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    Dear IBM Investor: I am very pleased to report to you on a superb year for your company— a year of record revenue, profit, cash flow and earnings per share. It reflects the hard work of some of the world’s brightest and most innovative women and men— the IBMers I’m proud to call my colleagues. It is also the result of important strategic choices we made several years ago— choices that have put IBM in a strong position to continue to grow profitably, to strengthen our client relationships, and to seize the most attractive opportunities in a very dynamic global economy.


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    006 07 Annual Report 08 9


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    IBM is a different company today. To understand why, let me briefly describe how we got to our present position. At the beginning of the decade, all of us in the information technology industry — indeed, in all of business — were confronted with funda- mental changes: the reality of global integration, a new computing model and new ways for businesses and institutions to apply technology to create value. Samuel J. Palmisano Chairman, President and Chief Executive Officer It was clear that we had to change — and not only to capture future opportunities. The fact is, if we had stayed still, the company’s competitiveness would have been at risk. So we made important decisions, and got to work. Global integration: As the decade began, we observed the accelerating integration of global economies, and with it the emergence of two important — I would say historic — opportunities. 1 We had a chance to capture rapid growth in dozens of countries as they invested heavily in information technology to modernize their societies. And we could also tap into enormous populations of skills all over the world. We set out to seize both opportunities. We’ve made major investments in emerging markets, building up our teams in nations all over the world. At the same time, we have


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    been globally integrating IBM’s operations rapidly, locating our work and functions wherever it makes the most sense, based on the right cost, the right skills and the right business environment. Today we have a truly global supply chain; we develop software globally; our network of research laboratories is worldwide; and we deliver services on an unmatched global scale. We are continuing to transform our processes and functions to move IBM to this profoundly new model of the corporation, which we call the Globally Integrated Enterprise. Results from Continuing Operations Revenue Income ($ in billions) ($ in billions) $100 $12 10 80 8 60 6 40 4 20 2 89.1 96.3 91.1 91.4 98.8 6.6 7.5 8.0 9.4 10.4 0 0 03 04 05 06 07 03 04 05 06 07 2005 performance includes results from four months of the IBM PC business, which was divested on April 30, 2005. Technology: IBM has been saying it for many years: The basic computing model has changed. The PC model of the 1980s has receded in importance to clients, and has been replaced by a new paradigm, based on openness, networks, powerful new technology and the integration of digital intelligence into the fabric of work and life. As you know, we have dramatically changed our mix of products, services, skills and technologies. We exited businesses like PCs and hard disk drives — businesses that we had invented. We shifted our internal R&D and have made more than 60 acquisi- 2 tions over the past five years. At the time, many were skeptical — but one need only look at today’s headlines to see how strongly some PC-era leaders are trying to move away from the old model and embrace the new one. IBM’s product and technology portfolio today is built around networked, modularized and embedded technologies, including


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    service-oriented architecture (SOA), information on demand, virtualization and open, modular systems for businesses of all sizes. IBM is a leader in all these areas. Put it all together, and IBM today is very different from what it was when we entered the decade. Business: Impelled by this new global arena and new technology model, business leaders expanded their horizons — driven both by competitive pressures and a remarkable array of new innovation capabilities. No longer content with cost savings from off-the-shelf technologies and solutions, they were seeking to innovate. And this involved not just their products and services, but their entire companies: business processes, management systems, policies and even their core business model. To accomplish that, they were looking to integrate advanced technology deep into their processes and operations. Our worldwide survey of CEOs has consistently confirmed this shift in businesses’ perceptions and priorities. To deliver this kind of client value requires intimate knowledge of each client and the ability to make that knowledge operational on a daily basis — and that can’t be done from corporate headquarters. So we changed our own processes and organization to push decision-making and delegation closer to the marketplace. A Transformed Put it all together, and IBM today is very different from what it Company was when we entered the decade. We are different strategically, with clarity around our twin imperatives of innovation and global integration. We are different operationally, with a lower center of gravity in our operations and with continually improving efficiency and productivity. And we have a business model that is better aligned with our clients’ needs and that generates stronger profitability and cash flow. We see no major strategic shift on the horizon for our company. So, how is this transformed company performing? Let me briefly recap 2007. It was, quite simply, a great year for IBM. Revenue and income: We delivered our strongest revenue growth since 2003 and our strongest profit performance in more than a decade. Our revenue as reported was a record $98.8 billion, up 8 percent. Pretax income from continuing operations was $14.5 billion, an increase of 9 percent and another record. Margins: IBM’s gross profit margin rose for the fourth consecu- 3 tive year — to 42.2 percent, up more than five points since 2003. We achieved this by continuing to shift our business mix to more profitable segments, such as software, and by focusing on productivity. Our pretax income margin rose to 14.7 percent. Both margins are at their highest in more than a decade. The improvement in our pretax


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    income margin compares very favorably to our technology peers and to the companies of the Dow 30. We have reversed the margin decline of the late 1990s, and we have a stronger business model today, with less volatility and more high-profit revenue opportunity. Earnings per share: We have continued to achieve strong EPS growth. Last year was another record, with diluted earnings per share from continuing operations of $7.18, up 18 percent. This marked 20 straight quarters of EPS growth. Cash flow: IBM has consistently generated strong cash flow. In 2007 our net cash from operations, excluding the year-to-year change in Global Financing receivables, was $17.4 billion — an increase of $2.1 billion from last year. Our business model has allowed us to generate more than $70 billion in cash flow over the past five years. IBM ended 2007 with $16.1 billion of cash and marketable securities. Our balance sheet remains strong, and the company is well positioned to take advantage of new strategic opportunities. Investment and return to shareholders: Our superior cash flow has enabled us to invest in the business — through strategic acquisitions and capital expenditures to drive growth — and to generate substantial returns to investors through increased dividends and significant share repurchase. Our 2007 cash investment was $1 billion for 12 acquisitions — six of them in key areas of software. And after investing $6.2 billion in R&D and $5 billion in net capital expenditures, we were able to return a record of nearly $21 billion to you — $18.8 billion through share repurchase and $2.1 billion through dividends — or more than 100 percent of our net earnings. This year’s dividend increase was 33 percent, marking the 12th year in a row in which we have raised our dividend. In the last two years, IBM has doubled its quarterly dividend. Our balance sheet remains strong, and the company is well positioned to take advantage of new strategic opportunities. The results of IBM’s strategic choices and actions over the last several years have been better client focus, clearer marketplace differentiation and a stronger financial engine. We have also achieved superior flexibility — a competitive advantage in uncertain economic times. This strengthened business model and our excellent performance in 2007 have increased our confidence that we will meet our 2010 objective of $10 to $11 in earnings per share. I think 4 the information on pages 6 to 7 will help you understand the sources of that confidence. The IBM We have entered 2008 with strong momentum — but can we Difference sustain it? This is a legitimate question, especially given the current economic indicators in the United States and other parts of the developed world. A number of companies aren’t sounding


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    very optimistic. At IBM, we have a different view. The reason why is best understood in terms of five key factors that differentiate our company today. 1. Our global reach and scale. IBM’s global operations are accelerating our company’s growth. IBM today does business in 170 countries and enjoys an increasingly broad-based geographic distribution of revenue. In 2007, 63 percent of our revenue came from outside the United States. Many people think of “emerging markets” as the so-called BRIC countries of Brazil, Russia, India and China — and last year our revenue increased 26 percent in those markets. But our global footprint extends much farther. Consider more than 50 countries — including Czech Republic, Poland, Malaysia, Singapore, South Africa, Venezuela and Mexico — in each of which we grew more than 10 percent in local currency in 2007. In aggregate, IBM’s business in this group grew at a rate of more than 20 percent in local currency last year and comprised 15 percent of our geographic revenues. 2. Our infrastructure leadership. IBM arguably invented the concept of the data center, and today our solutions provide a foundation for more of the world’s IT infrastructure than any other company. So we are well positioned to serve businesses across the world’s emerging markets that are installing their first data centers — as well as those in the developed world that are upgrading and transforming their existing infrastructure. However, today’s opportunity is not simply about replicating or upgrading what already exists. The data center itself is going through its most significant transformation in decades. According to one IT analyst firm, more than 70 percent of Global 1000 companies will have to modify their data centers significantly during the next five years. This is driven not only by new technology but by new business imperatives: constraints on power and real estate; systems that are grossly underutilized; and the need for greater flexibility to innovate business processes and models. These needs have shaped our transformed portfolio. Our green data center solutions dramatically impact energy efficiency and physical space constraints, while also helping our planet. Demand is climbing for these solutions, and we hit more than $400 million in signings last year, after introducing the offering in the third quarter. Virtualization, which significantly improves system utilization, generated about $200 million in incremental gross profit 5 for us in 2007. And our industry-leading solutions in SOA enable clients to reinvent their entire business model. Clients in both the developed and developing worlds will be migrating to this new data center model, and IBM is very well positioned.


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    Generating Higher Value at IBM 1 Several years ago, we saw change coming. Value was shifting in the IT industry, 2 We remixed our businesses in order to move to the emerging higher-value spaces. We exited commoditizing businesses like Over the past five years we have acquired driven by the rising tide of global PCs and hard disk drives, and strengthened our more than 60 companies to complement integration, a new computing paradigm position in areas like service-oriented architec- and scale our portfolio of products and and new client needs. ture (SOA), information on demand, virtualization offerings. This has changed our business mix and open, modular systems for businesses toward higher-value, more profitable segments UÑÑ V › –‹iÈÑ wÑ`iäi’ °‹›€Ñ›>Ӌ ›ÈÑ of all sizes. of the industry. åiÅiрŠ勛€ÑÅ>°‹`’ç]Ñ`ŋäi›ÑLçш‹ÈÓ Å‹VÑ ‹›äiÈӖi›ÓÈы›Ñwޛ`>–i›Ó>’ÑLÞȋ›iÈÈÑ 2003 2007 ‹›wÅ>ÈÓÅÞVÓÞÅiµÑ ›ÓiŰŋÈiÈÑåiÅiђ ‘‹›€Ñ  Ñ°ÅiÓ>æы›V –iÑfœµ}ÑL‹’’‹ ›Ñ  Ñ°ÅiÓ>æы›V –iÑf§}µyÑL‹’’‹ › Ó ÑÓ>°Ñȑ‹’’ÈÑ>›`Ñiæ°iÅӋÈiÑ>ä>‹’>L’iÑ>’’Ñ  Ñ°ÅiÓ>æі>ŀ‹›Ñ§íµÎ´Ñ  Ñ°ÅiÓ>æі>ŀ‹›Ñ§}µÌ´ äiÅÑӈiÑå Œ`Ñ>›`ÑÓ Ñ‹›Ói€Å>ÓiÑӈi‹ÅÑ °iÅ>Ӌ ›Èр’ L>’’çµ UÑÑ ˆ>›€iы›ÑV –°ÞӋ›€Ñ>ÅVˆ‹ÓiVÓÞÅiÑå>ÈÑ Software Hardware and Hardware and ŋ°°’‹›€Ñ>VÅ ÈÈÑӈiÑ`>Ó>ÑVi›ÓiÅÑ>›`Ñ 34% Financing Software Financing Segment 25% 40% 23% ӈiћiÓå ő]Ñ>’ ›€Ñå‹ÓˆÑ>Ñ°Å ’‹wiÅ>Ӌ ›Ñ Pretax Segment wÑÓiVˆ› ’ €çы›wÞÈi`ы›Ó Ñ>’’Ñ>È°iVÓÈÑ wÑ Income Pretax work and life. Mix Income UÑÑ –°>›‹iÈÑåiÅiÑÈii‘‹›€ÑÓ Ñ‹›Ói€Å>ÓiÑ Mix >`ä>›Vi`ÑÓiVˆ› ’ €çÑå‹ÓˆÑӈi‹ÅÑLÞȋ›iÈÈÑ °Å ViÈÈiÈÑ>›`Ñ °iÅ>Ӌ ›È]ћ ÓÑ ›’çÑÓ Ñ Åi`ÞViÑV ÈÓÈ]ÑLÞÓÑÓ Ñi›>L’iы›› ä>Ӌ ›Ñ Services >›`рŠåӈµ 41% Services 37% 3 And we decided to become a globally integrated enterprise in order to participate in the world’s growth markets and improve IBM’s productivity. IBM operates in 170 countries and enjoys an increasingly broad-based including Czech Republic, Poland, Malaysia, Singapore, South Africa, geographic distribution of revenue. Our non-U.S. operations generated Venezuela and Mexico — in each of which we grew more than 10 percent 63 percent of IBM’s revenue in 2007. in local currency in 2007. In aggregate, IBM’s business in this group Last year our revenue increased 26 percent (18 percent in local grew at a rate of more than 20 percent in local currency last year, currency) in the BRIC countries — Brazil, Russia, India and China. But our and comprised 15 percent of our geographic revenues. global footprint extends much farther. Consider more than 50 countries — Strong Geographic Growth 2007 Revenue by Geographic Region (excludes OEM) 21% Asia Pacific 36% Europe, Middle East and Africa Î 43% Americas Countries with IBM revenue growth greater than 10 percent in local currency in 2007


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    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 5 That has enabled us to invest in future sources of growth and provide record return to investors … financial results. Primary Uses of Cash over We have achieved record … and record cash the Past Five Years earnings per share … performance. Pretax earnings from continuing In 2007 our net cash from operations, operations were $14.5 billion, an excluding the year-to-year change increase of 9 percent. Diluted earnings in Global Financing receivables, per share were $7.18, up 18 percent, was $17.4 billion — an increase of marking 20 straight quarters of $2.1 billion from last year. More than growth and five consecutive years $83 billion of double-digit growth. Net Cash from Operations, since 2003 Excluding Global Financing Reinvested Returned to Earnings Per Share Receivables $30 billion Shareholders (from continuing operations) ($ in billions) Acquisitions and $53 billion Capital Expenditures Share Repurchases $8 $18 and Dividends 16 14 6 … while continuing to invest in 12 R&D — more than $29 billion 10 4 over the past five years. 8 6 2 4 2 3.76 4.39 4.91 6.06 7.18 12.6 12.9 13.1 15.3 17.4 0 0 03 04 05 06 07 03 04 05 06 07 6 This gives us confidence that we can achieve our long-term financial objectives. In May 2007 we shared with investors our 2010 Earnings Per Share so to give our shareholders a clear understanding of the key factors Roadmap — which explains how we expect to achieve EPS growth of driving IBM’s long-term financial objectives. In 2007 we made progress 14 to 16 percent and $10 to $11 in earnings per share by 2010. We did toward our 2010 objectives by growing earnings per share 18 percent. 2010 Earnings Per Share Roadmap $12 12% -15% CGR Key Drivers 11 10 Revenue growth: Growth initiatives and future 10 We maintain historical revenue acquisitions: growth through annuity businesses, We invest in key growth initia- 8 global presence and a balanced tives and strategic acquisitions to 18% business mix. complement and scale our product 7.18 14%-16% portfolio. 6 Margin expansion: EPS CGR We focus on delivering higher Retirement-related savings: 6.06 (2006-2010) value to clients and on increasing We expect to achieve retirement- Ì 4 productivity, to improve profitability. related cost savings over the next Share repurchases: several years, driven in part by Our strong cash generation lets us Plan redesigns. 2 return value to shareholders by reducing shares outstanding while 0 reinvesting for future growth. 06 07 08 09 10


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    3. Our technology leadership. IBM’s leadership position in IT infrastructure is underpinned by a superior technology base. In 2007, for the 15th consecutive year, IBM was issued more U.S. patents (3,125) than any other company. And our offerings in the year ahead look especially promising. Major IBM product launches will include our next-generation System z mainframe; System p servers, which bring POWER6 innovation to the entry level; and POWER-based virtualization offerings, which improve energy and space efficiency for UNIX customers. We are also introducing a new BladeCenter offering and a highly innovative storage architecture, thanks to our acquisition of XIV. Finally, we expect to see continued strong growth in strategic middleware fueled by organic investment and strategic software acquisitions — such as FileNet and Cognos, which have augmented our information on demand capabilities. 4. Our delivery of unique client value. As we head into uncertain economic times in some parts of the world, one fact remains constant: Businesses continue to invest in IT. It saves them money and manages business-critical needs — such as enterprise security, real-time analytics, risk management, business intelligence, business optimization and transformation, as well as how a company expands its client base in order to gain share. Companies are seeking to identify and classify security risks and protect their data from all forms of attack. They face regulatory demands and pressure to increase productivity without buying more “stuff.” They need to use both structured and unstructured data— such as the information contained in memos, reports and phone calls— to generate reports to their customers in minutes, not days. In addition, we are seeing multiple areas of investment growth within particular industries. For example, telecommunications companies continue to upgrade their infrastructure to broadband. Also, utilities face outdated systems, the transformation from analog to digital and new regulatory requirements. Across the world, businesses and institutions are continuing to make investments that save them money, preserve capital and address issues they simply may not defer. 5. Our financial strength and flexibility. As I’ve described, our focus on higher-value offerings helps drive profitable growth and strong cash generation, which have enabled IBM to return value to shareholders and to invest opportunistically for growth. We also possess the financial capacity to adjust to changes in near-term business conditions, thanks to a business model in which about 8 50 percent of the company’s revenues are recurring streams — far less subject to volatility in uncertain economic conditions. We believe these differentiating capabilities — our global pres- ence and integration; preeminence in the data center; technology leadership; and the ability to deliver measurable client value — will be drivers of profitable growth in both good times and bad. As a result,


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    we believe that IBM has excellent opportunities in 2008 and beyond — in an environment that presents significant challenges for our competitors. They are not as global, as strong in high-growth segments or as able to deliver complete solutions, nor do many have the experience and discipline to adjust their economic models as conditions require. So we will pursue growth, while at the same time remaining prudent and disciplined about expenses and productivity. That is, we will operate ambidextrously — seizing the new opportunities that the external marketplace presents, while never ceasing to reexamine our own operations or to transform our organization. This is difficult; not every workforce has the focus and maturity to do it. But IBM has been here before, and we know what to do. Historically, this is when we have gone on offense. A New At the opening of this letter, I said that we intend to capitalize World on our strengths in order to seize the growth, profit and leadership opportunities presented by today’s global marketplace. Let me close with some thoughts on what will be required of any company seeking to do that. On the prospects for continued global growth: When people look out at the global economy today, some are concerned about ripple effects. They fear the impact on overall growth — even in the developing world — of a possible downturn in parts of the developed world. Now, I’m not an economist, but let me offer a perspective based on my experiences as I visit IBM’s clients and our own opera- tions around the world. You only have to get outside of the United States to see that something very new is happening today. The world’s growth markets are no longer as dependent on import-export, on the exchange of raw materials for industrial goods. Instead, they are innovating. They are differentiating. Most importantly, their people are becoming consumers; they’re joining the middle class. Hundreds of millions of people are opening their first bank accounts, getting their first cell phones, using their first credit cards. Tens of millions are buying their first automobiles. These are historic developments, and are pretty far removed from economic fluctuations in the United States, Europe and Japan. Hundreds of millions of people are opening their first bank accounts, getting their first cell phones, using their first credit cards. 9 And consider what has to happen to give all of those people cell phones, financial services and cars. Infrastructure has to be built and developed, and not only the IT infrastructure I discussed earlier, but business infrastructure — for banking, manufacturing, telecommunications, transportation and government services.


