10-Q 1 a05-7213_110q.htm 10-Q

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10 - Q

 

QUARTERLY REPORT
PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED MARCH 31, 2005

 

1-2360

(Commission file number)

 

INTERNATIONAL BUSINESS MACHINES CORPORATION

(Exact name of registrant as specified in its charter)

 

New York

 

13-0871985

(State of incorporation)

 

(IRS employer identification number)

 

 

 

Armonk, New York

 

10504

(Address of principal executive offices)

 

(Zip Code)

 

 

 

914-499-1900

(Registrant’s telephone number)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section l3 or l5(d) of the Securities Exchange Act of 1934 during the preceding l2 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes   ý    No   o

 

Indicate by check mark whether registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).     Yes  ý    No  o

 

The registrant has 1,613,320,501 shares of common stock outstanding at March 31, 2005.

 

 



 

Index

 

Part I - Financial Information:

 

 

 

Item 1. Consolidated Financial Statements

 

 

 

Consolidated Statement of Earnings for the three months ended March 31, 2005 and 2004

 

 

 

Consolidated Statement of Financial Position at March 31, 2005 and December 31, 2004

 

 

 

Consolidated Statement of Cash Flows for the three months ended March 31, 2005 and 2004

 

 

 

Notes to Consolidated Financial Statements

 

 

 

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

 

 

 

Item 4. Controls and Procedures

 

 

 

Part II - Other Information

 

 

 

Item 1. Legal Proceedings

 

 

 

Item 2. Unregistered Sale of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

 

 

Item 6. Exhibits

 

 



 

Part I - Financial Information

 

ITEM 1. Consolidated Financial Statements

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF EARNINGS
(UNAUDITED)

 

(Dollars in millions except
per share amounts)

 

Three Months Ended
March 31,

 

 

 

2005

 

2004*

 

Revenue:

 

 

 

 

 

Global Services

 

$

11,696

 

$

11,024

 

Hardware

 

6,749

 

6,735

 

Software

 

3,551

 

3,466

 

Global Financing

 

580

 

662

 

Enterprise Investments/Other

 

332

 

288

 

Total revenue

 

22,908

 

22,175

 

 

 

 

 

 

 

Cost:

 

 

 

 

 

Global Services

 

8,858

 

8,409

 

Hardware

 

4,891

 

4,952

 

Software

 

482

 

487

 

Global Financing

 

266

 

261

 

Enterprise Investments/Other

 

157

 

174

 

 

 

 

 

 

 

Total cost

 

14,654

 

14,283

 

 

 

 

 

 

 

Gross profit

 

8,254

 

7,892

 

 

 

 

 

 

 

Expense and other income:

 

 

 

 

 

Selling, general and administrative

 

4,933

 

4,658

 

Research, development and engineering

 

1,459

 

1,416

 

Intellectual property and custom development income

 

(219

)

(180

)

Other (income) and expense

 

22

 

13

 

Interest expense

 

49

 

35

 

Total expense and other income

 

6,244

 

5,942

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

2,010

 

1,950

 

Provision for income taxes

 

603

 

586

 

 

 

 

 

 

 

Income from continuing operations

 

1,407

 

1,364

 

 


* Restated to include the impact of share-based compensation expense and changes to previously reported first quarter results; see Notes 2 and 3 on page 6 for additional information.

 

(The accompanying notes are an integral part of the financial statements.)

 

1



 

(Dollars in millions except
per share amounts)

 

Three Months Ended
March 31,

 

 

 

 

2005

 

2004*

 

 

Discontinued operations

 

 

 

 

 

Loss from discontinued operations

 

5

 

1

 

Net income

 

$

1,402

 

$

1,363

 

 

 

 

 

 

 

Earnings per share of common stock:

 

 

 

 

 

 

 

 

 

 

 

Assuming dilution

 

 

 

 

 

Continuing operations

 

$

0.85

 

$

0.79

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

0.84

**

$

0.79

 

 

 

 

 

 

 

Basic

 

 

 

 

 

Continuing operations

 

$

0.86

 

$

0.81

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$0.86

 

$

0.81

 

 

 

 

 

 

 

Weighted average number of common shares outstanding: (millions)

 

 

 

 

 

 

 

 

 

 

 

Assuming dilution

 

1,660.6

 

1,727.4

 

 

 

 

 

 

 

Basic

 

1,628.7

 

1,691.7

 

 

 

 

 

 

 

Cash dividends per common share

 

$

0.18

 

$

0.16

 

 


* Restated to include the impact of share-based compensation expense and changes to previously reported first quarter results; see Notes 2 and 3 on page 6 for additional information.

 

** Does not total due to rounding.

 

(The accompanying notes are an integral part of the financial statements.)

 

2



 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
(UNAUDITED)


ASSETS

 

(Dollars in millions)

 

At March 31,
2005

 

At December 31,
2004*

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

8,637

 

$

10,053

 

Marketable securities

 

14

 

517

 

Notes and accounts receivable — trade (net of allowances of $275 in 2005 and $277 in 2004)

 

9,708

 

10,522

 

Short-term financing receivable (net of allowances of $562 in 2005 and $681 in 2004)

 

13,333

 

15,801

 

Other accounts receivable (net of allowances of $12 in 2005 and $13 in 2004)

 

1,538

 

1,813

 

Inventories, at lower of average cost or net realizable value:

 

 

 

 

 

Finished goods

 

1,176

 

1,179

 

Work in process and raw materials

 

2,241

 

2,137

 

Total inventories

 

3,417

 

3,316

 

Deferred taxes

 

1,950

 

2,413

 

Prepaid expenses and other current assets

 

2,746

 

2,708

 

Total current assets

 

41,343

 

47,143

 

 

 

 

 

 

 

Plant, rental machines and other property

 

35,506

 

36,385

 

Less: Accumulated depreciation

 

20,798

 

21,210

 

Plant, rental machines and other property — net

 

14,708

 

15,175

 

Long-term financing receivable

 

9,799

 

10,950

 

Prepaid pension assets

 

21,779

 

20,394

 

Intangible assets — net

 

1,739

 

1,789

 

Goodwill

 

8,593

 

8,437

 

Investments and sundry assets

 

6,938

 

7,115

 

 

 

 

 

 

 

Total assets

 

$

104,899

 

$

111,003

 

 


* Restated to include the impact of share-based compensation expense; see Notes 2 and 3 on page 6 for additional information.

 

(The accompanying notes are an integral part of the financial statements.)

 

3



 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

(Dollars in millions)

 

At March 31,
2005

 

At December 31,
2004*

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

3,838

 

$

4,728

 

Short-term debt

 

6,329

 

$

8,099

 

Accounts payable and accruals

 

23,655

 

26,959

 

Total current liabilities

 

33,822

 

39,786

 

 

 

 

 

 

 

Long-term debt

 

17,083

 

14,828

 

Retirement and nonpension postretirement benefit obligations

 

15,596

 

15,883

 

Other liabilities

 

8,478

 

8,818

 

Total liabilities

 

74,979

 

79,315

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

 

 

 

Common stock, par value $0.20 per share, and additional paid-in capital

 

27,296

 

26,673

 

 

 

 

 

 

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:

2005 - 1,968,498,504

 

 

 

 

 

 

2004 - 1,962,687,087

 

 

 

 

 

 

 

 

 

 

 

Retained earnings

 

39,219

 

38,148

 

 

 

 

 

 

 

Treasury stock - at cost

 

(34,432

)

(31,072

)

Shares:

2005 - 355,178,003

 

 

 

 

 

 

2004 - 317,094,633

 

 

 

 

 

 

 

 

 

 

 

Accumulated gains and (losses) not affecting retained earnings

 

(2,163

)

(2,061

)

 

 

 

 

 

 

Total stockholders’ equity

 

29,920

 

31,688

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

104,899

 

$

111,003

 

 


* Restated to include the impact of share-based compensation expense; see Notes 2 and 3 on page 6 for additional information.

 

(The accompanying notes are an integral part of the financial statements.)

