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    2017 Annual Report

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    Dear IBM Investor: The businesses of the world are changing the way they work. We have prepared your company for this moment. During the past five years, propelled by our belief that the phenomenon of data would reorder technology and business, we have undertaken one of the most ambitious reinventions in IBM’s modern history. This phase is largely complete. IBM is now a cognitive solutions and cloud platform company. IBM now possesses capabilities that are unmatched in our industry to address our clients’ most pressing needs. In my letter to you this year, I will describe our performance in 2017, which reflects the progress we have made in building these capabilities. And I will explain why we believe this moment marks an inflection point, not just for our company, but for business and society at large.

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    2 The substantial progress we made last year In addition, our Technology Services and Cloud Platform team is working with clients worldwide to integrate public, private We achieved operating earnings per share of $13.80, up and managed cloud environments through a single architecture. 2 percent. Our revenue for the year was $79.1 billion, with operating pre-tax income of $13.9 billion. In the fourth quarter, IBM is the clear leader in quantum computing. The world’s first we grew revenue 4 percent, 1 percent adjusted for the effects (and only) prototype 50-qubit system, announced in 2017, was of currency (as are all other revenue numbers in this letter). a major step toward systems that can tackle problems beyond the scope of classical computation. Through IBM Q Experience, We did so in significant part because our strategic imperatives the world’s first publicly available quantum computers, more reached critical mass. With revenue of $36.5 billion and growing than 75,000 users have run more than 2.5 million quantum 11 percent, these products and services now contribute experiments. A dozen clients, including partners JPMorgan Chase, 46 percent of IBM’s revenue. And we expect to achieve our Daimler AG, Samsung and JSR, are now exploring practical goal of growing these new products and services to $40 billion applications on our latest commercial systems. in 2018. We have also achieved global leadership in blockchain. Watson strengthened its position as the AI platform for By providing a permissioned and immutable shared ledger, business. We are embedding AI into more of what we offer— blockchain is doing for trusted transactions what the Internet including security, the Internet of Things, commerce and did for information. Hundreds of leading organizations already verticals, such as Watson Health. Together, these helped IBM’s have embraced IBM’s blockchain platform. Walmart, Nestlé, Cognitive Solutions business generate more than $18 billion Dole, Kroger and others are applying blockchain to improve in revenue in 2017. food safety. Early in 2018, we announced a joint venture with Maersk to apply blockchain to the complex world of international We also remained the global leader in cloud for the enterprise. shipping. We also are working with The Depository Trust & In 2017, our cloud revenue grew 24 percent, to $17 billion. Clearing Corporation (DTCC) on new blockchain approaches Cloud by itself is now more than 21 percent of our total revenue. for complex derivatives, such as credit default swaps. Our reinvented systems franchises generated strong growth. Finally, 2017 saw a milestone in innovation as IBM, for the Mainframes enjoyed a very strong fourth quarter, thanks to the 25th year in a row, led the world in U.S. patents earned, setting launch of the new z14, the world’s first system that can encrypt a new record of 9,043. Importantly, nearly half of those patents data pervasively without requiring changes to applications were in AI, cloud, blockchain, quantum, security and other and with no downtime. We expect this breakthrough will drive technologies that will power our portfolio for years to come. significant expansion of the mainframe’s already broad market. We did all this while continuing to invest heavily for long-term Similarly, we are reinventing our services business. Global competitiveness—$5.6 billion in research and development and Business Services saw signings growth throughout the year, $3.3 billion in net capital expenditures, adding to the capabilities as clients engaged with our high-value consulting practices in of our high-growth strategic businesses. areas such as AI, blockchain, and digital strategy and design. We also returned $9.8 billion to you, our owners, including dividends of $5.5 billion and $4.3 billion in gross share repurchases. We raised our dividend for the 22nd consecutive year—it was IBM’s 102nd straight year of providing one. All of this is due to the creativity and passion of IBMers. They are the reason we have reached an inflection point, and they are our greatest competitive advantage.

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

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    4 Today’s IBM: Built For over a century, IBM has reinvented itself again and again to help its clients services grounded in their professions and industries. And they need a for smarter businesses move from one era to the next. Today, technology infrastructure infused with we are witnessing another such transition, intelligence, protected with advanced at the dawn of smarter business. All security and future-proofed against the companies need an enterprise-strength flow of new breakthroughs and risks. cloud platform. They need AI capable of understanding all their data. They need That is, they need today’s IBM. IBM Cloud: 58 10 1,900+ The platform for smarter businesses cloud data centers of the largest global cloud-technology patents IBM Cloud uniquely provides a single architecture across 19 countries banks and 9 of the top awarded in 2017 that unifies infrastructure and higher-value services, 10 retailers use IBM including AI, IoT, quantum computing and blockchain. Cloud-as-a-Service IBM Watson: 100,000+ 70+ percent 1,400+ AI for the enterprise patients and consumers growth in organizations artificial intelligence Watson offers the fullest spectrum of cognitive touched by Watson Health using Watson patents awarded in 2017 technologies to professionals who are transforming work and decision-making in healthcare, transportation, retail, insurance, education and more. IBM Services: 1,000+ Half 38 IBM iX studios Business and technology clients served from the of the world’s where clients co-create partners of choice IBM Services Platform telecommunications IT with IBM strategists and with Watson infrastructure managed designers Teams of global experts in business strategy, by IBM Services technology and design, with professional experience across multiple industries, help companies transform for competitive advantage. IBM Systems: z14 87 percent POWER9 The industry’s most is the only server that of all credit card introduced as the most powerful infrastructure can encrypt all data transactions and nearly advanced servers for pervasively without $8 trillion in payments enterprise AI and data- IBM’s mainframe, cognitive systems and storage requiring application are supported by intensive workloads offerings provide the world’s most powerful, secure changes or downtime IBM Z systems and flexible foundation for AI and data-intensive applications and workloads. IBM Security: 60 billion 22 of 25 X-Force Command The gold standard for security events of the world’s largest opened as the industry’s cyber protection monitored each day banks protected first commercial cyber range, allowing clients IBM’s industry-leading enterprise security offerings to experience simulated have been taken to the next level through AI and cyberattacks advanced analytics. IBM Research: 50-qubit 5 nanometer MIT-IBM The world’s premier private prototype quantum transistors developed, Watson AI Lab research organization system debuted which will lead to launched as a large, long- high-performance, term collaboration with Twelve global research labs bring an unmatched low-power chips MIT for joint research in range of scientific expertise—from AI, to blockchain, to quantum computing and more—to bear on the AI science and technology needs of clients and their industries.

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    The world’s incumbents own the most valuable sources of data: the 80 percent not on the Web. Inflection points • Businesses are becoming smarter by making their systems and processes intelligent—which is why IBM’s services and This is not just an inflection point for IBM. It is also an inflection solutions are grounded in deep knowledge of our clients’ point for our clients—the enterprises and institutions of industries. This has made IBM the partner of choice for the world. smarter businesses’ digital and cognitive transformation and IT services. Clients include RBS, Autodesk and Hyundai Card, Until a year or so ago, you would find many who believed as well as the large client bases of our strategic partners, that “digital disruption” was here to stay. They believed that such as Salesforce, Workday, Apple, SAP and VMware. the world’s incumbent businesses were at risk of being This deep industry dimension is also what has allowed us marginalized. to establish successful new solutions businesses, such as Watson Health, Watson IoT and Watson Financial Services. We had a different point of view. We did not believe the platform giants alone would dominate a data-centric economy—in large • Businesses are becoming smarter by embedding AI and data measure because they lack access to the most valuable sources to change how work is done, equipping themselves for an of the world’s data: the 80 percent that is not searchable on the era of man + machine. Watson for Oncology is helping doctors Web. The world’s incumbent businesses and institutions own identify treatment options for their patients at more than and generate this data, coming from their professional expertise, 150 hospitals around the world, including Gachon University their industry’s practices and market dynamics, their processes Gil Medical Center in South Korea, Svet Zdravia in Slovakia and operations, their people and cultures. Therefore, we believe and Taipei Medical University in Taiwan. A year ago, Watson they are positioned to lead. for Oncology was trained in four types of cancer. Today, it is trained in multidisciplinary support for 13 cancer types. In this letter and throughout this report, you will find the names Watson is helping tax preparers at H&R Block provide the of many of the world’s great enterprises and institutions. This is best advice to millions of clients. Bankers and customer not a coincidence. It is a reflection of an important new reality: service representatives at Crédit Mutuel, Banco Bradesco, The incumbents of the world understand that they can be the Orange Bank and other financial institutions are reinventing new disruptors, and they are going on offense to seize this banking. Woodside Energy chose Watson to help it preserve opportunity and to capture this moment. the institutional knowledge—and reinvent the work—of petroleum engineers. They are doing so by becoming smarter businesses. You can read in this report how these and other leaders are • Businesses are becoming smarter by leveraging intelligent making their companies smarter, in all dimensions. They are digital platforms. The IBM Cloud has emerged as the placing big bets on the future to increase their competitiveness platform of choice for business—built for all applications, and to reconnect with their company’s true reason for being. ready for AI and secure to the core. It is the unifying platform for IBM’s capabilities, integrated into a single architecture that spans public and private clouds. Through this powerful platform, we are delivering to the world’s businesses a continuous stream of innovative capabilities: computation and storage, data and Watson services, IoT and blockchain services, and IBM Q.

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    6 We also stand at an inflection point for society, everywhere IBM patent leadership is building in the world. the future for smarter businesses IBM does not believe that the future belongs to the few. IBMers received a record-breaking 9,043 U.S. patents We believe it belongs to all of us—and we translate that belief during 2017—the 25th consecutive year that the company into practice and policy. has led the world. On data and AI responsibility: As the world’s new natural Even more important, nearly half of IBM’s new patents are resource, unleashed by the maturation of AI, data holds the advancing AI, cloud computing, blockchain, quantum computing, cybersecurity and other technologies that will potential to generate growth, prosperity and societal progress. change the way the world works—again. But it will only do so if the world can trust that data is being collected, managed and analyzed responsibly. At a time when many are questioning the power and behavior Five 2017 patents that are of some companies, IBM is stepping forward as a responsible shaping the future: steward of data and AI. We believe that AI’s purpose is to augment, not replace, human intelligence. We are clear on Luring Hackers the need for transparency—on where AI is used, who trained U.S. Patent 9,560,075: Cybersecurity it and what data sets were ingested. We also believe that technology that enables AI systems to lure data and the insights it generates belong to their creators. malicious hackers with email exchanges and websites that divert their attacks. No one should have to give up ownership or control of their data to benefit from AI and cloud computing. We have built and are deploying Watson accordingly. Personalizing AI Communication U.S. Patent 9,601,104: A system that analyzes, interprets and mirrors a user’s unique speech Trust also requires the protection of data through strong and linguistic traits. encryption and security systems that are constantly tested and strengthened. The privacy of data must be respected. Those, too, are core dimensions of the IBM Cloud with Watson. Forecasting Cloud Resources U.S. Patent 9,755,923: A system to predict cloud computing needs, based on human behaviors and On jobs: Without question, new technology will eliminate work; current events. it always has. At the same time, new job categories will emerge. The challenge, however, is that AI will transform the skills required for all jobs. There still will be doctors, lawyers, Improving Quantum Signal Fidelity salespeople, teachers and engineers. But the tasks and tools U.S. Patent 9,818,064: A method for improving a quantum computer’s ability to read signals, they need to perform their work will be different. which can lead to efficiency in the system’s components. Speeding Trust on Blockchain U.S. Patent 9,824,031: A method to remove steps for settling transactions among multiple parties, even untrusted ones, without involving a third party.

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    For more than a century, IBMers have earned the world’s trust. We continue that legacy. This is why building skills for the jobs of the future—not blue We also are clear on the markets we serve. IBM is global collar or white collar, but “new collar” jobs—will require in presence and mind-set. a major reinvention of education. We at IBM are leading that transformation, in the U.S. and worldwide, through public-private We earn trust. We take positions—and act—on issues that partnerships to create the revolutionary Pathways in Technology matter for our time. Today, that begins with data, AI and Early College High Schools (P-TECH) education model, security, and extends to inclusion and trust. 21st century apprenticeships and retraining programs. This includes investing $5 billion over 10 years in the continuous Put it all together, and you have a company that always has been renewal of IBMers and the re-skilling of mid-career unique in combining innovative technology with deep industry professionals looking to get back into the tech workforce. expertise, underpinned by security, trust and responsible stewardship. In helping businesses move from era to era, On inclusion: Today, we proudly carry forward a global we seek to be essential—to our clients and to the world. commitment to inclusion that has defined IBM for more than a century. We are stepping forward to support the open Let me close by expressing my gratitude to the treasured clients exchange of people, information and ideas, as well as to we serve, and to the hundreds of thousands of IBMers whose protect cross-border data flows for international privacy brilliance and resilience make it possible for us all to achieve and security agreements. our life’s work at the world’s most essential enterprise. IBM is the recognized gold standard for inclusion, reflected I never have been more optimistic in my IBM career—optimistic in winning the 2018 Catalyst Award for advancing women in about our technology, about our clients, about IBM and about business. IBM is the first company to win this award four times. the world we are building together. We advocate for fairness and equality—as everyone is, and always has been, welcome at IBM. For more than a century, IBMers have earned the world’s trust by building progress with responsibility. We continue this legacy today. Virginia M. Rometty Chairman, President and Chief Executive Officer Rediscovering IBM At the deepest level, the most important fact about IBM’s 2017 was not our return to revenue growth in the fourth quarter or the continued scaling of our new products and services or our patent achievement. It is our reaffirmation of IBM’s essential identity. IBM is an enterprise technology company. We deliver services In an effort to provide additional and useful information regarding the company’s financial results and other financial information, as determined by generally with the simplicity, speed and delight of the best consumer accepted accounting principles (GAAP), these materials contain certain non-GAAP products and services, but we are very clear on whom we serve. financial measures on a continuing operations basis, including revenue at constant currency, strategic imperatives revenue at constant currency, cloud revenue at We are dedicated to our clients’ success, and our reinvention constant currency, operating pre-tax income, operating (non-GAAP) research, during the past five years has been driven by helping our clients development and engineering and operating earnings per share. The rationale for management’s use of this non-GAAP information is included on pages 26, 27 and serve their customers. This unrelenting focus on the client is 68 of the company’s 2017 Annual Report, which is Exhibit 13 to the Form 10-K a particular source of pride. submitted with the SEC on February 27, 2018. For reconciliation of these non-GAAP financial measures to GAAP and other information, please refer to pages 28, 43, 49 and 50 of the company’s 2017 Annual Report.

