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    What will we make of this moment? 2013 IBM Annual Report


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    Dear IBM Investor: What will we make of this moment—as businesses, as individuals, as societies? What will we make with a planet generating unprecedented amounts of data? What will we create from—and with—global networks of consumers, workers, citizens, students, patients? How will we make use of powerful business and technology services available on demand? How will we engage with an emerging global culture, defined not by age or geography, but by people determined to change the practices of business and society? To capture the potential of this moment, IBM is executing a bold agenda. It is reshaping your company, and we believe it will reshape our industry. In this letter I will describe the actions we have taken and are taking, and the changed company that is emerging from this transformation. I believe that if you understand our strategy, you will share our confidence in IBM’s prospects—for the near term, for this decade and beyond. Let’s start with the phenomenon of our age—data.


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    A planet of data Today, every discussion about changes in technology, business and society must begin with data. In its exponentially increasing volume, velocity and variety, data is becoming a new natural resource. It promises to be for the 21st century what steam power was for the 18th, electricity for the 19th and hydrocarbons for the 20th. This is what we mean by enterprises, institutions and our planet becoming smarter. “Traditional computing systems, which Thanks to a proliferation of devices and the infusion of technology into all things and processes, the world is generating more only do what they are programmed than 2.5 billion gigabytes of data every day, and 80 percent of to do, simply cannot keep up with it is “unstructured”—everything from images, video and audio Big Data in constant motion. For that, to social media and a blizzard of impulses from embedded sensors and distributed devices. we need a new paradigm.” This is the driver of IBM’s first strategic imperative: To make markets by transforming industries and professions with data. The market for data and analytics is estimated at $187 billion by 2015. To capture this growth potential, we have built the world’s broadest and deepest capabilities in Big Data and analytics—both technology and expertise. We have invested more than $24 billion, including $17 billion of gross spend on more than 30 acquisitions. We have 15,000 consultants and 400 mathematicians. Two- thirds of IBM Research’s work is now devoted to data, analytics and cognitive computing. IBM has earned 4,000 analytics patents. We have an ecosystem of 6,000 industry partners and 1,000 university partnerships around the world developing new, analytics-related curricula. IBM provides the full array of capabilities our clients need to extract the value of Big Data. They can mine multiple structured and unstructured data sets across their business. They can


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    apply a range of analytics—from descriptive to predictive to rose 9 percent—led by Global Business Services and Software. prescriptive. And importantly, they can capture the time value of This is already a nearly $16 billion business for us, and we have data. This matters, because the battle for competitive advantage raised our expectations for it. in this new world can be lost or won in fractions of a second. An IT industry remade by cloud Our data and analytics portfolio today is the deepest in the At the same time that industries and professions are being remade industry. It includes decision management, content analytics, by data, the information technology infrastructure of the world is planning and forecasting, discovery and exploration, business being transformed by the emergence of cloud computing—that intelligence, predictive analytics, data and content management, is, the delivery of IT and business processes as digital services. stream computing, data warehousing, information integration It is estimated that by 2016, more than one-fourth of the world’s and governance. applications will be available in the cloud, and 85 percent of new software is now being built for cloud. This portfolio provides the basis for the next major era in computing—cognitive systems. Traditional computing systems, This is driving IBM’s second strategic imperative: To remake which only do what they are programmed to do, simply cannot enterprise IT infrastructure for the era of cloud. keep up with Big Data in constant motion. For that, we need a new paradigm. These new systems are not programmed; rather, they As important as cloud is, its economic significance is often learn, from the vast quantities of information they ingest, from their misunderstood. That lies less in the technology, which is relatively own experiences, and from their interactions with people. straightforward, than in the new business models cloud will enable for enterprises and institutions. This is creating a market IBM launched this era three years ago, when our Watson system that is expected to reach $250 billion by 2015. defeated the two all-time champions on the quiz show Jeopardy! Watson has since matured from a research grand challenge IBM today is the leader in enterprise cloud, a position we have into a multifaceted business platform, enabled globally via the enhanced through investments of $7 billion on 15 acquisitions, cloud. Earlier this year we launched the IBM Watson Group. most notably SoftLayer in 2013. We provide the full spectrum of It will comprise 2,000 professionals, a $1 billion investment and cloud delivery models—infrastructure as a service, platform as a an ecosystem of partners and developers that we expect to service, software as a service and business process as a service. scale rapidly. In the process, we believe Watson will change IBM’s cloud capabilities are built on 1,500 cloud patents and the nature of computing, as it is already beginning to change supported by thousands of cloud experts. Eighty percent of the practice of healthcare, retail, travel, banking and more. Fortune 500 companies use IBM’s cloud capabilities. Taken together, our investments in data and analytics are driving Our cloud foundation at the infrastructure level is SoftLayer, the significant growth, with 40,000 service engagements to date, market’s premier public and private cloud environment, with “bare growing by double digits. In 2013 our business analytics revenue metal” dedicated servers that provide unmatched compute power,


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    FPO Virginia M. Rometty Chairman, President and Chief Executive Officer


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    deployed in real time, with hundreds of configuration options. Our of organizations are currently using or planning to use compos- public cloud processes 5.5 million client transactions every day. able business services. In terms of technology, security, flexibility and pricing, IBM surpasses Finally, enterprises will want—and need—to manage their data in all our major competitors. And our rapidly growing roster of 30,000 the cloud with the same rigor as if it were on-premises. Companies client engagements—including companies like Honda, Sun Life will do this in order to ensure auditability, visibility, change control, Stadium, US Open Tennis and hundreds of top online games with access control and data loss protection. Indeed, data manage- a user base exceeding 100 million—is a testament to that. ment will arguably be the single most important design point for enterprise cloud environments, driven not only by security and These companies and a growing number of others understand cost, but also by regulation. that their customer-facing applications—which they deploy on public clouds for reasons of cost, accessibility and speed—must To meet growing demand for greater speed, and legal requirements be integrated with their core enterprise systems—such as finance, for compliance and data residency, IBM is aggressively expanding inventory, manufacturing and human resources. This is why one its global cloud footprint. We currently have 25 data centers globally, analyst predicts that by 2017, nearly 50 percent of large enterprises and the new $1.2 billion investment announced in January will will use hybrid cloud environments that are part public, part private see the opening of 15 more, in the US, the UK, Australia, Brazil, and integrated with back-end systems. Canada, China, France, Germany, India, Japan and Mexico. It is also why a new class of “cloud middleware services” is The impact of our cloud investments shows up clearly in our emerging to manage these complex environments. Last month results. IBM’s cloud business grew 69 percent in 2013, delivering we announced several capabilities that will connect enterprise $4.4 billion of revenue. As we actively embrace cloud in order data and applications to the cloud. IBM’s entire enterprise to deliver “IBM as a Service” to our clients, we expect to software portfolio is becoming available to developers in an open, see significant benefits in client experience, revenue growth composable business environment to build applications with and enterprise productivity. flexibility and scalability. A “cloud first” approach is being implemented in IBM software development labs globally. Engagement in a world of empowered individuals The phenomena of data and cloud are changing the arena of For line-of-business users looking to drive innovation—including global business and society. At the same time, proliferating mobile heads of finance, marketing, human resources, procurement technology and the spread of social business are empowering and other functions—we offer an unmatched array of more than people with knowledge, enriching them through networks and 100 software-as-a-service (SaaS) offerings. IBM’s SaaS offerings changing their expectations. today support 24 of the top 25 companies in the Fortune 500. Going forward, companies will continue to unlock the value This leads to IBM’s third strategic imperative: To enable of these business applications. For example, nearly 70 percent “systems of engagement” for enterprises.


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    Complementing traditional back-office systems of record, We have strengthened our already clear leadership in enterprise- enterprises are now taking a systematic approach to engagement class social business and in security. Our acquisitions in social with all of their constituencies—customers, employees, partners, include Kenexa, which helps companies use behavioral science investors and citizens. Indeed, 57 percent of companies now not just to connect with people, but to understand and build lasting expect to devote more than a quarter of their IT spending to these engagement with them. And we have made a dozen acquisitions new systems of engagement by 2016, nearly twice the level of in security, building a capability of more than 6,000 security experts, 12 months ago. 3,000 patents and 25 labs worldwide. They are doing so because the way their customers and their Finally, IBM is leading by example in building modern enterprise own workers expect to engage is undergoing profound change. systems of engagement and learning. Our social platform, Seventy percent of people who contact a company via social Connections, has 300,000 IBM users and 200,000 communities. media today expect a response within five minutes. Nearly There are more than 30,000 IBMers active on Client Collaboration 80 percent of adult smartphone users keep their phones with Hubs for our top 300 accounts. Last year, hundreds of thousands them an average of 22 hours a day. This is why we launched of IBMers worldwide shaped the practices that define how we work. IBM MobileFirst in 2013, and why we have made eight acquisitions And they are enhancing their skills daily through a massive open to advance our mobile initiatives. We have 3,000 mobile experts, online learning system called THINK Academy. and have been awarded hundreds of patents in mobile and wireless technologies. In 2013, we achieved year-over-year growth of 69 percent in mobile, 19 percent in security and 45 percent in social business. When these individuals use their mobile devices to engage with a company, they expect personalized service. Indeed, Our performance in 2013 80 percent of people are willing to trade their information for You can learn more about the IBM Strategy on pp. 10–23. This a customized offering. is the context in terms of which to understand our performance in 2013. The good news is that this is increasingly possible, thanks to social business and data analytics. But it’s not that simple. By many measures, it was a successful year for IBM. Our diluted One only needs to follow the news to see rapidly rising concerns— operating earnings per share in 2013 were $16.28, a new record. legitimate concerns—about data security and institutional trust. This marked 11 straight years of operating EPS growth. We grew Two-thirds of US adults say they would not return to a business operating net income by 2 percent, to $18 billion. that lost their confidential information. And the economic stakes are enormous. One analyst estimates that by 2016, there could In 2013 we invested $3.1 billion for 10 acquisitions. We invested be an additional $1 trillion of growth in global online retail—if the $3.8 billion in net capital expenditures. We invested $6.2 billion in industry can enhance trust. R&D, while earning the most US patents for the 21st straight year.


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    A Letter from the Chairman 7 Generating Higher Value at IBM A long-term perspective ensures IBM is well-positioned to take advantage of major shifts occurring in technology, business and the global economy. 1. We continuously remix our business 2. This generates significant profit and cash, which toward higher-value, more profitable allows us to invest in future sources of growth and markets and opportunities. provide strong returns to shareholders. Segment Pre-tax Income Mix* Free Cash Flow Primary Uses of Cash Since 2000 ($ in billions) ($ in billions) ($ in billions) Operating Pre-tax Income Margin* Net capital expenditures Hardware/Financing $59 Services Software 21% $170 $108 $32 Net share Net repurchases acquisitions** 10% $30 $165 Dividends 2000 2013 2000 2013 At Least 3. We deliver long-term value and performance $20 while achieving our 2015 operating EPS target Operating EPS in 2015* along the way. $16.28 Key drivers: Revenue Growth A combination of base revenue growth, a shift to faster-growing businesses and strategic acquisitions. Operating Leverage A shift to higher-margin businesses and enterprise productivity derived from global integration and process efficiencies. Share Repurchase Leveraging our strong cash generation to return value to shareholders by reducing shares outstanding. Operating Earnings Per Share* 2000 2013 2015 * Excludes acquisition-related and nonoperating retirement-related charges. ** Net acquisitions include cash used in acquisitions and from divestitures.


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    While making all these investments in IBM’s future capabilities, we were able to return $17.9 billion to you in 2013—approximately $13.9 billion through gross share repurchases and $4.1 billion through dividends. Last year’s dividend increase was 12 percent, marking the 18th year in a row in which we have raised our dividend, and the 98th consecutive year in which we have paid one. However, we must acknowledge that while 2013 was an important year of transformation, our performance did not meet our “Every generation of IBMers has the expectations. Our operating pre-tax income was down 8 percent. Our revenue in 2013, at $99.8 billion, was down 5 percent as opportunity—and, I believe, the reported and 2 percent at constant currency. responsibility—to invent a new IBM. This is our time.” So, while we continue to remix to higher value, we must also address those parts of our business that are holding us back. We have two specific challenges, and we are taking steps to address both. The first involves shifting the IBM hardware business for new realities and opportunities. We are accelerating the move of our Systems product portfolio—in particular, Power and storage—to growth opportunities and to Linux, following the lead of our successful mainframe business. The modern demands of Big Data, cloud and mobile require enterprise- strength computing, and no other company can match IBM’s ongoing capabilities and commitment to developing those essential technologies. We also announced, in January, an agreement to sell much of our Intel-based x86 server business to Lenovo. This divestiture is consistent with our continuing strategy of exiting lower- margin businesses, such as PCs, hard-disk drives and retail store solutions. But let me be clear—we are not exiting hardware.


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    IBM will remain a leader in high-performance and high-end I am deeply proud of the global IBM team for bringing us here, systems, storage and cognitive computing, and we will continue and I am grateful to you, our shareholders, for your unwavering to invest in R&D for advanced semiconductor technology. support. I hope you share our excitement about your company’s path and the shared opportunity we have, together, to build The second challenge involves the world’s growth markets. a brighter future on a smarter planet. While IBM’s growth in Latin America and Middle East and Africa was strong, enterprise spending slowed in other key growth markets. We are intensifying focus on new growth opportunities. Overall, the opportunity in the world’s growth markets remains attractive. Virginia M. Rometty On being essential Chairman, President and Chief Executive Officer As we have learned throughout our history, the key to success is getting the big things right, innovating and investing accordingly, and challenging our organization, operations and especially our culture to adapt. When you do all those things, you do more than stay abreast of change. You lead it. You invent entirely new capabilities— such as cognitive computing and Watson. You translate these innovations into sustainable economic value—such as building cloud infrastructure that is enterprise-class and societally robust. And you make yourself a laboratory for the future—of work, of engagement, of the modern enterprise. The progress we are making on these strategic imperatives is highly encouraging. No company in our industry is positioned as strongly as 103-year-old IBM for the world now taking shape. We are confident in our vision, our strategy and our prospects. Every generation of IBMers has the opportunity—and, I believe, This letter includes selected references to certain non-GAAP financial measures that are made to facilitate a comparative view of the company’s ongoing operational performance. For information the responsibility—to invent a new IBM. This is our time. We about the company’s financial results related to (i) operating net income, operating pre-tax income, are working to make this not just a successful business, but an operating pre-tax margin and operating earnings per share and (ii) free cash flow, which are in each case non-GAAP measures, see the company’s Forms 8-K submitted to the SEC on January 21, 2014 essential institution for our clients and the world in a new era. and February 28, 2013 (Attachment II—Non-GAAP Supplementary Materials).


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    What we see shifting: Competitive advantage will be created through data and analytics, business models will be shaped by cloud, and individual engagement will be powered by mobile and social technologies. Therefore, IBM is making a new future for our clients, our industry and our company. This is how. The IBM Strategy.


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    The IBM Strategy 11 01 We are making markets by transforming industries and professions with data. 02 We are remaking enterprise IT for the era of cloud. 03 We are enabling systems of engagement for enterprises. And leading by example.


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    12 01 We are making markets by transforming industries and professions with data.


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    The IBM Strategy 13 WHAT WE SEE SHIFTING: Data is becoming the world’s new natural resource. Today, every discussion about changes in technology, business and society must begin with data. In its exponentially increasing volume, velocity and variety, data is becoming a new natural resource. It promises to be for the 21st century what steam power was for the 18th, electricity for the 19th and hydrocarbons for the 20th. 1 trillion connected objects and devices on 2.5 billion gigabytes of data generated every day the planet generating data by 2015 80% of the world’s data is unstructured. Audio. Video. Sensor data. Social media. All represent new areas to mine for insights.