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    Your company knows a thing or two about how to build both kinds of infrastructure to support the way the world works. We’ve been doing that for nearly 100 years. However, our ability to focus on markets that are small today but with great upside potential was inhibited in the past by our own organizational structure. When you group such smaller markets with big ones, they tend to be overshadowed and to lack proper management attention, investment, skills and support. That is the reason we are creating a new Growth Markets organization, to be headquartered in Shanghai. Its goal is to acceler- ate IBM’s global growth significantly. I believe this is the best way to ensure that these markets get the talent, investment and attention they deserve and need in order to keep growing. On local engagement: To be truly global today, a company has to do a lot more than set up sales offices or research facilities in multiple markets, or send its people on international assignments. Doing business in the developing world is about relationships, not just transactions. You have to engage at the level of culture, as well as process. You have to build trust. You have to be integrated on the ground, working shoulder-to-shoulder with local suppliers, governments and communities, and understanding their point of view on business and innovation. You have to help them advance their agendas, not just your own. And you have to train your leaders everywhere to be global leaders. This takes time. You can’t “leapfrog” into being a global company. You’ve got to be committed for the long term, and you have to invest, on multiple levels. IBM has some unique historical, organizational and skill advantages here — but they will only remain advantages to the extent that we continue to make them real every day, in IBMers’ actions, behavior and relationships as global professionals and global citizens. You can’t “leapfrog” into being a global company. You’ve got to be committed for the long term, and you have to invest, on multiple levels. On developing global professionals and citizens: Of all the issues facing business and society with regard to global integration, perhaps the most challenging is this: How does the individual com- pete and win in a global economy? This is, on the one hand, what makes globalization such an emotional and polarizing issue to many §í people. But it also opens up some of the most promising opportuni- ties for organizational innovation in business today — driven by the need to help our people succeed in this new environment. Last year we introduced the IBM Global Citizen’s Portfolio. It aims to provide our employees with the tools they need to enhance their expertise in a global context. Those tools include a matching fund to


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    support the IBMer’s own learning and exploration — even if not related to his or her current job. We are helping retiring IBMers to transition to second careers in teaching, government service and nongovernmental organizations. And we’ve established a program called the Corporate Service Corps, in which teams of high-potential IBMers from around the world — our leaders of the future — will come together for one-month projects on economic development, environmental and other problems in developing countries. The underlying idea here is that individuals are in the best position to make decisions about their own work, learning and careers. This shift of control and decision-making to the IBMer represents a very new relationship between enterprises and individuals — and that involves a certain degree of risk. Sharing power always does. But if you trust your strategy, your capabilities and your people — and if you are confident that all are grounded in a set of shared values — then this is the kind of innovation you pursue. It’s one more example of playing offense in a very new game. I’m deeply gratified that our employees’ reaction to the Global Citizen’s Portfolio has been so enthusiastic. We are, for instance, oversubscribed by thousands of applicants for the Corporate Service Corps. IBMers have a very mature understanding of today’s new environment. They know the world is changing. They don’t expect— or in many cases, even want — what business used to provide. What they do want is an opportunity and some help to learn and grow, so they can effectively compete on a world stage. This is probably the single strongest reason for my confidence in IBM’s future. UÊUÊU As we enter a new era of technology, business and global society, I am proud of the worldwide IBM team for bringing us to this point, and I am grateful to you, our shareholders, for your support in our journey. I hope and trust that you are pleased with how your company is growing and evolving. My colleagues and I are excited by the possibilities for how we, together with our clients, our partners and you, can bring this remarkable enterprise into its next era of leadership and discovery. 11 Samuel J. Palmisano Chairman, President and Chief Executive Officer The selected references in this letter to the company’s financial results excluding the Global Financing business are non-GAAP financial measures, and these 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 to the SEC on January 17, 2008 (Attachment II — Non-GAAP Supplementary Materials).


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    Financial Highlights International Business Machines Corporation and Subsidiary Companies ($ in millions except per share amounts) FOR THE YEAR: 2007 2006 Revenue $ 98,786 $ 91,424 Income from continuing operations $ 10,418 $ 9,416 (Loss)/income from discontinued operations (00) 76 Net income $ 10,418 $ 9,492 Earnings/(loss) per share of common stock: Assuming dilution: Continuing operations $ 7.18 $ 6.06 Discontinued operations (0.00) 0.05 Total $ 7.18 $ 6.11 Basic: Continuing operations $ 7.32 $ 6.15 Discontinued operations (0.00) 0.05 Total $ 7.32 $ 6.20 Net cash provided by operating activities from continuing operations $ 16,094 $ 15,019 Capital expenditures, net 4,968 4,737 Share repurchase 18,828 8,084 Cash dividends paid on common stock 2,147 1,683 Per share of common stock 1.50 1.10 AT YEAR END: 2007 2006 Cash, cash equivalents and marketable securities $ 16,146 $ 10,657 Total assets 120,431 103,234 Working capital 8,867 4,569 Total debt 35,274 22,682 Stockholders’ equity 28,470 28,506 Common shares outstanding (in millions) 1,385 1,506 Market capitalization $149,744 $146,355 Stock price per common share $ 108.10 $ 97.15 Number of employees in IBM/wholly owned subsidiaries 386,558 355,766 12


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    Report of Financials International Business Machines Corporation and Subsidiary Companies Management Discussion Notes to Consolidated Road Map 14 Financial Statements Forward-Looking and Cautionary Statements 15 A Significant Accounting Policies 64 Management Discussion Snapshot 16 B Accounting Changes 73 Description of Business 17 C Acquisitions/Divestitures 76 Year in Review 23 D Financial Instruments (excluding derivatives) 82 Prior Year in Review 37 E Inventories 83 Discontinued Operations 42 F Financing Receivables 83 Other Information 42 G Plant, Rental Machines and Other Property 84 Looking Forward 42 H Investments and Sundry Assets 84 Liquidity and Capital Resources 44 I Intangible Assets Including Goodwill 84 Critical Accounting Estimates 47 J Borrowings 85 Currency Rate Fluctuations 49 K Derivatives and Hedging Transactions 88 Market Risk 49 L Other Liabilities 91 Financing Risks 50 M Stockholders’ Equity Activity 92 Employees and Related Workforce 50 N Contingencies and Commitments 94 Global Financing 50 O Taxes 97 P Research, Development and Engineering 99 Report of Management 56 Q 2005 Actions 99 Report of Independent Registered R Earnings Per Share of Common Stock 101 Public Accounting Firm 57 S Rental Expense and Lease Commitments 101 T Stock-Based Compensation 102 Consolidated Financial U Retirement-Related Benefits 105 V Segment Information 116 Statements W Subsequent Events 119 Earnings 58 Financial Position 59 Five-year Comparison of Cash Flows 60 Selected Financial Data 120 Stockholders’ Equity 61 Selected Quarterly Data 121 Performance Graphs 122 Board of Directors and Senior Executive Officers 123 Stockholder Information 124 13


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Road Map Transparency The financial section of the International Business Machines Cor- Transparency is a primary goal of successful financial reporting. poration (IBM or the company) 2007 Annual Report, consisting The following are several key points for the reader of this year’s of this Management Discussion, the Consolidated Financial Annual Report. Statements that follow and the notes related thereto, comprises 109 U The company, in accordance with Section 404 of the Sarbanes-Oxley Act pages of information. This Road Map is designed to provide the of 2002, conducted an evaluation of its internal control over financial reader with some perspective regarding the information contained reporting and concluded that the internal control over financial reporting in the financial section. was effective as of December 31, 2007. IBM’s Business Model U The Management Discussion is designed to provide readers with a view of the company’s results and certain factors that may affect future pros- The company’s business model is built to support two principal pects from the perspective of the company’s management. Within the goals: helping clients succeed in delivering business value by becom- “Management Discussion Snapshot,” on pages 16 and 17, the key mes- ing more innovative, efficient and competitive through the use of sages and details will give readers the ability to quickly assess the most business insight and information technology (IT) solutions; and, important drivers of performance within this brief overview. providing long-term value to shareholders. The business model has been developed over time through strategic investments in capabilities U In the first quarter of 2007, the company changed the presentation of and technologies that have the best long-term growth and profit- revenue and cost in the Consolidated Statement of Earnings to reflect the ability prospects based on the value they deliver to clients. The categories of Services, Sales and Financing. Previously, the presentation company’s strategy is to focus on the high-growth, high-value seg- included Global Services, Hardware, Software, Global Financing and an ments of the IT industry. Other category. In the past, these categories were aligned with the com- The company’s global capabilities include services, software, pany’s reportable segment presentation of external revenue and cost. hardware, fundamental research and financing. The broad mix of However, as the company moves toward delivering solutions which bring businesses and capabilities are combined to provide business insight integrated software and services capabilities to its clients, the alignment and solutions for the company’s clients. between segments and categories will diverge. Therefore, there are situ- The business model is flexible, and allows for periodic change ations where the Global Services segments could include software revenue, and rebalancing. The company has exited commoditizing businesses and conversely, the Software segment may have services revenue. The like personal computers and hard disk drives, and strengthened its change was made to avoid possible confusion between the segment revenue position through strategic investments and acquisitions in emerging and cost presentation and the required category presentation in the higher value segments like service oriented architecture (SOA) and Consolidated Statement of Earnings. The change only impacts the format Information on Demand. In addition, the company has transformed for the presentation of the company’s revenue and cost in the Consolidated itself into a globally integrated enterprise which has improved overall Statement of Earnings and does not reflect any change in the company’s productivity and is driving investment and participation in the reportable segment results or in the company’s organizational structure. world’s fastest growing markets. As a result, the company is a higher- The periods presented in this Annual Report are reported on a comparable performing enterprise today than it was several years ago. basis. The Management Discussion and Analysis of revenue and gross The business model, supported by the company’s long-term profit from continuing operations will focus on the segment view, as this financial model, enables the company to deliver consistently strong is how the business is managed and is the best reflection of the company’s earnings, cash flows and returns on invested capital in changing eco- operating results and strategy. nomic environments. U On January 29, 2008, IBM International Group Capital LLC, an indirect, wholly owned subsidiary of the company, issued $3.5 billion of 18-month floating rate notes. The proceeds will be utilized to reduce the 364-day bridge loan associated with the 2007 accelerated share repur- chase (ASR). (See pages 31 and 32 for additional information.) In the Consolidated Statement of Financial Position included in the company’s press release and Form 8-K filing on January 17, 2008, the company 14 classified the $3.5 billion related to the 364-day bridge loan as Short-term debt. As a result of this refinancing in January, and consistent with the Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map.................................................... 14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements ............................... 15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 17

    Management Discussion International Business Machines Corporation and Subsidiary Companies provisions of Statement of Financial Accounting Standards (SFAS) No. 6, Organization of Information “Classification of Short-Term Obligations Expected to Be Refinanced,” the U This Management Discussion section provides the reader of the financial company has classified this amount as Long-term debt in its Consolidated statements with a narrative on the company’s financial results. It con- Statement of Financial Position on page 59. tains the results of operations for each segment of the business, followed by U Effective December 31, 2006, the company adopted the provisions of a description of the company’s financial position, as well as certain SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and employee data. It is useful to read the Management Discussion in con- Other Postretirement Plans, an amendment to FASB Statements No. junction with note V, “Segment Information,” on pages 116 to 119. 87, 88, 106, and 132(R).” SFAS No. 158 requires that the funded status U Global Financing is a reportable segment that is measured as if it were of the company’s pension and nonpension postretirement benefit plans be a standalone entity. A separate “Global Financing” section is included recognized as an asset or a liability in the Consolidated Statement of beginning on page 50. This section is separately presented given this Financial Position, the recognition of any changes in that funded status segment’s unique impact on the company’s financial condition and lever- in the year in which the changes occur and the recognition of previously age, and the information presented in this section is consistent with this unrecognized gains/(losses), prior service costs/(credits) and transition separate company view. assets as a component of Accumulated gains and (losses) not affecting retained earnings in the Consolidated Statement of Stockholder’s Equity. U Pages 58 through 63 include the Consolidated Financial Statements. The adoption of SFAS No. 158 had a significant non-cash impact on the These statements provide an overview of the company’s income and cash company’s 2006 reported financial position and stockholder’s equity, flow performance and its financial position. reducing equity by $9.5 billion, net of tax. The adoption of SFAS No. U The notes follow the Consolidated Financial Statements. Among other 158 had no impact on the company’s existing debt covenants, credit ratings items, the notes contain the company’s accounting policies (pages 64 to or financial flexibility. See note U, “Retirement-Related Benefits,” on 73), acquisitions and divestitures (pages 76 to 82), detailed information pages 105 to 116 for additional information, including 2007 impacts. on specific items within the financial statements, certain contingencies U The company divested its Personal Computing business to Lenovo on and commitments (pages 94 through 96), and the results of each report- April 30, 2005. The details of this significant transaction are discussed able segment (pages 116 to 119). in note C, “Acquisitions/Divestitures,” on pages 81 and 82. As a result of this divestiture, the company’s reported financial results do not include Discontinued Operations any activity in 2007 and 2006, but includes four months of activity for On December 31, 2002, the company sold its hard disk drive (HDD) the Personal Computing Division in 2005. This lack of comparable business to Hitachi, Ltd. (Hitachi). The HDD business was accounted periods has a material impact on the company’s reported revenue growth. for as a discontinued operation under generally accepted accounting Therefore, in the Management Discussion, within the “Prior Year in principles (GAAP) which requires that the income statement and Review” section on pages 38 to 41, the company has presented an analysis cash flow information be reformatted to separate the divested busi- of revenue both on an as-reported basis and on a basis that excludes the ness from the company’s continuing operations. See page 42 for revenue from the divested Personal Computing business from the 2005 additional information. period. The company believes that the analysis that excludes the Personal Computing revenue is a better indicator of operational revenue perfor- Forward-Looking and mance on an ongoing basis. Cautionary Statements U The reference to “adjusted for currency” in the Management Discussion Certain statements contained in this Annual Report may constitute is made so that certain financial results can be viewed without the impacts forward-looking statements within the meaning of the Private of fluctuating foreign currency exchange rates and therefore facilitates a Securities Litigation Reform Act of 1995. These statements involve comparative view of business performance. See “Currency Rate Fluctuations” a number of risks, uncertainties and other factors that could cause on page 49 for additional information. actual results to be materially different, as discussed more fully else- U 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 2007 Form 10-K filed on February 26, 2008. Report are calculated from the underlying whole-dollar numbers. 15


  • Page 18

    Management Discussion International Business Machines Corporation and Subsidiary Companies Management Discussion Snapshot Continuing Operations ($ and shares in millions except per share amounts) The company’s performance in 2007 reflected the strength of its YR.-TO-YR. global model. Revenue increased in all geographies, with strong PERCENT/ MARGIN growth in emerging markets worldwide. The company capitalized on FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE the opportunities in the global economies, generating 63 percent of Revenue $ 98,786 $ 91,424 8.1%* its revenue outside the United States, in delivering full-year growth Gross profit margin 42.2% 41.9% 0.4 pts. of 8.1 percent (4 percent adjusted for currency). Total expense and other income $ 27,240 $ 24,978 9.1% Gross profit margins improved reflecting a shift to higher value Total expense and other offerings and continued benefits from productivity initiatives and the income-to-revenue ratio 27.6% 27.3% 0.3 pts. transformation to a globally integrated enterprise. Pre-tax income Income from continuing from continuing operations grew 8.8 percent and Net income from operations before income taxes $ 14,489 $ 13,317 8.8% continuing operations increased 10.6 percent versus 2006. Diluted Provision for income taxes $ 4,071 $ 3,901 4.4% earnings per share improved 18.5 percent, reflecting the strong Income from continuing growth in Net income and the benefits of the common stock repur- operations $ 10,418 $ 9,416 10.6% chase program. In 2007, the company repurchased approximately Net income $ 10,418 $ 9,492 9.7% $18.8 billion of its common stock, including a $12.5 billion ASR in Net income margin 10.5% 10.4% 0.2 pts. the second quarter. Earnings per share of The increase in 2007 revenue, as compared to 2006, was primarily common stock: due to: Assuming dilution: Continuing operations $ 7.18 $ 6.06 18.5% U Strong performance from Global Technology Services and Global Business Discontinued operations (0.00) 0.05 NM Services with growth in all business lines; Total $ 7.18 $ 6.11 17.5% U Continued strong demand in the Software business, driven by Key Branded Weighted-average shares Middleware products, with positive contributions from strategic acquisi- outstanding: tions; and Diluted 1,450.6 1,553.5 (6.6)% Assets** $120,431 $103,234 16.7% U Continued growth in emerging countries (Brazil, Russia, India and Liabilities** $ 91,962 $ 74,728 23.1% China: up 26 percent) and solid performance in all geographies, led by Equity** $ 28,470 $ 28,506 (0.1)% Asia Pacific. * 4.2 percent adjusted for currency. The increase in Income from continuing operations before income ** At December 31. taxes in 2007 was primarily due to: NM — Not meaningful U Revenue growth as discussed above; and U Gross profit margin improvements in the Global Services and Systems and Technology segments. 16 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ............ 16 Report of Independent Registered Description of Business ............................. 17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 19

    Management Discussion International Business Machines Corporation and Subsidiary Companies The consolidated gross profit margin increased 0.4 points versus Stockholders’ equity of $28,470 million was essentially flat 2006 to 42.2 percent. An improvement in the Systems and Technology versus 2006. Increased Treasury stock ($17,649 million) from margin (2.0 points) contributed 0.5 points to the overall margin share repurchases, which included the ASR, was largely offset improvement. This increase was primarily driven by higher margins by increased Retained earnings ($8,208 million) driven by Net in System z, System p and System x servers. The Software margin income, increased Common stock ($3,917 million) related to stock was flat at 85.2 percent, but contributed 0.2 points to the overall options and a decline in Accumulated gains and (losses) not affect- margin improvement due to the mix of revenue by segment. The ing retained earnings ($5,487 million) primarily due to the effects Global Technology Services and Global Business Services margins of pension remeasurements. increased 0.1 points and 0.4 points to 29.9 percent and 23.5 percent, The company generated $16,094 million in cash flow provided by respectively, versus the prior year. Although gross profit margins operating activities, an increase of $1,075 million compared to 2006, improved for Global Services, the increased Global Services revenue primarily driven by increased Net income. Net cash used in investing content contributed to a 0.2 point decline in the consolidated gross activities of $4,675 million was $6,874 million lower than 2006 margin due to the mix impact. The Global Financing margin declined driven primarily by proceeds from disposition of short-term market- 3.5 points versus 2006 to 46.7 percent, causing a 0.1 point decline in able securities and a reduction in cash used for acquisitions. Net cash the overall company margin. used in financing activities of $4,740 million decreased $3,464 million Total expense and other income increased 9.1 percent (5 percent versus 2006 driven by increased net proceeds from total debt adjusted for currency) in 2007 versus 2006. The increase was primar- ($12,233 million), partially offset by increased share repurchases ily due to increases in Selling, general and administrative (SG&A) ($10,744 million). expense and Interest expense. SG&A expense increased $1,801 million Global Services signings were $50 billion in 2007 as compared to primarily due to acquisition related spending, as well as increased $49 billion in 2006. The Global Services backlog is estimated to be investments in emerging countries and the software and services $118 billion at December 31, 2007, versus $116 billion at December businesses. Interest expense increased $333 million primarily due to 31, 2006. higher debt associated with the financing of the ASR. In addition, For additional information and details, see the “Year in Review” Other (income) and expense declined $140 million in income year- section on pages 23 to 37. to-year primarily due to higher losses on derivative instruments. The effective tax rate for 2007 was 28.1 percent, compared with Description of Business 29.3 percent in 2006. Please refer to IBM’s Annual Report on Form 10-K filed on February 26, Total assets increased $17,197 million ($12,957 million adjusted 2008, with the SEC for a more detailed version of this Description of for currency) primarily due to increases in Cash and cash equivalents Business, especially Item 1A. entitled “Risk Factors.” ($6,969 million), Prepaid pension assets ($6,788 million), total financing receivables ($2,729 million) and Goodwill ($1,431 million). IBM is a globally integrated enterprise that targets the intersection of These increases were partially offset by decreases in long-term technology and effective business. The company seeks to be a partner deferred tax assets ($2,367 million) and short-term marketable secu- in its clients’ success by enabling their own capacity for distinctive rities ($1,479 million). innovation. To help clients achieve growth, effectiveness, efficiency Total liabilities increased $17,234 million ($13,642 million adjusted and the realization of greater value through innovation, IBM draws for currency) driven primarily by increases in total debt ($12,592 upon the world’s leading systems, software and services capabilities. million), tax liabilities ($1,492 million) and total deferred income ($1,773 million). 17


