10-Q 1 a17-21131_110q.htm 10-Q

Table of Contents

 

 

 

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 SEPTEMBER 30, 2017

 

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 12 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 x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

 

Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act). o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The registrant had 925,791,378 shares of common stock outstanding at September 30, 2017.

 

 

 


 

 


Table of Contents

 

Index

 

 

Page

Part I - Financial Information:

 

 

 

Item 1. Consolidated Financial Statements (Unaudited):

 

 

 

Consolidated Statement of Earnings for the three and nine months ended September 30, 2017 and 2016

3

 

 

Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017 and 2016

4

 

 

Consolidated Statement of Financial Position at September 30, 2017 and December 31, 2016

5

 

 

Consolidated Statement of Cash Flows for the nine months ended September 30, 2017 and 2016

7

 

 

Consolidated Statement of Changes in Equity for the nine months ended September 30, 2017 and 2016

8

 

 

Notes to Consolidated Financial Statements

9

 

 

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

50

 

 

Item 4. Controls and Procedures

87

 

 

Part II - Other Information:

 

 

 

Item 1. Legal Proceedings

87

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities

87

 

 

Item 6. Exhibits

88

 

2



Table of Contents

 

Part I - Financial Information

 

Item 1. Consolidated Financial Statements:

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions except per share amounts)

 

2017

 

2016

 

2017

 

2016

 

Revenue:

 

 

 

 

 

 

 

 

 

Services

 

$

12,703

 

$

12,938

 

$

37,592

 

$

38,347

 

Sales

 

6,017

 

5,872

 

17,744

 

18,542

 

Financing

 

433

 

417

 

1,260

 

1,260

 

Total revenue

 

19,153

 

19,226

 

56,597

 

58,149

 

Cost:

 

 

 

 

 

 

 

 

 

Services

 

8,426

 

8,418

 

25,502

 

25,492

 

Sales

 

1,605

 

1,536

 

4,839

 

4,496

 

Financing

 

322

 

259

 

890

 

760

 

Total cost

 

10,353

 

10,213

 

31,232

 

30,748

 

Gross profit

 

8,800

 

9,013

 

25,365

 

27,401

 

Expense and other (income):

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

4,648

 

4,732

 

14,959

 

16,093

 

Research, development and engineering

 

1,342

 

1,397

 

4,360

 

4,320

 

Intellectual property and custom development income

 

(308

)

(528

)

(1,118

)

(1,110

)

Other (income) and expense

 

(114

)

(8

)

(218

)

281

 

Interest expense

 

168

 

158

 

451

 

473

 

Total expense and other (income)

 

5,735

 

5,751

 

18,434

 

20,056

 

Income from continuing operations before income taxes

 

3,065

 

3,263

 

6,931

 

7,345

 

Provision for/(benefit from) income taxes

 

339

 

409

 

120

 

(31

)

Income from continuing operations

 

$

2,726

 

$

2,854

 

$

6,811

 

$

7,375

 

Loss from discontinued operations, net of tax

 

0

 

(1

)

(3

)

(4

)

Net income

 

$

2,726

 

$

2,853

 

$

6,807

 

$

7,371

 

 

 

 

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.92

 

$

2.98

 

$

7.24

 

$

7.67

 

Discontinued operations

 

0.00

 

0.00

 

0.00

 

0.00

 

Total

 

$

2.92

 

$

2.98

 

$

7.24

 

$

7.67

 

Basic:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.93

 

$

2.99

 

$

7.28

 

$

7.70

 

Discontinued operations

 

0.00

 

0.00

 

0.00

 

0.00

 

Total

 

$

2.93

 

$

2.99

 

$

7.28

 

$

7.70

 

 

 

 

 

 

 

 

 

 

 

Weighted-average number of common shares outstanding: (millions)

 

 

 

 

 

 

 

 

 

Assuming dilution

 

933.2

 

957.3

 

940.2

 

960.7

 

Basic

 

929.4

 

954.0

 

935.6

 

957.7

 

 

 

 

 

 

 

 

 

 

 

Cash dividend per common share

 

$

1.50

 

$

1.40

 

$

4.40

 

$

4.10

 

 

(Amounts may not add due to rounding.)

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

 

3



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

 (UNAUDITED)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions)

 

2017

 

2016

 

2017

 

2016

 

Net income

 

$

2,726

 

$

2,853

 

$

6,807

 

$

7,371

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

89

 

(99

)

213

 

(109

)

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(1

)

(1

)

2

 

(36

)

Reclassification of (gains)/losses to net income

 

0

 

(1

)

1

 

36

 

Total net changes related to available-for-sale securities

 

(2

)

(2

)

2

 

0

 

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(70

)

35

 

(198

)

(221

)

Reclassification of (gains)/losses to net income

 

(73

)

15

 

(347

)

26

 

Total unrealized gains/(losses) on cash flow hedges

 

(143

)

50

 

(545

)

(195

)

Retirement-related benefit plans:

 

 

 

 

 

 

 

 

 

Prior service costs/(credits)

 

0

 

 

0

 

 

Net (losses)/gains arising during the period

 

1

 

11

 

106

 

(57

)

Curtailments and settlements

 

2

 

4

 

3

 

19

 

Amortization of prior service (credits)/costs

 

(22

)

(28

)

(66

)

(81

)

Amortization of net (gains)/losses

 

733

 

696

 

2,156

 

2,079

 

Total retirement-related benefit plans

 

713

 

683

 

2,200

 

1,960

 

Other comprehensive income/(loss), before tax

 

658

 

632

 

1,869

 

1,656

 

Income tax (expense)/benefit related to items of other comprehensive income

 

11

 

(192

)

7

 

(213

)

Other comprehensive income/(loss)

 

669

 

440

 

1,877

 

1,442

 

Total comprehensive income/(loss)

 

$

3,394

 

$

3,293

 

$

8,684

 

$

8,813

 

 

(Amounts may not add due to rounding.)

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

 

4



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

 

ASSETS

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

10,915

 

$

7,826

 

Marketable securities

 

600

 

701

 

Notes and accounts receivable - trade (net of allowances of $296 in 2017 and $290 in 2016)

 

8,150

 

9,182

 

Short-term financing receivables (net of allowances of $270 in 2017 and $337 in 2016)

 

18,050

 

19,006

 

Other accounts receivable (net of allowances of $39 in 2017 and $48 in 2016)

 

926

 

1,057

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

430

 

358

 

Work in process and raw materials

 

1,281

 

1,195

 

Total inventories

 

1,711

 

1,553

 

Prepaid expenses and other current assets

 

4,389

 

4,564

 

Total current assets

 

44,742

 

43,888

 

Property, plant and equipment

 

31,937

 

30,133

 

Less: Accumulated depreciation

 

20,880

 

19,303

 

Property, plant and equipment — net

 

11,057

 

10,830

 

Long-term financing receivables (net of allowances of $84 in 2017 and $101 in 2016)

 

8,459

 

9,021

 

Prepaid pension assets

 

4,521

 

3,034

 

Deferred taxes

 

7,289

 

5,224

 

Goodwill

 

36,782

 

36,199

 

Intangible assets — net

 

3,981

 

4,688

 

Investments and sundry assets

 

4,806

 

4,585

 

Total assets

 

$

121,636

 

$

117,470

 

 

(Amounts may not add due to rounding.)

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

 

5



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION — (CONTINUED)
(UNAUDITED)

 

LIABILITIES AND EQUITY

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

3,038

 

$

3,235

 

Short-term debt

 

4,299

 

7,513

 

Accounts payable

 

5,442

 

6,209

 

Compensation and benefits

 

3,918

 

3,577

 

Deferred income

 

10,649

 

11,035

 

Other accrued expenses and liabilities

 

4,352

 

4,705

 

Total current liabilities

 

31,697

 

36,275

 

Long-term debt

 

41,327

 

34,655

 

Retirement and nonpension postretirement benefit obligations

 

17,554

 

17,070

 

Deferred income

 

3,579

 

3,600

 

Other liabilities

 

7,723

 

7,477

 

Total liabilities

 

101,879

 

99,078

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

54,395

 

53,935

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued: 2017 - 2,228,489,401

 

 

 

 

 

2016 - 2,225,116,815

 

 

 

 

 

Retained earnings

 

155,565

 

152,759

 

Treasury stock - at cost

 

(162,812

)

(159,050

)

Shares: 2017 - 1,302,698,023

 

 

 

 

 

2016 - 1,279,249,412

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(27,521

)

(29,398

)

Total IBM stockholders’ equity

 

19,627

 

18,246

 

Noncontrolling interests

 

130

 

146

 

Total equity

 

19,757

 

18,392

 

Total liabilities and equity

 

$

121,636

 

$

117,470

 

 

(Amounts may not add due to rounding.)

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

 

6



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 

 

 

Nine Months Ended September 30,

 

(Dollars in millions)

 

2017

 

2016

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

6,807

 

$

7,371

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

2,231

 

2,106

 

Amortization of intangibles

 

1,161

 

1,148

 

Stock-based compensation

 

388

 

403

 

Net (gain)/loss on asset sales and other

 

92

 

100

 

Changes in operating assets and liabilities, net of acquisitions/divestitures

 

312

 

1,978

* **

Net cash provided by operating activities

 

10,991

 

13,105

* **

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(2,273

)

(2,594

)

Proceeds from disposition of property, plant and equipment

 

337

 

234

 

Investment in software

 

(411

)

(441

)

Acquisition of businesses, net of cash acquired

 

(442

)

(5,445

)

Divestitures of businesses, net of cash transferred

 

35

 

35

 

Non-operating finance receivables — net

 

469

 

1,441

*

Purchases of marketable securities and other investments

 

(3,770

)

(4,021

)

Proceeds from disposition of marketable securities and other investments

 

2,778

 

3,501

 

Net cash used in investing activities

 

(3,278

)

(7,289

)*

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

9,355

 

8,368

 

Payments to settle debt

 

(6,252

)

(5,616

)

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

 

(794

)

(864

)

Common stock repurchases

 

(3,674

)

(2,632

)

Common stock repurchases for tax withholdings

 

(153

)

(115

)**

Common stock transactions — other

 

137

 

166

 

Cash dividends paid

 

(4,119

)

(3,927

)

Net cash used in financing activities

 

(5,499

)

(4,619

)**

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

875

 

155

 

Net change in cash and cash equivalents

 

3,089

 

1,352

 

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

7,826

 

7,686

 

Cash and cash equivalents at September 30

 

$

10,915

 

$

9,039

 

 


*   Revised classification of certain financing receivables.

** Reclassified to reflect adoption of the FASB guidance on share-based compensation.

 

(Amounts may not add due to rounding.)

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

 

7



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
 AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
(UNAUDITED)

 

 

 

Common

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock and

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Other

 

Total IBM

 

Non-

 

 

 

 

 

Paid-in

 

Retained

 

Treasury

 

Comprehensive

 

Stockholders’

 

Controlling

 

Total

 

(Dollars in millions)

 

Capital

 

Earnings

 

Stock

 

Income/(Loss)

 

Equity

 

Interests

 

Equity

 

Equity - January 1, 2017

 

$

53,935

 

$

152,759

 

$

(159,050

)

$

(29,398

)

$

18,246

 

$

146

 

$

18,392

 

Cumulative effect of change in accounting principle *

 

 

 

102

 

 

 

 

 

102

 

 

 

102

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

6,807

 

 

 

 

 

6,807

 

 

 

6,807

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

1,877

 

1,877

 

 

 

1,877

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

8,684

 

 

 

$

8,684

 

Cash dividends paid — common stock

 

 

 

(4,119

)

 

 

 

 

(4,119

)

 

 

(4,119

)

Common stock issued under employee plans (3,372,586 shares)

 

460

 

 

 

 

 

 

 

460

 

 

 

460

 

Purchases (960,186 shares) and sales (363,335 shares) of treasury stock under employee plans — net

 

 

 

15

 

(106

)

 

 

(91

)

 

 

(91

)

Other treasury shares purchased, not retired (22,851,760 shares)

 

 

 

 

 

(3,655

)

 

 

(3,655

)

 

 

(3,655

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(16

)

(16

)

Equity - September 30, 2017

 

$

54,395

 

$

155,565

 

$

(162,812

)

$

(27,521

)

$

19,627

 

$

130

 

$

19,757

 

 

 

 

Common

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock and

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Other

 

Total IBM

 

Non-

 

 

 

 

 

Paid-in

 

Retained

 

Treasury

 

Comprehensive

 

Stockholders’

 

Controlling

 

Total

 

(Dollars in millions)

 

Capital

 

Earnings

 

Stock

 

Income/(Loss)

 

Equity

 

Interests

 

Equity

 

Equity - January 1, 2016

 

$

53,262

 

$

146,124

 

$

(155,518

)

$

(29,607

)

$

14,262

 

$

162

 

$

14,424

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

7,371

 

 

 

 

 

7,371

 

 

 

7,371

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

1,442

 

1,442

 

 

 

1,442

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

8,813

 

 

 

$

8,813

 

Cash dividends paid — common stock

 

 

 

(3,927

)

 

 

 

 

(3,927

)

 

 

(3,927

)

Common stock issued under employee plans (3,370,992 shares)

 

513

 

 

 

 

 

 

 

513

 

 

 

513

 

Purchases (787,805 shares) and sales (336,480 shares) of treasury stock under employee plans — net

 

 

 

16

 

(72

)

 

 

(56

)

 

 

(56

)

Other treasury shares purchased, not retired (17,793,841 shares)

 

 

 

 

 

(2,579

)

 

 

(2,579

)

 

 

(2,579

)

Changes in other equity

 

(16

)

0

 

 

 

 

 

(17

)

 

 

(17

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(12

)

(12

)

Equity - September 30, 2016

 

$

53,759

 

$

149,585

 

$

(158,170

)

$

(28,164

)

$

17,010

 

$

149

 

$

17,159

 

 


* Reflects the adoption of the FASB guidance on intra-entity transfers of assets in the first-quarter 2017.