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    14 OUR POINT OF VIEW: Data is the new basis of competitive advantage. Leaders will: Drive business outcomes by applying more sophisticated analytics across more disparate data sources in more parts of their organization. Capture the time value of data by developing “speed of insight” and “speed of action” as core differentiators. Change the game in their industry or profession with cognitive capability. THEREFORE: We have built the world’s broadest and deepest portfolio in data and analytics. $24 billion $17billion invested to date to of gross spend for Big Data 15,000 analytics consultants 40,000 client engagements to date build IBM’s capabilities and analytics acquisitions, and 400 mathematicians in Big Data and analytics, including more than with $7 billion in organic 30 acquired companies investment 1 $ billion investment in Flash 1,000 university partnerships, 500 analytics patents 2/3 of IBM Research is technology, providing and 2,215 IBM generated each year focused on data, analytics industry-leading speed Business Partners and cognitive computing and efficiency to enable data to be real- time ready for analytics


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    The IBM Strategy 15 We are building Watson solutions and technologies for the era of cognitive computing. In January 2014 we launched the IBM Watson Group to bring cognitive capabilities—built on technologies like machine learning, complex algorithms and natural language processing—to enterprises, institutions and individuals via the cloud. Watson technology processes information by understanding natural language, generating hypo- theses based on evidence, and learning as it goes. This means organizations and individuals can more fully understand the data that surrounds them, and use that data to make better decisions. 1 $ billion investment, including 2,000 engineers, researchers, $100 million to equip developers, designers an ecosystem of entre- and sellers preneurs and partners We have significantly increased analytics revenue through strategic investments, and new skills and capabilities. Analytics Revenue 16 billion $ 2013 2010 11 billion $


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    16 02 We are remaking enterprise IT for the era of cloud.


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    The IBM Strategy 17 WHAT WE SEE SHIFTING: The emergence of cloud is transforming IT and business processes into digital services. At the same time industries and professions are being remade by data, the information technology infrastructure of the world is being transformed by the emergence of cloud computing—that is, the delivery of IT and business processes as digital services. 85% of new software is now being built for the cloud 1/4 of the world’s applications will be available in the cloud by 2016 72% of developers already report that cloud-based services or APIs are part of the applications they’re designing


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    18 OUR POINT OF VIEW: Cloud demands—and enables— new business models. Leaders will: Integrate public and private clouds with back-end systems to create hybrid environments. This will create demand for cloud middleware services. Seek—or be required—to manage cloud environments with the same rigor as an on-premises data center. Use cloud to reinvent core business processes and to innovate. THEREFORE: We have built the world’s most complete cloud portfolio, delivering our clients’ technology and business processes as digital services. 7 $ billion invested to date to 1,500+ cloud patents 5.5 million 80% client transactions of Fortune 500 build cloud capabilities processed daily through companies use IBM’s IBM’s public cloud cloud capabilities 15 acquired companies, 2,000 SoftLayer APIs to 100+ industry-leading Software 5,000+ private and hybrid cloud including SoftLayer, provide a view of the as a Service (SaaS) engagements in more for cloud infrastructure client’s environment offerings than 100 countries included IBM Systems in 2013


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    The IBM Strategy 19 In 2014, we will expand our cloud footprint and capabilities. IBM is investing $1.2 billion to expand a massive network of local cloud hubs for businesses worldwide, to meet growing demands for capacity, choice, compliance and data residency. 15 Markets planned to open in 2014: Australia (2) planned 2014 Brazil market expansions Canada (2) China (2) France Germany 40 total cloud data centers India across five continents Japan Mexico United Kingdom Connecting applications via the cloud United States (2) “Cloud middleware services” are emerging to connect securely customer applications and core enterprise systems such as finance, inventory or human resources via the cloud. In 2014, we are opening up our entire enterprise software portfolio via BlueMix, a platform to equip the tens of millions of corporate and web developers with an open environment and tools to build enterprise-class cloud applications at consumer scale. In 2013 we grew our cloud revenue 69 percent, and we exited the year with a run rate for cloud “as a service” double that of 2012. Cloud Revenue Cloud “as a Service” Revenue Run Rate $ 4.4 billion $ 2 billion 2013 2013 2012 2012 $ 2.6 billion $ 1 billion


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    20 03 We are enabling systems of engagement for enterprises. And we are leading by example.


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    The IBM Strategy 21 WHAT WE SEE SHIFTING: Social. Mobile. Security. They are empowering people with knowledge, enriching them through networks and changing expectations. The phenomena of data and cloud are changing the arena of global business and society. At the same time, rapidly growing mobile technology and social business are giving birth to a new category of IT services and capabilities, aimed at engagement with increasingly empowered individuals. 84% of Millennials say social and 70% of Boomers agree user-generated content has an influence on what they buy 5 minutes the response time users expect from a company once they have contacted it via social media 84% of smartphone users check an app as soon as they wake up 80% of individuals are willing to trade their information for a personalized offering 2 /3 of US adults say they would not return to a business that lost their personal, confidential information


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    22 OUR POINT OF VIEW: A systematic approach to engagement is now required. Leaders will: Use mobile and social to increase speed and responsiveness—and meet customers, partners and employees where they are. Want to personalize every meaningful interaction. Need to earn continuously the right to serve customers—which demands privacy, security and trust. THEREFORE: We have built a portfolio that enables enterprises and communities to engage customers, employees and citizens securely. # 6,000 security experts, 4,300 patents in mobile, 1 and #1 market leader for enterprise 7of 10 top banks in the US, 3,000 mobile experts, social and security social software; market 9 of the top 10 in the UK and 2,800 social business technologies leader in security and 2 of the top 4 in Australia experts vulnerability management* use IBM Security Solutions 8 companies acquired 12companies acquired 25 security labs globally, 15 billion security events monitored for mobile capabilities for security technologies 10 security operations daily in 130 countries like mobile messaging like web fraud detection, centers globally for marketers and secure sophisticated malware, mobile app delivery and device management * IDC, Worldwide Enterprise Social Software 2013–2017 Forecast and 2012 Vendor Shares, Doc #241323, June, 2013 IDC, Worldwide Security and Vulnerability Management 2013–2017 Forecast and 2012 Vendor Shares, Doc #242465, August, 2013


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    The IBM Strategy 23 Our mobile, social and security portfolio And we are leading by example. generated double- digit revenue growth in 2013. 69% growth in Mobile Collectively developing insights For more than a decade we’ve used Jams—large-scale online collaborations— to collectively define our corporate values, generate new business ideas and rally around opportunities for societal improvement. In 2013, IBMers worldwide shaped nine practices that translate our values into consistent actions and behaviors. These practices are now shaping our systems for hiring, learning and management. 45% growth in Social Business 30,000+ IBMers active in Client Collaboration 300,000 active IBM users on our Hubs for our top 300 accounts Connections social platform 250,000 employees collaborated in an 200,000 Connections communities online Jam to shape nine practices established by employees for that distinguish IBMers projects, areas of expertise or general interests 19% growth in Security


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    24 Financial Highlights International Business Machines Corporation and Subsidiary Companies ($ in millions except per share amounts) For the year ended December 31: 2013 2012 Revenue $ 99,751 $104,507 Net income $ 16,483 $ 16,604 Operating (non-GAAP) earnings* $ 17,959 $ 17,627 Earnings per share of common stock Assuming dilution $ 14.94 $ 14.37 Basic $ 15.06 $ 14.53 Diluted operating (non-GAAP)* $ 16.28 $ 15.25 Net cash provided by operating activities $ 17,485 $ 19,586 Capital expenditures, net 3,768 4,307 Share repurchases 13,859 11,995 Cash dividends paid on common stock 4,058 3,773 Per share of common stock 3.70 3.30 At December 31: 2013 2012 Cash, cash equivalents and marketable securities $ 11,066 $ 11,128 Total assets 126,223 119,213 Working capital 11,196 5,807 Total debt 39,718 33,269 Total equity 22,929 18,984 Common shares outstanding (in millions) 1,054 1,117 Market capitalization $197,772 $214,032 Stock price per common share $ 187.57 $ 191.55 Number of employees in IBM/wholly owned subsidiaries 431,212 434,246 * See page 46 for a reconciliation of net income to operating earnings.


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    Report of Financials 25 International Business Machines Corporation and Subsidiary Companies MANAGEMENT DISCUSSION NOTES TO CONSOLIDATED Overview 26 FINANCIAL STATEMENTS Forward-Looking and Cautionary Statements 26 A Significant Accounting Policies 84 Management Discussion Snapshot 27 B Accounting Changes 94 Description of Business 28 C Acquisitions/Divestitures 95 Year in Review 35 D Financial Instruments 100 Prior Year in Review 53 E Inventories 107 Other Information 63 F Financing Receivables 107 Looking Forward 63 G Property, Plant and Equipment 110 Liquidity and Capital Resources 65 H Investments and Sundry Assets 110 Critical Accounting Estimates 67 I Intangible Assets Including Goodwill 111 Currency Rate Fluctuations 70 J Borrowings 112 Market Risk 70 K Other Liabilities 114 Financing Risks 71 L Equity Activity 116 Cybersecurity 71 M Contingencies and Commitments 119 Employees and Related Workforce 72 N Taxes 121 Global Financing 72 O Research, Development and Engineering 123 P Earnings Per Share of Common Stock 123 Report of Management 76 Q Rental Expense and Lease Commitments 124 R Stock-Based Compensation 124 Report of Independent Registered S Retirement-Related Benefits 127 Public Accounting Firm 77 T Segment Information 141 U Subsequent Events 146 CONSOLIDATED FINANCIAL STATEMENTS Five-Year Comparison of Selected Financial Data 147 Earnings 78 Comprehensive Income 79 Selected Quarterly Data 148 Financial Position 80 Cash Flows 81 Performance Graph 149 Changes in Equity 82 Board of Directors and Senior Leadership 150 Stockholder Information 151


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    26 Management Discussion International Business Machines Corporation and Subsidiary Companies OVERVIEW Operating (non-GAAP) Earnings The financial section of the International Business Machines In an effort to provide better transparency into the operational results Corporation (IBM or the company) 2013 Annual Report includes the of the business, the company separates business results into oper- Management Discussion, the Consolidated Financial Statements ating and non-operating categories. Operating earnings is a and the Notes to Consolidated Financial Statements. This Over- non-GAAP measure that excludes the effects of certain acquisition- view is designed to provide the reader with some perspective related charges and retirement-related costs, and their related tax regarding the information contained in the financial section. impacts. For acquisitions, operating earnings exclude the amortiza- tion of purchased intangible assets and acquisition-related charges Organization of Information such as in-process research and development, transaction costs, • The Management Discussion is designed to provide readers applicable restructuring and related expenses and tax charges with an overview of the business and a narrative on the company’s related to acquisition integration. For retirement-related costs, the financial results and certain factors that may affect its future company characterizes certain items as operating and others as prospects from the perspective of the company’s management. non-operating. The company includes defined benefit plan and The “Management Discussion Snapshot,” on pages 27 and 28, nonpension postretirement benefit plan service cost, amortization presents an overview of the key performance drivers in 2013. of prior service cost and the cost of defined contribution plans in • Beginning with the “Year in Review” on page 35, the Manage- operating earnings. Non-operating retirement-related cost includes ment Discussion contains the results of operations for each defined benefit plan and nonpension postretirement benefit plan reportable segment of the business and a discussion of the interest cost, expected return on plan assets, amortized actuarial company’s financial position and cash flows. Other key sections gains/losses, the impacts of any plan curtailments/settlements and within the Management Discussion include: “Looking Forward” multi-employer plan costs, pension insolvency costs and other on pages 63 to 65, and “Liquidity and Capital Resources” on costs. Non-operating costs are primarily related to changes in pen- pages 65 to 67. sion plan assets and liabilities which are tied to financial market • Global Financing is a reportable segment that is measured as a performance and the company considers these costs to be outside stand-alone entity. A separate “Global Financing” section is the operational performance of the business. included in the Management Discussion beginning on page 72. Overall, the company believes that providing investors with a view • The Consolidated Financial Statements are presented on pages of operating earnings as described above provides increased trans- 78 through 83. These statements provide an overview of the parency and clarity into both the operational results of the business company’s income and cash flow performance and its financial and the performance of the company’s pension plans; improves position. visibility to management decisions and their impacts on operational • The Notes follow the Consolidated Financial Statements. Among performance; enables better comparison to peer companies; and other items, the Notes contain the company’s accounting poli- allows the company to provide a long-term strategic view of the cies (pages 84 through 93), acquisitions and divestitures (pages business going forward. For its 2015 road map, the company is utiliz- 95 through 99), detailed information on specific items within the ing an operating view to establish its objectives and track its financial statements, certain contingencies and commitments progress. The company’s reportable segment financial results (pages 119 to 121) and retirement-related benefits information reflect operating earnings, consistent with the company’s manage- (pages 127 to 141). ment and measurement system. • The Consolidated Financial Statements and the Notes have been prepared in accordance with accounting principles generally FORWARD-LOOKING AND accepted in the United States (GAAP). CAUTIONARY STATEMENTS • The references to “adjusted for currency” or “at constant cur- Certain statements contained in this Annual Report may constitute rency” in the Management Discussion do not include operational forward-looking statements within the meaning of the Private impacts that could result from fluctuations in foreign currency Securities Litigation Reform Act of 1995. Any forward-looking state- rates. Certain financial results are adjusted based on a simple ment in this Annual Report speaks only as of the date on which it is mathematical model that translates current period results in local made; the company assumes no obligation to update or revise any currency using the comparable prior year period’s currency con- such statements. Forward-looking statements are based on the version rate. This approach is used for countries where the company’s current assumptions regarding future business and functional currency is the local country currency. This informa- financial performance; these statements, by their nature, address tion is provided so that certain financial results can be viewed matters that are uncertain to different degrees. Forward-looking without the impact of fluctuations in foreign currency rates, statements involve a number of risks, uncertainties and other factors thereby facilitating period-to-period comparisons of business that could cause actual results to be materially different, as discussed performance. See “Currency Rate Fluctuations” on page 70 for more fully elsewhere in this Annual Report and in the company’s additional information. filings with the Securities and Exchange Commission (SEC), includ- • Within the financial statements and tables in this Annual Report, ing the company’s 2013 Form 10-K filed on February 25, 2014. certain columns and rows may not add due to the use of rounded numbers for disclosure purposes. Percentages reported are calculated from the underlying whole-dollar numbers.


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    Management Discussion 27 International Business Machines Corporation and Subsidiary Companies MANAGEMENT DISCUSSION SNAPSHOT The company also continued to shift its investments to address ($ and shares in millions except per share amounts) the key trends in information technology (IT)—social, mobile, big data/ Yr.-to-Yr. analytics and cloud. Several years ago, the company identified and Percent/ established objectives for four key growth initiatives—Smarter Planet, Margin For the year ended December 31: 2013 2012 Change business analytics, cloud and growth markets—to address these Revenue $ 99,751 $104,507 (4.6)%* trends. In 2013, across the business, Smarter Planet, business analyt- Gross profit margin 48.6% 48.1 % 0.5 pts. ics and cloud had strong performance. Smarter Planet revenue grew Total expense and other (income) $ 28,981 $ 28,396 2.1% about 20 percent compared to 2012, with strength across all areas, including Smarter Commerce, Smarter Cities, Social Business and Total expense and other (income)-to-revenue ratio 29.1% 27.2 % 1.9 pts. industry solutions. The company believes that data, as a natural Income before income taxes $ 19,524 $ 21,902 (10.9)% resource, will drive demand going forward, and that big data/analytics will provide the basis for competitive differentiation. Business analyt- Provision for income taxes 3,041 5,298 (42.6)% ics revenue of $15.7 billion increased 9 percent year to year, led by Net income $ 16,483 $ 16,604 (0.7)% Global Business Services and Software. The company’s cloud solu- Net income margin 16.5% 15.9 % 0.6 pts. tions address the full scope of client requirements including private Earnings per share clouds, public clouds and hybrid clouds, as well as platform and of common stock software-as-a-solution (SaaS)-based solutions. In 2013, the company Assuming dilution $ 14.94 $ 14.37 4.0% delivered $4.4 billion of cloud-based solutions revenue, an increase Weighted-average shares of 69 percent compared to 2012. In addition, within that content, $1.7 outstanding billion was delivered as a service. Across the company’s performance, Assuming dilution 1,103.0 1,155.4 (4.5)% there is overlap between these initiatives. In total, software makes up Assets** $126,223 $119,213 5.9% about half of that combined content. The software content improves Liabilities** $103,294 $100,229 3.1% the company’s business mix and contributes to margin expansion. Equity** $ 22,929 $ 18,984 20.8% Segment revenue was led by Software which increased 1.9 per- * (2.5) percent adjusted for currency. cent (3 percent adjusted for currency) driven by key branded ** At December 31. middleware which increased 4.8 percent (6 percent adjusted for cur- rency). The key growth initiatives fueled this performance. Global The following table provides the company’s operating (non-GAAP) Business Services returned to revenue growth at constant currency earnings for 2013 and 2012. (down 0.9 percent as reported; up 3 percent adjusted for currency) driven by the company’s investments in the Digital Front Office. While ($ in millions except per share amounts) revenue in Global Technology Services declined 4.2 percent (1 per- Yr.-to-Yr. Percent cent adjusted for currency), revenue trajectory improved in the For the year ended December 31: 2013 2012 Change second half and was stabilizing. Global Financing revenue improved Net income as reported $16,483 $16,604 (0.7)% 0.4 percent (3 percent adjusted for currency) versus 2012. The Soft- Non-operating adjustments ware, Global Services and Global Financing businesses all grew (net of tax) pre-tax income and expanded their pre-tax margin in 2013 compared Acquisition-related charges 747 641 16.5 to 2012. Systems and Technology impacted the company’s overall Non-operating retirement-related performance in 2013. Revenue decreased 18.7 percent (18 percent costs/(income) 729 381 91.2 adjusted for currency) year to year driven by the back end of the Operating (non-GAAP) earnings* $17,959 $17,627 1.9% mainframe product cycle and business model challenges specific Diluted operating (non-GAAP) to Power Systems, Storage and System x. Pre-tax income in Systems earnings per share $ 16.28 $ 15.25 6.8% and Technology decreased $1.7 billion compared to the prior year. * See page 46 for a more detailed reconciliation of net income to operating (non-GAAP) Revenue from the company’s growth markets underperformed earnings. in 2013, particularly in the second half of the year. For the full year, growth markets revenue decreased 4.9 percent as reported and In 2013, the company reported revenue of $99.8 billion, expanded 2 percent at constant currency. Overall, the company believes that gross and net income margins, and delivered diluted earnings per the opportunity in the growth markets remains attractive, and it is share growth of 4.0 percent as reported and 6.8 percent on an oper- intensifying its efforts on new growth opportunities in these markets. ating (non-GAAP) basis. The company generated $17.5 billion in cash The consolidated gross profit margin increased 0.5 points versus from operations and $15.0 billion in free cash flow driving shareholder 2012 to 48.6 percent. This was the tenth consecutive year of improve- returns of $17.9 billion in gross common stock repurchases and divi- ment in the gross profit margin. The operating (non-GAAP) gross margin dends. In 2013, the company continued the transformation of its of 49.7 percent increased 0.9 points compared to the prior year. The portfolio to higher value expending $3.1 billion to acquire 10 compa- increase in gross margin in 2013 was driven by margin improvements nies to expand its capabilities in its key growth areas, in addition to in the Global Services segments and an improved mix driven by Soft- maintaining high levels of investment of $6.2 billion in research and ware, partially offset by margin decreases in Systems and Technology. development and $3.8 billion in net capital expenditures.