 

4



 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED)

 

(Dollars in millions)

 

2005

 

2004*

 

Cash flow from operating activities from continuing operations:

 

 

 

 

 

Income from continuing operations

 

$

1,407

 

$

1,364

 

Adjustments to reconcile income from continuing operations to cash provided from operating activities:

 

 

 

 

 

Depreciation

 

1,032

 

998

 

Amortization of intangibles

 

250

 

239

 

Stock-based compensation

 

286

 

396

 

Gain on disposition of fixed and other assets

 

(8

)

(71

)

Changes in operating assets and liabilities

 

(887

)

706

 

 

 

 

 

 

 

Net cash provided by operating activities from continuing operations

 

2,080

 

3,632

 

 

 

 

 

 

 

Cash flow from investing activities from continuing operations:

 

 

 

 

 

Payments for plant, rental machines and other property, net of proceeds from dispositions

 

(749

)

(771

)

Investment in software

 

(207

)

(155

)

Acquisition of businesses

 

(242

)

(62

)

Purchases of marketable securities and other investments

 

(593

)

(2,181

)

Proceeds from sale of marketable securities and other investments

 

1,111

 

1,462

 

 

 

 

 

 

 

Net cash used in investing activities from continuing operations

 

(680

)

(1,707

)

 

 

 

 

 

 

Cash flow from financing activities from continuing operations:

 

 

 

 

 

Proceeds from new debt

 

2,430

 

153

 

Payments to settle debt

 

(1,649

)

(148

)

Short-term borrowings/(repayments) less than 90 days — net

 

80

 

(198

)

Common stock transactions — net

 

(3,154

)

(1,217

)

Cash dividends paid

 

(294

)

(271

)

 

 

 

 

 

 

Net cash used in financing activities from continuing operations

 

(2,587

)

(1,681

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

(227

)

(15

)

 

 

 

 

 

 

Net cash used in discontinued operations

 

(2

)

(69

)

 

 

 

 

 

 

Net change in cash and cash equivalents

 

(1,416

)

160

 

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

10,053

 

7,290

 

Cash and cash equivalents at March 31

 

$

8,637

 

$

7,450

 

 


* Restated to include the impact of share-based compensation expense and changes to previously reported first quarter results; see Notes 2 and 3 on page 6 for additional information; also, reclassified to conform with 2005 presentation.

 

(The accompanying notes are an integral part of the financial statements.)

 

5



 

Notes to Consolidated Financial Statements

 

1.     In the opinion of the management of International Business Machines Corporation (the company), all adjustments, which are of a normal recurring nature, necessary to a fair statement of the results for the unaudited three-month periods have been made.

 

2.     As discussed in Note 3 below, the company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) in the first quarter.  Due to the timing of the issuance of the Securities and Exchange Commission Staff Accounting Bulletin No. 107 and the company’s subsequent adoption,  this expense was not part of the company’s management and measurement systems in the quarter.  Therefore, the results for the quarters ended March 31, 2005 and March 31, 2004 reflect the compensation charge with the exception of the segment results presented in this Form 10-Q.  Management will implement SFAS 123(R) in its management and measurement system and segment reporting going forward.

 

In addition, 2004 results have been restated in this Form 10-Q to reflect a subsequent event reported in IBM’s 2004 Annual Report.  See IBM’s 2004 Annual Report, “Subsequent Event”, page 12 for additional information.

 

3.     Effective January 1, 2005, the company adopted the provisions of SFAS 123(R). SFAS 123(R) establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the employee requisite service period.  The company previously applied Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). The company elected to adopt the modified retrospective application method as provided by SFAS 123(R) and accordingly, financial statement amounts for the prior period presented in this Form 10-Q have been restated to reflect the fair value method of expensing prescribed by SFAS 123(R).

 

The following table shows total stock-based compensation expense (see page 8 for types of stock-based awards) included in the Consolidated Statement of Earnings:

 

(Dollars in millions)
For the quarter ended March 31:

 

2005

 

2004

 

 

 

 

 

 

 

Cost

 

$

91

 

$

117

 

Selling general and administrative

 

165

 

230

 

Research development and engineering

 

30

 

49

 

Income tax benefits

 

(95

)

(120

)

Total stock-based compensation expense

 

$

191

 

$

276

 

 

 

As of March 31, 2005, $2,175 million of total unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted average period of 3 years.

 

There were no significant capitalized stock-based compensation costs at March 31, 2005 and 2004.

 

6



 

As previously discussed, the company elected to adopt SFAS 123(R) under the modified retrospective application method.  The company believes that the modified retrospective application of this standard achieves the highest level of clarity and comparability among the presented periods. Accordingly, financial statement amounts for the prior period presented in this Form 10-Q have been restated to reflect the fair value method of expensing prescribed by SFAS 123(R).

 

The following table details the retroactive application impact of SFAS 123(R)  on previously reported results:

 

(Dollars in millions, except per share amounts)
For the quarter ended March 31, 2004

 

Restated

 

As
previously reported

 

 

 

 

 

 

 

Income from continuing operations before taxes

 

$

1,950

 

$

2,290

 

Income from continuing operations

 

$

1,364

 

$

1,603

 

Net income

 

$

1,363

 

$

1,602

 

Earnings per share of common stock:

 

 

 

 

 

Basic earnings per share from continuing operations

 

$

0.81

 

$

0.95

 

Diluted earnings per share from continuing operations

 

$

0.79

 

$

0.93

 

 

 

 

 

 

 

Net cash provided by operating activities from continuing operations

 

$

3,632

 

$

3,661

 

Net cash used in financing activities from continuing operations

 

$

(1,681

)

$

(1,710

)

 

 

 

 

 

 

At December 31, 2004:

 

 

 

 

 

 

 

 

 

 

 

Deferred taxes

 

$

2,413

 

$

2,229

 

Total current assets

 

$

47,143

 

$

46,970

 

Investment and sundry assets

 

$

7,115

 

$

5,468

 

Total assets

 

$

111,003

 

$

109,183

 

 

 

 

 

 

 

Total current liabilities

 

$

39,786

 

$

39,798

 

Other liabilities

 

$

8,818

 

$

8,927

 

Total liabilities

 

$

79,315

 

$

79,436

 

 

 

 

 

 

 

Common stock and additional paid-in capital

 

$

26,673

 

$

18,355

 

Retained earnings

 

$

38,148

 

$

44,525

 

Total stockholders’ equity

 

$

31,688

 

$

29,747

 

Total liabilities and stockholders’ equity

 

$

111,003

 

$

109,183

 

 

7



 

Incentive Awards

 

Stock-based incentive awards are provided to employees under the terms of the company’s plans (the “Plans”). The Plans are administered by the Executive Compensation and Management Resources Committee of the Board of Directors (the “Committee”). Awards under the Plans may include at-the-money stock options, premium-priced stock options, restricted stock (units), performance share units, stock appreciation rights, cash or stock awards, or any combination thereof.  The non-management members of the IBM Board of Directors also receive stock options under a Plan (director stock option plan).

 

Restricted Stock Units (“RSUs”) are stock awards that are granted to employees and entitle the holder to shares of common stock as the award vests, typically over a two to five year period. The fair value of the awards is determined and fixed on the grant date based on the company’s stock price.

 

Performance Share Units (“PSUs”) are stock awards where the number of shares ultimately received by the employee depends on company performance against specified targets and typically vest over a three year period. The fair value of each PSU is determined on the date of grant, based on the fair value of the company’s stock, and assumes that performance targets will be achieved. Over the performance period, the number of shares of stock that will be issued is adjusted upward or downward based upon the probability of achievement of performance targets.  The ultimate number of shares issued and the related compensation cost recognized will be based on a comparison of the final performance metrics to the specified targets.

 

Stock options are awards which allow the employee to purchase shares of the company’s stock at a fixed price.  Stock options are granted at an exercise price equal to or greater than the company stock price at the date of grant. These awards, which vest 25 percent per year, are fully vested four years from the grant date and have a contractual term of ten years.  In 2004, the company implemented a new program for equity awards for its senior executives, designed to drive improved performance and increase the ownership executives have in the company.  Under this program, the company’s top executives now receive stock options priced at a 10 percent premium to the average market price of IBM stock on the grant date.  In addition, these executives have the opportunity to receive at-the-money options by agreeing to defer a certain percentage of their annual incentive compensation into IBM equity, where it is held for three years or until retirement.  These options become 100 percent vested three years from the date of grant and have a contractual term of ten years.