 

(Amounts may not add due to rounding.)

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

 

8


 


Table of Contents

 

Notes to Consolidated Financial Statements:

 

1. Basis of Presentation: The accompanying Consolidated Financial Statements and footnotes of the International Business Machines Corporation (IBM or the company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial statements and footnotes are unaudited. In the opinion of the company’s management, these statements include all adjustments, which are only of a normal recurring nature, necessary to present a fair statement of the company’s results of operations, financial position and cash flows.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amount of assets, liabilities, revenue, costs, expenses and other comprehensive income/(loss) that are reported in the Consolidated Financial Statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events, historical experience, actions that the company may undertake in the future and on various other assumptions that are believed to be reasonable under the circumstances. As a result, actual results may be different from these estimates. Refer to the company’s 2016 Annual Report on pages 71 to 74, for a discussion of the company’s critical accounting estimates.

 

The company revised the classification of certain financing receivables for the three and nine months ended September 30, 2016, decreasing net cash provided by operating activities and net cash used in investing activities in the amount of $99 million and $311 million, respectively, which the company concluded to be immaterial to the periods presented. The twelve-month revision for the period ended December 31, 2016 was provided in the company’s 2016 Annual Report on page 26. There was no impact to total GAAP cash flows or free cash flow.

 

In the first quarter of 2017, the company reported a benefit from income taxes of $329 million, and its effective tax rate was (23.1) percent. This was primarily driven by a discrete tax benefit of $582 million from a first-quarter 2017 transaction accounted for under the new Financial Accounting Standards Board (FASB) guidance related to intra-entity transfers of assets. This benefit was partially offset by a discrete tax charge related to foreign audit activity of $99 million. The company had additional discrete tax benefits of $170 million in second-quarter 2017. For the nine months ended September 30, 2017, the company reported a provision for income taxes of $120 million and its effective tax rate was 1.7 percent, primarily as a result of the first and second quarter discrete items. For the nine months ended September 30, 2016, the company reported a benefit from income taxes of $31 million and its effective tax rate was (0.4) percent. The negative effective tax rate in the comparable period of 2016 was due to the resolution of a long-standing Japan tax matter in February 2016. Refer to note 2, “Accounting Changes,” and the Taxes section of the Management Discussion for additional information.

 

Noncontrolling interest amounts of $4.4 million and $3.1 million, net of tax, for the three months ended September 30, 2017 and 2016, respectively, and $11.5 million and $7.5 million, net of tax, for the nine months ended September 30, 2017 and 2016, respectively, are included as a reduction within other (income) and expense in the Consolidated Statement of Earnings.

 

Interim results are not necessarily indicative of financial results for a full year. The information included in this
Form 10-Q should be read in conjunction with the company’s 2016 Annual Report.

 

Within the financial statements and tables presented, certain columns and rows may not add due to the use of rounded numbers for disclosure purposes. Percentages presented are calculated from the underlying whole-dollar amounts. Certain prior year amounts have been reclassified to conform to the current year presentation. This is annotated where applicable.

 

2. Accounting Changes:

 

New Standards to be Implemented

 

In August 2017, the FASB issued guidance to simplify the application of current hedge accounting in certain areas, better portray the economic results of an entity’s risk management activities in its financial statements and make targeted improvements to presentation and disclosure requirements. The guidance is effective January 1, 2019 with early adoption permitted. The company plans to adopt the guidance as of January 1, 2018. The guidance is not expected to have a material impact in the consolidated financial results.

 

In March 2017, the FASB issued guidance that impacts the presentation of net periodic pension and postretirement benefit costs. Under the guidance, the service cost component of net benefit cost will continue to be presented in the same line items as other employee compensation costs, unless eligible for capitalization in the Consolidated Statement of Financial Position. The other components of net benefit costs will be presented separately from service cost as non-operating costs in the Consolidated Statement of Earnings or Notes to the Consolidated Financial Statements. The guidance is effective

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

January 1, 2018 with early adoption permitted. The company will adopt the guidance as of the effective date. The guidance is primarily a change in financial statement presentation and is not expected to have a material impact in the consolidated financial results.

 

In June 2016, the FASB issued guidance for credit impairment based on an expected loss model rather than an incurred loss model. The guidance requires the consideration of all available relevant information when estimating expected credit losses, including past events, current conditions and forecasts and their implications for expected credit losses. The guidance is effective January 1, 2020 with a one year early adoption permitted. The company is evaluating the impact of the new guidance.

 

In February 2016, the FASB issued guidance which changes the accounting for leases. The guidance requires lessees to recognize right-of-use assets and lease liabilities for most leases in the Consolidated Statement of Financial Position. The guidance makes some changes to lessor accounting, including the elimination of the use of third-party residual value guarantee insurance in the capital lease test, and overall aligns with the new revenue recognition guidance. The guidance also requires qualitative and quantitative disclosures to assess the amount, timing and uncertainty of cash flows arising from leases. The guidance is effective January 1, 2019 and early adoption is permitted. The company will adopt the guidance as of the effective date. A cross-functional implementation team has been established which is evaluating the lease portfolio, system, process and policy change requirements. The company is currently evaluating the impact of the new guidance on its consolidated financial results and expects it will have a material impact on the Consolidated Statement of Financial Position. The company’s operating lease commitments were $6.9 billion at December 31, 2016. In 2016, the use of third-party residual value guarantee insurance resulted in the company recognizing $220 million of sales-type lease revenue that would otherwise have been recognized over the lease period as operating lease revenue.

 

In January 2016, the FASB issued guidance which addresses aspects of recognition, measurement, presentation and disclosure of financial instruments. Certain equity investments will be measured at fair value with changes recognized in net income. The amendment also simplifies the impairment test of equity investments that lack readily determinable fair value. The guidance is effective January 1, 2018 and early adoption is not permitted except for limited provisions. The guidance is not expected to have a material impact in the consolidated financial results.

 

The FASB issued guidance on the recognition of revenue from contracts with customers in May 2014 with amendments in 2015 and 2016. Revenue recognition will depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented, or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). The company will adopt the guidance on January 1, 2018 and apply the cumulative catch-up transition method. The transition adjustment to be recorded to stockholders’ equity upon adoption of the new standard is not expected to be material.

 

Given the scope of work required to implement the recognition and disclosure requirements under the new standard, the company began its assessment process in 2014 and has identified changes to policy, processes, systems and controls. This also includes the assessment of data availability and presentation necessary to meet the additional disclosure requirements of the guidance in the Notes to the Consolidated Financial Statements.

 

The company expects revenue recognition for its broad portfolio of hardware, software and services offerings to remain largely unchanged. However, the guidance is expected to change the timing of revenue recognition in certain areas, including accounting for certain software licenses. These impacts are not expected to be material. The company expects to continue to recognize revenue for term license (recurring license charge) software arrangements on a monthly basis over the period that the client is entitled to use the license due to the contractual terms in these arrangements.

 

Since the company currently expenses sales commissions as incurred, the requirement in the new standard to capitalize certain in-scope sales commissions will result in an accounting change for the company.  However, the impact to the consolidated financial statements is not expected to be material, with no impact to cash flows.

 

The company continues to assess all potential impacts of the guidance and given normal ongoing business dynamics, preliminary conclusions are subject to change.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Standards Implemented

 

In January 2017, the FASB issued guidance which clarifies the definition of a business. The guidance provides a more robust framework to use in determining when a set of assets and activities acquired or sold is a business. The guidance is effective January 1, 2018 and early adoption is permitted. The company adopted the guidance effective January 1, 2017, and it did not have a material impact in the consolidated financial results.

 

In October 2016, the FASB issued guidance which requires an entity to recognize the income tax consequences of intra-entity transfers of assets, other than inventory, at the time of transfer. Assets within the scope of the guidance include intellectual property and property, plant and equipment. The guidance is effective January 1, 2018 and early adoption is permitted. The company adopted the guidance on January 1, 2017 using the required modified retrospective method. At adoption, $95 million and $47 million were reclassified from investments and sundry assets and prepaid expenses and other current assets, respectively into retained earnings. Additionally, net deferred taxes of $244 million were established in deferred taxes in the Consolidated Statement of Financial Position, resulting in a cumulative-effect net credit to retained earnings of $102 million. In January 2017, the company had one transaction that generated a $582 million benefit to income tax expense, income from continuing operations and net income and a benefit to both basic and diluted earnings per share of $0.62 per share for the nine months ended September 30, 2017. There was no impact in the consolidated financial results for the three months ended September 30, 2017. The ongoing impact of this guidance will be dependent on any transaction that is within its scope.

 

In March 2016, the FASB issued guidance which changes the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification in the Consolidated Statement of Cash Flows. The guidance was effective and adopted by the company on January 1, 2017, and it did not have a material impact in the Consolidated Statement of Financial Position. The ongoing impact of the guidance could result in increased volatility in the provision for income taxes and earnings per share in the Consolidated Statement of Earnings, depending on the company’s share price at exercise or vesting of share-based awards compared to grant date, however these impacts are not expected to be material. These impacts are recorded on a prospective basis. See note 5, “Stock-Based Compensation,” for additional information. The company continues to estimate forfeitures in conjunction with measuring stock-based compensation cost. The guidance also requires cash payments on behalf of employees for shares directly withheld for taxes to be presented as financing outflows in the Consolidated Statement of Cash Flows. Prior to adoption, the company reported this activity as an operating cash outflow and as a result, prior periods have been reclassified as required. The FASB also issued guidance in May 2017, which relates to the accounting for modifications of share-based payment awards. The company adopted the guidance in the second quarter of 2017. The guidance had no impact in the consolidated financial results.

 

In September 2015, the FASB issued guidance eliminating the requirement that an acquirer in a business combination account for a measurement-period adjustment retrospectively. Instead, an acquirer will recognize a measurement-period adjustment during the period in which the amount of the adjustment is determined. In addition, the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date should be presented separately on the face of the income statement or disclosed in the notes. The guidance was effective January 1, 2016 on a prospective basis. The guidance did not have a material impact in the consolidated financial results.

 

In May 2015, the FASB issued guidance which removed the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also removed the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. The guidance was effective January 1, 2016. The guidance was a change in disclosure only and did not have an impact in the consolidated financial results.

 

In April 2015, the FASB issued guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a services contract. All software licenses recognized under this guidance will be accounted for consistent with other licenses of intangible assets. The guidance was effective January 1, 2016 and the company adopted it on a prospective basis. The guidance did not have a material impact in the consolidated financial results.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

3. Financial Instruments:

 

Fair Value Measurements

 

Accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Under this guidance, the company is required to classify certain assets and liabilities based on the following fair value hierarchy:

 

·                  Level 1—Quoted prices (unadjusted) in active markets for identical assets or liabilities that can be accessed at the measurement date;

·                  Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and

·                  Level 3—Unobservable inputs for the asset or liability.

 

The guidance requires the use of observable market data if such data is available without undue cost and effort.

 

When available, the company uses unadjusted quoted market prices in active markets to measure the fair value and classifies such items as Level 1. If quoted market prices are not available, fair value is based upon internally developed models that use current market-based or independently sourced market parameters such as interest rates and currency rates. Items valued using internally generated models are classified according to the lowest level input or value driver that is significant to the valuation.

 

The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments. For derivatives and debt securities, the company uses a discounted cash flow analysis using discount rates commensurate with the duration of the instrument.

 

In determining the fair value of financial instruments, the company considers certain market valuation adjustments to the “base valuations” calculated using the methodologies described below for several parameters that market participants would consider in determining fair value:

 

·                  Counterparty credit risk adjustments are applied to financial instruments, taking into account the actual credit risk of a counterparty as observed in the credit default swap market to determine the true fair value of such an instrument.

·                  Credit risk adjustments are applied to reflect the company’s own credit risk when valuing all liabilities measured at fair value. The methodology is consistent with that applied in developing counterparty credit risk adjustments, but incorporates the company’s own credit risk as observed in the credit default swap market.

 

As an example, the fair value of derivatives is derived utilizing a discounted cash flow model that uses observable market inputs such as known notional value amounts, yield curves, spot and forward exchange rates as well as discount rates. These inputs relate to liquid, heavily traded currencies with active markets which are available for the full term of the derivative.

 

Certain financial assets are measured at fair value on a nonrecurring basis. These assets include equity method investments that are recognized at fair value at the measurement date to the extent that they are deemed to be other-than-temporarily impaired. Certain assets that are measured at fair value on a recurring basis can be subject to nonrecurring fair value measurements. These assets include available-for-sale equity investments that are deemed to be other-than-temporarily impaired. In the event of an other-than-temporary impairment of a financial investment, fair value is measured using a model described above.

 

Non-financial assets such as property, plant and equipment, land, goodwill and intangible assets are also subject to nonrecurring fair value measurements if they are deemed to be impaired. The impairment models used for nonfinancial assets depend on the type of asset. During the nine months ended September 30, 2016, a pre-tax impairment charge related to certain property, plant and equipment of $218 million was recorded. There were no material impairments of non-financial assets for the nine months ended September 30, 2017.