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    28 Management Discussion International Business Machines Corporation and Subsidiary Companies Total expense and other (income) increased 2.1 percent in 2013 Total assets increased $7,010 million ($9,337 million adjusted for versus the prior year. Total operating (non-GAAP) expense and currency) from December 31, 2012 driven by: other (income) increased 1.4 percent compared to the prior year. • Increases in prepaid pension assets ($4,607 million), goodwill The year-to-year drivers were approximately: ($1,937 million) and total receivables ($1,202 million); partially offset by Total Operating Consolidated (non-GAAP) • Decreases in deferred taxes ($687 million). • Currency* (1) point (1) point Total liabilities increased $3,065 million ($4,494 million adjusted for • Acquisitions** 2 points 2 points currency) from December 31, 2012 driven by: • Base expense 1 point 1 point • Increased total debt ($6,449 million) and increases * Reflects impacts of translation and hedging programs. in deferred tax liabilities ($1,336 million); partially offset by ** Includes acquisitions completed in prior 12-month period. • Decreased retirement and nonpension postretirement benefit obligations ($4,176 million) and decreases in There were several items that had an impact on total expense and compensation and benefits ($853 million). other (income) year to year. Workforce rebalancing charges for 2013 were $1,064 million compared to $803 million in the prior year. Bad Total equity of $22,929 million increased $3,945 million from debt expense increased $106 million year to year driven by higher December 31, 2012 as a result of: specific account reserves. In addition, in 2012, the company recorded • Higher retained earnings ($12,401 million), decreased losses a gain of $446 million related to the divestiture of the Retail Store in accumulated other comprehensive income/(loss) of Solutions (RSS) business, and also recorded a charge of $162 million $4,157 million and increased common stock ($1,484 million); related to a court ruling in the UK regarding one of IBM’s UK defined partially offset by benefit pension plans. This charge was not included in the compa- • Increased treasury stock ($14,110 million) driven by share ny’s operating (non-GAAP) expense and other (income). Also, the repurchases. company has a performance-based compensation structure. As a result of certain parts of the business not performing as expected, The company generated $17,485 million in cash flow provided by performance-related compensation in 2013 across both cost and operating activities, a decrease of $2,102 million when compared to expense was down $777 million compared to the prior year. 2012, primarily driven by operational performance and a net increase Pre-tax income decreased 10.9 percent and the pre-tax margin in the use of cash for taxes of $2,200 million primarily driven by an was 19.6 percent, a decrease of 1.4 points versus 2012. Net income increase in cash tax payments. Net cash used in investing activities decreased 0.7 percent and the net income margin was 16.5 percent, of $7,326 million was $1,679 million lower than 2012, primarily due an increase of 0.6 points versus 2012. The effective tax rate for 2013 to a decrease in cash used associated with the net purchases and was 15.6 percent, a decrease of 8.6 points versus the prior year sales of marketable securities and other investments ($1,232 million) driven by an improvement in the ongoing tax rate and discrete tax and decreased net capital investments ($539 million). Net cash used items, including audit settlements. Operating (non-GAAP) pre-tax in financing activities of $9,883 million was $2,094 million lower income decreased 7.7 percent and the operating (non-GAAP) pre- compared to 2012, primarily due to increased proceeds from net tax margin was 21.4 percent, a decrease of 0.7 points versus the debt ($4,708 million), partially offset by increased cash used for prior year. Operating (non-GAAP) net income increased 1.9 percent gross common stock repurchases ($1,865 million). and the operating (non-GAAP) net income margin of 18.0 percent In January 2014, the company disclosed that it is expecting GAAP increased 1.1 points versus the prior year. The operating (non-GAAP) earnings of at least $17.00 and operating (non-GAAP) earnings of at effective tax rate was 16.0 percent versus 24.0 percent in 2012 driven least $18.00 per diluted share for the full-year 2014. The company by the same factors described above. also stated that in the first quarter of 2014 it expects to close the initial Diluted earnings per share improved 4.0 percent year to year reflect- phase of the sale of its customer care business to SYNNEX and that ing the benefits of the common stock repurchase program. In 2013, it also expects to take the majority of its workforce rebalancing the company repurchased approximately 73 million shares of its actions for the year in the same period. As a result, the company common stock. Diluted earnings per share of $14.94 increased $0.57 expects its first-quarter 2014 GAAP and operating (non-GAAP) earn- from the prior year. Operating (non-GAAP) diluted earnings per share ings per share to be approximately 14 percent of the full year of $16.28 increased $1.03 versus 2012 driven by the following factors: expectation, reflecting about half of the divestiture gain, the workforce • Revenue decrease at actual rates $ (0.69) rebalancing charges and continued impacts from currency. • Margin expansion $ 0.98 For additional information and details, see the “Year in Review” • Common stock repurchases $ 0.74 section on pages 35 through 52. At December 31, 2013, the company’s balance sheet and liquidity DESCRIPTION OF BUSINESS positions remained strong and were well positioned to support the Please refer to IBM’s Annual Report on Form 10-K filed with business over the long term. Cash and marketable securities at the SEC on February 25, 2014 for a more detailed version of this year end was $11,066 million, consistent with the year-end 2012 Description of Business, especially Item 1A. entitled “Risk Factors.” balance. Key drivers in the balance sheet and total cash flows are:


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    Management Discussion 29 International Business Machines Corporation and Subsidiary Companies The company creates value for clients and solves business prob- investing more than $1 billion to expand its global footprint to 40 data- lems through integrated solutions that leverage information technology centers worldwide. IBM now has more than 100 SaaS offerings, and and deep knowledge of business processes. IBM solutions typically IBM cloud supports 24 of the top 25 Fortune 500 companies. All of create value by reducing a client’s operational costs or by enabling this drove $4.4 billion of revenue for cloud-based solutions in 2013. new capabilities that generate revenue. These solutions draw from an industry-leading portfolio of consulting, delivery and implementa- 3. Enable “Systems of Engagement” for Enterprises tion services, enterprise software, systems and financing. and Lead by Example Social, mobile and unprecedented access to data are changing how Strategy individuals are understood and engaged. A new class of individual is IBM’s strategy is one of innovation, transformation and a constant emerging: one that is empowered with knowledge, enriched by net- evolution to higher value. The company delivers innovative solutions, works and expects value in return for its information. Enterprises must software and infrastructure to improve client outcomes. The company create a systematic approach to engage this new class of individual helps enterprises apply technology to capture new value across their and increase its speed and responsiveness by becoming mobile. entire organizations, and it provides a differentiated client experience Interactions need to be personalized to offer more value. In addition, through a highly engaged and skilled global workforce and a broad enterprises will benefit from securing information and increasing trust. ecosystem of partners. The ultimate goal of this strategy is to deliver Therefore, IBM’s strategy is to enable “systems of engagement” on IBM’s purpose of making our company essential to clients, for enterprises, and the company is leading by example. IBM has employees, partners, investors and communities. acquired 20 companies related to mobile, social and security. IBMers Three strategic imperatives shape our approach as we continu- are collaborating in more than 200,000 internal social communities ously transform IBM and align the company for higher value. and 85 percent of IBM’s sellers use the company’s Sales Connect portal. In 2013, the company’s mobile, social and security portfolio 1. Make Markets by Transforming Industries and generated double-digit revenue growth with mobile increasing Professions with Data 69 percent, security 19 percent and social business 45 percent. The emergence of big data as the world’s new natural resource is the To capture the opportunities arising from these strategic impera- phenomenon of our time. It is being fueled by the proliferation of mobile tives, IBM is focused on four key growth initiatives: Smarter Planet, devices, the rise of social media and the infusion of technology into all Business Analytics, Cloud Computing and Growth Markets. things and processes. Today, enterprises must harness data to create competitive advantage. The value for enterprises increases as they Smarter Planet apply more sophisticated analytics across more disparate data Smarter Planet is IBM’s strategy to lead in a technology-enabled sources. Their real-time use of data will increasingly become a com- world that is more instrumented, interconnected and intelligent than petitive differentiator. Enterprises will also need cognitive computing ever before, allowing people and organizations to address significant capabilities as data continues to grow in all dimensions. Therefore, business and societal challenges. At the heart of this strategy are IBM’s strategy is to make markets by transforming industries and pro- solutions that drive innovation and outcomes for clients—extending fessions with data. The company has invested more than $22 billion, the boundaries of businesses, industries and communities. It is including $15 billion on more than 30 acquisitions, to build its capabili- about helping the company’s clients become better at what they do ties in big data and analytics. One third of IBM’s research is focused for their customers. IBM does this through advanced, integrated on data, analytics and cognitive computing. The company is investing solutions based on capabilities such as analytics for business and $1 billion in Watson solutions to build out the next era of cognitive physical systems, cloud computing, mobile, social business and systems and services. In 2013, the company realized $15.7 billion in business process management. business analytics revenue. The original target for this business was IBM continues to deepen its commitment to delivering on the to achieve $16 billion in revenue in 2015—as a result of this perfor- promise of Smarter Planet for both line of business executives (CFOs, mance, the company has taken its 2015 objective for business CHROs, CMOs, etc.) as well as IT executives across a broad range of analytics revenue to $20 billion. industries. IBM’s industry-based approach and solutions are grounded in a deep understanding of the distinct set of challenges 2. Remake Enterprise IT for the Era of Cloud and opportunities that are confronting companies and executives in Enterprises are increasingly relying on cloud, which is being fueled various industries. Whether ‘smarter’ means helping a bank to retain by abundant bandwidth, the emergence of standards and the more customers through world-class mobile solutions, a hospital demand for consumability. They are benefitting from cloud by using group to deliver highly individualized care coordinated with social it to transform their IT and business processes into digital services, services, a local government to anticipate and alleviate traffic conges- to reinvent their core business processes and to drive innovation. tion before it happens, or a retail chain to provide a seamless customer Enterprises are integrating public and private clouds with back-end experience across multiple channels, IBM is developing and investing systems to create hybrid, dynamic environments. They will increas- in a portfolio of replicable industry solutions to help clients achieve ingly need to manage their cloud environments with the same rigor their goals and drive important outcomes for their customers. as an on-premise datacenter. Therefore, IBM’s strategy is to remake There are several areas of focus within the Smarter Planet strat- enterprise IT for the era of cloud. The company has invested over $6 egy, including IBM’s Social Business, MobileFirst, Smarter Commerce billion to acquire more than 15 companies related to cloud, and is and Smarter Cities initiatives.


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    30 Management Discussion International Business Machines Corporation and Subsidiary Companies IBM’s Social Business initiative helps clients integrate social IBM can serve new buyers and make new market segments by capabilities across core business processes to drive measurable bringing IT to industries and professions that are being transformed business results. The Social Business initiative can unlock the intrin- by data. The company has a unique set of offerings and deep exper- sic knowledge of people within an organization to help companies tise related to big data and analytics to help organizations: fuel customer-centric innovation, improve productivity and expand • Acquire, grow and retain customers by improving customer sales, loyalty and advocacy. To capitalize on the new market oppor- interactions, building long-term, profitable relationships and tunities that arise from a digital economy, IBM Social Business can realizing new value from customer sentiment. let clients apply increasingly sophisticated analytics to gain action- • Create new business models by tapping into information and able insight and to more effectively engage with customers. Behavioral, insight to identify and explore strategic options for growth. human data is the newest form of data and can be used to build a • Transform financial management processes by improving stronger, more agile workforce and reinvent human capital manage- enterprise agility, anticipating outcomes and driving business ment by applying behavioral sciences across the talent lifecycle. The model innovation through a discipline of performance. Social Business initiative is powered by world class IBM services and • Better monitor, predict and manage risk to build trust and software, developed organically by IBM and through acquisitions. value amidst uncertainty, by having confidence in their data, In 2013, the company launched IBM MobileFirst, a unified risk exposures and ability to make risk-aware actionable approach to help clients and partners deliver best-in-class mobile decisions. solutions, take advantage of more commercial opportunities and • Optimize operations and counter fraud and other threats to provide a superior customer experience. IBM has a breadth of exper- reduce costs, increase efficiencies and productivity and tise and technology to help organizations efficiently build and deploy improve public safety. mobile applications, maintain visibility and control over their mobile • Improve IT economics by developing and enabling new value and infrastructure, engage customers in context and transform the value agility at practically all levels of the organization and across lines chain in ways that can drive growth and return on investment. The of business while helping keep costs low and profitability high. company can help its clients achieve these goals through a complete portfolio of IBM mobile software, services and industry expertise. The company’s approach to big data and analytics helps organiza- Throughout 2013, IBM invested in core mobile enterprise capabilities tions to succeed in their industries. IBM recommends organizations such as IBM Worklight and IBM Rational, while rounding out its port- do three things to be successful. First, build a culture that infuses folio with strategic acquisitions such as Fiberlink, Trusteer, Xtify and analytics everywhere. Second, be proactive about the privacy, secu- The Now Factory. Integrated with 270 patents in wireless innovations rity and governance of their data. Third, invest in the right platform and strengthened by thousands of mobile specialists from IBM Mobile and solutions to harness and analyze all of their data for new insights Enterprise Services and IBM Interactive, the company has already and outcomes. helped more than 1,000 clients become more mobile enterprises. IBM is committed to continually innovating across the spectrum of In addition to Social and Mobile, IBM’s deep commitment to big data and analytics capabilities, solutions, systems, research, ser- building a smarter planet can be seen in the ongoing efforts around vices, deployment and skills. For example, in 2013, the company Smarter Commerce and Smarter Cities. IBM’s Smarter Commerce announced a breakthrough dynamic in-memory database technology model can integrate and transform how companies manage and called BLU Acceleration, predictive analytics for big data with IBM Ana- adapt their buy, market, sell and service processes to place the lytic Catalyst, a PureData System for Hadoop that marries IBM’s customer experience at the center of their business. IBM’s Smarter enterprise-class Hadoop distribution (InfoSphere BigInsights) with the Cities initiative helps federal, state and local governments to make simplicity of an appliance, InfoSphere Data Privacy for Hadoop that pro- better decisions, anticipate issues and coordinate resources across vides security and protection for sensitive big data, a Watson agencies more effectively and deliver citizen-centric services that Engagement Advisor solution to help transform how brands and their can drive sustainable economic growth. customers interact and new academic partnerships to help prepare students for the expanding scope of careers in big data and analytics. Business Analytics Business Analytics is the category of software, systems and ser- Cloud Computing vices that helps organizations take advantage of big data to make Cloud is a model for consuming and delivering business and IT better and faster decisions and optimize processes. Big data services that can result in significant improvements in economies includes both enterprise data, content and new data from both of scale and business agility and serve as a platform for business structured and unstructured sources: in previously unimaginable transformation. IBM has developed a portfolio of solutions, services volumes (petabytes), with huge variety (from blogs, tweets, pictures, and products that is helping thousands of clients adopt and leverage videos and text), at high velocity (machine-to-machine data from the the transformative power of the cloud. IBM’s breadth of capabilities Internet of things) and with decreasing veracity (from uncertain or gives the company a unique advantage to help clients think, build incomplete sources). Big data and analytics are core to achieving and tap into the cloud. IBM has the deep industry expertise to help the Smarter Planet strategy, helping data-savvy, insight-driven lead- clients transform business processes, industry optimized software ers to infuse intelligence into business decisions, processes and solutions to support business processes, software development client interactions for faster actions and better outcomes. platforms to create new cloud-based business applications and standardized infrastructure to run these applications.