 

The following tables summarize option activity under the Plans during the first quarter of 2005:

 

 

 

WTD. AVG.
EXERCISE
PRICE

 

NO. OF
SHARES
UNDER
OPTION

 

WTD. AVG.
REMAINING
CONTRACTUAL
LIFE (IN YEARS)

 

Balance at December 31, 2004

 

$

 89

 

249,347,906

 

 

 

Options granted

 

101

 

11,736,944

 

 

 

Options exercised

 

39

 

(4,443,135

)

 

 

Options canceled/expired

 

91

 

(1,854,516

)

 

 

Balance at March 31, 2005

 

$

90

 

254,787,199

 

6

 

 

 

 

 

 

 

 

 

Exercisable at March 31, 2005

 

$

91

 

168,972,412

 

5

 

 

8



 

The shares under option at March 31, 2005, were in the following exercise price ranges:

 

 

 

OPTIONS OUTSTANDING

 

OPTIONS CURRENTLY
EXERCISABLE

 

EXERCISE
PRICE
RANGE

 

WTD. AVG.
EXERCISE
PRICE

 

NO. OF
OPTIONS

 

AGGREGATE
INTRINSIC
VALUE

 

WTD. AVG.
EXERCISE
PRICE

 

NO. OF
OPTIONS

 

AGGREGATE
INTRINSIC
VALUE

 

$18-$60

 

$

48

 

41,712,278

 

$

1,800,508,607

 

$

45

 

35,377,563

 

$

1,608,368,895

 

$61-$85

 

77

 

54,481,476

 

735,084,788

 

76

 

22,514,671

 

337,161,966

 

$86-$105

 

98

 

91,559,817

 

20,371,591

 

98

 

49,691,695

 

16,812,784

 

$106 and over

 

117

 

67,033,628

 

 

117

 

61,388,483

 

 

 

 

$

90

 

254,787,199

 

$

2,555,964,986

 

$

91

 

168,972,412

 

$

1,962,343,645

 

 

In connection with the adoption of SFAS 123(R), the company reassessed its valuation technique and related assumptions.  The company estimates the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of SFAS 123(R), Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 107 and the company’s prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS 123). Key input assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the company’s stock, the risk-free rate and the company’s dividend yield. The company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in estimating the fair values of IBM stock options granted in the quarter ended March 31, 2005 and are consistent with those used in prior periods as disclosed in the footnotes to the 2004 IBM Annual Report.  Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the company under SFAS 123(R).

 

The fair value of stock option grants was estimated using a Black-Scholes valuation model with the following assumptions:

 

For the quarter ended March 31:

 

2005

 

2004

 

Option term (years)*

 

5

 

5

 

Volatility**

 

34.9

%

38.6

%

Risk-free interest rate (zero coupon U.S. treasury note)

 

4.04

%

2.9

%

Dividend yield

 

0.8

%

0.7

%

Weighted-average fair value per option granted

 

$

29

 

$

35

 

 


*      The option term is the number of years that the company estimates, based primarily on history, that options will be outstanding prior to settlement.

 

**   Measured using historical daily price changes of the company’s stock over the respective term of the option.

 

The weighted average fair value of options granted during the quarter ended March 31, 2005 declined, when compared to the corresponding quarter of the prior year.  This decrease was the result of a lower stock price on the grant date in 2005 and a greater number of premium priced stock options granted in the first quarter of 2005, which generally have a lower fair value.

 

9



 

Exercises of employee stock options

 

The total intrinsic value of options exercised during the three month periods ended March 31, 2005 and 2004, was $242 million and $311 million, respectively. The total cash received from employees as a result of employee stock option exercises for the quarters ended March 31, 2005 and 2004 was approximately $178 million and $237 million, respectively.  In connection with these exercises, the tax benefits realized by the company for the quarters ended March 31, 2005 and 2004 were $76 million and $106 million, respectively.

 

The company settles employee stock option exercises primarily with newly issued common shares and, occasionally, with treasury shares. Total treasury shares held at March 31, 2005 were approximately 355 million shares.

 

IBM Employees Stock Purchase Plan

 

The Company maintains an Employees Stock Purchase Plan (ESPP). The ESPP enables eligible participants to purchase full or fractional shares of IBM common stock through payroll deductions of up to 10 percent of eligible compensation. The ESPP provides for offering periods during which shares may be purchased and continues as long as shares remain available under the ESPP, unless terminated earlier at the discretion of the Board of Directors. The share price paid by an employee shall not be lower than the lesser of 85 percent of the average market price on the first business day of each offering period or 85 percent of the average market price on the last business day of each pay period. Individual ESPP participants are restricted from purchasing more than $25,000 of common stock in one calendar year or 1,000 shares in an offering period. Prior to April 1, 2005, the ESPP was compensatory.

 

Effective April 1, 2005, eligible participants may purchase full or fractional shares of IBM common stock under the ESPP at a five percent discount off the average market price on the day of purchase.  In accordance with the provisions of SFAS 123(R), effective April 1, 2005, the ESPP is not compensatory.

 

 

10



 

4.     The following table summarizes Net income plus gains and losses not affecting retained earnings.

 

(Dollars in millions)

 

Three Months Ended
March 31,

 

 

 

2005

 

2004

 

Net income

 

$

1,402

 

$

1,363

 

Gains and losses not affecting retained earnings (net of tax):

 

 

 

 

 

Foreign currency translation adjustments

 

(472

)

(173

)

Minimum pension liability adjustments

 

(1

)

55

 

Net unrealized gains on marketable securities

 

12

 

28

 

Net unrealized gains on cash flow hedge derivatives

 

359

 

193

 

Total net (losses)/gains not affecting retained earnings

 

(102

)

103

 

Net income plus gains and losses not affecting retained earnings

 

$

1,300

 

$

1,466

 

 

5.     As discussed on pages 40 and 41, the American Jobs Creation Act of 2004 (the Act) introduces a temporary incentive for the company to repatriate earnings accumulated outside the U.S.  In the fourth quarter of 2004, the company adopted the provisions of FASB Staff Position (FSP) No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.”  According to FSP FAS 109-2, the company is allowed time beyond the financial reporting period of enactment to evaluate the effects of the Act on its plan for repatriation of foreign earnings for purposes of applying SFAS No. 109, “Accounting for Income Taxes.” The company has not yet completed its evaluation of the possible effect of the Act on its plan for repatriation of foreign earnings. Accordingly, the company has not adjusted its income tax expense or deferred tax liability as of March 31, 2005 to reflect the possible effect of the new repatriation provision.  Income tax expense, if any, associated with any repatriation under the Act will be provided in the company’s financial statements in the reporting period in which the required management and Board of Directors approvals have been completed.

 

In March 2005, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (FIN 47).  FIN 47 clarifies that conditional asset retirement obligations meet the definition of liabilities and should be recognized when incurred if their fair values can be reasonably estimated. The Interpretation is effective no later than December 31, 2005. The cumulative effect of initially applying the Interpretation will be recognized as a change in accounting principle. The company is in the process of evaluating the expected effect of FIN 47 on its Consolidated Financial Statements.

 

 

11



 

6.     The company offers defined benefit pension plans, defined contribution pension plans, as well as nonpension postretirement plans primarily consisting of retiree medical benefits.  The following table provides the total retirement-related benefit plans’ impact on income before income taxes.

 

(Dollars in millions)
For the three months ended March 31:

 

2005

 

2004

 

Yr. to Yr.
Percent
Change

 

Retirement-related plans - cost:

 

 

 

 

 

 

 

Defined benefit and contribution pension plans - cost

 

$

456

 

$

199

 

129.1

%

Nonpension postretirement benefits costs

 

93

 

103

 

(9.7

)

Total

 

$

549

 

$

302

 

81.8

%

 

The following table provides the components of the cost/(income) for the company’s pension plans.

 

Cost/(Income) of Pension Plans

 

(Dollars in millions)
Three Months Ended March 31:

 

U.S. Plans

 

Non-U.S. Plans 

 

 

2005

 

2004

 

2005

 

2004

 

Service cost

 

$

 175

 

$

 160

 

$

 180

 

$

 153

 

Interest cost

 

615

 

612

 

425

 

406

 

Expected return on plan assets

 

(918

)

(904

)

(585

)

(595

)

Amortization of transition assets

 

 

(18

)

(1

)

(2

)

Amortization of prior service cost

 

15

 

15

 

17

 

9

 

Recognized actuarial losses

 

144

 

53

 

133

 

49

 

Net periodic pension cost/(income)—U.S. Plan and material non-U.S. Plans

 

31

*

(82

)*

169

**

20

**

Cost of other defined benefit plans

 

32

 

34

 

35

 

34

 

Total net periodic pension cost/(income) for all defined benefit plans

 

63

 

(48

)

204

 

54

 

Cost of defined contribution plans

 

103

 

101

 

86

 

92

 

Total retirement plan cost recognized in the Consolidated Statement of Earnings

 

$

166

 

$

53

 

$

290

 

$

146

 

 


*    Represents the qualified portion of the IBM Personal Pension Plan.

