact on the company’s reported revenue 4 percent adjusted for currency) and Latin America 8.6 percent ( 3 growth. The company believes that a more appropriate analysis is one percent adjusted for currency). that excludes the revenue results of the Personal Computing Division EMEA revenue increased a modest 0.2 percent on an as-reported in 2005 because it presents results on a comparable basis and provides basis (declined 1 percent adjusted for currency) in 2006 when com- a more meaningful focus on the company’s ongoing operational per- pared to 2005. In the major countries, the U.K. increased 0.5 percent formance. Such discussion is presented on pages 24 and 25. (decreased 1 percent adjusted for currency), France increased 1.6 Total revenue, as reported, increased 0.3 percent versus 2005. In percent (flat adjusted for currency), Italy increased 1.6 percent (flat addition to the revenue presentation in the Consolidated Statement of adjusted for currency) and Spain increased 2.1 percent (flat adjusted Earnings, the company also measures revenue performance on both for currency). These increases were largely offset by lower revenue in an industry sector and geographic basis. Germany of 2.8 percent (4 percent adjusted for currency) in 2006 As-reported revenue performance by industry sector was mixed in versus the year-ago period. 2006 when compared to 2005. Revenue in the Financial Services sec- Asia Pacific revenue declined 5.7 percent (3 percent adjusted for tor increased 4.1 percent versus the year-ago period, driven by currency) year over year. Japan, which represents over 50 percent of Banking, which increased 7.2 percent. The Public sector revenue the Asia Pacific revenue base, declined 10.1 percent ( 5 percent decline of 4.7 percent was attributable to decreased revenue in the adjusted for currency). Partially offsetting the Japan decline were Government ( 3.2 percent) and Education (25.1 percent) industries. revenue increases in Korea 12.6 percent and India 22.9 percent. The Industrial sector revenue decline (1.4 percent) was driven by The emerging countries of Brazil, India, Russia and China Automotive (5.5 percent), partially offset by increased revenue in together grew 9.9 percent ( 5 percent adjusted for currency), as the Chemical and Petroleum (12.4 percent). Revenue in the Distribution company continues to invest to build capabilities in these countries. sector increased (0.8 percent) with growth in Consumer Products Brazil grew 15.4 percent ( 4 percent adjusted for currency), India ( 5.3 percent) and the Retail industry (2.4 percent), partially offset by increased 22.9 percent (26 percent adjusted for currency) and Russia decreased revenue in Travel and Transportation (4.5 percent). The increased 13.9 percent (14 percent adjusted for currency). China Communications sector revenue increase (0.9 percent) was driven by declined 0.3 percent (2 percent adjusted for currency) in 2006 as this increased revenue in Utilities (9.3 percent). Revenue from Small and country’s performance was significantly impacted by the Personal Medium Business decreased 3.5 percent in 2006 when compared to Computing divestiture. 2005, with revenue declines in all geographic markets. This sector was OEM revenue increased 17.9 percent (18 percent adjusted for cur- impacted most significantly by the loss of the Personal Computing rency) in 2006 driven by strong demand for game processors in the business revenue. Microelectronics business. The following geographic, regional and country-specific revenue performance excludes OEM revenue, which is presented separately. 23


  • Page 26

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies Revenue Excluding Divested Personal Computing Business (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE CURRENCY Statement of Earnings Revenue Presentation: Global Services $48,247 $47,407 1.8% 1.7% Hardware 22,499 21,468 4.8 3.9 Software 18,204 16,830 8.2 7.5 Global Financing 2,379 2,407 (1.1) (1.6) Other 94 147 (36.4) (33.4) Total $91,424 $88,259 3.6% 3.2% (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE CURRENCY Industry Sector: Financial Services $25,181 $23,916 5.3% 4.9% Public 13,401 13,599 (1.5) (2.1) Industrial 11,535 11,470 0.6 0.4 Distribution 9,034 8,836 2.3 1.7 Communications 8,679 8,468 2.5 2.1 Small & Medium Business 16,981 16,018 6.0 5.7 OEM 3,856 3,271 17.9 17.9 Other 2,756 2,681 2.8 2.9 Total $91,424 $88,259 3.6% 3.2% * Reclassified to conform with 2006 presentation. (Dollars in millions) YR. TO YR. PERCENT YR. TO YR. CHANGE PERCENT CONSTANT FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE CURRENCY Geographies: Americas $39,511 $37,725 4.7% 3.7% Europe/Middle East/Africa 30,491 29,549 3.2 1.8 Asia Pacific 17,566 17,714 (0.8) 1.8 OEM 3,856 3,271 17.9 17.9 Total $91,424 $88,259 3.6% 3.2% Total revenue, excluding the divested Personal Computing business, sector revenue increased 2.5 percent on the strength of increased increased 3.6 percent (3.2 percent adjusted for currency) versus 2005. Utilities revenue (11.7 percent). Small and Medium Business increased Revenue across all industry sectors increased in 2006 when com- 6.0 percent in 2006 versus 2005 with growth in all geographic markets pared to 2005, except for the Public sector. Financial Services sector and enabled by growth in the company’s ibm.com channel. revenue increased 5.3 percent driven by Banking (8.5 percent). Public The following geographic, regional and country-specific revenue sector revenue decreased 1.5 percent driven by a 15.0 percent decline performance and the table above excludes OEM revenue, which is in the Education industry. Industrial sector revenue increased 0.6 presented separately. percent driven by Chemical and Petroleum (16.3 percent), partially Adjusted for currency, revenue increased in all geographic markets offset by decreased revenue from Automotive (4.2 percent). Distribution in 2006 when compared with 2005, with the strongest growth coming sector revenue increased 2.3 percent driven by Consumer Products (8.0 from the Americas. percent) and Retail (3.2 percent) industries, partially offset by decreased Americas’ revenue grew 4.7 percent as reported (4 percent revenue in Travel and Transportation (3.2 percent). Communications adjusted for currency), with growth in all regions. From a product 24 2006 Annual Report


  • Page 27

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES perspective, the increased revenue was driven by software. Latin Software revenue increased 8.2 percent in 2006 versus 2005 driven America led the regions with growth of 14.4 percent (9 percent by growth in the company’s Key Branded Middleware offerings (17.1 adjusted for currency). Brazil grew 18.9 percent (8 percent adjusted percent), partially offset by lower Operating Systems revenue (6.3 for currency). The U.S. increased 3.6 percent and Canada grew 6.5 percent). The Key Branded Middleware growth was driven by strong percent (flat adjusted for currency). performance in the WebSphere family of products (23.3 percent) and EMEA revenue increased 3.2 percent (2 percent adjusted for cur- Tivoli (26.3 percent). All five brands in Key Branded Middleware had rency) in 2006 when compared with 2005, with revenue growth in all double-digit revenue growth in 2006 versus 2005 with the exception the major countries, except Germany. Revenue increased in the U.K. of Rational which grew 4.4 percent. 3.0 percent (1 percent adjusted for currency), France 4.0 percent (2 Global Financing revenue decreased 1.1 percent in 2006 versus percent adjusted for currency), Spain 4.1 percent (2 percent adjusted 2005 due to lower remarketing equipment sales, partially offset by an for currency) and Italy 3.6 percent (2 percent adjusted for currency). increase in financing revenue. See pages 49 through 53 for additional Germany declined a modest 0.3 percent as reported (2 percent information regarding Global Financing. adjusted for currency) in 2006 when compared to 2005. Russia grew 21.1 percent (21 percent adjusted for currency). Gross Profit Asia Pacific revenue declined 0.8 percent (increased 2 percent YR. TO YR. adjusted for currency) in 2006 versus the prior year. Although Japan FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE revenue declined 7.5 percent (2 percent adjusted for currency), its Consolidated Gross performance improved sequentially throughout 2006 and returned to Profit Margins: growth in the fourth quarter. Partially offsetting the revenue decline Global Services 27.5% 26.0% 1.5 pts. in Japan was growth in other Asia Pacific regions. China grew 15.8 Hardware 37.0 35.1 1.9 percent (14 percent adjusted for currency), Korea grew 14.2 percent Software 85.2 84.9 0.3 (6 percent adjusted for currency) and India increased 38.5 percent (42 Global Financing 50.3 54.7 (4.4) percent adjusted for currency). Other (13.2) 45.2 (58.4) For the year, the company benefited from solid contributions from Total 41.9% 40.1% 1.8 pts. the emerging countries of Brazil, India, Russia and China . Collectively, revenue from these four countries increased 20.5 percent (16 percent The increase in the overall Global Services gross profit margin was adjusted for currency) in 2006 versus 2005. primarily due to benefits from the company’s productivity initiatives OEM revenue increased 17.9 percent (18 percent adjusted for cur- and cost efficiencies, including improved utilization. The increase in rency) in 2006 versus 2005 driven by strong game processor demand Hardware margin was primarily due to the divestiture of the Personal in the Microelectronics business. Computing business (which had a lower gross profit margin than the Total Global Services revenue increased 1.8 percent in 2006 versus other hardware businesses) in the second quarter of 2005. The absence 2005. The increase was driven by GTS (2.4 percent) and GBS (0.4 of the Personal Computing business contributed 3.5 points to the percent). The increase in GTS was driven by Strategic Outsourcing increase in the 2006 hardware margin. This increase was partially (3.2 percent) and BTO (17.2 percent), partially offset by a decline in offset by a 2.7 point decline in the Systems and Technology Group ITS revenue of 1.8 percent. margin in 2006 versus 2005. Overall, Hardware revenue declined as reported in 2006 compared The decrease in Global Financing gross profit margin was primar- to 2005 due to the divestiture of the Personal Computing business. ily driven by lower financing margins due to higher borrowing costs Systems and Technology Group revenue increased 4.7 percent as related to the external interest rate environment. System z revenue increased 7.8 percent and MIPS (millions of instruc- In addition, an increase in retirement-related plan costs of approx- tions per second) volumes increased 11 percent versus 2005. System imately $235 million partially offset by a decrease in stock-based Storage revenue increased 6.4 percent as Total disk grew 7.8 percent compensation costs of approximately $114 million compared to 2005 driven by midrange disk (16.5 percent), while tape products revenue also impacted overall segment margins. See “Segment Details” dis- increased 3.1 percent. Microelectronics revenue increased 21.9 per- cussion on pages 29 to 32 for further details on gross profit. cent driven by strong demand in games processors and networking components. System x increased 3.7 percent compared to 2005 driven expense by increased revenue for servers (5.3 percent) and Blades (22.3 per- (Dollars in millions) cent). Retail Stores Solutions revenue increased 21.4 percent versus YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE 2005. These increases were partially offset by declines in System i servers (15.0) percent, System p servers (1.1 percent), Printing Total expense and other income $24,978 $24,306 2.8% Systems (7.6 percent) and E&TS (16.2 percent). Expense to Revenue (E/R) 27.3% 26.7% 0.7 pts. Personal Computing Division had no revenue in 2006 versus four months of revenue in 2005. See note C, “Acquisitions/Divestitures,” on pages 77 and 78 for additional information. 25


  • Page 28

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies Total expense and other income increased 2.8 percent (2.4 percent additional information. In addition, retirement-related expense and adjusted for currency) in 2006 versus 2005. Overall, the increase was stock-based compensation expense (see “Retirement-Related Benefits” primarily due to increased Research, development and engineering and “Stock-Based Compensation,” on pages 27 and 28 for additional expense driven by acquisitions and lower Other (income) and expense information) decreased in 2006 versus 2005. These decreases were driven by the gain associated with the sale of the Personal Computing partially offset by increased operational expenses (SG&A-base) as a business and the Microsoft settlement in 2005. These increases were result of strategic acquisitions and investments the company is making partially offset by lower Selling, general and administrative expense in its software and services businesses as well as emerging countries. due primarily to the restructuring charges recorded in the second The returns on these investments are reflected in the revenue growth quarter of 2005. The expense-to-revenue ratio increased 0.7 points to in the company’s key middleware brands and emerging countries dur- 27.3 percent in 2006, as revenue increased 0.3 percent and expense ing 2006 and strong services signings in the fourth quarter. increased 2.8 percent in 2006 versus 2005. For additional information regarding the increase in Total expense and other income, see the other (incoMe) anD expense following analyses by category: (Dollars in millions) YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE SELLING, GENERAL AND ADMINISTRATIVE (Dollars in millions) Other (income) and expense: YR. TO YR. Foreign currency FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE transaction (gains)/losses $(130) $ 218 NM Selling, general and Losses on derivative instruments 135 4 NM administrative expense: Interest income (536) (307) 74.8% Selling, general and Net gains from securities administrative—base $17,459 $16,620 5.0% and investments assets (40) (111) (63.9) Advertising and Net realized gains from promotional expense 1,195 1,284 (6.9) certain real estate activities (41) (179) (77.2) Workforce reductions— Restructuring (7) 230 NM ongoing 289 289 0.4 Lenovo/Microsoft gains (45) (1,883) (97.6) Restructuring (7) 1,482 NM Other (102) (93) 9.6 Amortization expense— Total $(766) $(2,122) (63.9)% acquired intangibles 208 218 (4.5) * Reclassified to conform with 2006 presentation. Retirement-related expense 587 846 (30.6) NM —Not meaningful Stock-based compensation 541 606 (10.7) Bad debt expense (13) (31) (57.2) Other (income) and expense was net income of $766 million and Total $20,259 $21,314 (4.9)% $2,122 million in 2006 and 2005, respectively. The decrease in net * Reclassified to conform with 2006 presentation. income was primarily driven by the gain on the sale of the company’s NM —Not meaningful Personal Computing business recorded in 2005. The pre-tax gain associated with this transaction was $1,108 million. See note C, Total Selling, general and administrative (SG&A) expense decreased “Acquisitions/Divestitures,” on pages 77 and 78 for additional infor- 4.9 percent (5.3 percent adjusted for currency). The decrease was mation. In addition, the company settled certain antitrust issues with primarily driven by the restructuring charges recorded in the second the Microsoft Corporation in 2005 and the gain from this settlement quarter of 2005. See note R, “2005 Actions,” on pages 93 and 94 for was $775 million. The company also had lower income from certain real estate activities, as 2005 had unusually high gains from a few large real estate transactions. These decreases in income were par- tially offset by additional Interest income generated by the company Management Discussion ........................................................ 12 in 2006; foreign currency transaction gains in 2006 versus losses in road Map............................................................................. 12 2005 and real estate related restructuring charges recorded in the Forward-Looking and Cautionary statements ..................... 13 second quarter of 2005. See note R, “2005 Actions,” on pages 93 and Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 94 for additional information. The Losses on derivative instruments Year in review...................................................................... 22 relate to losses on certain hedge contracts offset by settlement of Prior Year in review ............................................................. 37 foreign currency receivables and payables. See “Currency Rate Fluc- Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 tuations,” on page 47 for additional discussion of currency impacts on Global Financing .................................................................. 49 the company’s financial results. report of Management ......................................................... 54 report of independent registered public accounting firm .... 55 consolidated statements ....................................................... 56 26 2006 Annual Report


