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    2014 IBM Annual Report


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    A Letter from the Chairman 1 Dear IBM Investor: The cover of our report to you last year asked: “What will we make of this moment?” This was the critical and urgent decision that we — and our clients — faced. Would we seize upon the major shifts that are reordering our industry and opening up vast new applications of information technology? In my letter, I described our answer: • IBM would help transform industries and professions with data. • We would remake enterprise IT for the era of cloud. • We would reimagine work by helping clients build systems of engagement, underpinned by the imperative of security. At the same time, we would address significant challenges in some of our businesses, principally hardware. We knew we faced a critical year of transformation. It proved to be just that. The work of transforming IBM continues, and much remains to be done. But I am pleased to report that we made significant progress and built momentum in 2014. In this letter I will describe what we have done, and continue to do, to transform and differentiate your company and to position ourselves for leadership in the new era now taking shape.


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    2 VIRGINIA M. ROMETTY Chairman, President and Chief Executive Officer


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    A Letter from the Chairman 3 Continuing to move to higher value Information technology is one of the most dynamic, fast- changing and fiercely competitive industries in the world, characterized by relentless cycles of innovation and commoditization. Our choice is clear: We pursue a model of high-value innovation, rather than commodity technology, products and services. Our commitment to this model compels us to reinvent businesses continually; grow new ones organically and through acquisitions; and occasionally divest businesses that do not fit our profile. You see all of this reflected in our 2014 results — a dynamic shift of our portfolio underneath our $92.8 billion in revenue, 2014 $21 billion in operating pre-tax income and operating earnings per share of $16.53 from continuing operations. $ 92.8 billion Consider that we completed or announced the divestiture Revenue of three businesses in 2014 that a year earlier drove $7 billion in revenue, but lost about $500 million in profit — $ 21 billon what I call “empty calories.” At the same time, we are Operating pre-tax making significant investments in line with the strategy income I described to you last year. Throughout the year you saw the bold moves we made: $ 16.53 • $1 billion to accelerate the commercialization of IBM Operating EPS Watson, bringing cognitive computing to more clients and partners in more industries. • $1.2 billion to expand our SoftLayer cloud centers around the world. We expect to have 46 locations by the end of 2015. • $1 billion to create IBM Bluemix, our cloud platform-as- a-service for software developers. • Further scaling our global IBM Cloud business through partnerships with SAP and Tencent.


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    4 • IBM Watson Analytics, offering powerful cognitive and For example, the planetwide footprint of cloud centers that visually intuitive analytics in the palm of your hand. we are building will provide clients the combination of global and localized data access and security that they • A landmark partnership with Apple to bring mobility to need. This is unmatched in the industry. the enterprise and reimagine the work of professionals. Engagement, underpinned by security. In mobile, • A strategic alliance with Twitter to bring an entire new our growth more than tripled in 2014. Going forward, we category of Big Data to business. expect this to benefit from the apps from our strategic These investments will contribute to the strong growth we alliance with Apple and our global network of digital design are seeing in our strategic imperatives, which deliver high studios. Further, IBM is the global leader in enterprise value and now represent a significant part of IBM. Together, security, grounded not only in technology and our 3,700 cloud, analytics, mobile, social and security generated patents, but in our experience-based understanding $25 billion of revenue in 2014, growing by 16 percent. Five years of the changing nature of the challenge. Enterprises and ago, these businesses represented just 13 percent of our institutions discover that they cannot wall out attackers. revenue. Today, that has risen to 27 percent of IBM’s revenue. Twenty-first century security is a Big Data problem — which is why our security business, with unequalled data Big Data and analytics. Our analytics business grew and analytics capability, grew 19 percent in 2014. 7 percent to $17 billion in 2014. We are driving growth by helping our clients integrate all data sources — structured At the same time that we have been growing new businesses, and unstructured — and apply a range of analytics — we have been reinventing our core franchises. Last year descriptive, predictive and prescriptive. We combine we promised to address challenges in our Systems and this capability with deep knowledge of industries and Technology business. We did so in 2014, with hardware going professions. Our analytics portfolio draws upon more than from losses in the first half to nearly $400 million of profit in 30 acquisitions and includes nine Analytics Solutions the fourth quarter alone. That is a remarkable swing. Centers with an ecosystem of more than 6,000 business In transforming this business, we took several important actions: partners. Further, we are creating the next stage of Big Data and analytics with cognitive computing. • We sold our x86 server business and announced the divestiture of our commercial semiconductor Cloud. Our cloud business is growing rapidly — up 60 technology business. percent to $7 billion in 2014, with “as-a-service” at $3 billion, up nearly 80 percent and exiting the year with a run rate of • We committed $3 billion over the next five $3.5 billion. IBM Cloud is set apart by focusing on hybrid years to the development of next-generation environments optimized for data and security, shaped by semiconductor technologies. our knowledge of the requirements of enterprise clients.


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    A Letter from the Chairman 5 Engines of Growth: IBM’s Strategic Imperatives Today, our strategic imperatives have become a significant part of IBM. Together, cloud, analytics, mobile, In 2014, our strategic social and security represented imperatives generated $25B 27 percent of IBM’s revenue in 2014. IBM generated more than 3,000 patents in these areas in 2014 and remains in revenue, growing differentiated in our ability to integrate by 16 percent. these technologies with our clients’ core business processes, data and systems. STRATEGIC IMPERATIVE STRATEGIC IMPERATIVE REVENUE MIX REVENUE GROWTH VS THE MARKET* 23% 27% 20% 18% 17% 16% 16% 13% 10% 9% 9% 9% 2010 2014 2010 2011 2012 2013 2014 IBM Strategic Imperatives Served Market Strategic Imperatives * Data reflects actual currency rates.


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    6 • We introduced major technological advances with 2015: Our transformation continues POWER8 and software defined storage — built for cloud Our direction is clear. We remain confident in our strategy, and Big Data. and we have made much progress. In 2015 we will build on • In January 2015 we launched our new z13 mainframe. our momentum: Built for the mobile era, it processes massive volumes 1. We will shift an additional $4 billion of spending of transactions while tapping back-office data and to data, cloud and engagement this year, aimed at simultaneously applying real-time analytics for deeper deepening our differentiation in the marketplace. insights and fraud detection. In February we introduced innovations to make hybrid • Historically, we kept our industry-leading Power technology cloud a reality for the enterprise. We are also growing our all to ourselves. Today, we see greater value by enabling portfolio of industry-specific analytics solutions in areas an OpenPOWER ecosystem, which allows partners to ranging from counter-fraud and oil and gas exploration, to innovate and build on the Power technology. Launched airline maintenance and the Internet of Things. And we in 2013, the OpenPOWER Foundation began with five began the year by establishing a number of business units members and now stands at more than 100 around the focused on markets and industries being transformed by world. The U.S. Department of Energy recently awarded our strategic imperatives: IBM Commerce, IBM Analytics, IBM a long-term, $325 million contract to create future IBM Security and IBM Cloud. We have announced plans supercomputers based on OpenPOWER technology. for an IBM Healthcare unit. All of this speaks to the enduring quality of IBM as a high- 2. We will continue to bring innovation to our core value innovation company. Last year we again spent about franchises — innovation highly valued by our clients. 6 percent of our revenue on research and development — I previously mentioned the entirely refreshed line of and the ratio within our software business is double that. mainframes, IBM Power Systems and storage. We will We invested $4 billion on capital expenditures. IBMers are continue to apply breakthroughs from IBM Research to prolific innovators. For the 22nd straight year, we earned the our products and services. In software, we will accelerate most U.S. patents of any organization, averaging 20 a day. our march to “as-a-service.” In services, we will deploy advanced automation to delivery. And we will continue helping new and existing outsourcing clients transform their infrastructure and processes by leveraging IBM’s hybrid cloud platform. This was an important differentiator in helping us to sign nearly 50 contracts worth greater


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    A Letter from the Chairman 7 than $100 million in 2014 and to maintain a services backlog of $128 billion. These core franchises also provide the foundation for future innovation and growth. One example is our partnership with Apple. Together, we are placing powerful “IBM lives at the intersection analytics capabilities in the hands of professionals. These apps are integrated with critical business systems, of technology and business. work flows and data sets. That’s what enables an airline This enables us to change the attendant to rebook a flight while en route; a financial advisor to model a portfolio in the client’s living room; way the world works, and in an in-store sales assistant to act as a trusted fashion so doing, to be essential to our advisor; or an emergency responder to have real-time situation-risk awareness, including live video. clients and to society.” 3. We believe open ecosystems and partnerships are key to our future innovation. This is a significant new element of our growth strategy. We will add to and scale partnerships with companies like Apple, Twitter, SAP, Tencent and now, SoftBank. Also, the IBM Watson Ecosystem is rapidly expanding, with 4,000 companies in the pipeline. Together, these actions will make IBM an even higher-value business. We expect our strategic imperatives of cloud, analytics, mobile, social and security to continue growing by double digits and to become a greater percentage of IBM. We will remain the enterprise leader in these markets. Finally, we will continue to return substantial value to you, our owners, through dividends and gross share repurchases. Last year, these were $4.3 billion and $13.7 billion, respectively. In 2014 we marked our 19th consecutive year of raising our dividend and our 99th year of paying one.


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    8 An essential company So I come back to this moment, full of rapid change, but even more opportunity — and to IBM’s unique purpose as an enterprise. IBM lives at the intersection of technology and business. This enables us to change the way the world works, and in so doing, to be essential to our clients and to society. We work with 90 percent of the world’s top banks, 9 of the top 10 oil and gas companies, 40 of the top 50 retailers and 92 of the top 100 healthcare organizations. IBM systems manage banking, reservations, transportation, retail, trading and healthcare systems. Our mainframes alone process 75 percent of the world’s business data. Today we are building upon this foundation to create an entirely new generation of critical systems. IBM’s clients are unclogging city traffic, exploring a cure for cancer, improving the safety of food supplies, reducing risk, and serving their own customers, employees, citizens and patients with greater levels of understanding, personalization and intimacy. A new world is taking shape before our eyes, remade by data, rewritten in code and growing smarter every day. This is the work that energizes me and all of my fellow IBMers. I am deeply grateful to the IBM team for bringing us here, and to you, our shareholders, for your support. I hope you share our excitement about your company’s path and the shared opportunity we have, together, to do something that is truly essential. 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. This letter also includes certain historical information on strategic imperatives revenue which has been measured on a consistent basis. For information about the company’s financial results related to operating pre-tax income and operating earnings per share, on a continuing operations Virginia M. Rometty basis, which are non-GAAP measures, see the company’s 2014 Annual Report, which is Exhibit 13 to the Form 10-K submitted to the SEC on February 24, 2015. For reconciliation and other Chairman, President and Chief Executive Officer information concerning these items refer to page 45 of the company’s 2014 Annual Report.


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    2014 IBM Annual Report 9 What We Are Making of this Moment: A year of transformation One year ago, we described our strategy to lead ad a rapidly r reordering information technology industry. We saisaid that a new era was driving the reinvention of all enterprises — including our own. And we committed to accelerate that transformation. In the year that followed, ed, the pace of change picked up, and we made much progress. rogress. In the following pages, we share sh highlights of that storyy — some of the ways we are: • Transformingindustries and professions with data. • Remaking enterprise IT for the era of cloud. • Reimagining work through mobile and social technolog logies. • Rethinking the challenge of security. • Creating new infrastructure for a new era.


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    10 Transforming industries and professions with data To mine and refine the world’s vast new natural resource of Big Data requires a new class of advanced analytics. IBM’s unmatched analytics capabilities draw upon more than 30 acquisitions and include nine Analytics Solutions Centers with an ecosystem of more than 6,000 business partners. Our global leadership in analytics was also key to last year’s alliance between IBM and Twitter. Together, we will help enterprises unlock insights from the 500 million Tweets generated every day — bringing a whole new category of data to the enterprise and using it to develop unique solutions for financial services, consumer products, retail and more. THE WORLD’S FIRST COGNITIVE IBM WATSON SOLUTIONS SYSTEM: IBM WATSON AND APPLICATIONS IBM Watson enables entirely new A growing portfolio of Watson applications kinds of discovery, as well as new ways is extending the expertise of leading for humans and computers to work professionals — wealth managers, together. In 2014 we turned this researchers, retailers and more — to their technology breakthrough into a thriving, peers around the world. For example, multidimensional business. Through the doctors at Bumrungrad International cloud-based IBM Watson Ecosystem, Hospital in Bangkok treat 1.1 million patients developers and partners can now embed from 190 countries each year, and will cognitive computing APIs (application be using IBM Watson for Oncology, program interfaces) into their apps. trained by Memorial Sloan Kettering Since November 2014, 6,800 developers Cancer Center, to plan the most effective have built more than 7,000 cognitive treatments based on each cancer apps. Finally, IBM Watson Analytics patient’s profile. brings intuitive visualization and predictive analytics to every business user.


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    2014 IBM Annual Report 11 Business analytics revenue was $17B in 2014 Business analytics revenue increased 7% in 2014 $1B investment in IBM Watson, including $100 million dedicated to venture capital to support start-ups IBM Watson doubled its client base every quarter in 2014. It now spans 17 industries in 24 countries


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    12 Remaking enterprise SPEECH TO TE XT (IBM WATSON) IT for the era of cloud INTERNET OF THINGS QUESTION AND ANSWER (IBM WATSON) TR ADEOFF ANALYTICS (IBM WATSON) TIME SERIES DATABASE CLOUDANT NoSQL DB DASH DB GEOSPATIAL ANALYTICS


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    2014 IBM Annual Report 13 Cloud revenue was $7B in 2014 Cloud revenue increased 60% in 2014 IBM’s cloud business has grown rapidly, thanks to increasing client demand for high-value solutions across public, private and hybrid clouds. Cloud revenue grew 60 percent, to $7 billion, 46 IBM Cloud data centers worldwide in 2014. One reason for this growth is that we understand the data will be in place and architectural requirements of enterprise clients. In 2014 we by the end of 2015 globally scaled our hybrid cloud platform with new data centers. These feature our SoftLayer “pod” design, giving clients local access to virtual and bare metal servers, all integrated with low- latency networking capabilities. IBM’s cloud footprint is designed for a business IT future that will be both global and local. $4B invested in software- as-a-service acquisitions for business professionals IBM BLUEMIX FORGING PARTNERSHIPS We are investing $1 billion in IBM Bluemix Our partnership with SAP is delivering to give developers cloud-based tools to world-leading enterprise applications as design, deploy and manage enterprise- services on the IBM Cloud. And our alliance grade apps at start-up speed. It is offered with Chinese Internet giant Tencent will on the IBM Cloud marketplace, which bring cloud-based transformation to that features nearly 500 IBM and third-party country’s growing enterprise economy. cloud services. MAKING HYBRID REAL FOR THE ENTERPRISE Major innovations for hybrid cloud, introduced in February 2015, offer clients control, visibility and security as they use open standards to break down barriers among environments. As we advance IBM’s leadership in this space, more than half of our cloud development team is devoted to hybrid cloud services and platforms on open standards.


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    14 Reimagining work Mobile and social technologies are changing the way organizations engage with the world, and especially with individuals — consumers, employees, patients, students and citizens. This means reimagining work itself — the ways in which professionals in any field do their jobs. That’s why enterprises are now building new systems of engagement, infused with their unique expertise and integrated with their critical business systems and data sets. Enabling people to work smarter means putting more real-time information and decision-making power literally in the palms of their hands, integrated securely with business processes and workflow. IBM MOBILEFIRST IBM INTERACTIVE EXPERIENCE Drawing upon thousands of patents in Reimagining work also means mobile and social, our IBM MobileFirst transforming how products and services solutions, built for the cloud, provide more are created, delivered and used. We are than 5,000 enterprise clients with security, globally expanding our hybrid consulting data and analytics integration and end- and digital agency services to help to-end device management. Our mobile clients create new, personalized models revenue more than tripled in 2014. of engagement through data and design. The 10 new IBM Interactive Experience studios allow clients to work side-by-side with researchers and consultants, as well as experts in experience design, mobile and digital marketing.


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    2014 IBM Annual Report 15 NO. IBM Interactive 1 Experience is the world’s largest digital agency We now have 6,000 IBM mobile consultants and experts 100 industry specific IBM MobileFirst for iOS apps to be developed APPLE + IBM Apple and IBM are developing intuitive business apps for professionals across multiple industries — from flight crews and retailers, to bankers, financial advisors, insurance agents, government caseworkers and law enforcement officers. We currently have 14 IBM MobileFirst for iOS apps in market, and many more are planned by the end of 2015. Built exclusively for iPhone and iPad, these apps are delivered in a security- rich environment, embedded with analytics and linked to core enterprise processes.