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    Management Discussion 31 International Business Machines Corporation and Subsidiary Companies IBM offers a full array of cloud delivery models, including private with the Saudi Ministry of Health to help manage the risk of clouds, public clouds and a hybrid cloud that includes a mix of both. infectious and communicable diseases across the Kingdom. The company enables clients to build private, on-premises cloud- • Faced with rising fuel costs and a goal to reduce greenhouse based environments that have the control, security and isolation emissions, Jet Airways, India’s premier international airline, required for their most mission-critical workloads. IBM also offers turned to IBM to more accurately calculate, track and report air- public cloud services, including the newly acquired SoftLayer plat- craft emissions and reduce fuel usage. form that provides an infrastructure and ecosystem for middleware IBM continues to build out its shared services facilities and talent to and applications. IBM’s public cloud services can be simply provi- support its clients in growth markets. In China, the company has sioned as a self service, pay-as-you-go consumption model. IBM’s increased its Big Data software skills, and it will leverage an IBM software defined environments can provide a seamless integration Integrated Managed Services Centre to capture the significant across private and public cloud models, with interoperability, porta- growth in cloud. In November 2013, IBM opened its first Africa bility and scalability to help clients realize the full value of cloud. Research Lab in Kenya, IBM’s 12th lab worldwide. The facility will In the new era of computing, IBM’s plans to enable nearly every- conduct applied and exploratory research into the challenges Africa thing as a digital service. During 2013, IBM made several cloud- faces, and deliver commercially viable solutions to help improve the related strategic announcements, notably: lives of people across the continent. • IBM’s Watson technology is being made available as a development platform in the cloud to enable a worldwide Summary community of software application providers to build IBM’s strategy is one of innovation, transformation and a constant evo- a new generation of apps infused with Watson’s cognitive lution to higher value. The company has steadily remixed its portfolio computing intelligence. and business model to reflect its strategic beliefs and pursue its growth • The acquisition of SoftLayer is enabling IBM to deliver initiatives. IBM has a balanced history of exiting commodity businesses industry-leading cloud solutions that offer the security, that no longer fit the high-value model while investing in strategic privacy and reliability of private clouds and the economy acquisitions and organic capabilities. In 2013, the company invested and speed of a public cloud. $3.1 billion for acquisitions, $3.8 billion in net capital expenditures and • New fast-start industry solutions, which are hosted on a private $6.2 billion in research and development. The company has acquired cloud using SoftLayer and offered as a managed service more than 150 companies since 2000 to bolster its portfolio in areas through Global Business Services, designed to meet growing like big data and analytics, cloud and systems of engagement. demand from clients for rapid deployment, implementation As the company looks ahead to 2014 and beyond, it will continu- and experimentation. ously transform itself to take advantage of new opportunities and • The acquisition of Xtify Inc., a leading provider of cloud- pursue bold new plays in areas such as Watson solutions, new offer- based mobile messaging tools that help organizations ings for big data and analytics, the mobile enterprise and high-value improve mobile sales, drive in-store traffic and engage cloud services. IBM will continue to deliver differentiated client value customers with personalized offers. based on its sustained investments in research and development, its • An open-standards IBM cloud platform that provides engaged employee base, industry expertise, global reach, and the capabilities to power the next generation of cloud and breadth and depth of the company’s technologies and capabilities. mobile application development and services. Growth Markets Business Model IBM continues to invest in growth markets where many countries The company’s business model is built to support two principal goals: and companies are embracing big data, mobile, social and cloud, helping enterprise clients to become more innovative, efficient and often at faster rates than mature countries. In China, for example, competitive through the application of business insight and IT solu- 32 percent of consumers make their purchases online, compared tions; and providing long-term value to shareholders. The business to only 14 percent of consumers globally. In Africa, 18 percent of the model has been developed over time through strategic investments continent’s GDP is expected to be handled through mobile money in capabilities and technologies that have superior long-term growth transfers by 2015, while in Singapore, citizens spend 40 minutes on and profitability prospects based on the value they deliver to clients. average each day on Facebook, compared to less than 25 minutes The company’s global capabilities include services, software, in the United States. IBM is helping clients in growth markets capitalize systems, fundamental research and related financing. The broad on these trends. For example: mix of businesses and capabilities are combined to provide inte- • In Mexico, IBM is using its analytics tools to enable grated solutions to the company’s clients. Banorte-Ixe Bank to know and service its more than The business model is resilient, adapting to the continuously chang- 13 million customers as individuals. ing market and economic environment. The company continues to • Using IBM’s Big Data technologies and predictive analytics, divest certain businesses and strengthen its position through strategic Da Nang’s (Vietnam) traffic control center is better forecasting organic investments and acquisitions in higher-value areas. In addition, and preventing potential congestion and better coordinating the company has transformed itself into a globally integrated enterprise city responses to issues like accidents and adverse weather. which has improved overall productivity and is driving investment and • In Saudi Arabia, the company developed a public health expanding participation in the world’s fastest growing markets. solution for disease management that was implemented


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    32 Management Discussion International Business Machines Corporation and Subsidiary Companies This business model, supported by the company’s financial building customized dedicated managed clouds, to allowing clients model, has enabled the company to deliver strong earnings, cash to leverage standardized cloud infrastructure services from the Soft- flows and returns to shareholders over the long term. Layer and SmartCloud Enterprise+ offerings, to creating hybrid environments linking their private and public workloads together. This Business Segments and Capabilities portfolio of cloud offerings spans across the GTS business lines. The company’s major operations consists of five business seg- Technology Support Services: delivers a complete line of support ments: Global Technology Services and Global Business Services, services from product maintenance through solution support to which the company collectively calls Global Services, Software, maintain and improve the availability of clients’ IT infrastructures. Systems and Technology and Global Financing. Global Business Services (GBS) has the mission to deliver pre- Global Services: is a critical component of the company’s strategy dictable business outcomes to the company’s clients across two of providing IT infrastructure and business insight and solutions to primary business areas: Consulting and Application Management clients. While solutions often include industry-leading IBM software Services. These professional services deliver business value and and systems, other suppliers’ products are also used if a client solu- innovation to clients through solutions which leverage industry and tion requires it. Approximately 60 percent of external Global Services business process expertise. The role of GBS is to drive initiatives segment revenue is annuity based, coming primarily from outsourc- that integrate IBM content and solutions and drive the progress of ing and maintenance arrangements. The Global Services backlog the company’s four primary growth initiatives. As clients transform provides a solid revenue base entering each year. Within Global themselves in response to market trends like big data, social and Services, there are two reportable segments: Global Technology mobile computing, GBS is aligning its expertise and capabilities to Services and Global Business Services. address two interdependent categories of opportunity: Front Office Global Technology Services (GTS) primarily provides IT infra- Digitization, which describes the markets forming around new structure and business process services, creating business value models of engagement with all audiences; and the Globally Inte- for clients through unique technology and IP integrated services grated Enterprise, which describes the mandate to integrate data within its global delivery model. By leveraging insights and experi- and processes in support of the new front-office programs, and ence drawn from IBM’s global scale, skills and technology, with build far more flexible information applications. applied innovation from IBM Research, clients gain access to leading- edge, high-quality services with improved productivity, flexibility, GBS Capabilities cost and outcomes. Consulting: delivering client value with solutions in Strategy and Transformation, Application Innovation Services, Enterprise Applica- GTS Capabilities tions and Smarter Analytics. Consulting is also focused on bringing Strategic Outsourcing Services: delivers comprehensive IT out- to market client solutions that drive Front Office Digitization in sourcing services dedicated to transforming clients’ existing Smarter Commerce, Cloud, Mobile and Social Business. infrastructures to consistently deliver improved quality, flexibility, risk Application Management Services: application management, main- management and financial value. The company integrates long- tenance and support services for packaged software, as well as standing expertise in service management and technology with the custom and legacy applications. Value is delivered through advanced ability to exploit the power of new technologies from IBM systems capabilities in areas such as application testing and modernization, and software, such as cloud computing, analytics and virtualization, cloud application services, the company’s highly differentiated globally to deliver high performance, innovation and improved ability to integrated capability model, industry knowledge and the standardiza- achieve business objectives. tion and automation of application management. Global Process Services: delivers a range of offerings consisting of Software consists primarily of middleware and operating systems standardized through transformational solutions including process- software. Middleware software enables clients to integrate systems, ing platforms and business process outsourcing. These services processes and applications across a standard software platform to deliver improved business results to clients through the strategic improve their business results, solve critical problems and gain com- change and/or operation of the client’s business processes, applica- petitive advantage within their industries. IBM middleware is designed tions and infrastructure. on open standards, making it easier to integrate disparate business applications, developed by different methods and implemented at Integrated Technology Services: delivers a portfolio of project- different times. Operating systems are the software engines that run based and managed services that enable clients to transform and computers. Approximately two-thirds of external Software segment optimize their IT environments by driving efficiency, flexibility and revenue is annuity based, coming from recurring license charges and productivity, while reducing costs. The standardized portfolio is built ongoing post-contract support. The remaining one-third relates around key assets and patented software, and incorporates best to one-time charge (OTC) arrangements in which clients pay one, practices and proven methodologies that ensure predictive quality up-front payment for a perpetual license. Typically, the sale of OTC of delivery, security and compliance. software includes one year of post-contract support. Clients can Cloud Services: delivers a comprehensive set of cloud services rang- also purchase ongoing post-contract support after the first year, ing from assisting clients with building their own private clouds, to which includes unspecified product upgrades and technical support.


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    Management Discussion 33 International Business Machines Corporation and Subsidiary Companies Software Capabilities Leveraging powerful analytics and usage data, customers are pro- WebSphere Software: delivers capabilities that enable organizations vided with the ability to have more compelling interactions with their to run high-performance business applications. With these applica- clients and workforce, increasing touchpoints and deepening rela- tions, clients can integrate and manage business processes across tionships. The mobile offerings provide the ability to increase their organizations with the flexibility and agility they need to respond workforce productivity through enhanced collaboration, improved to changing conditions. Built on services-oriented architecture (SOA), knowledge sharing and increased response speed. and open standards support for cloud, mobile and social interactions, Systems and Technology (STG) provides clients with business the WebSphere platform enables enterprises to extend their reach solutions requiring advanced computing power and storage capa- and optimize interactions with their key constituents. Smarter Com- bilities. Approximately half of Systems and Technology’s server and merce software helps companies better manage and improve each storage sales transactions are through the company’s business step of their value chain and capitalize on opportunities for profitable partners; with the balance direct to end-user clients. In addition, growth, efficiency and increased customer loyalty. Systems and Technology provides leading semiconductor technol- Information Management Software: enables clients to integrate, ogy, products and packaging solutions for IBM’s own advanced manage and analyze enormous amounts of data from a large variety technology needs and for external clients. of sources in order to gain competitive advantage and improve their business outcomes. With this approach, clients can extract real value Systems and Technology Capabilities out of their data and use it to make better business decisions. IBM’s Systems: a range of general purpose and integrated systems middleware and integrated solutions include advanced database designed and optimized for specific business, public and scientific management, information integration, data governance, enterprise computing needs. These systems—System z, Power Systems and content management, data warehousing, business analytics and intel- System x—are typically the core technology in data centers that pro- ligence, predictive analytics and big data analytics. vide required infrastructure for business and institutions. Also, these systems form the foundation for IBM’s integrated offerings, such as Watson Solutions: included within Information Management Soft- IBM PureSystems, IBM Smart Analytics, IBM PureData System for ware, Watson is the first commercially available cognitive computing Analytics powered by Netezza, IBM SmartCloud Entry and IBM platform that has the ability to interact in natural language, process- BladeCenter for Cloud. IBM servers use both IBM and non-IBM micro- ing vast amounts of big data, and learning from its interactions with processor technology and operating systems. All IBM servers run people and computers. As an advisor, Watson is able to sift through Linux, a key open-source operating system, and the company is and understand large amounts of data delivering insights with expanding its Linux relevance further on the Power platform. unprecedented speeds and accuracy. Storage: data storage products and solutions that allow clients to Tivoli Software: helps clients optimize the value they get from their retain and manage rapidly growing, complex volumes of digital infor- infrastructures and technology assets through greater visibility, con- mation. These solutions address critical client requirements for trol and automation across their end-to-end business operations. information retention and archiving, security, compliance and stor- These asset management solutions foster integrated service deliv- age optimization including data deduplication, availability and ery for cloud and datacenter management, enterprise endpoint virtualization. The portfolio consists of a broad range of disk and and mobile device management, asset and facilities management, tape storage systems, leveraging the breadth of IBM’s software and storage management. Tivoli includes security systems software offerings, and includes Flash storage and solutions. that provides clients with a single security intelligence platform that enables them to better secure all aspects of their enterprise and Microelectronics: semiconductor design and manufacturing primarily prevent security breaches. for use in IBM systems and storage products as well as delivering semiconductors and related services to external clients. Social Workforce Solutions: enables businesses to connect people and processes for more effective communication and increased Global Financing facilitates clients’ acquisition of IBM systems, soft- productivity through collaboration, messaging and social network- ware and services. Global Financing invests in financing assets, ing software. By remaining at the forefront of collaboration tools, leverages with debt and manages the associated risks with the objective IBM’s social business offerings help organizations reap real ben- of generating consistently strong returns on equity. The primary focus efits associated with social networking, as well as create a more on the company’s offerings and clients mitigates many of the risks nor- efficient and effective workforce. mally associated with a financing company. Global Financing has the benefit of both a deep knowledge of its client base and a clear insight Rational Software: supports software development for both IT and into the products and services that are being financed. This combina- complex embedded system solutions, with a portfolio of products tion allows Global Financing to effectively manage two of the major risks and solutions supporting DevOps and Smarter Product Develop- (credit and residual value) that are normally associated with financing. ment, transforming the way lines of business, development and operations work together to deliver innovation via software. Global Financing Capabilities Mobile Software: spans middleware and offers customers true end- Client Financing: lease and loan financing to end users and internal to-end mobile solutions across platform and application clients for terms generally between one and seven years. Internal development, mobile security, and mobile device management. financing is predominantly in support of Global Services’ long-term