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    This is smart at work. It’s a business remaking itself on platforms infused with digital intelligence. An enterprise whose operations and processes are designed to learn with intelligent systems. A company of experts whose knowledge is augmented by systems that learn. This is smarter business—a new era, brought to the world by a new IBM.

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    IBM Cloud The platform for smarter businesses Many types of clouds exist, but only the IBM Cloud is built for the enterprise, is able to handle all kinds of data and applications, and provides seamless integration of artificial intelligence, world-leading security and the ability to evolve over time. IBMers deliver the IBM Cloud’s Left to right: broad array of services and AI to surface new insights expertise. They help the world’s and augment decision-making To support innovation, the public cloud allows smarter businesses transform Vivian Lee, their processes, assimilate new IBM Watson Development businesses to quickly create, deploy and manage technologies and capabilities, new cloud-native apps; they can also easily and pivot quickly to new Cloud-based services market opportunities. to manage IT complexity isolate specific computing workloads to ensure and capitalize on the performance and security. IBM’s private cloud speed of innovation Twannia Arnold, offerings let leading enterprises re-architect Global Technology Services critical applications for the cloud, while maintaining regulatory compliance and security on their own premises.

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    Security to help protect all NVIDIA GPUs to boost Blockchain to digitize Workday implementation data and ensure regulatory artificial intelligence and transactions through a secured, for workforce insight and HR compliance deep-learning workloads shared and replicated ledger management Cameron Will, IBM Security Glen Wiedemeier, Noi Sukaviriya, Mickey Patel, IBM Systems IBM Blockchain Solutions Global Business Services Data Science Experience to help data scientists learn, Video streaming to deliver VMware implementation to Storage to provide consistent, create and collaborate in high-quality content to audiences easily deploy workloads from highly secure and fast data a single workspace of any size, anywhere on-premises to the cloud delivery Armand Ruiz Gabernet, Arpad Kun, IBM Cloud Video Camilla Sharpe, Sam Werner, IBM Systems Watson Machine Learning Global Technology Services Quantum computing to tackle Developer tools to rapidly The Internet of Things business and scientific problems SAP implementation to bring build, deploy and manage to capture data and insights that are intractable with classical optimized business operations cloud services from the physical world computers to the cloud Remko De Knikker, Lisa Seacat DeLuca, Jerry Chow, IBM Research Bridget Jones, IBM Industry Platforms IBM Watson IoT Global Business Services

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    A single, integrated architecture for all the needs of smarter businesses z14 pervasively encrypts data at scale, all the time. The z14, the world’s most powerful transaction system, is the first that can encrypt every piece of data at the silicon level, without requiring changes to applications or downtime. Open and connected in the cloud, the z14 is capable of running 12.5 billion fully encrypted transactions per day. IBM Cloud is the most flexible and intelligent cloud for business—a fully managed, unified platform built on secure containers across public and private clouds, with 170+ services for developers to build, deploy and manage cloud- native applications, as well as the capacity to easily integrate new products and offerings. Left: Above: POWER9 is built for data- IBM Cloud Private is a scalable intensive workloads, including cloud platform that runs on a AI and scientific discovery. company’s own infrastructure POWER9 systems and software and behind its firewalls. This are designed for the compute- offers the benefits of the public intensive workloads of smarter cloud but gives customers the businesses. POWER9 systems power to address proprietary cut deep learning training times data, regulatory requirements by at least 4x, unleashing and security threats on-premises. mission-critical insights that would otherwise be trapped in massive data sets. POWER9 servers with NVIDIA GPUs substantially boost AI accuracy and accelerate the performance of AI frameworks.

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    Quantum computing will solve problems that require exploring the previously unsolvable. an exponential number of Quantum computers embody possibilities—like drug discovery, the most radical new computing alternative fuel design and technology in generations. financial risk optimization. They encode information in Already, the IBM Q Experience, quantum bits, or qubits, which available via the IBM Cloud, is can represent tremendous being used by more than 75,000 amounts of data, and can interact early adopters who are getting with one another in ways that “quantum ready”: learning and are impossible for classical bit- exploring the implications of based computers. As a result, quantum computing for science quantum computers may offer and business. paths to finding solutions to hard

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    IBM Services and Solutions Making smarter real, industry by industry Walmart uses blockchain to provide traceability from “farm to fork” and to improve transparency, efficiency and food safety. The leading businesses and institutions of the world are going on offense, moving from the disrupted to the disruptors. To do so, they rely on the deep industry and technology expertise of IBM Services and solutions professionals and consultants around the world. These Maersk’s blockchain platform IBMers—experts in industries ranging from eliminates millions of pieces of healthcare, to financial services, to retail and paperwork, reduces fraud and increases transparency for more—help organizations transform at scale global shipping. and become smarter.

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    CEMEX’s digital transformation provides its customers with real- time tracking and analytics that help them make better decisions and improve their supply chains. London Stock Exchange Group and the Santiago Stock Exchange are building blockchain solutions to take cost and complexity out of trading and settlement. Japan Airlines’ custom mobile app frees up engineers’ time, improves its aircraft quality and on-time arrivals and has eliminated 3.3 million paper documents in one year.

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    The Port of Rotterdam is fully Mercedes-Benz Stadium’s digitizing—with IoT and artificial technology infrastructure and intelligence—to maximize cargo mobile apps create personalized loads and speed shipping traffic. game-day experiences for fans in Atlanta. Goldcorp is using artificial Toronto Western Hospital’s intelligence to sift through drilling Movement Disorders Clinic has logs, geological surveys and reviewed thousands of drugs to other data to pinpoint where identify medications that might be to explore next. repurposed for Parkinson’s disease.

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    17 Welgevonden Game Reserve uses the Internet of Things and predictive analytics to track animal movements and protect endangered rhinos. ABB applies artificial intelligence and the Internet of Things on factory floors to quickly identify defects not always picked up by the naked eye. Plastic Bank’s blockchain-based system turns trust into sustainability, as recyclers in developing countries earn credits, helping to alleviate poverty and reduce ocean waste.

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    IBM Watson Empowering professionals with AI IBM Watson’s enterprise-strength artificial intelligence is transforming the way people work in nearly every industry. It helps organizations derive insight from complex and unstructured information. And it allows professionals to scale their expertise and focus their efforts on higher-value work.

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    Left: Bottom left: 19 Working with Watson for Cyber Elementary school instructors Security allows experts to are using Teacher Advisor With identify threats up to 60 times Watson to tailor high-quality faster than traditional methods. instructional resources to the specific needs of their students. Carlos Aguilera, Security Expert, IBM Lisnerva Nuez, Kindergarten Teacher, New York City “We trained Watson Virtual Agent in Brazilian Portuguese so it can answer customers’ questions in seconds.” Customer service representatives at Banco Bradesco use Watson Virtual Agent to answer questions quickly, which boosts customer satisfaction. Jacqueline Pessoa Ferreira, Digital Channels Analyst and Trainer, Banco Bradesco

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    Watson helps KONE’s data 21 scientists provide technicians with real-time information from elevators and escalators around the world, to predict maintenance issues and help keep people moving. Aleksi Seppänen, Data Scientist, KONE “Watson speeds up how we find important patterns— and ones we Trained by H&R Block on millions of customer conversations and didn’t know returns, Watson helps tax pros engage with their clients to look for.” in new ways. Gloria Bridges, Tax Professional, H&R Block AI, machine learning and analytics are allowing Kraft Heinz experts to evaluate thousands of variables in real time and address previously unsolvable problems, leading to reductions in food loss. Pat Doyle, Supply Chain Expert, Kraft Heinz Company

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    A smarter future does not belong to the few. It belongs to all of us. The coming era offers vast new opportunities to change the way the world works—but it will take more than technology and more than business. At IBM we are working to build new levels of trust and new forms of collaboration across all sectors of society. Data and AI: Only an economy where data is protected will produce a society where data is trusted. In 2017, IBM issued principles for AI and for Data Responsibility, ensuring that wherever our cognitive technology is used, we will be transparent about how it was trained and clear about who owns its data and insights. Jobs: To build the “new collar” skills required for the future of work, we are pioneering new models of education, including P-TECH, a six-year high school and community college program that enables students to earn an associate degree. From its roots in 2010 with one school in Brooklyn, New York, P-TECH is on track to serve more than 60,000 students on four continents, and build upon partnerships with more than 430 other companies. Workforce inclusion: New technology can lift everyone up—and it must. We have led in inclusion for more than a century, hiring our first women and African American employees in 1899. And in 2005, IBM became the first company to protect employees’ Gabriel Rosa, a 2015 graduate of P-TECH, now works in IBM’s genetics privacy. We are committed to extending Digital Business Group, following an that legacy into the future. internship guided by Maria Arbusto, who still acts as his mentor. Gabriel Rosa (left), Front-End Engineer, and Maria Arbusto, Director, Marketing

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    24 Financial Highlights International Business Machines Corporation and Subsidiary Companies ($ in millions except per share amounts) For the year ended December 31: 2017 2016 Revenue $ 79,139 $ 79,919 Net Income $ 5,753* $ 11,872 Income from continuing operations $ 5,758* $ 11,881 Operating (non-GAAP) earnings** $ 12,935 $ 13,031 Earnings per share of common stock Assuming dilution $ 6.14* $ 12.39 Basic $ 6.17* $ 12.44 Diluted operating (non-GAAP)** $ 13.80 $ 13.59 Net cash provided by operating activities $ 16,724 $ 17,084*** Capital expenditures, net $ 3,312 $ 3,726 Share repurchases $ 4,340 $ 3,502 Cash dividends paid on common stock $ 5,506 $ 5,256 Per share of common stock $ 5.90 $ 5.50 At December 31: 2017 2016 Cash, cash equivalents and marketable securities $ 12,580 $ 8,527 Total assets $125,356 $117,470 Working capital $ 12,373 $ 7,613 Total debt $ 46,824 $ 42,169 Total equity $ 17,725 $ 18,392 Common shares outstanding (in millions) 922 946 Stock price per common share $ 153.42 $ 165.99 * Includes a one-time charge of $5.5 billion associated with the enactment of U.S. tax reform in 2017. ** See page 49 for a reconciliation of net income to operating earnings. ***Reclassified to reflect adoption of the FASB guidance on share-based compensation.

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    Report of Financials 25 International Business Machines Corporation and Subsidiary Companies MANAGEMENT DISCUSSION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Overview 26 A Significant Accounting Policies 84 Forward-Looking and Cautionary Statements 27 B Accounting Changes 94 Management Discussion Snapshot 27 C Acquisitions/Divestitures 96 Description of Business 30 D Financial Instruments 100 Year in Review 35 E Inventories 107 Prior Year in Review 56 F Financing Receivables 107 Other Information 66 G Property, Plant and Equipment 111 Looking Forward 66 H Investments and Sundry Assets 111 Liquidity and Capital Resources 67 I Intangible Assets Including Goodwill 111 Critical Accounting Estimates 70 J Borrowings 112 Currency Rate Fluctuations 73 K Other Liabilities 115 Market Risk 74 L Equity Activity 116 Cybersecurity 75 M Contingencies and Commitments 119 Employees and Related Workforce 75 N Taxes 121 O Research, Development and Engineering 124 Report of Management 76 P Earnings Per Share of Common Stock 124 Report of Independent Registered Q Rental Expense and Lease Commitments 125 Public Accounting Firm 77 R Stock-Based Compensation 125 S Retirement-Related Benefits 128 CONSOLIDATED FINANCIAL STATEMENTS T Segment Information 142 Earnings 78 U Subsequent Events 146 Comprehensive Income 79 Financial Position 80 Five-Year Comparison of Selected Financial Data 147 Cash Flows 81 Selected Quarterly Data 148 Changes in Equity 82 Performance Graphs 149 Board of Directors and Senior Leadership 150 Stockholder Information 151