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    16 Rethinking the challenge of security


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    2014 IBM Annual Report 17 Cybersecurity attacks can go undetected for months. Security for complex, 21st century enterprises is no longer only about building “firewalls” to keep intruders out. It’s now a Big Data problem — which 15B events monitored is why IBM is the global leader in enterprise IT security. Our unique and managed each day analytics capabilities anticipate and protect against a fluid threat landscape and a new generation of organized cybercriminals. IBM’s intelligent immune systems can detect even the smallest anomalies, Security revenue in time to protect an organization’s vital data. increased SECURITY ANALYTICS SECURITY OPERATIONS CENTERS 19% in 2014 Our security software and services help Over the past decade, we have spent clients protect against advanced threats. nearly $2 billion on security research and We offer analytics, fraud protection, development resulting in 3,700 security- Double-digit identity and access management, and related patents. Our 10 global Security revenue growth leading application, data and infrastructure Operations Centers manage and monitor security capabilities — as well as cloud 15 billion events daily. We help protect in security for and mobile solutions to help clients innovate without increasing risk. For example, in 2014 IBM introduced the more than 10,000 clients worldwide. 9 straight quarters Threat Protection System which includes an end-to-end architecture of analytics and forensics software that helps organizations continuously prevent, detect and respond to ongoing and sophisticated cyberattacks, and in many cases, eliminate the threat before the damage has occurred.


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    18 Creating new infrastructure for a new era With the onset of real-time Big Data, hybrid clouds and an increasingly mobile economy, companies’ IT infrastructures face unprecedented demands. The world’s leading banks, oil and gas companies, retailers, healthcare organizations and more rely on IBM to run their systems of record, manage their data, help to ensure their security and integrate their applications and processes. Our hardware and software foundation is essential to their business — and to ours. Which is why we continuously reinvent our core. During the last 18 months, we have reimagined the mainframe for the tremendous growth of mobile workloads, created a breakout IBM Power Systems strategy focused on open innovation, developed next-generation software defined storage technology and made strategic moves across our portfolio to combine the strengths of middleware, servers and storage for a modern IT backbone. At the same time, we exited businesses that do not offer similar opportunities for innovation and growth.


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    2014 IBM Annual Report 19 One z13 mainframe can perform 30,000 transactions per second IBM software defined storage can reduce storage costs by up to 90% IBM z13 The new z13, launched in January 2015, reinvents the mainframe for the growing mobile economy. Capable of processing 2.5 billion transactions a day, it incorporates real-time encryption and analytics to exceed consumers’ expectations for security, speed and response time. POWER8 IBM debuted new Power Systems servers that allow data centers to manage Big Data with unprecedented speed, on an open server platform. Built on IBM’s POWER8 technology, IBM Power Systems servers are the result of a $2.4 billion investment and three-plus years of development, leveraging the innovations in hundreds of IBM patents. OPENPOWER SOFTWARE DEFINED STORAGE Through the OpenPOWER Foundation, Leveraging more than 700 patents in industry leaders are building innovative, this space, the IBM Spectrum Storage custom systems based on the portfolio helps clients unify their POWER architecture for fully optimized storage management, store data of all industry and workload-specific solutions. types, and flexibly deploy storage either Today, the OpenPOWER Foundation as software, as an appliance or as a has more than 100 members, including cloud-based service. founders Google, IBM, Mellanox, NVIDIA, Tyan and new member Rackspace.


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    20 Financial Highlights International Business Machines Corporation and Subsidiary Companies ($ in millions except per share amounts) For the year ended December 31: 2014 2013 Revenue $ 92,793 $ 98,367 Net income $ 12,022 $ 16,483 Income from continuing operations $ 15,751 $ 16,881 Operating (non-GAAP) earnings* $ 16,702 $ 18,356 Earnings per share of common stock (continuing operations) Assuming dilution $ 15.59 $ 15.30 Basic $ 15.68 $ 15.42 Diluted operating (non-GAAP)* $ 16.53 $ 16.64 Net cash provided by operating activities $ 16,868 $ 17,485 Capital expenditures, net 3,779 3,768 Share repurchases 13,679 13,859 Cash dividends paid on common stock 4,265 4,058 Per share of common stock 4.25 3.70 At December 31: 2014 2013 Cash, cash equivalents and marketable securities $ 8,476 $ 11,066 Total assets 117,532 126,223 Working capital 9,822 11,196 Total debt 40,804 39,718 Total equity 12,014 22,929 Common shares outstanding (in millions) 991 1,054 Market capitalization $158,920 $197,772 Stock price per common share $ 160.44 $ 187.57 * See pages 45 and 46 for a reconciliation of net income to operating earnings.


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    Report of Financials 21 International Business Machines Corporation and Subsidiary Companies MANAGEMENT DISCUSSION NOTES TO CONSOLIDATED Overview 22 FINANCIAL STATEMENTS Forward-Looking and Cautionary Statements 23 A Significant Accounting Policies 86 Management Discussion Snapshot 23 B Accounting Changes 96 Description of Business 26 C Acquisitions/Divestitures 97 Year in Review 33 D Financial Instruments 103 Prior Year in Review 53 E Inventories 110 Other Information 64 F Financing Receivables 110 Looking Forward 64 G Property, Plant and Equipment 113 Liquidity and Capital Resources 65 H Investments and Sundry Assets 113 Critical Accounting Estimates 68 I Intangible Assets Including Goodwill 114 Currency Rate Fluctuations 71 J Borrowings 115 Market Risk 72 K Other Liabilities 118 Financing Risks 72 L Equity Activity 118 Cybersecurity 73 M Contingencies and Commitments 122 Employees and Related Workforce 73 N Taxes 124 Global Financing 73 O Research, Development and Engineering 127 P Earnings Per Share of Common Stock 127 Report of Management 78 Q Rental Expense and Lease Commitments 128 R Stock-Based Compensation 128 Report of Independent Registered S Retirement-Related Benefits 131 Public Accounting Firm 79 T Segment Information 145 U Subsequent Events 150 CONSOLIDATED FINANCIAL STATEMENTS Earnings 80 Five-Year Comparison of Selected Financial Data 151 Comprehensive Income 81 Financial Position 82 Selected Quarterly Data 152 Cash Flows 83 Changes in Equity 84 Performance Graph 153 Board of Directors and Senior Leadership 154 Stockholder Information 155


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    22 Management Discussion International Business Machines Corporation and Subsidiary Companies OVERVIEW based on a simple mathematical model that translates current The financial section of the International Business Machines Cor- period results in local currency using the comparable prior poration (IBM or the company) 2014 Annual Report includes the year period’s currency conversion rate. This approach is used Management Discussion, the Consolidated Financial Statements for countries where the functional currency is the local country and the Notes to Consolidated Financial Statements. This Over- currency. This information is provided so that certain finan- view is designed to provide the reader with some perspective cial results can be viewed without the impact of fluctuations regarding the information contained in the financial section. in foreign currency rates, thereby facilitating period-to-period comparisons of business performance. See “Currency Rate Organization of Information Fluctuations” on page 71 for additional information. • The Management Discussion is designed to provide • Within the financial statements and tables in this Annual readers with an overview of the business and a narrative on Report, certain columns and rows may not add due to the company’s financial results and certain factors that the use of rounded numbers for disclosure purposes. may affect its future prospects from the perspective of the Percentages reported are calculated from the underlying company’s management. The “Management Discussion whole-dollar numbers. Snapshot,” beginning on page 23, presents an overview of the key performance drivers in 2014. Operating (non-GAAP) Earnings • Beginning with the “Year in Review” on page 33, the In an effort to provide better transparency into the operational Management Discussion contains the results of operations results of the business, the company separates business results for each reportable segment of the business and a discus- into operating and non-operating categories. Operating earn- sion of the company’s financial position and cash flows. ings from continuing operations is a non-GAAP measure that Other key sections within the Management Discussion excludes the effects of certain acquisition-related charges, retire- include: “Looking Forward” on page 64, and “Liquidity and ment-related costs, discontinued operations and their related tax Capital Resources” on page 65. impacts. For acquisitions, operating earnings exclude the amor- • Global Financing is a reportable segment that is measured tization of purchased intangible assets and acquisition-related as a stand-alone entity. A separate “Global Financing” section charges such as in-process research and development, transac- is included in the Management Discussion beginning on tion costs, applicable restructuring and related expenses and tax page 73. charges related to acquisition integration. For retirement-related • The Consolidated Financial Statements are presented on costs, the company characterizes certain items as operating and pages 80 through 85. These statements provide an overview others as non-operating. The company includes defined benefit of the company’s income and cash flow performance and plan and nonpension postretirement benefit plan service cost, its financial position. amortization of prior service cost and the cost of defined contribu- • The Notes follow the Consolidated Financial Statements. tion plans in operating earnings. Non-operating retirement-related Among other items, the Notes contain the company’s cost includes defined benefit plan and nonpension postretirement accounting policies (pages 86 through 96), acquisitions and benefit plan interest cost, expected return on plan assets, amor- divestitures (pages 97 through 102), detailed information on tized actuarial gains/losses, the impacts of any plan curtailments/ specific items within the financial statements, certain contin- settlements and multi-employer plan costs, pension insolvency gencies and commitments (pages 122 to 124) and costs and other costs. Non-operating retirement-related costs are retirement-related plans information (pages 131 to 145). primarily related to changes in pension plan assets and liabilities • The Consolidated Financial Statements and the Notes have which are tied to financial market performance and the company been prepared in accordance with accounting principles considers these costs to be outside the operational performance generally accepted in the United States (GAAP). of the business. • In October 2014, the company announced a definitive agree- Overall, the company believes that providing investors with a ment to divest its Microelectronics business. The assets and view of operating earnings as described above provides increased liabilities of the Microelectronics business are reported as transparency and clarity into both the operational results of the held for sale at December 31, 2014. The operating results of business and the performance of the company’s pension plans; the Microelectronics business are reported as discontinued improves visibility to management decisions and their impacts on operations. Prior periods have been reclassified to conform operational performance; enables better comparison to peer com- to this presentation in the Management Discussion, the panies; and allows the company to provide a long-term strategic Consolidated Financial Statements and the Notes, where view of the business going forward. The company’s reportable applicable, to allow for a meaningful comparison of continu- segment financial results reflect operating earnings from continu- ing operations. ing operations, consistent with the company’s management and • The references to “adjusted for currency” or “at constant measurement system. currency” in the Management Discussion do not include operational impacts that could result from fluctuations in foreign currency rates. Certain financial results are adjusted


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    Management Discussion 23 International Business Machines Corporation and Subsidiary Companies FORWARD-LOOKING AND The following table provides the company’s operating (non-GAAP) CAUTIONARY STATEMENTS earnings for 2014 and 2013. Certain statements contained in this Annual Report may consti- tute forward-looking statements within the meaning of the Private ($ in millions except per share amounts) Secur ities Litigation Reform Act of 1995. Any forward-looking Yr.-to-Yr. Percent statement in this Annual Report speaks only as of the date on For the year ended December 31: 2014 2013 Change which it is made; the company assumes no obligation to update Net income as reported $12,022 $16,483 (27.1)% or revise any such statements. Forward-looking statements are Loss from discontinued operations, based on the company’s current assumptions regarding future net of tax (3,729) (398) NM business and financial performance; these statements, by their Income from continuing operations $15,751 $16,881 (6.7)% nature, address matters that are uncertain to different degrees. Non-operating adjustments Forward-looking statements involve a number of risks, uncer- (net of tax): tainties and other factors that could cause actual results to be Acquisition-related charges 670 747 (10.3) materially different, as discussed more fully elsewhere in this Annual Report and in the company’s filings with the Securities Non-operating retirement-related costs/(income) 280 729 (61.5) and Exchange Commission (SEC), including the company’s 2014 Form 10-K filed on February 24, 2015. Operating (non-GAAP) earnings* $16,702 $18,356 (9.0)% Diluted operating (non-GAAP) earnings per share $ 16.53 $ 16.64 (0.7)% MANAGEMENT DISCUSSION SNAPSHOT ($ and shares in millions except per share amounts) * See pages 45 and 46 for a more detailed reconciliation of net income to operating earnings. Yr.-to-Yr. NM—Not meaningful Percent/ Margin For the year ended December 31: 2014 2013 Change In 2014, the company reported $92.8 billion in revenue, and Revenue $ 92,793 $ 98,367 (5.7)%* delivered $20.0 billion in pre-tax income and diluted earnings Gross profit margin 50.0% 49.5 % 0.5 pts. per share from continuing operations of $15.59 as reported and Total expense and other (income) $ 26,421 $ 28,440 (7.1)% $16.53 on an operating (non-GAAP) basis. The results of continu- ing operations exclude a net loss from discontinued operations of Total expense and other (income)-to-revenue ratio 28.5% 28.9 % (0.4) pts. $3.7 billion in 2014 and $0.4 billion in 2013 related to the expected divestiture of the Microelectronics business. On a consolidated Income from continuing operations before income taxes $ 19,986 $ 20,244 (1.3)% basis, net income in 2014 was $12.0 billion, with diluted earnings per share of $11.90. The company generated $16.9 billion in cash Provision for income taxes from continuing operations $ 4,234 $ 3,363 25.9% from operations and $12.4 billion in free cash flow in 2014 enabling shareholder returns of $17.9 billion in gross common stock repur- Income from continuing operations $ 15,751 $ 16,881 (6.7)% chases and dividends. Total consolidated revenue decreased 5.7 percent as reported Income from continuing operations margin 17.0% 17.2 % (0.2) pts. and 1 percent adjusted for divestitures (3 points) and currency (2 points) in 2014 versus 2013. In 2014, the company divested its Loss from discontinued operations, net of tax $ (3,729) $ (398) NM industry standard server and customer care businesses. The com- pany’s strategy is focused on leading in the areas with the most Net income $ 12,022 $ 16,483 (27.1)% value in enterprise information technology (IT), and in 2014 the Earnings per share from company made tremendous progress in repositioning its portfolio continuing operations: and making investments to shift into these areas. Assuming dilution $ 15.59 $ 15.30 1.9% The company’s portfolio includes: strategic imperatives for Consolidated earnings per share— growth, recurring core franchises and high value transactional assuming dilution $ 11.90 $ 14.94 (20.3)% businesses. These areas of the portfolio span across all of the Weighted-average shares company’s business segments. Each area of the portfolio has outstanding different business model characteristics and objectives. The com- Assuming dilution 1,010.0 1,103.0 (8.4)% pany’s results in 2014 reflected these characteristics. Assets** $117,532 $126,223 (6.9)% First, the company has a set of strategic imperatives for growth Liabilities** $105,518 $103,294 2.2% that are focused on the market shifts in data, cloud and engage- ment. The model for these combined strategic imperatives is to Equity** $ 12,014 $ 22,929 (47.6)% deliver double-digit revenue growth, with high contribution from * (4.0) percent adjusted for currency; (1.5) percent adjusted for divestitures and Software, which drives a more profitable business mix. In 2014, currency. revenue from cloud, analytics, mobile, social and security solutions ** At December 31. NM—Not meaningful