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    34 Management Discussion International Business Machines Corporation and Subsidiary Companies client service contracts. Global Financing also factors a selected The majority of IBM’s revenue, excluding the company’s original portion of the company’s accounts receivable, primarily for cash equipment manufacturer (OEM) technology business, occurs in management purposes. All internal financing arrangements are at industries that are broadly grouped into six sectors: arm’s-length rates and are based upon market conditions. • Financial Services: Banking, Financial Markets, Insurance • Public: Education, Government, Healthcare, Life Sciences Commercial Financing: short-term inventory and accounts receiv- • Industrial: Aerospace and Defense, Automotive, able financing to dealers and remarketers of IT products. Chemical and Petroleum, Electronics Remanufacturing and Remarketing: as equipment is returned at • Distribution: Consumer Products, Retail, the conclusion of a lease transaction, these assets are refurbished Travel and Transportation and sold or leased to new or existing clients both externally and • Communications: Telecommunications, internally. Externally remarketed equipment revenue represents Media and Entertainment, Energy and Utilities sales or leases to clients and resellers. Internally remarketed equip- • General Business: Cross-sector representation of intermediate- ment revenue primarily represents used equipment that is sold sized large enterprises as well as mid-market clients internally to Systems and Technology and Global Services. Systems Research, Development and Intellectual Property and Technology may also sell the equipment that it purchases from IBM’s research and development (R&D) operations differentiate the Global Financing to external clients. company from its competitors. IBM annually invests approximately IBM Worldwide Organizations $6 billion for R&D, focusing on high-growth, high-value opportunities. The following worldwide organizations play key roles in IBM’s delivery IBM Research works with clients and the company’s business units of value to its clients: through 12 global labs on near-term and mid-term innovations. It • Sales and Distribution contributes many new technologies to IBM’s portfolio every year • Research, Development and Intellectual Property and helps clients address their most difficult challenges. IBM • Enterprise Transformation Research also explores the boundaries of science and technol- • Integrated Supply Chain ogy—from nanotechnology to future systems, big data analytics, secure clouds and to IBM Watson, a ‘‘cognitive’’ learning system. Sales and Distribution IBM Research also focuses on differentiating IBM’s services IBM has a significant global presence, operating in more than 175 businesses, providing new capabilities and solutions. It has the countries, with an increasingly broad-based geographic distribution world’s largest mathematics department of any public company, of revenue. The company’s Sales and Distribution organization man- enabling IBM to create unique analytic solutions and actively engage ages a strong global footprint, with dedicated country-based with clients on their toughest challenges. operating units focused on delivering client value. Within these units, In 2013, IBM was awarded more U.S. patents than any other client relationship professionals work with integrated teams of con- company for the 21st consecutive year. IBM’s 6,809 patents sultants, product specialists and delivery fulfillment teams to improve awarded in 2013 represent a diverse range of inventions poised to clients’ business performance. These teams deliver value by under- enable significant innovations that will position the company to com- standing the clients’ businesses and needs, and then bring together pete and lead in strategic areas such as Watson, cloud computing capabilities from across IBM and an extensive network of Business and big data analytics. These inventions also will advance the new Partners to develop and implement solutions. era of cognitive systems where machines will learn, reason and inter- By combining global expertise with local experience, IBM’s act with people in more natural ways. It was the most U.S. patents geographic structure enables dedicated management focus for ever awarded to one company in a single year. local clients, speed in addressing new market opportunities and The company continues to actively seek intellectual property timely investments in emerging opportunities. The geographic protection for its innovations, while increasing emphasis on other units align industry-skilled resources to serve clients’ agendas. initiatives designed to leverage its intellectual property leadership. IBM extends capabilities to mid-market client segments by lever- Some of IBM’s technological breakthroughs are used exclusively in aging industry skills with marketing, Inside Sales and local Business IBM products, while others are licensed and may be used in IBM Partner resources. products and/or the products of the licensee. While the company’s The company continues to invest to capture the long-term oppor- various proprietary intellectual property rights are important to its tunity in markets around the world that have market growth rates success, IBM believes its business as a whole is not materially greater than the global average—countries within Southeast Asia, dependent on any particular patent or license, or any particular group Eastern Europe, the Middle East and Latin America. The company’s of patents or licenses. IBM owns or is licensed under a number of major markets include the G7 countries of Canada, France, Germany, patents, which vary in duration, relating to its products. Italy, Japan, the United States (U.S.) and the United Kingdom (UK) plus Austria, the Bahamas, Belgium, the Caribbean region, Cyprus, Enterprise Transformation Denmark, Finland, Greece, Iceland, Ireland, Israel, Malta, the Nether- A key element of the company’s strategy is becoming a Smarter lands, Norway, Portugal, Spain, Sweden and Switzerland. Enterprise. The transformation to a Smarter Enterprise is built on the foundation of internal transformation undertaken in the recent past, where IBM standardized business processes, drove enterprisewide


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    Management Discussion 35 International Business Machines Corporation and Subsidiary Companies transformation governance, implemented a global operating model, Integrated Supply Chain instrumented data, and connected employees to drive collaboration IBM has an extensive integrated supply chain, procuring materials and across geographic and functional boundaries. services globally. In 2013, the company also managed approximately The Smarter Enterprise is enabled through application of $20 billion in procurement spending for its clients through the Global analytics, social, mobile and cloud tools, approaches and technolo- Process Services organization. The supply, manufacturing and logistics gies. Analytics enable data-driven insights for faster, smarter and sales transaction support operations are integrated in one operat- decision making. Social tools encourage peer-to-peer interactions, ing unit that has optimized inventories over time. Simplifying and and allow data to be shared within and outside IBM in a social way. streamlining internal processes has improved sales force productivity Mobile technology allows workers to work seamlessly from any- and operational effectiveness and efficiency. Supply chain resiliency where. Cloud infrastructure and services enable application delivery. enables IBM to reduce its risk during marketplace changes. Collectively these enablers allow IBM to make decisions differently, The company continues to derive business value from its own create value differently and deliver value differently, thereby improv- globally integrated supply chain providing a strategic advantage for ing employee engagement and client experience and ultimately the company to create value for clients. IBM leverages its supply driving better business performance. The company primarily rein- chain expertise for clients through its supply chain business trans- vests the benefits of its enterprise transformation initiatives in formation outsourcing service to optimize and help operate clients’ remixing its spending profile and resources to its higher growth, end-to-end supply chain processes, from procurement to logistics. higher margin initiatives, in addition to improving profitability. The company has expanded its use of analytics to measure, manage and fine tune its supply chain operations, which will help reshape its operations and create value for clients. YEAR IN REVIEW Segment Details The following is an analysis of the 2013 versus 2012 reportable segment results. The table below presents each reportable segment’s external revenue and gross margin results. Segment pre-tax income includes transactions between segments that are intended to reflect an arm’s- length transfer price and excludes certain unallocated corporate items; see note T, “Segment Information,” on pages 141 to 146 for additional information. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent/ Percent Change Margin Adjusted for For the year ended December 31: 2013 2012 Change Currency Revenue Global Technology Services $38,551 $ 40,236 (4.2)% (1.4)% Gross margin 38.1% 36.6% 1.5 pts. Global Business Services 18,396 18,566 (0.9)% 2.6% Gross margin 30.9% 30.0% 0.9 pts. Software 25,932 25,448 1.9% 2.9% Gross margin 88.8% 88.7% 0.1 pts. Systems and Technology 14,371 17,667 (18.7)% (17.9)% Gross margin 35.6% 39.1% (3.5) pts. Global Financing 2,022 2,013 0.4% 2.8% Gross margin 45.6% 46.5% (0.9 ) pts. Other 478 577 (17.1)% (16.4)% Gross margin (195.6)% (71.6)% (124.0) pts. Total consolidated revenue $99,751 $104,507 (4.6)% (2.5)% Total consolidated gross profit $48,505 $ 50,298 (3.6)% Total consolidated gross margin 48.6% 48.1% 0.5 pts. Non-operating adjustments Amortization of acquired intangible assets 388 375 3.5% Acquisition-related charges 5 1 NM Retirement-related costs/(income) 629 264 138.1% Operating (non-GAAP) gross profit $49,527 $ 50,938 (2.8)% Operating (non-GAAP) gross margin 49.7% 48.7% 0.9 pts. NM—Not meaningful


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    36 Management Discussion International Business Machines Corporation and Subsidiary Companies Global Services In 2013, the Global Services segments, Global Technology Services business analytics and cloud, and is continuing to invest to expand (GTS) and Global Business Services (GBS), delivered $56,947 million its capabilities in these areas. Total outsourcing revenue of $26,157 of revenue, grew pre-tax income 2.5 percent and expanded pre-tax million decreased 5.1 percent (2 percent adjusted for currency) and margin 1.0 points. GBS returned to revenue growth in 2013, at con- total transactional revenue of $23,678 million decreased 1.0 percent stant currency, leveraging the investments made in the Digital Front as reported, but increased 2 percent adjusted for currency year to Office practices. GTS revenue performance improved during the year. The estimated Global Services backlog was $143 billion at second half of 2013 and is stabilizing. Global Services had December 31, 2013, an increase of 1.8 percent (5 percent adjusted good performance in the key growth initiatives of Smarter Planet, for currency) versus the prior year-end balance. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2013 2012 Change Currency Global Services external revenue $56,947 $58,802 (3.2)% (0.2)% Global Technology Services $38,551 $40,236 (4.2)% (1.4)% Outsourcing 22,060 23,344 (5.5) (2.7) Integrated Technology Services 9,380 9,550 (1.8) 1.0 Maintenance 7,111 7,343 (3.1) (0.7) Global Business Services $18,396 $18,566 (0.9)% 2.6% Outsourcing 4,097 4,209 (2.6) 1.5 Consulting and Systems Integration 14,298 14,358 (0.4) 2.9 Global Technology Services revenue of $38,551 million in 2013 while Europe was flat year to year. By offering, growth was driven by decreased 4.2 percent (1 percent adjusted for currency) year to year. the practices that address the Digital Front Office. GBS delivered From a geographic perspective, revenue declines in North America double-digit growth in each of the strategic growth initiatives of busi- and Europe were partially offset by growth in Japan, adjusted for ness analytics, Smarter Planet and cloud. The company has been currency. GTS Outsourcing revenue decreased 5.5 percent (3 per- investing to build capabilities in these key areas and now has nearly cent adjusted for currency) in 2013. Revenue performance was 20,000 resources in GBS focused on the growing Digital Front Office impacted by a decline in revenue from sales into existing base opportunity. In the area of big data, the GBS capabilities span from accounts. This activity is more transactional in nature and can be Business Analytics and Optimization strategy, through Front Office economically sensitive. Revenue was also impacted by the work done Analytics to Fraud and Regulatory Compliance and Risk Management. to improve the profitability of the restructured low margin outsourcing Application Outsourcing revenue decreased 2.6 percent as reported, contracts. GTS Outsourcing had double-digit signings growth in 2013 but increased 2 percent adjusted for currency. C&SI revenue decreased and started to realize the benefit from several of the large transfor- 0.4 percent as reported, but increased 3 percent adjusted for currency. mational contract signings in its fourth-quarter 2013 revenue. Both lines of business had constant currency revenue growth year Integrated Technology Services (ITS) revenue decreased 1.8 percent to year in the growth markets. In 2013, the GBS backlog grew for the as reported, but increased 1 percent adjusted for currency in 2013 fifth consecutive year at constant currency led by the major markets. compared to 2012. The company continues to shift the ITS business toward higher value managed services such as business continuity, ($ in millions) security and cloud. Within the cloud offerings, SoftLayer contributed Yr.-to-Yr. Percent/ 2 points of revenue growth to the ITS performance in 2013, and a Margin half-point to total GTS revenue for the year. SoftLayer provides For the year ended December 31: 2013 2012 Change unmatched performance, flexibility and breadth for public and hybrid Global Services cloud workloads. In January 2014, the company announced plans Global Technology Services to invest over $1.2 billion to double its SoftLayer centers, and with External gross profit $14,691 $14,740 (0.3)% 40 cloud datacenters in 15 countries, the company will have cloud External gross profit margin 38.1% 36.6% 1.5 pts. centers in every major geography and key financial center. Pre-tax income $ 6,983 $ 6,961 0.3% Global Business Services revenue of $18,396 million decreased Pre-tax margin 17.6% 16.8% 0.8 pts. 0.9 percent as reported, but increased 3 percent at constant currency Global Business Services in 2013 with growth in both GBS Outsourcing and Consulting and External gross profit $ 5,676 $ 5,564 2.0% Systems Integration (C&SI), adjusted for currency. GBS revenue External gross profit margin 30.9% 30.0% 0.9 pts. increased 0.5 percent (4 percent at constant currency) in the second half of the year. On a geographic basis, revenue growth at constant Pre-tax income $ 3,214 $ 2,983 7.7% currency was led by North America, Japan and the growth markets, Pre-tax margin 16.8% 15.5% 1.3 pts.


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    Management Discussion 37 International Business Machines Corporation and Subsidiary Companies GTS gross profit decreased 0.3 percent in 2013 and the gross profit Global Services Backlog margin improved 1.5 points year to year with margin expansion in The estimated Global Services backlog at December 31, 2013 was each line of business, as well as in the growth markets and major $143 billion, an increase of 1.8 percent as reported and 5 percent markets. Pre-tax income increased 0.3 percent year to year and the adjusted for currency compared to the December 31, 2012 balance, pre-tax margin expanded 0.8 points to 17.6 percent. The 2013 with growth across both the transactional and outsourcing busi- margin improvement was driven by reductions in performance- nesses. Revenue generated from the opening backlog is approximately related compensation, benefits from the second-quarter 2013 70 percent of total services annual revenue in any year. In 2014, the workforce rebalancing activity and efficiency improvements primarily projected total services revenue from the backlog is expected to be through the company’s enterprise productivity initiatives, partially up 1 percent year to year at consistent foreign currency exchange offset by higher year-to-year workforce rebalancing charges. rates. The divestiture of the company’s customer care business in the The GBS gross profit margin expanded 0.9 points in 2013 with first quarter of 2014 will impact performance from the backlog. This improved profit performance in Application Outsourcing. GBS pre-tax will reduce the total backlog and impact revenue growth from the income increased 7.7 percent in 2013 with a pre-tax margin of 16.8 backlog by approximately 3 points; including the divestiture, revenue percent, an improvement of 1.3 points year to year. GBS benefitted generated from the backlog is expected to be down 2 percent year from reductions in performance-related compensation, the compa- to year. The balance of the revenue, the other approximately 30 per- ny’s enterprise productivity initiatives and the second-quarter 2013 cent of total services revenue in any year, comes from yield from workforce rebalancing activity, partially offset by higher year-to-year current year signings, and sales and volumes into the existing client workforce rebalancing charges. The savings from those actions fuel base. It also includes SoftLayer and some other cloud services, which the investments being made in the key growth initiatives. generate period revenue that isn’t reflected in the backlog. The total Global Services business delivered profit growth and The estimated transactional backlog at December 31, 2013 margin expansion throughout 2013. Pre-tax income of $10,197 mil- increased 5.3 percent (8 percent adjusted for currency) and the esti- lion in 2013 increased 2.5 percent year to year and the pre-tax mated outsourcing backlog increased 1.5 percent (5 percent adjusted margin expanded 1.0 points to 17.4 percent. for currency), respectively, from the December 31, 2012 levels. ($ in billions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for At December 31: 2013 2012 Change Currency Backlog Total backlog $142.8 $140.3 1.8% 4.8% Outsourcing backlog 90.8 89.4 1.5 4.7 Total Global Services backlog includes GTS Outsourcing, ITS, GBS involves estimates and judgments to gauge the extent of a client’s Outsourcing, Consulting and Systems Integration and Maintenance. commitment, including the type and duration of the agreement, and Outsourcing backlog includes GTS Outsourcing and GBS Outsourc- the presence of termination charges or wind-down costs. ing. Transactional backlog includes ITS and Consulting and Systems Signings include GTS Outsourcing, ITS, GBS Outsourcing and Integration. Total backlog is intended to be a statement of overall work Consulting and Systems Integration contracts. Contract extensions under contract and therefore does include Maintenance. Backlog and increases in scope are treated as signings only to the extent of estimates are subject to change and are affected by several factors, the incremental new value. Maintenance is not included in signings including terminations, changes in the scope of contracts, periodic as maintenance contracts tend to be more steady state, where revalidations, adjustments for revenue not materialized and adjust- revenues equal renewals. ments for currency. Contract portfolios purchased in an acquisition are treated as Global Services signings are management’s initial estimate of positive backlog adjustments provided those contracts meet the the value of a client’s commitment under a Global Services contract. company’s requirements for initial signings. A new signing will be There are no third-party standards or requirements governing recognized if a new services agreement is signed incidental or coin- the calculation of signings. The calculation used by management cidental to an acquisition or divestiture. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2013 2012 Change Currency Total signings $63,203 $56,595 11.7% 14.8% Outsourcing signings $35,027 $27,891 25.6% 28.7% Transactional signings 28,176 28,703 (1.8) 1.4