 

Accounting guidance permits the measurement of eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. This election is irrevocable. The company has not applied the fair value option to any eligible assets or liabilities.

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at September 30, 2017 and December 31, 2016.

 

12



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At September 30, 2017

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

5,553

 

$

 

$

5,553

 

Money market funds

 

1,375

 

 

 

1,375

 

U.S. government securities

 

 

200

 

 

200

 

Canadian government securities

 

 

460

 

 

460

 

Total

 

1,375

 

6,214

 

 

7,589

(6)

Debt securities - current (2)

 

 

599

 

 

599

(6)

Debt securities - noncurrent (3)

 

4

 

7

 

 

11

 

Available-for-sale equity investments (3)

 

5

 

 

 

5

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

517

 

 

517

 

Foreign exchange contracts

 

 

416

 

 

416

 

Equity contracts

 

 

23

 

 

23

 

Total

 

 

957

 

 

957

(7)

Total assets

 

$

1,384

 

$

7,775

 

$

 

$

9,159

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

333

 

$

 

$

333

 

Equity contracts

 

 

4

 

 

4

 

Interest rate contracts

 

 

15

 

 

15

 

Total liabilities

 

$

 

$

352

 

$

 

$

352

(7)

 


(1) Included within cash and cash equivalents in the Consolidated Statement of Financial Position.

(2) U.S. government securities reported as marketable securities in the Consolidated Statement of Financial Position.

(3) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

(4) The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at September 30, 2017 were $269 million and $687 million, respectively.

(5) The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at September 30, 2017 were $332 million and $20 million, respectively.

(6) Available-for-sale securities with carrying values that approximate fair value.

(7) If derivative exposures covered by a qualifying master netting agreement had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions each would have been reduced by $274 million.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2016

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

3,629

 

$

 

$

3,629

 

Money market funds

 

1,204

 

 

 

1,204

 

Total

 

1,204

 

3,629

 

 

4,832

(6)

Debt securities - current (2)

 

 

699

 

 

699

(6)

Debt securities - noncurrent (3)

 

1

 

6

 

 

8

 

Available-for-sale equity investments (3)

 

7

 

 

 

7

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

555

 

 

555

 

Foreign exchange contracts

 

 

560

 

 

560

 

Equity contracts

 

 

11

 

 

11

 

Total

 

 

1,126

 

 

1,126

(7)

Total assets

 

$

1,212

 

$

5,460

 

$

 

$

6,672

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

188

 

$

 

$

188

 

Equity contracts

 

 

10

 

 

10

 

Interest rate contracts

 

 

8

 

 

8

 

Total liabilities

 

$

 

$

206

 

$

 

$

206

(7)

 


(1) Included within cash and cash equivalents in the Consolidated Statement of Financial Position.

(2) U.S government securities reported as marketable securities in the Consolidated Statement of Financial Position.

(3) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

(4) The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at December 31, 2016 were $532 million and $594 million, respectively.

(5) The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at December 31, 2016 were $145 million and $61 million, respectively.

(6) Available-for-sale securities with carrying values that approximate fair value.

(7) If derivative exposures covered by a qualifying master netting agreement had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions each would have been reduced by $116 million.

 

There were no transfers between Levels 1 and 2 for the nine months ended September 30, 2017 and the year ended December 31, 2016.

 

Financial Assets and Liabilities Not Measured at Fair Value

 

Short-Term Receivables and Payables

 

Notes and other accounts receivable and other investments are financial assets with carrying values that approximate fair value. Accounts payable, other accrued expenses and short-term debt (excluding the current portion of long-term debt) are financial liabilities with carrying values that approximate fair value. If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy, except for short-term debt, which would be classified as Level 2.

 

Loans and Long-term Receivables

 

Fair values are based on discounted future cash flows using current interest rates offered for similar loans to clients with similar credit ratings for the same remaining maturities. At September 30, 2017 and December 31, 2016, the difference between the carrying amount and estimated fair value for loans and long-term receivables was immaterial. If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Long-Term Debt

 

Fair value of publicly-traded long-term debt is based on quoted market prices for the identical liability when traded as an asset in an active market. For other long-term debt for which a quoted market price is not available, an expected present value technique that uses rates currently available to the company for debt with similar terms and remaining maturities is used to estimate fair value. The carrying amount of long-term debt was $41,327 million and $34,655 million, and the estimated fair value was $43,623 million and $36,838 million at September 30, 2017 and December 31, 2016, respectively. If measured at fair value in the financial statements, long-term debt (including the current portion) would be classified as Level 2 in the fair value hierarchy.

 

Debt and Marketable Equity Securities

 

The company’s cash equivalents and current debt securities are considered available-for-sale and recorded at fair value, which is not materially different from carrying value, in the Consolidated Statement of Financial Position.

 

The following tables summarize the company’s noncurrent debt and marketable equity securities which are considered available-for-sale and recorded at fair value in the Consolidated Statement of Financial Position.

 

 

 

 

 

Gross

 

Gross

 

 

 

(Dollars in millions)

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

At September 30, 2017:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

7

 

$

3

 

$

 

$

11

 

Available-for-sale equity investments(1)

 

$

1

 

$

4

 

$

0

 

$

5

 

 


(1) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

 

 

 

 

 

Gross

 

Gross

 

 

 

(Dollars in millions)

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

At December 31, 2016:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

5

 

$

3

 

$

 

$

8

 

Available-for-sale equity investments(1)

 

$

3

 

$

5

 

$

0

 

$

7

 

 


(1) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

 

Sales of debt and available-for-sale equity investments during the period were as follows:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended September 30:

 

2017

 

2016

 

Proceeds

 

$

0

 

$

1

 

Gross realized gains (before taxes)

 

0

 

1

 

Gross realized losses (before taxes)

 

 

 

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Proceeds

 

$

5

 

$

150

 

Gross realized gains (before taxes)

 

1

 

1

 

Gross realized losses (before taxes)

 

2

 

37

 

 

The after-tax net unrealized holding gains/(losses) on available-for-sale debt and equity securities that have been included in other comprehensive income/(loss) for the period and after-tax net (gains)/losses reclassified from accumulated other comprehensive income/(loss) to net income were as follows:

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

For the three months ended September 30:

 

2017

 

2016

 

Net unrealized gains/(losses) arising during the period

 

$

1

 

$

(1

)

Net unrealized (gains)/losses reclassified to net income*

 

0

 

(1

)

 


*There were no writedowns for the three months ended September 30, 2017 and 2016, respectively.

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Net unrealized gains/(losses) arising during the period

 

$

1

 

$

(22

)

Net unrealized (gains)/losses reclassified to net income*

 

0

 

22

 

 


* There were no writedowns for the nine months ended September 30, 2017 and 2016, respectively.

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at September 30, 2017.

 

Derivative Financial Instruments

 

The company operates in multiple functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity and commodity price changes and client credit risk. The company limits these risks by following established risk management policies and procedures, including the use of derivatives, and, where cost effective, financing with debt in the currencies in which assets are denominated. For interest rate exposures, derivatives are used to better align rate movements between the interest rates associated with the company’s lease and other financial assets and the interest rates associated with its financing debt. Derivatives are also used to manage the related cost of debt. For foreign currency exposures, derivatives are used to better manage the cash flow volatility arising from foreign exchange rate fluctuations.

 

As a result of the use of derivative instruments, the company is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. To mitigate the counterparty credit risk, the company has a policy of only entering into contracts with carefully selected major financial institutions based upon their overall credit profile. The company’s established policies and procedures for mitigating credit risk on principal transactions include reviewing and establishing limits for credit exposure and continually assessing the creditworthiness of counterparties. The right of set-off that exists under certain of these arrangements enables the legal entities of the company subject to the arrangement to net amounts due to and from the counterparty reducing the maximum loss from credit risk in the event of counterparty default.

 

The company is also a party to collateral security arrangements with most of its major derivative counterparties. These arrangements require the company to hold or post collateral (cash or U.S. Treasury securities) when the derivative fair values exceed contractually established thresholds. Posting thresholds can be fixed or can vary based on credit default swap pricing or credit ratings received from the major credit agencies. The aggregate fair value of all derivative instruments under these collateralized arrangements that were in a liability position at September 30, 2017 and December 31, 2016 was $45 million and $11 million, respectively, for which no collateral was posted at either date. Full collateralization of these agreements would be required in the event that the company’s credit rating falls below investment grade or if its credit default swap spread exceeds 250 basis points, as applicable, pursuant to the terms of the collateral security arrangements. The aggregate fair value of derivative instruments in asset positions as of September 30, 2017 and December 31, 2016 was $957 million and $1,126 million, respectively. This amount represents the maximum exposure to loss at the reporting date if the counterparties failed to perform as contracted. This exposure was reduced by $274 million and $116 million at September 30, 2017 and December 31, 2016, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at September 30, 2017 and December 31, 2016, this exposure was reduced by $123 million and $141 million of cash collateral, respectively, and $35 million of non-cash collateral in U.S. Treasury securities at December 31, 2016. There were no non-cash collateral balances in U.S. Treasury securities at September 30, 2017. At September 30, 2017 and December 31, 2016, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $559 million and $834 million, respectively. At September 30, 2017 and December 31, 2016, the net position related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $78 million and $90 million, respectively.

 

In the Consolidated Statement of Financial Position, the company does not offset derivative assets against liabilities in master netting arrangements nor does it offset receivables or payables recognized upon payment or receipt of cash collateral

 

16



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

against the fair values of the related derivative instruments. No amount was recognized in other receivables at September 30, 2017 or December 31, 2016 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral was $123 million and $141 million at September 30, 2017 and December 31, 2016, respectively. The company restricts the use of cash collateral received to rehypothecation, and therefore reports it in prepaid expenses and other current assets in the Consolidated Statement of Financial Position. No amount was rehypothecated at September 30, 2017 and December 31, 2016.

 

The company may employ derivative instruments to hedge the volatility in stockholders’ equity resulting from changes in currency exchange rates of significant foreign subsidiaries of the company with respect to the U.S. dollar. These instruments, designated as net investment hedges, expose the company to liquidity risk as the derivatives have an immediate cash flow impact upon maturity which is not offset by a cash flow from the translation of the underlying hedged equity. The company monitors this cash loss potential on an ongoing basis and may discontinue some of these hedging relationships by de-designating or terminating the derivative instrument in order to manage the liquidity risk. Although not designated as accounting hedges, the company may utilize derivatives to offset the changes in the fair value of the de-designated instruments from the date of de-designation until maturity.

 

In its hedging programs, the company uses forward contracts, futures contracts, interest-rate swaps, cross-currency swaps, and options depending upon the underlying exposure. The company is not a party to leveraged derivative instruments.

 

A brief description of the major hedging programs, categorized by underlying risk, follows.

 

Interest Rate Risk

 

Fixed and Variable Rate Borrowings

 

The company issues debt in the global capital markets to fund its operations and financing business. Access to cost-effective financing can result in interest rate mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company uses interest-rate swaps to convert specific fixed-rate debt issuances into variable-rate debt (i.e., fair value hedges) and to convert specific variable-rate debt issuances into fixed-rate debt (i.e., cash flow hedges). At September 30, 2017 and December 31, 2016, the total notional amount of the company’s interest rate swaps was $9.1 billion and $7.3 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2017 and December 31, 2016 was approximately 5.0 years and 6.2 years, respectively.

 

Forecasted Debt Issuance

 

The company is exposed to interest rate volatility on future debt issuances. To manage this risk, the company may use forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuance. These swaps are accounted for as cash flow hedges. The company did not have any derivative instruments relating to this program outstanding at September 30, 2017 and December 31, 2016.

 

At December 31, 2016, net gains of less than $1 million (before taxes) were recorded in accumulated other comprehensive income/(loss) in connection with cash flow hedges of the company’s borrowings. During 2017, all gains and losses associated with this program that were recorded in other comprehensive income/(loss) were reclassified to net income and there are no gains and losses remaining in accumulated other comprehensive income/(loss) at September 30, 2017.

 

Foreign Exchange Risk

 

Long-Term Investments in Foreign Subsidiaries (Net Investment)

 

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At September 30, 2017 and December 31, 2016, the total notional amount of derivative instruments designated as net investment hedges was $8.8 billion and $6.7 billion, respectively. At September 30, 2017 and December 31, 2016, the weighted-average remaining maturity of these instruments was approximately 0.1 years and 0.2 years, respectively.

 

17



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Anticipated Royalties and Cost Transactions

 

The company’s operations generate significant nonfunctional currency, third-party vendor payments and intercompany payments for royalties and goods and services among the company’s non-U.S. subsidiaries and with the company. In anticipation of these foreign currency cash flows and in view of the volatility of the currency markets, the company selectively employs foreign exchange forward contracts to manage its currency risk. These forward contracts are accounted for as cash flow hedges. The maximum length of time over which the company has hedged its exposure to the variability in future cash flows is four years. At September 30, 2017 and December 31, 2016, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $7.9 billion and $8.3 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2017 and December 31, 2016 was 0.7 years at both periods.

 

At September 30, 2017 and December 31, 2016, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net losses of $70 million and net gains of $462 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts, $161 million of losses and $397 million of gains, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

 

Foreign Currency Denominated Borrowings

 

The company is exposed to exchange rate volatility on foreign currency denominated debt. To manage this risk, the company employs cross-currency swaps to convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. These swaps are accounted for as cash flow hedges. The maximum length of time over which the company has hedged its exposure to the variability in future cash flows is approximately nine years. At September 30, 2017 and December 31, 2016, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $1.4 billion at both periods.