  • Page 29

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies RESEARCH, DEVELOPMENT AND ENGINEERING stock-based compensation (Dollars in millions) Total pre-tax stock-based compensation expense of $846 million YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE decreased $189 million compared to 2005. The decrease was princi- Research, development pally the result of: (1) a reduction in the level and fair value of stock and engineering: option grants ($284 million), (2) changes to the terms of the company’s Total $6,107 $5,842 4.5% employee stock purchase plan, which rendered it non-compensatory in the second quarter of 2005 in accordance with the provisions of SFAS No. 123(R) ($18 million), offset by (3) increased expense for The increase in Research, development and engineering (RD&E) performance-based stock units ($34 million) resulting from changes was primarily driven by acquisitions and the company’s investments to in the probabilities of achieving performance metrics and (4) an maintain its technology leadership across the product offerings. Soft- increase in the level of restricted stock units ($78 million). The effects ware spending increased $210 million and Systems and Technology on pre-tax stock-based compensation expense of the 2005 sale of the spending increased $92 million in 2006 versus 2005. These increases Personal Computing business were recorded in Other (income) and were partially offset by the year-to-year reduction in the Personal expense in the Consolidated Statement of Earnings for the year ended Computing Division of $52 million due to the divestiture of that December 31, 2005. The year-to-year reductions in pre-tax compen- business in the prior year. Retirement-related expense increased $32 sation expense were reflected in the following categories: Cost ($114 million in 2006 versus 2005, partially offset by lower stock-based million); Selling, general and administrative expense ($65 million); compensation expense of $18 million. Research, development and engineering ($18 million); and an increase in Other (income) and expense ($8 million). intellectual property anD There was no significant capitalized stock-based compensation custoM DevelopMent incoMe expense at December 31, 2006 and 2005. (Dollars in millions) See note U, “Stock-Based Compensation,” on page 96 to 100 for YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE additional information on the company’s stock-based incentive awards. Intellectual property and custom development income: retirement-related benefits Sales and other transfers The following table provides the total pre-tax cost for all retirement- of intellectual property $167 $236 (29.1)% related plans. Cost amounts are included as an addition to the cost and Licensing/royalty-based fees 352 367 (4.1) expense amounts in the Consolidated Statement of Earnings within Custom development income 381 345 10.5 the caption (e.g., Cost, SG&A, RD&E) relating to the job function of Total $900 $948 (5.0)% the individuals participating in the plans. (Dollars in millions) The timing and amount of Sales and other transfers of IP may vary YR. TO YR. significantly from period to period depending upon timing of divesti- FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE tures, industry consolidation, economic conditions and the timing of Retirement-related plans cost: new patents and know-how development. There were no significant Defined benefit and IP transactions in 2006 and 2005. contribution pension plans cost $2,040 $1,726 18.2% interest expense Nonpension postretirement (Dollars in millions) plans costs 388 379 2.4 YR. TO YR. Plan amendments/curtailments — 332 NM FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE Total $2,428 $2,437 (0.4)% Interest expense: * Reclassified to conform with 2006 presentation. Total $278 $220 26.6% NM —Not meaningful The increase in Interest expense was primarily driven by higher effec- Overall, retirement-related plan costs decreased $9 million versus tive interest rates in 2006 versus 2005. Interest expense is presented in 2005. The 2005 retirement-related plan costs included $332 million Cost of Global Financing in the Consolidated Statement of Earnings related to unique items: a curtailment charge of $267 million recorded only if the related external borrowings are to support the Global in the fourth quarter as a result of U.S. pension plan amendments and Financing external business. See page 52 for additional information a $65 million charge recorded in the second quarter related to the regarding Global Financing debt and interest expense. 27


  • Page 30

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies company’s restructuring actions. These non-recurring charges were income taxes recorded in SG&A ($318 million) and Other (income) and expense The provision for income taxes resulted in an effective tax rate of 29.3 ($14 million). This decrease year to year in retirement-related plan percent for 2006, compared with the 2005 effective tax rate of 34.6 costs was essentially offset by an increase in the recognition of previ- percent. The 5.3 point decrease in the 2006 effective tax rate was ously deferred actuarial losses in accordance with SFAS No. 87, primarily attributable to the net effect of several items. In 2006, the “Employers’ Accounting for Pensions.” tax rate was favorably impacted by the absence of the foreign earnings Retirement-related expense within SG&A decreased $262 million repatriation-related tax charge recorded in the third quarter of 2005 year to year: a $318 million decrease as a result of the prior year (4.3 points) as well as a benefit from the fourth-quarter 2006 settle- charges discussed previously, offset by recurring plan cost increases of ment of the U.S. federal income tax audit for the years 2001 through $56 million versus 2005. Other (income) and expense decreased $14 2003 ( 3.0 points). These benefits were partially offset by a one-time million as discussed above. Increases year to year in Cost and RD&E tax cost associated with the 2006 intercompany transfer of certain expense of approximately $235 million and $32 million, respectively, intellectual property (4.3 points). The remaining items were indi- were a result of recurring plan cost increases. See note V, “Retirement- vidually insignificant. Related Benefits,” on pages 100 to 111 for additional information on the company’s benefit plans including a description of the plans, plan earnings per share financial information and assumptions. Basic earnings per share is computed on the basis of the weighted- average number of shares of common stock outstanding during the Acquired Intangible Asset Amortization period. Diluted earnings per share is computed on the basis of the The company has been investing in targeted acquisitions primarily weighted-average number of shares of common stock plus the effect of within its Software and Global Services segments to increase its capa- dilutive potential common shares outstanding during the period using bilities in higher value market segments. The following table presents the treasury stock method. Dilutive potential common shares include the total acquired intangible asset amortization included in the outstanding stock options, stock awards and convertible notes. Consolidated Statement of Earnings. See note I, “Intangible Assets Including Goodwill,” on pages 80 and 81 for additional information. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 YR. TO YR. CHANGE (Dollars in millions) Earnings per share of YR. TO YR. common stock: FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE Assuming dilution: Cost: Continuing operations $6.06 $ 4.91 23.4% Software $ 81 $118 (30.9)% Discontinued operations 0.05 (0.01) NM Global Services 23 27 (15.3) Cumulative effect of change Hardware 3 4 (16.7) in accounting principle* — (0.02) NM Selling, general and Total $6.11 $ 4.87 25.5% administrative expense 208 218 (4.5) Basic: Total $316 $367 (13.9)% Continuing operations $6.15 $ 4.99 23.2% Discontinued operations 0.05 (0.02) NM Cumulative effect of change in accounting principle* — (0.02) NM Total $6.20 $ 4.96 25.0% Weighted-average shares outstanding (in millions): Assuming dilution 1,553.5 1,627.6 (4.6)% Basic 1,530.8 1,600.6 (4.4)% Management Discussion ........................................................ 12 * Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting road Map............................................................................. 12 Changes,” on page 72 for additional information. Forward-Looking and Cautionary statements ..................... 13 NM —Not meaningful Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Actual shares outstanding at December 31, 2006 and December 31, Prior Year in review ............................................................. 37 2005 were 1,506.5 million and 1,574.0 million, respectively. The Discontinued Operations ..................................................... 41 average number of common shares outstanding assuming dilution was Other Information ................................................................ 41 Global Financing .................................................................. 49 lower by 74.1 million shares in 2006 versus 2005. The decrease was report of Management ......................................................... 54 primarily the result of the company’s common share repurchase pro- report of independent registered public accounting firm .... 55 gram. See note N, “Stockholders’ Equity Activity,” on page 88 for consolidated statements ....................................................... 56 additional information regarding the common share activities. Also see note S, “Earnings Per Share of Common Stock,” on page 95. 28 2006 Annual Report


  • Page 31

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies SEGMENT DETAILS Global Technology Services revenue increased 2.6 percent (2 per- The following is an analysis of the 2006 versus 2005 reportable cent adjusted for currency) in 2006 versus the prior year period. Total segment results. The analysis of 2005 versus 2004 reportable segment signings in GTS increased 1 percent in 2006 when compared to 2005, results is on pages 39 and 40. with shorter term signings increasing 5 percent while longer term The following table presents each reportable segment’s external signings were flat. revenue as a percentage of total external segment revenue, excluding Revenue from Strategic Outsourcing was up 3.2 percent (3 percent the Personal Computing business. adjusted for currency) due primarily to signings growth in 2005 and a continued focus on increasing services into existing accounts. Signings FOR THE YEAR ENDED DECEMBER 31: 2006 2005 in 2006 increased 7 percent when compared to 2005. Global Technology Services 35.6% 36.0% Integrated Technology Services revenue decreased 1.2 percent (2 Global Business Services 17.6 18.2 percent adjusted for currency) in 2006 versus 2005. The rate of reve- Total Global Services 53.2 54.1 nue growth in ITS improved during the second half of 2006 reflecting Hardware 24.2 23.9 progress from the changes implemented throughout 2006 to improve Global Financing 2.6 2.7 the ITS business, including streamlining offerings and aligning skills Total Hardware/Financing 26.8 26.7 to address higher growth and higher value areas. The acquisition of Software 20.0 19.2 Internet Security Systems Inc. (ISS), added to the company’s capabili- Total 100.0% 100.0% ties in security and intrusion protection, and contributed to improved performance in the fourth quarter. ITS signings increased 5 percent in 2006 over the year-ago period. The table below presents each reportable segment’s pre-tax income as Business Transformation Outsourcing revenue increased 17.2 a percentage of total reportable segment pre-tax income, excluding percent (17 percent adjusted for currency) in 2006 when compared to the Personal Computing business and the 2005 restructuring charges. 2005. The rate of growth in BTO was negatively impacted by a sig- Segment pre-tax income includes transactions between the segments nificant contract renegotiation in 2006 which will continue through that are intended to reflect an arms-length transfer price. the first quarter of 2007. While BTO signings in 2006 decreased 33 FOR THE YEAR ENDED DECEMBER 31: 2006 2005 percent versus 2005, the company continues to see opportunity within this business, particularly in Finance and Accounting, Human Global Technology Services 24.0% 25.5% Resources and Procurement. Global Business Services 12.5 9.5 Maintenance revenue increased 2.0 percent (2 percent adjusted for Total Global Services 36.5 35.0 currency) driven by increased availability services on non-IBM IT Hardware 12.7 15.4 equipment, primarily in the Americas and Asia Pacific geographies. Global Financing 10.6 12.2 The GTS segment pre-tax margin was 9.6 percent in 2006, an Total Hardware/Financing 23.3 27.6 increase of 1.9 points versus 2005. The improvement was primarily Software 40.1 37.4 the result of the incremental restructuring charges recorded in the Total 100.0% 100.0% second quarter of 2005 and the continued focus on productivity ini- tiatives. The company is continuing to make investments in sales, global services delivery and business development skills across the entire set of GTS The company’s two services segments, Global Technology Services offerings, as well as investing in strategic outsourcing infrastructure and Global Business Services had revenue of $48,291 million, an and BTO capabilities. increase of 1.9 percent (2 percent adjusted for currency) in 2006 ver- Global Business Services revenue increased 0.4 percent (1 percent sus 2005. Revenue growth and the profile of the services business adjusted for currency) in 2006 versus 2005. The rate of year-over-year improved throughout 2006. revenue growth in GBS increased in the second half of 2006 reflecting progress made on actions taken throughout the year that focused on (Dollars in millions) operational transformation and profitable growth initiatives. Total sign- YR. TO YR. ings in GBS increased 10 percent in 2006. Shorter term signings were FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE up 6 percent; with particular strength in the larger, higher value-add Global Services engagements during the second half of the year. Longer term signings segment revenue: $48,291 $47,407 1.9% increased 17 percent, driven by the Application Management business. Global Technology Services $32,322 $31,501 2.6% The GBS segment pre-tax margin was 9.8 percent in 2006, an Strategic Outsourcing 17,044 16,522 3.2 improvement of 5.3 points versus 2005. In addition to the benefits Integrated Technology received from the incremental restructuring charges recorded in the Services 7,448 7,538 (1.2) second quarter of 2005 (2.6 points of improvement), the margin Business Transformation improvement was driven by improved utilization, better contract Outsourcing 1,845 1,573 17.2 Maintenance 5,986 5,868 2.0 management and delivery and stable-to-improved pricing. Global Business Services $15,969 $15,906 0.4% 29