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    24 Management Discussion International Business Machines Corporation and Subsidiary Companies combined increased 16 percent with double-digit growth in each secular challenges faced in some parts of the hardware business quarter. In total, the strategic imperatives generated $25 billion as the company works through the transitions resulting from the in revenue, which represented approximately 27 percent of total actions taken to reposition the hardware business for high value. revenue. Business analytics revenue of $17 billion increased 7 per- In 2014, the company divested businesses that no longer fit its cent year to year with growth led by the consulting business as strategic profile—industry standard servers, customer care busi- the company helps clients extract value from their data. Cloud ness process outsourcing services and the announced divestiture revenue of $7 billion was up 60 percent year to year as client of the Microelectronics business. These three businesses gener- demand grows for higher-value cloud solutions across public, ated approximately $7 billion of revenue when reported in 2013, but private and hybrid clouds. Cloud delivered as a service revenue had a pre-tax loss of approximately $500 million. The divestitures increased approximately 75 percent to $3 billion in 2014, and exited reduce revenue but improve the company’s profit profile, consis- the year with an annual run rate of $3.5 billion. Cloud revenue also tent with the shift to higher value. includes the company’s foundational offerings where it provides From a segment perspective, Global Services revenue declined software, hardware and services to clients to build private clouds. 3.5 percent as reported, but increased 1 percent adjusted for the In engagement, the mobile business more than tripled year to year divestitures (2 points) and currency (2 points). Global Technology with strong growth in MobileFirst driven by the integrated portfo- Services (GTS) declined 3.7 percent as reported, but increased lio of offerings. In addition, Social was up 3 percent and Security 2 percent adjusted for the divestitures (3 points) and currency increased 19 percent year to year. (3 points) with growth in Outsourcing and Integrated Technology The company is continuing to shift its investments and Services. Global Business Services revenue decreased 3.1 percent resources to the strategic imperatives and solutions that address (1 percent adjusted for currency) with Application Outsourcing rev- clients’ most critical needs. During 2014, the company spent enue down 8 percent (6 percent adjusted for currency). Software approximately 6 percent of revenue in research and development revenue declined 1.9 percent (1 percent adjusted for currency). and invested approximately $4 billion on capital investments— Total middleware revenue was flat as reported, but increased supporting actions in a number of areas that will yield financial 1 percent at constant currency. Systems and Technology revenue benefits in the future. For example: decreased 23.0 percent as reported and 17 percent adjusted for • Launched Bluemix, the company’s cloud platform-as-a- the divested industry standard server business (5 points) and cur- service for the enterprise. rency (1 point). Performance reflected the impact of the System z • Investing to globally expand the SoftLayer cloud datacenters. product cycle as well as declines in Power Systems and Stor- • Investing to bring Watson’s capabilities to the enterprise and age. In 2014, the company took significant actions to reposition building a partner ecosystem, effectively creating a market the Systems and Technology business for higher value, and rein- for cognitive computing. forced its commitment to driving innovation in high-end systems • Introduced cloud application innovations around Watson and storage. Analytics and Verse. From a geographic perspective, revenue in the major markets • Launched POWER8, and building the OpenPOWER consortium. declined 4.3 percent as reported and 1 percent adjusted for the • Formed a partnership with Apple for enterprise mobility, with divestitures (2 points) and currency (1 point). Growth markets reve- Twitter for big data, and with SAP and Tencent for cloud. nue decreased 9.9 percent as reported and 3 percent adjusted for the divestitures (3 points) and currency (4 points) compared to the The recurring core franchises include the annuity businesses, and prior year. Within the growth markets, the BRIC countries (Brazil, the highly recurring portions of the transactions business, such as Russia, India and China) decreased 10.7 percent as reported mainframe revenue from the largest clients. This content has annu- and 5 percent adjusted for divestitures (3 points) and currency ity characteristics, and in many cases, it supports mission critical (3 points). processes for clients. The model for these combined businesses The consolidated gross profit margin of 50.0 percent improved is to have stable revenue, with improving margins. In 2014, rev- 0.5 points year to year. The operating (non-GAAP) gross margin enue was down approximately 3 percent with a modest decline in of 50.6 percent increased 0.1 points compared to the prior year margin. The decline was primarily driven by the mainframe product primarily driven by an improved mix toward Software. cycle and currency. Total expense and other (income) decreased 7.1 percent in 2014 The company’s high-value transactional businesses include versus the prior year. Total operating (non-GAAP) expense and project-based work in services, transactional software, Power Sys- other (income) decreased 6.3 percent compared to the prior year. tems and Storage—in areas other than the strategic imperatives. The objective for these businesses is to optimize the business model and maintain margins. In 2014, revenue declined year to year, with gross margins over 40 percent. Performance reflected the


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    Management Discussion 25 International Business Machines Corporation and Subsidiary Companies The year-to-year drivers were approximately: At December 31, 2014, the company continued to have the financial flexibility to support the business over the long term. Cash Total Operating Consolidated (non-GAAP) and marketable securities at year end was $8.5 billion, a decrease • Currency* (1) point (1) point of $2.6 billion from December 31, 2013. Key drivers in the balance • Acquisitions** 2 points 2 points sheet and total cash flows were: • Base expense (8) points (7) points Total assets decreased $8.7 billion ($2.7 billion adjusted for currency) from December 31, 2013 driven by: * Reflects impacts of translation and hedging programs. • Decreases in prepaid pension assets ($3.4 billion), property, ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is plant and equipment ($3.1 billion) driven primarily by the net of non-operating acquisition-related charges. expected divestiture of the Microelectronics business ($2.4 billion), cash and cash equivalents ($2.2 billion) and The reported base expense reflects not only the ongoing run rate total receivables ($1.7 billion); partially offset by of the business, but also the impact of divestitures and work- • Increased deferred taxes ($2.2 billion). force rebalancing charges. The company recorded pre-tax gains of $1.6 billion in 2014 related to the divestitures of the industry Total liabilities increased $2.2 billion ($7.0 billion adjusted for cur- standard server ($1.4 billion) and customer care ($0.2 billion) busi- rency) from December 31, 2013 driven by: nesses. Workforce rebalancing charges in 2014 were $1.5 billion, • Increases in pension liabilities ($2.0 billion) and total debt an increase of $0.4 billion year to year. Excluding the gains from ($1.1 billion). the divested businesses and the impact of workforce rebalancing charges, operating (non-GAAP) base expense decreased 3 points Total equity of $12.0 billion decreased $10.9 billion from Decem- year to year versus the 7 point as reported decrease. Within ber 31, 2013 as a result of: base expense, the company is continuing to shift resources and • Increased treasury stock ($13.5 billion) primarily from share spending to areas with the most opportunity—including Watson, repurchases, and increased losses in accumulated other SoftLayer, Bluemix and support of strategic partnerships, including comprehensive income/(loss) ($6.3 billion), driven primarily the Apple partnership. by the year-end remeasurement of the retirement-related Pre-tax income from continuing operations decreased 1.3 per- liabilities; partially offset by cent and the pre-tax margin was 21.5 percent, an increase of • Higher retained earnings ($7.8 billion) and higher common 1.0 points versus 2013. The continuing operations effective tax stock ($1.1 billion). rate for 2014 was 21.2 percent, an increase of 4.6 points versus the prior year primarily driven by benefits in the 2013 rate associ- The company generated $16.9 billion in cash flow provided by ated with discrete items. Income from continuing operations of operating activities, a decrease of $0.6 billion when compared $15.8 billion decreased 6.7 percent and the net income margin was to 2013, driven primarily by a higher level of cash tax payments 17.0 percent, a decrease of 0.2 points versus 2013. Losses from ($1.7 billion). Net cash used in investing activities of $3.0 billion discontinued operations, net of tax, were $3.7 billion in 2014 com- was $4.3 billion lower than 2013, primarily due to a decrease in pared to $0.4 billion 2013. Net income of $12.0 billion decreased cash used for acquisitions ($2.4 billion) and an increase in cash $4.5 billion year to year. Operating (non-GAAP) pre-tax income provided from divestitures ($2.1 billion). Net cash used in financing from continuing operations decreased 4.4 percent year to year activities of $15.5 billion increased $5.6 billion compared to the and the operating (non-GAAP) pre-tax margin from continuing prior year, driven primarily by lower net cash proceeds from total operations improved 0.3 points to 22.8 percent versus the prior debt ($5.2 billion). year. Operating (non-GAAP) income from continuing operations In 2014, the company made significant progress in its con- of $16.7 billion decreased 9.0 percent and the operating (non- tinuing transformation, investing to position the business for the GAAP) income margin from continuing operations of 18.0 percent longer term. In January 2015, the company disclosed that it is decreased 0.7 points. The operating (non-GAAP) effective tax expecting GAAP earnings in the range of $14.35 to $15.10 and rate from continuing operations in 2014 was 21.0 percent versus operating (non-GAAP) earnings between $15.75 and $16.50 per 17.0 percent in 2013. diluted share from continuing operations for 2015. The company Diluted earnings per share from continuing operations of also stated that it expects free cash flow in 2015 to be relatively $15.59 increased 1.9 percent year to year reflecting the benefits flat compared to 2014. of the common stock repurchase program. In 2014, the company For the first quarter of 2015, the company expects mid sin- repurchased 71.5 million shares of its common stock. Operat- gle-digit earnings per share growth from continuing operations, ing (non-GAAP) diluted earnings per share of $16.53 decreased primarily driven by the large workforce rebalancing charge that 0.7 percent versus the prior year driven primarily by the impacts was recorded in the first quarter of 2014. of decreased revenue and the higher tax rate, partially offset by the impact of share repurchases. Diluted earnings per share from discontinued operations was ($3.69) in 2014 compared to ($0.36) in 2013.


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    26 Management Discussion International Business Machines Corporation and Subsidiary Companies DESCRIPTION OF BUSINESS 1. Our Strategic Imperatives Please refer to IBM’s Annual Report on Form 10-K filed with the Data: transforming industries and professions SEC on February 24, 2015 for a more detailed version of this Des- Fueled by the proliferation of mobile devices, social media and the cription of Business, especially Item 1A. entitled “Risk Factors.” infusion of technology into virtually all aspects of business, data is the world’s new natural resource. Without powerful analytics, The company creates value for clients through integrated solu- however, it is just data. tions and products that leverage: data, information technology, Across all industries, enterprises are working hard to harvest deep expertise in industries and business processes, and a broad new insights from the explosion of available data—the new basis ecosystem of partners and alliances. IBM solutions typically create for today’s competitive advantage. The advantage for enterprises value by enabling new capabilities for clients that transform their increases as they apply more sophisticated approaches to refin- businesses and help them engage with their customers and ing their data, turning them into insights that are actionable and employees in new ways. These solutions draw from an industry- add value. The advent of cognitive computing, which mirrors the leading portfolio of consulting and IT implementation services, same cognitive process that people use every day to understand cloud and cognitive offerings, and enterprise systems and software; the world around them, is profoundly redefining the relation- all bolstered by one of the world’s leading research organizations. ship between humans and information. Cognitive systems learn, navigate the language and protocols of expert communities, and Strategy communicate in natural language. In a time of unprecedented technological change, IBM’s strategy IBM has invested more than $26 billion, including over $17 remains one of innovation and a constant drive to deliver higher billion on more than 30 acquisitions, to build its capabilities in value for our clients. big data and analytics. One third of IBM Research’s spending is focused on data, analytics and cognitive computing. Key tenets of the company’s strategy include: In 2014, IBM reported nearly $17 billion in business analyt- 1. Our strategic imperatives: Data, cloud and engagement are ics revenue, and the company established the Watson Group fundamentally transforming the IT industry, the company and our to develop and commercialize cognitive computing innovations. clients’ businesses. The tremendous growth of data is redefin- The company has committed a $1 billion investment to Watson, ing today’s competitive advantage. With data as the world’s new including $100 million dedicated to venture investments to support “natural resource,” it is fundamentally transforming industries and start-ups building cognitive apps through the Watson Developer professions. Yet as with all natural resources, only by refining data Zone on Bluemix. The company is also making Watson more into actionable insights through analytics does it become valuable widely available through the Watson Ecosystem, which has grown to the customer’s business. Cloud computing—the delivery of IT to more than 160 partners with nearly 4,000 future partners seek- and business processes as digital services—offers opportunities ing to build a new generation of cognitive apps. IBM also launched for enterprises to reinvent not just their operations, but their entire Watson Analytics, a breakthrough natural language-based cogni- business model and approaches to innovation. Engagement, tive service that provides instant access to powerful predictive including mobile and social technologies, is profoundly changing and visual analytic tools for businesses. Through Watson Analyt- how people interact and the way work gets done. Finally, these ics, IBM is extending analytics to the end user, not just the data transformations are all supported and protected by high levels scientist. IBM’s goal is to give every business professional access of security to ensure privacy and integrity of action. These three to advanced cognitive-powered predictive analytics, coupled with imperatives—data, cloud and engagement—are the foundation of new forms of data. IBM’s strategy today and its vision for the future. In addition in 2014, the company made bold moves by estab- lishing key alliances. In the data space, the company announced a 2. Our unique strength: Our ability to connect new technologies ground-breaking partnership with Twitter to incorporate Twitter’s with the systems currently running today’s enterprises is a key massive data streams into IBM’s cloud-based analytics, customer value-added service and market differentiator for IBM. Clients engagement platforms and consulting services. Enterprises will today want more than just adopting new technologies—they want now be able to understand customer sentiment more deeply and IBM to fuse new solutions with their existing systems. This “bring- anticipate sudden shifts in moods and markets by tapping into the ing together” is what the company calls Hybrid Cloud, and IBM is Twitter data in powerful new ways. This capability will also allow uniquely able to bring this value to its clients. clients to integrate Twitter data into their own cloud services and mobile apps. 3. Our migration to higher levels of business value: Clients look to IBM to solve their business challenges and opportunities rather than just providing technology. Our evolution over decades—from hardware to software and services, and increasingly to full-fledged business solutions—reflects this critical shift in meeting client needs. IBM brings together the full breadth of its integrated offer- ings and industry expertise to be essential to its clients and deliver higher value.


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    Management Discussion 27 International Business Machines Corporation and Subsidiary Companies Cloud: reinventing IT Engagement: re-imagining work Cloud is at the heart of the digital revolution. No enterprise is Social, mobile and unprecedented access to data are changing untouched by this revolution and the shifts are occurring rapidly. how individuals and institutions work together. A new class of Enterprises are benefitting from cloud by using it to transform customer has emerged: one who is empowered with knowledge, their IT and business processes into digital services. Much has enriched by networks and expects value in return for sharing infor- been written about how cloud enables the sharing of infrastruc- mation. Enterprises must create a systematic approach to engage ture—this is true. However the real promise of cloud is much more these newly empowered customers through more personalized profound. By forcing greater levels of standards up and down the interactions. IBM calls these new forms of interactions “engage- technology value chain, new products and services, and even ment”—and includes social collaboration and mobile—both entire business models, are able to be created in weeks rather underpinned by high levels of security. than months or years. In 2014, the mobile, social and security portfolio generated Cloud is a catalyst for innovation. IBM has invested more than double-digit growth with mobile revenue more than tripling versus $8 billion to acquire 18 companies related to cloud, and is investing 2013, security revenue up 19 percent and social business growing more than $1 billion to expand its global footprint to 40 datacen- 3 percent. In addition, IBM has acquired 23 companies related to ters worldwide. IBM now has more than 120 software-as-a-service mobile, social and security. (SaaS) offerings, and IBM Cloud supports 24 of the top 25 Fortune On the mobile front, IBM and Apple formed an historic part- 500 companies, driving $7 billion of revenue for cloud-based solu- nership to transform enterprise mobility as we know it today. tions in 2014. Together, IBM and Apple are joining forces to bring the ease-of-use • SoftLayer is the foundation for IBM’s expansive infrastruc- of personal apps to the enterprise environment. Together, the two ture-as-a-service portfolio. It offers bare metal, private cloud companies are bringing the first wave of industry-specific apps to and virtual server instances, which means it can cover many the market—targeting the needs of individual workers and helping different workloads with unprecedented performance. Soft- to solve long-standing industry challenges. Layer offers a built-in private network which can handle huge In addition, MobileFirst remains IBM’s unified approach to help capacity and gives users the ability to isolate public/private clients and partners deliver best-in-class mobile solutions, take networks with controls for access and location of data. advantage of more commercial opportunities and provide a supe- • Bluemix is IBM’s platform-as-a-service, built on the open rior customer experience. standards foundation of Cloud Foundry and powered by On the social collaboration front, in 2014, IDC named IBM the SoftLayer’s cloud infrastructure. SoftLayer offers cloud- worldwide market share leader in Enterprise Social Software for based services, APIs and leading third-party services to the fifth consecutive year.(1) In addition, IBM Verse, powered by IBM developers in an integrated platform. Bluemix also allows analytics and advanced search, is a new cloud-based messag- them to mix and match different tools to build apps in ing and social collaboration solution to manage the workday. It the cloud for mobile, Web, big data and analytics—to name provides a seamless user experience across social networking, just a few. meetings, chat, documents, mail, and an array of intelligent, secu- • IBM Cloud marketplace brings together the company’s vast rity-rich and engaging social apps on mobile devices or the Web. portfolio of cloud capabilities, delivering a self-service, digital Security is a boardroom-level issue. It is also a key enabler experience for developers, IT and business leaders. Visitors for the continued growth of data, cloud and engagement. Enter- have access to a growing portfolio of cloud capabilities from prises—and their clients—demand that these activities be secure IBM and qualified third-party vendors. Open integration as a requirement for participation. including pre-built APIs and hybrid options enable enterprise The magnitude, sophistication and complexity of today’s secu- integration and composable business models. rity threats are growing. With the proliferation of data on mobile devices, in social media and in the cloud, breaches are more vis- The IBM Cloud is the most powerful choice for enterprise-grade ible and occur on a heightened scale. IBM Security solutions use environments—bringing unparalleled levels of security, perfor- sophisticated analytics to identify and thwart attacks in real time— mance and scalability. As a result, in 2014, IBM formed a strategic protecting our clients’ information, processes and people. alliance with SAP to run its business applications on IBM’s cloud. IBM Security brings to our clients high-end consulting, advanced fraud and threat protection, identity and access man- agement, application and data security, mobile and cloud security, network and end-point protection with services for cloud. (1) IDC Worldwide Enterprise Social Networks 2014–2018 Forecast and 2013 Vendor Shares, July 23, 2014.