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    38 Management Discussion International Business Machines Corporation and Subsidiary Companies Software ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2013 2012 Change Currency Software external revenue $25,932 $25,448 1.9% 2.9% Middleware $21,557 $20,983 2.7% 3.7% Key Branded Middleware 17,322 16,528 4.8 5.7 WebSphere Family 8.2 9.1 Information Management 2.8 3.7 Social Workforce Solutions* 10.8 11.9 Tivoli 3.9 4.8 Rational 4.9 6.0 Other middleware 4,235 4,455 (4.9) (3.9) Operating systems 2,447 2,525 (3.1) (1.9) Other 1,929 1,940 (0.6) 0.2 * Formerly Lotus Software revenue of $25,932 million increased 1.9 percent as Information Management revenue increased 2.8 percent (4 per- reported and 3 percent adjusted for currency in 2013 compared to cent adjusted for currency) in 2013 compared to 2012. Performance 2012. The Software business delivered revenue growth, at constant in 2013 included strong growth in the distributed database offerings, currency, in all four quarters of the year. Revenue continued to mix including Netezza, and content management software. toward key branded middleware with growth in all five brands. The Tivoli revenue increased 3.9 percent (5 percent adjusted for cur- Software value proposition remains strong for enterprise clients. rency) in 2013 and gained share, driven by storage growth and the Customers continue to increase deployment of the company’s security solutions portfolio. Tivoli storage revenue was up 7 percent (8 middleware products and the business is investing and gaining percent adjusted for currency) in 2013. Tivoli security revenue increased share in social, mobile, analytics, cloud and security. Some of this is 17 percent (19 percent adjusted for currency) and reflects contribution delivered in a SaaS model, and the company has over 100 SaaS from the acquisition of Trusteer in the third quarter of 2013, which offerings in its software portfolio. Across the Software brands, there extended Tivoli’s data security capabilities further into cloud and mobile was strong performance in the growth initiatives that address the environments. The transformation driven by mobile and cloud comput- key market trends—Smarter Planet, business analytics and cloud. ing is raising the importance of security for enterprise customers. The The Software business completed eight acquisitions in 2013, adding company has been building and expanding its security capabilities and to its capabilities in mobile, big data analytics and security. The Soft- now has 6,000 security experts worldwide, 3,000 patents in security ware business grew segment pre-tax profit 2.7 percent to $11.1 billion and 25 security laboratories worldwide across software and services. and expanded pre-tax margin 0.5 points. Social Workforce Solutions revenue increased 10.8 percent In January 2014, the company announced a $1 billion investment in (12 percent adjusted for currency) in 2013. Performance was driven Watson, and it established a new Watson Group within the Software by Kenexa, which provides cloud-based recruiting and talent business. This new unit is dedicated to the development and com- management solutions. mercialization of cloud-delivered cognitive innovations. Rational revenue increased 4.9 percent (6 percent adjusted for Key branded middleware revenue increased 4.8 percent (6 percent currency) in 2013 year over year. adjusted for currency), with strong performance in the areas of analytics, Operating systems revenue decreased 3.1 percent (2 percent cloud, mobile, social and security. The faster growing and higher value adjusted for currency) in 2013 compared to 2012, driven by declines in branded middleware accounted for 67 percent of total Software revenue Systems z and Power Systems. in 2013, an increase of 2 points from 2012. WebSphere revenue increased 8.2 percent (9 percent adjusted ($ in millions) for currency) in 2013 and gained share. Revenue performance was Yr.-to-Yr. Percent/ driven by double-digit growth in the Commerce offerings, and Margin growth in Business Integration and the on-premises Application For the year ended December 31: 2013 2012 Change Server business. Mobile contributed strong revenue growth in 2013. Software MobileFirst, the company’s comprehensive portfolio of mobile soft- External gross profit $23,032 $22,569 2.0% ware and services, was introduced in 2013 and extends value to External gross profit margin 88.8% 88.7% 0.1 pts. clients to reach new markets and gain competitive advantage. The Pre-tax income $11,106 $10,810 2.7% company continues to add capabilities to the WebSphere brand. In Pre-tax margin 38.1% 37.6% 0.5 pts. January 2014, the business acquired Aspera, Inc. which provides best in class transfer speeds for movement of big data.


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    Management Discussion 39 International Business Machines Corporation and Subsidiary Companies Software gross profit increased 2.0 percent in 2013, with a gross enterprise productivity initiatives, to drive profit growth and margin profit margin of 88.8 percent. Software pre-tax income increased expansion. The relative strength of the Software business, fueled by 2.7 percent and the pre-tax margin improved 0.5 points to 38.1 per- growth in the key growth initiatives, improved the company’s busi- cent. The Software business had another successful year leveraging ness mix and contributed to its operating (non-GAAP) consolidated revenue growth and expense savings, primarily from the company’s gross and net margin improvements. Systems and Technology ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2013 2012 Change Currency Systems and Technology external revenue $14,371 $17,667 (18.7)% (17.9)% System z (13.4)% (12.6)% Power Systems (31.4) (30.7) System x (13.5) (12.7) Storage (10.8) (9.7) Total Systems excluding Retail Store Solutions (17.6) (16.8) Microelectronics OEM (11.9) (11.9) Total Systems and Technology excluding Retail Store Solutions (17.0) (16.3) Retail Store Solutions (Divested in 2012) (98.2) (98.2) Systems and Technology (STG) revenue decreased 18.7 percent Power Systems revenue decreased 31.4 percent (31 percent (18 percent adjusted for currency) in 2013 versus 2012. Adjusting for adjusted for currency) in 2013 versus 2012. The Power platform the divested RSS business, revenue declined 17.0 percent (16 per- continues to ship significant capacity into the UNIX market, however cent adjusted for currency) in 2013. Growth markets revenue this has been more than offset by significant price performance, decreased 16.5 percent (16 percent adjusted for currency) in 2013, resulting in lower revenue. The company has been very successful compared to the prior year, while major markets revenue decreased in the UNIX market, and is taking two actions to improve its business 21.5 percent (20 percent adjusted for currency). Japan declined 18 model in Power Systems. First, it is making the platform more rele- percent as reported, but was essentially flat adjusted for currency. vant to clients. To achieve this: Two issues within the business significantly impacted the segment’s • In the fourth quarter of 2013, the company introduced a new revenue and profit performance in 2013. First, STG is dealing with Integrated Facility for Linux offering which enables clients to run challenges in its hardware business models specific to Power Sys- Linux workloads in their existing servers. This mirrors the suc- tems, Storage and x86. In addition, System z revenue was impacted cessful strategy the company executed on the System z platform; by the product cycle, particularly in the second half, as the company • The company will expand its Linux relevance even further entered the back end of the current mainframe cycle with difficult with POWER8 in 2014, which will provide additional big data period-to-period comparisons driving revenue declines. and cloud capabilities; and System z revenue decreased 13.4 percent (13 percent adjusted • Through the company’s OpenPOWER consortium it is making for currency) in 2013 versus 2012. The decrease was primarily driven Power technology available to an open development alliance, by lower revenue in North America, while revenue increased in the building an ecosystem around the Power technologies. growth markets. MIPS (millions of instructions per second) ship- These effects will take some time. ments increased 6 percent in 2013 versus the prior year. The Secondly, even with these additional capabilities, the company increase in MIPS was driven by specialty engines, which increased recognizes that the size of the Power platform will not return to prior 17 percent year over year and continue to be more than 50 percent revenue levels. The company will take action by right-sizing the busi- of the total volumes. The decline in System z revenue was expected ness for the demand characteristics it expects. based on the product’s movement through the product cycle in System x revenue decreased 13.5 percent (13 percent adjusted for 2013. In the current mainframe cycle, the company has shipped 28 currency) in 2013 versus 2012. High-end System x revenue decreased percent more MIPS compared to the same period in the prior cycle. 16 percent (16 percent adjusted for currency) and blades revenue The revenue and gross profit in the current cycle are each about 99 declined 45 percent (45 percent adjusted for currency) in 2013 versus percent of the previous cycle, net of currency. Mainframe products the prior year. These decreases were partially offset by increased provide the highest levels of availability, reliability, efficiency and revenue driven by PureSystems. security, which position it as the ideal platform for high volume, mis- PureSystems continued to gain momentum. Globally to date, the sion critical workloads. The additional MIPS capacity in the current company has shipped over 10,000 systems across its hardware brands. product cycle is a reflection of the ongoing relevance of the main- Storage revenue decreased 10.8 percent (10 percent adjusted for frame to clients, and provides the company with financial returns currency) in 2013 versus 2012. The company’s flash solutions contin- consistent with past cycles. ued to gain momentum in 2013 with positive revenue growth. The


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    40 Management Discussion International Business Machines Corporation and Subsidiary Companies Storwize products delivered double-digit growth, which were more The decrease in external gross profit in 2013 versus 2012 was due than offset by declines in legacy OEM mid-range offerings, and to lower revenue and a lower overall gross profit margin reflecting declines in high-end offerings driven by significant pricing pressure. the business model challenges. Overall gross margin decreased 3.5 Retail Store Solutions (RSS) revenue decreased 98.2 percent points in 2013 versus the prior year. The decrease was driven by (98 percent adjusted for currency) in 2013 versus 2012. In the third lower margins in Power Systems (1.0 points), System x (0.9 points), quarter of 2012, the company divested the RSS business to Toshiba Microelectronics (0.7 points) and Storage (0.4 points) as well as a TEC. See the caption, “Divestitures,” on page 98 for additional infor- decline due to revenue mix (0.7 points), partially offset by margin mation regarding the transaction. improvement in System z (0.1 points). Microelectronics OEM revenue decreased 11.9 percent (12 percent Systems and Technology’s pre-tax income decreased $1,734 adjusted for currency) in 2013 versus 2012. million to a loss of $507 million in 2013, when compared to the prior year. Pre-tax margin decreased 10.1 points in 2013 versus 2012. The ($ in millions) decline in pre-tax income was driven by the hardware businesses Yr.-to-Yr. which are dealing with business model challenges due to market Percent/ Margin shifts and System z, as it entered the backend of the mainframe For the year ended December 31: 2013 2012 Change product cycle late in the year. Systems and Technology External gross profit $5,120 $6,903 (25.8)% Global Financing External gross profit margin 35.6% 39.1% (3.5) pts. See pages 72 through 75 for an analysis of Global Financing’s Pre-tax income $(507) $1,227 NM segment results. Pre-tax margin (3.4)% 6.7% (10.1) pts. NM—Not meaningful Geographic Revenue In addition to the revenue presentation by reportable segment, the company also measures revenue performance on a geographic basis. The following geographic, regional and country-specific revenue performance excludes OEM revenue, which is discussed separately below. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2013 2012 Change Currency Total revenue $99,751 $104,507 (4.6)% (2.5)% Geographies $97,800 $102,268 (4.4)% (2.2)% Americas 43,249 44,556 (2.9) (2.0) Europe/Middle East/Africa 31,628 31,775 (0.5) (2.1) Asia Pacific 22,923 25,937 (11.6) (2.8) Major markets (4.2)% (2.2)% Growth markets (4.9)% (2.4)% BRIC countries (8.2)% (5.6)% Total geographic revenue of $97,800 million decreased 4.4 per- and China, combined revenue declined 8.2 percent (6 percent cent (2 percent adjusted for currency) in 2013. Revenue in the adjusted for currency). The company continues to see good oppor- major markets decreased 4.2 percent (2 percent adjusted for cur- tunity in all regions over the long term and is continuing to invest in rency). Revenue from the growth markets, which represented these key markets. approximately 23 percent of the total geographic revenue for the Americas revenue decreased 2.9 percent (2 percent adjusted for year, decreased 4.9 percent on a year-to-year basis (2 percent currency) compared to the prior year. The major market countries were adjusted for currency). Performance at constant currency in the down 3.9 percent (4 percent adjusted for currency), partially offset by growth markets was mixed, with year-to-year growth in the first an increase in the Latin America growth markets of 4.4 percent half offset by declines in the second half. The company had (9 percent adjusted for currency). Within the major market countries, strength in Latin America and the Middle East and Africa region. the U.S. was down 3.4 percent and Canada was down 6.3 percent However, declines in some of the larger growth markets, for example (3 percent adjusted for currency). Within the growth market countries, China and Australia, impacted the overall performance in the Brazil increased 3.3 percent (10 percent adjusted for currency) and growth markets. Within the BRIC countries of Brazil, Russia, India Mexico increased 7.8 percent (8 percent adjusted for currency).


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    Management Discussion 41 International Business Machines Corporation and Subsidiary Companies Europe/Middle East/Africa (EMEA) revenue decreased 0.5 per- Total expense and other (income) increased 2.1 percent in 2013 cent (2 percent adjusted for currency) compared to the prior year. versus 2012. Total operating (non-GAAP) expense and other The major market countries were down 0.5 percent (3 percent (income) increased 1.4 percent versus the prior year. The key drivers adjusted for currency), while the growth market countries were down of the year-to-year change in total expense and other (income) were 0.6 percent (up 1 percent adjusted for currency). In the major market approximately: countries, the UK decreased 1.4 percent (flat adjusted for currency), Total Operating Germany decreased 0.1 percent (3 percent adjusted for currency), Consolidated (non-GAAP) France decreased 1.8 percent (5 percent adjusted for currency), and • Currency* (1) point (1) point Italy decreased 2.1 percent (5 percent adjusted for currency). Within • Acquisitions** 2 points 2 points the EMEA growth markets, the Middle East and Africa region • Base expense 1 point 1 point increased 5.0 percent (11 percent adjusted for currency), but this * Reflects impacts of translation and hedging programs. growth was offset primarily by a decrease in Russia of 22.7 percent ** Includes acquisitions completed in prior 12-month period. (22 percent adjusted for currency). Asia Pacific revenue decreased 11.6 percent (3 percent adjusted In the execution of its strategy, the company continues to invest for currency) year to year. Japan revenue decreased 15.2 percent as in its growth initiatives, innovation and strategic acquisitions. The reported, but increased 4 percent overall and grew in every quarter company also has had an ongoing focus on increasing efficiency on a constant currency basis. This growth reflects the benefits of and productivity across the business. shifting investment and redirection of the company’s go-to-market For additional information regarding total expense and other focus to improve performance in Japan. The Asia Pacific growth (income), see the following analyses by category. markets decreased 9.1 percent (7 percent adjusted for currency), with China down 12.2 percent (14 percent adjusted for currency) and Selling, General and Administrative Australia down 15.9 percent (10 percent adjusted for currency). ($ in millions) During 2013, performance in China was impacted by the process Yr.-to-Yr. Percent surrounding the implementation of a broad governmental economic For the year ended December 31: 2013 2012 Change reform plan. Selling, general and OEM revenue of $1,951 million in 2013 decreased 12.9 percent administrative expense (12 percent adjusted for currency) compared to the prior year, driven Selling, general and by the Microelectronics OEM business. administrative—other $19,187 $19,589 (2.1)% Advertising and promotional expense 1,294 1,339 (3.3) Total Expense and Other (Income) Workforce rebalancing charges 1,064 803 32.4 ($ in millions) Retirement-related costs 995 945 5.3 Yr.-to-Yr. Amortization of acquired Percent/ Margin intangible assets 370 328 12.9 For the year ended December 31: 2013 2012 Change Stock-based compensation 435 498 (12.6) Total consolidated expense Bad debt expense 156 50 210.0 and other (income) $28,981 $28,396 2.1% Total consolidated selling, general Non-operating adjustments and administrative expense $23,502 $23,553 (0.2)% Amortization of acquired Non-operating adjustments intangible assets (370) (328) 12.9 Amortization of acquired Acquisition-related charges (40) (35) 14.9 intangible assets (370) (328) 12.9 Non-operating retirement-related Acquisition-related charges (25) (22) 13.3 (costs)/income (433) (274) 58.3 Non-operating retirement-related Operating (non-GAAP) (costs)/income (376) (294) 28.1 expense and other (income) $28,137 $27,760 1.4% Operating (non-GAAP) Total consolidated selling, general and expense-to-revenue ratio 29.1% 27.2% 1.9 pts. administrative expense $22,731 $22,910 (0.8)% Operating (non-GAAP) expense-to-revenue ratio 28.2% 26.6% 1.6 pts.