**  Represents the qualified and non-qualified portion of material non-U.S. plans.

 

In 2005, the company expects to contribute to its material non-U.S. Defined Benefit Plans an amount of between $361 million and $583 million.  The legally mandated minimum contribution included in the amount above for the company’s non-U.S. plans is expected to be $361 million.  In the first quarter of 2005, the company contributed approximately $86 million to its non-U.S. plans.  In addition, the company contributed $1.7 billion to the qualified portion of the IBM Personal Pension Plan (PPP) in January 2005.

 

12



 

The following table provides the components of the cost for the company’s nonpension postretirement benefits.

 

Cost of Nonpension Postretirement Benefits

 

(Dollars in millions)

 

Three Months Ended
March 31,

 

 

 

2005

 

2004

 

 

 

 

 

 

 

Service cost

 

$

12

 

$

10

 

Interest cost

 

80

 

88

 

Amortization of prior service cost

 

(16

)

(16

)

Recognized actuarial losses

 

6

 

9

 

Net periodic postretirement benefit cost - U.S. Plan

 

82

 

91

 

Cost of non-U.S. Plans

 

11

 

12

 

Total nonpension postretirement plan cost recognized in the Consolidated Statement of Earnings

 

$

93

 

$

103

 

 

The Medicare Prescription Drug Improvement and Modernization Act of 2003 did not have a material impact on the company’s Consolidated Financial Statements as of or for the period ended March 31, 2005.

 

7.     The changes in the carrying amount of goodwill, by external reporting segment, for the quarter ended March 31, 2005, are as follows:

 

(Dollars in millions)
Segment

 

Balance
12/31/04

 

Goodwill
Additions

 

Purchase
Price
Adjustments

 

Divestitures

 

Foreign
Currency
Translation
and Other
Adjustments

 

Balance
3/31/05

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Global Services

 

$

5,171

 

$

217

 

$

(8

)

$

 

$

(111

)

$

5,269

 

Systems and

 

 

 

 

 

 

 

 

 

 

 

 

 

Technology Group

 

169

 

 

 

 

 

169

 

Personal Systems Group

 

76

 

 

 

 

 

76

 

Software

 

3,021

 

64

 

(4

)

 

(2

)

3,079

 

Global Financing

 

 

 

 

 

 

 

Enterprise Investments

 

 

 

 

 

 

 

Total

 

$

8,437

 

$

281

 

$

(12

)

$

 

$

(113

)

$

8,593

 

 

There were no goodwill impairment losses recorded during the quarter.

 

13



 

The following schedule details the company’s intangible asset balances by major asset class:

 

 

 

At March 31, 2005

 

(Dollars in millions)
Intangible asset class

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Net Carrying
Amount

 

 

 

 

 

 

 

 

 

Capitalized software

 

$

1,704

 

$

(768

)

$

936

 

Client-related

 

842

 

(368

)

474

 

Completed technology

 

338

 

(200

)

138

 

Strategic alliances

 

1 04

 

(52

)

52

 

Patents/Trademarks

 

33

 

(13

)

20

 

Other(a)

 

244

 

(125

)

119

 

Total

 

$

3,265

 

$

(1,526

)

$

1,739

 

 

 

 

At December 31, 2004

 

(Dollars in millions)
Intangible asset class

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Net Carrying
Amount

 

 

 

 

 

 

 

 

 

Capitalized software

 

$

1,565

 

$

(680

)

$

885

 

Client-related

 

861

 

(335

)

526

 

Completed technology

 

364

 

(206

)

158

 

Strategic alliances

 

104

 

(47

)

57

 

Patents/Trademarks

 

33

 

(11

)

22

 

Other(a) 

 

247

 

(106

)

141

 

Total

 

$

3,174

 

$

(1,385

)

$

1,789

 

 


(a) Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems, and impacts from currency translation.

 

The net carrying amount of intangible assets decreased $50 million during the first quarter of 2005, primarily due to the amortization of acquired intangibles, partially offset by increases in capitalized software.  The aggregate intangible amortization expense was $250 million and $239 million for the quarters ended March 31, 2005 and 2004, respectively.

 

The amortization expense for each of the five succeeding years relating to intangible assets currently recorded in the Consolidated Statement of Financial Position is estimated to be the following at March 31, 2005:

 

2005 (for Q2-Q4)

 

$

688 million

 

2006

 

$

534 million

 

2007

 

$

312 million

 

2008

 

$

98 million

 

2009

 

$

70 million

 

 

14



 

8.     During the three months ended March 31, 2005, the company completed 3 acquisitions at an aggregate cost of $320 million. The acquisitions were Corio, Inc. (Corio) for $211 million, SRD for $69 million and Equitant for $40 million.

 

Corio is a publicly-held enterprise application service provider that delivers best-of-breed enterprise applications over a secure global network for a fixed monthly fee.  The acquisition strengthens the company’s application services offerings and helps companies manage rising costs, increasing complexity and regulatory compliance issues as they implement and manage enterprise software in today’s environment.

 

SRD is a privately-held provider of analytics software that increases business insight by delivering an accurate view into individuals and business relationships in near real-time.

 

Equitant is a business transformation outsourcing provider that focuses on the management and optimization of the order-to-cash cycle for large global companies.  The acquisition enables the company to build additional capabilities to address opportunities in the Business Performance Transformation Services marketplace.

 

Purchase price consideration was paid primarily in cash and includes certain amounts subject to holdbacks that expire with the passage of time.  These acquisitions are disclosed in the Consolidated Statement of Cash Flows net of acquired cash and cash equivalents.

 

The table below presents the purchase price related to the acquisitions and purchase price allocations as of March 31, 2005:

 

(Dollars in millions)

 

Amortization
Life (yrs.)

 

Purchase
Price

 

Current assets

 

 

 

$

50

 

Fixed assets/non-current

 

 

 

18

 

Intangible assets:

 

 

 

 

 

Goodwill

 

N/A

 

281

 

Completed technology

 

3

 

9

 

Client relationships

 

5

 

1

 

Total assets acquired

 

 

 

359

 

Current liabilities

 

 

 

(25

)

Non-current liabilities

 

 

 

(14

)

Total liabilities assumed

 

 

 

(39

)

Total purchase price

 

 

 

$

320

 

 

The acquisitions were accounted for as purchase transactions, and accordingly, the assets and liabilities of the acquired entities were recorded at their estimated fair values at the date of acquisition. The primary items that generated the goodwill are the value of the synergies between the acquired companies and IBM and the acquired assembled workforce, neither of which qualify as an amortizable intangible asset. None of the goodwill is deductible for tax purposes.  The overall weighted-average life of the identified amortizable intangible assets acquired is 3.2 years.  With the exception of goodwill, these identified intangible assets will be

 

15



 

amortized on a straight-line basis over their useful lives.  Goodwill of $281 million has been assigned to the Software ($64 million) and Global Services ($217 million) segments.

 

9.     The tables on pages 57 and 58 of this Form 10-Q reflect the results of the company’s segments consistent with the management system used by the company’s chief operating decision maker. These results are not necessarily a depiction that is in conformity with generally accepted accounting principles (GAAP). For example, employee retirement plan costs are developed using actuarial assumptions on a country-by-country basis and allocated to the segments based on headcount. A different result could occur for any segment if actuarial assumptions unique to each segment were used. Performance measurement is based on income before income taxes (pre-tax income). These results are used, in part, by management, both in evaluating the performance of, and in allocating resources to, each of the segments.

 

The individual segment results do not include the effect of the adoption of SFAS No. 123(R), “Share-Based Payment.”  The impact of this change is shown in the reconciliation to IBM as Reported on page 57.

 

On April 20, 2005, the company announced that the Printing Systems Division and Retail Store Solutions (divisions of the Personal Systems Group segment) will become part of the Systems and Technology Group.

 

The segment information, on pages 57 and 58, for the quarters ended March 31, 2005 and March 31, 2004 does not include this organizational change.  In this Form 10-Q, these units are reported as part of the company's Personal Systems Group, consistent with the company's measurement and management system in the quarters reported.