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    28 Management Discussion International Business Machines Corporation and Subsidiary Companies 2. Our Unique Strength Summary Data, cloud and engagement are powerful forces changing the One constant throughout IBM’s over 100-year history has been the landscape of technology and businesses. However, enterprise need to continually transform the company in an ever-changing clients need more. Enterprises need to bring this new world of industry. Our industry, our clients—and IBM itself—is in the midst technology together with the existing systems that currently run of such a fundamental transformation. their businesses if they are to capture their full value. This combina- This is a transformation of unparalleled growth and promise: tion is what we refer to as Hybrid Cloud. • The promise of technology to bring extraordinary levels of Without bringing these worlds together, these new tech- insight to human endeavors through advances in analytics nologies become “islands” within the enterprise. For example, a and cognitive computing. business that invests in a social media platform engages with and • The promise of the cloud as a catalyst for innovation, freeing captures the sentiment of individual customers. These can be valu- enterprises to focus more on the uses of technology rather able interactions. However, much deeper insight into the needs than just the technology itself. and wants of an individual customer comes when combining the • The promise of enterprises engaging with their customers, social media interactions with the historical purchase and engage- their employees and their business partners through richer, ment records of that customer—as stored in existing systems. By more personalized means. combining these insights, the enterprise personalizes interactions • All underscored by security to help protect the integrity of in ways that are relevant and meaningful to that customer. every interaction. IBM is unique in bringing this Hybrid world to its clients with our unparalleled strength in both the existing and the new worlds of IT. We are excited about the prospects for growth and value for our IBM supports its clients’ mission critical processes, and clients—and for IBM—and we look forward to helping our clients remains the “go-to” platform for the enterprise. For example, transform their businesses for the future. more than 90 percent of the top 100 banks and the top 25 U.S. retailers run on IBM systems. In addition, nearly half of the Fortune Business Model 100 companies outsource IT operations to IBM. The company’s The company’s business model is built to support two principal leadership in enterprise computing provides the foundation for goals: helping enterprise clients to become more innovative, effi- strategic partnerships as leading companies want to work with cient and competitive through the application of business insight IBM, as evidenced by the Apple, SAP, Twitter and Tencent partner- and IT solutions; and providing long-term value to shareholders. ships announced in 2104. The business model has been developed over time through strate- Combine this with the company’s strength in the new worlds gic investments in capabilities and technologies that have superior of data, cloud and engagement—and IBM brings a unique and long-term growth and profitability prospects based on the value important capability to the market. they deliver to clients. The company’s global capabilities include services, software, 3. Our Migration to Higher Value systems, fundamental research and related financing. The broad Technology by itself does not create value for a business. Tech- mix of businesses and capabilities are combined to provide inte- nology enables a business to achieve its aspirations by facilitating grated solutions to the company’s clients. richer interactions with clients and ecosystems, by unlocking The business model is dynamic, adapting to the continuously deeper insight and by enabling faster actions. changing market and economic environment. The company con- IBM has continuously evolved its mission to deliver increasingly tinues to divest certain businesses and strengthen its position higher levels of business value to its clients. Starting primarily as through strategic organic investments and acquisitions in higher- a hardware company, IBM has added a rich portfolio of software value areas. In addition, the company has transformed itself into and services to add higher value. a globally integrated enterprise which has improved overall pro- This next phase of IBM’s transformation will realize the full ductivity and is driving investment and expanding participation in breadth of the portfolio by bringing higher-value added solutions markets with significant long-term opportunity. to our clients. Examples include: This business model, supported by the company’s financial • Using predictive analytics to reduce customer attrition rates model, has enabled the company to deliver strong earnings, cash through the IBM Customer Data solution. flows and returns to shareholders over the long term. • Detecting fraudulent claims before payments are made through the IBM Counter Fraud solution. Business Segments and Capabilities • Preventing costly and unscheduled downtime of equipment The company’s major operations consists of five business seg- through early detection of anomalies with the IBM Predictive ments: Global Technology Services and Global Business Services, Asset Optimization solution. which the company collectively calls Global Services, Software, Systems and Technology and Global Financing. The focus on integrated solutions will make IBM a stronger partner with its clients as the company takes another step in its continuous evolution to higher levels of value.


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    Management Discussion 29 International Business Machines Corporation and Subsidiary Companies Global Services: is a critical component of the company’s strategy Technology Support Services (Maintenance Services): delivers of providing IT infrastructure and business insight and solutions to a complete line of support services from product maintenance clients. While solutions often include industry-leading IBM software through solution support to maintain and improve the availability and systems, other suppliers’ products are also used if a client of clients’ IT infrastructures. solution requires it. Approximately 60 percent of external Global Services segment revenue is annuity based, coming primarily from Global Business Services (GBS) has the mission to deliver pre- outsourcing and maintenance arrangements. The Global Services dictable business outcomes to the company’s clients across two backlog provides a solid revenue base entering each year. Within primary business areas: Consulting and Systems Integration and Global Services, there are two reportable segments: Global Tech- Application Management Services. These professional services nology Services and Global Business Services. deliver business value and innovation to clients through solu- tions which leverage industry and business process expertise. Global Technology Services (GTS) primarily provides IT infra- The role of GBS is to drive initiatives that integrate IBM content structure and business process services, creating business value and solutions and drive the progress of the company’s strategic for clients through unique technology and IP integrated services imperatives. As clients transform themselves in response to market within its global delivery model. By leveraging insights and experi- trends like big data, social and mobile computing, GBS helps cli- ence drawn from IBM’s global scale, skills and technology, with ents use these technologies to reinvent relationships with their applied innovation from IBM Research, clients gain access to customers and realize new standards of efficacy and efficiency leading-edge, high-quality services with improved productivity, in the internal processes, data and applications that they use to flexibility, cost and outcomes. run their businesses. GTS Capabilities GBS Capabilities Strategic Outsourcing: delivers comprehensive IT outsourcing ser- Consulting and Systems Integration: delivering client value with vices dedicated to transforming clients’ existing infrastructures solutions in Strategy and Transformation, Application Innovation to consistently deliver improved quality, flexibility, risk manage- Services, Enterprise Applications and Smarter Analytics. Consult- ment and financial value. The company integrates long-standing ing is also focused on bringing to market client solutions that drive expertise in service management and technology with the ability Smarter Commerce, Cloud, Mobile and Social Business. to exploit the power of new technologies from IBM systems and software, such as cloud computing, analytics and virtualization, Application Management Services: delivers application manage- to deliver high performance, innovation and improved ability to ment, maintenance and support services for packaged software, achieve business objectives. as well as custom and legacy applications. Value is delivered through advanced capabilities in areas such as application test- Global Process Services: included within Strategic Outsourcing, ing and modernization, cloud application services, the company’s delivers a range of offerings consisting of standardized through highly differentiated globally integrated capability model, industry transformational solutions including processing platforms and knowledge and the standardization and automation of applica- business process outsourcing. These services deliver improved tion management. business results to clients through the strategic change and/or operation of the client’s business processes, applications and Software consists primarily of middleware and operating sys- infrastructure. Global Process Services will be integrated within tems software. Middleware software enables clients to integrate Global Business Services beginning in 2015. systems, processes and applications across a standard software platform to improve their business results, solve critical prob- Integrated Technology Services: delivers a portfolio of project- lems and gain competitive advantage within their industries. IBM based and managed services that enable clients to transform and middleware is designed on open standards, making it easier to optimize their IT environments by driving efficiency, flexibility and integrate disparate business applications, developed by different productivity, while reducing costs. The standardized portfolio is methods and implemented at different times. Operating systems built around key assets and patented software, and incorporates are the software engines that run computers. Approximately best practices and proven methodologies that ensure predictive 70 percent of external Software segment revenue is annuity based, quality of delivery, security and compliance. coming from recurring license charges, software sold “as a ser- vice” and ongoing post-contract support. The remaining revenue Cloud: delivers a comprehensive set of cloud services ranging relates to one-time charge (OTC) arrangements in which clients from assisting clients with building their own private clouds, to pay one, up-front payment for a perpetual license. Typically, the building customized dedicated managed clouds, to allowing cli- sale of OTC software includes one year of post-contract support. ents to leverage standardized cloud infrastructure services from Clients can also purchase ongoing post-contract support after the SoftLayer and Cloud Managed Services offerings, to creating the first year, which includes unspecified product upgrades and hybrid environments linking their private and public workloads technical support. together. This portfolio of cloud offerings spans across the GTS business lines.


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    30 Management Discussion International Business Machines Corporation and Subsidiary Companies Software Capabilities Mobile: spans middleware and offers customers true end-to-end WebSphere: delivers capabilities that enable organizations to run mobile solutions across platform and application development, high-performance business applications. With these applications, mobile security, and mobile device management. Leveraging pow- clients can integrate and manage business processes across their erful analytics and usage data, customers are provided with the organizations with the flexibility and agility they need to respond ability to have more compelling interactions with their clients and to changing conditions. Built on services-oriented architecture workforce, increasing touchpoints and deepening relationships. (SOA), and open standards support for cloud, mobile and social The mobile offerings provide the ability to increase workforce pro- interactions, the WebSphere platform enables enterprises to ductivity through enhanced collaboration, improved knowledge extend their reach and optimize interactions with their key con- sharing and increased response speed. stituents. Smarter Commerce software helps companies better In January 2015, the company made several changes designed manage and improve each step of their value chain and capitalize to more effectively align its key capabilities and resources to its on opportunities for profitable growth, efficiency and increased strategic imperatives. These changes will enable the company to customer loyalty. respond more quickly to critical client agendas and drive higher value. Across Software, the company is transitioning its portfolio to Information Management: enables clients to integrate, manage capture growth and continue to drive innovation. The focus will be and analyze enormous amounts of data from a large variety of centered around analytics, security, and commerce—similar to the sources in order to gain competitive advantage and improve their action the company implemented in 2014 with Watson—utilizing its business outcomes. With this approach, clients can extract real software assets to improve speed and agility in bringing integrated value out of their data and use it to make better business decisions. solutions to its clients. IBM’s middleware and integrated solutions include advanced database management, information integration, data governance, Systems and Technology (STG) provides clients with innovative enterprise content management, data warehousing, business ana- infrastructure technologies to help meet the new requirements of lytics and intelligence, predictive analytics and big data analytics. data, cloud and engagement—from deploying advanced analytics, to moving to digital service delivery with the cloud, and securing Watson Solutions: the first commercially available cognitive com- mobile transaction processing. Approximately half of Systems and puting platform that has the ability to interact in natural language, Technology’s server and storage sales transactions are through processing vast amounts of big data, and learning from its interac- the company’s business partners; with the balance direct to end- tions with people and computers. As an advisor, Watson is able user clients. In addition, Systems and Technology provides leading to sift through and understand large amounts of data delivering semiconductor technology, products and packaging solutions for insights with unprecedented speeds and accuracy. IBM’s own advanced technology needs. Tivoli: helps clients optimize the value they get from their infrastruc- Systems and Technology Capabilities tures and technology assets through greater visibility, control and Servers: a range of high-performance systems designed to address automation across their end-to-end business operations. These capacity, security, speed and compute power needs for busi- asset management solutions foster integrated service delivery nesses, organizations and technical computing applications. After for cloud and datacenter management, enterprise endpoint and the divestiture of the System x industry standard server business, mobile device management, asset and facilities management, and the portfolio includes System z, a trusted enterprise platform for storage management. Tivoli includes security systems software integrating data, transactions and insight, and Power Systems, a that provides clients with a single security intelligence platform system designed from the ground up for big data, optimized for that enables them to better secure all aspects of their enterprise scale-out cloud and Linux, and delivering open innovation with and prevent security breaches. OpenPOWER. The company is also a founding member of the OpenPOWER foundation, a group of industry-leading companies Workforce Solutions: enables businesses to connect people working together to develop high-performance compute solutions and processes for more effective communication and increased based on the IBM POWER architecture. productivity through collaboration, messaging and social network- ing software. By remaining at the forefront of collaboration tools, Storage: data storage products and solutions that allow clients IBM’s social business offerings help organizations reap real ben- to retain and manage rapidly growing, complex volumes of digital efits associated with social networking, as well as create a more information. These solutions address critical client requirements efficient and effective workforce. for information retention and archiving, security, compliance and storage optimization including data deduplication, availability and Rational: supports software development for both IT and com- virtualization. The portfolio consists of a broad range of software plex embedded system solutions, with a portfolio of products and defined storage solutions, disk and tape storage systems and solutions supporting DevOps and Smarter Product Development, Flash storage and solutions. transforming the way lines of business, development and opera- tions work together to deliver innovation via software.


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    Management Discussion 31 International Business Machines Corporation and Subsidiary Companies Technology: the company’s continued leadership in systems Sales and Distribution requires ongoing investments in semiconductor and material IBM has a significant global presence, operating in more than 175 science research and development that drives innovation that mat- countries, with an increasingly broad-based geographic distribu- ters for our clients. In 2014, the company announced a definitive tion of revenue. The company’s Sales and Distribution organization agreement to divest its Microelectronics business and manufac- manages the IBM global footprint, with dedicated country-based turing operations. This transaction is expected to close in 2015. operating units focused on delivering unique value and superior experiences for clients. Within these units, client relationship Global Financing facilitates IBM clients’ acquisition of information professionals work with integrated teams of consultants, prod- technology systems, software and services by providing financ- uct specialists and delivery fulfillment teams to enable clients’ ing solutions in the areas where the company has the expertise. business growth and innovation. These teams deliver value by The financing arrangements are predominantly for products or understanding the clients’ businesses and needs, and then bring services that are critical to the end users’ business operations. together capabilities from across IBM and an extensive network of These financing contracts are entered into after a comprehensive Business Partners to develop and implement solutions. credit evaluation and are secured by legal contracts. As a captive By combining global expertise with local experience, IBM’s financier, Global Financing has the benefit of both deep knowledge geographic structure enables dedicated management focus for of its client base and a clear insight into the products and services local clients, speed in addressing new market opportunities and financed. These factors allow the business to effectively manage timely investments in emerging opportunities. The geographic two of the major risks, credit and residual value, associated with units align industry-skilled resources to serve clients’ agendas. financing while generating strong returns on equity. Global Financ- IBM extends capabilities to mid-market client segments by ing also maintains a long term partnership with the companies’ leveraging industry skills with marketing, Inside Sales and local clients through various stages of IT asset life cycle—from initial Business Partner resources. purchase and technology upgrades to asset disposition decisions. The company continues to invest to capture the long-term opportunity in key growth markets around the world—China, India Global Financing Capabilities and countries within Southeast Asia, Eastern Europe, the Middle Client Financing: lease and loan financing to end users and internal East, Africa and Latin America. The company’s major markets clients for terms up to seven years. Assets financed are primarily IT include the G7 countries of Canada, France, Germany, Italy, Japan, products and services where the company has expertise. Internal the United States (U.S.) and the United Kingdom (UK) plus Austria, financing is predominantly in support of Global Services’ long-term the Bahamas, Belgium, the Caribbean region, Cyprus, Denmark, client service contracts. Global Financing also factors a selected Finland, Greece, Iceland, Ireland, Israel, Malta, the Netherlands, portion of the company’s accounts receivable, primarily for cash Norway, Portugal, Spain, Sweden and Switzerland. management purposes. All internal financing arrangements are at arm’s-length rates and are based upon market conditions. Research, Development and Intellectual Property IBM’s research and development (R&D) operations differentiate the Commercial Financing: short-term inventory and accounts company from its competitors. IBM annually invests approximately receivable financing to dealers and remarketers of IBM and OEM 6 percent of total revenue for R&D, focusing on high-growth, products. high-value opportunities. IBM Research works with clients and the company’s business units through global labs on near-term Remanufacturing and Remarketing: used equipment is returned and mid-term innovations. It contributes many new technologies from lease transactions, or may be surplus equipment inter- to IBM’s portfolio every year and helps clients address their most nally or externally purchased. These assets may be refurbished difficult challenges. IBM Research also explores the boundaries of or upgraded and sold or leased to new or existing clients both science and technology—from nanotechnology to future systems, externally or internally. Externally remarketed equipment reve- big data analytics, secure clouds and to IBM Watson, a ‘‘cognitive’’ nue represents sales or leases to clients and resellers. Internally learning system. remarketed equipment revenue primarily represents used equip- IBM Research also focuses on differentiating IBM’s services ment that is sold internally to Systems and Technology and Global businesses, providing new capabilities and solutions. It has the Services. Systems and Technology may also sell the equipment world’s largest mathematics department of any public company, that it purchases from Global Financing to external clients. enabling IBM to create unique analytic solutions and actively engage with clients on their toughest challenges. IBM Worldwide Organizations In February 2015, the company announced a new IBM Research The following worldwide organizations play key roles in IBM’s deliv- lab to be located in South Africa. This will be IBM Research’s 13th ery of value to its clients: global lab. • Sales and Distribution • Research, Development and Intellectual Property • Integrated Supply Chain