  • Page 32

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies (Dollars in millions) Global Services signings are management’s initial estimate of the FOR THE YEAR ENDED DECEMBER 31: 2006 2005 YR. TO YR. CHANGE value of a client’s commitment under a Global Services contract. Signings are used by management to assess period performance of Global Services: Global Services management. There are no third-party standards or Gross profit $13,317 $12,314 8.1% requirements governing the calculation of signings. The calculation Gross profit margin 27.6% 26.0% 1.6 pts. used by management is an approximation of constant currency, and involves estimates and judgments to gauge the extent of a client’s Global Services gross profit dollars increased primarily due to the commitment, including the type and duration of the agreement, and benefits from productivity initiatives and cost efficiencies, including the presence of termination charges or wind-down costs. For example, benefits resulting from the company’s targeted restructuring action in for longer term contracts that require significant up-front investment the second quarter of 2005. Gross profit margin improvement was by the company, the portions of these contracts that are counted as a achieved in each of the services lines of business. signing are those periods in which there is a significant economic impact on the client if the commitment is not achieved, usually global services signings through a termination charge or the client incurring significant wind- In 2006, total Global Services signings increased 4 percent year to down costs as a result of the termination. For shorter term contracts year to $49,174 million, driven by a 6 percent increase in shorter term that do not require significant up-front investments, a signing is usu- signings and a 4 percent increase in longer term signings. Global ally equal to the full contract value. Technology Services signings were $29,608 million and Global Signings include SO, BTO, ITS and GBS contracts. Contract Business Services signings were $19,565 million in 2006. The compa- extensions and increases in scope are treated as signings only to the ny’s total Global Services backlog increased to an estimated $116 extent of the incremental new value. Maintenance is not included in billion from the 2005 estimated backlog of $111 billion. signings as maintenance contracts tend to be more steady state, where revenue equal renewals, and therefore, the company does not think (Dollars in millions) they are as useful a predictor of future performance. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 Backlog includes SO, BTO, ITS, GBS, and Maintenance. Backlog Global Technology Services Signings is intended to be a statement of overall work under contract and Longer term* $21,337 $21,355 therefore does include Maintenance. Backlog estimates are subject to Shorter term* 8,271 7,886 change and are affected by several factors, including terminations, Total $29,608 $29,242 changes in the scope of contracts, periodic revalidations, adjustments Global Business Services Signings for revenue not materialized and currency assumptions used to Longer term* $ 6,838 $ 5,824 approximate constant currency. Shorter term* 12,727 12,015 Contract portfolios purchased in an acquisition are treated as Total $19,565 $17,839 positive backlog adjustments provided those contracts meet the * Longer term contracts are generally 7 to 10 years in length and represent SO and company’s requirements for initial signings. A new signing will be BTO contracts as well as GBS contracts with the U.S. federal government and its recognized if a new services agreement is signed incidental or coinci- agencies and AMS for custom and legacy applications. Shorter term are contracts generally three to nine months in length and represent the remaining GBS offer- dent to an acquisition. ings of Consulting and Systems Integration, AMS packaged applications and ITS contracts. These amounts have been adjusted to exclude the impact of year-to-year currency changes. hardware (Dollars in millions) YR. TO YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE Hardware segment revenue: $21,970 $23,857 (7.9)% Systems and Technology Group $21,970 $20,981 4.7% Management Discussion ........................................................ 12 System z 7.8 road Map............................................................................. 12 Forward-Looking and Cautionary statements ..................... 13 System i (15.0) Management Discussion snapshot ...................................... 14 System p (1.1) Description of Business ....................................................... 15 System x 3.7 Year in review...................................................................... 22 System Storage 6.4 Prior Year in review ............................................................. 37 Microelectronics 21.9 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Engineering & Global Financing .................................................................. 49 Technology Services (16.2) report of Management ......................................................... 54 Retail Store Solutions 21.4 report of independent registered public accounting firm .... 55 Printing Systems (7.6) Personal Computing Division — 2,876 NM consolidated statements ....................................................... 56 NM —Not meaningful 30 2006 Annual Report


  • Page 33

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies Systems and Technology Group revenue increased 4.7 percent Personal Computing business (which had a lower gross profit margin (4 percent adjusted for currency) in 2006 versus 2005. System z rev- than the other hardware products) in the second quarter of 2005. enue increased reflecting continued strong customer acceptance of This divestiture contributed 3.5 points of the improvement in the both specialty engines for Linux and Java workloads and traditional Hardware margin. mainframe workloads. MIPS shipments increased 11 percent versus Systems and Technology Group gross profit margins declined 2.7 2005. System x revenue increased driven by increased server revenue points to 37.7 percent in 2006 versus 2005. The decline in gross profit ( 5.3 percent) and System x blades growth of 22.3 percent. IBM margin was driven by revenue mix towards lower margin products in BladeCenter offers clients unique power and cooling capabilities and 2006 versus 2005 (2.5 points) and pricing pressure in the company’s the flexibility to efficiently handle various workloads. In addition to low- and mid-range server brands. the company’s System x blades, the company offers POWER blades Differences between the Hardware segment gross profit margin and blades utilizing the Cell Broadband Engine. Total blade growth, and gross profit dollar amounts above and the amounts reported on including System p blades, was 24.6 percent in 2006 versus 2005. page 25 (and derived from page 56) primarily relate to the impact of Although System p revenue declined for the year, high-end server certain cost hedging transactions (see “Anticipated Royalties and Cost revenue increased 9.4 percent. In the third quarter the company com- Transactions” on page 84) as well as the ongoing warranty costs asso- pleted its transition to POWER5+ and expanded the implementation ciated with the divested Personal Computing business. The recorded of POWER Quadcore technology to all POWER-based entry level amounts for these transactions are considered unallocated corporate System p products. These transitions allowed the company to sustain amounts for purposes of measuring the segment’s gross margin perfor- the price/performance and virtualization leadership position that mance and therefore are not included in the segment results above. has made the company the number one UNIX vendor worldwide. System i revenue declined as the company completed its transition to software (Dollars in millions) POWER5+ in the third quarter, however clients continued to lever- YR. TO YR. age their existing capacity. FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE System Storage revenue growth was driven by Total disk growth Software segment revenue: $18,161 $16,830 7.9% of 7.8 percent, while tape grew 3.1 percent in 2006 versus 2005. Within Total disk, mid-range disk revenue increased 16.5 percent and Middleware $13,891 $12,552 10.7% Key Branded Middleware 9,369 8,004 17.1 storage area network products increased 10.6 percent, while enter- WebSphere family 23.3 prise products revenue declined 6.7 percent in 2006 versus 2005. The Information Management 14.0 revenue increase in tape products was primarily driven by the new Lotus 12.0 tape security offering which includes unique encryption capabilities. Tivoli 26.3 Microelectronics revenue increased due to strong demand in the Rational 4.4 game processor business and networking components. Other middleware 4,522 4,548 (0.6) Retail Stores Solutions revenue increased primarily due to clients Operating systems 2,273 2,426 (6.3) replacing older technology in favor of integrated retail solutions. Product Lifecycle Printing Systems revenue decreased due primarily to lower mainte- Management 1,123 1,077 4.2 nance revenue as a result of a declining install base and lower sales of Other 873 775 12.7 hardware products. * Reclassified to conform with 2006 presentation. Personal Computing Division revenue decreased as a result of the company divesting its Personal Computing business to Lenovo on Software revenue increased 7.9 percent (7 percent adjusted for cur- April 30, 2005. The 2006 results do not include any revenue while the rency) in 2006 versus 2005 reflecting strong demand for the company’s 2005 results include four months of revenue. See note C, “Acquisitions/ industry-leading middleware capabilities. The revenue growth was Divestitures,” on pages 77 and 78 for additional information. driven from both organic sources and the company’s targeted acquisi- tions. The company’s leadership in technology and innovation has (Dollars in millions) allowed it to continue to capitalize on industry trends such as SOA FOR THE YEAR ENDED DECEMBER 31: 2006 2005 YR. TO YR. CHANGE and Information on Demand. Key Branded Middleware is made up of five key brands which Hardware: provide an integrated suite for the company’s customers. All five Gross profit $8,284 $8,718 (5.0)% brands grew in 2006, reflecting continued momentum and benefit Gross profit margin 37.7% 36.5% 1.2 pts. from the company’s sales and development investments along with additional benefit from acquisitions. The decrease in gross profit dollars for 2006 versus 2005 was primarily due to the absence of the Personal Computing business. The increase in gross profit margin was also primarily due to the divestiture of the 31


  • Page 34

    ManageMent Discussion international business Machines corporation anD subsiDiary coMpanies Revenue from the WebSphere family of products increased 23.3 Product Lifecycle Management (PLM) revenue increased 4.2 percent (22 percent adjusted for currency) and was led by double- percent (4 percent adjusted for currency) in 2006 versus 2005. This digit growth in WebSphere Application Servers (25.3 percent) and product set benefited from a number of large transactions in the sec- WebSphere Business Integration (22.7 percent) software versus 2005. ond quarter of 2006. WebSphere provides the foundation for Web-enabled applications (Dollars in millions) and is a key product set in deploying SOA. Information Management software helps companies integrate, FOR THE YEAR ENDED DECEMBER 31: 2006 2005 YR. TO YR. CHANGE manage and gain value from their business information. For the year, Software: revenue increased 14.0 percent (13 percent adjusted for currency). Gross profit $15,471 $14,296 8.2% Growth was driven by the company’s “Information on Demand” port- Gross profit margin 85.2% 84.9% 0.2 pts. folio of software products. The acquisition of FileNet Corporation, during the fourth quarter of 2006, also contributed to the growth The increase in Software gross profit dollars and gross profit margin when compared to the year-ago period. was primarily driven by the 7.9 percent growth in Software revenue. Lotus revenue increased 12.0 percent (11 percent adjusted for cur- The Software segment contributed $5.5 billion of pre-tax profit in rency) driven by the Notes/Domino family of collaboration products. 2006, an increase of 14.9 percent versus 2005. Pre-tax profit margins The company’s Lotus products provide clients with collaborative improved 1.5 points to 26.9%. solutions which enable the integration of people, data and business processes as part of the company’s On Demand and SOA offerings. global financing Customer loyalty to Lotus products remains strong. See pages 49 and 50 for a discussion of Global Financing’s revenue Tivoli revenue increased 26.3 percent (25 percent adjusted for and gross profit. currency) with double-digit growth in each of its key segments: Systems Management (24.5 percent), Security (40.8 percent) and Storage (27.4 percent). The acquisitions of Micromuse, Inc. in the financial position first quarter and MRO Software, Inc. in the fourth quarter added to Dynamics the company’s capabilities in the Tivoli brand and contributed to the The assets and debt associated with the company’s Global Financing revenue growth. business are a significant part of the company’s financial position. The Rational revenue increased 4.4 percent ( 3 percent adjusted for financial position amounts appearing below and on pages 33 and 34 currency) in 2006 versus 2005, in a slower growing market. Rational are the company’s consolidated amounts including Global Financing. software provides customers with products that manage the business However, to the extent the Global Financing business is a major driver process of software and systems delivery. of the consolidated financial position, this narrative section will refer Revenue from Other middleware products declined 0.6 percent to the separate Global Financing section in this Management Discussion (1 percent adjusted for currency) in 2006. This product set includes on pages 49 through 53. The amounts appearing in the separate Global more mature products which provide a more stable flow of revenue. Financing section are supplementary data presented to facilitate an Operating Systems revenue declined 6.3 percent ( 7 percent understanding of the company’s Global Financing business. adjusted for currency) in 2006 versus 2005. Operating Systems are closely tied to the company’s server products. The decline in revenue working capital was primarily driven by improved price performance in System z (Dollars in millions) operating systems. AT DECEMBER 31: 2006 2005 Current assets $44,660 $45,661 Current liabilities 40,091 35,152 Working capital $ 4,569 $10,509 Current ratio 1.11 1.30 Management Discussion ........................................................ 12 road Map............................................................................. 12 Forward-Looking and Cautionary statements ..................... 13 Working capital decreased $5,940 million compared to the prior year Management Discussion snapshot ...................................... 14 primarily as a result of an increase in Current liabilities. The key drivers Description of Business ....................................................... 15 are described below: Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Current assets decreased $1,001 million due to: Other Information ................................................................ 41 Global Financing .................................................................. 49 • Decline of $3,030 million, net of a favorable $202 million currency report of Management ......................................................... 54 impact, in Cash and cash equivalents and Marketable Securities due report of independent registered public accounting firm .... 55 to current-year requirements in pension funding, share repurchase, consolidated statements ....................................................... 56 32 2006 Annual Report