 

16



 

10.   The following table provides the liability balances for actions taken in the second-quarter of 2002 associated with the Microelectronics Division and the rebalancing of both the company’s workforce and leased space resources, fourth-quarter 2002 actions associated with the acquisition of the PricewaterhouseCoopers consulting business, the 2002 actions associated with the hard disk drive (HDD) business for reductions in workforce, manufacturing capacity and space, actions in 1999, and actions that took place through 1993.

 

(Dollars in millions)

 

Liability
as of
12/31/2004

 

Payments

 

Other Adj. *

 

Liability
as of
3/31/2005

 

 

 

 

 

 

 

 

 

 

 

Current:

 

 

 

 

 

 

 

 

 

Workforce

 

$

139

 

$

35

 

$

18

 

$

122

 

Space

 

86

 

20

 

10

 

76

 

Other

 

9

 

2

 

 

7

 

Total

 

$

234

 

$

57

 

$

28

 

$

205

 

Non-current:

 

 

 

 

 

 

 

 

 

Workforce

 

$

543

 

$

 

$

(39

)

$

504

 

Space

 

244

 

 

(19

)

225

 

Total

 

$

787 

 

$

 

$

(58)

 

$

729

 

 


* The other adjustments column in the table above includes the reclassification of non-current to current as well as foreign currency translation adjustments.  In addition, net adjustments of approximately $7 million were made in the first quarter of 2005 to reduce previously recorded liabilities.  These net adjustments were for changes in the estimated cost of employee terminations and vacant space for the 2002 actions ($6 million), and actions prior to 1999 ($1 million).  Of the $7 million of net adjustments,  $8 million credit is included in Other (income) and expense and a $1 million debit is included in Selling, general and administrative expense in the Consolidated Statement of Earnings.

 

11.   The company is involved in a variety of claims, suits, investigations and proceedings that arise from time to time in the ordinary course of its business, including actions with respect to contracts, intellectual property (IP), product liability, employment, securities, and environmental matters. The following is a discussion of some of the more significant legal matters involving the company.

 

On July 31, 2003, the U.S. District Court for the Southern District of Illinois, in Cooper et al. vs. The IBM Personal Pension Plan and IBM Corporation, held that the company ‘s pension plan violated the age discrimination provisions of the Employee Retirement Income Security Act of 1974 (ERISA). On September 29, 2004, the company announced that IBM and plaintiffs agreed in principle to resolve certain claims in the litigation. Under the terms of the agreement, plaintiffs will receive an incremental pension benefit in exchange for the settlement of some claims, and a stipulated remedy on remaining claims if plaintiffs prevail on appeal. Under the terms of the settlement, the judge will issue no further rulings on remedies. This settlement, together with a previous settlement of a claim referred to as the partial plan termination claim resulted in the company taking a one-time charge of $320 million in the third quarter of 2004.

 

This agreement ends the litigation on all claims except the two claims associated with IBM’s cash balance formula. The company will appeal the rulings on these claims. The company

 

17



 

continues to believe that its pension plan formulas are fair and legal. The company has reached this agreement in the interest of the business and the company shareholders, and to allow for a review of its cash balance formula by the Court of Appeals. The company continues to believe it is likely to be successful on appeal.

 

The agreement stipulates that if the company is not successful on appeal of the two remaining claims, the agreed remedy will be increased by up to $1.4 billion — $780 million for the claim that the company’s cash balance formula is age discriminatory, and $620 million for the claim that the method used to establish opening account balances during the 1999 conversion discriminated on the basis of age (referred to as the “always cash balance “ claim). The maximum additional liability the company could face in this case if it is not successful on appeal is therefore capped at $1.4 billion.

 

In the coming months, class members will receive formal notice of the settlement and the judge will hold a fairness hearing. Once the settlement is approved, IBM will appeal the liability rulings for the cash balance claims. As a result, the entire process could take up to 2 years before reaching final conclusion.

 

On March 21, 2005, the company and the Compuware Corporation entered into a business relationship as part of an agreement that settled all outstanding litigation matters between the parties. Under this relationship, the company will, over a four year period, license $140 million of software and offer to procure $260 million of selected services from Compuware to be used in the company’s Global Services business.  In the fourth quarter of 2004, the company established a provision for this suit, which fully covers the company’s remaining liability under this settlement agreement with respect to the software commitment.

 

The company is a defendant in an action filed on March 6, 2003 in state court in Salt Lake City, Utah by The SCO Group. The company removed the case to Federal Court in Utah. Plaintiff is successor in interest to some of AT&T’s Unix IP rights, and alleges copyright infringement, unfair competition, interference with contract and breach of contract with regard to the company’s distribution of AIX and contribution of unspecified code to Linux. The company has asserted counterclaims, including breach of contract, violation of the Lanham Act, unfair competition, intentional torts, unfair and deceptive trade practices, breach of the General Public License that governs open source distributions, patent infringement, promissory estoppel and copyright infringement. Trial was scheduled for November 1, 2005 but the scheduling order has been suspended and is under revision.

 

On June 2, 2003 the company announced that it received notice of a formal, nonpublic investigation by the Securities and Exchange Commission (SEC). The SEC is seeking information relating to revenue recognition in 2000 and 2001 primarily concerning certain types of client transactions. The company believes that the investigation arises from a separate investigation by the SEC of Dollar General Corporation, a client of the company’s Retail Stores Solutions unit, which markets and sells point of sale products.

 

On January 8, 2004, the company announced that it received a “Wells Notice” from the staff of the SEC in connection with the staff’s investigation of Dollar General Corporation, which as noted above, is a client of the company’s Retail Stores Solutions unit. It is the company’s understanding that an employee in the company’s Sales & Distribution unit also

 

 

18



 

received a Wells Notice from the SEC in connection with this matter. The Wells Notice notifies the company that the SEC staff is considering recommending that the SEC bring a civil action against the company for possible violations of the U.S. securities laws relating to Dollar General’s accounting for a specific transaction, by participating in and aiding and abetting Dollar General’s misstatement of its 2000 results. In that transaction, the company paid Dollar General $11 million for certain used equipment as part of a sale of IBM replacement equipment in Dollar General’s 2000 fourth fiscal quarter. Under the SEC’s procedures, the company responded to the SEC staff regarding whether any action should be brought against the company by the SEC. The separate SEC investigation noted above, relating to the recognition of revenue by the company in 2000 and 2001 primarily concerning certain types of client transactions, is not the subject of this Wells Notice.

 

In January 2004, the Seoul District Prosecutors Office in South Korea announced it had brought criminal bid rigging charges against several companies, including IBM Korea and LG IBM (a joint venture between IBM Korea and LG Electronics) and had also charged employees of some of those entities with, among other things, bribery of certain officials of government-controlled entities in Korea, and bid rigging. IBM Korea and LG IBM cooperated fully with authorities in these matters. A number of individuals, including former IBM Korea and LG IBM employees, were subsequently found guilty and sentenced. IBM Korea and LG IBM were also required to pay fines. IBM Korea has been debarred from doing business directly with certain government controlled entities in Korea. The orders, imposed at different times, cover a period of no more than a year from the date of issuance. The orders do not prohibit IBM Korea from selling products and services to business partners who sell to government controlled entities in Korea. In addition, the U.S. Department of Justice and the SEC have both contacted the company in connection with this matter.

 

The company is party to, or otherwise involved in, proceedings brought by U.S. federal or state environmental agencies under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), known as “Superfund,” or laws similar to CERCLA. Such statutes require potentially responsible parties to participate in remediation activities regardless of fault or ownership of sites. The company is also conducting environmental investigations or remediations at or in the vicinity of several current or former operating sites pursuant to permits, administrative orders or agreements with state environmental agencies, and is involved in lawsuits and claims concerning certain current or former operating sites.

 

In accordance with SFAS No. 5, “Accounting for Contingencies,” the company records a provision with respect to a claim, suit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Any provisions are reviewed at least quarterly and are adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information pertinent to a particular matter. Any recorded liabilities for the above items, including any changes to such liabilities for the three months ended March 31, 2005, were not material to the Consolidated Financial Statements. Based on its experience, the company believes that the damage amounts claimed in the matters referred to above are not a meaningful indicator of the potential liability. Litigation is inherently uncertain and it is not possible to predict the ultimate outcome of the matters previously discussed. While the company will continue to defend itself vigorously in all such matters, it is possible that the company’s business, financial condition, results of operations, or cash flows could be affected in any particular period by the resolution of one or more of these matters.