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    32 Management Discussion International Business Machines Corporation and Subsidiary Companies In 2014, IBM was awarded more U.S. patents than any other Integrated Supply Chain company for the 22nd consecutive year. IBM’s 7,534 patents IBM has an extensive integrated supply chain, procuring materials awarded in 2014 represent a diverse range of inventions poised and services globally. In 2014, the company also managed approxi- to enable significant innovations that will position the company to mately $21.8 billion in procurement spending for its clients through compete and lead in the emerging opportunities represented by the Global Process Services organization. The supply, manufactur- cloud, big data and analytics, security, social and mobile. These ing and logistics operations are integrated in one operating unit inventions also will advance the new era of cognitive systems that has optimized inventories over time. Simplifying and streamlin- where machines will learn, reason and interact with people in more ing internal processes has improved sales force productivity and natural ways. It was the most U.S. patents ever awarded to one operational effectiveness and efficiency. Supply chain resiliency company in a single year. enables IBM to reduce its risk during marketplace changes. The company continues to actively seek intellectual property The company continues to derive business value from its own (IP) protection for its innovations, while increasing emphasis on globally integrated supply chain providing a strategic advantage other initiatives designed to leverage its IP leadership. Some of for the company to create value for clients. IBM leverages its supply IBM’s technological breakthroughs are used exclusively in IBM chain expertise for clients through its supply chain business trans- products, while others are licensed and may be used in IBM prod- formation outsourcing service to optimize and help operate clients’ ucts and/or the products of the licensee. While the company’s end-to-end supply chain processes, from procurement to logistics. various proprietary IP rights are important to its success, IBM Utilizing analytics, mobile, cloud and social—with numerous proj- believes its business as a whole is not materially dependent on ects, has allowed the integrated supply chain to drive positive any particular patent or license, or any particular group of patents business outcomes for the company and its clients. or licenses. IBM owns or is licensed under a number of patents, which vary in duration, relating to its products.


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    Management Discussion 33 International Business Machines Corporation and Subsidiary Companies YEAR IN REVIEW Results of Continuing Operations Segment Details The following is an analysis of the 2014 versus 2013 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 145 to 150 for additional information. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent/ Percent Change Margin Adjusted for For the year ended December 31: 2014 2013 Change Currency Revenue Global Technology Services $37,130 $38,551 (3.7)% 1.6%* Gross margin 38.3% 38.1% 0.2 pts. Global Business Services 17,825 18,396 (3.1)% (1.1)% Gross margin 30.8% 30.9% 0.0 pts. Software 25,434 25,932 (1.9)% (0.9)% Gross margin 88.6% 88.8% (0.2) pts. Systems and Technology 9,996 12,988 (23.0)% (16.8)%* Gross margin 39.5% 40.8% (1.3) pts. Global Financing 2,034 2,022 0.6% 3.0% Gross margin 49.4% 45.6% 3.7 pts. Other 374 478 (21.7)% (20.4)% Gross margin (215.0)% (195.6)% (19.4) pts. Total consolidated revenue $92,793 $98,367 (5.7)% (1.5)%* Total consolidated gross profit $46,407 $48,684 (4.7)% Total consolidated gross margin 50.0% 49.5% 0.5 pts. Non-operating adjustments Amortization of acquired intangible assets 416 388 7.2% Acquisition-related charges — 5 (100.0)% Retirement-related costs/(income) 173 629 (72.4)% Operating (non-GAAP) gross profit $46,996 $49,706 (5.5)% Operating (non-GAAP) gross margin 50.6% 50.5% 0.1 pts. * Adjusted for divestitures and currency.


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    34 Management Discussion International Business Machines Corporation and Subsidiary Companies Global Services In 2014, the Global Services segments, Global Technology Services pre-tax margin decreased 0.8 points to 16.5 percent. Total outsourc- (GTS) and Global Business Services (GBS), delivered revenue of ing revenue of $24,520 million decreased 6.3 percent as reported, $54,954 million, a decrease of 3.5 percent as reported, but an but was flat year to year when adjusted for currency (2 points) and increase of 1 percent adjusted for the divestitures of the customer the divestitures (4 points). Total transactional revenue of $23,581 care and industry standard server businesses (2 points) and cur- million decreased 0.4 percent, but increased 2 percent adjusted rency (2 points). Pre-tax income decreased 8.4 percent and the for currency. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2014 2013 Change Currency Global Services external revenue $54,954 $56,947 (3.5)% 0.7%* Global Technology Services $37,130 $38,551 (3.7)% 1.6%* Outsourcing 20,770 22,060 (5.8) 1.2* Integrated Technology Services 9,506 9,380 1.3 3.7 Maintenance 6,853 7,111 (3.6) (0.1)* Global Business Services $17,825 $18,396 (3.1)% (1.1)% Outsourcing 3,750 4,097 (8.5) (6.1) Consulting and Systems Integration 14,075 14,298 (1.6) 0.4 * Adjusted for divestitures and currency. Global Technology Services revenue of $37,130 million decreased July, the company announced a strategic partnership with Apple 3.7 percent as reported in 2014 compared to the prior year, but to deliver a new class of “enterprise ready” MobileFirst business increased 2 percent adjusted for currency (3 points) and the dives- applications for iOS combining mobility and analytics. In the fourth titures (3 points). Integrated Technology Services (ITS) revenue quarter of 2014, the first applications were launched with additional grew 1.3 percent (4 percent adjusted for currency) compared to applications focused on healthcare, energy and utilities expected 2013. The SoftLayer platform, which provides highly differentiated in the first quarter of 2015. GBS Outsourcing revenue decreased solutions for clients looking to deploy across public, private or 8.5 percent (6 percent adjusted for currency) in 2014, but had hybrid clouds all unified on one platform, had strong performance. sequential improvement in the year-to-year growth rate in the last Throughout the year, SoftLayer attracted new workloads to the two quarters of the year adjusted for currency. Throughout the platform and the company is investing to expand its datacenter year, performance was impacted by pricing pressure and client footprint globally. GTS Outsourcing revenue decreased 5.8 percent renegotiations, as well as a reduction in elective projects. as reported in 2014, but increased 1 percent adjusted for currency (2 points) and the divestitures (5 points). Growth was driven by ($ in millions) performance from the substantial new contracts brought on during Yr.-to-Yr. Percent/ 2013. In 2014, clients continued to sign large outsourcing engage- Margin ments that leverage the company’s cloud, business analytics and For the year ended December 31: 2014 2013 Change mobile solutions. Maintenance revenue decreased 3.6 percent Global Services but was flat year to year adjusted for the divestiture of the industry Global Technology Services standard server business (1 point) and currency (2 points). External gross profit $14,237 $14,691 (3.1)% Global Business Services revenue of $17,825 million decreased External gross profit margin 38.3% 38.1% 0.2 pts. 3.1 percent (1 percent adjusted for currency) compared to the prior year. Consulting and Systems Integration (C&SI) revenue declined Pre-tax income $ 6,340 $ 6,983 (9.2)% 1.6 percent as reported, but was flat adjusted for currency in 2014. Pre-tax margin 16.7% 17.6% (1.0) pts. There was strong growth in the practices that are highly differenti- Global Business Services ated in the marketplace which address cloud, analytics, mobile External gross profit $ 5,493 $ 5,676 (3.2)% and social, offset by declines in the more traditional parts of the External gross profit margin 30.8% 30.9% 0.0 pts. portfolio, such as back office implementations. As the new offer- ings continue to become a larger part of the portfolio they will Pre-tax income $ 2,999 $ 3,214 (6.7)% contribute more meaningfully to the revenue performance. In Pre-tax margin 16.3% 16.8% (0.5) pts.


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    Management Discussion 35 International Business Machines Corporation and Subsidiary Companies GTS gross profit margin increased 0.2 points to 38.3 percent in differentiation, such as solutions that address the strategic imper- 2014. Pre-tax income decreased 9.2 percent to $6,340 million and atives, there was good growth and gross margin performance. the pre-tax margin declined 1.0 points to 16.7 percent compared However, in the more traditional parts of the portfolio, there was to the prior year. While there was a benefit from the pre-tax gain continued price and profit pressure. The company will continue of $202 million related to the customer care divestiture in 2014, to invest in the strategic imperatives and accelerate the transi- this benefit was offset by investments in areas like new resil- tion to global delivery. Additionally, Global Process Services, the iency centers, additional security skills and the SoftLayer cloud business process outsourcing business, will be integrated with hub expansion, plus the lost profit from the divested businesses. GBS beginning in 2015 to create a seamless end-to-end business Overall, the profit performance in GTS reflects the actions that transformation capability for clients. the company has taken to transform the business. The company has invested in its strategic imperatives to accelerate growth, Global Services Backlog continued to optimize its delivery platform through workforce The estimated Global Services backlog at December 31, 2014 rebalancing and broader use of automation, and divested busi- was $128 billion. This included a backlog reduction in 2014 of $3.7 nesses, all impacting the year-to-year results. While these actions billion associated with the customer care and industry standard all have near-term impacts to profit, they position the business server divestitures. Adjusting for the divested businesses, backlog more effectively going forward and will enable it to deliver more was down 7.5 percent as reported, but flat adjusted for currency value to clients. year to year. The estimated transactional backlog at December GBS gross profit margin of 30.8 percent was flat year to 31, 2014 decreased 7.6 percent (1 percent adjusted for currency) year compared to 2013. Pre-tax income decreased 6.7 percent from the December 31, 2013 levels. The estimated outsourcing to $2,999 million and the pre-tax margin declined 0.5 points to backlog decreased 11.0 percent as reported, but increased 1 per- 16.3 percent. In 2014, profit was impacted by lower revenue on a cent adjusted for the customer care divestiture (4 points) and relatively fixed cost base. In areas where the company has strong currency (8 points). ($ in billions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for At December 31: 2014 2013 Change Currency Backlog Total backlog $128.4 $142.8 (10.1)% (2.9)% Adjusted for divested businesses (7.5) (0.2) Outsourcing backlog 80.8 90.8 (11.0) (3.3) Adjusted for customer care (7.1) 0.8 Total Global Services backlog includes GTS Outsourcing, ITS, involves estimates and judgments to gauge the extent of a client’s GBS Outsourcing, Consulting and Systems Integration and Main- commitment, including the type and duration of the agreement, tenance. Outsourcing backlog includes GTS Outsourcing and GBS and the presence of termination charges or wind-down costs. Outsourcing. Transactional backlog includes ITS and Consulting Signings include GTS Outsourcing, ITS, GBS Outsourcing and and Systems Integration. Total backlog is intended to be a state- Consulting and Systems Integration contracts. Contract exten- ment of overall work under contract and therefore does include sions and increases in scope are treated as signings only to the Maintenance. Backlog estimates are subject to change and are extent of the incremental new value. Maintenance is not included affected by several factors, including terminations, changes in the in signings as maintenance contracts tend to be more steady state, scope of contracts, periodic revalidations, adjustments for revenue where revenues equal renewals. not materialized and adjustments 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 con- company’s requirements for initial signings. A new signing will be tract. There are no third-party standards or requirements governing recognized if a new services agreement is signed incidental or the calculation of signings. The calculation used by management coincidental to an acquisition or divestiture.


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    36 Management Discussion International Business Machines Corporation and Subsidiary Companies ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2014 2013 Change Currency Total signings $51,569 $63,203 (18.4)% (15.7)% Outsourcing signings $26,517 $35,027 (24.3)% (21.1)% Transactional signings 25,052 28,176 (11.1) (8.9) Software ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2014 2013 Change Currency Software external revenue $25,434 $25,932 (1.9)% (0.9)% Middleware $21,474 $21,557 (0.4)% 0.6% Key Branded Middleware 17,098 17,322 (1.3) (0.2) WebSphere Family 2.7 3.5 Information Management (4.1) (3.0) Workforce Solutions (6.1) (5.1) Tivoli 2.0 3.0 Rational (3.3) (1.3) Other middleware 4,376 4,235 3.3 4.2 Operating systems 2,119 2,447 (13.4) (12.6) Other 1,841 1,929 (4.5) (3.7) Software revenue of $25,434 million decreased 1.9 percent (1 per- been providing more flexibility on how clients deploy its software cent adjusted for currency) in 2014 compared to the prior year. acquired through enterprise licensing agreements. This enables Middleware decreased 0.4 percent (increased 1 percent adjusted clients to more effectively manage their capacity and commit to for currency) while operating systems were down 13.4 percent the company’s platforms for the long term, however, it does impact (13 percent adjusted for currency). The decline in operating sys- period transactional revenue. tems impacted total software revenue growth year to year at Key branded middleware revenue, which accounted for constant currency by approximately 1 point. The company had 67 percent of total Software revenue in 2014, decreased 1.3 per- solid growth in many of its solution areas, including security, mobile cent (flat percent adjusted for currency) compared to the prior and cloud. In addition, across the software brands, software-as- year. While there was growth in several strategic areas like cloud, a-service (SaaS) offerings grew rapidly throughout the year, mobile and security, other parts of the portfolio declined on a increasing approximately 50 percent compared to 2013. In the first year-to-year basis. quarter of 2014, the company launched Bluemix, a cloud platform- WebSphere revenue increased 2.7 percent (4 percent adjusted as-a-service for the enterprise and, during the year, the Software for currency) in 2014 compared to the prior year. Revenue per- business completed five acquisitions adding to its capabilities formance was driven by growth in Application Server, Business in mobile, cloud and security. Across Software, the company is Integration and Commerce offerings. In Commerce, there was transitioning its portfolio to capture growth areas while continuing strong momentum in Commerce-as-a-service, which includes the to drive innovation in its core franchises. It is growing and build- acquisitions of Silverpop and Aspera. MobileFirst, the comprehen- ing capabilities in emerging areas like SaaS, mobile and security. sive portfolio of mobile software and services that enable clients Performance in 2014 reflected business model changes that to manage, integrate and leverage mobile devices, contributed to impacted the transactional revenue growth. Given clients’ sub- the significant growth of the company’s mobile business. stantial investment in the IBM software platform, the company has