  • Page 35

    ManageMent DisCussion international business MaChines Corporation anD subsiDiary CoMpanies dividend payments, tax payments, acquisitions and capital spending. Net cash from operating activities for 2006 increased $105 million See Cash Flow analysis below. as compared to 2005 driven by the following key factors: • Increase of $2,420 million in short-term receivables driven by: • Increase in net income of $1,559 million; — increase of $769 million in trade receivables as a result of fourth • Decrease in cash related to deferred income taxes, $461 million, quarter revenue growth; due to the utilization of tax credit carryforwards in 2005; — increase of $743 million in financing receivables due to asset • Decrease in net gains on asset sales, $1,350 million, driven by the growth in commercial financing and customer loans; and gain related to the Personal Computing business divestiture in 2005; — approximately $1,106 million favorable currency impact. • Pension assets and liabilities contributed an increase in cash of $878 million, primarily driven by lower pension funding of $549 million Current liabilities increased $4,939 million as a result of: ($1,840 million funding of non-U.S. plans in 2006 versus $2,389 • Increase of $1,686 million in Short-term debt as the company increased million total funding in 2005); commercial paper balances in support of the increased Global Financing • Increase in cash driven by Accounts payable of $891 million primarily asset base discussed above; as a result of the Personal Computing business divestiture in 2005; and • Growth in Deferred income driven by Software ($557 million) and • Growth in accounts receivable drove a use of cash of $2,731 million; Global Services ($423 million); this was driven by Global Financing receivables ($2,071 million) • Increase of $1,270 million in Compensation and benefits primarily as primarily due to asset growth in the second half of 2006; in addition, a result of SFAS No. 158 implementation; the company is required to the Personal Computing business divestiture contributed to this year- record as a current liability the amount of retirement-related benefit to-year decrease in cash. payments that will be paid in the coming year ($990 million) that are Net cash used in investing activities increased $7,126 million on a year- not covered by retirement plan assets; this would occur in unfunded or underfunded plans; and to-year basis driven by: • Increase of $615 million in Accounts payable of which $256 million • Net purchases of marketable securities and other investments of was due to the effects of currency. $2,668 million; • Increased spending of $2,316 million for acquisitions; Cash Flow The company’s cash flow from operating, investing and financing • Increase in net capital spending of $1,210 million as a result of a activities, as reflected in the Consolidated Statement of Cash Flows $521 million increase in capital expenditures primarily to support the on page 58, is summarized in the table below. These amounts include SO business, and a $677 million decrease in real estate sales versus the prior year; and the cash flows associated with the company’s Global Financing busi- ness. See pages 49 through 53. • A decline in divestiture related cash proceeds of $932 million: $662 million related to the Personal Computing business divestiture and $268 (Dollars in millions) million received from Hitachi representing the final proceeds related to FOR THE YEAR ENDED DECEMBER 31: 2006 2005 the HDD business sale; both of these payments were received in 2005. Net cash provided by/(used in) continuing operations: Net cash used in financing activities increased $1,057 million com- Operating activities $ 15,019 $14,914 pared to 2005 as a result of: Investing activities (11,549) (4,423) Financing activities (8,204) (7,147) • Higher dividend payments of $434 million as a result of the increase Effect of exchange rate changes in the company’s quarterly common stock dividend from $0.20 to on cash and cash equivalents 201 (789) $0.30 per share; and Net cash used in discontinued • Increase in net cash used to retire debt of $730 million. operations—operating activities* (12) (40) Net change in cash and Within total debt, on a net basis, the company utilized $121 million cash equivalents $ (4,546) $ 2,515 in net cash to retire debt versus $609 million in net proceeds from * Does not include $319 million in 2005 of net proceeds from the sale of the HDD new debt in 2005. The net cash used in 2006 to retire debt was com- business. $51 million is included in Operating activities from continuing operations prised of: $3,400 million in cash payments to retire debt offset by and $268 million is included in Investing activities from continuing operations. $1,444 million of new debt issuances and $1,834 million in net short- term borrowings. See note K, “Borrowings,” on pages 81 to 83 for a listing of the company’s debt securities. 33


  • Page 36

    ManageMent DisCussion international business MaChines Corporation anD subsiDiary CoMpanies Non-Current Assets and Liabilities Other non-current liabilities, excluding debt, decreased $1,216 (Dollars in millions) million due to decreases of $951 million ($1,145 million before the AT DECEMBER 31: 2006 2005 effects of currency) in non-current deferred tax liabilities and $226 Non-current assets $58,574 $60,087 million ($858 million before the effects of currency) in Retirement Long-term debt $13,780 $15,425 and nonpension postretirement benefit obligations primarily due to Non-current liabilities (excluding debt) $20,857 $22,073 the implementation of SFAS No. 158. The decrease in Non-current assets of $1,513 million compared to Debt the prior year-end balance was primarily driven by: The company’s funding requirements are continually monitored and strategies are executed to manage the company’s overall asset and • A decline of $9,996 million ($10,776 million excluding the effects of liability profile. Additionally, the company maintains sufficient flexi- currency) in Prepaid pension assets primarily attributable to the imple- bility to access global funding sources as needed. mentation of SFAS No. 158 which requires that only overfunded plans ( fair value of plan assets exceed the benefit obligation) be recognized (Dollars in millions) as a Prepaid pension asset for the excess amount. AT DECEMBER 31: 2006 2005 Total company debt $22,682 $22,641 The significant decline in Prepaid pension assets was offset by increases Non-Global Financing debt* $ 395 $ 2,142 in other non-current asset categories as follows: Non-Global Financing debt/ • Increase in Goodwill of $3,413 million and $539 million in Intangible capitalization 1.5% 6.7% assets-net, both driven by the company’s acquisitions in the current year; * Non-Global Financing debt is the company’s total external debt less the Global Financing debt described in the Global Financing balance sheet on page 50. • Growth of $440 million in long-term financing receivables due to increased Global Financing volumes; Non-Global Financing debt decreased $1,747 million and the debt- • Increase of $3,408 million in Investments and sundry assets which to-capital ratio at December 31, 2006 was at 1.5 percent. Non-Global was attributable to three key factors: Financing debt decreased versus 2005 as the company paid down debt, including debt used in 2005 to facilitate the company’s repatria- — increase of $2,048 million in non-current deferred tax assets tion actions under the American Jobs Creation Act of 2004. primarily as a result of SFAS No. 158; — growth of $451 million in deferred transition costs driven by equity an increase in long-term services arrangements with clients; and (Dollars in millions) AT DECEMBER 31: 2006 2005 — $345 million due to increased investments in long-term marketable securities. Stockholders’ equity: Total $28,506 $33,098 Long-term debt decreased $1,644 million primarily due to a reclas- sification to short-term debt as these items approach maturity. The The company’s consolidated Stockholders’ equity decreased $4,592 company continually monitors its liquidity profile and interest rates, million in 2006 as a result of several key factors: and manages its short- and long-term debt portfolios accordingly. • A decline of $6,885 million in Accumulated gains and (losses) not affecting retained earnings primarily as a result of the non-cash equity impacts related to the implementation of SFAS No. 158; • Dividend payments of $1,683 million; and • A decrease driven by net stock transactions of $5,405 million, primarily Management Discussion ........................................................ 12 a result of the company’s ongoing common stock repurchase program. road Map............................................................................. 12 Forward-Looking and Cautionary statements ..................... 13 These reductions in Stockholders’ equity were partially offset by an Management Discussion snapshot ...................................... 14 increase in retained earnings driven by current year net income of Description of Business ....................................................... 15 Year in review...................................................................... 22 $9,492 million. Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 sFas no. 158 Other Information ................................................................ 41 Global Financing .................................................................. 49 The impacts related to the implementation of SFAS No. 158 on the report of Management ......................................................... 54 Consolidated Statement of Financial Position are discussed in detail in report of independent registered public accounting Firm .... 55 note V, “Retirement-Related Benefits,” on pages 100 to 111 and note Consolidated statements ....................................................... 56 A, “Significant Accounting Policies,” on pages 67 to 68. 34 2006 Annual Report


  • Page 37

    ManageMent DisCussion international business MaChines Corporation anD subsiDiary CoMpanies CONSOLIDATED FOURTH-QUARTER RESULTS • An improved services business profile that delivered accelerated revenue (Dollars and shares in millions except per share amounts) growth and $17.8 billion of new business signings; and YR. TO YR. PERCENT/ • Improved gross margins resulting from continued productivity initiatives MARGIN FOR FOURTH QUARTER: 2006 2005 CHANGE across the business segments. Revenue $26,257 $24,427 7.5%* Total revenue in the fourth quarter of $26.3 billion increased 7.5 Gross profit margin 44.6% 44.1% 0.5 pts. percent as reported (4 percent adjusted for currency). From a geo- Total expense and other income $ 6,887 $ 6,197 11.1% graphic perspective, the Americas and Asia Pacific had the strongest Total expense and other growth, (when adjusted for currency) with improved performance in income-to-revenue ratio 26.2% 25.4% 0.9 pts. Japan and positive contributions from emerging countries. Americas’ Income from continuing revenue was $11.1 billion, an increase of 5.9 percent as reported (5 operations before percent adjusted for currency). EMEA revenue was $9.3 billion, up income taxes $ 4,814 $ 4,568 5.4% 11.2 percent ( 3 percent adjusted for currency). Asia Pacific revenue Provision for income taxes $ 1,350 $ 1,348 0.2% increased 6.9 percent (5 percent adjusted for currency) to $4.8 billion. Income from continuing Revenue from Japan improved with an increase of 2.9 percent ( 3 operations $ 3,464 $ 3,220 7.6% percent adjusted for currency) when compared to the fourth quarter Income from of 2005. The emerging countries of Brazil, India, Russia and China discontinued operations $ 76 $ 3 NM together grew 20.7 percent (18 percent adjusted for currency). Cumulative effect of change in accounting principle** $ — $ (36) NM The company’s two services segments together had $12.8 billion Earnings per share of of revenue in the fourth quarter, an increase of 6.8 percent ( 3 percent common stock: adjusted for currency) when compared to the same period of 2005. Assuming dilution: Total signings for services in the fourth quarter were $17.8 billion, an Continuing operations $ 2.26 $ 2.01 12.4% increase of 55.1 percent over the year-ago period. Global Technology Discontinued operations 0.05 — NM Services revenue increased 7.1 percent (4 percent adjusted for cur- Cumulative effect rency). The acceleration in revenue growth was across the segment’s of change in key offerings. Integrated Technology Services, demonstrating progress accounting principle** — (0.02) NM from the implementation of new offerings and contribution from the Total $ 2.31 $ 1.99 16.1% newly acquired Internet Security Systems business grew 7.8 percent, Weighted-average shares with signings growth of 20 percent—all geographies grew signings. outstanding: Strategic Outsourcing revenue increased 7.2 percent and signings Assuming dilution 1,532.5 1,604.8 (4.5)% doubled year over year, with growth in all geographies. Business * 4.1 percent adjusted for currency. Transformation Outsourcing revenue increased 8.5 percent. BTO ** Reflects implementation of Financial Accounting Standards Board ( FASB) signings declined 57 percent year to year compared to a very strong Interpretation No. 47. See note B, “Accounting Changes,” on page 72 for additional information. fourth quarter of 2005. The GTS segment fourth-quarter pre-tax NM —Not meaningful margin was 9.3 percent, down 3.7 points as compared to a strong fourth quarter of 2005. The company is continuing to make invest- ments in sales, delivery and business development skills across its Continuing operations entire set of offerings, as well as investing in strategic outsourcing In the fourth quarter, the company increased Income from continuing infrastructure and BTO capabilities. operations by 7.6 percent ($244 million) to $3.5 billion versus the Global Business Services revenue increased 6.1 percent ( 3 percent fourth quarter of 2005. Diluted earnings per share from continuing adjusted for currency) led by solid performance in consulting. operations of $2.26 increased 12.4 percent versus the prior year. Revenue performance improved during the second half of 2006, as the The company’s performance in the fourth quarter was driven by company expanded its focus from operational transformation to a several factors: focus on profitable growth. Shorter term signings increased 13.5 per- • Strong revenue growth in the software business, driven by continued cent year to year due primarily to strength in higher value add momentum in strategic middleware and additional benefits from engagements. Longer term signings increased over 200 percent in the recent acquisitions; fourth quarter driven primarily by AMS. The GBS segment fourth- quarter pre-tax margin improved 2.3 points to 11.8 percent driven by improved resource utilization, strong contract management and delivery, and stable-to-improved pricing. 35