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    26 Management Discussion International Business Machines Corporation and Subsidiary Companies OVERVIEW than growth reported at actual exchange rates. See “Currency The financial section of the International Business Machines Rate Fluctuations” on page 73 for additional information. Corporation (IBM or the company) 2017 Annual Report includes • Within the financial statements and tables in this Annual the Management Discussion, the Consolidated Financial Report, certain columns and rows may not add due to Statements and the Notes to Consolidated Financial State- the use of rounded numbers for disclosure purposes. ments. This Over view is designed to provide the reader with Percentages reported are calculated from the underlying some perspective regarding the information contained in the whole-dollar numbers. financial section. Operating (non-GAAP) Earnings Organization of Information In an effort to provide better transparency into the operational • The Management Discussion is designed to provide readers results of the business, the company separates business with an overview of the business and a narrative on the results into operating and non-operating categories. Operating company’s financial results and certain factors that may earnings from continuing operations is a non-GAAP measure affect its future prospects from the perspective of the that excludes the effects of certain acquisition-related charges, company’s management. The “Management Discussion intangible asset amortization expense resulting from basis Snapshot,” beginning on page 27, presents an overview of differences on equity method investments, retirement-related the key performance drivers in 2017. costs, discontinued operations and related tax impacts. For • Beginning with the “Year in Review” on page 35, the the fourth-quarter and full-year 2017, operating (non-GAAP) Management Discussion contains the results of operations earnings also exclude a one-time charge associated with the for each reportable segment of the business and a enactment of U.S. tax reform due to its unique and non-recurring discussion of the company’s financial position and cash nature. For acquisitions, operating (non-GAAP) earnings exclude flows. Other key sections within the Management Discussion the amortization of purchased intangible assets and acquisition- include: “Looking Forward” on page 66, and “Liquidity and related charges such as in-process research and development, Capital Resources” on page 67, which includes a description transaction costs, applicable restructuring and related of management’s definition and use of free cash flow. expenses and tax charges related to acquisition integration. These charges are excluded as they may be inconsistent in • The Consolidated Financial Statements are presented on amount and timing from period to period and are dependent pages 78 through 83. These statements provide an overview on the size, type and frequency of the company’s acquisitions. of the company’s income and cash flow performance and its All other spending for acquired companies is included in both financial position. earnings from continuing operations and in operating (non- • The Notes follow the Consolidated Financial Statements. GAAP) earnings. Throughout the Management Discussion and Among other items, the Notes contain the company’s Analysis, the impact of acquisitions over the prior 12-month accounting policies (pages 84 to 93), acquisitions and period may be a driver of higher expense year to year. For divestitures (pages 96 to 99), detailed information on specific retirement-related costs, the company characterizes certain items within the financial statements, certain contingencies items as operating and others as non-operating. The company and commitments (pages 119 to 121) and retirement- includes defined benefit plan and nonpension postretirement related plans information (pages 128 to 142). benefit plan service cost, amortization of prior service cost and the cost of defined contribution plans in operating earnings. • The Consolidated Financial Statements and the Notes have Non-operating retirement-related cost includes defined benefit been prepared in accordance with accounting principles plan and nonpension postretirement benefit plan interest cost, generally accepted in the United States (GAAP). expected return on plan assets, amortized actuarial gains/losses, • On December 22, 2017, the Tax Cuts and Jobs Act (“U.S. tax the impacts of any plan curtailments/settlements and multi- reform”) was enacted in the U.S. This Act resulted in the employer plan costs, pension insolvency costs and other costs. company recognizing a fourth quarter provisional one-time Non-operating retirement-related costs are primarily related charge of $5.5 billion. Refer to note N, “Taxes,” on pages to changes in pension plan assets and liabilities which are tied 121 to 124 for additional information. to financial market performance, and the company considers these costs to be outside of the operational performance of the • The references to “adjusted for currency” or “at constant business. Effective January 1, 2018, the company adopted the currency” in the Management Discussion do not include new Financial Accounting Standards Board (FASB) guidance operational impacts that could result from fluctuations in on presentation of net periodic pension and nonpension foreign currency rates. When the company refers to growth postretirement benefits costs, and as a result, the company rates at constant currency or adjusts such growth rates for will align its presentation for operating (non-GAAP) earnings currency, it is done so that certain financial results can be to conform to the FASB presentation of these costs included in viewed without the impact of fluctuations in foreign the Consolidated Statement of Earnings. Operating (non-GAAP) currency exchange rates, thereby facilitating period-to- earnings will no longer include amortization of prior service costs period comparisons of its business performance. Financial and will now include multi-employer plan costs. The full-year results adjusted for currency are calculated by translating 2018 operating (non-GAAP) earnings per share expectation has current period activity in local currency using the comparable been calculated under this new definition. prior year period’s currency conversion rate. This approach is used for countries where the functional currency is the Overall, the company believes that providing investors with a local currency. Generally, when the dollar either strengthens view of operating earnings as described here provides increased or weakens against other currencies, the growth at constant transparency and clarity into both the operational results of the currency rates or adjusting for currency will be higher or lower business and the performance of the company’s pension plans;

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    Management Discussion 27 International Business Machines Corporation and Subsidiary Companies improves visibility to management decisions and their impacts forward-looking statement in this Annual Report speaks only as of on operational performance; enables better comparison to peer the date on which it is made; the company assumes no obligation companies; and allows the company to provide a long-term to update or revise any such statements. Forward-looking strategic view of the business going forward. The company’s statements are based on the company’s current assumptions reportable segment financial results reflect operating earnings regarding future business and financial performance; these from continuing operations, consistent with the company’s statements, by their nature, address matters that are uncertain management and measurement system. to different degrees. Forward-looking statements involve a number of risks, uncertainties and other factors that could cause actual results to be materially different, as discussed more fully FORWARD-LOOKING AND CAUTIONARY STATEMENTS elsewhere in this Annual Report and in the company’s filings with Certain statements contained in this Annual Report may the Securities and Exchange Commission (SEC), including the constitute forward-looking statements within the meaning company’s 2017 Form 10-K filed on February 27, 2018. of the Private Secur ities Litigation Reform Act of 1995. Any MANAGEMENT DISCUSSION SNAPSHOT ($ and shares in millions except per share amounts) Yr.-to-Yr. Percent/Margin For the year ended December 31: 2017 2016 Change Revenue $ 79,139 $ 79,919 (1.0)%* Gross profit margin 45.8% 47.9% (2.1) pts. Total expense and other (income) $ 24,827 $ 25,964 (4.4)% Total expense and other (income)-to-revenue ratio 31.4% 32.5% (1.1 ) pts. Income from continuing operations before income taxes $ 11,400 $ 12,330 (7.5)% Provision for income taxes from continuing operations $ 5,642** $ 449 NM Income from continuing operations $ 5,758** $ 11,881 (51.5)% Income from continuing operations margin 7.3% 14.9% (7.6) pts. Loss from discontinued operations, net of tax $ (5) $ (9) (44.7)% Net income $ 5,753** $ 11,872 (51.5)% Earnings per share from continuing operations: Assuming dilution $ 6.14** $ 12.39 (50.4)% Consolidated earnings per share — assuming dilution $ 6.14** $ 12.38 (50.4)% Weighted-average shares outstanding Assuming dilution 937.4 958.7 (2.2)% Assets+ $125,356 $117,470 6.7% Liabilities+ $107,631 $ 99,078 8.6% Equity+ $ 17,725 $ 18,392 (3.6)% * (1.3) percent adjusted for currency. ** Includes a one-time charge of $5.5 billion associated with the enactment of U.S. tax reform, or $5.84 of diluted earnings per share in 2017. + At December 31 NM — Not meaningful The following table provides the company’s (non-GAAP) operating earnings for 2017 and 2016. ($ in millions except per share amounts) Yr.-to-Yr. For the year ended December 31: 2017 2016 Percent Change Net income as reported $ 5,753** $11,872 (51.5)% Loss from discontinued operations, net of tax (5) (9) (44.7) Income from continuing operations $ 5,758** $11,881 (51.5)% Non-operating adjustments (net of tax) Acquisition-related charges 718 735 (2.3) Non-operating retirement-related costs/(income) 983 415 137.0 U.S. tax reform one-time charge 5,475 — NM Operating (non-GAAP) earnings* $12,935 $13,031 (0.7)% Diluted operating (non-GAAP) earnings per share $ 13.80 $ 13.59 1.5% * See page 49 for a more detailed reconciliation of net income to operating earnings. ** Includes a one-time charge of $5.5 billion associated with the enactment of U.S. tax reform in 2017. NM — Not meaningful

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    28 Management Discussion International Business Machines Corporation and Subsidiary Companies In 2017, the company reported $79.1 billion in revenue and $5.8 From a segment perspective, Cognitive Solutions revenue billion in income from continuing operations, which includes a increased 1.5 percent as reported and 1 percent adjusted for one-time charge of $5.5 billion associated with the enactment currency with growth in Solutions Software and Transaction of U.S. tax reform. Operating (non-GAAP) earnings were $12.9 Processing Software as reported and adjusted for currency. billion, which excludes the one-time charge. Diluted earnings Solutions Software performance included growth in annuity per share from continuing operations were $6.14 as reported revenue, led by as-a-Service solutions. Global Business Services and $13.80 on an operating (non-GAAP) basis. The company (GBS) revenue decreased 2.1 percent as reported and 2 percent generated $16.7 billion in cash from operations, $13.0 billion in adjusted for currency with declines across all lines of business. free cash flow and delivered shareholder returns of $9.8 billion However, GBS strategic imperatives revenue increased in gross common stock repurchases and dividends. 10 percent as reported and adjusted for currency year to year. The GBS business continued to shift resources and move into Total consolidated revenue in 2017 decreased 1.0 percent as the high-value strategic areas of digital, cloud and analytics. reported and 1.3 percent year to year adjusted for currency. The Technology Services & Cloud Platforms revenue decreased company returned to revenue growth in the fourth quarter with an 3.0 percent as reported and 3 percent adjusted for currency, increase of 3.6 percent as reported and 0.9 percent adjusted for primarily driven by a decline in Infrastructure Services. Within currency. Year-to-year revenue performance improved sequentially Technology Services & Cloud Platforms, strategic imperatives in the second half of 2017 compared to first-half performance. revenue was up 19 percent as reported and 18 percent adjusted Contributors to the second-half improvement included: for currency year to year, driven by hybrid cloud services, security momentum in cloud and as-a-Service offerings, strong Systems and mobile. Systems revenue increased 6.2 percent as reported growth across IBM Z, Power and Storage, improved software and 5 percent adjusted for currency driven by contributions from transactional performance and improved growth in Consulting. the z14 mainframe in the second half of 2017 and growth in Storage Systems. In 2017, the company continued to deliver solid revenue growth in its strategic imperatives which generated $36.5 billion of revenue From a geographic perspective, Americas revenue was essentially and grew 11 percent as reported and adjusted for currency, with flat year to year as reported (decreased 1 percent adjusted for double-digit growth in cloud, security and mobile, as the company currency) with the U.S. decline of 1.4 percent, partially offset continues to build new products and offerings and continuously by growth in Latin America (5.1 percent as reported, 3 percent reinvent its platforms. These are not separate businesses, they adjusted for currency) and Canada (4.9 percent as reported, are offerings across the segments that address opportunities 3 percent adjusted for currency). Europe/Middle East/Africa in analytics, cloud, security and mobile. The company is (EMEA) revenue decreased 1.7 percent (3 percent adjusted for embedding cloud and cognitive capabilities across the business currency) driven primarily by declines in the UK (11.2 percent and the strategic imperatives reflect the progress being made in as reported, 7 percent adjusted for currency) and Germany helping enterprise clients extract value from data and become (3.2 percent as reported, 6 percent adjusted for currency). Asia digital businesses. Strategic imperatives growth in 2017 largely Pacific revenue decreased 2.0 percent (1 percent adjusted for represented organic growth as the acquisitive content leveled currency) with a decline in China of 10.6 percent (10 percent on a year-to-year basis. Total Cloud revenue of $17.0 billion adjusted for currency). Japan declined 1.1 percent as reported increased 24 percent as reported and adjusted for currency, with (increased 2 percent adjusted for currency) and India grew 8.6 as-a-Service revenue up 31 percent as reported and adjusted percent (5 percent adjusted for currency). for currency. The annual exit run rate for as-a-Service revenue increased to $10.3 billion in 2017 compared to $8.6 billion in The consolidated gross margin of 45.8 percent decreased 2.1 2016. Analytics revenue of $20.6 billion increased 6 percent as points year to year and reflects investments, mix and higher reported and adjusted for currency. Mobile revenue increased retirement-related costs, partially offset by benefits from 19 percent as reported and adjusted for currency and Security productivity. The operating (non-GAAP) gross margin of 47.4 revenue increased 55 percent (54 percent adjusted for currency), percent decreased 1.6 points versus the prior year primarily driven by security software solutions and strong demand for the driven by the same factors, excluding the impact of higher non- pervasive encryption capabilities in the new z14 mainframe. operational retirement-related costs.

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    Management Discussion 29 International Business Machines Corporation and Subsidiary Companies Total expense and other (income) decreased 4.4 percent in At December 31, 2017, the balance sheet remains strong, and 2017 compared to the prior year. The year-to-year decrease with the newly reorganized financing entity, IBM Credit LLC, the was primarily the result of continued focus on efficiency in company is better positioned to support the business over the spending and reduced expenses for workforce transformation. long term. Cash and marketable securities at December 31, 2017 This included a lower level of workforce rebalancing charges were $12.6 billion, an increase of $4.1 billion from December 31, (3 points), lower operational spending (2 points) and a prior-year 2016. Key drivers in the balance sheet and total cash flows were: charge for real estate actions (1 point). The year-to-year decrease in expense and other (income) was partially offset by spending Total assets increased $7.9 billion ($3.0 billion adjusted for related to acquisitions completed in the prior 12 months (1 point) currency) from December 31, 2016 driven by: and a decline in intellectual property (IP) income (1 point). Total • Increases in cash and marketable securities ($4.1 billion), operating (non-GAAP) expense and other (income) decreased total receivables ($2.9 billion), retirement plan assets 6.2 percent year to year, driven primarily by the same factors. ($1.6 billion) and goodwill ($0.6 billion); partially offset by Pre-tax income from continuing operations of $11.4 billion • Decreases in intangible assets ($0.9 billion). decreased 7.5 percent and the pre-tax margin was 14.4 percent, a decrease of 1.0 points versus 2016. The continuing Total liabilities increased $8.6 billion ($4.0 billion adjusted for operations effective tax rate for 2017 was 49.5 percent, which currency) from December 31, 2016 driven by: includes a one-time charge of $5.5 billion from the enactment • Increases in total debt ($4.7 billion) and taxes ($3.5 billion). of U.S. tax reform in December 2017, compared to 3.6 percent in 2016. The charge encompasses several elements, including Total equity of $17.7 billion decreased $0.7 billion from taxes on accumulated overseas profits and the revaluation of December 31, 2016 as a result of: certain deferred tax assets and liabilities. The tax rate in 2016 was primarily the result of a refund ($1.0 billion) of previously • Decreases from dividends ($5.5 billion) and share paid Japan taxes plus interest in the first quarter of 2016. repurchases ($4.3 billion); partially offset by Income from continuing operations of $5.8 billion decreased • Increases from net income ($5.8 billion), retirement-related 51.5 percent, impacted by the one-time charge, and the net benefit plans ($2.3 billion) and equity translation income margin was 7.3 percent, a decrease of 7.6 points versus adjustments ($0.8 billion). 2016. Losses from discontinued operations, net of tax, were $5 million in 2017 compared to $9 million in 2016. Net income The company generated $16.7 billion in cash flow provided of $5.8 billion decreased 51.5 percent year to year. Operating by operating activities, a decrease of $0.4 billion compared to (non-GAAP) pre-tax income from continuing operations of $13.9 2016, driven primarily by performance-related declines within billion decreased 0.5 percent year to year and the operating net income and an increase in cash tax payments, partially (non-GAAP) pre-tax margin from continuing operations was offset by an increase in cash provided by receivables. Net essentially flat at 17.5 percent. Operating (non-GAAP) income cash used in investing activities of $7.1 billion was $3.9 billion from continuing operations of $12.9 billion decreased 0.7 percent lower than the prior year, primarily driven by a decrease in cash with an operating (non-GAAP) income margin from continuing used for acquisitions ($5.2 billion). Net cash used in financing operations of 16.3 percent, flat year to year. The operating (non- activities of $6.4 billion increased $0.5 billion compared to GAAP) effective tax rate from continuing operations in 2017 was 2016, driven primarily by increased gross common share 6.7 percent, which includes the effect of discrete tax benefits in repurchases ($0.8 billion). the first and second quarters of 2017. Diluted earnings per share from continuing operations of $6.14 in 2017, which includes the one-time charge associated with U.S. tax reform, decreased 50.4 percent year to year. In 2017, the company repurchased 27.2 million shares of its common stock at a cost of $4.3 billion and had $3.8 billion remaining in the current share repurchase authorization at December 31, 2017. Operating (non-GAAP) diluted earnings per share of $13.80 increased 1.5 percent versus 2016.