 

At September 30, 2017 and December 31, 2016, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net gains of $16 million and net gains of $29 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts, $34 million of gains and $27 million of gains, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying exposure.

 

Subsidiary Cash and Foreign Currency Asset/Liability Management

 

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2017 and December 31, 2016, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $10.8 billion and $12.7 billion, respectively.

 

Equity Risk Management

 

The company is exposed to market price changes in certain broad market indices and in the company’s own stock primarily related to certain obligations to employees. Changes in the overall value of these employee compensation obligations are recorded in selling, general and administrative (SG&A) expense in the Consolidated Statement of Earnings. Although not designated as accounting hedges, the company utilizes derivatives, including equity swaps and futures, to economically hedge the exposures related to its employee compensation obligations. The derivatives are linked to the total return on certain broad market indices or the total return on the company’s common stock, and are recorded at fair value with gains or losses also reported in SG&A expense in the Consolidated Statement of Earnings. At September 30, 2017 and December 31, 2016, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.2 billion at both periods.

 

18



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Other Risks

 

The company may hold warrants to purchase shares of common stock in connection with various investments that are deemed derivatives because they contain net share or net cash settlement provisions. The company records the changes in the fair value of these warrants in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any warrants qualifying as derivatives outstanding at September 30, 2017 and December 31, 2016.

 

The company is exposed to a potential loss if a client fails to pay amounts due under contractual terms. The company may utilize credit default swaps to economically hedge its credit exposures. The swaps are recorded at fair value with gains and losses reported in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any derivative instruments relating to this program outstanding at September 30, 2017 and December 31, 2016.

 

The company is exposed to market volatility on certain investment securities. The company may utilize options or forwards to economically hedge its market exposure. The derivatives are recorded at fair value with gains and losses reported in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2017 and December 31, 2016, the company did not have any derivative instruments relating to this program outstanding.

 

The following tables provide a quantitative summary of the derivative and non-derivative instrument-related risk management activity as of September 30, 2017 and December 31, 2016, as well as for the three and nine months ended September 30, 2017 and 2016, respectively.

 

19



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Fair Values of Derivative Instruments in the Consolidated Statement of Financial Position

As of September 30, 2017 and December 31, 2016

 

 

 

Fair Value of Derivative Assets

 

Fair Value of Derivative Liabilities

 

 

 

Balance Sheet

 

 

 

 

 

Balance Sheet

 

 

 

 

 

(Dollars in millions)

 

Classification

 

9/30/2017

 

12/31/2016

 

Classification

 

9/30/2017

 

12/31/2016

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts:

 

Prepaid expenses and other current assets

 

$

 

$

 

Other accrued expenses and liabilities

 

$

1

 

$

 

 

 

Investments and sundry assets

 

517

 

555

 

Other liabilities

 

15

 

8

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

208

 

421

 

Other accrued expenses and liabilities

 

272

 

46

 

 

 

Investments and sundry assets

 

170

 

17

 

Other liabilities

 

5

 

35

 

 

 

Fair value of derivative assets

 

$

896

 

$

993

 

Fair value of derivative liabilities

 

$

292

 

$

89

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

$

38

 

$

100

 

Other accrued expenses and liabilities

 

$

56

 

$

89

 

 

 

Investments and sundry assets

 

 

22

 

Other liabilities

 

 

18

 

Equity contracts:

 

Prepaid expenses and other current assets

 

23

 

11

 

Other accrued expenses and liabilities

 

4

 

10

 

 

 

Investments and sundry assets

 

 

 

Other liabilities

 

 

 

 

 

Fair value of derivative assets

 

$

61

 

$

133

 

Fair value of derivative liabilities

 

$

60

 

$

117

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Derivatives

 

 

 

$

957

 

$

1,126

 

 

 

$

352

 

$

206

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt designated as hedging instruments(1):

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt

 

 

 

N/A

 

N/A

 

 

 

$

377

 

$

1,125

 

Long-term debt

 

 

 

N/A

 

N/A

 

 

 

11,469

 

7,844

 

 

 

 

 

N/A

 

N/A

 

 

 

$

11,846

 

$

8,969

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

957

 

$

1,126

 

 

 

$

12,198

 

$

9,175

 

 


N/A - not applicable

 

(1)         Debt designated as hedging instruments are reported at carrying value.

 

20



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the three months ended September 30, 2017 and 2016

 

 

 

Gain (Loss) Recognized in Earnings

 

 

 

Consolidated

 

Recognized on

 

Attributable to Risk

 

(Dollars in millions)

 

Statement of

 

Derivatives

 

Being Hedged(2)

 

For the three months ended September 30:

 

Earnings Line Item

 

2017

 

2016

 

2017

 

2016

 

Derivative instruments in fair value hedges(1)(5):

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

(3

)

$

(20

)

$

20

 

$

40

 

 

 

Interest expense

 

(3

)

(21

)

20

 

43

 

Derivative instruments not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

(35

)

30

 

N/A

 

N/A

 

Interest rate contracts

 

Other (income) and expense

 

 

0

 

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

31

 

45

 

N/A

 

N/A

 

 

 

Other (income) and expense

 

 

0

 

N/A

 

N/A

 

Total

 

 

 

$

(10

)

$

34

 

$

41

 

$

83

 

 

 

 

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

Ineffectiveness and

 

(Dollars in millions)

 

Effective Portion

 

Consolidated

 

Effective Portion Reclassified

 

Amounts Excluded from

 

For the three months

 

Recognized in OCI

 

Statement of

 

from AOCI

 

Effectiveness Testing(3)

 

ended September 30:

 

2017

 

2016

 

Earnings Line Item

 

2017

 

2016

 

2017

 

2016

 

Derivative instruments in cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

 

$

 

Interest expense

 

$

(7

)

$

(7

)

$

 

$

 

Foreign exchange contracts

 

(70

)

35

 

Other (income) and expense

 

64

 

(6

)

(1

)

(1

)

 

 

 

 

 

 

Cost of sales*

 

1

 

(7

)

 

 

 

 

 

 

 

 

Cost of services*

 

20

 

3

 

 

 

 

 

 

 

 

 

SG&A expense

 

(6

)

2

 

 

 

Instruments in net investment hedges(4):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

(507

)

(131

)

Cost of financing

 

 

 

0

 

 

 

 

 

 

 

 

Interest expense

 

 

 

8

 

25

 

Total

 

$

(577

)

$

(96

)

 

 

$

73

 

$

(15

)

$

7

 

$

24

 

 


* Reclassified to conform to 2017 presentation

 

N/A - not applicable

 

Note: OCI represents other comprehensive income/(loss) in the Consolidated Statement of Comprehensive Income and AOCI represents accumulated other comprehensive income/(loss) in the Consolidated Statement of Changes in Equity.

 

(1)         The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2)         The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.

(3)         The amount of gain/(loss) recognized in income represents ineffectiveness on hedge relationships.

(4)         Instruments in net investment hedges include derivative and non-derivative instruments.

(5)         For the three month periods ended September 30, 2017 and 2016, fair value hedges resulted in a loss of less than $1 million and a loss of $3 million in ineffectiveness, respectively.

 

21



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the nine months ended September 30, 2017 and 2016

 

 

 

Gain (Loss) Recognized in Earnings

 

 

 

Consolidated

 

Recognized on

 

Attributable to Risk

 

(Dollars in millions)

 

Statement of

 

Derivatives

 

Being Hedged(2)

 

For the nine months ended September 30:

 

Earnings Line Item

 

2017

 

2016

 

2017

 

2016

 

Derivative instruments in fair value hedges(1)(5):

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

37

 

$

195

 

$

22

 

$

(127

)

 

 

Interest expense

 

34

 

214

 

20

 

(140

)

Derivative instruments not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

74

 

335

 

N/A

 

N/A

 

Interest rate contracts

 

Other (income) and expense

 

 

0

 

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

88

 

87

 

N/A

 

N/A

 

 

 

Other (income) and expense

 

 

(1

)

N/A

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

233

 

$

830

 

$

42

 

$

(267

)

 

 

 

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

Ineffectiveness and

 

(Dollars in millions)

 

Effective Portion

 

Consolidated

 

Effective Portion Reclassified

 

Amounts Excluded from

 

For the nine months

 

Recognized in OCI

 

Statement of

 

from AOCI

 

Effectiveness Testing(3)

 

ended September 30:

 

2017

 

2016

 

Earnings Line Item

 

2017

 

2016

 

2017

 

2016

 

Derivative instruments in cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

 

$

 

Interest expense

 

$

(21

)

$

(17

)

$

 

$

 

Foreign exchange contracts

 

(198

)

(221

)

Other (income) and expense

 

275

 

6

 

2

 

(1

)

 

 

 

 

 

 

Cost of sales*

 

23

 

(5

)

 

 

 

 

 

 

 

 

Cost of services*

 

47

 

(9

)

 

 

 

 

 

 

 

 

SG&A expense

 

23

 

(1

)

 

 

Instruments in net investment hedges(4):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

(1,513

)

(1,071

)

Cost of financing

 

 

 

0

 

 

 

 

 

 

 

 

Interest expense

 

 

 

34

 

51

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

(1,712

)

$

(1,292

)

 

 

$

347

 

$

(26

)

$

37

 

$

49

 

 


* Reclassified to conform to 2017 presentation.

 

N/A-not applicable

 

Note: OCI represents other comprehensive income/(loss) in the Consolidated Statement of Comprehensive Income and AOCI represents accumulated other comprehensive income/(loss) in the Consolidated Statement of Changes in Equity.

 

(1)         The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2)         The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.

(3)         The amount of gain/(loss) recognized in income represents ineffectiveness on hedge relationships.

(4)         Instruments in net investment hedges include derivative and non-derivative instruments.

(5)         For the nine month periods ended September 30, 2017 and 2016, fair value hedges resulted in a loss of less than $1 million and a gain of less than $1 million in ineffectiveness, respectively.

 

For the three and nine months ending September 30, 2017 and 2016, there were no significant gains or losses excluded from the assessment of hedge effectiveness (for fair value hedges), or associated with an underlying exposure that did not or was not expected to occur (for cash flow hedges); nor are there any anticipated in the normal course of business.

 

22



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

4. Financing Receivables: The following table presents financing receivables, net of allowances for credit losses, including residual values.

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Current:

 

 

 

 

 

Net investment in sales-type and direct financing leases

 

$

3,092

 

$

2,909

 

Commercial financing receivables

 

8,563

 

9,706

 

Client loan and installment payment receivables (loans)

 

6,395

 

6,390

 

Total

 

$

18,050

 

$

19,006

 

Noncurrent:

 

 

 

 

 

Net investment in sales-type and direct financing leases

 

$

3,579

 

$

3,950

 

Client loan and installment payment receivables (loans)

 

4,879

 

5,071

 

Total

 

$

8,459

 

$

9,021

 

 

Net investment in sales-type and direct financing leases relates principally to the company’s Systems products and are for terms ranging generally from two to six years. Net investment in sales-type and direct financing leases includes unguaranteed residual values of $567 million and $585 million at September 30, 2017 and December 31, 2016, respectively, and is reflected net of unearned income of $459 million and $513 million, and net of allowance for credit losses of $118 million and $133 million at those dates, respectively.

 

Commercial financing receivables, net of allowance for credit losses of $21 million and $28 million at September 30, 2017 and December 31, 2016, respectively, relate primarily to inventory and accounts receivable financing for dealers and remarketers of IBM and OEM products. Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days.

 

Client loan and installment payment receivables (loans), net of allowance for credit losses of $215 million and $276 million at September 30, 2017 and December 31, 2016, respectively, are loans that are provided primarily to clients to finance the purchase of hardware, software and services. Payment terms on these financing arrangements are generally for terms up to seven years.

 

Client loan and installment payment financing contracts are priced independently at competitive market rates. The company has a history of enforcing the terms of these financing agreements.

 

The company utilizes certain of its financing receivables as collateral for nonrecourse borrowings. Financing receivables pledged as collateral for borrowings were $640 million and $689 million at September 30, 2017 and December 31, 2016, respectively.

 

The company did not have any financing receivables held for sale as of September 30, 2017 and December 31, 2016.

 

Financing Receivables by Portfolio Segment

 

The following tables present financing receivables on a gross basis, excluding the allowance for credit losses and residual value, by portfolio segment and by class, excluding commercial financing receivables and other miscellaneous financing receivables at September 30, 2017 and December 31, 2016. The company determines its allowance for credit losses based on two portfolio segments: lease receivables and loan receivables, and further segments the portfolio into three classes: Americas, Europe/Middle East/Africa (EMEA), and Asia Pacific. This portfolio segmentation was changed from growth markets and major markets in 2017 as the company no longer manages the business under those market delineations. There was no impact to segment reporting or the company’s Consolidated Financial Statements.