  • Page 38

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Systems and Technology Group segment revenue was $7.1 billion and Storage software. Rational increased 12.0 percent in a slower and increased 3.2 percent as reported (flat adjusted for currency), when growing market. In addition to the strong revenue growth in the compared to the fourth quarter of 2005. System z revenue increased 4.5 fourth quarter, the software segment had pre-tax profit of $2.0 billion, percent, with MIPS volume growth of 6 percent year to year. System i an increase of 4.1 percent year to year. The pre-tax margin of 32.3 revenue declined 10.1 percent as sales of upgrades declined year to year percent decreased 3.2 points versus 2005, primarily due to the inte- as customers continue to leverage their existing capability. Revenue gration of new acquisitions. from System p grew 3.5 percent, driven by high-end server sales as Global Financing revenue increased 2.9 percent (flat adjusted for customers leverage the platform’s virtualization capabilities to consoli- currency), driven primarily by client financing revenue due to an date multiple smaller servers into high-end servers. System x server increased average asset base. revenue increased 6.8 percent with growth in both EMEA and Asia The company’s consolidated gross profit margin was 44.6 percent in Pacific, partially offset by decreased revenue in the Americas as cus- the fourth quarter, compared with 44.1 percent in the year-ago period. tomers continue to evaluate processor alternatives. Blades revenue was The increase of 0.5 points was driven primarily by improved margins essentially flat year over year, with growth in both EMEA and Asia in services and a mix towards the higher margin software business. Pacific offset by a decline in the Americas. Storage products increased Total expense and other income increased 11.1 percent compared 9.3 percent, driven by growth in Total disk products of 11.8 percent. to the prior-year period. Selling, general and administrative expense Tape products increased 3.9 percent on the continued strength of the increased 7.0 percent (4 percent adjusted for currency), driven pri- new tape security offering. Microelectronics OEM revenue declined marily by investments the company made in its software and services 5.6 percent when compared to a very strong fourth quarter of 2005. businesses, emerging markets and acquisitions. Partially offsetting Retail Store Solutions increased 24.9 percent as customers are replac- these increases was the year-over-year decline from the pre-tax curtail- ing older technology in favor of integrated retail solutions. ment charge of $267 million related to pension changes recorded in Software segment revenue of $5.6 billion, increased 14.4 percent the fourth quarter of 2005. RD&E expense increased 8.8 percent in (11 percent adjusted for currency), reflecting strong demand for the the fourth quarter, driven partially by acquisitions with the remainder company’s industry-leading middleware capabilities. In the fourth reflecting the company’s ongoing investments to maintain technology quarter, revenue from key branded middleware increased 25.1 percent leadership across its products and services. Other (income) and (21 percent adjusted for currency), with all of the five brands deliver- expense was $150 million of income, a reduction of $184 million (55.0 ing double-digit growth. The growth came from both organic sources percent) versus the fourth quarter of 2005. In the prior year, gains on and strategic acquisitions. The major acquisitions for the year of real estate transactions were unusually high due to several large trans- FileNet, MRO and Micromuse contributed to the growth in the actions compared with current year real estate activity. Information Management and Tivoli brands. The WebSphere family The company’s effective tax rate in the fourth-quarter 2006 was of software grew 21.8 percent, with continued strong performance 28.0 percent compared with 29.5 percent in the fourth quarter of from Application Servers and Business Integration products. 2005. The 1.5 point decrease in the fourth-quarter 2006 tax rate was Information Management software increased 27.9 percent, driven by primarily attributable to the net effect of several items in the quarter. the company’s distributed relational database and information on In 2006, the fourth-quarter tax rate was favorably impacted by the demand product sets. Lotus grew 29.7 percent, benefiting from settlement of the U.S. federal income tax audit for the years 2001 strong momentum in its Notes/Domino family of collaboration prod- through 2003 as well as the retroactive reinstatement of the U.S. ucts and broad adoption of its enhanced version of Sametime, which research tax credit during the quarter. These benefits were partially started shipping in the third quarter of 2006. Tivoli increased 25.4 offset by the one-time tax cost associated with the intercompany percent with double-digit growth in Systems Management, Security transfer of certain intellectual property, which also occurred in the fourth quarter. In addition, the quarter also benefited from a more favorable mix of income in lower tax jurisdictions. Share repurchases totaled approximately $1.4 billion in the fourth quarter. The weighted-average number of diluted common shares Management Discussion ........................................................ 12 outstanding in the fourth-quarter 2006 was 1,532.5 million compared road Map............................................................................. 12 with 1,604.8 million in the same period of 2005. Forward-Looking and Cautionary statements ..................... 13 The company generated $5,334 million in cash flow provided by Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 operating activities. This was driven primarily by net income and Year in review...................................................................... 22 continued focus on working capital. Net cash used in investing Prior Year in review ............................................................. 37 activities of $5,634 million, increased significantly ($4,203 million) Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 versus the fourth quarter of 2005, driven primarily by increased Global Financing .................................................................. 49 spending on acquisitions. report of Management ......................................................... 54 report of independent registered public accounting Firm .... 55 Consolidated statements ....................................................... 56 36 2006 Annual Report


  • Page 39

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES PRIOR YEAR IN REVIEW CONTINUING OPERATIONS In 2005, the company delivered solid growth in earnings and cash (Dollars and shares in millions except per share amounts) generation, balanced across its businesses and executed a series YR. TO YR. PERCENT/ of actions to improve productivity and to reallocate resources to the MARGIN FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE faster growing areas of the business. Revenue $ 91,134 $ 96,293 (5.4)%* The company’s reported results include the Personal Computing Gross profit margin 40.1% 36.9% 3.2 pts. business for four months in 2005 versus 12 months in 2004. Total expense and Total revenue, as reported, declined 5.4 percent versus 2004; exclud- other income $ 24,306 $ 24,900 (2.4)% ing the Personal Computing business external revenue from both years, Total expense and other total revenue increased 3.2 percent (2.8 percent adjusted for currency). income-to-revenue ratio 26.7% 25.9% 0.8 pts. Pre-tax income from continuing operations grew 14.6 percent, while Income from continuing diluted earnings per share from continuing operations increased 11.8 operations before percent compared to 2004. Net cash provided by operating activities income taxes $ 12,226 $ 10,669 14.6% was $14,914 million. The company’s financial performance in 2005 was Provision for income taxes $ 4,232 $ 3,172 33.4% driven by a combination of segment performance, portfolio actions and Income from continuing execution of the company’s productivity initiatives. operations $ 7,994 $ 7,497 6.6% Loss from discontinued The increase in revenue, excluding the Personal Computing busi- operations $ (24) $ (18) 38.2% ness, in 2005 as compared to 2004 was primarily due to: Income before cumulative • Improving demand in the hardware business driven by System p and effect of change in System x server products, as well as Storage products, Microelectronics accounting principle $ 7,970 $ 7,479 6.6% and Engineering and Technology Services; Cumulative effect of change in accounting principle, • Improved demand in the software business, driven by key branded net of tax + $ (36) $ — NM middleware products; and Net income $ 7,934 $ 7,479 6.1% • Continued growth in emerging countries (up 23 percent). Earnings per share of common stock: The increase in income from continuing operations in 2005 as com- Assuming dilution: pared to 2004 was primarily due to: Continuing operations $ 4.91 $ 4.39 11.8% Discontinued operations (0.01) (0.01) 45.0% • Moderate revenue growth in the Hardware and Software segments Cumulative effect of as discussed above; change in accounting principle+ (0.02) — NM • Execution of the company’s restructuring and productivity initiatives, primarily focused on Global Services; and Total $ 4.87 $ 4.38 11.2% Weighted-average shares • Improved demand and continued operational improvement in the outstanding: Microelectronics business. Assuming dilution 1,627.6 1,707.2 (4.7)% In addition to improved earnings, in 2005, the company executed a Assets** $105,748 $111,003 (4.7)% Liabilities** $ 72,650 $ 79,315 (8.4)% series of important actions that benefited the company’s performance Equity** $ 33,098 $ 31,688 4.4% in the current year and strengthened its capabilities going forward. These actions included: * (5.8) percent adjusted for currency. ** At December 31. + Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting • Completion of the divestiture of the Personal Computing business Changes,” on page 72 for additional information. to Lenovo; NM —Not meaningful • Continuation of investment in acquisitions to strengthen the company’s on demand capabilities; in 2005, the company completed 16 acquisitions at a cost of approximately $2 billion; • Implementation of a large restructuring action to improve the company’s cost competitiveness; 37


  • Page 40

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES • Change of the company’s operating model in Europe—shifting Revenue in EMEA declined ( 5.1 percent as reported and 4 per- resources and decision-making closer to the clients; cent adjusted for currency) across most major countries driven by the • Redesign of the company’s U.S. pension plan, as well as taking actions sale of the Personal Computing business. Of the major countries, in other countries; over the longer term, these actions will reduce Germany declined 12 percent (11 percent adjusted for currency), volatility and provide a more competitive cost structure; France declined 7 percent (6 percent adjusted for currency), Italy declined 11 percent (10 percent adjusted for currency), the U.K. • Repatriation of $9.5 billion of foreign earnings under the American declined 1 percent (flat adjusted for currency) and Spain declined 1 Jobs Creation Act of 2004 improving the company’s geographic percent (flat adjusted for currency). liquidity position; and Asia Pacific had the weakest results (decreased 12.5 percent as • Further extension of the company’s commitment to innovation and reported and 13 percent adjusted for currency) of the major geogra- open standards. phies in 2005. Japan, which represents about 60 percent of the Asia Pacific revenue base, declined 13 percent (11 percent adjusted for On April 30, 2005, the company sold its Personal Computing busi- currency) in 2005 versus 2004. In addition, ASEAN (Association of ness. Accordingly, the company’s reported revenue results include Southeast Asian Nations) revenue declined 3 percent ( 3 percent four months of revenue for the Personal Computing Division in 2005 adjusted for currency) and China declined 19 percent (20 percent versus 12 months in 2004. A significant driver of the changes in rev- adjusted for currency), while India revenue increased 10 percent (8 enue, on an as-reported basis, is the incomparable periods for which percent adjusted for currency). the Personal Computing business results are included in the as- The company continued to invest in growth initiatives in its reported results. emerging countries. Revenue growth in these emerging countries was As-reported revenue across all industry sectors declined, except for driven by client investment to build out their infrastructures, especially the Distribution sector, which was essentially flat, due to the sale of in the Financial Services sector. Overall revenue in these countries the Personal Computing business. The Financial Services revenue declined 2 percent (9 percent adjusted for currency). The declines decrease (1.7 percent) was driven by Financial Markets (12.2 percent) were driven by the sale of the Personal Computing business. China partially offset by increases in Insurance (1.9 percent) and Banking declined 19 percent (20 percent adjusted for currency), while Brazil’s (0.5 percent). The Public sector revenue decline ( 5.1 percent) was revenue grew 21 percent (1 percent adjusted for currency), India’s driven by Education ( 31.0 percent), Life Sciences (19.1 percent) and revenue grew 10 percent (8 percent adjusted for currency) and Russia’s Government (2.0 percent), partially offset by increased revenue in revenue increased 2 percent (2 percent adjusted for currency). Healthcare (13.1 percent). The Distribution sector revenue increase OEM revenue increased 13.4 percent primarily due to improved (0.1 percent) was driven by Travel and Transportation (11.0 percent) manufacturing yields for game processors driven by the ramp up of and Consumer Products (2.6 percent), partially offset by lower reve- production for these processors in the second half of 2005. In addi- nue in Retail industry (7.5 percent). The decrease ( 3.4 percent) in tion, E&TS revenue continued to show strong revenue growth. Communications sector revenue was driven by Media and The company believes that a more appropriate discussion is one Entertainment (11.5 percent), Utilities ( 5.4 percent) and Telecommu- that excludes the revenue results of the Personal Computing business nications (1.1 percent). Revenue from Small & Medium Business in both 2005 and 2004 because it presents results on a comparable declined 13.6 percent. basis and provides a more meaningful discussion which focuses on the Americas’ revenue declined 3.1 percent (4 percent adjusted for company’s ongoing operational performance. currency) and was driven by the sale of the Personal Computing busi- Revenue across all Industry sectors increased, except for the ness. The U.S. declined 5 percent, while Canada increased 5 percent Industrial sector, when excluding revenue from the Personal (declined 3 percent adjusted for currency) and Latin America increased Computing business. Revenue growth was lead by Small & Medium 8 percent (declined 2 percent adjusted for currency). Business (6.5 percent) followed by the Public sector (5.4 percent), Distribution sector (5.0 percent), Financial Services (1.7 percent) and Communications (0.8 percent). Revenue from the Industrial sector Management Discussion ........................................................ 12 declined 2.3 percent. road Map............................................................................. 12 Revenue in all geographies increased in 2005 versus 2004, with the Forward-Looking and Cautionary statements ..................... 13 exception of Asia Pacific. Americas’ revenue increased 5.1 percent Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 (4 percent adjusted for currency) with growth across all key brands Year in review...................................................................... 22 and regions. Revenue in EMEA increased 2.3 percent (4 percent Prior Year in review ............................................................. 37 adjusted for currency) with mixed performance across the major Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 countries. Asia Pacific revenue decreased 0.9 percent (1 percent Global Financing .................................................................. 49 adjusted for currency). Overall revenue in the emerging countries of report of Management ......................................................... 54 Brazil, India, Russia and China increased a combined 23 percent (14 report of independent registered public accounting Firm .... 55 percent adjusted for currency) in 2005 versus 2004. Consolidated statements ....................................................... 56 38 2006 Annual Report


  • Page 41

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The following is an analysis of the reportable segment results for Hardware Global Services, Hardware and Software. The Global Financing analy- (Dollars in millions) sis is included in the Global Financing section on pages 49 and 50. FOR THE YEAR ENDED DECEMBER 31: 2005 2004 YR. TO YR. CHANGE Hardware segment revenue: $23,857 $30,710 (22.3)% Global Services Global Services revenue increased 2.4 percent (2.0 percent adjusted Systems and Technology for currency) in 2005 versus 2004. Group $20,981 $19,973 5.0% System z (7.6) (Dollars in millions) System i 0.8 YR. TO YR. System p 14.6 FOR THE YEAR ENDED DECEMBER 31: 2005 2004 CHANGE System x 5.9 Global Services System Storage 15.3 segment revenue: $47,407 $46,283 2.4% Microelectronics 15.6 Engineering & Global Technology Services $31,501 $30,082 4.7% Technology Services 39.2 Strategic Outsourcing 16,522 15,957 3.5 Retail Store Solutions (23.0) Integrated Technology Printing Systems (8.6) Services 7,538 7,441 1.3 Personal Computing Division 2,876 10,737 NM Business Transformation Outsourcing 1,573 988 59.2 NM —Not meaningful Maintenance 5,868 5,696 3.0 Global Business Services $15,906 $16,201 (1.8)% Systems and Technology Group revenue increased 5.0 percent (5 percent adjusted for currency) in 2005 versus 2004. System p server Global Technology Services revenue increased 4.7 percent (4 percent revenue increased 14.6 percent with double-digit growth in all geog- adjusted for currency). Although SO revenue continued to grow raphies as clients continue to recognize the strength and leadership of ( 3.5 percent), it experienced a slowdown in its revenue growth rate the POWER architecture. In October 2005, the company announced due to the impact of high levels of backlog erosion experienced in a new POWER5+ processor that included the industry’s first Quad 2004 and the cumulative effect of lower signings, starting in 2004 Core Module, which puts four processor cores on a single piece of through the first quarter of 2005. SO revenue growth was driven by ceramic. System i server revenue increased 0.8 percent driven by EMEA (10 percent) and Asia Pacific (1 percent), while the Americas broad demand for the company’s POWER5 based offerings. In 2005, was essentially flat. ITS signings were down 7 percent in 2005 versus System i added over 2,500 new clients, reflecting a continued commit- 2004. The ITS business is more dependent upon short-term signings ment to the platform from ISVs, resellers and clients. Within System x, for revenue growth and signings declines in the third and fourth server revenue increased 7 percent despite strong competitive pressures quarter impacted the overall revenue growth rate (1.3 percent) for driving lower prices, particularly in EMEA and Asia. The company’s 2005. The company began to rebalance its ITS offerings and shift its momentum in Blades remained strong with revenue growth of 65 business development and delivery capabilities and skills to higher percent in 2005 versus 2004. Although System z server revenue growth areas in the third quarter of 2005. The company’s BTO busi- declined 7.6 percent versus 2004, MIPS volumes grew 7 percent in ness continued its strong year-to-year growth (59.2 percent) due to 2005. The MIPS growth was driven by the company’s new System z9 signings performance in both 2004 and 2005. Revenue growth was which began shipping in late September 2005. System z clients con- strong across all geographies. tinued to add new workloads to this platform as they build their on Global Business Services revenue decreased 1.8 percent (2 per- demand infrastructure. These new workloads have accelerated Java cent adjusted for currency) in 2005 versus 2004. Revenue declined 10 and Linux adoption on the System z platform. percent in both Asia Pacific and EMEA and increased in the Americas System Storage revenue growth (15.3 percent) was driven by Total by 14 percent. The company’s Consulting and Systems Integration disk revenue growth of 19 percent, while tape grew 9 percent in 2005 business had many areas of growth, with strong performance in the versus 2004. Within External disk, mid-range disk and enterprise Strategy and Change and Supply Chain Management practices. This products both had strong revenue growth of approximately 24 per- overall growth was mitigated by weakness year to year in Japan, cent in 2005 versus 2004. Germany and the company’s Federal Business in the U.S. However, across all practices, the company drove improved resource utilization and pricing trends remained stable to improving. 39