  • Page 20

    Management Discussion International Business Machines Corporation and Subsidiary Companies IBM’s Strategy DELIVER INTEGRATION AND INNOVATION TO CLIENTS In IBM’s view, today’s networked economy has created a global busi- Changes in the market have caused IBM’s clients to seek flexibility ness landscape and a mandate for business change. Integrated global and innovation in everything from technical architecture to their economies have opened markets of new opportunity and new sources business model. In response, IBM is focused on delivering integra- of skills. The Internet has enabled communication and collaboration tion and innovation to its clients — offering them technologies and across the world and brought with it a new computing model pre- services that support real value creation. mised on continuous global connection. In that landscape, companies can distribute work and technology anywhere in the world. U IBM has a long heritage of transforming the business operations of large Given these opportunities, IBM is working with its clients to enterprises and has earned the trust to be their innovation partner and develop new business designs and technical architectures that allow global integrator. their businesses the flexibility required to compete in this new U The company has a deep set of global assets and capabilities it is applying landscape. The business is also adjusting its footprint toward emerg- to improve services profitability, both for its clients and for itself. ing geographies, tapping their double-digit growth, providing the technology infrastructure they need, and taking advantage of the BECOME THE PREMIER GLOBALLY talent pools they provide to better service the company’s clients. INTEGRATED ENTERPRISE IBM’s strategy addresses this new era and delivers value to its As global networks and technology capabilities change business eco- clients through three strategic priorities: nomics, legacy business designs can quickly become noncompetitive. IBM believes a globally integrated enterprise, designed for this new FOCUS ON OPEN TECHNOLOGIES AND landscape can compete effectively and will benefit from the opportu- HIGH-VALUE SOLUTIONS nities offered. The PC era has ended, representing a fundamental shift in the tech- nology requirements of the company’s clients. IBM is well positioned U To reshape its business for the global economy, IBM has replaced vertical to provide its enterprise clients the open technologies and high-value hierarchies with horizontally integrated teams. solutions they will need to compete. U Across the business, the company has made significant investments in emerging markets, taking core processes and functions that were once U IBM is leveraging its leadership position in the convergence of software managed regionally and shifting them to a globally integrated model. and services, in SOA, in virtualization, in high-performance chips, in open and modular IT— continuing its shift from commoditizing seg- Looking forward, IBM is confident it understands the economic shift ments to higher value segments with better profit opportunity. of globalization, the evolution of the new computing model and the U The company continues to be a leading force in open source solutions to powerful role of innovation in this new landscape. Its unique capa- enable its clients to achieve higher levels of interoperability, cost efficiency bilities are well adapted to help the company’s clients innovate and and quality. compete effectively in the new landscape. 18 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ............................. 17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Strategic Outsourcing Consulting and Systems Integration Business Transformation Outsourcing Application Management Services Services Integrated Technology Services Maintenance WebSphere Systems & Servers Software Information Management Financing Storage Tivoli Retail Store Solutions Lotus Microelectronics Rational Commercial Financing Operating Systems Client Financing Business Segments and Capabilities Business Transformation Outsourcing. A range of offerings from stan- dardized processing platforms and Business Process Outsourcing The company’s major operations comprise a Global Technology through transformational offerings that delivers improved business Services segment; a Global Business Services segment; a Systems results to clients through the strategic change and/or operation of and Technology segment; a Software segment; and a Global Finan- the client’s business processes, applications and infrastructure. cing segment. Global Services is a critical component of the company’s strategy of Integrated Technology Services. Services offerings that help clients access, manage and support their technology infrastructures, through providing IT infrastructure and business insight and solutions to a combination of skilled resources, software and IBM’s knowledge of clients. While solutions often include industry-leading IBM software business processes. and hardware, other suppliers’ products are also used if a client solu- tion requires it. Contracts for IBM services — commonly referred to Maintenance. A number of support services from product maintenance as “signings” — can range from less than one year to over 10 years. through solution support to maintain and improve the availability of Within Global Services there are two reportable segments: Global clients’ IT infrastructure. Technology Services and Global Business Services. GLOBAL BUSINESS SERVICES (GBS) segment primarily reflects GLOBAL TECHNOLOGY SERVICES (GTS) segment primarily professional services and application outsourcing services, delivering reflects IT infrastructure services and business process services, business value and innovation to clients through solutions which delivering value through the company’s global scale, standardization leverage industry- and business-process expertise. and automation. GBS Capabilities GTS Capabilities 19 Consulting and Systems Integration. Delivery of value to clients through Strategic Outsourcing Services. Comprehensive IT services integrated consulting services for client-relationship management, financial man- with business insight working with clients to reduce costs and improve agement, human-capital management, business strategy and change, productivity through the outsourcing of processes and operations. and supply-chain management.


  • Page 22

    Management Discussion International Business Machines Corporation and Subsidiary Companies Application Management Services. Application development, manage- integration of disparate client applications that may have been built ment, maintenance and support services for packaged software, as well internally, or provided by package software vendors or system integra- as custom and legacy applications. Delivering value through the tors. Operating systems are the software engines that run computers. company’s global resource capabilities, industry knowledge, and the In addition, Software includes Product Lifecycle Management standardization and automation of application development. software which primarily serves the Industrial sector. Approximately two-thirds of external Software segment revenue is annuity-based, SYSTEMS AND TECHNOLOGY segment provides IBM’s clients coming from recurring license charges and ongoing subscription and with business solutions requiring advanced computing power and support from one-time charge (OTC) arrangements. The remaining storage capabilities. Approximately 55 percent of the Systems and one-third of external revenue relates to OTC arrangements, in which Technology’s server and storage sales transactions are through the the client pays one up-front payment for a perpetual license. Typically, company’s business partners; approximately 45 percent are direct to arrangements for the sale of OTC software include one year of main- end-user clients, more than 40 percent of which are through the tenance. The client can also purchase ongoing maintenance after the Internet at ibm.com. In addition, Systems and Technology provides first year, which includes product upgrades and technical support. leading semiconductor technology and products, packaging solutions While not reported as external revenue, software is also deployed to and engineering technology services to clients and for IBM’s own support services solutions. advanced technology needs. While not reported as external revenue, systems hardware is also deployed to support services solutions. Software Capabilities WebSphere Software. Management of a wide variety of business Systems and Technology Capabilities processes using open standards to interconnect applications, data and Servers. IBM systems, which are typically connected to a network and operating systems. Provides the foundation for Web-enabled appli- provide the required infrastructure for business. These systems use cations and is a key product set in deploying a SOA. both IBM and non-IBM operating systems and all IBM servers can also run Linux, a key open source operating system (System z, System i, Information Management Software. Advanced database, content man- System p, System x and BladeCenter). agement and information integration software that helps companies integrate, manage and gain value from their business information. Storage. Information infrastructure products and solutions, which address critical client requirements for information retention and Tivoli Software. Software for infrastructure management, including archiving, availability and virtualization, and security and compli- security and storage management that will help organizations better ance. The portfolio consists of a broad range of disk and tape storage manage their IT infrastructure to more effectively deliver IT services. systems and software. Lotus Software. Collaboration, messaging and social networking Microelectronics. Semiconductor design and manufacturing for use in software that enables businesses to communicate, collaborate and IBM systems and for sale to external clients. increase productivity. Engineering and Technology Services. System and component design Rational Software. Software tools that help clients manage their soft- services, Blue Gene “supercomputer systems,” outsourcing of clients’ ware development processes and capabilities. design teams and technology and manufacturing consulting services. Operating Systems. Software engines that manage the fundamental Retail Store Solutions. Point-of-sale retail systems (network connected processes that make computers run. cash registers) as well as solutions which connect them to other store systems (for example, inventory). GLOBAL FINANCING is described on pages 50 and 51. SOFTWARE consists primarily of middleware and operating systems Global Financing Capabilities software. Middleware software enables clients to integrate systems, Commercial Financing. Short-term inventory and accounts receivable processes and applications across a standard software platform. IBM financing to dealers and remarketers of IT products. middleware is designed to open standards which allows the efficient 20 Client Financing. Lease and loan financing to external and internal clients for terms generally between two and seven years. Management Discussion ............................ 14 Discontinued Operations .................................42 Remarketing. The sale and lease of used equipment (primarily sourced Road Map .........................................................14 Other Information............................................42 from the conclusion of lease transactions) to new or existing clients. Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ............................. 17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies IBM Worldwide Organizations RESEARCH, DEVELOPMENT AND The following worldwide organizations play key roles in IBM’s deliv- INTELLECTUAL PROPERTY ery of value to its clients: IBM’s research and development (R&D) operations differentiate the company from its competitors. IBM annually spends approximately U Sales and Distribution Organization $6 billion for R&D, focusing its investments in high-growth, high- U Research, Development and Intellectual Property value opportunities. In 2007, the company’s investment in R&D was approximately 15 percent of its combined hardware and software rev- U Integrated Operations enue. As a result of innovations in these and other areas, IBM was once again awarded more U.S. patents in 2007 than any other company. SALES AND DISTRIBUTION ORGANIZATION This marks the 15th year in a row that IBM achieved this distinction. The company’s Sales and Distribution organization manages a strong In addition to producing world-class hardware and software global footprint, with dedicated country based operating units products, IBM innovations are a major differentiator in providing focused on delivering client value. Within these units, client relation- solutions for the company’s clients through its growing services ship professionals work with integrated teams of consultants, product activities. The company’s investments in R&D also result in intel- specialists and delivery fulfillment teams to improve clients’ business lectual property (IP) income of approximately $1 billion annually. performance. These teams deliver value by understanding the client’s Some of IBM’s technological breakthroughs are used exclusively in business and needs, and then bring together capabilities from across IBM products, while others are licensed and may be used in either/ IBM and an extensive network of Business Partners to develop and both IBM products and/or the products of the licensee. implement solutions for clients. By combining global expertise with local experience, IBM’s geo- INTEGRATED OPERATIONS graphic structure enables dedicated management focus for local IBM’s ability to deliver differentiating innovation to its clients is clients, speed in addressing new market opportunities and timely being greatly enhanced by the company’s global integration which is investments in emerging opportunities. The geographic units align simultaneously giving the company better economics and deeper industry-skilled resources to serve clients’ agendas. IBM extends capa- capabilities, while eliminating redundancies that were built up over bilities to mid-market client segments by leveraging industry skills fifty years as a growing multinational enterprise. The company oper- with marketing, ibm.com and local Business Partner resources. ates in 170 countries, with approximately 69 percent of its employees The majority of IBM’s revenue, excluding the company’s original outside the U.S. As a globally integrated enterprise, the company equipment manufacturer (OEM) technology business, occurs in indus- organizes work based on the right costs, the right skills and the right tries that are broadly grouped into six sectors: business environment, integrating deeply with its partners, suppliers U Financial Services: Banking, Financial Markets, Insurance and clients. Being global is about gaining access to talent and skills and then scaling them globally to develop new, distinctive capabili- U Public: Education, Government, Healthcare, Life Sciences ties. The company’s integrated operations enable IBM to be the most U Industrial: Aerospace and Defense, Automotive, Chemical and Petroleum, efficient, responsive and globally integrated enterprise — able to Electronics instantly leverage its expertise and capabilities — anywhere, at any U Distribution: Consumer Products, Retail, Travel and Transportation time. Although bound by a common mission and principles, Integrated Operations is comprised of three distinct units, each with very specific U Communications: Telecommunications, Media and Entertainment, Energy objectives closely aligned with the IBM businesses they support. and Utilities U Small and Medium Business: Mainly companies with less than Integrated Supply Chain 1,000 employees Just as IBM works to transform its clients’ supply chains for greater efficiency and responsiveness to global market conditions, the com- pany continues to derive business value from its own globally integrated supply chain, reinvented as a strategic advantage for the company to create value for clients and shareholders. IBM leverages its supply-chain expertise for clients through its supply-chain business 21 transformation outsourcing service to optimize and help operate clients’ end-to-end supply-chain processes, from procurement to logistics.


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    Management Discussion International Business Machines Corporation and Subsidiary Companies IBM spends approximately $38 billion annually through its and solutions and effectively managing a skilled resource base. IBM supply chain, procuring materials and services around the world. continues to transform itself to take advantage of shifting demand The company’s supply, manufacturing and logistics and customer trends, focusing on client- and industry-specific solutions, business fulfillment operations are integrated in one operating unit that has performance and open standards. reduced inventories, improved response to marketplace opportuni- ties and external risks and converted fixed to variable costs. Simplifying INTERNAL BUSINESS TRANSFORMATION AND and streamlining internal processes has improved operations, sales GLOBAL INTEGRATION INITIATIVES force productivity and processes, and these actions have improved IBM is committed to its transformation to a globally integrated enter- client satisfaction. prise . The company continues to drive greater productivity, flexibility and cost savings by transforming and globally integrating its own Integrated Technology Delivery business processes and functions. In addition to eliminating redundan- Integrated Technology Delivery (ITD) brings together all of the com- cies and overhead structures to drive productivity, this integration has pany’s worldwide service delivery capabilities for Strategic Outsourcing improved IBM’s capacity to innovate by providing greater clarity of key with strong local and regional management teams supported by a set priorities around shared goals and objectives and led to a sharper focus of global competencies. ITD leverages the company’s global scale for the company on learning, development and knowledge sharing. and advanced technology to deliver standardized solutions that are automated, repeatable and globally integrated. Through the company’s INNOVATION INITIATIVES global position, clients gain cost advantages, access to industry- IBM invests to improve its ability to help its clients innovate. leading skills and access to IBM’s scale and overall flexibility. ITD Investment may occur in the research and development of new prod- manages the world’s largest privately-owned IT infrastructure with ucts and services, as well as in the establishment of new collaborative employees in over 30 countries supporting over 400 data centers. and cocreation relationships with developers, other companies and other institutions. Examples include IBM’s leadership positions in the Integrated Managed Business Process Delivery design of smaller, faster and energy-efficient semiconductor devices; Integrated Managed Business Process Delivery (IMBPD) provides systems virtualization, Green Data Centers and the design of “grid” highly efficient, world-class delivery capabilities in IBM’s business computing networks that allow computers to share processing power. process delivery operations, which include Business Transformation Outsourcing, Business Process Outsourcing, Business Process Services OPEN STANDARDS and Application on Demand. IMBPD has employees and delivery The broad adoption of open standards is essential to the computing centers in over 40 countries worldwide. model for an on demand business and is a significant driver of col- laborative innovation across all industries. Without interoperability Key Business Drivers among all manner of computing platforms, the integration of any The following are some of the key drivers of the company’s business. client’s internal systems, applications and processes remains a monu- mental and expensive task. The broad-based acceptance of open ECONOMIC ENVIRONMENT AND CORPORATE standards — rather than closed, proprietary architectures — also SPENDING BUDGETS allows the computing infrastructure to more easily absorb (and thus Global demand for systems, software and services is a key driver of benefit from) new technical innovations. IBM’s support of open stan- the company’s business and financial performance. IBM’s diverse set dards is evidenced by the enabling of its products to support open of products and offerings is designed to provide more consistent standards such as Linux, and the development of Rational software results in both strong and weak economic environments. The com- development tools, which can be used to develop and upgrade other pany accomplishes this by not only having a mix of offerings with companies’ software products. long-term cash and income streams, as well as cyclical transaction- based sales, but also by continually developing competitive products INVESTING IN GROWTH OPPORTUNITIES The company is continuing to refocus its business on the higher value segments of enterprise computing — providing technology and trans- 22 formation services to clients’ businesses. Consistent with that focus, the company continues to significantly invest in growth opportunities as a way to drive revenue growth and market share gains. Areas of Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 investment include strategic acquisitions, primarily in software and Forward-Looking and Global Financing ..............................................50 services, focused client- and industry-specific solutions, maintaining Cautionary Statements .....................................15 Report of Management ....................................56 technology leadership and emerging growth countries worldwide. Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ............................. 17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 25

    Management Discussion International Business Machines Corporation and Subsidiary Companies Year in Review Results of Continuing Operations SEGMENT DETAILS The following is an analysis of the 2007 versus 2006 reportable segment results. The analysis of 2006 versus 2005 reportable segment results is on pages 39 to 41. The following table presents each reportable segment’s external revenue and gross margin results. ($ in millions) YR.-TO-YR. YR.-TO-YR. PERCENT/ PERCENT CHANGE MARGIN ADJUSTED FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE FOR CURRENCY Revenue: Global Technology Services $36,103 $32,322 11.7% 7.4% Gross margin 29.9% 29.8% 0.1 pts. Global Business Services 18,041 15,969 13.0% 9.0% Gross margin 23.5% 23.1% 0.4 pts. Systems and Technology 21,317 21,970 (3.0)% (5.8)% Gross margin 39.7% 37.7% 2.0 pts. Software 19,982 18,161 10.0% 5.6% Gross margin 85.2% 85.2% (0.0) pts. Global Financing 2,502 2,365 5.8% 2.2% Gross margin 46.7% 50.3% (3.5) pts. Other 842 637 32.1% 29.5% Gross margin 4.4% 5.7% (1.4) pts. Total revenue $98,786 $91,424 8.1% 4.2% Gross profit $41,729 $38,295 9.0% Gross margin 42.2% 41.9% 0.4 pts. The following table presents each reportable segment’s external revenue as a percentage of total segment revenue and each reportable segment’s pre-tax income as a percentage of total segment pre-tax income. REVENUE PRE-TAX INCOME* FOR THE YEAR ENDED DECEMBER 31: 2007 2006 2007 2006 Global Technology Services 36.9% 35.6% 23.5% 24.0% Global Business Services 18.4 17.6 13.6 12.5 Total Global Services 55.3 53.2 37.1 36.5 Systems and Technology 21.8 24.2 14.2 12.7 Global Financing 2.6 2.6 9.1 10.6 Total Systems and Technology/Financing 24.3 26.8 23.3 23.3 Software 20.4 20.0 39.6 40.1 Total 100.0% 100.0% 100.0% 100.0% * Segment pre-tax income includes transactions between segments that are intended to reflect an arm’s-length transfer price. 23