 

23



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At September 30, 2017

 

Americas

 

EMEA

 

Asia Pacific

 

Total

 

Financing receivables

 

 

 

 

 

 

 

 

 

Lease receivables

 

$

3,541

 

$

1,297

 

$

1,304

 

$

6,142

 

Loan receivables

 

6,180

 

3,120

 

2,189

 

11,489

 

Ending balance

 

$

9,721

 

$

4,417

 

$

3,493

 

$

17,631

 

Collectively evaluated for impairment

 

$

9,581

 

$

4,386

 

$

3,391

 

$

17,358

 

Individually evaluated for impairment

 

$

140

 

$

31

 

$

102

 

$

273

 

Allowance for credit losses

 

 

 

 

 

 

 

 

 

Beginning balance at January 1, 2017

 

 

 

 

 

 

 

 

 

Lease receivables

 

$

54

 

$

4

 

$

76

 

$

133

 

Loan receivables

 

169

 

18

 

89

 

276

 

Total

 

$

223

 

$

22

 

$

165

 

$

410

 

Write-offs

 

$

(49

)

$

0

 

$

(63

)

$

(112

)

Recoveries

 

0

 

0

 

0

 

0

 

Provision

 

11

 

9

 

(4

)

16

 

Other

 

12

 

5

 

2

 

19

 

Ending balance at September 30, 2017

 

$

197

 

$

36

 

$

100

 

$

333

 

Lease receivables

 

$

77

 

$

6

 

$

35

 

$

118

 

Loan receivables

 

$

120

 

$

29

 

$

65

 

$

215

 

 

 

 

 

 

 

 

 

 

 

Collectively evaluated for impairment

 

$

66

 

$

12

 

$

6

 

$

85

 

Individually evaluated for impairment

 

$

131

 

$

23

 

$

94

 

$

248

 

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2016:*

 

Americas

 

EMEA

 

Asia Pacific

 

Total

 

Financing receivables:

 

 

 

 

 

 

 

 

 

Lease receivables

 

$

 3,830

 

$

1,171

 

$

1,335

 

$

6,336

 

Loan receivables

 

6,185

 

3,309

 

2,243

 

11,737

 

Ending balance

 

$

 10,015

 

$

4,480

 

$

3,578

 

$

18,073

 

Collectively evaluated for impairment

 

$

 9,847

 

$

4,460

 

$

3,419

 

$

17,726

 

Individually evaluated for impairment

 

$

 168

 

$

20

 

$

159

 

$

347

 

Allowance for credit losses

 

 

 

 

 

 

 

 

 

Beginning balance at January 1, 2016

 

 

 

 

 

 

 

 

 

Lease receivables

 

$

 52

 

$

17

 

$

143

 

$

213

 

Loan receivables

 

122

 

55

 

200

 

377

 

Total

 

$

 175

 

$

72

 

$

343

 

$

590

 

Write-offs

 

$

 (36

)

$

(48

)

$

(154

)

$

(237

)

Recoveries

 

2

 

0

 

0

 

2

 

Provision

 

65

 

(1

)

(6

)

58

 

Other

 

17

 

(1

)

(18

)

(3

)

Ending balance at December 31, 2016

 

$

 223

 

$

22

 

$

165

 

$

410

 

Lease receivables

 

$

 54

 

$

4

 

$

76

 

$

133

 

Loan receivables

 

$

 169

 

$

18

 

$

89

 

$

276

 

 

 

 

 

 

 

 

 

 

 

Collectively evaluated for impairment

 

$

 62

 

$

13

 

$

15

 

$

90

 

Individually evaluated for impairment

 

$

 161

 

$

9

 

$

150

 

$

320

 

 


* Reclassified to conform to 2017 presentation.

 

When determining the allowances, financing receivables are evaluated either on an individual or a collective basis. For individually evaluated receivables, the company determines the expected cash flow for the receivable and calculates an estimate of the potential loss and the probability of loss. For those accounts in which the loss is probable, the company records a specific reserve. In addition, the company records an unallocated reserve that is determined by applying a reserve rate to its different portfolios, excluding accounts that have been specifically reserved. This reserve rate is based upon credit rating, probability of default, term, characteristics (lease/loan) and loss history.

 

24



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Financing Receivables on Non-Accrual Status

 

The following table presents the recorded investment in financing receivables which were on non-accrual status at September 30, 2017 and December 31, 2016.

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016*

 

Americas

 

$

25

 

$

23

 

EMEA

 

0

 

2

 

Asia Pacific

 

4

 

14

 

Total lease receivables

 

$

30

 

$

40

 

 

 

 

 

 

 

Americas

 

$

79

 

$

128

 

EMEA

 

53

 

5

 

Asia Pacific

 

10

 

12

 

Total loan receivables

 

$

142

 

$

145

 

 

 

 

 

 

 

Total receivables

 

$

172

 

$

185

 

 


* Reclassified to conform to 2017 presentation.

 

Impaired Receivables

 

The company considers any receivable with an individually evaluated reserve as an impaired receivable. Depending on the level of impairment, receivables will also be placed on non-accrual status.

 

The following tables present impaired receivables. This presentation includes both loan and lease receivables.

 

 

 

At September 30, 2017

 

At December 31, 2016*

 

 

 

Recorded

 

Related

 

Recorded

 

Related

 

(Dollars in millions)

 

Investment

 

Allowance

 

Investment

 

Allowance

 

Americas

 

$

140

 

$

131

 

$

168

 

$

161

 

EMEA

 

31

 

23

 

20

 

9

 

Asia Pacific

 

102

 

94

 

159

 

150

 

Total

 

$

273

 

$

248

 

$

347

 

$

320

 

 


* Reclassified to conform to 2017 presentation.

 

 

 

 

 

 

 

Interest

 

 

 

Average

 

Interest

 

Income

 

(Dollars in millions)

 

Recorded

 

Income

 

Recognized on

 

For the three months ended September 30, 2017:

 

Investment

 

Recognized

 

Cash Basis

 

Americas

 

$

156

 

$

0

 

$

 

EMEA

 

31

 

0

 

 

Asia Pacific

 

101

 

0

 

 

Total

 

$

288

 

$

0

 

$

 

 

 

 

 

 

 

 

Interest

 

 

 

Average

 

Interest

 

Income

 

(Dollars in millions)

 

Recorded

 

Income

 

Recognized on

 

For the three months ended September 30, 2016:*

 

Investment

 

Recognized

 

Cash Basis

 

Americas

 

$

182

 

$

0

 

$

 

EMEA

 

61

 

0

 

 

Asia Pacific

 

302

 

0

 

 

Total

 

$

545

 

$

0

 

$

 

 


* Reclassified to conform to 2017 presentation.

 

25



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

 

 

 

 

Interest

 

 

 

Average

 

Interest

 

Income

 

(Dollars in millions)

 

Recorded

 

Income

 

Recognized on

 

For the nine months ended September 30, 2017:

 

Investment

 

Recognized

 

Cash Basis

 

Americas

 

$

165

 

$

0

 

$

 

EMEA

 

27

 

0

 

 

Asia Pacific

 

131

 

0

 

 

Total

 

$

323

 

$

0

 

$

 

 

 

 

 

 

 

 

Interest

 

 

 

Average

 

Interest

 

Income

 

(Dollars in millions)

 

Recorded

 

Income

 

Recognized on

 

For the nine months ended September 30, 2016:*

 

Investment

 

Recognized

 

Cash Basis

 

Americas

 

$

158

 

$

0

 

$

 

EMEA

 

65

 

0

 

 

Asia Pacific

 

322

 

0

 

 

Total

 

$

545

 

$

0

 

$

 

 


* Reclassified to conform to 2017 presentation.

 

Credit Quality Indicators

 

The company’s credit quality indicators, which are based on rating agency data, publicly available information and information provided by customers, are reviewed periodically based on the relative level of risk. The resulting indicators are a numerical rating system that maps to Moody’s Investors Service credit ratings as shown below. The company uses information provided by Moody’s, where available, as one of many inputs in its determination of customer credit ratings.

 

The following tables present the net recorded investment for each class of receivables, by credit quality indicator, at September 30, 2017 and December 31, 2016. Receivables with a credit quality indicator ranging from Aaa to Baa3 are considered investment grade. All others are considered non-investment grade. The credit quality indicators do not reflect mitigation actions that the company takes to transfer credit risk to third parties.

 

 

 

Lease Receivables

 

Loan Receivables

 

(Dollars in millions)

 

 

 

 

 

Asia

 

 

 

 

 

Asia

 

At September 30, 2017:

 

Americas

 

EMEA

 

Pacific

 

Americas

 

EMEA

 

Pacific

 

Credit Ratings:

 

 

 

 

 

 

 

 

 

 

 

 

 

Aaa – Aa3

 

$

358

 

$

52

 

$

56

 

$

626

 

$

124

 

$

94

 

A1 – A3

 

715

 

126

 

543

 

1,251

 

302

 

908

 

Baa1 – Baa3

 

807

 

404

 

329

 

1,412

 

968

 

550

 

Ba1 – Ba2

 

762

 

415

 

172

 

1,333

 

993

 

289

 

Ba3 – B1

 

421

 

197

 

86

 

736

 

473

 

143

 

B2 – B3

 

345

 

83

 

69

 

604

 

200

 

116

 

Caa – D

 

56

 

13

 

15

 

98

 

31

 

25

 

Total

 

$

3,465

 

$

1,290

 

$

1,269

 

$

6,059

 

$

3,091

 

$

2,124

 

 

At September 30, 2017, the industries which made up Global Financing’s receivables portfolio consisted of: Financial (33 percent), Government (14 percent), Manufacturing (14 percent), Services (13 percent), Retail (8 percent), Communications (7 percent), Healthcare (6 percent) and Other (5 percent).

 

26



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

Lease Receivables

 

Loan Receivables

 

(Dollars in millions)

 

 

 

 

 

Asia

 

 

 

 

 

Asia

 

At December 31, 2016:*

 

Americas

 

EMEA

 

Pacific

 

Americas

 

EMEA

 

Pacific

 

Credit Ratings:

 

 

 

 

 

 

 

 

 

 

 

 

 

Aaa – Aa3

 

$

447

 

$

51

 

$

53

 

$

712

 

$

143

 

$

90

 

A1 – A3

 

782

 

113

 

486

 

1,246

 

318

 

832

 

Baa1 – Baa3

 

772

 

366

 

330

 

1,230

 

1,032

 

565

 

Ba1 – Ba2

 

822

 

350

 

185

 

1,309

 

987

 

316

 

Ba3 – B1

 

574

 

208

 

106

 

914

 

585

 

182

 

B2 – B3

 

297

 

71

 

84

 

472

 

201

 

143

 

Caa – D

 

83

 

9

 

15

 

133

 

25

 

25

 

Total

 

$

3,776

 

$

1,167

 

$

1,259

 

$

6,016

 

$

3,291

 

$

2,154

 

 


* Reclassified to conform to 2017 presentation.

 

At December 31, 2016, the industries which made up Global Financing’s receivables portfolio consisted of: Financial (34 percent), Government (14 percent), Manufacturing (13 percent), Services (12 percent), Retail (8 percent), Communications (7 percent), Healthcare (6 percent) and Other (6 percent).

 

Past Due Financing Receivables

 

 

 

 

 

Fully

 

<90 Days

 

 

 

Recorded

 

 

 

Total

 

Reserved

 

or Unbilled

 

Total

 

Investment

 

(Dollars in millions)

 

Past Due

 

Financing

 

Financing

 

Financing

 

> 90 Days and

 

At September 30, 2017:

 

> 90 days (1)

 

Receivables

 

Receivables

 

Receivables

 

Accruing (2)

 

Americas

 

$

28

 

$

51

 

$

3,463

 

$

3,541

 

$

255

 

EMEA

 

9

 

4

 

1,283

 

1,297

 

15

 

Asia Pacific

 

5

 

32

 

1,266

 

1,304

 

19

 

Total lease receivables

 

$

42

 

$

87

 

$

6,012

 

$

6,142

 

$

290

 

Americas

 

$

43

 

$

80

 

$

6,057

 

$

6,180

 

$

401

 

EMEA

 

26

 

19

 

3,076

 

3,120

 

46

 

Asia Pacific

 

6

 

61

 

2,122

 

2,189

 

9

 

Total loan receivables

 

$

75

 

$

160

 

$

11,255

 

$

11,489

 

$

456

 

Total

 

$

117

 

$

247

 

$

17,267

 

$

17,631

 

$

746

 

 


(1) Only the portion of a financing receivable which is greater than 90 days past due, excluding amounts that are fully reserved.

(2) At a contract level, which includes total billed and unbilled amounts for aged financing receivables greater than 90 days.

 

 

 

 

 

Fully

 

<90 Days

 

 

 

Recorded

 

 

 

Total

 

Reserved

 

or Unbilled

 

Total

 

Investment

 

(Dollars in millions)

 

Past Due

 

Financing

 

Financing

 

Financing

 

> 90 Days and

 

At December 31, 2016:*

 

> 90 days (1)

 

Receivables

 

Receivables

 

Receivables

 

Accruing (2)

 

Americas

 

$

17

 

$

20

 

$

3,793

 

$

3,830

 

$

66

 

EMEA

 

2

 

10

 

1,159

 

1,171

 

6

 

Asia Pacific

 

12

 

59

 

1,264

 

1,335

 

40

 

Total lease receivables

 

$

31

 

$

89

 

$

6,216

 

$

6,336

 

$

111

 

Americas

 

$

19

 

$

90

 

$

6,075

 

$

6,185

 

$

80

 

EMEA

 

5

 

5

 

3,299

 

3,309

 

15

 

Asia Pacific

 

6

 

87

 

2,150

 

2,243

 

46

 

Total loan receivables

 

$

31

 

$

182

 

$

11,524

 

$

11,737

 

$

141

 

Total

 

$

62

 

$

271

 

$

17,740

 

$

18,073

 

$

253

 

 


(1) Only the portion of a financing receivable which is greater than 90 days past due, excluding amounts that are fully reserved.