  • Page 42

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Microelectronics revenue increased 15.6 percent due to improved Revenue from the WebSphere family of products increased 10.2 manufacturing yields and volumes for game processors. The fourth percent with growth in WebSphere Application Servers (15 percent) and quarter of 2005 was the first full quarter of production for these pro- WebSphere Portals (12 percent) versus 2004. The WebSphere family cessors. Partially offsetting this increase was a softening of demand for provides the foundation technologies for clients implementing business some of the company’s older technology. E&TS revenue continued to processes and applications in a Services Oriented Architecture (SOA). show strong growth (39.2 percent) as it represents a unique opportunity Information Management increased 8.2 percent driven by growth for the company to leverage its deep capabilities, expertise and assets in in content management and information integration products. engineering design to benefit client engineering and R&D processes. Lotus increased 9.7 percent as clients continue to demonstrate Retail Stores Solutions revenue decreased 23.0 percent primarily strong response to the Domino Version 7 product line, as well as high due to a number of large transactions in 2004 and demand from these interest in Workplace software. Workplace software more than dou- clients declined in 2005. Printing Systems revenue decreased 8.6 per- bled its revenue in 2005 versus 2004. cent due primarily to lower hardware and maintenance sales. Tivoli increased 11.5 percent with strong growth in storage soft- Personal Computing Division revenue decreased as a result of the ware as clients’ adoption of the company’s virtualization technologies company divesting its Personal Computing business to Lenovo on continued to gain traction. Tivoli systems management and security April 30, 2005. The 2005 results have four months of revenue versus software offerings also had good revenue growth in 2005 versus 12 months in 2004. 2004. The security products revenue was driven by the company’s new SOA Security offerings. Software Rational increased 3.6 percent in 2005 versus 2004; however, late (Dollars in millions) in the fourth quarter of 2005, client buying deferrals prevented stron- FOR THE YEAR ENDED DECEMBER 31: 2005 2004* YR. TO YR. CHANGE ger performance. Revenue from Other middleware products, including host soft- Software segment revenue: $16,830 $16,141 4.3% ware products such as compilers, certain tools and Other Storage and Middleware $12,552 $11,968 4.9% Printer software declined 1.4 percent versus 2004. Key Branded Middleware 7,957 7,306 8.9 Operating Systems revenue declined 2.0 percent in 2005 versus WebSphere family 10.2 2004, primarily due to lower System z and System p revenue, partially Information Management 8.2 Lotus 9.7 offset by increased System i and System x revenue. Tivoli 11.5 Product Lifecycle Management revenue increased 2.9 percent in Rational 3.6 2005 versus 2004, primarily for Industrial (5 percent) and Small & Other middleware 4,595 4,662 (1.4) Medium Business clients (2 percent). Operating systems 2,426 2,474 (2.0) The company’s consolidated gross profit margin increased 3.2 Product Lifecycle points versus 2004 to 40.1 percent. Margin improvement in both Management 1,077 1,047 2.9 Hardware and Global Services contributed to the overall increase. Other 775 652 18.8 Global Services gross profit margin increased 1.8 points year to * Reclassified to conform with 2005 presentation. year to 26.0 percent due to benefits from the restructuring actions taken in the second quarter of 2005, improved utilization/productivity Software revenue increased 4.3 percent (4 percent adjusted for cur- and a better overall contract profile. rency) in 2005 versus 2004 as the software market remained highly The increase in Hardware margins of 5.5 points to 36.5 percent competitive. Revenue growth was driven by the performance of the was primarily due to the divestiture of the Personal Computing busi- key Middleware brands, which increased 8.9 percent. ness (which had a lower gross profit margin than the other hardware businesses) in the second quarter of 2005. The absence of the Personal Computing business contributed 3.8 points to the increase in the 2005 margin. Microelectronics’ margin increased due to improving yields. Management Discussion ........................................................ 12 The Software margin at 84.9 percent increased 0.3 points due to road Map............................................................................. 12 growth in Software revenue and reduced external royalty costs. Forward-Looking and Cautionary statements ..................... 13 Total expense and other income decreased 2.4 percent (3 percent Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 adjusted for currency) in 2005 versus 2004. Overall, the decrease was Year in review...................................................................... 22 primarily due to the gain associated with the divestiture of the Prior Year in review ............................................................. 37 Personal Computing business ($1,108 million), a gain from a legal Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 settlement with Microsoft ($775 million) partially offset by incremen- Global Financing .................................................................. 49 tal restructuring charges ($1,706 million) recorded in the second report of Management ......................................................... 54 quarter of 2005. The expense-to-revenue ratio increased 0.8 points to report of independent registered public accounting Firm .... 55 26.7 percent in 2005, as revenue declined 5.4 percent and expense Consolidated statements ....................................................... 56 declined 2.4 percent in 2005 versus 2004. 40 2006 Annual Report


  • Page 43

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Total SG&A expense of $21,314 million increased 6.1 percent (6 Goodwill associated with 2005 acquisitions and increased Prepaid percent adjusted for currency). The increase was primarily driven by pension assets. These increases were partially offset by lower financ- the restructuring charges recorded in the second quarter of 2005. In ing receivables and lower deferred tax assets. addition, retirement-related expenses increased ($236 million) in 2005. These increases were partially offset by lower operational DISCONTINUED OPERATIONS expenses as a result of the restructuring actions and the Personal On December 31, 2002, the company sold its HDD business to Computing business divestiture, lower stock-based compensation Hitachi for approximately $2 billion. The final cash payment of $399 expense of $308 million and lower ongoing workforce reductions. In million was received on December 30, 2005. In addition, the company addition, Bad debt expense declined $164 million primarily due to paid Hitachi $80 million to settle warranty obligations during 2005. decreased specific reserve requirements, an overall reduction in the These transactions were consistent with the company’s previous esti- financing asset portfolio, an improvement in economic conditions and mates. The HDD business was accounted for as a discontinued improved credit quality. operation whereby the results of operations and cash flows were Other (income) and expense was income of $2,122 million and removed from the company’s results from continuing operations for $23 million in 2005 and 2004, respectively. The increase was primar- all periods presented. ily driven by the gain on the sale of the Personal Computing business. In 2006, the company reported net income of $76 million, net of The pre-tax gain associated with this transaction was $1,108 million. tax, primarily related to tax benefits from tax audit settlements. The In addition, the company settled certain antitrust issues with the company incurred a loss from discontinued operations of $24 million Microsoft Corporation and the gain from this settlement was $775 in 2005 and $18 million in 2004, net of tax. These losses were primar- million; additional Interest income ($127 million) generated by the ily due to additional costs associated with parts warranty as agreed company in 2005; and lower foreign currency transaction losses of upon by the company and Hitachi, under the terms of the agreement $211 million, which relate to losses on certain hedge contracts offset for the sale of the HDD business to Hitachi. by settlement of foreign currency receivables and payables. The com- pany also had additional gains ($108 million) from the sale of certain real estate transactions in 2005 versus 2004. These gains were par- OTHER INFORMATION tially offset by real-estate related restructuring charges recorded in LOOKING FORWARD the second quarter of 2005. The following key drivers impacting the company’s business are Research, development and engineering (RD&E) expense of discussed on page 21: $5,842 million decreased $32 million or 0.6 percent driven by the sale of the Personal Computing business in the second quarter of • Economic environment and corporate spending budgets; 2005 ($93 million) and lower spending in Microelectronics ($93 mil- • Internal business transformation and global integration initiatives; lion) and Software ($25 million). These decreases were partially offset by increased spending in Systems and Technology for server • Innovation initiatives; products ($171 million). Included in RD&E expense was increased • Open standards; and retirement-related expense of $95 million and a decrease of $94 mil- • Investing in growth opportunities. lion for stock-based compensation expense in 2005 versus 2004. Intellectual property (IP) and custom development income of Looking forward, while uncertainties make forecasts difficult, based $948 million decreased $222 million or 19.0 percent in 2005 versus on economic indicators, the company anticipates moderate growth 2004. The decrease was driven by Sales and other transfers of intel- for the world economy, capital investment and the traditional IT lectual property ($230 million) due primarily to Applied Micro industry. The pace of globalization is expected to increase competi- Circuits Corporation’s (AMCC) acquisition of the company’s IP tion, further driving clients to innovate and transform their business associated with its embedded PowerPC 4xx standard products for models, processes and practices, all of which create opportunities for $208 million in 2004. the company. The provision for income taxes resulted in an effective tax rate of As highlighted in the Management Discussion Snapshot on page 34.6 percent for 2005, compared with the 2004 effective tax rate of 14, the company has successfully transformed its business model over 29.7 percent. The 4.9 point increase in the effective tax rate in 2005 the past several years. This transformation led to the company’s per- was primarily due to the third-quarter 2005 tax charge associated with formance in 2006 and has positioned it to capture additional market the repatriation of $9.5 billion under the American Jobs Creation opportunities worldwide going forward. Act of 2004. The company has a significant global presence, operating in 170 Assets of $105,748 million declined $5,256 million or 4.7 percent, countries, with approximately 60 percent of its revenue generated of which, $5,715 million of the year-to-year decrease relates to the outside the United States. In addition, approximately 65 percent of the impact of currency translation. Other asset changes primarily con- company’s employees are located outside the United States, including sisted of an increase in Cash and cash equivalents, an increase in about 30 percent in Asia Pacific. This global reach gives the company 41


  • Page 44

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES access to markets, with local management teams who understand the In addition, continued Software growth is also dependent on the clients and their challenges and who can respond to these opportuni- company’s ability to bring these technologies to market effectively, ties with value-add solutions. leveraging its worldwide sales and marketing capabilities. The com- In emerging markets, the company will continue to invest for pany will continue to invest in sales and marketing resources, targeting revenue growth and leadership. The company has had good success in the faster growing regions, sectors and technologies in the industry. the emerging markets of China, India, Russia and Brazil. These coun- Finally, growth is fueled by the rapid deployment of these technolo- tries have been among the fastest growing IT markets in the world, gies in client accounts. The company’s unique ability to combine and the company expects them to continue to grow at a rate greater Software, Services and Hardware into robust customer solutions than the worldwide IT growth rate for several years. increases the rate of Software deployment, leading to higher loyalty As a globally integrated enterprise, the company will continue to rates and improved Software annuity streams. leverage the skills and capabilities of its global infrastructure and work- Within the Global Services business, revenue growth improved force. The company’s global scale provides a base to leverage its invest- over the course of the year and the company saw results from the ments and continue to focus on increased productivity and efficiency targeted actions and investments it has made the past two years. The in the coming year. In 2006, the company expanded its global delivery Integrated Technology Services business is improving after rebalanc- centers—improving its services delivery to clients—and significantly ing its offerings and resources. Global Business Services significantly increased its resources in service delivery centers. Going forward, the improved profitability. The company will continue to make invest- company will also continue the global integration of its internal sup- ments in sales, delivery and business development across its services port functions with a continued objective of increased productivity. offerings. The company will also continue to optimize its resources With respect to technology, in 2006, the company was awarded and processes to increase productivity and improve flexibility and more U.S. patents than any other company for the fourteenth year in scalability. The key to future success in Services will come from the a row. The company remains committed to technology leadership and company’s ability to integrate its business globally, leverage both local will continue to focus internal development investments on high- and global skills and effectively use technology to create solutions that value, high-growth opportunities and to broaden its ability to deliver deliver value and cost savings for clients. client and industry solutions. The company’s Systems and Technology Group is the leader in The company will also continue to selectively pursue acquisitions servers. Through continued development investment, the company to grow its capabilities. The company has a targeted acquisition strat- introduced POWER5+, extended virtualization capabilities and pro- egy and has developed the ability to efficiently acquire, integrate and vided leading technology for all major game platforms in 2006. Going accelerate new product and service offerings. In addition, the com- forward, the company will focus its investments on differentiating pany will continue to evaluate underperforming and less strategic technologies with high-growth potential including POWER6, blades, areas of its portfolio. high-performance computing and energy efficiency. In the Micro- The company’s continued investments in Software have led to this electronics business, the company anticipates that game processor segment’s emergence as a strong source of revenue growth and the demand will continue to moderate through the first half of 2007 given largest contributor to the company’s profit in 2006. The company’s the seasonality of the consumer segment. Software is differentiated in the industry by both the strength of its As discussed in note X, “Subsequent Events,” on page 115, the individual products and the breadth of the software offerings. The key company will form a joint venture with Ricoh based on the company’s to the company’s continued Software growth stems from the ability to Printing Systems Division and initially have a 49 percent ownership maintain and grow this industry-leading software business. The com- interest in the joint venture. This transaction is expected to close in pany expects to accomplish this through a combination of internal the second quarter of 2007, and the company will continue to operate development and strategic acquisitions. These products will be rapidly this business in the normal course until the closing. developed and integrated to bring continued value to clients. The company expects 2007 pre-tax retirement-related plan expense to increase approximately $100 million when compared to 2006. This expected year-to-year change is primarily driven by an increase in the Management Discussion ........................................................ 12 cost of defined contribution plans. The cost of defined benefit plans road Map............................................................................. 12 is estimated to be essentially flat year to year as increases due to Forward-Looking and Cautionary statements ..................... 13 changes in the actuarial assumptions (used to determine 2007 expense) Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 will be offset by expected savings due to better-than-expected 2006 Year in review...................................................................... 22 return on asset performance. The actual return on the U.S. Personal Prior Year in review ............................................................. 37 Pension Plan (PPP) assets for 2006 was 15 percent. Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Pre-tax stock-based compensation expense declined $189 million in Global Financing .................................................................. 49 2006, compared to 2005. The company expects stock-based compensa- report of Management ......................................................... 54 tion expense to decline in 2007, when compared to 2006. The anticipated report of independent registered public accounting Firm .... 55 decline is expected to be less than $100 million on a pre-tax basis. Consolidated statements ....................................................... 56 42 2006 Annual Report