 

19



 

Whether any losses, damages or remedies finally determined in any such claim, suit, investigation or proceeding could reasonably have a material effect on the company’s business, financial condition, results of operations, or cash flow will depend on a number of variables, including the timing and amount of such losses or damages, the structure and type of any such remedies, the significance of the impact any such losses, damages or remedies may have on the company’s Consolidated Financial Statements, and the unique facts and circumstances of the particular matter which may give rise to additional factors.

 

12.   The company’s extended lines of credit include unused amounts of $3,160 million and $2,714 million at March 31, 2005 and December 31, 2004, respectively.  A portion of these amounts was available to the company’s business partners to support their working capital needs. In addition, the company committed to provide future financing to its customers in connection with customer purchase agreements for approximately $1,902 million and $1,686 million at March 31, 2005 and December 31, 200 4, respectively.

 

The company has applied the disclosure provisions of FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” to its agreements that contain guarantee or indemnification clauses. These disclosure provisions expand those required by SFAS No. 5, “Accounting for Contingencies”, by requiring a guarantor to disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. The following is a description of arrangements in which the company is the guarantor.

 

The company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the company, under which the company customarily agrees to hold the party harmless against losses arising from a breach of representations and covenants related to such matters as title to the assets sold, certain IP rights, specified environmental matters, and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making an adverse claim pursuant to the procedures specified in the particular contract, which procedures typically allow the company to challenge the other party’s claims. Further, the company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the company may have recourse against third parties for certain payments made by the company.

 

It is not possible to predict the maximum potential amount of future payments under these or similar agreements, due to the conditional nature of the company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the company under these agreements did not have a material effect on the company’s business, financial condition or results of operations.  The company believes that if it were to incur a loss in any of these matters, such loss would not have a material effect on the company’s business, financial condition or results of operations.

 

 

20



 

In addition, the company guarantees certain loans and financial commitments. The maximum potential future payment under these financial guarantees was $55 million and $58 million at March 31, 2005 and December 31, 2004, respectively.

 

Changes in the company’s warranty liability balance are presented in the following table:

 

(Dollars in millions)

 

2005

 

2004

 

Balance at January 1

 

$

944

 

$

780

 

Current period accruals

 

219

 

205

 

Accrual adjustments to reflect actual experience

 

6

 

28

 

Charges incurred

 

(223

)

(207

)

Balance at March 31

 

$

946

 

$

806

 

 

The increase in the balance was primarily driven by increased warranty activity associated with personal computers due to increased sales volumes throughout 2004 and the first quarter of 2005.

 

13.   Subsequent Events:

 

On April 26, 2005, the company announced that the Board of Directors approved an increase in the quarterly dividend of 11.1 percent from $0.18 to $0.20 per common share.  The dividend is payable June 10, 2005, to shareholders of record on May 10, 2005.

 

On April 26, 2005, the company announced that the Board of Directors authorized the company to repurchase up to an additional $5.0 billion of IBM common shares.  The company plans to repurchase the shares in the open market or in private transactions from time to time, based on market conditions.

 

21



 

 

ITEM 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
FOR THE THREE MONTHS ENDED MARCH 31, 2005*

 

Snapshot

 

(Dollars in millions except per share amounts)
Three months ended March 31:

 

2005

 

2004** 

 

Yr. To Yr.
Percent/
Margin
Change

 

Revenue

 

$

22,908

 

$

22,175

 

3.3

%+

Gross profit margin

 

36.0

%

35.6

%

0.4

pts.

Total expense and other income

 

$

6,244

 

$

5,942

 

5.1

 %

Total expense and other income to revenue ratio

 

27.3

%

26.8

%

0.5

pts 

Provision for income taxes

 

$

603

 

$

586

 

2.8

 %

Income from continuing operations

 

$

1,407

 

$

1,364

 

3.2

 %

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

0.85

 

$

0.79

 

7.6

 %

Basic

 

$

0.86

 

$

0.81

 

6.2

 %

Weighted average shares outstanding:

 

 

 

 

 

 

 

Assuming dilution

 

1,660.6

 

1,727.4

 

(3.9%

)

Basic

 

1,628.7

 

1,691.7

 

(3.7%

)

 

 

 

3/31/05

 

12/31/04**

 

 

 

Assets

 

$

104,899

 

$

111,003

 

(5.5%

)

Liabilities

 

$

74,979

 

$

79,315

 

(5.5%

)

Equity

 

$

29,920

 

$

31,688

 

(5.6%

)

 


* The following Results of Continuing Operations discussion does not include the HDD business that the company sold to Hitachi, Ltd. on December 31, 2002. The HDD business was accounted for as a discontinued operation under generally accepted accounting principles.  Loss from Discontinued Operations for the three-months ended March 31, 2005 and 2004 was $5 million and $1 million, respectively.

** Restated to include the impact of share-based compensation expense.

 

The selected reference to “adjusting for currency” in the Management Discussion is made so that the financial results can be viewed without the impacts of changing foreign currency exchange rates and therefore facilitates a comparative view of business growth. In the first quarter of 2005, the U.S. dollar was generally weaker against other currencies compared to the first quarter of 2004, so growth rates that are adjusted for currency exchange rates were lower than growth at actual currency exchange rates.

+  0.7 percent adjusting for currency

 

Total revenue increased 3 percent as reported, 1 percent adjusting for currency.  Pre-tax income was $2 billion, up 3 percent versus the first quarter of 2004.  Diluted earnings per share from continuing operations of $0.85 was an 8 percent improvement year-to-year.  Diluted earnings per share included an incremental $0.10 impact related to equity compensation, based

 

 

22



 

on the company’s implementation in the first quarter of SFAS 123(R), compared to $0.14 in the first quarter of 2004.

 

The first quarter of 2005 had a strong start but did not play out as the company expected.  The company experienced a significant drop-off in March when monthly revenue declined versus March 2004.  Given the skew of business within the quarter, the March shortfall significantly impacted the first quarter’s overall growth rate and profitability.

 

There were some specific items that impacted the results:

 

                  First, the company's Global Services segment did not meet expectations in the quarter.  Contributing to the shortfall was a decline in short-term signings, that impacted not only the total reported signings, but also the company’s revenue and profit.

                  Second, the company experienced an elongated sales cycle in a few of its product areas due to both sales execution and customer deferrals.  The company always has transactions that don’t close, however more than a normal level of transactions slipped this quarter.

                  Third, while the company had good customer acceptance of its new storage products, the company’s results were impacted by late product availability.

 

This quarter, the business fell off very late in the period, and while the company was able to take some actions to improve performance, it was not able to deliver to the level that it had planned.

 

To put this in perspective:

 

                  The annuity-like stream of revenue and profit provided stability, even when the transaction business fell off.

                  The company’s products remained extremely competitive.

                  The company is taking actions to address the issues and improve its overall performance.

 

The gross profit margin was 36.0 percent, an improvement of 0.4 points versus the prior year.  Total expense and other income increased primarily due to increased expense for retirement-related plans and currency impact.  The ratio of Total expense and other income to revenue increased by 0.5 points.

 

The company’s effective tax rate for the first three months of 2005 and 2004 was 30.0 percent and 30.1 percent, respectively.

 

Assets declined $6.1 billion, primarily driven by a reduction in receivables of $4.7 billion related to the collection of higher year-end revenue amounts.

 

Cash and cash equivalents declined $1.4 billion, driven by the company’s U.S. pension plan contribution of $1.7 billion in January 2005.

 

Global Services signings were $10.0 billion for the quarter, down 4.5 percent compared to the first quarter of 2004.  The estimated Global Services backlog ended at $110 billion, versus an estimated backlog of $111 billion at December 31, 2004.