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    42 Management Discussion International Business Machines Corporation and Subsidiary Companies Total selling, general and administrative (SG&A) expense decreased Research, Development and Engineering 0.2 percent in 2013 versus 2012. The decrease was primarily driven ($ in millions) by the effects of currency (1 point) and base spending (1 point), Yr.-to-Yr. Percent partially offset by acquisition-related spending (2 points). Operating For the year ended December 31: 2013 2012 Change (non-GAAP) SG&A expense decreased 0.8 percent primarily driven Total consolidated research, by the effects of currency (1 point) and lower base spending development and engineering $6,226 $6,302 (1.2)% (1 point), partially offset by acquisition-related spending (1 point). Non-operating adjustment The decrease was driven by lower SG&A—other expense, as the Non-operating retirement-related company continues to shift its spending. The company is continuing (costs)/income (57) 20 NM to drive productivity across the business, primarily through its enter- Operating (non-GAAP) research, prise productivity initiatives, and is reinvesting most of those savings development and engineering $6,170 $6,322 (2.4)% into the business to drive its growth areas. The increase in workforce NM—Not meaningful rebalancing charges was due to actions the company took in the second quarter of 2013. Bad debt expense increased $106 million The company continues to invest in research and development, in 2013 versus 2012, primarily driven by higher specific account focusing its investments on high-value, high-growth opportunities reserves. The accounts receivable provision coverage was 1.6 per- and to extend its technology leadership. Total research, development cent at December 31, 2013, an increase of 20 basis points from and engineering (RD&E) expense decreased 1.2 percent in 2013 year-end 2012. versus 2012, primarily driven by lower base spending (3 points), par- tially offset by acquisitions (2 points). Operating (non-GAAP) RD&E Other (Income) and Expense expense decreased 2.4 percent in 2013 compared to the prior year ($ in millions) primarily driven by lower base spending (4 points), partially offset by Yr.-to-Yr. Percent acquisitions (2 points). Overall, the investment in RD&E represented For the year ended December 31: 2013 2012 Change 6.2 percent of revenue in 2013, compared to 6.0 percent in 2012. Other (income) and expense Foreign currency transaction Intellectual Property and Custom Development Income losses/(gains) $(260) $(240) 8.4% ($ in millions) (Gains)/losses on derivative Yr.-to-Yr. Percent instruments 166 72 132.5 For the year ended December 31: 2013 2012 Change Interest income (74) (109) (32.2) Sales and other transfers Net (gains)/losses from securities of intellectual property $352 $ 324 8.7% and investment assets (29) (55) (48.0) Licensing/royalty-based fees 150 251 (40.0) Other (131) (511) (74.4) Custom development income 320 500 (36.0) Total consolidated other Total $822 $1,074 (23.5)% (income) and expense $(327) $(843) (61.2)% Non-operating adjustment The timing and amount of sales and other transfers of intellectual Acquisition-related charges (16) (13) 17.4 property (IP) may vary significantly from period to period depending Operating (non-GAAP) upon timing of divestitures, industry consolidation, economic con- other (income) and expense $(343) $(857) (60.0)% ditions and the timing of new patents and know-how development. There were no significant individual IP transactions in 2013 or 2012. Other (income) and expense was income of $327 million and $843 Custom development income declined 36 percent compared to million in 2013 and 2012, respectively. The decrease in income of the prior year due to a reduction in payments from the company’s $516 million in 2013 was primarily driven by lower income from dives- technology alliance partners. titures ($405 million) driven by the gain associated with the divested RSS business ($446 million) in 2012 reflected in Other in the table Interest Expense above, and increased losses on derivative instruments ($95 million) ($ in millions) due to foreign currency rate volatility year to year. Yr.-to-Yr. Percent For the year ended December 31: 2013 2012 Change Interest expense Total $402 $459 (12.5)%


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    Management Discussion 43 International Business Machines Corporation and Subsidiary Companies The decrease in interest expense in 2013 versus 2012 was primarily In 2013, total retirement-related plan cost increased by $488 million driven by lower average interest rates, partially offset by higher aver- compared to 2012, primarily driven by an increase in recognized age debt levels. Interest expense is presented in cost of financing in actuarial losses ($1,027 million) and lower expected return on plan the Consolidated Statement of Earnings only if the related external assets ($169 million), partially offset by lower interest cost ($510 million) borrowings are to support the Global Financing external business. and lower pension litigation cost ($152 million). See page 75 for additional information regarding Global Financing As discussed in the “Operating (non-GAAP) Earnings” section debt and interest expense. Overall interest expense (excluding capi- on page 26, the company characterizes certain retirement-related talized interest) for 2013 was $989 million, a decrease of $15 million costs as operating and others as non-operating. Utilizing this year to year. characterization, operating retirement-related costs in 2013 were $1,815 million, a decrease of $36 million compared to 2012, driven Stock-Based Compensation by lower cost of defined contribution plans ($122 million), partially Total pre-tax stock-based compensation cost of $614 million offset by increased service cost ($52 million) and increased amor- decreased $74 million compared to 2012. The decrease was primar- tization of prior service cost ($34 million). Non-operating costs of ily related to performance share units ($48 million), the company’s $1,062 million increased $524 million in 2013, compared to the assumption of stock-based awards previously issued by acquired prior year, driven primarily by the increase in recognized actuarial entities ($16 million) and restricted stock units ($10 million). Stock- losses ($1,027 million) and lower expected return on plan assets based compensation cost, and the year-to-year change, was ($169 million), partially offset by lower interest cost ($510 million) reflected in the following categories: Cost: $122 million, down $10 and lower pension litigation cost ($152 million). million; SG&A expense: $435 million, down $63 million; and RD&E expense: $57 million, down $2 million. Income Taxes See note R, “Stock-Based Compensation,” on pages 124 to 127 The effective tax rate for 2013 was 15.6 percent, a decrease of 8.6 for additional information on stock-based compensation. points versus the prior year, driven by the following factors: • A benefit resulting from the completion of the U.S. 2008-2010 Retirement-Related Plans tax audit, including the associated reserve redeterminations The following table provides the total pre-tax cost for all retirement- (11.5 points); related plans. These amounts are included in the Consolidated • A benefit due to a more favorable geographic mix of pre-tax Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) income in 2013 (2.4 points); relating to the job function of the plan participants. • Benefits from the retroactive impact of the 2012 American Taxpayer Relief Act (0.7 points) and an increase in research ($ in millions) and development credits (0.6 points); Yr.-to-Yr. Percent • A benefit from a tax agreement which required a reassess- For the year ended December 31: 2013 2012 Change ment of certain valuation allowances on deferred tax assets Retirement-related plans—cost (1.5 points); and Service cost $ 545 $ 493 10.6% • Benefits from the resolution of certain non-U.S. tax audits Amortization of prior (0.8 points) and newly enacted U.S. state tax legislation service cost/(credits) (114) (148) (22.9) (0.6 points); partially offset by Cost of defined contribution plans 1,384 1,506 (8.1) • Tax charges related to certain intercompany payments Total operating costs $ 1,815 $ 1,851 (2.0)% made by foreign subsidiaries and the intercompany licensing Interest cost 3,728 4,238 (12.0) of certain IP (9.1 points); and Expected return on plan assets (6,187) (6,356) (2.7) • The year-over-year impact of the 2012 benefit related to a tax restructuring in Latin America (0.8 points). Recognized actuarial losses 3,434 2,407 42.7 Plan amendments/curtailments/ The operating (non-GAAP) effective tax rate was 16.0 percent, a settlements 0 1 (30.6) decrease of 8.0 points versus 2012 principally driven by the same Multi-employer plan/other costs 86 247 (65.4) factors described above. Total non-operating costs/(income) $ 1,062 $ 538 97.5% Total retirement-related Earnings Per Share plans—cost $ 2,876 $ 2,389 20.4% Basic earnings per share is computed on the basis of the weighted- average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted-average number of shares of common stock out- standing plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.


  • Page 45

    44 Management Discussion International Business Machines Corporation and Subsidiary Companies Yr.-to-Yr. During 2013, the company generated $17,485 million in cash from Percent operations, a decrease of $2,102 million compared to 2012. In addi- For the year ended December 31: 2013 2012 Change tion, the company generated $15,021 million in free cash flow, a Earnings per share of common stock decrease of $3,164 million versus the prior year. See pages 65 to 67 Assuming dilution $14.94 $14.37 4.0% for additional information on free cash flow. The company returned Basic $15.06 $14.53 3.6% $17,917 million to shareholders in 2013, with $13,859 million in gross Diluted operating (non-GAAP) $16.28 $15.25 6.8% share repurchases and $4,058 million in dividends. In 2013 the com- Weighted-average shares pany repurchased approximately 73 million shares and had outstanding (in millions) approximately $14.7 billion remaining in share repurchase authoriza- Assuming dilution 1,103.0 1,155.4 (4.5)% tion at year end. The company’s cash generation permits the Basic 1,094.5 1,142.5 (4.2)% company to invest and deploy capital to areas with the most attrac- tive long-term opportunities. Actual shares outstanding at December 31, 2013 and 2012 were The assets and debt associated with the Global Financing 1,054.4 million and 1,117.4 million, respectively. The average number business are a significant part of the company’s financial position. of common shares outstanding assuming dilution was 52.4 million The financial position amounts appearing on page 80 are the con- shares lower in 2013 versus 2012. The decrease was primarily the solidated amounts including Global Financing. The amounts result of the common stock repurchase program. See note L, appearing in the separate Global Financing section, beginning “Equity Activity,” on page 116 for additional information regarding on page 72, are supplementary data presented to facilitate an common stock activities. Also see note P, “Earnings Per Share of understanding of the Global Financing business. Common Stock,” on pages 124 and 125. Working Capital Financial Position ($ in millions) Dynamics At December 31: 2013 2012 At December 31, 2013, the company continues to have a high degree Current assets $51,350 $49,433 of financial flexibility with a strong balance sheet to support the busi- Current liabilities 40,154 43,625 ness over the long term. Cash and marketable securities at year end Working capital $11,196 $ 5,807 were $11,066 million, consistent with the prior year-end balance. Current ratio 1.28:1 1.13:1 During the year, the company continued to manage the investment portfolio to meet its capital preservation and liquidity objectives. Working capital increased $5,388 million from the year-end 2012 Total debt of $39,718 million increased $6,449 million from prior position. The key changes are described below: year-end levels. The commercial paper balance at December 31, Current assets increased $1,917 million ($2,815 million adjusted 2013, was $2,458 million, an increase of $658 million from the prior for currency), due to: year. Within total debt, $27,504 million is in support of the Global • An increase of $1,258 million ($1,886 million adjusted for Financing business which is leveraged at a 7.2 to 1 ratio. The com- currency) in short-term receivables primarily due to higher pany continues to have substantial flexibility in the market. During volumes related to inventory financing; and 2013, the company completed bond issuances totaling $10,956 • An increase of $463 million ($630 million adjusted for million, with terms ranging from 2 to 12 years, and priced from 0.22 currency) in prepaid expenses and other assets, to 3.38 percent depending on maturity. The company has consis- primarily driven by prepaid income taxes ($407 million). tently generated strong cash flow from operations and continues to have access to additional sources of liquidity through the capital Current liabilities decreased $3,471 million ($2,562 million adjusted markets and its $10 billion global credit facility, with 100 percent of for currency), as a result of: the facility available on a same day basis. • A decrease in short-term debt of $2,319 million ($2,096 million Consistent with accounting standards, the company remeasures adjusted for currency) (see debt analysis on pages 45 and 46); the funded status of its retirement and postretirement plans at • A decrease of $853 million ($770 million adjusted for currency) December 31. At December 31, 2013, the overall net underfunded in compensation and benefits reflecting lower accruals for position was $11,434 million, a decrease of $8,756 million from performance-related compensation; and December 31, 2012 driven by the increase in discount rates, primarily • A decrease in accounts payable of $490 million ($409 million in the U.S. At year end, the company’s qualified defined benefit plans adjusted for currency) reflecting payment of higher 2012 year- were well funded and the cash requirements related to these plans end volumes; partially offset by remain stable going forward at less than $700 million per year • An increase in deferred income of $605 million ($861 million through 2015. In 2013, the return on the U.S. Personal Pension Plan adjusted for currency) primarily driven by Software. assets was 7.1 percent and the plan was 109 percent funded. Overall, global asset returns were 7.1 percent and the qualified defined benefit plans worldwide were 102 percent funded. See note S, “Retirement- Related Benefits,” on pages 127 to 141 for additional information.


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    Management Discussion 45 International Business Machines Corporation and Subsidiary Companies Cash Flow Noncurrent Assets and Liabilities The company’s cash flows from operating, investing and financing ($ in millions) activities, as reflected in the Consolidated Statement of Cash Flows At December 31: 2013 2012 on page 81, is summarized in the table below. These amounts include Noncurrent assets $74,873 $69,780 the cash flows associated with the Global Financing business. Long-term debt $32,856 $24,088 Noncurrent liabilities (excluding debt) $30,284 $32,516 ($ in millions) For the year ended December 31: 2013 2012 Net cash provided by/(used in) The increase in noncurrent assets of $5,093 million ($6,521 million adjusted for currency) was driven by: Operating activities $17,485 $ 19,586 • An increase of $4,607 million ($4,578 million adjusted for Investing activities (7,326) (9,004) currency) in prepaid pension assets primarily driven by plan Financing activities (9,883) (11,976) remeasurements; and Effect of exchange rate changes • An increase in intangible assets and goodwill of $2,022 million on cash and cash equivalents 28 (116) ($2,385 million adjusted for currency) primarily driven by Net change in cash and cash equivalents $ 304 $ (1,511) current year acquisitions; partially offset by • A decrease of $922 million in deferred taxes ($753 million Net cash provided by operating activities decreased by $2,102 adjusted for currency) driven by retirement-related plans million in 2013 driven by operational performance and the following activity. key factors: • A net increase in the use of cash for taxes (deferred, payable, Long-term debt increased by $8,768 million ($8,779 million adjusted reserves) of $2,200 million primarily driven by an increase in for currency) primarily driven by new debt issuances of $12,898 million, cash income tax payments; partially offset by reclasses to short-term debt of $3,949 million. • A net decrease from compensation and benefits of approxi- Other noncurrent liabilities, excluding debt, decreased $2,232 mately $600 million primarily driven by reductions in million ($1,723 million adjusted for currency) primarily driven by: performance-related compensation; • A decrease in retirement and nonpension benefit obligations of • An increase in the use of cash of $438 million related to the $4,176 million driven by plan remeasurements; partially offset by fulfillment of services contracts; • An increase of $2,326 million in other liabilities primarily • Higher cash requirements for inventory ($337 million); driven by deferred tax increases related to the pension plan • Higher cash payments for workforce rebalancing of remeasurements. $332 million; and • Lower net income of $121 million; partially offset by Debt • Lower cash used by accounts receivables of $823 million The company’s funding requirements are continually monitored and primarily driven by financing receivables; and strategies are executed to manage the overall asset and liability • A decrease in cash funding related to retirement-related profile. Additionally, the company maintains sufficient flexibility to plans of $723 million driven by a decrease in nonpension access global funding sources as needed. postretirement contributions. ($ in millions) Net cash used in investing activities decreased $1,679 million driven by: At December 31: 2013 2012 • An increase in cash of $1,232 million from net sales of Total company debt $39,718 $33,269 marketable securities and other investments; Total Global Financing segment debt $27,504 $24,501 • A net decrease of $539 million in cash used for capital Debt to support external clients 24,471 21,583 expenditures; and Debt to support internal clients 3,033 2,919 • A net decrease of $363 million in cash used for acquisitions/ divestitures; partially offset by Global Financing provides financing predominantly for the com- • A net decrease in cash provided by non-operating financing pany’s external client assets, as well as for assets under contract by receivables of $455 million. other IBM units. These assets, primarily for Global Services, gener- ate long-term, stable revenue streams similar to the Global Financing Net cash used in financing activities decreased $2,094 million as asset portfolio. Based on their attributes, these Global Services compared to the prior year driven by the following factors: assets are leveraged with the balance of the Global Financing asset • An increase in net cash from debt transactions (including base. The debt analysis above is further detailed in the Global short-term borrowings) of $4,708 million; partially offset by Financing section on page 75. • An increase of $2,330 million of net cash used for common Given the significant leverage, the company presents a debt-to- stock transactions; and capitalization ratio which excludes Global Financing debt and equity • An increase in dividend payments of $285 million. as management believes this is more representative of the com- pany’s core business operations. This ratio can vary from period to period as the company manages its global cash and debt positions.