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    30 Management Discussion International Business Machines Corporation and Subsidiary Companies In January 2018, the company disclosed that it is expecting The IBM Cloud is uniquely: GAAP earnings per share from continuing operations of at least • Built for all applications: Applications require data. That $11.70 and operating (non-GAAP) earnings of at least $13.80 per data is in on-premise systems, in private clouds and in the diluted share for 2018. The company expects free cash flow to public cloud. The IBM Cloud enables one data platform be approximately $12 billion in 2018. Free cash flow realization that, regardless of data’s location, can run all applications. is expected to be in excess of 100 percent of GAAP net income. IBM’s hybrid cloud capabilities make this single platform Refer to page 68 in the Liquidity and Capital Resources section operate seamlessly. for additional information on this non-GAAP measure. Refer to the Looking Forward section on pages 66 and 67 for additional • Artificial intelligence (AI)-ready: The IBM Cloud is built information on the company’s expectations. from the ground up to handle the demanding data and computational requirements of AI. DESCRIPTION OF BUSINESS • Secure to the Core: IBM has a long history of helping clients Please refer to IBM’s Annual Report on Form 10-K filed with the keep data and transactions secure. Security is even more SEC on February 27, 2018 for Item 1A. entitled “Risk Factors.” important in an increasingly connected world, and IBM has extended this unparalleled level of security to the cloud. The company creates value for clients through integrated solu- For example, IBM’s cybersecurity offerings act as a business tions and products that leverage: data, information technology, immune system, with AI technology at its core, delivered deep expertise in industries and business processes, and a from the IBM Cloud. These systems help to defend and broad ecosystem of partners and alliances. IBM solutions respond to cyber-attacks across an organization’s data, typically create value by enabling new capabilities for clients applications, mobile and endpoint devices. that transform their businesses and help them engage with their customers and employees in new ways. These solutions The IBM Cloud is delivered with leading edge technology, draw from an industry-leading portfolio of consulting and IT including: implementation services, cloud and cognitive offerings, and • Modern infrastructure: IBM’s systems, including servers, enterprise systems and software which are all bolstered by one storage and operating system software, have been refreshed of the world’s leading research organizations. and redesigned for cloud and enterprise AI workloads. IBM’s new z14 is the world’s first system to offer pervasive Strategy encryption of data without requiring changes to applications, The IBM strategy starts with its clients. and with no performance degradation. With IBM’s systems, clients can build an IT infrastructure that is optimized for As a uniquely integrated technology and services company, IBM the scalability, reliability and growth that businesses need in helps clients change the way the world works by building smarter today’s data-driven world. businesses. • Future infrastructure: The Q Network on the IBM Cloud enables IBM’s clients include many of the world’s most successful clients around the world to explore quantum computing enterprises. These clients are at an inflection point, facing capabilities. IBM is the leader in quantum computing. tremendous new opportunity and incredible competition. Digital Clients are signing on to explore how to overcome foreseen technologies are unlocking unparalleled insight from previously constraints in traditional computing models. inaccessible data. Work processes are being reimagined for speed and vastly smarter decision-making. AI and Data Artificial intelligence can help clients extract insight and make To win in these disruptive times requires that businesses learn — intelligent decisions from data. Like cloud, enterprise AI is very learn by extracting insights from their data and by applying different from consumer AI. Enterprise applications deal with those insights to how work is done. Smarter businesses do this more complex use cases that benefit from expert knowledge, faster and more effectively supported by IBM’s combination of such as in healthcare or in the identification of business risk. Innovative Technology, Industry Expertise and Trust and Security. Enterprise AI applications are trained by expert data, through data sets of all sizes and with more specialization than those in The company’s capabilities include: the general-knowledge consumer world. IBM AI — through the Watson platform: Cloud • Learns more from less data: The ability to extract deep Cloud is enabling the emergence of platforms through insights from both large and small data sets is essential for standardization, agility and innovation in both IT and business enterprise applications. Watson excels at this and can processes. Enterprise cloud is very different from consumer produce more insights with less data than other AI systems. cloud: enterprises must bridge together mission-critical assets That means clients can get started more quickly and begin from on-premise systems with private cloud and public cloud. to gain experience deploying AI in the enterprise. Hybrid cloud technology provides that bridge. All three must coexist and interoperate as a single platform.

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    Management Discussion 31 International Business Machines Corporation and Subsidiary Companies • Protects clients’ insights: While Watson builds on cumulative • Pragmatic journey to Cloud and AI: Global Business Services experience and knowledge, IBM recognizes that data brings its deep experience when guiding clients through and insights are clients’ most important assets and a true the journey to cloud and AI. Clients gain from the thorough competitive advantage. Watson is built to safeguard this understanding of technology and the best ways to utilize it. type of information. As clients reinvent their businesses to be smarter, they need all • Reimagines your workflows: Watson has been built for — and of this to work together. This is what they expect from IBM, what trained in — areas requiring deep expertise. Watson brings they need from IBM and what sets IBM apart. AI to professionals so that work can be done more efficiently, and even more importantly, can improve as the systems * * * * learn from the data. Responsible stewardship is an enduring principle that under- Solutions scores all IBM endeavors. While IBM is constantly ushering in Creating smarter businesses requires reimagining a company’s new technology it does so by: core processes — for example, in healthcare, managing risk • Leading in data responsibility, ethics and transparency; or optimizing a supply chain. In addition to building solutions based on IBM’s experience, IBM is also creating a series of AI • Preparing workforces of the world; solutions — cognitive solutions — that embed artificial intelligence • Continuing the company’s century-long commitment to and data to change how work is done. Examples include: diversity and inclusion, and • Global Industry Platforms: provides cognitive, analytics, • Remaining grounded in a set of enduring IBM Values: security and cloud technology in comprehensive industry- specific platforms to remove much of the cost and complexity • Dedication to every client’s success of delivering core business functions. For example: Banking, • Innovation that matters — for our company and for wealth management, and insurance are some of the the world areas poised for dramatic change by using cognitive and AI solutions from IBM Watson Financial Services. Watson • Trust and personal responsibility in all relationships Health provides technology and expertise to empower leaders, advocates and influencers in health to accelerate IBM has built a reputation and track record of trust with its clients discovery, make essential connections and gain confidence for more than a century. IBM safeguards a client’s privacy, data on their path to solving the world’s biggest health challenges. and insights. For example, IBM was one of the first companies to appoint a Chief Privacy Officer, to develop and publish a genetics • Blockchain Solutions: IBM is working with clients and privacy policy, to be certified under the APEC Cross Borders developers across multiple industries to use blockchain to Privacy Rules system and to sign the EU Data Protection Code of transform how business is done in areas such as banking Conduct for Cloud Service Providers. and financial services and supply chain. For example, blockchain technology can be used to digitize global trade * * * * processes, providing a more efficient and secure method of moving goods across borders and trading zones. This is an era where being faster, more productive and lower cost is important but frankly not enough. To win, a business • Watson IoT: includes both a cloud-based platform and must be smarter: Being smarter means having deeper expertise, industry solutions infused with AI, helping organizations extracting better insights from data and being capable of rapidly mine intelligence from billions of connected devices. changing the way in which one does work. Enterprise Services This is core to the strategy of IBM’s clients and is at the heart of Through Global Business Services and Global Technology the IBM strategy. Services, IBM has helped the world’s most successful enterprises transition from era to era. Using proven methods, IBM Services Business Model bring globally delivered outcomes using proven methods by The company’s business model is built to support two principal focusing on: goals: helping enterprise clients to move from one era to the • Digital Reinvention for growth: a unique framework for next by bringing together innovative technology and industry business transformation focused on growth opportunities. expertise, and providing long-term value to shareholders. The business model has been developed over time through strategic • End-to-end Services integration: Global Technology Services investments in capabilities and technologies that have long-term brings the ability to connect previously disconnected growth and profitability prospects based on the value they deliver parts of an organization. By embedding Watson into these to clients. mission critical services, new levels of quality, resiliency and automation are achieved.

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    32 Management Discussion International Business Machines Corporation and Subsidiary Companies The company’s global capabilities include services, software, Global Business Services (GBS) provides clients with consulting, systems, fundamental research and related financing. The broad application management services and business process services. mix of businesses and capabilities are combined to provide These professional services deliver value and innovation to integrated solutions and platforms to the company’s clients. clients through solutions which leverage industry, technology and business strategy and process expertise. GBS is the The business model is dynamic, adapting to the continuously digital reinvention partner for IBM clients, combining industry changing industry and economic environment, including the knowledge, functional expertise, and applications with the power company’s transformation into cloud and as-a-Service delivery of business design and cognitive and cloud technologies. The models. The company continues to strengthen its position full portfolio of GBS services is backed by its globally integrated through strategic organic investments and acquisitions in higher- delivery network and integration with technologies, solutions and value areas, broadening its industry expertise and integrating AI services from IBM units including IBM Watson, IBM Cloud, IBM into more of what the company offers. In addition, the company is Research, and Global Technology Services. transforming into a more agile enterprise to drive innovation and speed, as well as helping to drive productivity, which supports In 2017, GBS deployed a new operating model designed to investments for participation in markets with significant long- address specific client digital transformation imperatives and term opportunity. take full advantage of IBM and GBS’s competitive differentiators in industry, cognitive and cloud. The operating model features This business model, supported by the company’s financial Digital Strategy and iX, Cognitive Process Transformation and model, has enabled the company to deliver strong earnings, cash Cloud Application Innovation. To bring value at scale to clients flows and returns to shareholders over the long term. around the world, GBS has implemented global service lines within each of the three focus areas, which are populated with Business Segments and Capabilities new practices staffed by practitioners with deep domain skills The company’s major operations consist of five business and industry expertise. segments: Cognitive Solutions, Global Business Services, Technology Services & Cloud Platforms, Systems and Global GBS Capabilities Financing. Consulting: provides business consulting services focused on bringing to market solutions that help clients shape their digital Cognitive Solutions comprises a broad portfolio of capabilities blueprints and customer experiences, define their cognitive that help IBM’s clients to identify actionable new insights and operating models, unlock the potential in all data to improve inform decision-making for competitive advantage. Leveraging decision-making, set their next-generation talent strategies and IBM’s research, technology and industry expertise, this business create new technology architectures in a cloud-centric world. delivers a full spectrum of capabilities, from descriptive, predictive and prescriptive analytics to cognitive systems. Application Management: delivers system integration, application Cognitive Solutions includes Watson, the first commercially management, maintenance and support services for packaged available AI platform that has the ability to interact in natural software, as well as custom and legacy applications. Value is language, process vast amounts of big data, and learn from delivered through advanced capabilities in areas such as security interactions with people and systems. These solutions are and privacy, application testing and modernization, cloud provided through the most contemporary delivery methods application migration and automation. including through cloud environments and “as-a-Service” models. Cognitive Solutions consists of Solutions Software and Global Process Services: delivers finance, procurement, talent Transaction Processing Software. and engagement, and industry-specific business process outsourcing services. These services deliver improved business Cognitive Solutions Capabilities results to clients through our consult-to-operate model which Solutions Software: provides the basis for many of the company’s includes the strategic change and/or operation of the client’s strategic areas. IBM has established the world’s deepest processes, applications and infrastructure. GBS is redefining portfolio of data and analytics solutions, including analytics process services for both growth and efficiency through the and data management platforms, cloud data services, talent application of the power of cognitive technologies like Watson, management solutions, and solutions tailored by industry. as well as the IoT, blockchain and deep analytics. Watson Platform, Watson Health and Watson Internet of Things (IoT) are certain capabilities included in Solutions Software. Technology Services & Cloud Platforms provides compre- IBM’s world-class security platform delivers integrated security hensive IT infrastructure services creating business value for intelligence across clients’ entire operations, including their clients. By leveraging insights and experience drawn from IBM’s cloud, applications, networks and data, helping them to prevent, global scale, skills and technology, with applied innovation from detect and remediate potential threats. IBM Research, clients gain access to leading-edge, high-quality services with improved outcomes in productivity, flexibility Transaction Processing Software: includes software that and cost. primarily runs mission-critical systems in industries such as banking, airlines and retail. Most of this software is on-premise and annuity in nature.