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Global Services acquisition of Internet Security Systems (ISS), in the fourth quarter The company’s Global Services segments, Global Technology of 2006, also contributed to the revenue growth this year. ITS sign- Services and Global Business Services had a combined revenue of ings increased 4 percent in 2007, with good performance in the key $54,144 million, an increase of 12.1 percent (8 percent adjusted for offerings, including Green Data Center, Server Management Services currency) in 2007 when compared to 2006. The Global Services seg- and SOA. ments delivered combined pre-tax profit of $5,622 million, an Business Transformation Outsourcing (BTO) revenue increased increase of 12.6 percent versus the prior year. The company has 24.4 percent (20 percent adjusted for currency), with double-digit made considerable progress implementing its strategies across the growth in all geographies. BTO signings increased 17 percent year Global Services offerings. These actions have resulted in improved over year. financial performance with strong and balanced contribution across Maintenance revenue increased 11.4 percent (7 percent adjusted all geographies and business lines. for currency) driven primarily by increased availability services on non-IBM IT equipment. Services provided to InfoPrint Solutions, ($ in millions) following the divestiture of the printer business in the second quar- YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE ter, contributed 4 points of growth. Global Business Services (GBS) revenue increased 13.0 percent Global Services revenue: $54,144 $48,291 12.1% (9 percent adjusted for currency) in 2007, with balanced growth across Global Technology Services $36,103 $32,322 11.7% all three geographies. Revenue performance was led by double-digit Strategic Outsourcing 18,701 17,044 9.7 growth in application management services offerings and growth in Integrated Technology Services 8,438 7,448 13.3 all consulting service lines. Total signings in GBS increased 1 percent, Business Transformation led by 5 percent growth in shorter term signings. Longer term sign- Outsourcing 2,294 1,845 24.4 ings decreased 7 percent year over year. Maintenance 6,670 5,986 11.4 Global Business Services $18,041 $15,969 13.0% ($ in millions) YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE Global Technology Services (GTS) revenue increased 11.7 percent Global Services gross profit: (7 percent adjusted for currency) in 2007 versus 2006. The strong Global Technology Services: performance reflects the extensive transformation which has occurred Gross profit $10,800 $9,623 12.2% in this business over the past few years. This transformation included Gross profit margin 29.9% 29.8% 0.1 pts. revamping the entire Integrated Technology Services (ITS) portfolio, Global Business Services: continued improvement in Strategic Outsourcing (SO) delivery and Gross profit $ 4,240 $3,694 14.8% a disciplined approach to driving new business in existing accounts. Gross profit margin 23.5% 23.1% 0.4 pts. Total signings in GTS increased 2 percent, with shorter term signings growth of 4 percent and 1 percent growth in longer term signings. GTS gross profit increased 12.2 percent compared to 2006, with SO revenue was up 9.7 percent (5 percent adjusted for currency) gross profit margin improving 0.1 points, driven primarily by margin with growth in all geographies, led by Europe/Middle East/Africa expansion in SO due to an improved cost structure and ITS, which (EMEA) and Asia Pacific. Revenue growth benefited from prior-year benefited from a mix to higher value offerings. Segment pre-tax signings, sales of new business in existing accounts, lower base con- profit increased 8.2 percent to $3.6 billion with a pre-tax margin of tract erosion and good yield from 2007 signings. SO signings in 2007 9.4 percent, a decline of 0.2 points versus 2006. Increased invest- decreased 1 percent when compared to 2006. ments in sales and delivery, acquisitions and restructuring charges ITS revenue increased 13.3 percent (9 percent adjusted for cur- were essentially offset by productivity improvements and effective rency) in 2007 versus 2006. Revenue growth was driven primarily by expense management. increased signings and reflects the strength of the ITS portfolio Transformation actions executed by GBS over the past two years worldwide. The revamped ITS portfolio includes 10 Service Product have resulted in profitable growth. GBS gross profit increased 14.8 Lines which complement hardware offerings from Systems and percent to $4.2 billion in 2007 when compared to 2006, and the gross Technology and software offerings from the Software business. The profit margin improved 0.4 points. Segment pre-tax profit increased 24 21.0 percent to $2.1 billion with a pre-tax margin of 10.7 percent, an improvement of 0.9 points year over year. The margin expansion has been driven primarily by revenue growth, ongoing productivity and Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 utilization initiatives and expense management. Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Global Services Signings Signings include SO, BTO, ITS and GBS contracts. Contract In 2007, total Global Services signings increased 1 percent year to extensions and increases in scope are treated as signings only to the year to $49,895 million. Shorter term signings were $22,014 million, extent of the incremental new value. Maintenance is not included in an increase of 5 percent year to year. Longer term signings decreased signings as maintenance contracts tend to be more steady state, 1 percent to $27,880 million, however, the average duration of longer where revenues equal renewals. term contracts signed in 2007 was 1.1 years shorter than contracts Backlog includes SO, BTO, ITS, GBS, and Maintenance. Backlog signed in 2006. Therefore, while longer term signings were essen- is intended to be a statement of overall work under contract and tially flat year to year, the annualized revenue expected from these therefore does include Maintenance. Backlog estimates are subject to signings is higher versus the prior year. GTS signings were $30,154 change and are affected by several factors, including terminations, million and GBS signings were $19,741 million in 2007. The total changes in the scope of contracts, periodic revalidations, adjustments Global Services backlog increased $2 billion from the prior year to for revenue not materialized and currency assumptions used to an estimated $118 billion. approximate constant currency. Contract portfolios purchased in an acquisition are treated as posi- ($ in millions) tive backlog adjustments provided those contracts meet the company’s FOR THE YEAR ENDED DECEMBER 31: 2007 2006 requirements for initial signings. A new signing will be recognized if Global Technology Services Signings a new services agreement is signed incidental or coincidental to an Longer term $21,550 $21,337 acquisition or divestiture. Shorter term 8,604 8,271 Total $30,154 $29,608 Systems and Technology Global Business Services Signings ($ in millions) Longer term $ 6,330 $ 6,838 YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE Shorter term 13,411 12,727 Systems and Technology revenue: $21,317 $21,970 (3.0)% Total $19,741 $19,565 System z (11.2) System i (10.6) Global Services signings are management’s initial estimate of the System p 8.8 value of a client’s commitment under a Global Services contract. System x 7.0 Signings are used by management to assess period performance of System Storage 5.1 Global Services management. There are no third-party standards or Microelectronics (11.8) requirements governing the calculation of signings. The calculation Engineering and used by management is an approximation of constant currency and Technology Services 6.5 involves estimates and judgments to gauge the extent of a client’s Retail Store Solutions 14.5 commitment, including the type and duration of the agreement, and Printing Systems (63.1) the presence of termination charges or wind-down costs. For example, for longer term contracts that require significant up-front investment Systems and Technology revenue decreased 3.0 percent (6 percent by the company, the portions of these contracts that are a signing are adjusted for currency) in 2007 versus 2006. On June 1, 2007, the those periods in which there is a significant economic impact on the company completed the divestiture of its printing business to Ricoh. client if the commitment is not achieved, usually through a termina- This resulted in the loss of approximately $600 million of Systems tion charge or the client incurring significant wind-down costs as a and Technology revenue in 2007 when compared to 2006. See note result of the termination. For shorter term contracts that do not C, “Acquisitions/Divestitures,” on pages 80 and 81 for additional require significant upfront investments, a signing is usually equal to information regarding this divestiture. Systems and Technology rev- the full contract value. Longer term contracts represent SO and enue, excluding the printing business, was flat (declined 3 percent BTO contracts as well as GBS contracts with the U.S. Federal gov- adjusted for currency) in 2007 versus 2006. ernment and its agencies and Application Management Services (AMS) for custom and legacy applications. Shorter term contracts represent the remaining GBS offerings of Consulting and Systems 25 Integration, AMS for packaged applications and ITS contracts. These amounts have been adjusted to exclude the impact of year-to- year currency changes.


  • Page 28

    Management Discussion International Business Machines Corporation and Subsidiary Companies System z revenue decreased 11.2 percent (15 percent adjusted for Retail Store Solutions revenue increased 14.5 percent (11 percent currency) year to year. System z MIPS (millions of instructions per adjusted for currency) in 2007 versus 2006, primarily due to the second) shipments increased 3 percent in 2007 versus 2006. System z continued roll out of new programmable point-of-sale solutions to revenue declined in the second half of 2007 following a long and large retail clients. successful technology cycle of over two-and-a-half years. The expected Printing Systems revenue decreased as a result of the divestiture announcement and availability of the next generation mainframe is of the business. The 2007 results include five months of revenue late February 2008. while the 2006 results include 12 months of revenue. System i revenue decreased 10.6 percent (14 percent adjusted for ($ in millions) currency) in 2007 versus 2006. Although System i revenue declined YR.-TO-YR. year over year, fourth-quarter 2007 revenue increased 2 percent with FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE growth in POWER6 servers which were introduced late in the third Systems and Technology gross profit: quarter of 2007. Gross profit $8,468 $8,284 2.2% System p revenue increased 8.8 percent (5 percent adjusted for Gross profit margin 39.7% 37.7% 2.0 pts. currency) in 2007 versus 2006. The increase was primarily driven by strength in mid-range POWER5+ and POWER6 servers, which The increase in Systems and Technology gross profit dollars for 2007 increased 23 percent in 2007 versus the prior year. System p revenue versus 2006 was primarily due to higher gross profit margins in System increased in all geographies, with particular strength in Asia Pacific. z, System p and System x servers. The Systems and Technology gross In the first quarter of 2008, the company will announce and ship profit margin increased 2.0 points to 39.7 percent in 2007. System p POWER6 technology in System p’s entry segment. performance contributed 1.3 points to the overall margin improve- System x revenue increased 7.0 percent (3 percent adjusted for ment, while System z and System x contributed 0.7 points and 0.4 currency) in 2007 versus 2006. Revenue performance was driven by points, respectively. These increases were partially offset by lower gross System x server products which grew 8 percent and System x blades margins in System i of 0.2 points and System Storage 0.2 points. which increased 16 percent in 2007 versus 2006. The new x86 servers Systems and Technology pre-tax margin expanded 2.1 points to with quad-core processors and BladeCenter-S for the Small and 9.6 percent in 2007, reflecting a strong combination of operational Medium Business sector shipped in the fourth quarter and were well cost management and the value that virtualization is driving in the received in the marketplace. enterprise space. System Storage revenue increased 5.1 percent (2 percent adjusted for currency) in 2007 versus 2006. The increase was primarily driven Software by 13 percent growth in tape products, while external disk products ($ in millions) increased 1 percent in 2007. Enterprise tape products had strong YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006* CHANGE double-digit revenue growth, while Midrange tape products had mid single-digit revenue growth. The company completed the acquisition Software revenue: $19,982 $18,161 10.0% of XIV in late December, which will further strengthen its storage Middleware $15,505 $13,891 11.6% portfolio in the long term. This acquisition positions the company to Key Branded Middleware 10,827 9,373 15.5 grow in emerging opportunities like Web 2.0 applications, digital WebSphere Family 19.1 archives and digital media. Information Management 14.7 Microelectronics revenue decreased 11.8 percent in 2007 versus Lotus 8.7 2006, driven by reduced demand for game processors. The Micro- Tivoli 18.0 electronics OEM business has minimal impact to the company’s Rational 13.7 overall Net income, but this business continues to deliver key tech- Other middleware 4,678 4,518 3.5 nology to the systems business, which is the fundamental objective of Operating Systems 2,319 2,273 2.0 the company’s investment. Product Lifecycle Management 1,051 1,123 (6.4) Other 1,107 874 26.7 * Reclassified to conform with 2007 presentation. 26 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Software segment revenue of $19,982 million increased 10.0 percent Rational revenue increased 13.7 percent (9 percent adjusted for (6 percent adjusted for currency) in 2007 reflecting strong demand currency) in 2007 which reflected strong customer acceptance of the for the Key Branded Middleware products. Revenue performance was integrated product set. Rational provides integrated tools to improve led by double-digit growth in the Financial Services, Public and Small the software development process for clients. The closing of the and Medium Business sectors. Clients are using IBM middleware to Telelogic acquisition is conditioned upon satisfactory completion of effectively improve their operating leverage and business efficiency. regulatory reviews in the European Union. Telelogic’s suite of system Revenue from Key Branded Middleware, which includes programming tools complements Rational’s IT tool set, providing a WebSphere, Information Management, Lotus, Tivoli and Rational complete tooling solution across a client’s enterprise. products, was $10.8 billion, up 15.5 percent (11 percent adjusted for Revenue from Other middleware products increased 3.5 percent currency) and increased 3 points to 54 percent of total Software seg- (flat adjusted for currency) in 2007 versus the prior year. This soft- ment revenue. The company has invested heavily in these products, ware product set includes more mature products which provide a through internal investments and targeted acquisitions, and expects more stable flow of revenue. the majority of its software revenue growth to come from this por- Operating Systems revenue increased 2.0 percent (decreased 2 per- tion of the product portfolio. cent adjusted for currency) in 2007 versus 2006. Revenue from the WebSphere Family of products increased 19.1 Product Lifecycle Management (PLM) revenue decreased 6.4 percent (14 percent adjusted for currency) and was led by double- percent (11 percent adjusted for currency) in 2007 driven by declines digit growth in WebSphere Application Servers and WebSphere in the Small and Medium Business sector. PLM software helps com- Business Integration software. The strong revenue performance panies improve their product development processes and their ability reflects the industry’s adoption of SOA. The WebSphere products to use product-related information across their businesses. provide the foundation for Web-enabled applications and are a key Other software segment revenue increased 26.7 percent (22 percent product set in deploying a client’s SOA. adjusted for currency) versus 2006 reflecting growth in software-related Information Management revenue increased 14.7 percent (10 per- services, such as consulting and education. cent adjusted for currency) in 2007 versus the prior year. Information ($ in millions) Management software enables clients to leverage Information on YR.-TO-YR. Demand. The acquisition of FileNet, in the fourth quarter of 2006, FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE contributed strong revenue growth throughout the year. The Cognos Software gross profit: acquisition, completed in the first quarter of 2008, will provide a Gross profit $17,015 $15,471 10.0% strong entry in the Business Intelligence marketplace and is expected Gross profit margin 85.2% 85.2% 0.0 pts. to provide synergies in software, services, servers and storage. Lotus revenue increased 8.7 percent (4 percent adjusted for cur- Software segment gross profit increased 10.0 percent to $17.0 billion rency) in 2007 driven by the Notes/Domino family of products. in 2007, driven primarily by strong revenue growth. Gross profit Lotus software is well established as a tool for providing improved margin was 85.2 percent in 2007, flat versus the prior year. workplace collaboration and productivity. Lotus Connections, The Software segment contributed $6.0 billion of pre-tax profit released in the second quarter, has been rapidly adapted by customers. in 2007, an increase of 9.3 percent versus 2006. The segment pre-tax The latest version of Lotus Notes, Lotus Notes 8.0, was delivered in profit margin of 26.8 percent was essentially flat (declined 0.1 pt) ver- the third quarter of 2007. sus the prior year, reflecting the integration of acquired businesses. Revenue from Tivoli software, infrastructure software that enables clients to centrally manage networks including security and storage Global Financing capability, increased 18.0 percent (13 percent adjusted for currency) See page 51 for an analysis of Global Financing’s revenue and gross with double-digit growth in each segment of the portfolio, Systems profit. Management, Security and Storage. The acquisitions of MRO, in the fourth quarter of 2006, and Vallent and Consul, in the first quarter Geographic Revenue of 2007, also contributed to the brand’s revenue growth. In addition to the revenue presentation by reportable segment, the company also measures revenue performance on a geographic basis. 27


  • Page 30

    Management Discussion International Business Machines Corporation and Subsidiary Companies The following geographic, regional and country-specific revenue performance excludes OEM revenue, which is presented separately. ($ in millions) YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE Geographies: Americas $41,122 $39,511 4.1% EMEA 34,699 30,491 13.8 Asia Pacific 19,501 17,566 11.0 OEM 3,465 3,856 (10.1) Total $98,786 $91,424 8.1% From a geographic perspective, revenue increased in all geographies Across the geographies, the emerging BRIC countries of Brazil, in 2007 when compared to 2006. Adjusted for currency, revenue Russia, India, and China together grew 26.3 percent (18 percent growth was led by Asia Pacific and steady performance throughout adjusted for currency), reflecting the investments made to build capa- the year in EMEA. bilities and capture opportunities in these countries. Brazil’s revenue Americas’ revenue increased 4.1 percent (3 percent adjusted for increased 14.3 percent (1 percent adjusted for currency), while currency) in 2007. Revenue increased in all regions with the U.S. up Russia’s revenue grew 30.3 percent (30 percent adjusted for cur- 2.9 percent, Canada 8.4 percent (2 percent adjusted for currency) and rency). India’s revenue increased 37.9 percent (26 percent adjusted Latin America 8.6 percent (2 percent adjusted for currency). for currency) and China’s revenue increased 32.5 percent (29 percent EMEA revenue increased 13.8 percent (5 percent adjusted for adjusted for currency). In addition to the BRIC markets, the company currency) in 2007 when compared to 2006. Within the European has also had strong revenue growth in other nations where there is market, IT spending grew at a moderate rate, and the company’s strong demand for business and IT infrastructure solutions. mid single-digit revenue growth rates throughout 2007 reflected Revenue growth rates, as reported, were impacted in 2007 as a that environment. In the major countries, Spain’s revenue grew 21.7 result of the divestiture of the printing business on June 1, 2007. percent (11 percent adjusted for currency), while Germany’s revenue Revenue, excluding the printing business in both years, increased as increased 14.6 percent (5 percent adjusted for currency) and the follows compared to 2006: U.K.’s revenue increased 11.3 percent (3 percent adjusted for cur- rency). France’s revenue increased 10.2 percent (1 percent adjusted U Americas — 5.2% for currency) and Italy’s revenue grew 8.7 percent (decreased 1 percent U EMEA — 14.5% adjusted for currency). U Asia Pacific — 11.8% Asia Pacific revenue increased 11.0 percent (8 percent adjusted for currency) year over year. Growth was led by strong performance U IBM Consolidated — 8.9% in the India, Greater China, Australia/New Zealand, ASEAN and The company believes that the analysis that excludes the printing Korea regions, where the economies remain strong, with combined business revenues is a better indicator of operational performance on revenue growth of 23.8 percent (17 percent adjusted for currency). an ongoing basis. Japan revenue, which represents 49 percent of the Asia Pacific reve- OEM revenue decreased 10.1 percent (10 percent adjusted for nue base, was flat (increased 1 percent adjusted for currency) in 2007 currency) in 2007 when compared to 2006, driven by a slowdown in when compared to 2006, reflecting a slower economy. demand for game processors. 28 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 31