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    Management Discussion 37 International Business Machines Corporation and Subsidiary Companies Information Management revenue decreased 4.1 percent ($ in millions) (3 percent adjusted for currency) in 2014 compared to the prior Yr.-to-Yr. Percent/ year. With the acquisition of Cloudant, the company has added Margin For the year ended December 31: 2014 2013 Change database-as-a-service capability. Cloudant extends the com- pany’s mobile and cloud platforms by enabling developers to Software easily and quickly create next-generation mobile and Web-based External gross profit $22,533 $23,032 (2.2)% applications. External gross profit margin 88.6% 88.8% (0.2) pts. Workforce Solutions revenue decreased 6.1 percent (5 percent Pre-tax income $10,699 $11,106 (3.7)% adjusted for currency) in 2014 compared to the prior year. Perfor- Pre-tax margin 37.0% 38.1% (1.2) pts. mance has been impacted by the transition from on premise Notes to SaaS offerings. The company is working to transform this busi- ness and build recurring revenue streams from the SaaS offerings. Software gross profit decreased 2.2 percent, with a gross profit Tivoli revenue increased 2.0 percent (3 percent adjusted for margin of 88.6 percent. Software pre-tax income decreased currency) in 2014 compared to the prior year. Year-to-year revenue 3.7 percent year to year and pre-tax margin declined 1.2 points. growth was driven by security software, which grew at double Across software, the company continues to drive innovation and digit rates again this year. As cybersecurity threats are a key issue capture growth areas, integrating analytics and security capabili- faced by all customers, these strong results are being driven in ties that are needed to operate seamlessly in a hybrid environment. part by incremental requirements for security with the expansion For example, the company is introducing several new offerings into cloud and mobile computing. that further enable its analytics portfolio in a cloud environment. Rational revenue decreased 3.3 percent (1 percent adjusted It recently announced IBM Verse, a cloud based email and col- for currency) in 2014 year over year. laboration offering that integrates Watson capabilities. This type of Operating systems revenue decreased 13.4 percent (13 percent continued innovation in offerings, together with expanding services adjusted for currency) in 2014 compared to 2013. This decline was on the Bluemix platform-as-a-service, will better allow customers primarily driven by declines in Power Systems. to move to a hybrid environment. Systems and Technology ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2014 2013 Change Currency Systems and Technology external revenue $9,996 $12,988 (23.0)% (16.8)%* System z (23.3)% (22.6)% Power Systems (18.9) (18.2) Storage (12.0) (11.0) System x (35.1) (34.9) * Adjusted for divestitures and currency. Systems and Technology (STG) revenue of $9,996 million System z revenue decreased 23.3 percent (23 percent adjusted decreased 23.0 percent as reported in 2014, 17 percent adjusted for currency) compared to the prior year. The fourth quarter of 2014 for the divestiture of the industry standard server business marked the tenth quarter of the current product cycle. In Janu- (5 points) and currency (1 point). In 2013, the STG business reported ary 2015, the company announced the z13, the new generation a profit decline of $1,653 million compared to 2012. During 2014, the mainframe. The z13 system culminates a billion dollar investment company worked to reposition this business and to stabilize profit. and five years of development, leverages the innovation of more It divested the industry standard server business and announced than 500 new patents and represents a collaboration with more the divestiture of the Microelectronics business. Performance in than 60 clients. The result of this effort is a mainframe that has the 2014 reflected year-to-year declines related to the System z prod- world’s fastest processor that can execute two-and-a-half billion uct cycle as well as declines in Power Systems and Storage. STG transactions a day. With this generation of mainframe, the com- grew profit in the fourth quarter, and was profitable for the year. pany has dramatically enhanced its capabilities around analytics, Profit performance year to year was impacted by the divestiture and currency, in addition to the revenue impacts.


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    38 Management Discussion International Business Machines Corporation and Subsidiary Companies mobile, security and cloud to address the needs clients see in ($ in millions) their businesses. These capabilities span from real-time insights Yr.-to-Yr. Percent/ to real-time fraud detection in a system that can consistently run Margin For the year ended December 31: 2014 2013 Change at 100-percent utilization with 100-percent uptime. The company continues to innovate on the platform to address client needs and Systems and Technology extend its leadership in high-end systems, a core franchise that External gross profit $3,945 $5,299 (25.6)% has nearly doubled in installed capacity over the last five years. External gross profit margin 39.5% 40.8% (1.3) pts. Power Systems revenue decreased 18.9 percent (18 percent Pre-tax income $ 34 $ 213 (84.1)% adjusted for currency) in 2014 compared to the prior year. Although Pre-tax margin 0.3% 1.6% (1.3) pts. down year to year, there was sequential improvement in the year- to-year revenue growth rate at constant currency in the last two quarters of the year. The company has repositioned Power which is Systems and Technology’s gross profit margin of 39.5 percent not only a systems business, but also an open chip processor and decreased 1.3 points versus the prior year. The decrease was an IP income opportunity through the OpenPOWER foundation. In driven by lower margins in Power Systems (1.3 points) and Storage June, scale-out systems based on POWER8 were introduced and (0.9 points), partially offset by an increase due to mix (0.7 points), high-end POWER8-based enterprise systems were announced in driven by the divestiture of the industry standard server business. October. These newly announced systems are highly scalable and Pre-tax income decreased $179 million or 84.1 percent and pre-tax can handle the most data intensive, mission critical applications margin decreased 1.3 points in 2014 versus the prior year. in the industry. In addition, the company saw continued expan- In 2014, the company took significant actions to reposition sion of the OpenPOWER consortium, now with over 80 members, its Systems and Technology business for higher value, and rein- 14 of which are in greater China. Since the establishment of the forced its commitment to driving innovation in high-end systems consortium a year ago, several offerings have been introduced and storage. It repositioned Power through the development of by consortium members based on the POWER architecture. In the POWER8 systems which are built for cloud and big data, addition, the company has initiated a strategic partnership with and it made available the POWER8 architecture through the Suzhou PowerCore, which intends to use POWER architecture to OpenPOWER consortium to build an open ecosystem and an IP develop and market processors for servers in China. opportunity. The company is divesting its Microelectronics busi- Storage revenue decreased 12.0 percent (11 percent adjusted ness with future chip supply coming from an at-scale provider, for currency) in 2014 compared to the prior year. However, at and has committed $3 billion of investment over five years in the constant currency, it delivered sequential improvement in the next era of chip technology as it strengthens its semiconductor year-to-year growth rate over the last three quarters of 2014. Full- research and development and systems innovation. The company year performance included strong contribution from FlashSystem also divested System x, the industry standard server business, and the Storwize portfolio. However, this was more than offset by and announced the z13, the new generation of the mainframe. weakness in high-end disk and the continued wind-down of the With its portfolio repositioned and the introduction of the new legacy storage-related OEM business. mainframe, this business segment should now see profit lever- age going forward. Global Financing See pages 73 through 77 for an analysis of Global Financing’s seg- ment results.


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    Management Discussion 39 International Business Machines Corporation and Subsidiary Companies 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. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2014 2013 Change Currency* Total revenue $92,793 $98,367 (5.7)% (1.5)% Geographies $92,326 $97,800 (5.6)% (1.5)% Americas 41,410 43,249 (4.3) (0.8) Europe/Middle East/Africa 30,700 31,628 (2.9) (0.6) Asia Pacific 20,216 22,923 (11.8) (4.1) Major markets (4.3)% (1.0)% Growth markets (9.9)% (3.2)% BRIC countries (10.7)% (4.5)% * Adjusted for divestitures and currency. Total geographic revenue of $92,326 million decreased 5.6 per- 1 percent adjusted for currency and divestitures. Australia, India cent as reported and 1 percent adjusted for divestitures (2 points) and Korea, which are some of the larger countries within the Asia and currency (2 points) in 2014 compared to the prior year. In total, Pacific growth markets, also declined compared to the prior year. major market countries decreased 4.3 percent as reported and Within the BRIC countries, combined revenue decreased 10.7 per- 1 percent adjusted for divestitures (2 points) and currency (1 point). cent as reported and 5 percent adjusted for divestitures (3 points) Growth market countries decreased 9.9 percent as reported and currency (3 points) compared to the prior year. On an adjusted and 3 percent adjusted for divestitures (3 points) and currency basis, this performance reflects growth in Brazil and Russia, more (4 points) compared to 2013. than offset by the declines in China and India. The year-to-year decline in growth markets revenue adjusted Americas revenue of $41,410 million decreased 4.3 percent as for currency and the divestitures reflected growth in the Latin Amer- reported and 1 percent adjusted for divestitures (2 points) and ican and Europe growth markets, more than offset by decreased currency (1 point) compared to the prior year. On an adjusted revenue in the Asia Pacific growth markets. The Latin American basis, there was increased revenue in the growth markets offset growth market countries decreased 1.0 percent as reported, but by year-to-year declines in the major market countries. Within the grew 8 percent adjusted for divestitures (2 points) and currency North American major markets, the U.S. declined 4.0 percent as (7 points). Within Latin America, Brazil decreased 3.1 percent as reported and 2 percent adjusted for divestitures (2 points). Canada reported, but grew 4 percent adjusted for divestitures (1 point) was down 9.8 percent as reported and 2 percent adjusted for and currency (6 points). There was also growth in most other divestitures (1 point) and currency (7 points). Latin American countries at constant currency. European growth Europe/Middle East/Africa (EMEA) revenue of $30,700 mil- markets were down 5.3 percent as reported, but increased 1 per- lion decreased 2.9 percent as reported and 1 percent adjusted cent adjusted for divestitures (3 points) and currency (3 points) for divestitures (3 points) and offset by currency (1 point). Major compared to the prior year. Asia Pacific growth market countries market countries were down 2.6 percent as reported and 1 per- decreased 14.6 percent as reported and 9 percent adjusted for cent adjusted for divestitures (2 points), offset by currency (1 point). divestitures (3 points) and currency (2 points). This performance This was offset by growth of 1 percent on an adjusted basis in the was driven by China and several of the other larger growth market growth market countries. Major market performance adjusted for countries. China decreased 17.2 percent as reported and 15 per- the divestitures and currency included growth in Germany, Italy cent adjusted for divestitures (3 points) and currency (0 points), but and Spain, which was more than offset by declines in the UK and reflected improvement in its sequential year-to-year growth rate France compared to the prior year. in the last quarter of the year with strong software performance and several large mainframe transactions. In the fourth quarter, China revenue decreased 19.9 percent as reported, but declined


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    40 Management Discussion International Business Machines Corporation and Subsidiary Companies Asia Pacific revenue of $20,216 million decreased 11.8 percent Selling, General and Administrative as reported and 4 percent adjusted for the divested businesses ($ in millions) (3 points) and currency (5 points). Japan was down 7.6 percent Yr.-to-Yr. as reported, but increased 3 percent adjusted for divestitures Percent For the year ended December 31: 2014 2013 Change (3 points) and currency (8 points). On this basis, Japan reflected Selling, general and year-to-year growth in every quarter of 2014. However, this growth administrative expense was more than offset by declines in the Asia Pacific growth markets. Selling, general and administrative—other $18,532 $19,178 (3.4)% Total Expense and Other (Income) Advertising and promotional expense 1,307 1,294 1.1 ($ in millions) Workforce rebalancing charges 1,472 1,031 42.7 Yr.-to-Yr. Percent/ Retirement-related costs 811 986 (17.8) Margin For the year ended December 31: 2014 2013 Change Amortization of acquired Total consolidated expense intangible assets 374 370 1.2 and other (income) $26,421 $28,440 (7.1)% Stock-based compensation 350 435 (19.4) Non-operating adjustments Bad debt expense 334 156 113.8 Amortization of acquired Total consolidated selling, general intangible assets (374) (370) 1.2 and administrative expense $23,180 $23,451 (1.2)% Acquisition-related charges (12) (40) (70.0) Non-operating adjustments Non-operating retirement-related Amortization of acquired (costs)/income (180) (433) (58.4) intangible assets (374) (370) 1.2 Operating (non-GAAP) Acquisition-related charges (11) (25) (54.1) expense and other (income) $25,855 $27,597 (6.3)% Non-operating retirement-related Total consolidated (costs)/income (257) (376) (31.7) expense-to-revenue ratio 28.5% 28.9% (0.4) pts. Operating (non-GAAP) Operating (non-GAAP) selling, general and expense-to-revenue ratio 27.9% 28.1% (0.2) pts. administrative expense $22,537 $22,680 (0.6)% The key drivers of the year-to-year change in total expense and Total selling, general and administrative (SG&A) expense other (income) were approximately: decreased 1.2 percent in 2014 versus 2013. The decrease was Total Operating primarily driven by the effects of currency (2 points) and lower base Consolidated (non-GAAP) expense (1 point), partially offset by acquisition-related spend- • Currency* (1) point (1) point ing (2 points). Operating (non-GAAP) SG&A expense decreased • Acquisitions** 2 points 2 points 0.6 percent primarily driven by the effects of currency (2 points), • Base expense (8) points (7) points partially offset by acquisition-related spending (1 point). Workforce rebalancing charges in 2014 were $1,472 million, an increase of * Reflects impacts of translation and hedging programs. $440 million year to year, which resulted in a 2 point year-to-year ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges. impact in operating (non-GAAP) SG&A base expense. Bad debt expense increased $178 million year to year driven by higher spe- Base expense includes the gains from the divestitures of the indus- cific provision additions, primarily in China and Latin America. The try standard server and customer care businesses, as well as the receivables provision coverage was 2.2 percent at December 31, impact of higher workforce rebalancing charges year to year. 2014, an increase of 60 basis points from year-end 2013. Excluding the gains from the divested businesses and the impact of workforce rebalancing, operating (non-GAAP) base expense Research, Development and Engineering decreased 3 points year to year versus the 7 point as reported ($ in millions) decrease. Within base expense, the company is continuing to shift Yr.-to-Yr. Percent its resources and spending to the strategic imperatives. For the year ended December 31: 2014 2013 Change For additional information regarding total expense and other Total consolidated research, (income) for both expense presentations, see the following analy- development and engineering $5,437 $5,743 (5.3)% ses by category. Non-operating adjustment Non-operating retirement-related (costs)/income 77 (57) NM Operating (non-GAAP) research, development and engineering $5,514 $5,686 (3.0)% NM—Not meaningful


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    Management Discussion 41 International Business Machines Corporation and Subsidiary Companies Research, development and engineering (RD&E) expense in The increase in income of $1,605 million year over year was pri- continuing operations was 5.9 percent of revenue in 2014 and marily driven by higher gains associated with divestitures ($1,710 5.8 percent of revenue in 2013. RD&E expense decreased 5.3 per- million), driven by the industry standard server ($1,400 million) and cent in 2014 versus 2013 primarily driven by: lower base expense customer care ($202 million) transactions. Divestiture gains are (7 points) and the effects of currency (1 point), partially offset by reflected in Other in the table above. higher expense due to acquisitions (2 points). Operating (non- GAAP) RD&E expense decreased 3.0 percent in 2014 compared to Interest Expense the prior year, primarily driven by lower base expense (4 points) and ($ in millions) the effects of currency (1 point), partially offset by higher expense Yr.-to-Yr. due to acquisitions (2 points). Percent For the year ended December 31: 2014 2013 Change Interest expense Intellectual Property and Custom Development Income Total $484 $402 20.4% ($ in millions) Yr.-to-Yr. Percent For the year ended December 31: 2014 2013 Change The increase in interest expense in 2014 versus 2013 was primar- ily driven by higher average debt levels, partially offset by lower Sales and other transfers of intellectual property $283 $352 (19.7)% average interest rates. Interest expense is presented in cost of financing in the Consolidated Statement of Earnings only if the Licensing/royalty-based fees 129 150 (13.9) related external borrowings are to support the Global Financing Custom development income 330 320 3.1 external business. Overall interest expense (excluding capitalized Total $742 $822 (9.8)% interest) in 2014 was $1,025 million, an increase of $36 million year to year. The timing and amount of Sales and other transfers of IP may vary significantly from period to period depending upon the timing of Stock-Based Compensation divestitures, economic conditions, industry consolidation and the Total pre-tax stock-based compensation cost of $512 million timing of new patents and know-how development. There were no decreased $102 million compared to 2013. The decrease was pri- significant individual IP transactions in 2014 or 2013. marily related to performance share units ($58 million), restricted stock units ($26 million) and the company’s assumption of stock- Other (Income) and Expense based awards previously issued by acquired entities ($18 million). Stock-based compensation cost, and the year-to-year change, ($ in millions) Yr.-to-Yr. was reflected in the following categories: Cost: $121 million, down Percent $1 million; SG&A expense: $350 million, down $85 million; RD&E For the year ended December 31: 2014 2013 Change expense: $54 million, down $3 million and Other (income) and Other (income) and expense expense: ($13 million), down $13 million. The amount of stock- Foreign currency transaction based compensation cost included in the loss from discontinued losses/(gains) $ (599) $(260) 130.4% operations, net of tax, was immaterial. (Gains)/losses on derivative instruments 654 166 293.3 Interest income (90) (74) 22.1 Net (gains)/losses from securities and investment assets (26) (29) (11.5) Other (1,878) (137) NM Total consolidated other (income) and expense $(1,938) $(333) 482.4% Non-operating adjustment Acquisition-related charges (1) (16) (94.7) Operating (non-GAAP) other (income) and expense $(1,939) $(349) 456.2% NM—Not meaningful