(2) At a contract level, which includes total billed and unbilled amounts for aged financing receivables greater than 90 days.

 *   Reclassified to conform to 2017 presentation.

 

27



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Troubled Debt Restructurings

 

The company did not have any significant troubled debt restructurings during the nine months ended September 30, 2017 or for the year ended December 31, 2016.

 

5. Stock-Based Compensation: Stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized over the employee requisite service period. The following table presents total stock-based compensation cost included in income from continuing operations.

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions)

 

2017

 

2016

 

2017

 

2016

 

Cost

 

$

22

 

$

23

 

$

68

 

$

67

 

Selling, general and administrative

 

88

 

105

 

277

 

295

 

Research, development and engineering

 

13

 

14

 

43

 

41

 

Pre-tax stock-based compensation cost

 

123

 

142

 

388

 

403

 

Income tax benefits

 

(41

)

(47

)

(128

)

(131

)

Total net stock-based compensation cost

 

$

82

 

$

95

 

$

260

 

$

272

 

 

Pre-tax stock-based compensation cost for the three months ended September 30, 2017 decreased $19 million compared to the corresponding period in the prior year. This was due to decreases related to performance share units ($11 million), the conversion of stock-based awards previously issued by acquired entities ($7 million) and restricted stock units ($2 million).

 

Pre-tax stock-based compensation cost for the nine months ended September 30, 2017 decreased $15 million compared to the corresponding period in the prior year. This was due to decreases related to the conversion of stock-based awards previously issued by acquired entities ($20 million) and performance share units ($17 million), partially offset by an increase in restricted stock units ($22 million).

 

The implementation of the new FASB guidance for share-based payment transactions resulted in an immaterial impact to income tax benefits as of the three months and nine months ended September 30, 2017. Refer to note 2, “Accounting Changes,” for additional information.

 

As of September 30, 2017, the total unrecognized compensation cost of $905 million related to non-vested awards was expected to be recognized over a weighted-average period of approximately 2.6 years.

 

There was no significant capitalized stock-based compensation cost at September 30, 2017 and 2016.

 

6. Segments: The tables on pages 29 and 30 reflect the results of continuing operations of the company’s segments consistent with the management and measurement system utilized within the company. Performance measurement is based on operating pre-tax income from continuing operations. The segments represent components of the company for which separate financial information is available that is utilized on a regular basis by the chief operating decision maker (the chief executive officer) in determining how to allocate resources and evaluate performance.

 

28



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

SEGMENT INFORMATION

 

 

 

Cognitive Solutions &
Industry Services

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Technology

 

 

 

 

 

 

 

 

 

 

 

Global

 

Services &

 

 

 

 

 

 

 

 

 

Cognitive

 

Business

 

Cloud

 

 

 

Global

 

Total

 

(Dollars in millions)

 

Solutions

 

Services

 

Platforms

 

Systems

 

Financing

 

Segments

 

For the three months ended September 30, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

External revenue

 

$

4,400

 

$

4,093

 

$

8,457

 

$

1,721

 

$

427

 

$

19,098

 

Internal revenue

 

629

 

92

 

164

 

227

 

272

 

1,384

 

Total revenue

 

$

5,030

 

$

4,185

 

$

8,621

 

$

1,948

 

$

698

 

$

20,482

 

Pre-tax income from continuing operations

 

$

1,649

 

$

453

 

$

1,192

 

$

339

 

$

244

 

$

3,876

 

Revenue year-to-year change

 

2.6

%

(2.3

)%

(3.4

)%

12.3

%

(8.5

)%

(0.6

)%

Pre-tax income year-to-year change

 

4.8

%

(16.8

)%

(7.5

)%

149.7

%

(31.4

)%

(0.5

)%

Pre-tax income margin

 

32.8

%

10.8

%

13.8

%

17.4

%

34.9

%

18.9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the three months ended September 30, 2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

External revenue

 

$

4,235

 

$

4,191

 

$

8,748

 

$

1,558

 

$

412

 

$

19,145

 

Internal revenue

 

667

 

93

 

180

 

176

 

352

 

1,468

 

Total revenue

 

$

4,902

 

$

4,284

 

$

8,929

 

$

1,734

 

$

763

 

$

20,613

 

Pre-tax income from continuing operations

 

$

1,574

 

$

544

 

$

1,288

 

$

136

 

$

355

 

$

3,897

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pre-tax income margin

 

32.1

%

12.7

%

14.4

%

7.8

%

46.5

%

18.9

%

 

Reconciliations to IBM as Reported:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended September 30:

 

2017

 

2016

 

Revenue:

 

 

 

 

 

Total reportable segments

 

$

20,482

 

$

20,613

 

Eliminations of internal transactions

 

(1,384

)

(1,468

)

Other revenue

 

56

 

81

 

Total consolidated revenue

 

$

19,153

 

$

19,226

 

 

 

 

 

 

 

Pre-tax income from continuing operations:

 

 

 

 

 

Total reportable segments

 

$

3,876

 

$

3,897

 

Amortization of acquired intangible assets

 

(238

)

(265

)

Acquisition-related (charges)/income

 

0

 

(4

)

Non-operating retirement-related (costs)/income

 

(306

)

(139

)

Eliminations of internal transactions

 

(126

)

(185

)

Unallocated corporate amounts

 

(141

)

(42

)

Total pre-tax income from continuing operations

 

$

3,065

 

$

3,263

 

 

29



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

SEGMENT INFORMATION

 

 

 

Cognitive Solutions &
Industry Services

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Technology

 

 

 

 

 

 

 

 

 

 

 

Global

 

Services &

 

 

 

 

 

 

 

 

 

Cognitive

 

Business

 

Cloud

 

 

 

Global

 

Total

 

(Dollars in millions)

 

Solutions

 

Services

 

Platforms

 

Systems

 

Financing

 

Segments

 

For the nine months ended September 30, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

External revenue

 

$

13,021

 

$

12,196

 

$

25,079

 

$

4,863

 

$

1,246

 

$

56,405

 

Internal revenue

 

2,001

 

271

 

497

 

571

 

925

 

4,265

 

Total revenue

 

$

15,022

 

$

12,467

 

$

25,576

 

$

5,434

 

$

2,171

 

$

60,670

 

Pre-tax income from continuing operations

 

$

4,539

 

$

1,065

 

$

2,888

 

$

227

 

$

836

 

$

9,555

 

Revenue year-to-year change

 

1.4

%

(3.3

)%

(3.6

)%

(6.0

)%

(16.0

)%

(3.1

)%

Pre-tax income year-to-year change

 

12.4

%

(12.0

)%

2.2

%

(35.9

)%

(30.7

)%

(0.8

)%

Pre-tax income margin

 

30.2

%

8.5

%

11.3

%

4.2

%

38.5

%

15.7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the nine months ended September 30, 2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

External revenue

 

$

12,889

 

$

12,578

 

$

26,029

 

$

5,184

 

$

1,245

 

$

57,926

 

Internal revenue

 

1,929

 

310

 

501

 

594

 

1,340

 

4,673

 

Total revenue

 

$

14,818

 

$

12,888

 

$

26,530

 

$

5,778

 

$

2,585

 

$

62,599

 

Pre-tax income from continuing operations

 

$

4,039

 

$

1,210

 

$

2,825

 

$

354

 

$

1,208

 

$

9,636

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pre-tax income margin

 

27.3

%

9.4

%

10.6

%

6.1

%

46.7

%

15.4

%

 

Reconciliations to IBM as Reported:

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Revenue:

 

 

 

 

 

Total reportable segments

 

$

60,670

 

$

62,599

 

Eliminations of internal transactions

 

(4,265

)

(4,673

)

Other revenue

 

192

 

223

 

Total consolidated revenue

 

$

56,597

 

$

58,149

 

 

 

 

 

 

 

Pre-tax income from continuing operations:

 

 

 

 

 

Total reportable segments

 

$

9,555

 

$

9,636

 

Amortization of acquired intangible assets

 

(731

)

(742

)

Acquisition-related (charges)/income

 

(19

)

(1

)

Non-operating retirement-related (costs)/income

 

(1,065

)

(444

)

Eliminations of internal transactions

 

(515

)

(873

)

Unallocated corporate amounts

 

(294

)

(230

)

Total pre-tax income from continuing operations

 

$

6,931

 

$

7,345

 

 

30



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

7. Equity Activity:

 

Reclassifications and Taxes Related to Items of Other Comprehensive Income

 

(Dollars in millions)

 

Before Tax

 

Tax (Expense)/

 

Net of Tax

 

For the three months ended September 30, 2017:

 

Amount

 

Benefit

 

Amount

 

Other comprehensive income/(loss):

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

$

89

 

$

195

 

$

284

 

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(1

)

$

1

 

$

0

 

Reclassification of (gains)/losses to other (income) and expense

 

0

 

0

 

0

 

Total net changes related to available-for-sale securities

 

$

(2

)

$

1

 

$

(1

)

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(70

)

$

20

 

$

(50

)

Reclassification of (gains)/losses to:

 

 

 

 

 

 

 

Cost of sales

 

(1

)

1

 

(1

)

Cost of services

 

(20

)

8

 

(12

)

SG&A expense

 

6

 

(1

)

4

 

Other (income) and expense

 

(64

)

25

 

(39

)

Interest expense

 

7

 

(3

)

4

 

Total unrealized gains/(losses) on cash flow hedges

 

$

(143

)

$

49

 

$

(94

)

Retirement-related benefit plans(1):

 

 

 

 

 

 

 

Prior service costs/(credits)

 

$

0

 

$

0

 

$

0

 

Net (losses)/gains arising during the period

 

1

 

0

 

1

 

Curtailments and settlements

 

2

 

(1

)

1

 

Amortization of prior service (credits)/costs

 

(22

)

7

 

(15

)

Amortization of net (gains)/losses

 

733

 

(242

)

491

 

Total retirement-related benefit plans

 

$

713

 

$

(235

)

$

479

 

Other comprehensive income/(loss)

 

$

658

 

$

11

 

$

669

 

 


(1)    These AOCI components are included in the computation of net periodic pension cost. (See note 8, “Retirement-Related Benefits,” for additional information.)

 

31



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Reclassifications and Taxes Related to Items of Other Comprehensive Income

 

(Dollars in millions)

 

Before Tax

 

Tax (Expense)/

 

Net of Tax

 

For the three months ended September 30, 2016:

 

Amount

 

Benefit

 

Amount

 

Other comprehensive income/(loss):

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

$

(99

)

$

50

 

$

(49

)

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(1

)

$

0

 

$

(1

)

Reclassification of (gains)/losses to other (income) and expense

 

(1

)

0

 

(1

)

Total net changes related to available-for-sale securities

 

$

(2

)

$

1

 

$

(1

)

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

35

 

$

(14

)

$

21

 

Reclassification of (gains)/losses to:

 

 

 

 

 

 

 

Cost of sales*

 

7

 

(3

)

4

 

Cost of services*

 

(3

)

1

 

(2

)

SG&A expense

 

(2

)

(1

)

(3

)

Other (income) and expense

 

6

 

(2

)

4

 

Interest expense

 

7

 

(3

)

4

 

Total unrealized gains/(losses) on cash flow hedges

 

$

50

 

$

(22

)

$

29

 

Retirement-related benefit plans(1):

 

 

 

 

 

 

 

Net (losses)/gains arising during the period

 

$

11

 

$

(5

)

$

6

 

Curtailments and settlements

 

4

 

(1

)

3

 

Amortization of prior service (credits)/costs

 

(28

)

9

 

(19

)

Amortization of net (gains)/losses

 

696

 

(225

)

471

 

Total retirement-related benefit plans

 

$

683

 

$

(222

)

$

461

 

Other comprehensive income/(loss)

 

$

632

 

$

(192

)

$

440

 

 


* Reclassified to conform to 2017 presentation.

 

(1)    These AOCI components are included in the computation of net periodic pension cost. (See note 8, “Retirement-Related Benefits,” for additional information.)

 

32



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Reclassifications and Taxes Related to Items of Other Comprehensive Income

 

(Dollars in millions)

 

Before Tax

 

Tax (Expense)/

 

Net of Tax

 

For the nine months ended September 30, 2017:

 

Amount

 

Benefit

 

Amount

 

Other comprehensive income/(loss):

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

$

213

 

$

581

 

$

794

 

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

2

 

$

0

 

$

1

 

Reclassification of (gains)/losses to other (income) and expense

 

1

 

0

 

0

 

Total net changes related to available-for-sale securities

 

$

2

 

$

0

 

$

2

 

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(198

)

$

53

 

$

(146

)

Reclassification of (gains)/losses to:

 

 

 

 

 

 

 

Cost of sales

 

(23

)

6

 

(17

)

Cost of services

 

(47

)

18

 

(29

)

SG&A expense

 

(23

)

6

 

(17

)

Other (income) and expense

 

(275

)

106

 

(169

)

Interest expense

 

21

 

(8

)

13

 

Total unrealized gains/(losses) on cash flow hedges

 

$

(545

)

$

180

 

$

(365

)

Retirement-related benefit plans(1):

 

 

 

 

 

 

 

Prior service costs/(credits)

 

$

0

 

$

0

 

$

0

 

Net (losses)/gains arising during the period

 

106

 

(36

)

70

 

Curtailments and settlements

 

3

 

(1

)

2

 

Amortization of prior service (credits)/costs

 

(66

)

23

 

(43

)

Amortization of net (gains)/losses

 

2,156

 

(739

)

1,417

 

Total retirement-related benefit plans

 

$

2,200

 

$

(754

)

$

1,446

 

Other comprehensive income/(loss)

 

$

1,869

 

$

7

 

$

1,877

 

 


(1)    These AOCI components are included in the computation of net periodic pension cost. (See note 8, “Retirement-Related Benefits,” for additional information.)