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    Management Discussion 33 International Business Machines Corporation and Subsidiary Companies Technology Services & Cloud Platforms Capabilities Storage: data storage products and solutions that allow clients Infrastructure Services: delivers a portfolio of cloud, project- to retain and manage rapidly growing, complex volumes of digital based, outsourcing and other managed services focused on information and to fuel data-centric cognitive applications. clients’ enterprise IT infrastructure environments to enable These solutions address critical client requirements for digital transformation and deliver improved quality, flexibility, information retention and archiving, security, compliance and risk management and financial value. The portfolio includes a storage optimization including data deduplication, availability comprehensive set of hybrid cloud services and solutions to and virtualization. The portfolio consists of a broad range of assist clients in building and running enterprise IT environments software-defined storage solutions, flash storage, disk and tape that utilize public and private clouds and traditional IT. The IBM storage solutions. Cloud Platform offers leading-edge services to developers and IBM’s Cloud Infrastructure-as-a-Service covers a wide variety Operating Systems Software: The company’s z/OS is a security- of workloads with high-quality performance. These offerings rich, scalable, high-performance enterprise operating system for integrate long-standing expertise in service management IBM Z. Power Systems offers a choice of AIX or Linux operating and technology with the ability to utilize the power of new systems. These operating systems leverage POWER architecture technologies, drawn from across IBM’s businesses and to deliver secure, reliable and high performing enterprise-class ecosystem partners. The portfolio is built around a key set of workloads across a breadth of server offerings. predictive and proactive solutions addressing systems, mobility, resiliency, networking, cloud and security. The company’s Global Financing encompasses two primary businesses: capabilities, including IBM Cloud, cognitive computing and hybrid financing, primarily conducted through IBM Credit LLC (IBM cloud implementation, provide high-performance, end-to-end Credit), and remanufacturing and remarketing. In 2017, the innovation and an improved ability to achieve business objectives. company reorganized its client and commercial financing business as a wholly owned subsidiary, IBM Credit LLC, and Technical Support Services: delivers comprehensive support it began accessing the capital markets directly in September services to maintain and improve the availability of clients’ IT 2017. IBM Credit, through its financing solutions, facilitates IBM infrastructures. These offerings include maintenance for IBM clients’ acquisition of information technology systems, software products and other technology platforms, as well as software and services in the areas where the company has the expertise. and solution support, drawing on innovative technologies and The financing arrangements are predominantly for products or leveraging the Watson platform’s predictive capabilities. services that are critical to the end users’ business operations. The company conducts a comprehensive credit evaluation of its Integration Software: delivers industry-leading hybrid cloud clients prior to extending financing. As a captive financier, Global solutions that empower clients to achieve rapid innovation, Financing has the benefit of both deep knowledge of its client hybrid integration, and process transformation with choice base and a clear insight into the products and services financed. and consistency across public, dedicated and local cloud These factors allow the business to effectively manage two of the environments, leveraging the IBM Platform-as-a-Service major risks associated with financing, credit and residual value, solution. Integration Software offerings and capabilities help while generating strong returns on equity. Global Financing also clients address the digital imperatives to create, connect and maintains a long-term partnership with the company’s clients optimize their applications, data and infrastructure on their through various stages of the IT asset life cycle — from initial journey to become cognitive businesses. purchase and technology upgrades to asset disposition decisions. Systems provides clients with innovative infrastructure Global Financing Capabilities platforms to help meet the new requirements of hybrid cloud and Client Financing: lease, installment payment plan and loan cognitive workloads. Approximately half of Systems Hardware’s financing to end users and internal clients for terms up to seven server and storage sales transactions are through the company’s years. Assets financed are primarily new and used IT hardware, business partners, with the balance direct to end-user clients. software and services where the company has expertise. Internal IBM Systems also designs advanced semiconductor and systems financing is predominantly in support of Technology Services & technology in collaboration with IBM Research, primarily for use Cloud Platforms’ long-term client service contracts. All internal in the company’s systems. financing arrangements are at arm’s-length rates and are based upon market conditions. Systems Capabilities Servers: a range of high-performance systems designed to Commercial Financing: short-term working capital financing to address computing capacity, security and performance needs suppliers, distributors and resellers of IBM and OEM products of businesses, hyperscale cloud service providers and scientific and services. This includes internal activity where Global computing organizations. The portfolio includes IBM Z, a trusted Financing factors a selected portion of the company’s accounts enterprise platform for integrating data, transactions and insight, receivable primarily for cash management purposes, at arm’s- and Power Systems, a system designed from the ground up for length rates. big data and analytics, optimized for scale-out cloud and Linux, and delivering open innovation with OpenPOWER.

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    34 Management Discussion International Business Machines Corporation and Subsidiary Companies Remanufacturing and Remarketing: assets include used Research, Development and Intellectual Property equipment returned from lease transactions, or used and surplus IBM’s research and development (R&D) operations differentiate equipment acquired internally or externally. These assets may the company from its competitors. IBM annually invests 7 to be refurbished or upgraded and sold or leased to new or existing 8 percent of total revenue for R&D, focusing on high-growth, clients both externally or internally. Externally remarketed high-value opportunities. IBM Research works with clients and equipment revenue represents sales or leases to clients and the company’s business units through global labs on near-term resellers. Internally remarketed equipment revenue primarily and mid-term innovations. It delivers many new technologies to represents used equipment that is sold internally to Systems IBM’s portfolio every year and helps clients address their most and Technology Services & Cloud Platforms. Systems may also difficult challenges. IBM Research scientists are conducting sell the equipment that it purchases from Global Financing to pioneering work in artificial intelligence, quantum computing, external clients. blockchain, security, cloud, nanotechnology, silicon and post- silicon computing architectures and more — applying these IBM Worldwide Organizations technologies across industries including healthcare, IoT, The following worldwide organizations play key roles in IBM’s education and financial services. delivery of value to its clients: In 2017, for the 25th consecutive year, IBM was awarded more • Global Markets U.S. patents than any other company. IBM’s 9,043 patents • Research, Development and Intellectual Property awarded in 2017 represent a diverse range of inventions in artificial intelligence, cloud, cybersecurity and other strategic Global Markets growth areas for the company. IBM has a global presence, operating in more than 175 countries with a broad-based geographic distribution of revenue. The The company continues to actively seek IP protection for its company’s Global Markets organization manages IBM’s global innovations, while increasing emphasis on other initiatives footprint, working closely with dedicated country-based designed to leverage its IP leadership. Some of IBM’s operating units to serve clients locally. These country teams technological breakthroughs are used exclusively in IBM have client relationship managers who lead integrated teams of products, while others are licensed and may be used in IBM consultants, solution specialists and delivery professionals to products and/or the products of the licensee. As part of its enable clients’ growth and innovation. business model, the company licenses certain of its intellectual property, which is high-value technology, but may be in more By complementing local expertise with global experience and mature markets. The licensee drives the future development of digital capabilities, IBM builds deep and broad-based client the IP and ultimately expands the customer base. This would relationships. This local management focus fosters speed generate IP income for the company both upon licensing, and in supporting clients, addressing new markets and making with any ongoing royalty arrangements between it and the investments in emerging opportunities. The Global Markets licensee. While the company’s various proprietary IP rights are organization serves clients with expertise in their industry as important to its success, IBM believes its business as a whole well as through the products and services that IBM and partners is not materially dependent on any particular patent or license, supply. IBM is also expanding its reach to new and existing clients or any particular group of patents or licenses. IBM owns or is through digital marketplaces, digital sales and local Business licensed under a number of patents, which vary in duration, Partner resources. relating to its products.

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    Management Discussion 35 International Business Machines Corporation and Subsidiary Companies YEAR IN REVIEW Results of Continuing Operations Segment Details The following is an analysis of the 2017 versus 2016 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. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent/ Percent Change Margin Adjusted for For the year ended December 31: 2017 2016 Change Currency Revenue Cognitive Solutions $18,453 $18,187 1.5% 1.0% Gross margin 78.6% 81.9% (3.2) pts. Global Business Services 16,348 16,700 (2.1)% (1.8)% Gross margin 25.2% 27.0% (1.8) pts. Technology Services & Cloud Platforms 34,277 35,337 (3.0)% (3.4)% Gross margin 40.4% 41.9% (1.5) pts. Systems 8,194 7,714 6.2% 5.4% Gross margin 53.2% 55.7% (2.5) pts. Global Financing 1,696 1,692 0.3% (0.7)% Gross margin 29.3% 38.7% (9.4) pts. Other 171 289 (40.7)% (41.1)% Gross margin (640.3)% (293.9)% (346.4) pts. Total consolidated revenue $79,139 $79,919 (1.0)% (1.3)% Total consolidated gross profit $36,227 $38,294 (5.4)% Total consolidated gross margin 45.8% 47.9% (2.1) pts. Non-operating adjustments Amortization of acquired intangible assets 449 494 (9.2)% Retirement-related costs/(income) 799 316 153.2% Operating (non-GAAP) gross profit $37,475 $39,104 (4.2)% Operating (non-GAAP) gross margin 47.4% 48.9% (1.6) pts.

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    36 Management Discussion International Business Machines Corporation and Subsidiary Companies Cognitive Solutions ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Cognitive Solutions external revenue $18,453 $18,187 1.5% 1.0% Solutions Software $12,806 $12,589 1.7% 1.3% Transaction Processing Software 5,647 5,598 0.9 0.3 Cognitive Solutions revenue of $18,453 million grew 1.5 percent Cognitive Solutions total strategic imperatives revenue of $12.0 as reported and 1 percent adjusted for currency in 2017 billion grew 2 percent year to year as reported and adjusted compared to the prior year. On an as-reported and constant for currency. Cloud revenue of $2.5 billion grew 19 percent as currency basis, there was growth in Solutions Software, which reported and adjusted for currency, with an as-a-Service exit run addresses many of the company’s strategic areas, while rate of $2.1 billion. Transaction Processing Software was relatively flat year to year. ($ in millions) Solutions Software revenue of $12,806 million grew 1.7 percent Yr.-to-Yr. as reported (1 percent adjusted for currency) compared to the Percent/ Margin prior year led by key areas including security, industry platforms For the year ended December 31: 2017 2016 Change and Watson offerings, as the company continued to embed Cognitive Solutions cognitive into its security offerings and drive vertical solutions. External gross profit $14,510 $14,890 (2.6)% In 2017, the company continued to expand the market for Watson External gross profit Health which had strong double-digit revenue growth as reported margin 78.6% 81.9% (3.2) pts. and adjusted for currency compared to the prior year. Most of the Pre-tax income $ 6,817 $ 6,352 7.3% strategic areas within Solutions Software have a Software-as- a-Service (SaaS) delivery model and the company continues to Pre-tax margin 32.3% 30.5% 1.8 pts. build scale in these areas. For the full year, there was year-to-year growth in annuity revenue as reported and at constant currency Cognitive Solutions gross profit margin decreased 3.2 points to with strong double-digit growth in SaaS revenue as reported and 78.6 percent in 2017 compared to the prior year. The gross profit adjusted for currency. margin decline year to year was driven by continued investment and an increasing mix toward SaaS which has a different margin Transaction Processing Software revenue of $5,647 million profile than traditional software delivery offerings and is not yet grew 0.9 percent as reported (flat adjusted for currency) in 2017 at scale. Margins were impacted by a higher level of royalty cost compared to the prior year. In the second half of 2017, there was associated with IP licensing agreements in 2017 compared to improved revenue performance with growth both sequentially the prior year. versus the first half 2017 and year to year as reported and adjusted for currency reflecting clients’ ongoing long-term Pre-tax income of $6,817 million increased 7.3 percent compared commitment and the value the company’s platform provides to the prior year with a pre-tax margin improvement of 1.8 points to them. This portfolio predominately runs on-premise mission to 32.3 percent as the company continues to invest to embed critical workloads running on IBM Z in industries such as banking, cognitive into offerings, scale platforms and build high-value airlines and retail. vertical solutions.

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    Management Discussion 37 International Business Machines Corporation and Subsidiary Companies Global Business Services ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Global Business Services external revenue $16,348 $16,700 (2.1)% (1.8)% Consulting $ 7,262 $ 7,332 (1.0)% (0.4)% Global Process Services 1,265 1,388 (8.8) (9.0) Application Management 7,821 7,980 (2.0) (1.9) Global Business Services revenue of $16,348 million decreased ($ in millions) 2.1 percent as reported and 2 percent adjusted for currency in Yr.-to-Yr. 2017 compared to the prior year. The company continues to Percent/ Margin transform this business and shift its practices to digital, cognitive For the year ended December 31: 2017 2016 Change and cloud. GBS signings grew each quarter of the year as reported Global Business Services and adjusted for currency, and strategic imperatives revenue for External gross profit $4,112 $4,501 (8.6)% the full year 2017 had strong growth year to year as reported External gross profit and adjusted for currency. However, this growth continues to be margin 25.2% 27.0% (1.8) pts. more than offset by declines in the more traditional areas that the Pre-tax income $1,401 $1,732 (19.1)% company is shifting away from such as large ERP and on-premise enterprise application implementation. Pre-tax margin 8.4% 10.1% (1.7) pts. Consulting revenue of $7,262 million decreased 1.0 percent GBS gross profit margin decreased 1.8 points to 25.2 percent year to year as reported (flat adjusted for currency). There was year to year and pre-tax income of $1,401 million decreased 19.1 improved performance in the second half of 2017 with revenue percent year to year. The pre-tax margin declined 1.7 points to growth both sequentially versus the first half of 2017 and year 8.4 percent. Pre-tax income performance for the year included a to year as reported and adjusted for currency. The improvement lower level of charges related to workforce rebalancing and real was driven by the company’s digital strategy and iX platform, estate actions as compared to the prior year. and a return to growth as reported and at constant currency in the Consulting backlog. Global Process Services (GPS) GBS margin has been impacted by investments to drive revenue of $1,265 million decreased 8.8 percent as reported transformation and reflects pricing and profit pressure in the (9 percent adjusted for currency) compared to the prior year. more traditional IT services. The company will continue to focus Application Management revenue of $7,821 million decreased on improving productivity with a streamlined practice model and 2.0 percent as reported (2 percent adjusted for currency). new project management approaches. The company continues to help clients implement new cloud- centric architectures in their critical applications. However, overall revenue performance in Application Management was impacted by certain areas that are not as differentiated and are experiencing pricing pressure, as well as the successful completion of some large contracts. Within GBS, total strategic imperatives revenue of $9.8 billion grew 10 percent as reported and adjusted for currency year to year. Cloud revenue of $4.0 billion grew 34 percent as reported (35 percent adjusted for currency), with an as-a-Service exit run rate of $1.3 billion.