  • Page 47

    46 Management Discussion International Business Machines Corporation and Subsidiary Companies “Core” debt-to-capitalization ratio (excluding Global Financing increase in equity as a result of retirement-related plan remeasure- debt and equity) was 39.0 percent at December 31, 2013 compared ments in December. to 36.1 percent at December 31, 2012. The increase was primarily driven by an increase in non-Global Financing debt of $3,446 million Equity partially offset by an increase in non-Global Financing equity of Total equity increased by $3,945 million from December 31, 2012 as $3,615 million from the December 31, 2012 balances. a result of an increase in retained earnings of $12,401 million, an Consolidated debt-to-capitalization ratio at December 31, 2013 increase in common stock of $1,484 million and lower accumulated was 63.4 percent versus 63.7 percent at December 31, 2012. other comprehensive losses of $4,157 million, partially offset by an The “core” debt-to-capitalization ratio and the consolidated increase in treasury stock of $14,110 million related to common stock debt-to-capitalization ratio were impacted by the $3,184 million repurchases during the year. GAAP Reconciliation The tables below provide a reconciliation of the company’s income statement results as reported under GAAP to its operating earnings presentation which is a non-GAAP measure. The company’s calculation of operating (non-GAAP) earnings, as presented, may differ from similarly titled measures reported by other companies. Please refer to the “Operating (non-GAAP) Earnings” section on page 26 for the company’s rationale for presenting operating earnings information. ($ in millions except per share amounts) Acquisition- Retirement- Related Related Operating For the year ended December 31, 2013: GAAP Adjustments Adjustments (non-GAAP) Gross profit $48,505 $ 394 $ 629 $49,527 Gross profit margin 48.6% 0.4 pts. 0.6 pts. 49.7% SG&A $23,502 $(394) $ (376) $22,731 RD&E 6,226 0 (57) 6,170 Other (income) and expense (327) (16) 0 (343) Total expense and other (income) 28,981 (410) (433) 28,137 Pre-tax income 19,524 804 1,062 21,390 Pre-tax income margin 19.6% 0.8 pts. 1.1 pts. 21.4% Provision for income taxes* $ 3,041 $ 57 $ 333 $ 3,431 Effective tax rate 15.6% (0.3) pts. 0.8 pts. 16.0% Net income $16,483 $ 747 $ 729 $17,959 Net income margin 16.5% 0.7 pts. 0.7 pts. 18.0% Diluted earnings per share $ 14.94 $0.68 $ 0.66 $ 16.28 * The tax impact on operating (non-GAAP) pre-tax income is calculated under the same accounting principles applied to the GAAP pre-tax income which employs an annual effective tax rate method to the results. ($ in millions except per share amounts) Acquisition- Retirement- Related Related Operating For the year ended December 31, 2012: GAAP Adjustments Adjustments (non-GAAP) Gross profit $50,298 $ 376 $ 264 $50,938 Gross profit margin 48.1% 0.4 pts. 0.3 pts. 48.7% SG&A $23,553 $(349) $ (294) $22,910 RD&E 6,302 0 20 6,322 Other (income) and expense (843) (13) 0 (857) Total expense and other (income) 28,396 (363) (274) 27,760 Pre-tax income 21,902 739 538 23,179 Pre-tax income margin 21.0% 0.7 pts. 0.5 pts. 22.2% Provision for income taxes* $ 5,298 $ 98 $ 156 $ 5,552 Effective tax rate 24.2% (0.4) pts. 0.1 pts. 24.0% Net income $16,604 $ 641 $ 381 $17,627 Net income margin 15.9% 0.6 pts. 0.4 pts. 16.9% Diluted earnings per share $ 14.37 $0.55 $ 0.33 $ 15.25 * The tax impact on operating (non-GAAP) pre-tax income is calculated under the same accounting principles applied to the GAAP pre-tax income which employs an annual effective tax rate method to the results.


  • Page 48

    Management Discussion 47 International Business Machines Corporation and Subsidiary Companies Consolidated Fourth-Quarter Results Within the company’s segments, revenue performance at con- ($ and shares in millions except per share amounts) stant currency was led by growth in Software, Global Services and Yr.-to-Yr. Global Financing which was more than offset by a decline in STG. Percent/ Software revenue improved 2.8 percent as reported and 4 percent Margin For the fourth quarter: 2013 2012 Change at constant currency. Performance was broad-based with constant Revenue $27,699 $29,304 (5.5)%* currency growth in all brands and strength in several of the areas Gross profit margin 51.7% 51.8% (0.1) pts. where the company has targeted it investments—business analyt- Total expense and other (income) $ 7,353 $ 7,336 0.2% ics, cloud and security. Total Global Services revenue declined 2.3 percent as reported, but increased 1 percent at constant currency Total expense and other (income)-to-revenue ratio 26.5% 25.0% 1.5 pts. consistent with performance in the third-quarter. Performance was Income before income taxes $ 6,962 $ 7,831 (11.1)% driven by GBS which increased 0.6 percent as reported and 4 per- cent adjusted for currency, driven by offerings that address Provision for income taxes 777 1,998 (61.1)% digitization of the front office. Revenue performance in strategic Net income $ 6,185 $ 5,833 6.0% outsourcing within GTS continued to improve, adjusted for currency. Net income margin 22.3% 19.9% 2.4 pts. The Global Services backlog increased 1.8 percent (5 percent Earnings per share of common stock adjusted for currency), also driven by GBS. STG revenue decreased Assuming dilution $ 5.73 $ 5.13 11.7% 26.1 percent as reported (25 percent adjusted for currency) and Weighted-average shares outstanding impacted the overall consolidated performance. The company is Assuming dilution 1,080.0 1,136.4 (5.0)% dealing with challenges in its hardware business models specific to * (3.5) percent adjusted for currency. Power Systems, Storage and x86. As expected, System z mainframe revenue was impacted by the product cycle and decreased 37.4 The following table provides the company’s operating (non-GAAP) percent (37 percent adjusted for currency) compared to a very earnings for the fourth quarter of 2013 and 2012. strong performance in the fourth quarter of 2012. These dynamics in the hardware business significantly impacted consolidated ($ in millions except per share amounts) revenue growth and profit in the fourth quarter of 2013. Yr.-to-Yr. On a geographic basis, revenue in the growth markets declined Percent For the fourth quarter: 2013 2012 Change 9.5 percent (6 percent adjusted for currency) with mixed results by Net income as reported $6,185 $5,833 6.0% region, though disappointing overall. In the two largest regions, Asia Non-operating adjustments (net of tax) Pacific growth markets were down 15.7 percent (12 percent adjusted Acquisition-related charges 268 243 10.6 for currency), primarily driven by China, while growth markets in Latin America were essentially flat as reported, but increased 5 percent Non-operating retirement-related costs/(income) 164 53 207.8 at constant currency. Operating (non-GAAP) earnings* $6,617 $ 6,129 8.0% The consolidated gross profit margin was essentially flat year to year at 51.7 percent. The operating (non-GAAP) gross profit margin Diluted operating (non-GAAP) earnings per share $ 6.13 $ 5.39 13.7% increased 0.3 points to 52.6 percent. Margins expanded in both Global Services segments, and the relative strength in the Software business * See page 52 for a more detailed reconciliation of net income to operating (non-GAAP) earnings. drove an improving mix. These improvements were mitigated by a 5.5 point margin decline in STG. System z margin improved year to year Snapshot as expected at this point in the product cycle, but the other hardware In the fourth quarter of 2013, the company reported $27.7 billion in rev- brands declined reflecting the business model challenges. enue, expanded its net income margin and delivered diluted earnings Total expense and other (income) increased 0.2 percent in the per share growth of 11.7 percent as reported and 13.7 percent on an fourth quarter compared to the prior year. Total operating (non- operating (non-GAAP) basis. The company generated $6.5 billion in GAAP) expense and other (income) decreased 1.0 percent versus cash from operations and $8.4 billion in free cash flow in the fourth quar- the prior year. The key drivers of the year-to-year change in total ter driving shareholder returns of $6.8 billion in gross common stock expense and other (income) were approximately: repurchases and dividends. The free cash flow performance repre- Total Operating sented 56 percent of the full year—the highest percent in several years. Consolidated (non-GAAP) Revenue in the fourth quarter decreased 5.5 percent, 3.5 percent • Currency* (2) points (2) points at constant currency. The currency impact to revenue was 2.0 points. • Acquisitions** 2 points 2 points Consistent with the full year, currency also impacted profit perfor- • Base expense 0 points (1) point mance in the fourth quarter as the depreciation of the Yen largely * Reflects impacts of translation and hedging programs. flows to profit due to the local services content within the company’s ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is business in Japan and the inability to hedge these cash flows. net of non-operating acquisition-related charges.


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    48 Management Discussion International Business Machines Corporation and Subsidiary Companies Pre-tax income declined 11.1 percent year to year and the pre-tax 3.0 points compared to the prior year. The operating (non-GAAP) margin was 25.1 percent. Net income increased 6.0 percent and effective tax rate was 11.0 percent versus 24.4 percent in the fourth the net income margin was 22.3 percent, an increase of 2.4 points quarter of 2012 driven by the same factors described above. year to year. The effective tax rate for the fourth quarter was 11.2 Diluted earnings per share of $5.73 increased 11.7 percent versus percent, compared to 25.5 percent in the prior year. The decrease the prior year. In the fourth quarter, the company repurchased 33.2 in the tax rate included substantial benefits from tax audit settle- million shares of its common stock. Operating (non-GAAP) diluted ments and a modest reduction in the ongoing tax rate. Specifically, earnings per share of $6.13 increased $0.74 or 13.7 percent versus the fourth-quarter tax rate included the conclusion of the U.S. tax the fourth quarter of 2012 driven by the following factors: audit for the three-year period from 2008-2010. The company • Revenue decrease at actual rates $ (0.29) accrues taxes for uncertain tax matters in the normal tax rate. The • Margin expansion $ 0.73 conclusion of the audit in November 2013 resulted in a reduction • Common stock repurchases $ 0.30 of tax expense previously recorded in the normal tax rate. While the audit closure had the most significant impact, there were additional The operating (non-GAAP) earnings per share growth in the fourth discrete items impacting the rate in the fourth quarter. Operating quarter was achieved through a combination of: continued momen- (non-GAAP) pre-tax income declined 8.4 percent year to year and tum in key growth areas, which drove a mix to higher-value Software the operating (non-GAAP) pre-tax margin was 26.8 percent, down and GBS; yield from productivity initiatives; a modest improvement 0.8 points year to year driven entirely by the hardware business. in the ongoing tax rate, along with substantial benefits from tax Operating (non-GAAP) net income increased 8.0 percent and the audit settlements; and, the effective use of cash to repurchase operating (non-GAAP) net income margin of 23.9 percent increased common shares. Segment Details The following is an analysis of the fourth quarter of 2013 versus the fourth quarter of 2012 reportable segment external revenue and gross margin results. Segment pre-tax income includes transactions between the segments that are intended to reflect an arms-length transfer price and excludes certain unallocated corporate items. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent/ Percent Change Margin Adjusted for For the fourth quarter: 2013 2012 Change Currency Revenue Global Technology Services $ 9,917 $10,284 (3.6)% (0.6)% Gross margin 38.8% 37.6% 1.2 pts. Global Business Services 4,747 4,720 0.6% 4.3% Gross margin 30.7% 29.9% 0.7 pts. Software 8,140 7,915 2.8% 3.5% Gross margin 90.5% 90.6% (0.1) pts. Systems and Technology 4,261 5,763 (26.1)% (25.4)% Gross margin 38.6% 44.1% (5.5) pts. Global Financing 534 535 (0.1)% 2.6% Gross margin 43.3% 43.8% (0.4) pts. Other 100 87 15.2% 16.9% Gross margin (234.8)% (73.2)% (161.6) pts. Total consolidated revenue $27,699 $29,304 (5.5)% (3.5)% Total consolidated gross profit $14,315 $15,167 (5.6)% Total consolidated gross margin 51.7% 51.8% (0.1) pts. Non-operating adjustments Amortization of acquired intangible assets 103 99 4.1% Acquisition-related charges 1 0 NM Retirement-related costs/(income) 154 60 155.7% Operating (non-GAAP) gross profit $14,574 $15,327 (4.9)% Operating (non-GAAP) gross margin 52.6% 52.3% 0.3 pts. NM—Not meaningful


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    Management Discussion 49 International Business Machines Corporation and Subsidiary Companies Global Services The Global Services segments, Global Technology Services and was driven by the practices that address the Digital Front Office. Global Business Services, generated $14,664 million of revenue in GBS delivered double-digit growth in each of the strategic growth the fourth quarter, a decrease year to year of 2.3 percent as initiatives—business analytics, Smarter Planet and cloud. In addi- reported, but an increase of 1 percent adjusted for currency. This tion, within the back office solutions that address the Globally was the second consecutive quarter of constant currency revenue Integrated Enterprise, implementation services that support the growth in total Global Services. Pre-tax income of $2,929 million in traditional packaged applications increased again in the fourth quar- the fourth quarter of 2013 was up 2.1 percent year to year and the ter at constant currency. Application Outsourcing revenue decreased pre-tax margin improved 0.9 points, with margin expansion in both 6.5 percent (2 percent adjusted for currency) and C&SI revenue segments. Global Services continued to have good performance in increased 2.7 percent (6 percent adjusted for currency), representing the key growth areas of cloud, business analytics and Smarter a 1 point sequential improvement at constant currency from the third Planet in the quarter, and the company is continuing to invest to quarter of 2013. The GBS gross profit margin improved 0.7 points extend its capabilities. Total outsourcing revenue of $6,662 million in the fourth quarter versus the prior year. GBS pre-tax income of decreased 4.5 percent (1 percent adjusted for currency) and total $940 million in the fourth quarter of 2013 increased 11.7 percent, transactional revenue of $6,202 million increased 0.3 percent with a pre-tax margin of 19.1 percent, an improvement of 2.0 points (4 percent adjusted for currency) year over year. year to year. The primary year-to-year profit drivers were reductions Global Technology Services revenue of $9,917 million decreased in performance-related compensation, continued benefits from the 3.6 percent (1 percent adjusted for currency) in the fourth quarter enterprise productivity initiatives and the second-quarter 2013 work- of 2013 with constant currency performance in line with the third force rebalancing actions. quarter of 2013. The major markets returned to constant currency growth for the first time since the first half of 2012, led by Europe, Software while the growth markets performance decelerated. GTS Outsourc- Software revenue of $8,140 million increased 2.8 percent (4 percent ing revenue decreased 4.2 percent (1 percent adjusted for currency) adjusted for currency) in the fourth quarter led by growth in key in the fourth quarter of 2013; however, constant currency perfor- branded middleware. Key branded middleware revenue increased mance improved 2 points from the third quarter. While GTS 5.5 percent (6 percent adjusted for currency) year to year and Outsourcing is beginning to realize the benefit from several of the gained share. large client transformational contracts signed earlier in 2013, it con- WebSphere revenue increased 14.3 percent (15 percent adjusted tinues to see a decline in revenue from sales into existing base for currency) in the fourth quarter and gained share. Revenue per- accounts where the activity is more transactional in nature and can formance included good growth in both the on-premise Application be economically sensitive. ITS revenue decreased 3.1 percent (flat Server business and the newer cloud-based offerings. Mobile con- adjusted for currency) in the fourth quarter. The company continues tinued to have strong growth—the comprehensive MobileFirst to shift the ITS business toward higher value managed services portfolio of software and services extends value to clients enabling such as business continuity, security and cloud. Within the cloud them to reach new markets and gain competitive advantage. In addi- offerings, SoftLayer contributed to the ITS revenue performance tion, the core WebSphere offerings of Business Integration and and drove one point of constant currency revenue growth to total Commerce delivered strong growth. Information Management rev- GTS in the fourth quarter. The GTS gross profit margin improved 1.2 enue increased 4.8 percent (5 percent adjusted for currency) in the points in the fourth quarter, with margin expansion across all lines fourth quarter and gained share. Distributed database offerings of business, led by ITS and Maintenance. Pre-tax income decreased were up double-digits at constant currency, and the business ana- 1.9 percent to $1,989 million while the pre-tax margin improved 0.4 lytics software offerings had its strongest growth in 2013 in the points to 19.5 percent in the fourth quarter of 2013 compared to the fourth quarter, led by business intelligence and Netezza appliances. prior year. Profit performance was impacted by the performance in Tivoli revenue increased 0.5 percent (1 percent adjusted for cur- the growth markets. In addition, the company continues to make rency) in the fourth quarter compared to the prior year period, driven investments in key growth areas such as cloud, mobility and secu- by double-digit growth in its security business. The transformation rity. These initiatives are beginning to contribute to revenue growth, driven by mobile and cloud computing is raising the importance of and will yield improved profit results as they achieve scale. Margin security for enterprise customers, and the company is continuing to expansion was driven by reductions in performance-related com- build its capabilities in this area. Social Workforce Solutions revenue pensation and benefits from the second-quarter 2013 workforce increased 2.4 percent (3 percent adjusted for currency) in the fourth rebalancing actions. quarter and continued to be driven by Kenexa, which provides Global Business Services revenue of $4,747 million increased cloud-based recruiting and talent management. Rational revenue 0.6 percent as reported and 4 percent at constant currency in the increased 0.3 percent (1 percent adjusted for currency) year to year fourth quarter of 2013 and gained share again in the period. GBS in the fourth quarter. had constant currency revenue growth in all geographic regions led The Software business delivered pre-tax income of $4,239 by North America and the growth markets. Japan continued its solid million in the fourth quarter of 2013, an increase of 5.5 percent year performance, and Europe had constant currency revenue growth to year, with a pre-tax margin of 47.0 percent, an improvement of for the second consecutive quarter. On an offering basis, growth 1.0 points.

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