  • Page 45

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The amount of IP and custom development income has been Cash Flow and Liquidity Trends declining in recent years, down 5 percent in 2006 and 19 percent in (Dollars in billions) 2005. A moderate declining trend may continue as the company does 2006 2005 2004 2003 2002 not expect IP income to be a contributor to growth. The overall level Net cash from of IP income is dependent on several factors: divestitures, industry operating activities $15.0 $14.9 $15.3 $14.5 $13.8 consolidation, economic conditions and the timing of new patents and Cash and short-term know-how development. marketable securities $10.7 $13.7 $10.6 $ 7.6 $ 6.0 The company’s business is designed to be measured over the long Size of global term. The strategies that the company deploys, investments and any credit facilities $10.0 $10.0 $10.0 $10.0 $12.0 Trade receivables other actions are implemented with an objective of optimizing the securitization facility $ — $ 0.5 $ 0.5 $ — $ — company’s long-term performance. In the coming year, the company expects to take actions to continue its transformation and improve the business. These actions are done within the framework of managing The major rating agencies’ ratings on the company’s debt securities at the business for sustainability and to deliver the company’s long-term December 31, 2006 appear in the following table and remain objective of 10 to 12 percent earnings per share growth. unchanged over the past five years. The company has no contractual arrangements that, in the event of a change in credit rating, would Income Taxes result in a material adverse effect on its financial position or liquidity. The company expects that its effective tax rate in 2007 will be approximately 28.5 percent. This rate is lower than the company’s STANDARD MOODY’S AND INVESTORS FITCH historical expected tax rate of 30 percent due to an expectation of a POOR’S SERVICE RATINGS more favorable mix of income in lower tax jurisdictions. The rate will Senior long-term debt A+ A1 AA- change year to year based on non-recurring events, such as the settle- Commercial paper A-1 Prime-1 F1+ ment of income tax audits, as well as recurring factors including the geographic mix of income before taxes, the timing and amount of The company prepares its Consolidated Statement of Cash Flows in foreign dividend repatriation, state and local taxes and the effects of accordance with SFAS No. 95, “Statement of Cash Flows,” on page 58 various global income tax strategies. and highlights causes and events underlying sources and uses of cash in In 2006 and 2005, the company’s cash tax rate was approximately that format on page 33. For purposes of running its business, the com- 16 percent. pany manages, monitors and analyzes cash flows in a different format. The company’s cash tax rate represents the amount of income taxes As discussed on page 49, one of the company’s two primary objec- paid during the year over Income from continuing operations before tives of its Global Financing business is to generate strong return on income taxes. The cash tax rate differs from the company’s effective tax equity. Increasing receivables is the basis for growth in a financing rate due to a number of variables including, but not limited to, certain business. Accordingly, management considers Global Financing receiv- items of income and expense that are recognized in different years for ables as a profit-generating investment, not as working capital that financial reporting purposes than for income tax purposes, differences should be minimized for efficiency. After classifying Global Financing in currency rates used in the translation of the non-U.S. income tax accounts receivables as an investment, the remaining net cash flow is provision and income tax payments and current year cash tax payments viewed by the company as the Cash available for investment and for or refunds that are related to prior years. The company anticipates that distribution to shareholders. With respect to the company’s cash flow its cash tax rate will increase in the near term as the company has now analysis for internal management purposes (see the table on page 44), fully utilized its U.S. federal tax credit carryforwards. Global Financing accounts receivables are combined with Global Financing debt to represent the Net Global Financing debt to accounts LIQUIDITY AND CAPITAL RESOURCES receivable (a profit-generating investment). The company has consistently generated strong cash flow from From the perspective of how management views cash flows, in operations, providing a source of funds ranging between $13.8 2006, net cash from operating activities, excluding Global Financing billion and $15.3 billion per year over the past five years. The company receivables, was $15.3 billion, an increase of $2.2 billion compared to provides for additional liquidity through several sources; maintaining 2005. This cash performance was driven primarily by the growth in a sizable cash balance, access to global funding sources and a commit- net income from continuing operations, continued focus on working ted global credit facility. The following table provides a summary of capital and lower pension funding year over year. The company these major sources of liquidity for the years ended December 31, returned over 100 percent of net income in 2006 to shareholders in 2002 through 2006. dividend payments and share repurchases. Over the past five years, the company generated over $64.3 billion in Cash available for investment and for distribution to shareholders. As a result, during that period the company invested $20.5 billion of net 43


  • Page 46

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES capital expenditures, invested $12.0 billion in strategic acquisitions, The company’s Board of Directors meets quarterly to consider the received $2.3 billion from divestitures and returned $37.7 billion to dividend payment. The company expects to fund dividend payments shareholders through dividends and share repurchases. The amount of through cash from operations. In the second quarter of 2006, the prospective returns to shareholders in the form of dividends and share Board of Directors increased the company’s quarterly common stock repurchases will vary based upon several factors including each year’s dividend from $0.20 to $0.30 per share. operating results, capital expenditures, research and development and The table below represents the way in which management reviews acquisitions, as well as the factors discussed following the table below. cash flow as described on page 43. (Dollars in billions) FOR THE YEAR ENDED DECEMBER 31: 2006 2005 2004 2003 2002 Net cash from operating activities (Continuing Operations): $15.0 $14.9 $15.3 $14.5 $13.8 Less: Global Financing accounts receivable (0.3) 1.8 2.5 1.9 3.3 Net cash from operating activities (Continuing Operations), excluding Global Financing receivables 15.3 13.1 12.9 12.6 10.5 Investing Activities: Capital expenditures, net (4.7) (3.5) (3.7) (3.9) (4.6) Global Financing accounts receivable (0.3) 1.8 2.5 1.9 3.3 Global Financing debt 1.0 (0.6) (1.7) (2.6) (3.1) Net Global Financing debt to accounts receivable 0.8 1.3 0.7 (0.7) 0.2 Acquisitions (3.8) (1.5) (1.7) (1.8) (3.2) Divestitures — 0.9 — 0.1 1.2 Return to shareholders: Share Repurchase (8.1) (7.7) (7.1) (4.3) (4.2) Dividends (1.7) (1.2) (1.2) (1.1) (1.0) Change in non-Global Financing debt (1.1) 1.2 0.7 (0.9) (0.1) Other 0.4 0.7 2.5 1.9 1.4 Discontinued operations — — (0.1) (0.2) (0.7) Change in cash, cash equivalents and short-term marketable securities $ (3.0) $ 3.1 $ 2.9 $ 1.7 $ (0.4) Events that could temporarily change the historical cash flow dynam- contributed approximately $1 billion to the U.K. pension plan, and on ics discussed above include significant changes in operating results, January 19, 2005, the company contributed $1.7 billion to the quali- material changes in geographic sources of cash, unexpected adverse fied portion of the PPP, a U.S. defined benefit plan. As highlighted in impacts from litigation or future pension funding during periods of the Contractual Obligations table on page 45, the company expects to severe and prolonged downturn in the capital markets. Whether any make legally mandated pension plan contributions to certain non- litigation has such an adverse impact will depend on a number of U.S. plans of approximately $2.6 billion in the next five years. The variables, which are more completely described on page 91. With company is not quantifying any further impact from pension funding respect to pension funding, in the first quarter of 2006, the company because it is not possible to predict future movements in the capital markets or pension plan funding regulations. As discussed in note B, “Accounting Changes,” on page 71, the company implemented SFAS No. 158 effective December 31, 2006. The effects of applying SFAS Management Discussion ........................................................ 12 No. 158 on the Consolidated Statement of Financial Position are road Map............................................................................. 12 highlighted in the table on page 101. The adoption of SFAS No. 158 Forward-Looking and Cautionary statements ..................... 13 will have no impact on the company’s existing debt covenants, credit Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 ratings or financial flexibility. Year in review...................................................................... 22 The Pension Protection Act of 2006 (the Act) was enacted into law Prior Year in review ............................................................. 37 in 2006, and, among other things, increases the funding requirements Discontinued Operations ..................................................... 41 for certain U.S. defined benefit plans beginning after December 31, Other Information ................................................................ 41 Global Financing .................................................................. 49 2007. The company currently does not expect the Act to have a mate- report of Management ......................................................... 54 rial effect on the company’s minimum mandatory contributions to its report of independent registered public accounting Firm .... 55 U.S. defined benefit plan. Consolidated statements ....................................................... 56 44 2006 Annual Report


  • Page 47

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Contractual Obligations (Dollars in millions) TOTAL PAYMENTS DUE IN CONTRACTUAL PAYMENT STREAM 2007 2008-09 2010-11 AFTER 2011 Long-term debt obligations $16,086 $2,724 $3,662 $3,852 $5,848 Capital (finance) lease obligations 363 83 148 93 39 Operating lease obligations 5,345 1,302 2,006 1,182 855 Purchase obligations 1,844 841 737 173 93 Other long-term liabilities: Minimum pension funding (mandated)* 2,625 563 1,055 1,007 — Executive compensation 994 60 129 141 664 Long-term termination benefits 2,160 315 277 176 1,392 Other 689 47 113 85 444 Total $30,106 $5,935 $8,127 $6,709 $9,335 * 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 2011 are not currently determinable. See note V, “Retirement-Related Benefits,” on pages 100 to 111 for additional information on the non-U.S. plans’ investment strategies and expected contributions and for information regarding the company’s unfunded pension liability of $14,543 million at December 31, 2006. Total contractual payments are reported in the table above excluding the note O, “Contingencies and Commitments,” on pages 91 and 92, for effects of time value and therefore, may not equal the amounts reported detailed information about the company’s guarantees, financial com- in the company’s Consolidated Statement of Financial Position. mitments and indemnification arrangements. The company does not Purchase obligations include all commitments to purchase goods have retained interests in assets transferred to unconsolidated entities or services of either a fixed or minimum quantity that meet any of the (see note J, “Securitization of Receivables,” on page 81) or other mate- following criteria: (1) they are noncancelable, (2) the company would rial off-balance sheet interests or instruments. incur a penalty if the agreement was canceled, or (3) the company must make specified minimum payments even if it does not take deliv- CRITICAL ACCOUNTING ESTIMATES ery of the contracted products or services (“take-or-pay”). If the The application of GAAP requires the company to make estimates obligation to purchase goods or services is noncancelable, the entire and assumptions about future events that directly affect its value of the contract is included in the table above. If the obligation reported financial condition and operating performance. The account- is cancelable, but the company would incur a penalty if canceled, the ing estimates and assumptions discussed in this section are those that dollar amount of the penalty is included as a purchase obligation. the company considers to be the most critical to its financial state- Contracted minimum amounts specified in take-or-pay contracts are ments. An accounting estimate is considered critical if both (a) the also included in the table as they represent the portion of each con- nature of the estimates or assumptions is material due to the levels of tract that is a firm commitment. subjectivity and judgment involved, and (b) the impact within a rea- In the ordinary course of business, the company enters into con- sonable range of outcomes of the estimates and assumptions is material tracts that specify that the company will purchase all or a portion of to the company’s financial condition or operating performance. The its requirements of a specific product, commodity or service from a critical accounting estimates related to the company’s Global Financing supplier or vendor. These contracts are generally entered into in business are described on page 53 in the Global Financing section. order to secure pricing or other negotiated terms. They do not specify The company’s significant accounting policies are described in note fixed or minimum quantities to be purchased and, therefore, the com- A, “Significant Accounting Policies,” on pages 62 to 71. pany does not consider them to be purchase obligations. A quantitative sensitivity analysis is provided where that informa- tion is reasonably available, can be reliably estimated and provides Off-Balance Sheet Arrangements material information to investors. The amounts used to assess sensi- In the ordinary course of business, the company entered into off-bal- tivity (e.g., 1 percent, 5 percent, etc.) are included to allow users of ance sheet arrangements as defined by the SEC Financial Reporting the Annual Report to understand a general direction cause and effect Release 67 (FRR-67), “Disclosure in Management’s Discussion and of changes in the estimates and do not represent management’s pre- Analysis about Off-Balance Sheet Arrangements and Aggregate dictions of variability. Contractual Obligations.” None of these off-balance sheet arrangements either has, or is Pension Assumptions reasonably likely to have, a material current or future effect on finan- The measurement of the company’s benefit obligation to its employ- cial condition, changes in financial condition, revenues or expenses, ees and net periodic pension cost/(income) requires the use of certain results of operations, liquidity, capital expenditures or capital resources. assumptions, including, among others, estimates of discount rates and See the table above for the company’s contractual obligations and expected return on plan assets. 45