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    38 Management Discussion International Business Machines Corporation and Subsidiary Companies Technology Services & Cloud Platforms ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Technology Services & Cloud Platforms external revenue $34,277 $35,337 (3.0)% (3.4)% Infrastructure Services $22,690 $23,543 (3.6)% (4.1)% Technical Support Services 7,196 7,272 (1.0) (1.5) Integration Software 4,390 4,521 (2.9) (3.4) Technology Services & Cloud Platforms revenue of $34,277 ($ in millions) million decreased 3.0 percent as reported and 3 percent adjusted Yr.-to-Yr. for currency in 2017 compared to the prior year. For the full year, Percent/ Margin there were declines across all lines of business, however, within For the year ended December 31: 2017 2016 Change the segment there was strong revenue growth year to year in Technology Services & cloud, analytics, mobile and security, as reported and adjusted Cloud Platforms for currency. External Technology Services gross profit $10,256 $10,969 (6.5)% Infrastructure Services revenue of $22,690 million declined 3.6 External Technology percent as reported (4 percent adjusted for currency) compared Services gross profit to the prior year. In Infrastructure Services, the business model margin 34.3% 35.6% (1.3) pts. is to deliver productivity to clients and then grow by expanding External Integration the scope of work and adding new clients to the platform. The Software gross profit $ 3,587 $ 3,830 (6.4)% revenue decline in 2017 reflects the continued impact associated External Integration with contract conclusions at the end of 2016 and the shift away Software gross profit from certain lower value work within this business. During margin 81.7% 84.7% (3.0) pts. 2017, there were some substantial new transactions signed External total gross profit $13,842 $14,800 (6.5)% to implement hybrid cloud environments. Technical Support External total gross Services revenue of $7,196 million decreased 1.0 percent as profit margin 40.4% 41.9% (1.5) pts. reported (2 percent adjusted for currency) year to year. Within Pre-tax income $ 4,344 $ 4,707 (7.7)% this line of business, the company is focused on growing its Pre-tax margin 12.4% 13.1% (0.6) pts. multi-vendor support services which provide clients with a single source of expertise and visibility across different vendor solutions. Integration Software full-year revenue of $4,390 Technology Services & Cloud Platforms gross profit margin million decreased 2.9 percent as reported (3 percent adjusted decreased 1.5 points year to year in 2017 to 40.4 percent driven for currency) compared to the prior year. While the annuity base primarily by large contract conclusions, delays in productivity remains relatively stable and there was strong double-digit improvements, mix from Integration Software and investments growth in SaaS offerings, transactional revenue declined year to in cloud. The current-year margin reflects savings from the prior- year as more of this portfolio shifts to the IBM Cloud. year workforce transformation action. Pre-tax income of $4,344 million decreased 7.7 percent. The pre-tax margin declined 0.6 Within Technology Services & Cloud Platforms, strategic points year to year to 12.4 percent. The year-to-year performance imperatives revenue of $10.4 billion grew 19 percent year to year in 2017 compared to the prior year includes a lower level of as reported (18 percent adjusted for currency). Cloud revenue charges related to workforce and real estate actions. of $7.1 billion grew 21 percent as reported (20 percent adjusted for currency), with an as-a-Service exit run rate of $6.9 billion. The company continues to focus on scaling its platforms, delivering productivity through automation, infusing AI into its offerings and investing to expand its cloud infrastructure. There are approximately 60 cloud centers across 19 countries providing clients with flexibility in how and where they store their data. However, these investments to transform the business continued to impact margins in 2017.

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    Management Discussion 39 International Business Machines Corporation and Subsidiary Companies Services Backlog and Signings ($ in billions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for At December 31: 2017 2016 Change Currency Total backlog $121.0 $118.7 1.9% (3.4)% The estimated total services backlog at December 31, 2017 was Services signings are management’s initial estimate of the $121 billion, an increase of 1.9 percent as reported (decrease value of a client’s commitment under a services contract. There of 3 percent adjusted for currency). There was growth in Global are no third-party standards or requirements governing the Technology Services backlog as reported, but a decrease year calculation of signings. The calculation used by management to year adjusted for currency. GBS backlog decreased year to involves estimates and judgments to gauge the extent of a client’s year as reported and adjusted for currency compared to the commitment, including the type and duration of the agreement, December 31, 2016 balance. and the presence of termination charges or wind-down costs. Total services backlog includes Infrastructure Services, Signings include Infrastructure Services, Consulting, Global Consulting, Global Process Services, Application Management Process Services and Application Management contracts. and Technical Support Services. Total backlog is intended to be Contract extensions and increases in scope are treated as a statement of overall work under contract for these businesses signings only to the extent of the incremental new value. and therefore includes Technical Support Services. It does not Technical Support Services is not included in signings as the include as-a-Service offerings that have flexibility in contractual maintenance contracts tend to be more steady state, where commitment terms. Backlog estimates are subject to change and revenues equal renewals. are affected by several factors, including terminations, changes in the scope of contracts, periodic revalidations, adjustments for Contract portfolios purchased in an acquisition are treated as revenue not materialized and adjustments for currency. positive backlog adjustments provided those contracts meet the company’s requirements for initial signings. A new signing will be recognized if a new services agreement is signed incidental or coincidental to an acquisition or divestiture. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Total signings $42,869 $44,645 (4.0)% (4.4)% Systems ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Systems external revenue $8,194 $7,714 6.2% 5.4% Systems Hardware $6,494 $5,926 9.6% 8.6% IBM Z 24.0 22.3 Power Systems (3.7) (4.3) Storage Systems 7.7 7.0 Operating Systems Software 1,701 1,788 (4.9) (5.3) Systems revenue of $8,194 million grew 6.2 percent year to Within Systems Hardware, IBM Z revenue grew 24.0 percent as year as reported (5 percent adjusted for currency) in 2017 reported (22 percent adjusted for currency) year to year, driven by driven by a combination of strong z14 market acceptance and the successful launch of the z14 mainframe in the third quarter of four consecutive quarters of growth as reported and adjusted 2017. This success is due to the strong demand for technology that for currency in Storage Systems. Systems Hardware revenue of helps address the growing threat of global data breaches and the $6,494 million grew 9.6 percent as reported (9 percent adjusted need for clients to operate within regulated environments. With for currency) with growth in IBM Z and Storage Systems partially unprecedented encryption capabilities, there has been strong offset by a decrease in Power Systems, as reported and adjusted demand for the z14 across a mix of industries and geographies for currency. Operating Systems Software revenue of $1,701 since its introduction. The company’s mainframe is a franchise million decreased 4.9 percent as reported (5 percent adjusted that continues to deliver a high value, secure and scalable for currency) compared to the prior year. platform that clients rely on for their mission critical applications.

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    40 Management Discussion International Business Machines Corporation and Subsidiary Companies Power Systems revenue decreased 3.7 percent as reported The Systems gross profit margin decreased 2.5 points to 53.2 (4 percent adjusted for currency) year to year with revenue growth percent in 2017 compared to the prior year. The overall decrease in the company’s high-end portfolio more than offset by declines year to year was driven by margin declines across all product in mid-range and low-range products, as reported and adjusted lines, partially offset by product mix primarily toward the higher for currency. Overall performance reflects the company’s margin IBM Z, reflecting product cycle dynamics. continued shift to a growing Linux market while continuing to serve a high-value, but declining UNIX market. Linux revenue Pre-tax income of $1,135 million grew 21.6 percent and pre-tax grew year to year as reported and adjusted for currency, while margin increased 1.7 points year to year to 12.7 percent driven UNIX revenue declined as reported and adjusted for currency by the strong performance in Systems Hardware. in 2017. In the fourth quarter of 2017, Power Systems revenue returned to growth as reported and adjusted for currency, and Overall Systems performance in 2017 reflected a successful the company released its next generation POWER9 system in the repositioning of the business through continuous reinvention of low-end Linux portfolio. With the new POWER9 processor, these core platforms and expansion into new workloads. systems bring unprecedented speed to AI workloads. Global Financing Storage Systems revenue increased by 7.7 percent as reported Global Financing is a reportable segment that is measured as (7 percent adjusted for currency) year to year. With the a stand-alone entity. Global Financing facilitates IBM clients’ company’s most competitive storage offerings in some time, acquisition of information technology systems, software and there was growth as reported and adjusted for currency in each services by providing financing solutions in the areas where the quarter of the year. All-flash array offerings were a catalyst for company has the expertise, while generating strong returns on Storage Systems growth in 2017 with strong double-digit growth equity. Global Financing also optimizes the recovery of residual as reported and adjusted for currency throughout the year. values by selling assets sourced from end of lease, leasing used equipment to new clients, or extending lease arrangements Within Systems, total strategic imperatives revenue of $4.3 billion with current clients. Sales of equipment include equipment grew 28 percent year to year as reported (26 percent adjusted returned at the end of a lease, surplus internal equipment for currency). Cloud revenue of $3.4 billion grew 26 percent as and used equipment purchased externally. Residual value is a reported (25 percent adjusted for currency). risk unique to the financing business and management of this risk is dependent upon the ability to accurately project future ($ in millions) equipment values at lease inception. Global Financing has Yr.-to-Yr. insight into product plans and cycles for the IBM products under Percent/ lease. Based upon this product information, Global Financing Margin For the year ended December 31: 2017 2016 Change continually monitors projections of future equipment values and Systems compares them with the residual values reflected in the portfolio. External Systems Hardware gross profit $2,894 $2,720 6.4% Results of Operations External Systems ($ in millions) Hardware gross Yr.-to-Yr. profit margin 44.6% 45.9% (1.3) pts. Percent For the year ended December 31: 2017 2016 Change External Operating Systems Software External revenue $1,696 $1,692 0.3% gross profit $1,469 $1,577 (6.9)% Internal revenue 1,471 1,802 (18.4) External Operating Total revenue $3,168 $3,494 (9.3)% Systems Software Pre-tax income $1,279 $1,656 (22.7)% gross profit margin 86.4% 88.2% (1.8) pts. External total gross profit $4,363 $4,298 1.5% External total gross profit margin 53.2% 55.7% (2.5) pts. Pre-tax income $1,135 $ 933 21.6% Pre-tax margin 12.7% 11.0% 1.7 pts.

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    Management Discussion 41 International Business Machines Corporation and Subsidiary Companies In 2017, Global Financing delivered external revenue of $1,696 Total unguaranteed residual value of leases at December 31, million and total revenue of $3,168 million, with a decline in 2017 and 2016 were $724 million and $725 million, respectively. gross margin of 6.7 points. Total pre-tax income of $1,279 million In addition to the unguaranteed residual value, on a limited basis, decreased 22.7 percent compared to 2016 and return on equity Global Financing will obtain guarantees of the future value of the increased 2.3 points to 32.9 percent. equipment to be returned at end of lease. Global Financing total revenue of $3,168 million decreased 9.3 Third-party residual value guarantees increase the minimum percent compared to the prior year. This was due to a decline lease payments as provided for by accounting standards that in internal revenue of 18.4 percent, driven by a decrease in are utilized in determining the classification of a lease as a internal used equipment sales (down 25.2 percent to $1,111 sales-type lease, direct financing lease or operating lease. The million) partially offset by an increase in internal financing (up aggregate asset values associated with the guarantees of sales- 13.9 percent to $360 million). External revenue grew 0.3 percent type leases were $716 million and $329 million for the financing due to an increase in external used equipment sales (up 14.9 transactions originated during the years ended December 31, percent to $530 million), partially offset by a decline in external 2017 and December 31, 2016, respectively. In 2017, the residual financing (down 5.2 percent to $1,167 million). value guarantee program resulted in the company recognizing approximately $452 million of revenue that would otherwise have The decrease in external financing revenue was due to lower been recognized in future periods as operating lease revenue. If asset yields, partially offset by an increase in average asset the company had chosen to not participate in a residual value balances. The increase in internal financing revenue was primarily guarantee program in 2017 and prior years, the 2017 impact due to higher average asset balances and higher asset yields. would be substantially mitigated by the effect of prior year asset values being recognized as operating lease revenue in Global Financing pre-tax income decreased 22.7 percent year to the current year. The aggregate asset values associated with year in 2017 primarily driven by a decrease in gross profit ($430 the guarantees of direct financing leases were $154 million and million), partially offset by a decline in financing receivables $169 million for the financing transactions originated during the provisions ($52 million). This decrease was primarily due to lower years ended December 31, 2017 and 2016, respectively. The reserves in Brazil in the current year. At December 31, 2017 the associated aggregate guaranteed future values at the scheduled overall allowance for credit losses coverage rate was 1.1 percent, end of lease were $45 million and $19 million for the financing a decrease of 48 basis points year over year primarily due to the transactions originated during the years ended December 31, write-off of previously reserved receivables. 2017 and 2016, respectively. The cost of guarantees was $4 million and $2 million for the years ended December 31, 2017 The increase in return on equity from 2016 to 2017 was primarily and 2016, respectively. due to a lower average equity balance. See page 48 for the details of the after-tax income and return on equity calculations. Geographic Revenue In addition to the revenue presentation by reportable segment, the company also measures revenue performance on a geographic basis. The following geographic, regional and country-specific revenue performance excludes OEM revenue. ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Change Percent Adjusted for For the year ended December 31: 2017 2016 Change Currency Total revenue $79,139 $79,919 (1.0)% (1.3)% Geographies $78,793 $79,594 (1.0)% (1.4)% Americas 37,479 37,513 (0.1) (0.6) Europe/Middle East/Africa 24,345 24,769 (1.7) (2.8) Asia Pacific 16,970 17,313 (2.0) (1.1) Total geographic revenue of $78,793 million in 2017 decreased 1.0 percent as reported (1 percent adjusted for currency) compared to the prior year.