 

33



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Reclassifications and Taxes Related to Items of Other Comprehensive Income

 

(Dollars in millions)

 

Before Tax

 

Tax (Expense)/

 

Net of Tax

 

For the nine months ended September 30, 2016:

 

Amount

 

Benefit

 

Amount

 

Other comprehensive income/(loss):

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

$

(109

)

$

411

 

$

303

 

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(36

)

$

14

 

$

(22

)

Reclassification of (gains)/losses to other (income) and expense

 

36

 

(14

)

22

 

Total net changes related to available-for-sale securities

 

$

0

 

$

0

 

$

0

 

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

$

(221

)

$

82

 

$

(139

)

Reclassification of (gains)/losses to:

 

 

 

 

 

 

 

Cost of sales*

 

5

 

(4

)

2

 

Cost of services*

 

9

 

(3

)

5

 

SG&A expense

 

1

 

(3

)

(1

)

Other (income) and expense

 

(6

)

2

 

(4

)

Interest expense

 

17

 

(6

)

10

 

Total unrealized gains/(losses) on cash flow hedges

 

$

(195

)

$

68

 

$

(127

)

Retirement-related benefit plans(1):

 

 

 

 

 

 

 

Net (losses)/gains arising during the period

 

$

(57

)

$

20

 

$

(37

)

Curtailments and settlements

 

19

 

(7

)

12

 

Amortization of prior service (credits)/costs

 

(81

)

29

 

(52

)

Amortization of net (gains)/losses

 

2,079

 

(735

)

1,344

 

Total retirement-related benefit plans

 

$

1,960

 

$

(693

)

$

1,267

 

Other comprehensive income/(loss)

 

$

1,656

 

$

(213

)

$

1,442

 

 


* Reclassified to conform to 2017 presentation.

 

(1)    These AOCI components are included in the computation of net periodic pension cost. (See note 8, “Retirement-Related Benefits,” for additional information.)

 

34



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Accumulated Other Comprehensive Income/(Loss) (net of tax)

 

 

 

 

 

 

 

Net Change

 

Net Unrealized

 

 

 

 

 

Net Unrealized

 

Foreign

 

Retirement-

 

Gains/(Losses)

 

Accumulated

 

 

 

Gains/(Losses)

 

Currency

 

Related

 

on Available-

 

Other

 

 

 

on Cash Flow

 

Translation

 

Benefit

 

For-Sale

 

Comprehensive

 

(Dollars in millions)

 

Hedges

 

Adjustments*

 

Plans

 

Securities

 

Income/(Loss)

 

January 1, 2017

 

$

319

 

$

(3,603

)

$

(26,116

)

$

2

 

$

(29,398

)

Other comprehensive income before reclassifications

 

(146

)

794

 

72

 

1

 

721

 

Amount reclassified from accumulated other comprehensive income

 

(219

)

0

 

1,374

 

0

 

1,155

 

Total change for the period

 

(365

)

794

 

1,446

 

2

 

1,877

 

September 30, 2017

 

$

(46

)

$

(2,809

)

$

(24,670

)

$

4

 

$

(27,521

)

 


*  Foreign currency translation adjustments are presented gross except for any associated hedges which are presented net of tax.

 

 

 

 

 

 

 

 

Net Change

 

Net Unrealized

 

 

 

 

 

Net Unrealized

 

Foreign

 

Retirement-

 

Gains/(Losses)

 

Accumulated

 

 

 

Gains/(Losses)

 

Currency

 

Related

 

on Available-

 

Other

 

 

 

on Cash Flow

 

Translation

 

Benefit

 

For-Sale

 

Comprehensive

 

(Dollars in millions)

 

Hedges

 

Adjustments*

 

Plans

 

Securities

 

Income/(Loss)

 

January 1, 2016

 

$

100

 

$

(3,463

)

$

(26,248

)

$

5

 

$

(29,607

)

Other comprehensive income before reclassifications

 

(139

)

303

 

(25

)

(22

)

117

 

Amount reclassified from accumulated other comprehensive income

 

12

 

0

 

1,292

 

22

 

1,326

 

Total change for the period

 

(127

)

303

 

1,267

 

0

 

1,442

 

September 30, 2016

 

$

(28

)

$

(3,161

)

$

(24,981

)

$

4

 

$

(28,164

)

 


*  Foreign currency translation adjustments are presented gross except for any associated hedges which are presented net of tax.

 

8. Retirement-Related Benefits: 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 tables provide the pre-tax cost for all retirement-related plans.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Retirement-related plans — cost

 

 

 

 

 

 

 

Defined benefit and contribution pension plans — cost

 

$

592

 

$

421

 

40.6

%

Nonpension postretirement plans — cost

 

61

 

64

 

(5.9

)

Total

 

$

653

 

$

486

 

34.4

%

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Retirement-related plans — cost

 

 

 

 

 

 

 

Defined benefit and contribution pension plans — cost

 

$

1,915

 

$

1,315

 

45.6

%

Nonpension postretirement plans — cost

 

182

 

185

 

(1.6

)

Total

 

$

2,097

 

$

1,500

 

39.8

%

 

35



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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

 

Cost/(Income) of Pension Plans

 

(Dollars in millions)

 

U.S. Plans

 

Non-U.S. Plans

 

For the three months ended September 30:

 

2017

 

2016

 

2017

 

2016

 

Service cost

 

$

 

$

 

$

106

 

$

108

 

Interest cost

 

478

 

512

 

215

 

257

 

Expected return on plan assets

 

(753

)

(922

)

(340

)

(468

)

Amortization of prior service costs/(credits)

 

4

 

3

 

(25

)

(28

)

Recognized actuarial losses

 

334

 

328

 

387

 

357

 

Curtailments and settlements

 

 

 

2

 

4

 

Multi-employer plans/other

 

 

 

(74

)

8

 

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

 

63

 

(79

)

271

 

239

 

Cost of defined contribution plans

 

156

 

159

 

102

 

103

 

Total defined benefit and contribution plans cost recognized in the Consolidated Statement of Earnings

 

$

219

 

$

79

 

$

373

 

$

342

 

 

(Dollars in millions)

 

U.S. Plans

 

Non-U.S. Plans

 

For the nine months ended September 30:

 

2017

 

2016

 

2017

 

2016

 

Service cost

 

$

 

$

 

$

308

 

$

318

 

Interest cost

 

1,435

 

1,536

 

622

 

787

 

Expected return on plan assets

 

(2,260

)

(2,767

)

(985

)

(1,419

)

Amortization of prior service costs/(credits)

 

12

 

8

 

(73

)

(79

)

Recognized actuarial losses

 

1,003

 

985

 

1,120

 

1,062

 

Curtailments and settlements

 

 

 

3

 

19

 

Multi-employer plan/other

 

 

 

(46

)

64

 

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

 

190

 

(238

)

950

 

751

 

Cost of defined contribution plans

 

475

 

484

 

301

 

318

 

Total defined benefit and contribution plans cost recognized in the Consolidated Statement of Earnings

 

$

665

 

$

246

 

$

1,250

 

$

1,069

 

 

On October 12, 2012, the High Court in London issued a ruling against IBM United Kingdom Limited and IBM United Kingdom Holdings Limited, both wholly-owned subsidiaries of the company, in litigation involving one of IBM UK’s defined benefit plans. As a result of the ruling, the company recorded a pre-tax retirement-related obligation of $162 million in the fourth quarter of 2012 in selling, general and administrative expense in the Consolidated Statement of Earnings. As a result of the final Court of Appeal ruling received in August 2017, the company adjusted its obligation under the plan. This adjustment resulted in a gain of $91 million recorded in selling, general and administrative expense in the Consolidated Statement of Earnings for the three and nine months ended September 30, 2017. This gain is reflected in “Non-U.S. Plans - Multi-employer plans/other” in the tables above. See note 12, “Contingencies” for additional information.

 

In March 2017, the company initiated a change to the investment strategy of its U.S. defined benefit plan. The 2017 target asset allocation was modified by reducing equity securities from 20 percent to 12 percent, increasing debt securities from 70 percent to 79 percent and other investments largely remained unchanged at 10 percent of total plan assets. This change was designed to reduce the risk associated with the potential negative impact that equity markets might have on the funded status of the U.S. defined benefit plan. The change is expected to reduce the 2018 expected long-term rate of return on assets from 5.75 percent to approximately 5.25 percent. See note S, “Retirement-Related Benefits,” on page 144 in the company’s 2016 Annual Report for additional information regarding the company’s investment strategy.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

In 2017, the company expects to contribute approximately $400 million to its non-U.S. defined benefit and multi-employer plans, the largest of which will be contributed to the defined benefit pension plans in Japan, Spain and the UK. This amount generally represents the legally mandated minimum contribution. Total contributions to the non-U.S. plans in the first nine months of 2017 were $301 million, of which $124 million was in cash and $176 million in U.S. Treasury securities. Total net contributions to the non-U.S. plans in the first nine months of 2016 were $261 million, of which $97 million was in cash and $164 million in U.S. Treasury securities. The contribution of U.S. Treasury securities is considered a non-cash transaction in the Consolidated Statement of Cash Flows.

 

The following tables provide the components of the cost/(income) for the company’s nonpension postretirement plans.

 

Cost of Nonpension Postretirement Plans

 

(Dollars in millions)

 

U.S. Plan

 

Non-U.S. Plans

 

For the three months ended September 30:

 

2017

 

2016

 

2017

 

2016

 

Service cost

 

$

4

 

$

4

 

$

1

 

$

1

 

Interest cost

 

38

 

41

 

14

 

15

 

Expected return on plan assets

 

 

 

(2

)

(2

)

Amortization of prior service costs/(credits)

 

(2

)

(2

)

0

 

(1

)

Recognized actuarial losses

 

5

 

5

 

2

 

2

 

Curtailments and settlements

 

 

 

0

 

0

 

Total nonpension postretirement plan cost recognized in Consolidated Statement of Earnings

 

$

45

 

$

49

 

$

16

 

$

16

 

 

 

 

 

 

 

 

 

 

 

(Dollars in millions)

 

U.S. Plan

 

Non-U.S. Plans

 

For the nine months ended September 30:

 

2017

 

2016

 

2017

 

2016

 

Service cost

 

$

11

 

$

13

 

$

4

 

$

4

 

Interest cost

 

115

 

124

 

43

 

37

 

Expected return on plan assets

 

 

 

(6

)

(5

)

Amortization of prior service costs/(credits)

 

(6

)

(6

)

0

 

(4

)

Recognized actuarial losses

 

15

 

15

 

5

 

7

 

Curtailments and settlements

 

 

 

0

 

0

 

Total nonpension postretirement plan cost recognized in Consolidated Statement of Earnings

 

$

135

 

$

146

 

$

47

 

$

39

 

 

The company contributed $259 million in U.S. Treasury securities to the U.S. nonpension postretirement benefit plan during the nine months ended September 30, 2017, and $200 million in U.S. Treasury securities and $40 million in cash during the nine months ended September 30, 2016. The contribution of U.S. Treasury securities is considered a non-cash transaction in the Consolidated Statement of Cash Flows.

 

9. Acquisitions/Divestitures:

 

Acquisitions: During the nine months ended September 30, 2017, the company completed four acquisitions at an aggregate cost of $128 million.

 

The Technology Services & Cloud Platforms segment completed acquisitions of three businesses: in the first quarter, Agile 3 Solutions, LLC (Agile 3 Solutions), a privately held business; in the third quarter, the cloud and managed hosting services business from a large U.S. telecommunications company, and Cloudigo Ltd. (Cloudigo), a privately held business. The Cognitive Solutions segment completed the acquisition of one privately held business: in the second quarter, XCC Web Content & Custom Apps Extension (XCC) from TIMETOACT Software & Consulting GmbH.

 

Each acquisition is expected to enhance the company’s portfolio of product and services capabilities. Agile 3 Solutions is a developer of software used by C-Suite and senior executives to better visualize, understand and manage risks associated with the protection of sensitive data and adds capabilities to the company’s security portfolio. The acquisition of the cloud and managed hosting services business strengthens the company’s services portfolio and aligns with its cloud strategy. Cloudigo brings talent and technology that aligns closely with the company’s cloud platform investments in advanced

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

network processing. XCC’s technology enhances IBM’s Connections Cloud platform by providing a single, accessible engagement center for sharing content.

 

Purchase price consideration for all acquisitions as reflected in the following table, was paid in cash. All acquisitions are reported in the Consolidated Statement of Cash Flows net of acquired cash and cash equivalents.

 

The following table reflects the purchase price related to these acquisitions and the resulting purchase price allocations as of September 30, 2017.

 

 

 

Amortization

 

Total

 

(Dollars in millions)

 

Life (in yrs.)

 

Acquisitions

 

Current assets

 

 

 

$

18

 

Fixed assets/noncurrent assets

 

 

 

69

 

Intangible assets:

 

 

 

 

 

Goodwill

 

N/A

 

16

 

Completed technology

 

5

 

9

 

Client relationships

 

7

 

62

 

Patents/trademarks

 

1-5

 

1

 

Total assets acquired

 

 

 

175

 

Current liabilities

 

 

 

(47

)

Total liabilities assumed

 

 

 

(47

)

Total purchase price

 

 

 

$

128

 

 

N/A - not applicable

 

The acquisitions were accounted for as business combinations using the acquisition method, and accordingly, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired entity 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 businesses and IBM and the acquired assembled workforce, neither of which qualify as an amortizable intangible asset.