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    42 Management Discussion International Business Machines Corporation and Subsidiary Companies Retirement-Related Plans Income Taxes The following table provides the total pre-tax cost for all retirement- The continuing operations effective tax rate for 2014 was 21.2 per- related plans. These amounts are included in the Consolidated cent, an increase of 4.6 points versus the prior year, driven by the Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) following factors: relating to the job function of the plan participants. • The year-to-year impact of factors that benefited the 2013 rate (14.5 points), including completion of the U.S. 2008–2010 ($ in millions) tax audit and the associated reserve redeterminations Yr.-to-Yr. (11.1 points), the retroactive impact of the 2012 American Percent For the year ended December 31: 2014 2013 Change Taxpayer Relief Act (0.7 points), a tax agreement which required a reassessment of certain valuation allowances on Retirement-related plans—cost deferred tax assets (1.4 points), the resolution of certain Service cost $ 482 $ 545 (11.5)% non-U.S. tax audits (0.7 points) and newly enacted U.S. state Amortization of prior tax legislation (0.6 points); and service cost/(credits) (114) (114) (0.1) • A tax charge related to the sale of the industry standard Cost of defined contribution plans 1,253 1,384 (9.5) server business (0.9 points); partially offset by; Total operating costs $ 1,621 $ 1,815 (10.7)% • A year-to-year benefit of reduced tax charges related to Interest cost 3,994 3,728 7.1 certain intercompany payments made by foreign subsidiaries Expected return on plan assets (6,351) (6,187) 2.7 and the intercompany licensing of certain IP (3.7 points); • An increased benefit in the utilization of foreign tax credits Recognized actuarial losses 2,467 3,434 (28.2) (4.7 points); and Plan amendments/curtailments/ • A benefit due to a more favorable geographic mix of pre-tax settlements 25 0 NM income in 2014 (2.5 points). Multi-employer plan/other costs 218 86 154.5 Total non-operating costs/ The continuing operations operating (non-GAAP) effective tax rate (income) $ 353 $ 1,062 (66.7)% was 21.0 percent, an increase of 4.0 points versus 2013 principally Total retirement-related driven by the same factors described above. plans—cost $ 1,974 $ 2,876 (31.4)% NM—Not meaningful Earnings Per Share Basic earnings per share is computed on the basis of the In 2014, total retirement-related plan cost decreased by $902 weighted-average number of shares of common stock outstand- million compared to 2013, primarily driven by a decrease in rec- ing during the period. Diluted earnings per share is computed on ognized actuarial losses ($967 million), higher actual return on plan the basis of the weighted-average number of shares of common assets ($165 million) and lower defined contribution plans cost stock outstanding plus the effect of dilutive potential common ($131 million), partially offset by higher interest cost ($266 million) shares outstanding during the period using the treasury stock and higher pension obligations related to litigation ($139 million). method. Dilutive potential common shares include outstanding As discussed in the “Operating (non-GAAP) Earnings” section stock options and stock awards. on page 22, the company characterizes certain retirement-related costs as operating and others as non-operating. Utilizing this char- Yr.-to-Yr. acterization, operating retirement-related costs in 2014 were $1,621 Percent For the year ended December 31: 2014 2013 Change million, a decrease of $194 million compared to 2013, primarily Earnings per share of common stock driven by lower defined contribution plans cost ($131 million) and from continuing operations decreased service cost ($63 million). Non-operating costs of $353 Assuming dilution $15.59 $15.30 1.9% million decreased $709 million in 2014, compared to the prior year, driven primarily by the decrease in recognized actuarial losses Basic $15.68 $15.42 1.7% ($967 million) and higher actual return on plan assets ($165 million), Diluted operating (non-GAAP) $16.53 $16.64 (0.7)% partially offset by higher interest cost ($266 million) and higher Weighted-average shares pension obligations related to litigation ($139 million). outstanding (in millions) Assuming dilution 1,010.0 1,103.0 (8.4)% Basic 1,004.3 1,094.5 (8.2)%


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    Management Discussion 43 International Business Machines Corporation and Subsidiary Companies Actual shares outstanding at December 31, 2014 and 2013 were Consistent with accounting standards, the company remea- 990.5 million and 1,054.4 million, respectively. The average number sures the funded status of its retirement and postretirement plans of common shares outstanding assuming dilution was 93.0 million at December 31. At December 31, 2014, the overall net under- shares lower in 2014 versus 2013. The decrease was primarily the funded position was $16,932 million, an increase of $5,498 million result of the common stock repurchase program. from December 31, 2013 driven by a decrease in discount rates and changes in U.S. mortality rate assumptions, partially offset Results of Discontinued Operations by strong asset returns worldwide. At year end, the company’s The loss from discontinued operations, net of tax, was $3.7 bil- qualified defined benefit plans were well funded and the cash lion in 2014 and $0.4 billion in 2013. The loss in 2014 included a requirements related to these plans remain stable going forward non-recurring pre-tax charge of $4.7 billion, or $3.4 billion, net of at approximately $600 million per year through 2019. In 2014, the tax. The charge included an impairment to reflect the fair value return on the U.S. Personal Pension Plan assets was 10.1 percent less estimated costs to sell the Microelectronics business, which and the plan was 102 percent funded at December 31. Overall, the company initially reported as held for sale at September 30, global asset returns were 12.2 percent and the qualified defined 2014. The charge also included other estimated costs related benefit plans worldwide were 97 percent funded at December 31. to the transaction, including cash consideration expected to be During 2014, the company generated $16,868 million in cash transferred of approximately $1.5 billion. The cash consideration is from operations, a decrease of $616 million compared to 2013. In expected to be paid over the next three years and will be adjusted addition, the company generated $12,372 million in free cash flow, down by the amount of the working capital due from GLOBAL- a decrease of $2,649 million versus the prior year. See pages 66 FOUNDRIES, estimated to be $0.2 billion. In addition, discontinued to 67 for additional information on free cash flow. The company operations includes the operational net losses from the Microelec- returned $17,944 million to shareholders in 2014, with $13,679 mil- tronics business of $0.3 billion in 2014 and $0.4 billion in 2013. The lion in gross share repurchases and $4,265 million in dividends. In discontinued operations effective tax rate in 2014 was 30.2 per- 2014, the company repurchased approximately 71.5 million shares cent compared to 44.8 percent in 2013. The year-to-year decrease and had approximately $6.3 billion remaining in share repurchase in the rate was driven primarily by a one-time tax charge of $428 authorization at year end. The company’s cash generation permits million in the third quarter of 2014 in connection with the disposal. the company to invest and deploy capital to areas with the most See note C, “Acquisitions/Divestitures,” on pages 100 and 101 attractive long-term opportunities. for additional information regarding the divestiture transaction. The assets and debt associated with the Global Financing business are a significant part of the company’s financial posi- Financial Position tion. The financial position amounts appearing on page 82 are the Dynamics consolidated amounts including Global Financing. The amounts At December 31, 2014, the company continued to have the finan- appearing in the separate Global Financing section, beginning on cial flexibility to support the business over the long term. Cash and page 73, are supplementary data presented to facilitate an under- marketable securities at year end were $8,476 million. During the standing of the Global Financing business. year, the company continued to manage the investment portfolio to meet its capital preservation and liquidity objectives. Working Capital Total debt of $40,804 million increased $1,087 million from ($ in millions) prior year-end levels. The commercial paper balance at Decem- At December 31: 2014 2013 ber 31, 2014, was $650 million, a decrease of $1,808 million from Current assets $49,422 $51,350 the prior year end. Within total debt, $29,103 million is in support Current liabilities 39,600 40,154 of the Global Financing business which is leveraged at a 7.2 to 1 Working capital $ 9,822 $11,196 ratio. The company continues to have substantial flexibility in the market. During 2014, the company completed bond issuances Current ratio 1.25:1 1.28:1 totaling $6,852 million, with terms ranging from 2 to 10 years, and interest rates ranging from 0.30 to 3.63 percent depending on Working capital decreased $1,374 million from the year-end 2013 maturity. The company has consistently generated strong cash position. The key changes are described below: flow from operations and continues to have access to additional Current assets decreased $1,928 million (an increase of $1,119 sources of liquidity through the capital markets and its $10 billion million adjusted for currency), as a result of: global credit facility, with 100 percent of the facility available on a • A decrease of $2,589 million in cash and cash equivalents same day basis. and marketable securities; and • A decline of $1,375 million ($734 million adjusted for currency) in trade receivables primarily due to the decline in revenue and improved customer collections; partially offset by


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    44 Management Discussion International Business Machines Corporation and Subsidiary Companies • An increase of $1,322 million ($1,378 million adjusted for Net cash used in investing activities decreased $4,325 million currency) in other receivables driven by anticipated tax driven by: refunds; and • A decrease in cash used for acquisitions of $2,401 million; and • An increase in deferred taxes of $394 million ($507 million • An increase in cash provided by divestitures of $2,061 million. adjusted for currency) primarily due to the expected Micro- electronics business divestiture. Net cash used in financing activities increased $5,569 million as compared to the prior year driven by the following factors: Current liabilities decreased $554 million (an increase of $1,623 • Lower cash from debt transactions (including short-term million adjusted for currency), as a result of: borrowings) of $5,177 million; and • A decrease in short-term debt of $1,131 million ($1,074 million • An increase of $392 million in net cash used for equity trans- adjusted for currency); and actions impacted by increased dividend payments in 2014. • A decrease in deferred income of $680 million (an increase of $42 million adjusted for currency) driven by currency; partially Noncurrent Assets and Liabilities offset by ($ in millions) • Other accrued expenses and liabilities increases of $1,265 At December 31: 2014 2013 million ($1,840 million adjusted for currency) driven by Noncurrent assets $68,110 $74,873 charges and expected payments related to the expected Long-term debt $35,073 $32,856 divestiture of the Microelectronics business and workforce rebalancing accruals. Noncurrent liabilities (excluding debt) $30,844 $30,284 Cash Flow The decrease in noncurrent assets of $6,763 million ($3,790 million The company’s cash flows from operating, investing and financ- adjusted for currency) was driven by: ing activities, as reflected in the Consolidated Statement of Cash • A decrease of $3,392 million ($3,260 million adjusted for Flows on page 83 are summarized in the table below. These currency) in prepaid pension assets primarily driven by plan amounts include the cash flows associated with the Global Financ- remeasurements; ing business. • A decrease in property, plant and equipment, net of $3,050 million ($2,381 million adjusted for currency) primarily driven ($ in millions) by a charge of $2,358 million associated with the expected For the year ended December 31: 2014 2013 divestiture of the Microelectronics business; and Net cash provided by/(used in) continuing • A decrease of $1,646 million ($917 million adjusted for cur- operations rency) in long term financing receivables; partially offset by Operating activities $ 16,868 $17,485 • An increase in deferred taxes of $1,757 million ($2,054 million Investing activities (3,001) (7,326) adjusted for currency) driven by retirement related plan activity. Financing activities (15,452) (9,883) Long-term debt increased $2,218 million ($3,042 million adjusted Effect of exchange rate changes on for currency) driven by new debt of $7,657 million offset by cash and cash equivalents (655) 28 reclasses to short-term debt of $4,809 million. Net change in cash and cash equivalents $ (2,240) $ 304 Other noncurrent liabilities, excluding debt, increased $561 mil- lion ($2,330 million adjusted for currency) primarily driven by: Net cash provided by operating activities decreased by $616 mil- • An increase in retirement and nonpension benefit obligations lion in 2014 driven by the following key factors: of $2,019 million ($3,210 million adjusted for currency) driven • An increase in income taxes paid of $1,724 million primarily by plan remeasurements, partially offset by driven by audit settlement payments and other prior period • Declines of $1,041 million ($708 million adjusted for currency) discrete tax impacts settled in 2014; in other liabilities driven by declines in deferred taxes. • A decrease in cash associated with deferred income of $814 million due to lower levels of customer prepayments; and Debt • Performance-related declines within net income; partially The company’s funding requirements are continually monitored offset by and strategies are executed to manage the overall asset and liabil- • An increase in cash provided by receivables of $2,676 million, ity profile. Additionally, the company maintains sufficient flexibility primarily driven by financing receivables; and to access global funding sources as needed. • A decrease in cash payments for performance-related com- pensation of $772 million.


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    Management Discussion 45 International Business Machines Corporation and Subsidiary Companies ($ in millions) associated with the disposal of the Microelectronics business of At December 31: 2014 2013 $3,381 million and declines from translation of $2,074 million due Total company debt $40,804 $39,718 to the strengthening U.S. dollar. Total Global Financing segment debt $29,103 $27,504 Consolidated debt-to-capitalization ratio at December 31, 2014 was 77.3 percent versus 63.4 percent at December 31, 2013 and Debt to support external clients 25,531 24,471 was similarly impacted by the retirement plan remeasurements Debt to support internal clients 3,572 3,033 and strengthening of the U.S. dollar as noted above. Non-Global Financing debt 11,701 12,214 Equity Global Financing provides financing predominantly for the com- Total equity decreased by $10,916 million from December 31, 2013 pany’s external client assets, as well as for assets under contract as a result of an increase in treasury stock of $13,474 million mainly by other IBM units. These assets, primarily for Global Services, due to gross common stock repurchases, an increase in other generate long-term, stable revenue streams similar to the Global comprehensive losses of $6,274 million primarily due to retirement Financing asset portfolio. Based on their attributes, these Global plan remeasurements, partially offset by an increase in retained Services assets are leveraged with the balance of the Global earnings of $7,751 million. The retirement plan remeasurement Financing asset base. The debt analysis above is further detailed impact to other comprehensive losses was driven by: changes in the Global Financing section on pages 76–77. in discount rates ($7.4 billion) and in mortality rate assumptions Given the significant leverage, the company presents a debt- ($1.7 billion), partially offset by improved asset returns ($3.1 billion). to-capitalization ratio which excludes Global Financing debt and equity as management believes this is more representative of the GAAP Reconciliation company’s core business operations. This ratio can vary from The tables below provide a reconciliation of the company’s income period to period as the company manages its global cash and statement results as reported under GAAP to its operating earn- debt positions. ings presentation which is a non-GAAP measure. The company’s “Core” debt-to-capitalization ratio (excluding Global Financ- calculation of operating (non-GAAP) earnings, as presented, may ing debt and equity) was 59.4 percent at December 31, 2014 differ from similarly titled measures reported by other companies. compared to 39.0 percent at December 31, 2013. The ratio was Please refer to the “Operating (non-GAAP) Earnings” section on impacted by retirement-related declines in equity of $6,366 million page 22 for the company’s rationale for presenting operating earn- primarily driven by plan remeasurements, the non-recurring charge ings information. ($ in millions except per share amounts) Acquisition- Retirement- Related Related Operating For the year ended December 31, 2014: GAAP Adjustments Adjustments (non-GAAP) Gross profit $46,407 $ 416 $ 173 $46,996 Gross profit margin 50.0% 0.4 pts. 0.2 pts. 50.6% SG&A $23,180 $(385) $(257) $22,537 RD&E 5,437 — 77 5,514 Other (income) and expense (1,938) (1) — (1,939) Total expense and other (income) 26,421 (386) (180) 25,855 Pre-tax income from continuing operations 19,986 803 353 21,142 Pre-tax income margin from continuing operations 21.5% 0.9 pts. 0.4 pts. 22.8% Provision for income taxes* $ 4,234 $ 133 $ 73 $ 4,440 Effective tax rate 21.2% (0.2) pts. 0.0 pts. 21.0% Income from continuing operations $15,751 $ 670 $ 280 $16,702 Income margin from continuing operations 17.0% 0.7 pts. 0.3 pts. 18.0% Loss from discontinued operations, net of tax $ (3,729) — $ — $ (3,729) Net income $12,022 $ 670 $ 280 $12,973 Diluted earnings per share: Continuing operations $ 15.59 $0.66 $0.28 $ 16.53 Discontinued operations $ (3.69) $ — $ — $ (3.69) * 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 effec- tive tax rate method to the results.