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    42 Management Discussion International Business Machines Corporation and Subsidiary Companies Americas revenue was essentially flat year to year as reported, Selling, General and Administrative but decreased 1 percent adjusted for currency with a decline in ($ in millions) North America partially offset by growth in Latin America, both Yr.-to-Yr. as reported and adjusted for currency. Within North America, the Percent U.S. decreased 1.4 percent and Canada increased 4.9 percent For the year ended December 31: 2017 2016 Change (3 percent adjusted for currency). In Latin America, Brazil Selling, general and increased 7.6 percent (1 percent adjusted for currency) and administrative expense Mexico increased 9.2 percent (10 percent adjusted for currency). Selling, general and administrative — other $16,568 $16,971 (2.4)% EMEA revenue decreased 1.7 percent as reported and 3 percent Advertising and promotional adjusted for currency. Revenue declined in the UK and Germany, expense 1,445 1,327 8.9 while there was growth in France and Spain. The UK decreased Workforce rebalancing 11.2 percent (7 percent adjusted for currency) and Germany charges 199 1,038 (80.9) decreased 3.2 percent (6 percent adjusted for currency). France Retirement-related costs 959 742 29.3 increased 6.3 percent (3 percent adjusted for currency), and Amortization of acquired Spain was up 8.3 percent (6 percent adjusted for currency). intangible assets 496 503 (1.4) Stock-based compensation 384 401 (4.1) Asia Pacific revenue decreased 2.0 percent as reported and Bad debt expense 55 87 (36.5) 1 percent adjusted for currency. Japan decreased 1.1 percent as reported, but increased 2 percent adjusted for currency. Total consolidated selling, general and India grew 8.6 percent as reported and 5 percent adjusted for administrative expense $20,107 $21,069 (4.6)% currency. China decreased 10.6 percent (10 percent adjusted for currency) and Australia decreased 5.8 percent (9 percent Non-operating adjustments adjusted for currency). Amortization of acquired intangible assets (496) (503) (1.4) Total Expense and Other (Income) Acquisition-related charges (13) 2 NM Non-operating retirement- ($ in millions) related (costs)/income (472) (253) 86.6 Yr.-to-Yr. Percent/ Operating (non-GAAP) Margin selling, general and For the year ended December 31: 2017 2016 Change administrative expense $19,126 $20,315 (5.9)% Total consolidated expense NM — Not meaningful and other (income) $24,827 $25,964 (4.4)% Non-operating adjustments Total selling, general and administrative (SG&A) expense Amortization of acquired decreased 4.6 percent in 2017 versus 2016, driven primarily by intangible assets (496) (503) (1.4) the following factors: Acquisition-related charges (52) (5) NM Non-operating retirement- • Lower workforce rebalancing charges (4 points); and related (costs)/income (669) (282) 137.2 • Lower spending (2 points); partially offset by Operating (non-GAAP) expense and • Spending related to acquisitions in the prior 12 months other (income) $23,609 $25,174 (6.2)% (1 point); and Total consolidated • Higher retirement-related costs (1 point). expense-to-revenue ratio 31.4% 32.5% (1.1) pts. Operating (non-GAAP) Operating (non-GAAP) expense decreased 5.9 percent year to expense-to-revenue ratio 29.8% 31.5% (1.7) pts. year driven primarily by the same factors. NM — Not meaningful Bad debt expense decreased $32 million in 2017 compared For additional information regarding total expense and other to 2016. The receivables provision coverage was 1.6 percent (income) for both expense presentations, see the following at December 31, 2017, a decrease of 40 basis points from analyses by category. December 31, 2016.

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    Management Discussion 43 International Business Machines Corporation and Subsidiary Companies Research, Development and Engineering Other (Income) and Expense ($ in millions) ($ in millions) Yr.-to-Yr. Yr.-to-Yr. Percent Percent For the year ended December 31: 2017 2016 Change For the year ended December 31: 2017 2016 Change Total consolidated Other (income) and expense research, development Foreign currency transaction and engineering $5,787 $5,751 0.6% losses/(gains) $ 405 $(116) NM Non-operating adjustment (Gains)/losses on derivative Non-operating retirement- instruments (341) 260 NM related (costs)/income (197) (29) 575.5 Interest income (144) (108) 33.5% Operating (non-GAAP) Net (gains)/losses from research, development securities and investment and engineering $5,590 $5,722 (2.3)% assets (20) 23 NM Other (116) 85 NM Research, development and engineering (RD&E) expense was Total consolidated other 7.3 percent of revenue in 2017 and 7.2 percent of revenue in 2016. (income) and expense $(216) $ 145 NM Non-operating adjustment RD&E expense increased 0.6 percent in 2017 versus 2016 Acquisition-related primarily driven by: charges (39) (7) 444.6 Operating (non-GAAP) other • The impact of acquisitions completed in the prior 12-month (income) and expense $(255) $ 138 NM period (1 point); and NM — Not meaningful • The effects of currency; partially offset by • Lower spending, net of higher retirement-related costs Total consolidated other (income) and expense was income of (1 point). $216 million in 2017 compared to expense of $145 million in 2016. The decrease in expense of $361 million year over year Operating (non-GAAP) RD&E expense decreased 2.3 percent in was primarily driven by: 2017 compared to the prior year, driven primarily by the same • Real estate capacity charges (reflected in Other in the table factors, excluding higher non-operating retirement-related costs. above) in the prior year related to workforce transformation ($328 million); Intellectual Property and Custom Development Income • Lower net exchange losses ($81 million); ($ in millions) Yr.-to-Yr. • Reduced losses from securities and investment assets Percent ($43 million), primarily related to the sale of Lenovo shares For the year ended December 31: 2017 2016 Change in 2016; and Licensing of intellectual property including • Higher interest income ($36 million); partially offset by royalty-based fees $1,193 $1,390 (14.1)% • Lower gains on divestitures ($61 million). Custom development income 252 214 17.5 Sales/other transfers of Interest Expense intellectual property 21 27 (24.2) Total $1,466 $1,631 (10.2)% ($ in millions) Yr.-to-Yr. Percent For the year ended December 31: 2017 2016 Change Licensing of intellectual property including royalty-based fees decreased 14.1 percent in 2017 compared to 2016. The company Interest expense entered into new partnership agreements in 2017, which included Total $615 $630 (2.3)% three transactions with period income greater than $100 million, compared to four transactions greater than $100 million in 2016. Interest expense decreased $15 million compared to 2016. The company licenses IP to partners who allocate their skills Interest expense is presented in cost of financing in the to extend the value of assets that are high value, but may be in Consolidated Statement of Earnings only if the related external mature markets. The timing and amount of licensing, sales or borrowings are to support the Global Financing external business. other transfers of IP may vary significantly from period to period Overall interest expense (excluding capitalized interest) in 2017 depending upon the timing of licensing agreements, economic was $1,273 million, an increase of $67 million year to year, conditions, industry consolidation and the timing of new patents primarily driven by higher average interest rates. and know-how development.

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    44 Management Discussion International Business Machines Corporation and Subsidiary Companies Stock-Based Compensation As discussed in the “Operating (non-GAAP) Earnings” section on Pre-tax stock-based compensation cost of $534 million pages 26 and 27, the company characterizes certain retirement- decreased $10 million compared to 2016. This was due related costs as operating and others as non-operating. Utilizing primarily to decreases related to the conversion of stock-based this characterization, operating retirement-related costs in 2017 awards previously issued by acquired entities ($23 million) and were $1,388 million, a decrease of $17 million compared to performance share units ($14 million); partially offset by an 2016, primarily driven by lower defined contribution plans cost increase in restricted stock units ($27 million). Stock-based ($23 million). Non-operating costs of $1,468 million increased compensation cost, and the year-to-year change, was reflected $871 million in 2017 compared to 2016, driven primarily by lower in the following categories: Cost: $91 million, up $3 million; SG&A expected return on plan assets ($1,217 million) and an increase expense: $384 million, down $16 million and RD&E expense: $59 in recognized actuarial losses ($120 million); partially offset by million, up $3 million. lower interest costs ($339 million) and other costs ($162 million) primarily due to impacts from pension litigation in both years. Retirement-Related Plans Effective January 1, 2018, the company adopted the new FASB The following table provides the total pre-tax cost for all guidance on presentation of net periodic pension and nonpension retirement-related plans. These amounts are included in the postretirement benefit costs, and as a result, beginning in Consolidated Statement of Earnings within the caption (e.g., Cost, 2018, the company will align its presentation of operating and SG&A, RD&E) relating to the job function of the plan participants. non-operating costs to the FASB presentation. Prior period non- operating cost/(income) will be recast for comparability. ($ in millions) Yr.-to-Yr. Income Taxes Percent The continuing operations effective tax rate for 2017 was For the year ended December 31: 2017 2016 Change 49.5 percent, an increase of 45.8 points versus the prior year. The Retirement-related fourth quarter charge of $5.5 billion related to the impact of the plans — cost enactment of the U.S. Tax Cuts and Jobs Act resulted in an increase Service cost $ 429 $ 443 (3.0)% to the effective tax rate of 48.0 points. Without this impact, the Amortization of prior continuing operations tax rate would have been 1.5 percent service costs/(credits) (88) (107) (18.5) compared to a 2016 rate of 3.6 percent, with the remaining Cost of defined change in the rate year to year driven by the following factors: contribution plans 1,046 1,070 (2.2) Total operating costs/ • An increased benefit year to year in the utilization of foreign (income) $ 1,388 $ 1,405 (1.2)% tax credits of 5.4 points; Interest cost $ 2,961 $ 3,300 (10.3)% • A benefit related to an intra-entity asset transfer in the first Expected return on quarter of 2017 of 5.1 points; plan assets (4,346) (5,563) (21.9) • A benefit due to the tax write down of an investment in the Recognized actuarial fourth quarter of 2017 of 1.7 points; and losses 2,871 2,751 4.4 Curtailments/settlements 19 (16) NM • A benefit due to the geographic mix of pre-tax earnings in Multi-employer plan/other (36) 126 NM 2017 of 1.0 points; partially offset by Total non-operating • The favorable resolution of the longstanding tax matter in costs/(income) $ 1,468 $ 598 145.6% Japan in 2016 of 9.5 points; and Total retirement-related • An increase year to year in tax charges related to plans — cost $ 2,857 $ 2,003 42.6% intercompany payments of 1.5 points. NM — Not meaningful The continuing operations operating (non-GAAP) effective tax Total pre-tax retirement-related plan cost increased by $854 rate was 6.7 percent, an increase of 0.3 points versus 2016, million compared to 2016, primarily driven by lower expected principally driven by the same factors described above. In return on plan assets ($1,217 million) and an increase in 2017, the geographic and product mix of pre-tax earnings were recognized actuarial losses ($120 million); partially offset by more favorable than the company expected and there was lower interest costs ($339 million) and other costs ($162 million) increased utilization of foreign tax credits. These impacts drove primarily due to impacts from pension litigation in both years. the underlying continuing operations operating (non-GAAP) effective tax rate to approximately 12 percent before discrete period benefits. For more information on the Tax Cuts and Jobs Act impact, see note N, “Taxes,” on pages 121 and 124.

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    Management Discussion 45 International Business Machines Corporation and Subsidiary Companies Earnings Per Share Consistent with accounting standards, the company remeasured Basic earnings per share is computed on the basis of the the funded status of its retirement and postretirement plans at weighted-average number of shares of common stock December 31. At December 31, 2017, the overall net under- outstanding during the period. Diluted earnings per share is funded position was $12,890 million, a decrease of $1,949 computed on the basis of the weighted-average number of million from December 31, 2016 driven by asset returns, partially shares of common stock outstanding plus the effect of dilutive offset by interest cost and a decrease in discount rates. At year potential common shares outstanding during the period using the end, the company’s qualified defined benefit plans were well treasury stock method. Dilutive potential common shares include funded and the cash requirements related to these plans remain outstanding stock options and stock awards. stable going forward at approximately $400 million per year through 2020. In 2017, the return on the U.S. Personal Pension Plan assets was 9.6 percent and the plan was 104 percent funded Yr.-to-Yr. at December 31. Overall, global asset returns were 8.3 percent Percent For the year ended December 31: 2017 2016 Change and the qualified defined benefit plans worldwide were 100 Earnings per share of percent funded at December 31, 2017. common stock from continuing operations During 2017, the company generated $16,724 million in cash Assuming dilution $ 6.14* $12.39 (50.4)% from operations, a decrease of $360 million compared to 2016. Basic $ 6.17 $12.44 (50.4)% In addition, the company generated $12,992 million in free cash flow, an increase of $1,293 million versus the prior year. Diluted operating See page 68 for additional information on free cash flow. The (non-GAAP) $13.80 $13.59 1.5% company returned $9,847 million to shareholders in 2017, with Weighted-average shares $5,506 million in dividends and $4,340 million in gross share outstanding (in millions) repurchases. In 2017, the company repurchased 27.2 million Assuming dilution 937.4 958.7 (2.2)% shares and had $3.8 billion remaining in share repurchase Basic 932.8 955.4 (2.4)% authorization at year end. The company’s cash generation * Includes a charge of $5.5 billion associated with the enactment of U.S. permits the company to invest and deploy capital to areas with tax reform, or $5.84 of diluted earnings per share in 2017. the most attractive long-term opportunities. Actual shares outstanding at December 31, 2017 and 2016 Global Financing Financial Position Key Metrics: were 922.2 million and 945.9 million, respectively. The average ($ in millions) number of common shares outstanding assuming dilution was At December 31: 2017 2016 21.3 million shares lower in 2017 versus 2016. The decrease was primarily the result of the common stock repurchase program. Cash and cash equivalents $ 2,696 $ 1,844 Net investment in sales-type Financial Position and direct financing leases 7,253 6,893 Dynamics Equipment under operating leases — At December 31, 2017, the company continued to have the external clients (1) 477 548 financial flexibility to support the business over the long term. Client loans 12,450 11,478 Cash and marketable securities at year end were $12,580 Total client financing assets 20,180 18,920 million. During the year, the company continued to manage the Commercial financing receivables 11,590 9,700 investment portfolio to meet its capital preservation and liquidity Intercompany financing receivables (2) (3) 5,056 4,959 objectives. Total assets $41,096 $36,492 Total debt of $46,824 million increased $4,655 million from prior Debt 31,434 27,859 year-end levels. The commercial paper balance at December 31, Total equity $ 3,484 $ 3,812 2017, was $1,496 million, an increase of $597 million from the (1) Includes intercompany mark-up, priced on an arm’s-length basis, on prior year end. Within total debt, $31,434 million is in support products purchased from the company’s product divisions which is of the Global Financing business which is leveraged at a 9.0 to eliminated in IBM’s consolidated results. (2) 1 ratio. The company continues to have substantial flexibility in Entire amount eliminated for purposes of IBM’s consolidated results and therefore does not appear on page 80. the debt markets. During 2017, the company completed bond (3) These assets, along with all other financing assets in this table, are issuances totaling $7,986 million, with terms ranging from 2 to leveraged at the value in the table using Global Financing debt. 12 years, and interest rates ranging from 0.95 to 3.30 percent depending on maturity. This includes IBM Credit’s first public debt issuance of $3,000 million in September 2017. The company has consistently generated strong cash flow from operations and continues to have access to additional sources of liquidity through the capital markets and its Credit Facilities.