  • Page 48

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Changes in the discount rate assumptions will impact the service differ from the estimates may result in more or less future company cost, (gain)/loss amortization and interest cost components of the net funding into the pension plans than is planned by management. periodic pension cost/(income) calculation (see page 107 for informa- Impacts of these types of changes on the company’s pension plans tion regarding the discount rate assumptions) and the projected benefit in other countries worldwide will vary depending upon the status of obligation (PBO). As presented on page 106, the company increased each respective plan. the discount rate assumption for the U.S. PPP by 25 basis points to 5.75 percent on December 31, 2006. This change will decrease pre-tax Costs to Complete Service Contracts cost and expense recognized in 2007 by $90 million. If the discount The company enters into numerous service contracts through its rate assumption for the PPP decreased by 25 basis points on GTS and GBS businesses. During the contractual period, revenue, December 31, 2006, pre-tax cost and expense recognized in 2007 cost and profits may be impacted by estimates of the ultimate profit- would have increased by $87 million. Changes in the discount rate ability of each contract, especially contracts for which the company assumptions will impact the PBO which, in turn, may impact the uses the percentage-of-completion (POC) method of accounting. If company’s funding decisions if the PBO exceeds plan assets. Each 25 at any time these estimates indicate the contract will be unprofitable basis point increase or decrease in the discount rate will cause a cor- for POC contracts, the entire estimated loss for the remainder of the responding decrease or increase, respectively, in the PPP’s PBO of an contract is recorded immediately in cost. The company performs ongo- estimated $1.2 billion based upon December 31, 2006 data. Page 104 ing profitability analyses of its services contracts in order to determine presents the PPP’s PBO (after the increase in discount rate presented whether the latest estimates require updating. Key factors reviewed by on page 106) and plan assets as of December 31, 2006. the company to estimate the future costs to complete each contract The expected long-term return on plan assets is used in calculating are future labor costs, future product costs and productivity efficiencies. the net periodic pension (income)/cost. See page 107 for information Contract loss provisions recorded as a component of Other accrued regarding the expected long-term return on plan assets assumption. expenses and liabilities are approximately $32 million and $70 million The differences between the actual return on plan assets and expected at December 31, 2006 and December 31, 2005, respectively. long-term return on plan assets are recognized over five years in the expected return on plan assets line in net periodic pension (income)/ Income Taxes cost and also as a component of actuarial gains/losses, which are rec- The company is subject to income taxes in both the U.S. and numerous ognized over the service lives of the employees in the plan, provided foreign jurisdictions. Significant judgments are required in determin- such amounts exceed thresholds which are based upon the obligation ing the consolidated provision for income taxes. or the value of plan assets, as provided by accounting standards. During the ordinary course of business, there are many transac- To the extent the outlook for long-term returns changes such that tions and calculations for which the ultimate tax determination is management changes its expected long-term return on plan assets uncertain. As a result, the company recognizes tax liabilities based on assumption, each 50 basis point increase or decrease in the expected estimates of whether additional taxes and interest will be due. These long-term return on PPP plan assets assumption will have an estimated tax liabilities are recognized when, despite the company’s belief that increase or decrease, respectively, of $232 million on the following its tax return positions are supportable, the company believes that year’s pre-tax net periodic pension (income)/cost (based upon the certain positions are likely to be challenged and may not be fully sus- PPP’s plan assets at December 31, 2006 and assuming no contribu- tained upon review by tax authorities. The company believes that its tions are made in 2007). accruals for tax liabilities are adequate for all open audit years based on The company may voluntarily make contributions or be required, its assessment of many factors including past experience and interpre- by law, to make contributions to its pension plans. Actual results that tations of tax law. This assessment relies on estimates and assumptions and may involve a series of complex judgments about future events. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact income tax expense in the period in which such determination is made. Management Discussion ........................................................ 12 Significant judgment is also required in determining any valuation road Map............................................................................. 12 allowance recorded against deferred tax assets. In assessing the need Forward-Looking and Cautionary statements ..................... 13 for a valuation allowance, management considers all available evi- Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 dence including past operating results, estimates of future taxable Year in review...................................................................... 22 income and the feasibility of ongoing tax planning strategies. In the Prior Year in review ............................................................. 37 event that the company changes its determination as to the amount of Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 deferred tax assets that can be realized, the company will adjust its Global Financing .................................................................. 49 valuation allowance with a corresponding impact to income tax report of Management ......................................................... 54 expense in the period in which such determination is made. report of independent registered public accounting Firm .... 55 Consolidated statements ....................................................... 56 46 2006 Annual Report


  • Page 49

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES To the extent that the provision for income taxes increases/decreases CURRENCY RATE FLUCTUATIONS by 1 percent of Income from continuing operations before income Changes in the relative values of non-U.S. currencies to the U.S. taxes, consolidated Income from continuing operations would have dollar affect the company’s results. At December 31, 2006, currency declined/improved by $133 million in 2006. changes resulted in assets and liabilities denominated in local curren- cies being translated into more dollars than at year-end 2005. The Valuation of Assets and Reporting Units company uses a variety of financial hedging instruments to limit spe- The application of business combination and impairment accounting cific currency risks related to financing transactions and other foreign requires the use of significant estimates and assumptions. The pur- currency-based transactions. Further discussion of currency and chase method of accounting for business combinations requires the hedging appears in note L, “Derivatives and Hedging Transactions,” company estimate the fair value of assets acquired and liabilities on pages 83 through 86. assumed to properly allocate purchase price consideration between The company earned approximately 45 percent of its net income assets that are depreciated and amortized from goodwill. Impairment in currencies other than the U.S. dollar. The company also maintains testing for assets, other than goodwill, requires the allocation of cash hedging programs to limit the volatility of currency impacts on the flows to those assets or group of assets and if required, an estimate of company’s financial results. These hedging programs limit the impact fair value for the assets or group of assets. Impairment testing for of currency changes on the company’s financial results but do not goodwill requires the company assign assets and liabilities to report- eliminate them. In addition to the translation of earnings and the ing units along with estimating future cash flows for those reporting company’s hedging programs, the impact of currency changes also units based on assumptions of future events. may affect the company’s pricing and sourcing actions. For example, The company’s estimates are based upon assumptions believed to the company may procure components and supplies in multiple func- be reasonable, but which are inherently uncertain and unpredictable. tional currencies and sell products and services in other currencies. When appropriate, the company engages independent third-party Therefore, it is impractical to quantify the impact of currency on appraisal firms to assist in determining the fair values of assets and these transactions and on consolidated net income. Generally, the reporting units. These valuations, whether performed by the com- company believes that extended periods of dollar weakness are positive pany or an independent third party, require the use of management’s for net income and extended periods of dollar strength are negative, assumptions, which would not reflect unanticipated events and cir- although the precise impact is difficult to assess. cumstances that may occur. For non-U.S. subsidiaries and branches that operate in U.S. dollars or whose economic environment is highly inflationary, translation Restructuring Actions adjustments are reflected in results of operations, as required by SFAS The company has executed, and may continue to execute, restructur- No. 52, “Foreign Currency Translation.” Generally, the company ing actions which require management to utilize significant estimates manages currency risk in these entities by linking prices and contracts related to expenses for severance and other employee separation to U.S. dollars and by entering into foreign currency hedge contracts. costs, realizable values of assets made redundant or obsolete, lease cancellation and other exit costs. If the actual amounts differ from the MARKET RISK company’s estimates, the amount of restructuring charges could be In the normal course of business, the financial position of the com- materially impacted. See note R, “2005 Actions,” on pages 93 and 94 pany is routinely subject to a variety of risks. In addition to the for a description of restructuring actions. market risk associated with interest rate and currency movements on outstanding debt and non-U.S. dollar denominated assets and liabili- Loss Contingencies ties, other examples of risk include collectibility of accounts receivable The company is currently involved in various claims and legal pro- and recoverability of residual values on leased assets. ceedings. Quarterly, the company reviews the status of each significant The company regularly assesses these risks and has established matter and assesses its potential financial exposure. If the potential loss policies and business practices to protect against the adverse effects of from any claim or legal proceeding is considered probable and the these and other potential exposures. As a result, the company does not amount can be reasonably estimated, the company accrues a liability anticipate any material losses from these risks. for the estimated loss. Significant judgment is required in both the The company’s debt, in support of the Global Financing business determination of probability and the determination as to whether an and the geographic breadth of the company’s operations, contains an exposure is reasonably estimable. Because of uncertainties related to element of market risk from changes in interest and currency rates. these matters, accruals are based only on the best information avail- The company manages this risk, in part, through the use of a variety able at the time. As additional information becomes available, the of financial instruments including derivatives, as explained in note L, company reassesses the potential liability related to its pending claims “Derivatives and Hedging Transactions,” on pages 83 through 86. and litigation and may revise its estimates. Such revisions in the esti- To meet disclosure requirements, the company performs a sensitivity mates of the potential liabilities could have a material impact on the analysis to determine the effects that market risk exposures may have on company’s results of operations and financial position. the fair values of the company’s debt and other financial instruments. 47


  • Page 50

    MANAGEMENT DISCUSSION INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES The financial instruments that are included in the sensitivity The results of the sensitivity analysis at December 31, 2006, and analysis comprise all of the company’s cash and cash equivalents, mar- December 31, 2005, are as follows: ketable securities, long-term non-lease receivables, investments, long- term and short-term debt and all derivative financial instruments. Interest Rate Risk The company’s portfolio of derivative financial instruments generally At December 31, 2006, a 10 percent decrease in the levels of interest includes interest rate swaps, foreign currency swaps, forward con- rates, with all other variables held constant, would result in a decrease tracts and option contracts. in the fair market value of the company’s financial instruments of $113 To perform the sensitivity analysis, the company assesses the risk million as compared with an increase of $18 million at December 31, of loss in fair values from the effect of hypothetical changes in inter- 2005. A 10 percent increase in the levels of interest rates with all other est rates and foreign currency exchange rates on market-sensitive variables held constant would result in a increase in the fair value of instruments. The market values for interest and foreign currency the company’s financial instruments of $96 million as compared to a exchange risk are computed based on the present value of future cash decrease of $8 million at December 31, 2005. Changes in the relative flows as affected by the changes in rates that are attributable to the sensitivity of the fair value of the company’s financial instrument market risk being measured. The discount rates used for the present portfolio for these theoretical changes in the level of interest rates are value computations were selected based on market interest and for- primarily driven by changes in the company’s debt maturities, interest eign currency exchange rates in effect at December 31, 2006 and rate profile and amount. 2005. The differences in this comparison are the hypothetical gains or losses associated with each type of risk. Foreign Currency Exchange Rate Risk Information provided by the sensitivity analysis does not necessar- At December 31, 2006, a 10 percent weaker U.S. dollar against foreign ily represent the actual changes in fair value that the company would currencies, with all other variables held constant, would result in a incur under normal market conditions because, due to practical limi- decrease in the fair value of the company’s financial instruments of $348 tations, all variables other than the specific market risk factor are held million as compared with a decrease of $257 million at December 31, constant. In addition, the results of the model are constrained by the 2005. Conversely, a 10 percent stronger U.S. dollar against foreign cur- fact that certain items are specifically excluded from the analysis, rencies, with all other variables held constant, would result in an increase while the financial instruments relating to the financing or hedging of in the fair value of the company’s financial instruments of $330 million those items are included by definition. Excluded items include leased compared with an increase of $278 million at December 31, 2005. assets, forecasted foreign currency cash flows and the company’s net investment in foreign operations. As a consequence, reported changes FINANCING RISKS in the values of some of the financial instruments impacting the See the “Global Financing—Description of Business” on page 49 for results of the sensitivity analysis are not matched with the offsetting a discussion of the financing risks associated with the company’s changes in the values of the items that those instruments are designed Global Financing business and management’s actions to mitigate to finance or hedge. such risks while striving for consistently strong returns on Global Financing’s equity. EMPLOYEES AND RELATED WORKFORCE PERCENTAGE CHANGES FOR THE YEAR ENDED DECEMBER 31: 2006 2005 2004 2006-05 2005-04 IBM/wholly owned subsidiaries 355,766 329,373 329,001 8.0 0.1 Less-than-wholly owned subsidiaries 10,720 12,377 19,051 (13.4) (35.0) Complementary 28,063 24,595 21,225 14.1 15.9 Management Discussion ........................................................ 12 road Map............................................................................. 12 Forward-Looking and Cautionary statements ..................... 13 Management Discussion snapshot ...................................... 14 Description of Business ....................................................... 15 Year in review...................................................................... 22 Prior Year in review ............................................................. 37 Discontinued Operations ..................................................... 41 Other Information ................................................................ 41 Global Financing .................................................................. 49 report of Management ......................................................... 54 report of independent registered public accounting Firm .... 55 Consolidated statements ....................................................... 56 48 2006 Annual Report

  • View More

Get the full picture and Receive alerts on lawsuits, news articles, publications and more!