    Management Discussion International Business Machines Corporation and Subsidiary Companies Total Expense and Other Income Global Services revenue. In addition, Bad debt expense increased ($ in millions) $113 million primarily due to an increase in the provision for doubt- YR.-TO-YR. ful accounts. The reserve coverage for receivables at year end was FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE 1.5 percent, essentially flat versus year-end 2006. Workforce reduc- Total expense and other income $27,240 $24,978 9.1% tions — ongoing increased as a result of actions taken to address cost Expense to Revenue 27.6% 27.3% 0.3 pts. issues in GTS, primarily in SO, during the second quarter of 2007. Total expense and other income increased 9.1 percent (5 percent Other (Income) and Expense adjusted for currency) in 2007 versus 2006. Overall, the increase was ($ in millions) primarily due to increased Selling, general and administrative YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006* CHANGE (SG&A) expense and Interest expense. SG&A expense increased $1,801 million primarily due to acquisition related spending, as well Foreign currency as increased investments in emerging countries and the software and transaction gains $(143) $(130) 10.1% services businesses. Interest expense increased $333 million primarily Losses on derivative instruments 382 135 183.5 Interest income (565) (536) 5.3 due to higher debt associated with the financing of the ASR agree- Net gains from securities ments. In addition, Other (income) and expense declined $140 million and investments assets (68) (40) 68.5 in income primarily due to higher losses on derivative instruments. Net realized gains from The expense-to-revenue ratio increased 0.3 points to 27.6 percent in certain real estate activities (18) (41) (56.0) 2007, as revenue increased 8.1 percent and expense increased 9.1 Other (214) (154) 39.3 percent in 2007 versus 2006. For additional information regarding Total $(626) $(766) (18.3)% the increase in Total expense and other income, see the following analyses by category: * Reclassified to conform with 2007 presentation deleting 2006 categories for Restructuring $(7) million and $(45) million for Lenovo/Microsoft gains and combining these items in the Other category for both years. Selling, General and Administrative ($ in millions) Other (income) and expense was income of $626 million and $766 YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006* CHANGE million in 2007 and 2006, respectively. The decrease in income was Selling, general and primarily due to higher losses on derivative instruments. The com- administrative — base $19,078 $17,457 9.3% pany hedges its major cross-border cash flows to mitigate the effect Advertising and promotional expense 1,242 1,195 3.9 of currency volatility in the year-over-year results. The impact of Workforce reductions — ongoing 318 272 16.6 these hedging programs is primarily reflected in Other (income) and Amortization expense — expense, as well as cost of goods sold. This year, losses from deriva- acquired intangibles 234 220 6.7 tives, as a result of currency movements, resulted in $247 million of Retirement-related expense 607 587 3.5 year-to-year impact to Other (income) and expense. This decrease in Stock-based compensation 480 541 (11.3) income was partially offset by a gain from the divestiture of the printing Bad debt expense 100 (13) NM business in the second quarter and sales of Lenovo stock in the first Total $22,060 $20,259 8.9% and second quarters of 2007 (see note C, “Acquisitions/Divestitures,” on pages 80 and 81 for additional information). * Reclassified to conform with 2007 presentation as the Restructuring category ($33 million in 2007 and $15 million in 2006) was combined into the SG&A — base category. NM — Not meaningful Research, Development and Engineering ($ in millions) YR.-TO-YR. Total SG&A expense increased 8.9 percent (6 percent adjusted for FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE currency). The increase was primarily driven by acquisition-related Research, development spending (3 points), the effects of currency (3 points) and investments and engineering: in the software and services businesses, as well as emerging markets. Total $6,153 $6,107 0.8% These investments reflect the continuing business mix shift to higher 29 value offerings which require higher operating expenses. The returns on these investments are reflected in the momentum in Key Branded Middleware offerings, growth in emerging markets and improved


  • Page 32

    Management Discussion International Business Machines Corporation and Subsidiary Companies The increase in Research, development and engineering (RD&E) Stock-Based Compensation expense was primarily driven by acquisitions and investments to Total pre-tax stock-based compensation cost of $713 million decreased maintain technology leadership across the product offerings. Soft- $134 million compared to 2006. The decrease was principally the ware spending increased $339 million partially offset by lower result of a reduction in the level of stock option grants ($159 million), Systems and Technology spending of $204 million in 2007 versus offset by an increase related to restricted and performance-based 2006. Retirement-related expense increased $13 million in 2007 stock units ($25 million). The effects of stock-based compensation versus 2006, while stock-based compensation expense decreased $21 cost related to the divestiture of the printing business (a decrease of million year over year. $1 million) were included in Other (income) and expense in the Consolidated Statement of Earnings. The year-to-year reductions in Intellectual Property and Custom Development Income pre-tax stock-based compensation cost were reflected in the following ($ in millions) categories: Cost ($50 million); SG&A expense ($61 million); RD&E YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE expense ($21 million) and Other (income) and expense ($1 million). There was no significant capitalized stock-based compensation Sales and other transfers of intellectual property $138 $167 (17.7)% cost at December 31, 2007 and 2006. Licensing/royalty-based fees 368 352 4.6 See note T, “Stock-Based Compensation,” on pages 102 to 105 Custom development income 452 381 18.8 for additional information on the company’s stock-based incentive awards. Total $958 $900 6.4% Retirement-Related Benefits The timing and amount of Sales and other transfers of IP may vary The following table provides the total pre-tax cost for all retirement- significantly from period to period depending upon timing of dives- related plans. Cost amounts are included as an addition to the cost titures, industry consolidation, economic conditions and the timing and expense amounts in the Consolidated Statement of Earnings of new patents and know-how development. There were no significant within the caption (e.g., Cost, SG&A, RD&E) relating to the job IP transactions in 2007 and 2006. function of the plan participants. Interest Expense ($ in millions) ($ in millions) YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 CHANGE Defined benefit and contribution Interest expense: pension plans cost $2,198 $2,040 7.7% Total $611 $278 119.6% Nonpension postretirement plans costs 399 388 2.8 The increase in Interest expense was primarily due to the increase in Total $2,597 $2,428 7.0% debt to finance the ASR agreements. See note M, “Stockholders’ Equity,” on pages 92 and 93 for additional information regarding this Overall, retirement-related plan costs increased $169 million versus transaction. Interest expense is presented in Cost of Financing in the 2006. Consolidated Statement of Earnings only if the related external bor- The increase in retirement-related plan costs was driven primar- rowings are to support the Global Financing external business. See ily as a result of changes in retirement plan assumptions as well as the page 54 for additional information regarding Global Financing debt impact of changes in foreign currency. and interest expense. Retirement-related plan costs increased approximately $131 mil- lion in Cost, $21 million in SG&A expense, $13 million in RD&E expense and $5 million in Other (income) and expense year to year. See note U, “Retirement-Related Benefits,” on pages 105 to 116 for additional information on the company’s benefit plans including a description of the plans, plan financial information and assumptions. 30 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies Acquired Intangible Asset Amortization FOR THE YEAR ENDED DECEMBER 31: 2007 2006 YR.-TO-YR. CHANGE The company has been investing in targeted acquisitions primarily in Earnings per share of common stock: its Software and Global Services segments to increase its capabilities Assuming dilution: in higher value market segments. The following table presents the Continuing operations $ 7.18 $6.06 18.5% total acquired intangible asset amortization included in the Consol- Discontinued operations (0.00) 0.05 NM idated Statement of Earnings. See note I, “Intangible Assets Including Total $ 7.18 $6.11 17.5% Goodwill,” on pages 84 and 85 for additional information. Basic: ($ in millions) Continuing operations $ 7.32 $6.15 19.0% YR.-TO-YR. Discontinued operations (0.00) 0.05 NM FOR THE YEAR ENDED DECEMBER 31: 2007 2006* CHANGE Total $ 7.32 $6.20 18.1% Cost: Software $ 91 $ 81 12.6% Weighted-average shares Services 42 12 252.7 outstanding (in millions): Hardware — 3 NM Assuming dilution 1,450.6 1,553.5 (6.6)% Selling, general and Basic 1,423.0 1,530.8 (7.0)% administrative expense 234 220 6.7 NM — Not meaningful Total $367 $316 16.3% Actual shares outstanding at December 31, 2007 and December 31, * Reclassified to conform with 2007 presentation of Services and Selling, general and administrative expense categories. 2006 were 1,385.2 million and 1,506.5 million, respectively. The NM — Not meaningful average number of common shares outstanding assuming dilution was 103.0 million shares lower in 2007 versus 2006. The decrease was Income Taxes primarily the result of the company’s common share repurchase pro- gram. See note M, “Stockholders’ Equity Activity,” on pages 92 and The effective tax rate for 2007 was 28.1 percent, compared with 29.3 93 for additional information regarding common share activities. Also percent in 2006. The 1.2 point decrease was primarily driven by the see note R, “Earnings Per Share of Common Stock,” on page 101. absence of the one-time tax cost associated with the intercompany transfer of certain intellectual property in the fourth quarter of 2006 FINANCIAL POSITION (4.3 points) and the absence of the benefit from the settlement of the U.S. federal income tax audit for the years 2001 through 2003, also in Dynamics the fourth quarter of 2006 (3.0 points). The company also benefited The assets and debt associated with the Global Financing business in 2007 from a more favorable mix of income in lower tax rate juris- are a significant part of the company’s financial position. The finan- dictions and increased capital loss and state credit benefits, offset by a cial position amounts appearing below and on pages 32 to 35 are the reduction in certain tax incentives. consolidated amounts including Global Financing. The amounts appearing in the separate Global Financing section are supplemen- Earnings Per Share tary data presented to facilitate an understanding of the Global Basic earnings per share is computed on the basis of the weighted- Financing business. average number of shares of common stock outstanding during the In 2007, the company repurchased $18.8 billion of its outstanding period. Diluted earnings per share is computed on the basis of the common stock, of which $12.5 billion was the initial purchase price weighted-average number of shares of common stock plus the effect of the shares repurchased through ASR agreements. Under the of dilutive potential common shares outstanding during the period agreements, which were executed on May 25, 2007, the company using the treasury stock method. Dilutive potential common shares repurchased 118.8 million shares from three banks for an initial price include outstanding stock options, stock awards, convertible notes of $105.18 per share. The banks were expected to purchase an and shares which may be required to settle ASR agreements. equivalent number of shares in the open market in the nine month period following May 25, 2007. As discussed in note M, “Stockholders’ Equity Activity,” on pages 92 and 93, the initial price of the ASR is 31


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    Management Discussion International Business Machines Corporation and Subsidiary Companies subject to an adjustment based on the volume weighted average price In addition, Stockholders’ equity improved $4.7 billion as a result of the shares during this period and this adjustment will be recorded of changes from pension remeasurements and current year activity in Stockholders’ equity in the Consolidated Statement of Financial within Accumulated gains and (losses) not affecting retained earn- Position on each of the settlement dates. The first settlement ings. See note U, “Retirement-Related Benefits,” on pages 105 to occurred on September 6, 2007, resulting in a settlement payment by 116 for additional information. the company of $151.8 million; the second settlement occurred on December 5, 2007, resulting in a settlement payment by the com- Working Capital pany of $253.1 million. The final settlement is expected to occur in ($ in millions) March 2008. AT DECEMBER 31: 2007 2006 The ASR transaction was guaranteed by the company and was Current assets $53,177 $44,660 executed through IBM International Group (IIG), a wholly owned Current liabilities 44,310 40,091 foreign subsidiary of the company. The formation of IIG enabled the Working capital $ 8,867 $ 4,569 company to create a centralized foreign holding subsidiary to own Current ratio 1.20 1.11 most of its non-U.S. operations. IIG funded the repurchases with $1 billion in cash and an $11.5 billion, 364-day bridge loan with a num- ber of financial institutions. The bridge loan was guaranteed by the Working capital increased $4,298 million compared to the prior year company and carries an interest rate of the LIBOR plus 10 basis primarily as a result of a net increase in Current assets. The key driv- points. Principal and interest on IIG debt will be paid by IIG with ers are described below: cash generated by its non-U.S. operating subsidiaries. The execution Current assets increased $8,517 million due to: of the ASR enabled the company to achieve a substantial share reduc- U An increase of $5,490 million in Cash and cash equivalents and Marketable tion, a lower cost of capital and an effective use of non-U.S. cash. securities including a $299 million currency impact. See Cash Flow In the second half of 2007, IBM International Group Capital analysis on page 33. LLC (IIGC), an indirect, wholly owned subsidiary of the company, issued $4.1 billion in long-term debt and $2.8 billion in commercial U An increase of $1,941 million in short-term receivables driven by: paper. These proceeds were utilized to refinance the bridge loan — increase of $460 million in financing receivables due to asset growth associated with the ASR. In addition, approximately $750 million of in commercial financing and client loans; and the original amount has been repaid. At December 31, 2007, the — approximately $1,325 million currency impact. outstanding balance of the bridge loan was $3.9 billion. In addition, on January 29, 2008, IIGC issued $3.5 billion of U An increase of $1,351 million in Prepaid expenses and other current assets 18-month floating rate notes. The proceeds will be utilized to further primarily resulting from: reduce the bridge loan associated with the ASR. Consistent with retirement and postretirement plan accounting — an increase of $335 million in derivative assets primarily due to standards, the company remeasures the funded status of its plans at changes in foreign currency rates for certain cash flow hedges; December 31. The funded status is measured as the difference between — an increase of $164 million due to prepaid software for services contracts the fair value of the plan assets and the benefit obligation. The funded ($94 million) and maintenance agreements ($70 million); status is recognized in the Consolidated Statement of Financial Posi- — an increase of $170 million in prepaid taxes; tion. (See note A, “Significant Accounting Policies,” on pages 69 and 70 for additional information). At December 31, 2007, as a result of — an increase of $128 million in deferred services arrangements transi- the company’s plan contributions, returns on plan assets and changes tion costs; and in certain retirement plan assumptions, the overall net funded status — approximately $158 million currency impact. improved $7.2 billion from December 31, 2006 to a net over-funded position of $3.3 billion. This change is primarily reflected in Prepaid Current liabilities increased $4,220 million as a result of: pension assets in the Consolidated Statement of financial position U An increase of $3,333 million in Short-term debt primarily driven by which increased $6.8 billion from the prior year-end balance. increases in commercial paper; 32 U An increase of $1,215 million in Deferred income mainly driven by Software ($502 million) and Global Technology Services ($543 million); Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies U An increase of $528 million in Other accrued liabilities primarily due to Net cash used in investing activities decreased $6,874 million on a an increase in derivative liabilities as a result of changes in foreign cur- year-to-year basis driven by: rency rates for hedges of net investment; partially offset by U The net impact of the purchases and sales of marketable securities and U A decrease of $997 million in Taxes payable primarily due to the adoption other investments resulted in an increase in cash of $4,006 million; of FASB Interpretation Number (FIN) 48, “Accounting for Uncertainty in Income Taxes” (FIN 48); consistent with the provisions of FIN 48, U A decrease of $2,790 million utilized for acquisitions (see note C, “Acquisi- $2,066 million of income tax liabilities on January 1, 2007 was reclas- tions/Divestitures,” on pages 76 to 78 for additional information); and sified from current to noncurrent liabilities; this was offset by current U An increase of $310 million received from divestitures driven by the print- year income tax activity. ing business transaction; Cash Flow Partially offset by: The company’s cash flow from operating, investing and financing U An increase in net capital spending of $231 million resulting from: activities, as reflected in the Consolidated Statement of Cash Flows on page 60, is summarized in the following table. These amounts — an increase of $160 million primarily driven by Global Technology include the cash flows associated with the Global Financing business. Services to support the outsourcing business; and See pages 52 through 55. — an increase of $71 million in capitalized software development ($ in millions) expenditures. FOR THE YEAR ENDED DECEMBER 31: 2007 2006 Net cash used in financing activities decreased $3,464 million com- Net cash provided by/(used in) pared to 2006 as a result of: continuing operations: Operating activities $16,094 $ 15,019 U An increase of $12,233 million in net cash proceeds from debt transactions Investing activities (4,675) (11,549) primarily from issuances in support of the ASR; and Financing activities (4,740) (8,204) U An increase of $2,438 million due to higher other common stock transac- Effect of exchange rate changes on cash and cash equivalents 294 201 tions mainly due to stock option exercises; Net cash used in discontinued Partially offset by: operations — Operating activities (5) (12) Net change in cash and cash equivalents $ 6,969 $ (4,546) U Higher common stock repurchases of $10,744 million driven by the ASR; and Net cash from operating activities for 2007 increased $1,075 million U Higher dividend payments of $464 million as a result of the increase in as compared to 2006 driven by the following key factors: the common stock dividend from $1.10 to $1.50 per share. U An increase in Net income of $925 million; Within total debt, on a net basis, the company had $12,112 million U A decrease in cash related to deferred income taxes of $984 million in net cash proceeds from new debt versus $121 million in net cash primarily due to the impact of pension activity; used in 2006 to retire debt. The net proceeds from new debt in 2007 was comprised of: $21,744 million of new debt issuances and $1,674 U Retirement-related cash flows increased $622 million primarily due to million in net short-term borrowings, partially offset by $11,306 mil- lower pension funding of $795 million year to year; lion in cash payments to settle debt. See note J, “Borrowings,” on U Growth in accounts receivable drove a use of cash of $896 million; this pages 85 to 88 for a listing of the company’s debt securities. was driven by Global Financing receivables ($1,045 million) as a result of asset growth; Noncurrent Assets and Liabilities ($ in millions) U Other assets/other liabilities drove an increase in cash of $1,587 million AT DECEMBER 31: 2007 2006 primarily resulting from: Noncurrent assets $67,254 $58,574 — an increase in cash from tax liabilities of $1,185 million mainly 33 Long-term debt $23,039 $13,780 driven by an increase in income tax provisions and reserves; and Noncurrent liabilities (excluding debt) $24,612 $20,857 — an increase in cash from deferred income of $398 million primarily due to prepayment of future services to be provided to Infoprint.