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    46 Management Discussion International Business Machines Corporation and Subsidiary Companies ($ 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 $48,684 $ 394 $ 629 $49,706 Gross profit margin 49.5% 0.4 pts. 0.6 pts. 50.5% SG&A $23,451 $(394) $ (376) $22,680 RD&E 5,743 — (57) 5,686 Other (income) and expense (333) (16) — (349) Total expense and other (income) 28,440 (410) (433) 27,597 Pre-tax income from continuing operations 20,244 804 1,062 22,110 Pre-tax margin from continuing operations 20.6% 0.8 pts. 1.1 pts. 22.5% Provision for income taxes* $ 3,363 $ 57 $ 333 $ 3,753 Effective tax rate 16.6% (0.4) pts. 0.7 pts. 17.0% Income from continuing operations $16,881 $ 747 $ 729 $18,356 Income margin from continuing operations 17.2% 0.8 pts. 0.7 pts. 18.7% Loss from discontinued operations, net of tax $ (398) $ — $ — $ (398) Net income $16,483 $ 747 $ 729 $17,959 Diluted earnings per share: Continuing operations $ 15.30 $0.68 $ 0.66 $ 16.64 Discontinued operations $ (0.36) $ — $ — $ (0.36) * 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. Consolidated Fourth-Quarter Results The following table provides the company’s operating (non-GAAP) ($ and shares in millions except per share amounts) earnings for the fourth quarter of 2014 and 2013. Yr.-to-Yr. Percent/ ($ in millions except per share amounts) Margin For the fourth quarter: 2014 2013 Change Yr.-to-Yr. Percent Revenue $24,113 $ 27,385 (11.9)%* For the fourth quarter: 2014 2013 Change Gross profit margin 53.3% 52.4% 1.0 pts. Net income as reported $5,484 $6,185 (11.3)% Total expense and other (income) $ 5,767 $ 7,235 (20.3)% Loss from discontinued operations, net of tax (31) (32) (1.7) Total expense and other (income)-to-revenue ratio 23.9% 26.4% (2.5) pts. Income from continuing operations 5,515 6,216 (11.3) Income from continuing operations Non-operating adjustments before income taxes $ 7,094 $ 7,102 (0.1)% (net of tax): Provision for income taxes from Acquisition-related charges 186 268 (30.5) continuing operations $ 1,580 $ 885 78.4% Non-operating retirement-related Income from continuing operations $ 5,515 $ 6,216 (11.3)% costs/(income) 84 164 (49.1) Income from continuing Operating (non-GAAP) earnings* $5,785 $ 6,649 (13.0)% operations margin 22.9% 22.7% 0.2 pts. Diluted operating (non-GAAP) Loss from discontinued operations, earnings per share $ 5.81 $ 6.16 (5.7)% net of tax (31) (32) (1.7)% * See page 52 for a more detailed reconciliation of net income to operating earning. Net income $ 5,484 $ 6,185 (11.3)% Earnings per share from continuing Snapshot operations: In the fourth quarter of 2014, the company reported $24.1 billion Assuming dilution $ 5.54 $ 5.76 (3.8)% in revenue and delivered diluted earnings per share from continu- Consolidated earnings per share— ing operations of $5.54 as reported and $5.81 on an operating assuming dilution $ 5.51 $ 5.73 (3.8)% (non-GAAP) basis. The results of continuing operations exclude a Weighted-average shares outstanding net loss from discontinued operations of $31 million related to the Assuming dilution 995.4 1,080.0 (7.8)% announced divestiture of the Microelectronics business. On a con- solidated basis, net income in the fourth quarter was $5.5 billion, * (7.6) percent adjusted for currency; (2.3) percent adjusted for divestitures and currency.


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    Management Discussion 47 International Business Machines Corporation and Subsidiary Companies with diluted earnings per share of $5.51. The company generated Total expense and other (income) decreased 20.3 percent in $6.1 billion in cash from operations and $6.6 billion in free cash flow the fourth quarter of 2014 compared to the prior year. Total oper- in the fourth quarter driving shareholder returns of $1.2 billion in ating (non-GAAP) expense and other (income) also decreased gross common stock repurchases and dividends. 20.3 percent year to year. The key drivers of the year-to-year The company’s results in the fourth quarter were impacted change in total expense and other (income) were approximately: by the dramatic strengthening of the U.S. dollar which began in Total Operating September and continued at a rapid pace. In addition, nearly all the Consolidated (non-GAAP) currencies moved in an unfavorable direction for the company’s • Currency* (5) points (4) points business profile and impacted revenue and earnings. Although the • Acquisitions** 1 points 1 points company hedges a portion of its cross-border cash flows which • Base expense (17) points (17) points defers the impacts of currency movement, it does not eliminate it. The company’s hedges are designed to provide stability around * Reflects impacts of translation and hedging programs. the receipt of cash, but there is no year-to-year benefit in the ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges. income statement when a currency’s direction is sustained over a longer period. The reported level of expense in the fourth quarter reflected not In the fourth quarter, total consolidated revenue decreased only the ongoing run rate of the business, but also the impact of 11.9 percent as reported and 2 percent adjusted for currency the industry standard server divestiture and a charge for workforce (5 points) and the divestitures of the industry standard server and rebalancing. The entire year-to-year decline was driven by the com- customer care businesses (5 points). These impacts represented bination of the gain on the divestiture and the fact that the expense approximately $2.8 billion in revenue and a 10-point impact to for the industry standard server business is no longer in the run the year-to-year growth rate. In the fourth quarter, the company rate. Adjusting for this divestiture, total operating (non-GAAP) continued its strong performance in its strategic imperatives expense and other (income) would have increased approximately that address the market shifts in data, cloud and engagement. 2 percent (6 percent adjusted for currency and acquisitions) Together they delivered double-digit growth, as they did in every including the workforce rebalancing charge of approximately $580 quarter during 2014. million, nearly all of which was a year-to-year increase. Within the company’s segments, Global Services revenue Pre-tax income from continuing operations of $7.1 billion declined 7.8 percent as reported, but was flat year to year adjusted decreased 0.1 percent year to year and the pre-tax margin was for currency (6 points) and the divestitures (2 points). Global 29.4 percent, an increase of 3.5 points versus the fourth quar- Technology Services revenue decreased 7.6 percent as reported, ter of 2013. The continuing operations effective tax rate for the but increased 2 percent adjusted for currency (6 points) and the fourth quarter was 22.3 percent, up 9.8 points year to year. This divested businesses (4 points) with growth across all business increase was primarily due to a benefit included in the prior year lines. Global Business Services revenue decreased 8.4 percent rate associated with the settlement of a U.S. tax audit in the fourth (3 percent adjusted for currency). Software revenue decreased quarter of 2013. Income from continuing operations of $5.5 billion 6.9 percent (3 percent adjusted for currency). Systems and decreased 11.3 percent year to year and the net income margin Technology revenue decreased 39.0 percent as reported and was 22.9 percent, an increase of 0.2 points. Net income of $5.5 12 percent adjusted for the industry standard server divestiture billion decreased $701 million year to year. Operating (non-GAAP) (24 points) and currency (3 points), reflecting the end of the product pre-tax income from continuing operations decreased 2.3 per- cycle in System z and declines in Power Systems and Storage. cent year to year and the operating (non-GAAP) pre-tax margin From a geographic perspective, revenue in the major markets was 30.7 percent, an increase of 3.0 points year to year. Operat- declined 10.8 percent as reported and 2 percent adjusted for cur- ing (non-GAAP) income from continuing operations decreased rency (5 points) and the divestitures (4 points). The growth markets 13.0 percent and the operating (non-GAAP) income margin of declined 15.7 percent as reported and 2 percent adjusted for the 24.0 percent decreased 0.3 points compared to the prior year. The divestitures (9 points) and currency (5 points) compared to the operating (non-GAAP) effective tax rate from continuing operations fourth quarter of the prior year. Within the growth markets, the was 21.8 percent versus 12.2 percent in the fourth quarter of 2013 BRIC countries decreased 21.4 percent as reported and 8 percent driven by the same factor described above. adjusted for the divestitures (9 points) and currency (4 points). Diluted earnings per share from continuing operations of $5.54 The consolidated gross profit margin increased 1.0 points decreased 3.8 percent year to year. Operating (non-GAAP) diluted versus the fourth quarter of 2013 to 53.3 percent. The operating earnings per share of $5.81 decreased 5.7 percent versus the (non-GAAP) gross margin of 53.9 percent increased 0.6 points fourth quarter of 2013. Diluted earnings per share from discontin- year to year driven primarily by improvements in GBS, and a mix ued operations was ($0.03) in the fourth quarter of both years. In away from the low margin industry standard server business. the fourth quarter of 2014, the company repurchased 0.7 million shares of its common stock.


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    48 Management Discussion International Business Machines Corporation and Subsidiary Companies Results of Continuing Operations Segment Details The following is an analysis of the fourth quarter of 2014 versus the fourth quarter of 2013 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: 2014 2013 Change Currency Revenue Global Technology Services $ 9,167 $ 9,917 (7.6)% 1.6%* Gross margin 38.5% 38.8% (0.3) pts. Global Business Services 4,349 4,747 (8.4)% (3.0)% Gross margin 32.0% 30.7% 1.4 pts. Software 7,578 8,140 (6.9)% (3.4)% Gross margin 90.0% 90.5% (0.6) pts. Systems and Technology 2,406 3,947 (39.0)% (12.2)%* Gross margin 49.6% 42.2% 7.3 pts. Global Financing 532 534 (0.5)% 4.6% Gross margin 48.7% 43.3% 5.3 pts. Other 82 100 (17.7)% (14.2)% Gross margin (401.7)% (234.8)% (166.9) pts. Total consolidated revenue $24,113 $27,385 (11.9)% (2.3)%* Total consolidated gross profit $12,862 $14,337 (10.3)% Total consolidated gross margin 53.3% 52.4% 1.0 pts. Non-operating adjustments Amortization of acquired intangible assets 101 103 (2.0)% Acquisition-related charges — 1 (100.0)% Retirement-related costs/(income) 33 154 (78.8)% Operating (non-GAAP) gross profit $12,996 $14,596 (11.0)% Operating (non-GAAP) gross margin 53.9% 53.3% 0.6 pts. * Adjusted for divestitures and currency. Global Services In the fourth quarter of 2014, the Global Services segments, GTS Global Technology Services revenue of $9,167 million and GBS, delivered revenue of $13,516 million, a decrease of decreased 7.6 percent as reported, but increased 2 percent 7.8 percent as reported, but flat year to year adjusted for currency adjusted for currency (6 points) and the divested businesses (6 points) and the divested customer care and industry standard (4 points). Within GTS, outsourcing revenue of $5,109 million server businesses (2 points). Pre-tax income in the fourth quar- decreased 9.6 percent as reported, but increased 1 percent ter decreased 25.0 percent and the pre-tax margin decreased adjusted for currency (6 points) and the divestitures (5 points). 3.5 points to 15.9 percent. Total outsourcing revenue of $6,042 Clients are continuing to sign large outsourcing engagements million decreased 9.3 percent as reported, but flat year to year that leverage the company’s cloud, business analytics and mobile adjusted for currency (6 points) and the divestitures (3 points). solutions. Clients are using these outsourcing engagements as Total transactional revenue of $5,839 million decreased 5.9 per- a way to optimize their IT infrastructure while at the same time cent (flat adjusted for currency). enabling new services to their customers. Lufthansa and ABN AMRO, both signings which were over $1 billion in contract


  • Page 50

    Management Discussion 49 International Business Machines Corporation and Subsidiary Companies value, are recent examples of this. ITS revenue of $2,423 million Software decreased 1.6 percent from the fourth quarter of the prior year as Software revenue of $7,578 million decreased 6.9 percent (3 per- reported, but increased 4 percent adjusted for currency. The year- cent adjusted for currency) in the fourth quarter compared to the to-year increase was driven largely by the company’s high-value prior year. Middleware decreased 5.6 percent (2 percent adjusted security, mobility and resiliency offerings. SoftLayer continues to for currency), while operating systems were down 18.8 percent attract new workloads to the platform, and in October, the com- (16 percent adjusted for currency). As expected, there was not a pany announced that IBM was selected by SAP to be the global change in trajectory in the fourth quarter and performance was cloud provider for their enterprise cloud solution. IBM’s ability to similar to the previous quarter. Total growth reflected a headwind integrate public and private workloads within its hybrid cloud was from operating systems, driven by the divestiture of the indus- a critical differentiator for SAP. The company has continued to try standard server business and Power Systems results. It also expand its datacenter footprint and in the fourth quarter opened reflected business model changes, which impacted transaction cloud centers in Melbourne, Paris, Mexico City, Tokyo and Frank- revenue growth as customers continue to use the flexibility that furt. Maintenance revenue of $1,635 million decreased 9.2 percent has been provided in the deployment of software purchased as reported, but was up 1 percent for the quarter, adjusted for through enterprise licensing agreements. This flexibility enables currency (6 points) and the industry standard server divestiture clients to optimize their capacity on the company’s platform for (4 points). The GTS gross profit margin of 38.5 percent decreased the long term. There was solid growth in many of the solution 0.3 points in the fourth quarter of 2014 compared to prior year. areas, including security, mobile and cloud. Security software In the fourth quarter, pre-tax income decreased 26.4 percent again grew at a double-digit rate, marking the ninth consecu- to $1,464 million and the pre-tax margin declined 3.9 points to tive quarter of double-digit growth. With cybersecurity threats as 15.6 percent compared to the prior year. The year-to-year decrease one of the key issues that all customers are facing, the company was driven by several key factors. First, GTS lost profit on a year-to- has brought its analytics, big data, research IP, mobile and cloud year basis as a result of the customer care and industry standard capabilities together to create security offerings to address this server divestitures. Second, the fourth quarter workforce rebalanc- market opportunity. The company’s software mobile offerings ing charge of $277 million impacted profit. Finally, the company more than doubled in the quarter, as it leveraged the integrated continued to invest in both offerings and operational capabilities. MobileFirst portfolio, and software-as-a-service offerings were This includes targeted investments in mobility, security and cloud up nearly 50 percent. which complement clients’ systems-of-record, as well as opera- Key branded middleware revenue, which accounted for tional improvements such as the yield from the rebalancing action 72 percent of total Software revenue in the fourth quarter of taken earlier in the year, and more broadly deployed automation in 2014, decreased 6.4 percent (3 percent adjusted for currency) the delivery centers. compared to the prior year. Within key branded middleware, Web- Global Business Services revenue of $4,349 million decreased Sphere revenue decreased 6.4 percent (4 percent adjusted for 8.4 percent (3 percent adjusted for currency) in the fourth quarter currency). Information Management revenue decreased 9.1 per- of 2014. Consulting and Systems Integration revenue of $3,416 cent (6 percent adjusted for currency). Tivoli revenue decreased million declined 8.6 percent (3 percent adjusted for currency) 2.4 percent, but was up 1 percent adjusted for currency driven in the fourth quarter. Revenue was down in the traditional back by security software. Workforce Solutions revenue decreased office implementations, particularly in North America. However, 12.1 percent (8 percent adjusted for currency). Rational revenue the company again had strong double-digit growth in its practices increased 4.1 percent (10 percent adjusted for currency) in the that address cloud, analytics, mobile and security. Through its fourth quarter with improved year-to-year performance compared partnership with Apple, the company released the first 10 Mobile- to the earlier quarters of 2014. First for iOS solutions in the fourth quarter. GBS Outsourcing The Software gross profit margin remained strong at 90.0 per- revenue of $933 million decreased 7.5 percent (2 percent adjusted cent in the fourth quarter compared to 90.5 percent in fourth for currency) in the fourth quarter, reflecting sequential improve- quarter of the prior year. Software pre-tax income of $3,765 mil- ment at constant currency compared to the third quarter of 2014. lion in the fourth quarter decreased 11.2 percent year to year, However, performance continued to be impacted by a challenging with a pre-tax margin of 44.7 percent, a decline of 2.3 points. The pricing environment. fourth quarter of 2014 included a workforce rebalancing charge The GBS gross profit margin of 32.0 percent expanded of $120 million that represented approximately 3 points of the 1.4 points in the fourth quarter of 2014 compared to prior year, year-to-year decline. which is a good indicator of the value its offerings deliver. Pre-tax income decreased 22.0 percent to $733 million including a 15 point impact from the workforce rebalancing charge, which will pay back in 2015. Pre-tax margin declined 2.7 points to 16.4 percent com- pared to the prior year. Although the company continued to see a slowdown in back office implementations in the traditional parts of the portfolio, it is investing in strategic partnerships and those should yield benefits in 2015.

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