 

23



 

Quarter in Review

 

Results of Continuing Operations

 

Revenue

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr. to Yr.
Percent
Change

 

Yr. to Yr.
Percent
Change
Adjusting
for
Currency

 

 

 

 

 

 

 

 

 

 

 

Statement of Earnings Revenue Presentation:

 

 

 

 

 

 

 

 

 

Global Services

 

$

11,696

 

$

11,024

 

6.1

%

3.3

%

Hardware

 

6,749

 

6,735

 

0.2

 

(2.1

)

Software

 

3,551

 

3,466

 

2.4

 

(0.3

)

Global Financing

 

580

 

662

 

(12.5

)

(14.6

)

Enterprise Investments/Other

 

332

 

288

 

15.2

 

11.8

 

Total

 

$

22,908

 

$

22,175

 

3.3

%

0.7

%

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004*

 

Yr. to Yr.
Percent
Change

 

Yr. to Yr.
Percent
Change
Adjusting
for
Currency

 

 

 

 

 

 

 

 

 

 

 

Industry Sector**:

 

 

 

 

 

 

 

 

 

Financial Services

 

$

5,723

 

$

5,507

 

3.9

%

1.0

%

Public

 

3,369

 

3,253

 

3.6

 

1.1

 

Industrial

 

2,997

 

3,042

 

(1.5

)

(4.2

)

Distribution

 

2,186

 

2,086

 

4.8

 

2.1

 

Communications

 

2,085

 

2,063

 

1.1

 

(1.3

)

Small & Medium

 

5,110

 

4,769

 

7.2

 

4.3

 

OEM

 

691

 

671

 

2.9

 

2.8

 

Other

 

747

 

784

 

(4.7

)

(6.7

)

Total

 

$

22,908

 

$

22,175

 

3.3

%

0.7

%

 


*            Reclassified to conform with 2005 presentation.

**     The majority of the company’s enterprise business, which excludes the company’s original equipment manufacturer (OEM) technology business, occurs in industries that are broadly grouped into six sectors around which the company’s sales and distribution activities, as well as an increasing number of its services and products businesses are organized. The majority of the businesses in the Small & Medium category have fewer than 1,000 employees.

 

 

24



 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr.to Yr.
Percent
Change

 

Yr. To Yr.
Percent
Change
Adjusting for
Currency

 

 

 

 

 

 

 

 

 

 

 

Geographies:

 

 

 

 

 

 

 

 

 

Americas

 

$

9,297

 

$

9,097

 

2.2

%

1.2

%

Europe/Middle East/Africa

 

7,734

 

7,251

 

6.7

 

1.8

 

Asia Pacific

 

5,186

 

5,156

 

0.6

 

(2.1

)

OEM

 

691

 

671

 

2.9

 

2.8

 

Total

 

$

22,908

 

$

22,175

 

3.3

%

0.7

%

 

Revenue from four of the five industry sectors, as well as Small and Medium Business increased in the first quarter of 2005 when compared to the first quarter of 2004, on an as-reported basis, reflecting the company’s continuing go-to-market strategy of designing industry and client-specific solutions.  Revenue from Small & Medium Business led the growth in the first quarter, with growth in all geographies.  The Financial Services sector growth was primarily driven by growth in Banking (6 percent), while the Public sector revenue growth was primarily driven by Health (15 percent) and Government in the Americas (3 percent).  The Communications sector revenue increase was driven by increased revenue in Telecommunications (4 percent), while the Distribution sector revenue growth was driven by Travel and Transportation (16 percent).

 

Revenue increased slightly in all geographies, except Asia Pacific, after adjusting for currency.  There were four major countries that had revenue declines after adjusting for currency. Japan declined 4 percent, Germany 8 percent, France 3 percent and Italy 7 percent. Together these countries represent over a quarter of the company’s revenue, and they were down 5 percent in the quarter.

 

These four countries are all facing economic challenges, and spending has lagged other countries.  In light of this environment, the company has been looking at its structure and operating model to ensure that it serves its clients in the most efficient and effective way possible.  This includes reexamining its operations and organizational structure in Europe. This activity created some sales execution disruption toward the end of the quarter.

 

Helping to offset these challenges is the company’s continued pattern of revenue growth in emerging countries.  China (6 percent), Russia (33 percent), India (45 percent) and Brazil (24 percent) together grew 18 percent in the first quarter to over $1 billion.  The company will continue to shift investments to these areas to better address these important markets.

 

Global Services revenue increased 6.1 percent year-to-year; however, contrary to the trend the company saw in the second half of 2004, short-term signings declined more rapidly than long-term signings, which resulted in a deceleration in the revenue growth rate from 2004 quarterly periods.

 

25



 

Revenue was essentially flat for Hardware as pSeries server revenue grew 11.6 percent, xSeries revenue growth decelerated to 8.2 percent and iSeries server revenue returned to growth increasing 0.8 percent.  Storage products revenue increased 5.1 percent despite late availability of the company’s new products.  These increases were offset by an expected decline in zSeries server revenue, following a strong first half of 2004, and lower personal computer revenue which was impacted by the pending sale of this business to Lenovo Group.

 

Software revenue increased 2.4 percent as results were consistent with the company’s performance in the second half of 2004.  Total Middleware software increased 2.9 percent, driven by strong growth in many of the company’s strategic offerings.  Operating Systems products declined 2.2 percent.

 

Global Financing revenue declined in the first quarter of 2005 versus the first quarter of 2004 primarily due to a decline in the income-generating asset base and lower external used equipment sales.  See pages 43 to 49 for additional information regarding Global Financing results.

 

The following table presents each segment’s revenue as a percentage of the company’s total:

 

For the period ended March 31:

 

2005

 

2004

 

Global Services

 

51.1

%

49.7

%

Hardware

 

29.5

 

30.4

 

Software

 

15.5

 

15.6

 

Global Financing

 

2.5

 

3.0

 

Enterprise Investments/Other

 

1.4

 

1.3

 

Total

 

100.0

%

100.0

%

 

Gross Profit

 

For the period ended March 31:

 

2005

 

2004

 

Yr. To Yr
Change

 

 

 

 

 

 

 

 

 

Gross Profit Margin:

 

 

 

 

 

 

 

Global Services

 

24.3

%

23.7

%

0.6 pts.

 

Hardware

 

27.5

 

26.5

 

1.0

 

Software

 

86.4

 

8 5.9

 

0.5

 

Global Financing

 

54.2

 

60.5

 

(6.3

)

Enterprise Investments/Other

 

52.5

 

39.5

 

13.0

 

Total

 

36.0

%

35.6

%

0.4pts.

 

 

The increase in  Hardware gross profit margin was due to year-to-year manufacturing yield improvements in the Microelectronics business and continued focus on cost in personal computers, offsetting a decline in Storage Systems.  The increase in Software gross profit margin was primarily driven by the growth in Software revenue and the positive impact from currency.  The decrease in Global Financing gross profit margin was primarily due to declining financing margins as a result of declining asset yields, as well as a change in mix away from higher margin financing income and towards lower margin used equipment sales.  In addition, an increase in

 

 

26



 

retirement-related plan costs of approximately $159 million compared to the first quarter of 2004 impacted the overall gross profit margin, partially offset by lower equity compensation costs ($26 million).

 

Expense

 

The Total expense and other income to revenue ratio increased 0.5 points to 27.3 percent in the first quarter of 2005 versus the first quarter of 2004.  For additional information regarding Total expense and other income, see the following analyses by category.

 

Selling, general and administrative expense

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr. To Yr.
Percent
Change

 

Selling, general and administrative expense:

 

 

 

 

 

 

 

Selling, general and administrative - base

 

$

4,548

 

$

4,181

 

8.8

%

Advertising and promotional expense

 

325

 

311

*

4.5

 

Workforce reductions - ongoing

 

94

 

163

 

(42.3

)

Bad debt expense

 

(34

)

3

 

nm

 

Total

 

$

4,933

 

$

4,658

 

5.9

%

 


* Reclassified to conform with 2005 presentation.

nm - not meaningful

 

Total Selling, general and administrative (SG&A) expense increased 5.9 percent (4 percent adjusting for currency) in the first quarter of 2005 primarily due to increased expense for retirement-related plans ($64 million), effects of currency ($90 million) and increased salaries and sales commissions ($120 million). These increases were partially offset by reduced expense associated with ongoing workforce reduction actions and lower Bad debt expense primarily due to lower reserve requirements associated with improved economic conditions and improved credit quality, as well as the lower asset base of the Global Financing receivable portfolio (see pages 46 and 47).  In addition, equity compensation expense decreased $65 million in first quarter of 2005 versus the first quarter of 2004.