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    Management Discussion International Business Machines Corporation and Subsidiary Companies The increase in Noncurrent assets of $8,680 million compared to the Debt prior year-end balance was primarily driven by: The company’s funding requirements are continually monitored and strategies are executed to manage the overall asset and liability pro- U An increase of $6,788 million ($505 million due to currency) in Prepaid file. Additionally, the company maintains sufficient flexibility to access pension assets primarily resulting from an increase in overfunded pension global funding sources as needed. plans reflecting year-end remeasurements; ($ in millions) U An increase of $1,535 million ($526 million due to currency) in Long-term AT DECEMBER 31: 2007 2006 financing receivables mainly due to increased Global Financing volumes; Total company debt $35,274 $22,682 U An increase of $1,431 million ($347 million due to currency) in Goodwill Total Global Financing segment debt $24,532 $22,287 driven by acquisitions in 2007; and Debt to support external clients 21,072 18,990 U An increase of $642 million in Plant, rental machines and other property Debt to support internal clients 3,460 3,297 (net) effectively all due to currency effects. The Global Financing business provides funding predominantly for These increases were partially offset by: the company’s external client assets as well as for assets under con- tract by other IBM units. These assets, primarily for Global Services, U A decrease of $1,621 million in Investments and sundry assets primarily generate long-term, stable revenue streams similar to the Global resulting from: Financing asset portfolio. Based on their nature, these Global Services — a decrease of $2,367 million in noncurrent deferred tax assets pri- assets are leveraged with the balance of the Global Financing asset marily related to the pension remeasurements; base. The debt analysis above is further detailed in the Global — growth of $243 million in noncurrent deferred transition costs driven Financing section on page 54. by an increase in long-term services arrangements with clients; and Non-Global Financing debt increased $10,348 million and the debt-to-capital ratio at December 31, 2007 was 30.0 percent. Non- — $170 million due to increased investments in long-term marketable Global Financing debt increased versus 2006 primarily due to the securities. financing of the ASR agreements in the second quarter of 2007. The Long-term debt increased $9,259 million due to new borrowings in debt-to-capital ratio was 46.7 percent at June 30, 2007. A reduction 2007 primarily to finance the ASR agreements. See note M, “Stock- of $1,034 million in non-Global Financing debt and an increase of holders’ Equity Activity,” on pages 92 and 93 for detailed discussion. $11,554 million in equity has reduced the ratio from the half-year Other Noncurrent liabilities, excluding debt, increased $3,755 point. See note M, “Stockholders’ Equity Activity,” on pages 92 and million primarily driven by: 93 for detailed information. U An increase in noncurrent tax reserves of $2,107 million as a result of a Equity reclassification from current ($2,066 million) related to FIN 48 imple- ($ in millions) mentation and current year activity; AT DECEMBER 31: 2007 2006 U Growth of $558 million in noncurrent deferred income mainly driven by Stockholders’ equity: Global Technology Services; Total $28,470 $28,506 U An increase of $399 million in noncurrent deferred tax liabilities pri- marily due to pension remeasurement; and The company’s consolidated Stockholders’ equity decreased $36 mil- lion in 2007 as a result of several key factors: U An increase of $298 million in long-term derivative liabilities due to changes in foreign currency rates for hedge of net investments. U A decrease related to net stock transactions of $13,732 million, driven by common stock repurchases which resulted in an increase in Treasury stock in 2007. 34 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies This reduction was offset by: The company’s performance in the fourth quarter was driven by several factors: U An increase of $8,208 million in Retained earnings primarily driven by Net income of $10,418 million, partially offset by dividends ($2,147 mil- U The strength of the company’s global business model — led by strong lion); and performance in Asia Pacific and emerging country markets, plus contin- U An increase of $5,487 million in Accumulated gains and (losses) not ued solid performance in Europe; affecting retained earnings primarily resulting from the non-cash equity U Double-digit revenue growth in the Services and Software segments; and impacts related to an increase in overfunded pension plans reflecting year- U Margin expansion led by the Systems and Technology and Software segments. end remeasurements. Total revenue in the fourth quarter of $28.9 billion increased 9.9 Consolidated Fourth-Quarter Results percent as reported (4 percent adjusted for currency). Revenue growth ($ and shares in millions except per share amounts) was led by the Global Services and Software segments and, on a YR.-TO-YR. geographic basis, by Asia Pacific, EMEA and the emerging countries. PERCENT/ MARGIN The two services segments together had $14.9 billion of revenue FOR THE FOURTH QUARTER: 2007 2006 CHANGE in the fourth quarter, an increase of 16.5 percent (10 percent adjusted Revenue $28,866 $26,257 9.9%* for currency) year to year, with double-digit revenue growth across Gross profit margin 44.9% 44.6% 0.4 pts. all lines of business. Total signings for Global Services in the fourth Total expense and other income $ 7,481 $ 6,887 8.6% quarter were $15.4 billion, a decrease of 13 percent versus the fourth Total expense and other quarter of 2006. Longer term signings decreased 25 percent com- income-to-revenue ratio 25.9% 26.2% (0.3) pts. pared to a very strong fourth quarter in 2006. Shorter term signings Income from continuing increased 8 percent. GTS revenue increased 16.4 percent (10 percent operations before income taxes $ 5,489 $ 4,814 14.0% adjusted for currency), with double-digit growth across all business Provision for income taxes $ 1,537 $ 1,350 13.9% lines, geographies and sectors. GTS signings decreased 9 percent in Income from continuing operations $ 3,951 $ 3,464 14.1% the fourth quarter, with longer term signings decreasing 14 percent, Income from partially offset by a 6 percent increase in shorter term signings. SO discontinued operations $ 1 $ 76 NM revenue increased 14.5 percent, driven primarily by prior-year sign- Net income $ 3,952 $ 3,541 11.6% ings, the continued sales of new business in existing accounts and Net income margin 13.7% 13.5% 0.2 pts. Earnings per share of common stock: good yield from current-year signings. SO signings decreased 26 Assuming dilution: percent versus fourth-quarter 2006. ITS revenue increased 11.4 per- Continuing operations $ 2.80 $ 2.26 23.9% cent, with growth in all geographies, led by EMEA and Asia Pacific. Discontinued operations 0.00 0.05 NM ITS signings increased 6 percent versus fourth-quarter 2006, led by double-digit growth in the Americas. BTO revenue increased 56.5 Total $ 2.80 $ 2.31 21.2% percent with double-digit growth in all geographies and continued Weighted-average shares strength in the Daksh business, which increased over 40 percent year outstanding: to year. BTO signings increased 147 percent year to year. Maintenance Assuming dilution 1,412.9 1,532.5 (7.8)% revenue increased 16.2 percent and included services provided to * 4.2 percent adjusted for currency. InfoPrint Solutions, which contributed 7 points of growth in the NM — Not meaningful quarter. GTS gross profit in the quarter increased 17.2 percent, with gross profit margin improving 0.2 points, primarily driven by margin CONTINUING OPERATIONS expansion in SO and ITS. The GTS segment fourth-quarter pre-tax margin improved 0.9 points to 10.2 percent from fourth-quarter In the fourth quarter, the company increased Income from continuing 2006. The margin improvement was driven primarily by an improved operations by 14.1 percent ($487 million) to $4.0 billion versus the cost structure in SO, a mix to higher value products in ITS and good fourth quarter of 2006. Diluted earnings per share from continuing operations of $2.80 increased 23.9 percent versus the prior year. 35


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    Management Discussion International Business Machines Corporation and Subsidiary Companies expense management. GBS revenue increased 16.8 percent (10 percent operational cost management, a mix to higher end models within the adjusted for currency) with growth in all geographies and sectors. brands and the value of the new POWER6 products in the market. Revenue performance was led by growth in AMS offerings and Software segment revenue of $6.3 billion, increased 11.6 percent double-digit growth across all consulting service lines. GBS signings (6 percent adjusted for currency), reflecting strong execution in clos- decreased 20 percent, driven by a 48-percent decline in longer term ing transactions in the quarter and continued strong demand for the signings when compared to a very strong fourth quarter of 2006. Key Branded Middleware products. Revenue growth this quarter was Shorter term signings increased 9 percent to $3.9 billion for the primarily organic, as the company wrapped around prior year acqui- quarter, the highest level of shorter term signings achieved in any sitions. Revenue from Key Branded Middleware increased 15.4 percent quarter in this business. GBS gross profit increased 9.0 percent in the (9 percent adjusted for currency) and represented 58 percent of total quarter, with a gross margin decline of 1.7 points due to higher software revenue. Revenue from the WebSphere Family of products employee bonus compensation costs. The GBS segment contributed grew 22.8 percent in the quarter, with strong performance tied to the $0.6 billion of pre-tax profit in the quarter, an increase of 9.2 percent industry’s adoption of services-oriented architecture. Information versus the fourth quarter of 2006. Pre-tax profit margin declined 0.5 Management revenue increased 11.4 percent. The FileNet acquisi- points to 11.3 percent driven primarily by the impact of higher tion, now in its second year, contributed to the revenue growth. employee bonus compensation in the quarter, partially offset by Lotus revenue increased 6.7 percent compared to a very strong improved expense productivity. fourth quarter of 2006. This is the thirteenth consecutive quarter of Systems and Technology segment revenue was $6.8 billion, a growth from Lotus software. Lotus Connections, which was released decrease of 3.9 percent as reported (8 percent adjusted for currency), in June 2007, has been rapidly adopted by customers. Tivoli software when compared to the fourth quarter of 2006; excluding the divested revenue increased 19.0 percent with double-digit growth in Systems printer business, revenue was essentially flat (decreased 4 percent Management, Security and Storage products. Rational revenue adjusted for currency). System z revenue decreased 15.1 percent, increased 22.2 percent in the quarter, as the company’s largest cus- with revenue declines in the U.S. and EMEA, partially offset by tomers embraced this integrated product set. Software gross profit double-digit revenue growth in Asia Pacific. This was the tenth quar- increased 12.4 percent in the quarter, with margin improvement of ter of a long and successful technology cycle for System z; MIPS 0.6 points. In addition to the strong revenue and gross profit perfor- shipments decreased 4 percent year to year. System i revenue mance in the fourth quarter, the Software segment delivered pre-tax increased 2.0 percent driven primarily by growth in POWER6 servers. profit of $2.4 billion, an increase of 20.8 percent. The pre-tax margin System p revenue grew 9.5 percent, with growth in all geographies of 34.9 percent increased 2.6 points, reflecting the strong revenue led by double-digit growth in Asia Pacific. This was the sixth con- growth with a relatively fixed cost base. secutive quarter of revenue growth for System p, driven primarily by Global Financing revenue increased 7.7 percent (2 percent adjusted POWER6 servers. System x revenue increased 4.3 percent with for currency), driven primarily by increased sales of used equipment. growth in server products (6 percent) and blades (31 percent). From a geographic perspective, revenue increased in all geogra- Performance in the quarter reflected strong acceptance of the new phies, led by strong performance in Asia Pacific, EMEA and the BladeCenter-S, which was introduced at the end of the quarter, and emerging countries. Americas’ revenue was $11.7 billion, an increase strong demand for the new high-end Quad-Core processor servers. of 4.8 percent as reported (2 percent adjusted for currency). EMEA Systems Storage revenue increased 10.8 percent, driven by growth in revenue increased 16.2 percent (6 percent adjusted for currency) to tape products of 22 percent and external disk products of 7 percent. $10.8 billion. Revenue increased in most of the major countries, Retail Store Solutions revenue increased 5.9 percent. Microelectronics when adjusted for currency, led by Spain which was up 15 percent. revenue declined 15.2 percent driven by a slowdown in demand for Asia Pacific revenue increased 14.7 percent (9 percent adjusted for game processors. Segment gross margin at 45.7 percent, improved currency) to $5.5 billion, led by growth in the India, Greater China, 3.9 points versus the fourth quarter of 2006 with margin improve- Australia/New Zealand, ASEAN and Korea regions. Collectively, ment in every system brand, except System i. Systems and Technology these regions increased 20.3 percent, adjusted for currency, versus segment pre-tax profit increased 17.8 percent to $1.4 billion. Pre-tax the fourth quarter of 2006. The emerging BRIC countries of Brazil, margin improved 3.8 points to 19.4 percent, driven primarily by Russia, India and China together grew 29.4 percent (18 percent 36 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ............................................ 23 Consolidated Statements..................................58 Prior Year in Review .................................. 37 Notes.................................................................64


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    Management Discussion International Business Machines Corporation and Subsidiary Companies adjusted for currency). In addition to the BRIC markets, there are Prior Year in Review many other nations with a similar profile that have demonstrated ($ and shares in millions except per share amounts) rapidly growing markets with strong demand for business and IT YR.-TO-YR. infrastructure solutions. In December 2007, the company announced PERCENT/ MARGIN a new organization and management structure aimed at continuing FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE to capture these opportunities. Revenue $ 91,424 $ 91,134 0.3%* Total expense and other income increased 8.6 percent compared Gross profit margin 41.9% 40.1% 1.8 pts. to the fourth quarter of 2006. Total expense and other income to Total expense and other income $ 24,978 $ 24,306 2.8% revenue ratio improved 0.3 points to 25.9 percent. Selling, general Total expense and other and administrative expense increased 7.0 percent (3 percent adjusted income-to-revenue ratio 27.3% 26.7% 0.7 pts. for currency), primarily driven by currency, continuing investments Income from continuing in key markets and acquisitions and increased accounts receivable operations before income taxes $ 13,317 $ 12,226 8.9% provisions. Interest expense was $214 million, an increase of $144 Provision for income taxes $ 3,901 $ 4,232 (7.8)% million versus the fourth quarter of 2006. The higher level of interest Income from continuing expense was primarily driven by the increased debt utilized to fund the operations $ 9,416 $ 7,994 17.8% ASR agreements in the second quarter. Other (income) and expense Income/(loss) from was $98 million of income, a reduction of $52 million (34.5 percent) discontinued operations $ 76 $ (24) NM versus the fourth quarter of 2006. A reduction in gains on real estate Income before cumulative transactions and losses from foreign currency transactions were par- effect of change in tially offset by increased interest income due to higher cash balances. accounting principle $ 9,492 $ 7,970 19.1% The company’s effective tax rate in the fourth-quarter 2007 was Cumulative effect of change 28.0 percent, flat when compared to the fourth-quarter 2006 rate. in accounting principle, Share repurchases totaled approximately $0.5 billion in the fourth net of tax** $ — $ (36) NM quarter, including $0.3 billion related to the settlement of the ASR Net income $ 9,492 $ 7,934 19.6% agreements (see note M, “Stockholders Equity Activity,” on pages 92 Net income margin 10.4% 8.7% 1.7 pts. and 93). The weighted-average number of diluted common shares Earnings per share of outstanding in the fourth quarter of 2007 was 1,412.9 million com- common stock: pared with 1,532.5 million in the fourth quarter of 2006. Assuming dilution: The company generated $5,151 million in cash flow provided by Continuing operations $ 6.06 $ 4.91 23.4% operating activities, driven primarily by Net income. Net cash from Discontinued operations 0.05 (0.01) NM investing activities was a source of cash of $1,098 million in fourth Cumulative effect of change in accounting quarter of 2007 versus a use of cash of $5,634 million in the fourth principle** — (0.02) NM quarter of 2006, resulting primarily from the disposition of higher levels of short term marketable securities. Total $ 6.11 $ 4.87 25.5% Weighted-average shares outstanding: Assuming dilution 1,553.5 1,627.6 (4.6)% Assets + $103,234 $105,748 (2.4)% Liabilities + $ 74,728 $ 72,650 2.9% Equity + $ 28,506 $ 33,098 (13.9)% * Flat adjusted for currency. ** Reflects implementation of FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” See note B, “Accounting Changes,” on page 75 for additional information. + At December 31. NM — Not meaningful 37


  • Page 40

    Management Discussion International Business Machines Corporation and Subsidiary Companies Continuing Operations Total revenue, as reported, increased 0.3 percent (flat adjusted for currency) versus 2005. From a geographic perspective, as-reported The company’s 2006 performance was the result of a series of actions revenue performance was mixed in 2006 compared to 2005, with taken over the last several years to steadily transform the company. growth in the Americas and EMEA, being offset by decreased reve- The company has divested of businesses that are commoditizing, while nue in Asia Pacific. investing in targeted acquisitions to continue to build capabilities in Americas’ revenue increased 1.8 percent (1 percent adjusted for higher value areas. The company has also been focused on increasing currency) in 2006 versus 2005 and increased in all regions with the productivity, to expand margins and improve efficiency. In addition, U.S. up 1.0 percent, Canada 2.4 percent (decreased 4 percent adjusted it has accelerated its move to become a globally integrated company. for currency) and Latin America 8.6 percent (3 percent adjusted These actions have resulted in a more balanced mix of businesses and a for currency). stronger, more competitive and sustainable global business. The com- EMEA revenue increased 0.2 percent on an as-reported basis pany’s 2006 financial results reflected this improved business model. (declined 1 percent adjusted for currency) in 2006 when compared to The company divested its Personal Computing business on April 2005. In the major countries, the U.K. increased 0.5 percent (decreased 30, 2005. Therefore, the reported results for 2006 did not include any 1 percent adjusted for currency), France increased 1.6 percent (flat activity for the Personal Computing Division, while the results for adjusted for currency), Italy increased 1.6 percent (flat adjusted for 2005 included four months of activity. This lack of comparable periods currency) and Spain increased 2.1 percent (flat adjusted for cur- had a material impact on the company’s reported revenue growth. rency). Revenue in Germany declined 2.8 percent (4 percent adjusted Total revenue, as reported, increased 0.3 percent versus 2005; for currency) year to year. excluding the Personal Computing business external revenue from Asia Pacific revenue declined 5.7 percent (3 percent adjusted for 2005, total 2006 revenue increased 3.6 percent (3.2 percent adjusted currency) year over year. Japan, which represented over 50 percent of for currency). Pre-tax income from continuing operations grew 8.9 the Asia Pacific revenue base, declined 10.1 percent (5 percent adjusted percent, while diluted earnings per share from continuing operations for currency). The Japan revenue decline was partially offset by increased 23.4 percent compared to 2005. Income from continuing increased revenue in Korea (12.6 percent) and India (22.9 percent). operations increased 17.8 percent compared to 2005, benefiting from The emerging countries of Brazil, Russia, India and China a 5.3 point improvement in the effective tax rate year to year. together grew 9.9 percent (5 percent adjusted for currency) as the The increased revenue, excluding the Personal Computing busi- company continued to invest to build capabilities in these countries. ness, in 2006 as compared to 2005, was primarily due to: Brazil grew 15.4 percent (4 percent adjusted for currency), Russia U Improved demand in the Software business, driven by Key Branded increased 13.9 percent (14 percent adjusted for currency) and India Middleware products, with positive contributions from key acquisitions; increased 22.9 percent (26 percent adjusted for currency). China declined 0.3 percent (2 percent adjusted for currency) as performance U Increased demand in the Systems and Technology business driven by Micro- was significantly impacted by the Personal Computing divestiture. electronics, System z and Storage; growth in System x and Retail Store OEM revenue increased 17.9 percent (18 percent adjusted for Solutions; and currency) in 2006 driven by strong demand for game processors in U Continued growth in the emerging countries, Brazil, Russia, India and the Microelectronics business. China, (up 21 percent) and solid performance in the Americas and The company believes that a more appropriate revenue analysis is EMEA geographies. one that excludes the revenue results of the Personal Computing Division in 2005 because it presents results on a comparable basis The increased income from continuing operations before income and provides a more meaningful focus on the company’s ongoing taxes in 2006 as compared to 2005 was primarily due to: operational performance. Total revenue, excluding the divested Personal Computing busi- U Revenue growth in the Software segment as discussed above; ness, increased 3.6 percent (3.2 percent adjusted for currency) versus U Continued execution of the company’s productivity initiatives driving 2005. Adjusted for currency, revenue increased in all geographic improved Global Services gross margins; and markets with the strongest growth coming from the Americas. U Revenue growth and continued operational improvement in the Micro- Americas’ revenue grew 4.7 percent as reported (4 percent electronics business. adjusted for currency), with growth in all regions. From a product 38 perspective, the increased revenue was driven by software. Latin Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review .................................. 37 Notes.................................................................64