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    46 Management Discussion International Business Machines Corporation and Subsidiary Companies At December 31, 2017, substantially all financing assets were IT Receivables and Allowances related assets, and approximately 53 percent of the total external Roll Forward of Total IBM Receivables Allowance portfolio was with investment-grade clients with no direct for Credit Losses exposure to consumers. The improvement in investment-grade ($ in millions) year to year (1 point) was driven primarily by rating changes within January 1, December 31, the existing portfolio, not by changing the company’s approach 2017 Additions* Write-offs** Other+ 2017 to the market. This investment-grade percentage is based on $776 $55 $(199) $37 $668 credit ratings of the companies in the portfolio. Additionally, the company takes actions to transfer exposure to third parties. * Additions for Allowance for Credit Losses are charged to expense. On that basis, the investment-grade content would increase by ** Refer to note A, “Significant Accounting Policies,” on pages 92 and 93 for additional information regarding Allowance for Credit Loss write-offs. 17 points to 70 percent, an increase of 5 points year to year. + Primarily represents translation adjustments. The company has a long-standing practice of taking mitigation The total IBM receivables provision coverage was 1.6 percent actions, in certain circumstances, to transfer credit risk to at December 31, 2017, a decrease of 40 basis points compared third parties, including credit insurance, financial guarantees, to December 31, 2016. The majority of the write-offs during nonrecourse borrowings, transfers of receivables recorded as 2017 related to Global Financing receivables, which had been true sales in accordance with accounting guidance or sales of previously reserved. equipment under operating lease. Global Financing Receivables and Allowances IBM Working Capital The following table presents external financing receivables ($ in millions) excluding residual values, and the allowance for credit losses: At December 31: 2017 2016 Current assets $49,735 $43,888 ($ in millions) Current liabilities 37,363 36,275 At December 31: 2017 2016 Working capital $12,373 $ 7,613 Gross financing receivables $31,044 $28,043 Current ratio 1.33:1 1.21:1 Specific allowance for credit losses 258 335 Unallocated allowance for credit losses 78 103 Total allowance for credit losses 336 438 Working capital increased $4,760 million from the year-end 2016 Net financing receivables $30,709 $27,605 position. The key changes are described below: Allowance for credit losses coverage 1.1% 1.6% Current assets increased $5,847 million ($3,239 million adjusted for currency), as a result of: The percentage of Global Financing receivables reserved was • An increase of $4,053 million ($3,105 million adjusted for 1.1 percent at December 31, 2017, compared to 1.6 percent currency) in cash and marketable securities; and at December 31, 2016. In 2017, write-offs of $144 million of receivables previously reserved, primarily in China, resulted in a • An increase of $2,386 million ($993 million adjusted for 23 percent reduction in the specific reserves, from $335 million currency) in receivables driven by financing receivables; at December 31, 2016, to $258 million at December 31, 2017. partially offset by See note F, “Financing Receivables,” on page 107 for additional • A decrease of $622 million ($841 million adjusted for information. Unallocated reserves decreased 24 percent currency) in prepaid expenses and other current assets. from $103 million at December 31, 2016, to $78 million at December 31, 2017 due to higher general reserve requirements Current liabilities increased $1,087 million (a decrease of $542 in Brazil in the prior year. million adjusted for currency), as a result of: • An increase in taxes of $984 million ($849 million adjusted for currency); and • An increase in deferred income of $517 million driven by currency-related increases of $583 million; partially offset by • A decrease in short-term debt of $526 million ($537 million adjusted for currency).

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    Management Discussion 47 International Business Machines Corporation and Subsidiary Companies Roll Forward of Global Financing Receivables Allowance Debt for Credit Losses (included in Total IBM) The company’s funding requirements are continually monitored and strategies are executed to manage the overall asset and ($ in millions) liability profile. Additionally, the company maintains sufficient January 1, December 31, 2017 Additions* Write-offs** Other+ 2017 flexibility to access global funding sources as needed. $438 $17 $(144) $24 $336 ($ in millions) * Additions for Allowance for Credit Losses are charged to expense. At December 31: 2017 2016 ** Refer to note A, “Significant Accounting Policies,” on pages 92 and 93 for additional information regarding Allowance for Credit Loss write-offs. Total company debt $46,824 $42,169 + Primarily represents translation adjustments. Total Global Financing segment debt $31,434 $27,859 Debt to support external clients 27,556 24,034 Global Financing’s bad debt expense was $17 million in 2017, Debt to support internal clients 3,878 3,825 compared to $69 million in 2016. The year-to-year decrease in Non-Global Financing debt 15,390 14,309 bad debt expense was primarily due to lower general reserve requirements in Brazil. Global Financing provides financing predominantly for the Noncurrent Assets and Liabilities company’s external client assets, as well as for assets under contract by other IBM units. These assets, primarily for ($ in millions) Technology Services & Cloud Platforms, generate long-term, At December 31: 2017 2016 stable revenue streams similar to the Global Financing asset Noncurrent assets $75,621 $73,582 portfolio. Based on their attributes, these Technology Services Long-term debt $39,837 $34,655 & Cloud Platforms assets are leveraged with the balance of the Noncurrent liabilities (excluding debt) $30,432 $28,147 Global Financing asset base. The increase in debt was consistent with the company’s expectations in 2017 to increase leverage in the Global Financing business. The increase in noncurrent assets of $2,039 million (a decrease of $233 million adjusted for currency) was driven by: Non-Global Financing debt of $15,390 million was up $1,081 • An increase in prepaid pension assets of $1,609 million million from prior year-end levels. ($1,357 million adjusted for currency) driven by the expected returns on plan assets partially offset by interest costs. Consolidated debt-to-capitalization ratio at December 31, 2017 was 72.5 percent, which includes a 5.7 point impact from the one- Long-term debt increased $5,182 million ($4,120 million time charge of $5.5 billion associated with the enactment of U.S. adjusted for currency) driven by: tax reform in 2017, versus 69.6 percent at December 31, 2016. • Bond issuances of $7,986 million; partially offset by Given the significant leverage, the company also presents a debt- • Current upcoming maturities of long-term debt of to-capitalization ratio which excludes Global Financing debt and $5,214 million. equity as management believes this is more representative of the company’s core business operations. This ratio can vary Other noncurrent liabilities, excluding debt, increased $2,285 from period to period as the company manages its global million ($378 million adjusted for currency) primarily driven by: cash and debt positions. “Core” debt-to-capitalization ratio (excluding Global Financing debt and equity) was 51.9 percent at • An increase of $2,488 million ($1,953 million adjusted for December 31, 2017, which includes an 8.1 point impact from the currency) in other liabilities driven by the charge associated charge of $5.5 billion associated with the enactment of U.S. tax with the enactment of U.S. tax reform. reform in 2017, compared to 49.5 percent at December 31, 2016. At December 31: 2017 2016 Global Financing debt-to-equity ratio 9.0x 7.3x The debt used to fund Global Financing assets is composed of intercompany loans and external debt. Total debt changes generally correspond with the level of client and commercial financing receivables, the level of cash and cash equivalents, the change in intercompany and external payables and the change in intercompany investment from IBM. The terms of the intercompany loans are set by the company to substantially match the term, currency and interest rate variability underlying the financing receivable and are based on arm’s-length pricing.

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    48 Management Discussion International Business Machines Corporation and Subsidiary Companies Global Financing provides financing predominantly for the Net cash provided by operating activities decreased by $360 company’s external client assets, as well as for assets under million in 2017 driven by the following key factors: contract by other IBM units. As previously stated, the company • Performance-related declines within net income; and measures Global Financing as a stand-alone entity, and accordingly, interest expense relating to debt supporting Global • An increase in cash income tax payments of $519 million; Financing’s external client and internal business is included in partially offset by the “Global Financing Results of Operations” on page 40 and • An increase in cash provided by receivables of $585 million. in note T, “Segment Information,” on pages 142 to 146. In the company’s Consolidated Statement of Earnings, the external Net cash used in investing activities decreased $3,881 million debt-related interest expense supporting Global Financing’s driven by: internal financing to the company is reclassified from cost of financing to interest expense. • A decrease in cash used related to acquisitions of $5,184 million, partially offset by an increase of net non-operating Equity financing receivables of $1,137 million. Total equity decreased by $667 million from December 31, 2016 as a result of an increase in treasury stock of $4,457 million Net cash used in financing activities increased $502 million as mainly due to gross common stock repurchases, partially offset compared to the prior year driven by the following factors: by lower accumulated other comprehensive losses of $2,806 • An increase of $838 million of cash used for gross common million primarily due to retirement plan remeasurements, an share repurchases; partially offset by increase in common stock of $631 million and an increase in retained earnings of $368 million. • An increase in net cash sourced from debt transactions of $683 million driven by a higher level of issuances in the Cash Flow current year. The company’s cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement Global Financing Return on Equity Calculation of Cash Flows on page 81 are summarized in the table below. ($ in millions) These amounts include the cash flows associated with the Global At December 31: 2017 2016 Financing business. Numerator ($ in millions) Global Financing after-tax income (1) * $1,116 $1,126 For the year ended December 31: 2017 2016 Denominator Net cash provided by/(used in) Average Global Financing equity (2) ** $3,394 $3,680 continuing operations Global Financing return on equity (1)/(2) 32.9% 30.6% Operating activities $16,724 $ 17,084* * Calculated based upon an estimated tax rate principally based on Investing activities (7,096) (10,976) Global Financing’s geographic mix of earnings as IBM’s provision for Financing activities (6,418) (5,917)* income taxes is determined on a consolidated basis. ** Average of the ending equity for Global Financing for the last five Effect of exchange rate changes on quarters. cash and cash equivalents 937 (51) Net change in cash and cash equivalents $ 4,146 $ 140 * Reclassified to reflect adoption of the FASB guidance on share-based compensation.

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    Management Discussion 49 International Business Machines Corporation and Subsidiary Companies GAAP Reconciliation The tables below provide a reconciliation of the company’s income statement results as reported under GAAP to its operating earnings presentation which is a non-GAAP measure. The company’s calculation of operating (non-GAAP) earnings, as presented, may differ from similarly titled measures reported by other companies. Please refer to the “Operating (non-GAAP) Earnings” section on pages 26 and 27 for the company’s rationale for presenting operating earnings information. ($ in millions except per share amounts) Acquisition- Retirement- Tax Reform Related Related One-Time Operating For the year ended December 31, 2017: GAAP Adjustments Adjustments Charge(1) (non-GAAP) Gross profit $36,227 $ 449 $ 799 $ — $37,475 Gross profit margin 45.8% 0.6 pts. 1.0 pts. — pts. 47.4% SG&A $20,107 $(509) $ (472) $ — $19,126 RD&E 5,787 — (197) — 5,590 Other (income) and expense (216) (39) — — (255) Total expense and other (income) 24,827 (548) (669) — 23,609 Pre-tax income from continuing operations 11,400 997 1,468 — 13,886 Pre-tax margin from continuing operations 14.4% 1.3 pts. 1.9 pts. — pts. 17.5% Provision for income taxes* $ 5,642 $ 279 $ 485 $(5,475) $ 931 Effective tax rate 49.5% (1.5) pts. (1.7) pts. (39.5) pts. 6.7% Income from continuing operations $ 5,758 $ 718 $ 983 $ 5,475 $12,935 Income margin from continuing operations 7.3% 0.9 pts. 1.2 pts. 6.9 pts. 16.3% Diluted earnings per share from continuing operations $ 6.14 $0.77 $ 1.05 $ 5.84 $ 13.80 * 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. (1) Operating (non-GAAP) earnings excludes a charge of $5.5 billion associated with the enactment of U.S. tax reform due to its unique non-recurring nature. ($ in millions except per share amounts) Acquisition- Retirement- Related Related Operating For the year ended December 31, 2016: GAAP Adjustments Adjustments (non-GAAP) Gross profit $38,294 $ 494 $ 316 $39,104 Gross profit margin 47.9% 0.6 pts. 0.4 pts. 48.9% SG&A $21,069 $ (501) $(253) $20,315 RD&E 5,751 — (29) 5,722 Other (income) and expense 145 (7) — 138 Total expense and other (income) 25,964 (508) (282) 25,174 Pre-tax income from continuing operations 12,330 1,003 598 13,931 Pre-tax margin from continuing operations 15.4% 1.3 pts. 0.7 pts. 17.4% Provision for income taxes* $ 449 $ 268 $ 183 $ 900 Effective tax rate 3.6% 1.7 pts. 1.2 pts. 6.5% Income from continuing operations $11,881 $ 735 $ 415 $13,031 Income margin from continuing operations 14.9% 0.9 pts. 0.5 pts. 16.3% Diluted earnings per share from continuing operations $ 12.39 $ 0.77 $0.43 $ 13.59 * 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.

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