 

27



 

Other (income) and expense

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the period ended March 31:

 

2005

 

2004

 

Change

 

Other (income) and expense:

 

 

 

 

 

 

 

Foreign currency transaction losses

 

$

81

 

$

112

 

(27.7

)%

Interest income

 

(57

)

(39

)

46.2

 

Net gains from securities and investment assets

 

(3

)

(4

)

(25.0

)

Net realized (gains)/losses from certain real estate activities

 

1

 

(4

)

nm

 

Other

 

 

(52

)

nm

 

Total

 

$

22

 

$

13

 

71.3

%

 


nm - not meaningful

 

Other (income) and expense increased in the first quarter 2005 versus the first quarter of 2004.  The increase was primarily a result of gains on asset sales, as well as adjustments associated with previously recorded vacant space actions recorded in the first quarter of 2004, with no corresponding activity in the first quarter of 2005.  This increase in expense was partially offset by lower foreign currency transaction losses and increased interest income in the first quarter of 2005 versus 2004.

 

Research, Development and Engineering

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the period ended March 31:

 

2005

 

2004

 

Change

 

Research, development and engineering:

 

 

 

 

 

 

 

Total

 

$

1,459

 

$

1,416

 

3.0

%

 

Research, development and engineering expense increased in the first quarter of 2005 versus the first quarter of 2004 primarily due to increased spending in the Systems and Technology Group for server and storage products (approximately $60 million),  partially offset by lower spending in Microelectronics ($22 million) as well as increased spending in Software (approximately $27 million).  In addition, retirement-related plans expense increased by $24 million, partially offset by a decrease in equity compensation expense of $19 million.

 

Intellectual Property and Custom Development Income

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the period ended March 31:

 

2005

 

2004

 

Change

 

Intellectual Property and Custom Development Income:

 

 

 

 

 

 

 

Sales and other transfers of intellectual property

 

$

34

 

$

22

 

54.5

%

Licensing/royalty-based fees

 

106

 

90

 

17.8

 

Custom development income

 

79

 

68

 

16.2

 

Total

 

$

219

 

$

180

 

21.9

%

 

28



 

Intellectual Property and Custom Development Income increased across all categories in the first quarter of 2005 versus the same period of 2004.  The timing and amount of Sales and other transfers of IP may vary significantly from period to period depending upon the timing of divestitures, economic conditions, industry consolidation and the timing of new patents and know-how development.  There were no significant IP transactions in the quarter.

 

Interest Expense

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the period ended March 31:

 

2005

 

2004

 

Change

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

Total

 

$

49

 

$

35

 

40.0

%

 

The increase in Interest expense was primarily due to higher interest rates and higher average non-Global Financing debt in the first quarter of 2005 versus first quarter of 2004.

 

Interest expense is presented in Cost of Global Financing in the Consolidated Statement of Earnings only if the related external borrowings are to support the Global Financing external business.  See page 48 for additional information regarding Global Financing debt and interest expense.

 

Retirement-Related Benefits

 

The following table provides the total pre-tax cost for all retirement-related plans.  Cost amounts are included as an addition to the company’s cost and expense amounts in the Consolidated Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the individuals participating in the plans.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the period ended March 31:

 

2005

 

2004

 

Change

 

Retirement-related plans - cost:

 

 

 

 

 

 

 

Defined benefit and contribution pension plans - cost

 

$

456

 

$

199

 

129.1

%

Nonpension postretirement benefits costs

 

93

 

103

 

(9.7

)

Total

 

$

549

 

$

302

 

81.8

%

 

Included in the amounts above, the company had costs of approximately $267 million and $6 million associated with its defined benefit pension plans for the quarter ended March 31, 2005 and 2004, respectively.  This increase was driven by several factors including changes in the U.S. and non-U.S. discount rate assumptions, changes in the non-U.S. expected long-term return on asset assumptions, and recognition of previously deferred pension costs in accordance with SFAS 87, “Employers’ Accounting for Pensions,” partially offset by the company’s contributions.  The year-to-year increase impacted gross profit, SG&A expense and RD&E expense by approximately $159 million, $64 million and $24 million, respectively.

 

29



 

Provision for Income Taxes

 

The effective tax rate for the first three months of 2005 and 2004 was 30.0 percent and 30.1 percent, respectively.

 

In October 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act creates a temporary incentive for the company to repatriate earnings accumulated outside the U.S. by allowing the company to reduce its taxable income by 85 percent of certain eligible dividends received from non-U.S. subsidiaries by the end of 2005. In order to benefit from this incentive, the company must reinvest the qualifying dividends in the U.S. under a domestic reinvestment plan approved by the chief executive officer and board of directors.  The company has commenced an evaluation of the possible effects of the Act’s repatriation provision and expects to complete this evaluation within a reasonable period of time following the issuance of additional clarifying language and guidance from Congress and the Treasury Department on key elements of the repatriation provision. It is reasonably possible that the company may repatriate up to approximately $8 billion of the undistributed earnings under the Act and the corresponding income tax expense may be as much as approximately $550 million. The resulting income tax expense, if any, will be provided in the company’s financial statements in the quarter in which the evaluation and approvals have been completed.

 

Weighted-Average Common Shares

 

For the period ended March 31:

 

2005

 

2004

 

Yr. To Yr.
Percent
Change

 

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

0.85

 

$

0.79

 

7.6

%

Basic

 

$

0.86

 

$

0.81

 

6.2

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding: (in millions)

 

 

 

 

 

 

 

Assuming dilution

 

1, 660.6

 

1,727.4

 

(3.9

)%

Basic

 

1,628.7

 

1,691.7

 

(3.7

)

 

The amount of shares actually outstanding at March 31, 2005 was 1,613.3 million.

 

The weighted average number of common shares outstanding assuming dilution was lower by 66.8 million in the first quarter of 2005 compared to the first quarter of 2004, primarily as a result of the company’s common share repurchase program.

 

Segment Details

 

The following is an analysis of the first quarter 2005 versus first quarter 2004 external segment results. The external segment results do not include the effect of the company’s implementation of SFAS 123(R) in the first quarter of 2005 as discussed on pages 31 to 35.

 

30



 

Global Services

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr. to Yr.
Percent
Change

 

 

 

 

 

 

 

 

 

Global Services Revenue:

 

$

11,696

 

$

11,024

 

6.1

%

Strategic Outsourcing

 

$

5,004

 

$

4,616

 

8.4

 

Business Consulting

 

3,442

 

3,286

 

4.7

 

Integrated Technology

 

1,801

 

1,699

 

6.0

 

Maintenance

 

1,449

 

1,423

 

1.9

 

 

Global Services revenue increased 6.1 percent (3 percent adjusting for currency) in the first quarter of 2005 versus the first quarter of 2004.  Strategic Outsourcing (SO) continued its trend of double digit revenue growth in EMEA and also had growth in Asia Pacific.  The Americas declined, reflecting the cumulative effect of lower signings.  The company over the past couple of quarters has been able to maintain acceptable revenue growth while signings were declining, due primarily to increases in yield and scope expansion in existing contracts.

 

This quarter, many of the signings were late in the quarter, and the company had a higher percentage of its total signings come from extensions to existing contracts.  While these extensions are positive for client satisfaction and drive revenue over future periods, they didn’t contribute to the company’s current period revenue.

 

Although the company’s SO yields continued to increase year-to-year, the increase was not sufficient to offset the impact from short-term signings.

 

Business Consulting Services (BCS) revenue increased with double digit growth in the Americas offset by a decline in Asia Pacific.  In Consulting and Systems Integration, the company had modest signings growth in the Americas and EMEA, and signing declines in Asia Pacific, driven primarily by weakness in Japan.  Revenue was impacted in the quarter by signing delays in Asia, and yield declines in EMEA.

 

Integrated Technology Services (ITS) revenue grew in the quarter, but it is more dependent upon signings in the quarter.  ITS signings were flat to down across all geographies, due to weakness in small transactions.

 

Business Transformation Outsourcing (BTO) signings nearly doubled year-to-year, and continued to show strong revenue growth year-to-year.

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr. to Yr.
Percent/
Margin
Change

 

Global Services:

 

 

 

 

 

 

 

Gross profit

 

$

2,920

 

$

2,717

 

7.5

%

Gross profit margin

 

25.0

%

24.6

%

0.4 pts.

 

 

 

31



 

Global Services gross profit dollars and margin increased primarily due to the corresponding increase in revenue.

 

Hardware

 

(Dollars in millions)
For the period ended March 31:

 

2005

 

2004

 

Yr. to Yr.
Percent
Change

 

Hardware Revenue:

 

$

6,608

 

$

6,602

 

0.1

%

 

 

 

 

 

 

 

 

Systems and Technology Group

 

$

3,869

 

$

3,776

 

2.5

%