  • Page 41

    Management Discussion International Business Machines Corporation and Subsidiary Companies America led the regions with growth of 14.4 percent (9 percent GTS revenue increased 2.6 percent (2 percent adjusted for currency). adjusted for currency). Brazil grew 18.9 percent (8 percent adjusted SO revenue increased 3.2 percent due primarily to signings growth for currency). The U.S. increased 3.6 percent and Canada grew in 2005 and a continued focus on increasing sales in existing accounts. 6.5 percent (flat adjusted for currency). ITS revenue decreased 1.2 percent. The rate of revenue growth in EMEA revenue increased 3.2 percent (2 percent adjusted for cur- ITS improved during the second half of 2006 reflecting progress rency) in 2006 when compared with 2005, with revenue growth in all from the changes implemented throughout the year to improve the the major countries, except Germany. Revenue increased in the U.K. business, including streamlining offerings and aligning skills to 3.0 percent (1 percent adjusted for currency), France 4.0 percent address higher growth and higher value areas. The acquisition of ISS, (2 percent adjusted for currency), Spain 4.1 percent (2 percent added to the company’s capabilities in security and intrusion protec- adjusted for currency) and Italy 3.6 percent (2 percent adjusted for tion and contributed to improved performance in the fourth quarter currency). Germany declined a modest 0.3 percent as reported of 2006. BTO revenue increased 17.2 percent. Maintenance revenue (2 percent adjusted for currency) in 2006 when compared to 2005. increased 2.0 percent driven by increased availability services on non- Russia grew 21.1 percent (21 percent adjusted for currency). IBM IT equipment, primarily in the Americas and Asia Pacific. Asia Pacific revenue declined 0.8 percent (increased 2 percent GBS revenue increased 0.4 percent (1 percent adjusted for cur- adjusted for currency) in 2006 versus the prior year. Although Japan rency). The rate of year-over-year revenue growth in GBS increased revenue declined 7.5 percent (2 percent adjusted for currency), its in the second half of 2006 reflecting progress made on actions taken performance improved sequentially throughout 2006 and returned to throughout the year that focused on operational transformation and growth in the fourth quarter; partially offsetting the revenue decline profitable growth initiatives. in Japan was growth in other Asia Pacific regions. China grew 15.8 ($ in millions) percent (14 percent adjusted for currency), Korea grew 14.2 percent YR.-TO-YR. (6 percent adjusted for currency) and India increased 38.5 percent FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE (42 percent adjusted for currency). Global Services gross profit: For the year, the company benefited from solid contributions Global Technology Services: from the emerging countries of Brazil, Russia, India and China. Gross profit $9,623 $9,226 4.3% Collectively, revenue from these four countries increased 20.5 per- Gross profit margin 29.8% 29.3% 0.5 pts. cent (16 percent adjusted for currency) in 2006 versus 2005. Global Business Services: OEM revenue increased 17.9 percent (18 percent adjusted for Gross profit $3,694 $3,088 19.6% currency) in 2006 versus 2005 driven by strong game processor Gross profit margin 23.1% 19.4% 3.7 pts. demand in the Microelectronics business. The following is an analysis of the reportable segment results for The GTS segment pre-tax margin was 9.6 percent, an increase of Global Services, Systems and Technology and Software. The Global 1.9 points versus 2005. This increase and the gross margin increase Financing segment analysis is included in the Global Financing sec- were driven by productivity initiatives and cost efficiencies, includ- tion on page 51. ing benefits from the targeted restructuring action in the second quarter of 2005. GLOBAL SERVICES GBS gross profit increased 19.6 percent to $3.7 billion and gross ($ in millions) margin improved 3.7 points versus 2005. The segment pre-tax mar- YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE gin was 9.8 percent, an improvement of 5.3 points versus 2005. In addition to the benefit received from the incremental restructur- Global Services revenue: $48,291 $47,407 1.9% ing in the second quarter of 2005, the margin improvements were Global Technology Services $32,322 $31,501 2.6% driven by improved utilization, better contract management and Strategic Outsourcing 17,044 16,522 3.2 stable-to-improved pricing. Integrated Technology Services 7,448 7,538 (1.2) Maintenance 5,986 5,868 2.0 Business Transformation Outsourcing 1,845 1,573 17.2 Global Business Services $15,969 $15,906 0.4% 39


  • Page 42

    Management Discussion International Business Machines Corporation and Subsidiary Companies SYSTEMS AND TECHNOLOGY Retail Store Solutions revenue increased 21.4 percent primarily ($ in millions) due to clients replacing older technology in favor of integrated retail YR.-TO-YR. solutions. Printing Systems revenue decreased 7.6 percent due pri- FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE marily to lower maintenance revenue as a result of a declining install Systems and Technology revenue: $21,970 $20,981 4.7% base and lower sales of hardware products. System z 7.8% ($ in millions) System i (15.0) YR.-TO-YR. System p (1.1) FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE System x 3.7 Systems and Technology gross profit: System Storage 6.4 Gross profit $8,284 $8,473 (2.2)% Microelectronics 21.9 Gross profit margin 37.7% 40.4% (2.7) pts. Engineering & Technology Services (16.2) Retail Store Solutions 21.4 Systems and Technology gross profit margin declined 2.7 points to Printing Systems (7.6) 37.7 percent in 2006 versus 2005. The decline in gross profit margin was driven by revenue mix towards lower margin products in 2006 Systems and Technology revenue increased 4.7 percent (4 percent versus 2005 (2.5 points) and pricing pressure in the low- and middle- adjusted for currency) in 2006 versus 2005. System z revenue increased range server brands. Segment pre-tax margin was 7.5 percent, down 7.8 percent reflecting continued strong customer acceptance of both 1.0 point versus the prior year. specialty engines for Linux and Java workloads and traditional main- frame workloads. MIPS shipments increased 11 percent versus 2005. SOFTWARE System x revenue increased 3.7 percent driven by increased server ($ in millions) revenue (5.3 percent) and System x blades growth of 22.3 percent. YR.-TO-YR. Although System p revenue declined 1.1 percent for the year, high- FOR THE YEAR ENDED DECEMBER 31: 2006 2005* CHANGE end server revenue increased 9.4 percent. In the third quarter of Software revenue: $18,161 $16,830 7.9% 2006, the company completed its transition to POWER5+ and Middleware $13,891 $12,552 10.7% expanded the implementation of POWER Quadcore technology to Key Branded Middleware 9,369 8,004 17.1 all POWER-based entry level System p products. System i revenue WebSphere Family 23.3 declined 15.0 percent as the company completed its transition to Information Management 14.0 POWER5+ in the third quarter of 2006, however clients continued Lotus 12.0 to leverage their existing capacity. Tivoli 26.3 Systems Storage revenue increased 6.4 percent and was driven by Rational 4.4 Total disk growth of 7.8 percent, while tape grew 3.1 percent. Within Other middleware 4,522 4,548 (0.6) Total disk, mid-range disk revenue increased 16.5 percent and stor- Operating systems 2,273 2,426 (6.3) age area network products increased 10.6 percent, while enterprise Product Lifecycle Management 1,123 1,077 4.2 products revenue declined 6.7 percent. The revenue increase in tape Other 873 775 12.7 products was primarily driven by the new tape security offering * Reclassified to conform with 2006 presentation. which includes unique encryption capabilities. Microelectronics revenue increased 21.9 percent due to strong Software segment revenue increased 7.9 percent (7 percent adjusted demand in the game processor business and networking components. for currency) in 2006 versus 2005 reflecting strong demand for the company’s industry-leading middleware capabilities. The revenue growth was driven from both organic sources and acquisitions. Key Branded Middleware revenue increased 17.1 percent, reflect- ing continued momentum and benefit from sales and development investments along with additional benefit from acquisitions. 40 Revenue from the WebSphere family of products increased 23.3 percent and was led by double-digit growth in WebSphere Application Servers (25.3 percent) and WebSphere Business Integration (22.7 Management Discussion ............................ 14 Discontinued Operations .................................42 percent) software. Road Map .........................................................14 Other Information............................................42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review .................................. 37 Notes.................................................................64


  • Page 43

    Management Discussion International Business Machines Corporation and Subsidiary Companies Information Management revenue increased 14.0 percent. Growth Total SG&A expense of $20,259 million decreased 4.9 percent was driven by the Information on Demand portfolio of software versus 2005. The decrease was primarily driven by the restructuring products. The acquisition of FileNet Corporation, during the fourth charges recorded in the second quarter of 2005. In addition, retire- quarter of 2006, also contributed to the growth. ment-related expense and stock-based compensation decreased versus Lotus revenue increased 12.0 percent driven by the Notes/Domino 2005. Those decreases were partially offset by increased operational family of collaboration products. expenses as a result of strategic acquisitions and investments in the Tivoli revenue increased 26.3 percent with double-digit growth software and services businesses as well as emerging countries. in each of its key segments: Systems Management (24.5 percent), Other (income) and expense was income of $766 million and Security (40.8 percent) and Storage (27.4 percent). The 2006 acquisi- $2,122 million in 2006 and 2005, respectively. The decrease in income tions of Micromuse, Inc. in the first quarter and MRO Software, Inc. was primarily driven by the $1,108 million pre-tax gain on the sale of in the fourth quarter added to the Tivoli brand capabilities and con- the Personal Computing business in 2005. In addition, the company tributed to the revenue growth. settled certain antitrust issues with the Microsoft Corporation in Rational revenue increased 4.4 percent in 2006 versus 2005, in a 2005 and the gain from this settlement was $775 million. Income slower growing market. Revenue from Other Middleware products from certain real estate activities decreased year to year, as 2005 had declined 0.6 percent in 2006. This product set includes more mature unusually large gains from a few transactions. Partially offsetting products which provide a more stable flow of revenue. those decreases were additional Interest income; foreign currency Operating Systems revenue declined 6.3 percent. The decline in transaction gains in 2006 versus losses in 2005 and real estate related revenue was primarily driven by improved price performance in restructuring charges recorded in the second quarter of 2005. System z operating systems. PLM revenue increased 4.2 percent. RD&E expense of $6,107 million increased 4.5 percent primarily This product set benefited from a number of large transactions in the driven by acquisitions and investments to maintain technology lead- second quarter of 2006. ership across the product offerings. Software spending increased $210 million and Systems and Technology spending increased $92 ($ in millions) million in 2006 versus 2005. These increases were partially offset by YR.-TO-YR. FOR THE YEAR ENDED DECEMBER 31: 2006 2005 CHANGE the year-to-year reduction in Personal Computing of $52 million due Software gross profit: to the divestiture of that business in 2005. Gross profit $15,471 $14,296 8.2% Intellectual property and custom development income of $900 Gross profit margin 85.2% 84.9% 0.2 pts. million decreased $48 million or 5.0 percent versus 2005. There were no significant IP transactions in 2006 and 2005. The increase in Software gross profit dollars and gross profit margin Interest expense of $278 million increased $58 million, or 26.6 was primarily driven by the growth in Software revenue. percent in 2006, primarily driven by higher effective interest rates The Software segment contributed $5.5 billion of pre-tax profit year to year. in 2006, an increase of 14.9 percent versus 2005. Pre-tax profit mar- gins improved 1.5 points to 26.9 percent. INCOME TAXES The provision for income taxes resulted in an effective tax rate of GLOBAL FINANCING 29.3 percent for 2006, compared with the 2005 effective tax rate of See page 51 for a discussion of Global Financing’s revenue and 34.6 percent. The 5.3 point improvement in the tax rate was driven gross profit. by the absence of the foreign earnings repatriation-related tax charge recorded in the third quarter of 2005 (4.3 points) as well as a benefit TOTAL EXPENSE AND OTHER INCOME from the fourth-quarter 2006 settlement of the U.S. federal income tax audit for the years 2001 through 2003 (3.0 points). Those benefits Total expense and other income increased 2.8 percent versus 2005. were partially offset by a one-time tax cost associated with the 2006 Overall, the increase was primarily due to increased Research, devel- intercompany transfer of certain intellectual property (4.3 points). opment and engineering expense driven by acquisitions and lower Other (income) and expense income driven by the gains associated with the sale of the Personal Computing business and the Microsoft Corporation settlement in 2005. Those increases were partially offset 41 by lower SG&A expense due primarily to the restructuring charges recorded in the second quarter of 2005.The expense-to-revenue ratio increased 0.7 points to 27.3 percent in 2006, as revenue increased 0.3 percent and expense increased 2.8 percent in 2006 versus 2005.


  • Page 44

    Management Discussion International Business Machines Corporation and Subsidiary Companies FINANCIAL POSITION estimates. The HDD business was accounted for as a discontinued Total assets of $103,234 million declined $2,514 million ($6,223 mil- operation whereby the results of operations and cash flows were lion adjusted for currency) primarily due to lower prepaid pension removed from the company’s results from continuing operations for assets and a decrease in Cash and cash equivalents. These decreases all periods presented. were partially offset by increases in Goodwill, long-term deferred tax In 2006, the company reported net income of $76 million, net of assets, Marketable Securities, trade receivables, financing receivables tax, primarily related to tax benefits from tax audit settlements. The and Intangible Assets. company incurred a loss from discontinued operations of $24 million Total liabilities of $74,728 million increased $2,078 million (down in 2005, net of tax. This loss was primarily due to additional costs $362 million adjusted for currency) primarily driven by Compensation associated with parts warranty as agreed upon by the company and and benefits, Deferred income and Accounts payable. Partially off- Hitachi, under the terms of the agreement for the sale of the HDD setting those increases were decreases in long-term deferred tax and business to Hitachi. restructuring liabilities. Stockholders’ equity decreased $4,592 million to $28,506 million Other Information primarily driven by retirement-related charges and net common Looking Forward stock transactions, partially offset by increased Retained earnings. The retirement-related driven decrease in Stockholders’ equity and Looking forward, the company enters 2008 in an excellent opera- the decrease in prepaid pension assets were a result of the adoption tional and financial position. of SFAS No. 158 in 2006. The company has a significant global presence, operating in 170 The company generated $15,019 million in cash flow provided by countries, with approximately 63 percent of its revenue generated operating activities, an increase of $105 million compared to 2005. outside the U.S. In addition, approximately 69 percent of the com- The increase was primarily driven by increased Net income ($1,559 pany’s employees are located outside the United States, including million), lower pension funding in 2006 ($549 million) and an about 35 percent in Asia Pacific. This global reach gives the company increase in cash driven by Accounts payable ($891 million) primarily access to markets, with well-established organizations and manage- resulting from the divestiture of the Personal Computing business in ment systems who understand the clients and their challenges and 2005. These increases were partially offset by growth in accounts who can respond to these opportunities with value-add solutions. receivable ($2,731 million) primarily driven by asset growth in The company’s transformation to a globally integrated enterprise Global Financing and a decrease in cash related to deferred income provides the capabilities to service clients globally and deliver the taxes ($461 million), due to utilization of tax credit carryforwards in best skills and cost from anywhere in the world. 2005. Net cash used in investing increased $7,126 million versus In emerging markets, the company will continue to invest for 2005 primarily due to net purchases of marketable securities and revenue growth and leadership. The company is focused on identi- other investments ($2,668 million), increased spending on acquisitions fying growth opportunities and following a disciplined investment ($2,316 million), increased net capital spending ($1,210 million) and policy to capitalize on these opportunities. The company has had a decline in divestiture-related cash proceeds ($932 million). Net good success in the emerging markets of Brazil, Russia, India and cash used in financing activities increased $1,057 million primarily China. In addition, there are additional opportunities around due to higher dividend payments ($434 million) and increased net the world that are growing at a rapid rate; countries and markets cash used to retire debt ($730 million). within Southeast Asia, Eastern Europe, the Middle East and Latin America that have market growth rates greater than the global average. Through its investments, the company has developed Discontinued Operations extensive capabilities in emerging countries to capture these growth On December 31, 2002, the company sold its HDD business to opportunities. In 2008, the company will also implement a new Hitachi for approximately $2 billion. The final cash payment of $399 organization and management structure that will focus on these million was received on December 30, 2005. In addition, the com- emerging nations and markets. pany paid Hitachi $80 million to settle warranty obligations during The company is a proven infrastructure provider of IT technology. 2005. These transactions were consistent with the company’s previous Through its history, the company has built the infrastructure in most countries that are now considered to have “mature” economies. This 42 track record will enable the company to capture opportunities in new, expanding markets worldwide. The company’s broad product and services portfolio delivers value to clients — through a combina- Management Discussion ............................ 14 Discontinued Operations ........................... 42 tion of services, hardware and software. The portfolio is focused on Road Map .........................................................14 Other Information...................................... 42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review .................................. 37 Notes.................................................................64


  • Page 45

    Management Discussion International Business Machines Corporation and Subsidiary Companies high-value solutions that can deliver measurable benefit to clients with a complement of offerings and capabilities that deliver both with offerings that can address a wide scope of client issues including: high value and productivity to clients. The overall Global Services energy savings, security and resiliency, risk management and cost business is well-positioned going forward. reduction among many others. In the Systems and Technology business, the company will focus The company remains committed to technology leadership and its investments on differentiating technologies with high-growth will continue to focus internal investments, complemented with potential including POWER6, BladeCenter-S, high-performance strategic acquisitions, on high-value, high-growth opportunities. computing, virtualization and energy efficiency. The transition to The company invested over $6 billion in RD&E in 2007 and POWER6 technology will be completed in the first half of 2008. approximately $30 billion over the past five years. New POWER-based virtualization offerings will be announced to In addition, the company’s financial position is strong. Through extend the company’s lead in UNIX virtualization. The next genera- its efficient cash generation business model based on disciplined tion mainframe product will be available beginning late in the balance sheet management, in 2007, the company generated $12.4 first quarter — that quarter will likely be a period of transition with billion in free cash flow and ended the year with $16.1 billion in cash benefits coming in the second quarter. This product will have fifty and marketable securities. This provides the company with the finan- percent more capacity than the current system and will extend the cial flexibility for investments in changing business environments. company’s leadership in energy efficiency, security and resiliency. The company also has a significant annuity content in its business The December, 2007 acquisition of XIV will strengthen the storage which reduces its business risk versus more transaction-dependent portfolio with solutions based on XIV architecture expected to be business models. announced in 2008. In May 2007, the company met with investors and analysts and The company expects 2008 pre-tax retirement-related plan cost discussed a road map to deliver earnings per share in 2010 in the range to be approximately $1.6 billion — a decrease of $950 million to $1 of $10 to $11 per share, or 14 to 16 percent compound growth rate billion compared to 2007. This estimate reflects current pension from 2006. The company’s 2010 road map is to generate earnings per plan assumptions and the impacts of pension plan redesign efforts. share growth through a combination of revenue growth, margin See note U, “Retirement-Related Benefits,” on page 106 for addi- improvement, growth initiatives, acquisitions, the current projected tional information. The actual return on the IBM Personal Pension benefit of retirement-related cost and effective capital deployment to Plan (PPP) assets in 2007 was 14 percent, compared to a 15 percent fund growth and provide returns to shareholders through dividends return in 2006. and common stock repurchases. The company expects that its effective tax rate in 2008 will be The company’s performance in 2007 highlighted the benefits of approximately 27.5 percent. This rate is lower than the 2007 tax rate its global reach and the strength of its business model. The financial of 28.1 percent due to an expectation of a more favorable mix of results reflected solid progress on major elements of the long-term income in lower tax jurisdictions. The rate will change year to year goals, however, the company measures the success of its business based on non-recurring events, such as the settlement of income tax model over the long term, not any individual quarter or year. The audits, as well as recurring factors including the geographic mix of company’s strategies, investments and actions are all taken with an income before taxes, the timing and amount of foreign dividend objective of optimizing long-term performance. repatriation, state and local taxes and the effects of various global The continued investments in Software have led to this segment’s income tax strategies. emergence as a strong source of revenue growth and the largest con- In 2007 and 2006, the company’s cash tax rate was approximately tributor to the company’s profit in 2007. The Software business is 18 percent and 16 percent, respectively. differentiated in the industry by both the strength of its individual The company’s cash tax rate represents the amount of income products and the breadth of the software offerings. The key to con- taxes paid during the year over Income from continuing operations tinued Software growth stems from the ability to maintain and grow before income taxes. The cash tax rate differs from the company’s this industry-leading software business, and by continuing to capitalize effective tax rate due to a number of variables including, but not on industry trends such as SOA and Information on Demand. The limited to, certain items of income and expense that are recognized company expects to accomplish this through a combination of inter- in different years for financial reporting purposes than for income tax nal development and strategic acquisitions. These products will be purposes, differences in currency rates used in the translation of the rapidly developed and integrated to bring continued value to clients. non-U.S. income tax provision and income tax payments and current Within the Global Services business, revenue and profit growth year cash tax payments or refunds that are related to prior years. The 43 improved and the company saw significant results from the targeted company anticipates that its cash tax rate may increase in the near actions and investments it has made the last few years. The Global term as a result of the settlement of audits. Services business enters 2008 with a revenue backlog of $118 billion, an increase of $2 billion from the prior year. The portfolio is strong


  • Page 46

    Management Discussion International Business Machines Corporation and Subsidiary Companies Liquidity and Capital Resources The company prepares its Consolidated Statement of Cash Flows in accordance with SFAS No. 95, “Statement of Cash Flows,” on page The company has consistently generated strong cash flow from 60 and highlights causes and events underlying sources and uses operations, providing a source of funds ranging between $14.5 bil- of cash in that format on page 33. For purposes of running its busi- lion and $16.1 billion per year over the past five years. The company ness, the company manages, monitors and analyzes cash flows in a provides for additional liquidity through several sources; maintaining different format. a sizable cash balance, access to global funding sources and a commit- As discussed on page 50, one of the company’s two primary objec- ted global credit facility. The following table provides a summary of tives of its Global Financing business is to generate strong return on these major sources of liquidity for the years ended December 31, equity. Increasing receivables is the basis for growth in a financing 2003 through 2007. business. Accordingly, management considers Global Financing receivables as a profit-generating investment, not as working capital Cash Flow and Liquidity Trends that should be minimized for efficiency. After classifying Global ($ in billions) Financing accounts receivables as an investment, the remaining net 2007 2006 2005 2004 2003 operational cash flow less capital expenditures is viewed by the com- Net cash from pany as the free cash flow available for investment and distribution operating activities $16.1 $15.0 $14.9 $15.3 $14.5 to shareholders. Cash and short-term From the perspective of how management views cash flow, in marketable securities $16.1 $10.7 $13.7 $10.6 $ 7.6 2007, free cash flow was $12.4 billion, an increase of $1.9 billion Size of global credit compared to 2006. This cash performance was driven primarily by facilities $10.0 $10.0 $10.0 $10.0 $10.0 the growth in Net income from continuing operations, continued Trade receivables focus on working capital and lower pension funding year over year. securitization facility $ — $ — $ 0.5 $ 0.5 $ — Over the past five years, the company generated over $50 billion in free cash flow available for investment and distribution to share- The major rating agencies’ ratings on the company’s debt securities holders. As a result, during that period the company invested $9.9 at December 31, 2007 appear in the following table. The Standard billion in strategic acquisitions, received $1.4 billion from divestitures and Poor’s and Moody’s Investors Services ratings remain unchanged and returned over $53 billion to shareholders through dividends and from December 31, 2006. In May 2007, Fitch Ratings lowered its share repurchases. The amount of prospective returns to sharehold- ratings on senior long-term debt from AA- to A+ and on commercial ers in the form of dividends and share repurchases will vary based paper from F1+ to F1. Fitch changed its ratings following the com- upon several factors including each year’s operating results, capital pany’s issuance of new debt utilized to fund the ASR in the second expenditure requirements, research and development and acquisi- quarter. The company has no contractual arrangements that, in the tions, as well as the factors discussed following the table on page 45. event of a change in credit rating, would result in a material adverse The company’s Board of Directors meets quarterly to consider effect on its financial position or liquidity. The company believes its the dividend payment. The company expects to fund dividend pay- earnings and cash flow growth provide sufficient flexibility within the ments through cash from operations. In the second quarter of 2007, existing credit ratings to continue to execute its current investment, the Board of Directors increased the company’s quarterly common dividend and acquisition strategies. stock dividend from $0.30 to $0.40 per share. STANDARD MOODY’S AND INVESTORS FITCH POOR’S SERVICE RATINGS Senior long-term debt A+ A1 A+ Commercial paper A-1 Prime-1 F1 44 Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information...................................... 42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 47

    Management Discussion International Business Machines Corporation and Subsidiary Companies The table below represents the way in which management reviews cash flow as described on page 44. ($ in billions) FOR THE YEAR ENDED DECEMBER 31: 2007 2006 2005 2004 2003 Net cash from operating activities (Continuing Operations) $16.1 $15.0 $14.9 $15.3 $14.5 Less: Global Financing accounts receivable (1.3) (0.3) 1.8 2.5 1.9 Net cash from operating activities (Continuing Operations), excluding Global Financing receivables 17.4 15.3 13.1 12.9 12.6 Capital expenditures, net (5.0) (4.7) (3.5) (3.7) (3.9) Free cash flow (excluding Global Financing accounts receivable) 12.4 10.5 9.6 9.1 8.7 Acquisitions (1.0) (3.8) (1.5) (1.7) (1.8) Divestitures 0.3 — 0.9 — 0.1 Share repurchase (18.8) (8.1) (7.7) (7.1) (4.3) Dividends (2.1) (1.7) (1.2) (1.2) (1.1) Non-Global Financing debt 10.9 (1.1) 1.2 0.7 (0.9) Other (includes Global Financing accounts receivable and Global Financing debt) 3.8 1.1 1.9 3.1 1.0 Change in cash, cash equivalents and short-term marketable securities $ 5.5 $ (3.0) $ 3.1 $ 2.9 $ 1.7 Events that could temporarily change the historical cash flow dynam- addition, on January 19, 2005, the company contributed $1.7 billion ics discussed on page 44 include significant changes in operating to the qualified portion of the PPP, a U.S. defined benefit plan. As results, material changes in geographic sources of cash, unexpected highlighted in the Contractual Obligations table on page 46, the com- adverse impacts from litigation or future pension funding during pany expects to make legally mandated pension plan contributions to periods of severe and prolonged downturn in the capital markets. certain non-U.S. plans of approximately $3.3 billion in the next five Whether any litigation has such an adverse impact will depend on a years. The company is not quantifying any further impact from pen- number of variables, which are more completely described on page sion funding because it is not possible to predict future movements 96. In January 2008, the company closed the previously announced in the capital markets or pension plan funding regulations. Cognos acquisition for approximately $5.0 billion in cash; the The Pension Protection Act of 2006 (the Act) was enacted into Telelogic acquisition is also expected to close for approximately $0.8 law in 2006, and, among other things, increases the funding require- billion following the completion of regulatory reviews. With respect ments for certain U.S. defined benefit plans beginning after December to pension funding, in the first quarter of 2007, the company made a 31, 2007. No mandatory contribution is required for the U.S. defined $500 million voluntary cash contribution to the U.S. nonpension benefit plan in 2008. postretirement plan, and in the first quarter of 2006, the company contributed approximately $1 billion to the U.K. pension plan. In 45


  • Page 48

    Management Discussion International Business Machines Corporation and Subsidiary Companies CONTRACTUAL OBLIGATIONS ($ in millions) TOTAL PAYMENTS DUE IN CONTRACTUAL PAYMENT STREAM 2008 2009-10 2011-12 AFTER 2012 Long-term debt obligations $26,066 $3,618 $10,450 $4,629 $ 7,369 Capital (finance) lease obligations 297 88 135 36 38 Operating lease obligations 5,074 1,220 1,958 1,143 753 Purchase obligations 1,814 702 676 306 130 Other long-term liabilities: Minimum pension funding (mandated)* 3,258 637 1,308 1,313 — Executive compensation 1,118 60 135 154 769 Long-term termination benefits 2,123 254 241 158 1,470 Tax reserves** 2,737 772 — — — Other 844 89 195 89 472 Total $43,331 $7,440 $15,098 $7,828 $11,001 * Represents future pension contributions that are mandated by local regulations or statute, all associated with non-U.S. pension plans. The projected payments beyond 2012 are not currently determinable. See note U, “Retirement-Related Benefits,” on pages 105 to 116 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 $14,109 million at December 31, 2007. ** These amounts represent the liability for unrecognized tax benefits under FIN 48. The company estimates that approximately $772 million of the liability is expected to be settled within the next 12 months. The settlement period for the noncurrent portion of the income tax liability cannot be reasonably estimated as the timing of the payments will depend on the progress of tax examinations with the various tax authorities; however, it is not expected to be due within the next 12 months. Total contractual obligations are reported in the table above excluding OFF-BALANCE SHEET ARRANGEMENTS the effects of time value and therefore, may not equal the amounts In the ordinary course of business, the company enters into off-bal- reported in the Consolidated Statement of Financial Position. ance sheet arrangements as defined by the SEC Financial Reporting Purchase obligations include all commitments to purchase goods Release 67 (FRR-67), “Disclosure in Management’s Discussion and or services of either a fixed or minimum quantity that meet any of the Analysis about Off-Balance Sheet Arrangements and Aggregate Con- following criteria: (1) they are noncancelable, (2) the company would tractual Obligations.” incur a penalty if the agreement was canceled, or (3) the company On May 25, 2007, the company entered into ASR agreements must make specified minimum payments even if it does not take with three investment banks. The initial purchase price of the ASR delivery of the contracted products or services (“take-or-pay”). If the agreements is subject to adjustment based on the volume weighted- obligation to purchase goods or services is noncancelable, the entire average price of the company’s common stock over the contractual value of the contract is included in the table above. If the obligation settlement period. The settlement can be effected in cash or common is cancelable, but the company would incur a penalty if canceled, the shares of the company at the company’s election. In accordance with dollar amount of the penalty is included as a purchase obligation. Emerging Issues Task Force Issue No. 00-19, “Accounting for Contracted minimum amounts specified in take-or-pay contracts are Derivative Financial Instruments Indexed to, and Potentially Settled also included in the table as they represent the portion of each con- in, a Company’s Own Stock,” the financial instruments generated by tract that is a firm commitment. this settlement mechanism are not recognized in the company’s In the ordinary course of business, the company enters into con- financial statements until settlement, at which time the settlement tracts that specify that the company will purchase all or a portion of payment or receipt is recorded in Stockholders’ equity. The liquidity its requirements of a specific product, commodity or service from a risk related to the settlement of these contracts is mitigated by the supplier or vendor. These contracts are generally entered into in order company’s contractual ability to elect cash or share settlement. to secure pricing or other negotiated terms. They do not specify fixed Additionally, these contracts restrict the maximum amount of shares or minimum quantities to be purchased and, therefore, the company potentially deliverable by the company. Refer to note M, “Stock- 46 does not consider them to be purchase obligations. holders’ Equity Activity,” on pages 92 and 93 for further information on the ASR agreements entered into by the company. Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information...................................... 42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64


  • Page 49

    Management Discussion International Business Machines Corporation and Subsidiary Companies We have no other off-balance sheet arrangements that has, or is expense recognized in 2008 would have increased by approximately reasonably likely to have, a material current or future effect on finan- $65 million. Changes in the discount rate assumptions will impact cial condition, changes in financial condition, revenues or expenses, the PBO which, in turn, may impact the company’s funding decisions results of operations, liquidity, capital expenditures or capital resources. if the PBO exceeds plan assets. Each 25 basis point increase or See the table on page 46 for the company’s contractual obligations decrease in the discount rate will cause a corresponding decrease or and note N, “Contingencies and Commitments,” on pages 95 and 96, increase, respectively, in the PPP’s PBO of an estimated $1.2 billion for detailed information about the company’s guarantees, financial based upon December 31, 2007 data. Page 109 presents the PPP’s commitments and indemnification arrangements. The company does PBO (after the increase in discount rate presented on page 111) and not have retained interests in assets transferred to unconsolidated plan assets as of December 31, 2007. entities or other material off-balance sheet interests or instruments. The expected long-term return on plan assets is used in calculating the net periodic pension (income)/cost. See page 112 for information Critical Accounting Estimates regarding the expected long-term return on plan assets assumption. The application of GAAP requires the company to make estimates The differences between the actual return on plan assets and expected and assumptions about future events that directly affect its reported long-term return on plan assets are recognized over five years in the financial condition and operating performance. The accounting esti- expected return on plan assets line in net periodic pension cost/ mates and assumptions discussed in this section are those that the (income) and also as a component of gains/losses in Accumulated company considers to be the most critical to its financial statements. gains and (losses) not affecting retained earnings, which is recognized An accounting estimate is considered critical if both (a) the nature of over the service lives of the employees in the plan, provided such the estimates or assumptions is material due to the levels of subjectiv- amounts exceed certain thresholds which are based upon the obliga- ity and judgment involved, and (b) the impact within a reasonable tion or the value of plan assets, as provided by accounting standards. range of outcomes of the estimates and assumptions is material to To the extent the outlook for long-term returns changes such that the company’s financial condition or operating performance. Senior management changes its expected long-term return on plan assets management has discussed the development, selection and disclosure assumption, each 50 basis point increase or decrease in the expected of these estimates with the Audit Committee of the company’s Board long-term return on PPP plan assets assumption will have an estimated of Directors. The critical accounting estimates related to the Global decrease or increase, respectively, of $249 million on the following Financing business are described on page 55 in the Global Financing year’s pre-tax net periodic pension cost/(income) (based upon the section. The company’s significant accounting policies are described PPP’s plan assets at December 31, 2007 and assuming no contribu- in note A, “Significant Accounting Policies,” on pages 64 to 73. tions are made in 2008). A quantitative sensitivity analysis is provided where that informa- The company may voluntarily make contributions or be required, tion is reasonably available, can be reliably estimated and provides by law, to make contributions to its pension plans. Actual return on material information to investors. The amounts used to assess sensi- pension plan assets that differ from the expected long-term return on tivity (e.g., 1 percent, 5 percent, etc.) are included to allow users of plan asset assumptions, may result in more or less future company the Annual Report to understand a general direction cause and effect contributions than is planned by management. of changes in the estimates and do not represent management’s pre- Impacts of these types of changes on the company’s pension plans dictions of variability. in other countries worldwide will vary depending upon the status of each respective plan. PENSION ASSUMPTIONS REVENUE RECOGNITION The measurement of the company’s benefit obligation and net peri- odic pension cost/(income) requires the use of certain assumptions, Application of the various accounting principles in GAAP related to including, among others, estimates of discount rates and expected the measurement and recognition of revenue requires the company return on plan assets. to make judgments and estimates. Specifically, complex arrange- Changes in the discount rate assumptions will impact the service ments with nonstandard terms and conditions may require significant cost, (gain)/loss amortization and interest cost components of the net contract interpretation to determine the appropriate accounting, periodic pension cost/(income) calculation (see pages 111 and 112 including whether the deliverables specified in a multiple element for information regarding the discount rate assumptions) and the arrangement should be treated as separate units of accounting. Other 47 projected benefit obligation (PBO). As presented on page 111, the significant judgments include determining whether IBM or a reseller company increased the discount rate assumption for the PPP by 25 is acting as the principal in a transaction and whether separate con- basis points to 6.00 percent on December 31, 2007. This change will tracts are considered part of one arrangement. decrease pre-tax cost and expense recognized in 2008 by approxi- mately $65 million. If the discount rate assumption for the PPP decreased by 25 basis points on December 31, 2007, pre-tax cost and


  • Page 50

    Management Discussion International Business Machines Corporation and Subsidiary Companies Revenue recognition is also impacted by the company’s ability to assessment relies on estimates and assumptions and may involve a estimate sales incentives, expected returns, and allowances for uncol- series of complex judgments about future events. To the extent that lectible receivables. The company considers various factors, including the final tax outcome of these matters is different than the amounts a review of specific transactions, the credit-worthiness of the custom- recorded, such differences will impact income tax expense in the ers, historical experience and market and economic conditions when period in which such determination is made. calculating these provisions and allowances. Estimates are evaluated Significant judgment is also required in determining any valua- each quarter to assess the adequacy of the estimates. If these estimates tion allowance recorded against deferred tax assets. In assessing the were changed by 5 percent in 2007, Net income would be impacted need for a valuation allowance, management considers all available by $46 million (excluding Global Financing receivables reserves dis- evidence including past operating results, estimates of future taxable cussed on page 55). income and the feasibility of ongoing tax planning strategies. In the event that the company changes its determination as to the amount COSTS TO COMPLETE SERVICE CONTRACTS of deferred tax assets that can be realized, the company will adjust its The company enters into numerous service contracts through its GTS valuation allowance with a corresponding impact to income tax and GBS businesses. During the contractual period, revenue, cost expense in the period in which such determination is made. and profits may be impacted by estimates of the ultimate profitability To the extent that the provision for income taxes increases/ of each contract, especially contracts for which the company uses the decreases by 1 percent of Income from continuing operations before percentage-of-completion (POC) method of accounting. If at any income taxes, consolidated Income from continuing operations time these estimates indicate the POC contract will be unprofitable, would have declined/improved by $145 million in 2007. the entire estimated loss for the remainder of the contract is recorded immediately in cost. The company performs ongoing profitability VALUATION OF ASSETS AND REPORTING UNITS analyses of its services contracts in order to determine whether the The application of business combination and impairment accounting latest estimates require updating. Key factors reviewed by the com- requires the use of significant estimates and assumptions. The pur- pany to estimate the future costs to complete each contract are future chase method of accounting for business combinations requires the labor costs, future product costs and productivity efficiencies. company to estimate the fair value of assets acquired and liabilities Contract loss provisions recorded as a component of Other accrued assumed to properly allocate purchase price consideration between expenses and liabilities are approximately $41 million and $32 million assets that are depreciated and amortized from goodwill. Impairment at December 31, 2007 and December 31, 2006, respectively. testing for assets, other than goodwill, requires the allocation of cash flows to those assets or group of assets and if required, an estimate of INCOME TAXES fair value for the assets or group of assets. Impairment testing for The company is subject to income taxes in both the U.S. and numerous goodwill requires the company assign assets and liabilities to report- foreign jurisdictions. Significant judgments are required in determin- ing units along with estimating future cash flows for those reporting ing the consolidated provision for income taxes. units based on assumptions of future events. During the ordinary course of business, there are many transac- The company’s estimates are based upon assumptions believed to be tions and calculations for which the ultimate tax determination is reasonable, but which are inherently uncertain and unpredictable. These uncertain. As a result, the company recognizes tax liabilities based on valuations require the use of management’s assumptions, which would estimates of whether additional taxes and interest will be due. These not reflect unanticipated events and circumstances that may occur. tax liabilities are recognized when, despite the company’s belief that its tax return positions are supportable, the company believes that RESTRUCTURING ACTIONS certain positions may not be fully sustained upon review by tax The company has executed, and may continue to execute, restructur- authorities. The company believes that its accruals for tax liabilities ing actions which require management to utilize significant estimates are adequate for all open audit years based on its assessment of many related to expenses for severance and other employee separation factors including past experience and interpretations of tax law. This costs, realizable values of assets made redundant or obsolete, lease cancellation and other exit costs. If the actual amounts differ from the company’s estimates, the amount of restructuring charges could 48 be materially impacted. See note Q, “2005 Actions,” on pages 99 and 100 for a description of restructuring actions. Management Discussion ............................ 14 Discontinued Operations .................................42 Road Map .........................................................14 Other Information...................................... 42 Forward-Looking and Global Financing ..............................................50 Cautionary Statements .....................................15 Report of Management ....................................56 Management Discussion Snapshot ..................16 Report of Independent Registered Description of Business ....................................17 Public Accounting Firm ...................................57 Year in Review ..................................................23 Consolidated Statements..................................58 Prior Year in Review ........................................37 Notes.................................................................64

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