 

The overall weighted-average life of the identified amortizable intangible assets acquired is 6.6 years. These identified intangible assets will be amortized on a straight-line basis over their useful lives. Goodwill of $13 million has been assigned to the Technology Services & Cloud Platforms segment and goodwill of $3 million has been assigned to the Cognitive Solutions segment. It is expected that approximately 50 percent of the goodwill will be deductible for tax purposes. Each of the acquisitions was for 100 percent of the acquired businesses.

 

On October 4, 2017, the company announced its intent to acquire Vivant Digital (Vivant), a boutique digital and innovation agency. The acquisition extends the strategy and design expertise of IBM Interactive Experience (IBM iX) and will help accelerate clients’ digital transformations. The transaction is expected to close in the fourth quarter of 2017 and the business will be integrated within the GBS segment.

 

Divestitures:

 

Microelectronics — On October 20, 2014, IBM and GLOBALFOUNDRIES announced a definitive agreement in which GLOBALFOUNDRIES would acquire the company’s Microelectronics business, including existing semiconductor manufacturing assets and operations in East Fishkill, NY and Essex Junction, VT. The commercial OEM business acquired by GLOBALFOUNDRIES includes custom logic and specialty foundry, manufacturing and related operations. The transaction closed on July 1, 2015.

 

At September 30, 2014, the company concluded that the Microelectronics business met the criteria for discontinued operations reporting. The disposal group constituted a component under accounting guidance. The continuing cash inflows and outflows with the discontinued component are related to the manufacturing sourcing arrangement and the transition, packaging and test services. These cash flows are not direct cash flows as they are not significant and the company has no significant continuing involvement.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

All assets and liabilities of the business, classified as held for sale at June 30, 2015, were transferred at closing. The company transferred $515 million of net cash to GLOBALFOUNDRIES in the third quarter of 2015. This amount included $750 million of cash consideration, adjusted by the amount of working capital due from GLOBALFOUNDRIES and other miscellaneous items. A second cash payment in the amount of $500 million was transferred in December 2016. The remaining cash consideration of $250 million is expected to be transferred in December 2017.

 

Summarized financial information for discontinued operations is immaterial.

 

Industry Standard Server — On January 23, 2014, IBM and Lenovo Group Limited (Lenovo) announced a definitive agreement in which Lenovo would acquire the company’s industry standard server portfolio (System x) for an adjusted purchase price of $2.1 billion, consisting of approximately $1.8 billion in cash, with the balance in Lenovo common stock. The stock represented less than 5 percent equity ownership in Lenovo. The company sold to Lenovo its System x, BladeCenter and Flex System blade servers and switches, x86-based Flex integrated systems, NeXtScale and iDataPlex servers and associated software, blade networking and maintenance operations. As of March 31, 2016, all Lenovo common stock was sold.

 

The initial closing was completed on October 1, 2014. A subsequent closing occurred in most other countries in which there was a large business footprint on December 31, 2014. The remaining countries closed on March 31, 2015. An assessment of the ongoing contractual terms of the transaction resulted in the recognition of pre-tax gains of $63 million, $57 million and $13 million in 2015, 2016 and the first nine months of 2017, respectively.

 

Overall, the company expects to recognize a total pre-tax gain on the sale of approximately $1.6 billion, which does not include associated costs related to transition and performance-based costs. Net of these charges, the pre-tax gain was approximately $1.3 billion, of which the cumulative gain recorded as of September 30, 2017 is $1.2 billion. The balance of the gain is expected to be recognized in 2019 upon conclusion of the maintenance agreement.

 

Others – In the first quarter of 2017, the company completed one research-related divestiture. The company completed two Cognitive Solutions divestitures in the second quarter of 2017 and one Cognitive Solutions divestiture in the third quarter of 2017. The financial terms related to these transactions were not material. Overall, the company recognized a pre-tax gain of $25 million related to these transactions in 2017.

 

39



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

10. Intangible Assets Including Goodwill:  The following table details the company’s intangible asset balances by major asset class:

 

 

 

At September 30, 2017

 

(Dollars in millions)

 

Gross Carrying

 

Accumulated

 

Net Carrying

 

Intangible asset class

 

Amount

 

Amortization

 

Amount

 

Capitalized software

 

$

1,586

 

$

(750

)

$

835

 

Client relationships

 

2,416

 

(1,054

)

1,363

 

Completed technology

 

2,872

 

(1,562

)

1,310

 

Patents/trademarks

 

707

 

(267

)

440

 

Other*

 

52

 

(19

)

32

 

Total

 

$

7,633

 

$

(3,652

)

$

3,981

 

 


* Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems.

 

 

 

At December 31, 2016

 

(Dollars in millions)

 

Gross Carrying

 

Accumulated

 

Net Carrying

 

Intangible asset class

 

Amount

 

Amortization

 

Amount

 

Capitalized software

 

$

1,537

 

$

(661

)

$

876

 

Client relationships

 

2,831

 

(1,228

)

1,602

 

Completed technology

 

3,322

 

(1,668

)

1,654

 

Patents/trademarks

 

730

 

(205

)

525

 

Other*

 

46

 

(15

)

31

 

Total

 

$

8,466

 

$

(3,778

)

$

4,688

 

 


* Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems.

 

The net carrying amount of intangible assets decreased $707 million during the first nine months of 2017, primarily due to intangible asset amortization, partially offset by additions resulting from capitalized software. The aggregate intangible amortization expense was $383 million and $1,161 million for the third quarter and first nine months of 2017, respectively, versus $403 million and $1,148 million for the third quarter and first nine months of 2016, respectively. In addition, in the first nine months of 2017, the company retired $1,255 million of fully amortized intangible assets, impacting both the gross carrying amount and accumulated amortization by this amount.

 

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 September 30, 2017:

 

 

 

Capitalized

 

Acquired

 

 

 

(Dollars in millions)

 

Software

 

Intangibles

 

Total

 

2017 (for Q4)

 

$

144

 

$

216

 

$

359

 

2018

 

441

 

811

 

1,252

 

2019

 

202

 

671

 

873

 

2020

 

48

 

559

 

607

 

2021

 

 

446

 

446

 

 

The change in the goodwill balances by reportable segment, for the nine months ended September 30, 2017 and for the year ended December 31, 2016 are as follows:

 

40



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

 

 

 

 

 

 

 

 

Foreign

 

 

 

 

 

 

 

 

 

 

 

 

 

Currency

 

 

 

 

 

 

 

 

 

Purchase

 

 

 

Translation

 

 

 

(Dollars in millions)

 

Balance

 

Goodwill

 

Price

 

 

 

And Other

 

Balance

 

Segment

 

01/01/17

 

Additions

 

Adjustments

 

Divestitures

 

Adjustments*

 

9/30/17

 

Cognitive Solutions

 

$

19,484

 

$

3

 

$

(36

)

$

(15

)

$

243

 

$

19,679

 

Global Business Services

 

4,607

 

 

4

 

 

186

 

4,797

 

Technology Services & Cloud Platforms

 

10,258

 

13

 

(3

)

 

175

 

10,444

 

Systems

 

1,850

 

 

 

 

13

 

1,863

 

Total

 

$

36,199

 

$

16

 

$

(36

)

$

(15

)

$

618

 

$

36,782

 

 


* Primarily driven by foreign currency translation.

 

 

 

 

 

 

 

 

 

 

 

Foreign

 

 

 

 

 

 

 

 

 

 

 

 

 

Currency

 

 

 

 

 

 

 

 

 

Purchase

 

 

 

Translation

 

 

 

(Dollars in millions)

 

Balance

 

Goodwill

 

Price

 

 

 

And Other

 

Balance

 

Segment

 

01/01/16

 

Additions

 

Adjustments

 

Divestitures

 

Adjustments*

 

12/31/16

 

Cognitive Solutions

 

$

15,621

 

$

3,821

 

$

5

 

$

(12

)

$

48

 

$

19,484

 

Global Business Services

 

4,396

 

303

 

4

 

(1

)

(95

)

4,607

 

Technology Services & Cloud Platforms

 

10,156

 

119

 

(12

)

(5

)

(1

)

10,258

 

Systems

 

1,848

 

 

(4

)

 

5

 

1,850

 

Total

 

$

32,021

 

$

4,244

 

$

(7

)

$

(18

)

$

(42

)

$

36,199

 

 


* Primarily driven by foreign currency translation.

 

There were no goodwill impairment losses recorded during the first nine months of 2017 or the full year of 2016 and the company has no accumulated impairment losses.

 

Purchase price adjustments recorded in the first nine months of 2017 and full year 2016 were related to acquisitions completed on or prior to June 30, 2017 or September 30, 2016, respectively, and were still subject to the measurement period that ends at the earlier of 12 months from the acquisition date or when information becomes available. Net purchase price adjustments of $36 million were recorded during the first nine months of 2017, with the primary drivers being deferred tax assets, other taxes payable and other current liabilities associated with the Truven Health Analytics, Inc. and The Weather Company acquisitions. Net purchase price adjustments of $7 million were recorded during 2016, with the primary drivers being deferred tax assets, accounts receivable, deferred income, inventory and other current liabilities.

 

11. Borrowings:

 

Short-Term Debt

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Commercial paper

 

$

 

$

899

 

Short-term loans

 

407

 

375

 

Long-term debt — current maturities

 

3,892

 

6,239

 

Total

 

$

4,299

 

$

7,513

 

 

The weighted-average interest rate for commercial paper at December 31, 2016 was 0.7 percent. The weighted-average interest rate for short-term loans was 5.4 percent and 9.5 percent at September 30, 2017 and December 31, 2016, respectively.

 

41



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Long-Term Debt

 

Pre-Swap Borrowing

 

 

 

 

 

Balance

 

Balance

 

(Dollars in millions)

 

Maturities

 

9/30/2017

 

12/31/2016

 

U.S. dollar debt (average interest rate at September 30, 2017):*

 

 

 

 

 

 

 

2.7%

 

2017

 

$

2

 

$

5,104

 

3.0%

 

2018–2019

 

10,208

 

8,856

 

2.0%

 

2020–2021

 

7,416

 

4,941

 

2.4%

 

2022

 

3,492

 

1,901

 

3.4%

 

2023

 

1,529

 

1,500

 

3.6%

 

2024

 

2,000

 

2,000

 

7.0%

 

2025

 

600

 

600

 

3.5%

 

2026

 

1,350

 

1,350

 

4.7%

 

2027

 

969

 

469

 

6.5%

 

2028

 

313

 

313

 

5.9%

 

2032

 

600

 

600

 

8.0%

 

2038

 

83

 

83

 

5.6%

 

2039

 

745

 

745

 

4.0%

 

2042

 

1,107

 

1,107

 

7.0%

 

2045

 

27

 

27

 

4.7%

 

2046

 

650

 

650

 

7.1%

 

2096

 

316

 

316

 

 

 

 

 

$

31,408

 

$

30,563

 

Other currencies (average interest rate at September 30, 2017, in parentheses):*

 

 

 

 

 

 

 

Euros (1.5%)

 

2019–2029

 

$

10,342

 

$

7,122

 

Pound sterling (2.7%)

 

2020–2022

 

1,409

 

1,296

 

Japanese yen (0.9%)

 

2017–2026

 

1,669

 

1,576

 

Canadian (2.2%)

 

2017

 

 

373

 

Other (7.4%)

 

2018–2020

 

694

 

215

 

 

 

 

 

$

45,522

 

$

41,145

 

Less: net unamortized discount

 

 

 

833

 

839

 

Less: net unamortized debt issuance costs

 

 

 

99

 

82

 

Add: fair value adjustment**

 

 

 

627

 

669

 

 

 

 

 

$

45,218

 

$

40,893

 

Less: current maturities

 

 

 

3,892

 

6,239

 

Total

 

 

 

$

41,327

 

$

34,655

 

 


*              Includes notes, debentures, bank loans, secured borrowings and capital lease obligations.

**       The portion of the company’s fixed-rate debt obligations that is hedged is reflected in the Consolidated Statement of Financial Position as an amount equal to the sum of the debt’s carrying value and a fair value adjustment representing changes in the fair value of the hedged debt obligations attributable to movements in benchmark interest rates.

 

There are no debt securities issued and outstanding by IBM International Group Capital LLC, which is an indirect, 100 percent owned finance subsidiary of International Business Machines Corporation, the parent. Any debt securities issued by IBM International Group Capital LLC, would be fully and unconditionally guaranteed by the parent.

 

During the third quarter of 2017, IBM Credit LLC, a wholly owned subsidiary of the company, filed a shelf registration statement with the Securities and Exchange Commission (SEC) allowing it to offer for sale public debt securities. IBM Credit LLC issued fixed and floating rate debt securities in the aggregate amount of $3.0 billion with maturity dates ranging from 2019 to 2022. This debt is included in the long-term debt table above.

 

The company’s indenture governing its debt securities and its various credit facilities each contain significant covenants which obligate the company to promptly pay principal and interest, limit the aggregate amount of secured indebtedness and sale and leaseback transactions to 10 percent of the company’s consolidated net tangible assets, and restrict the company’s ability to merge or consolidate unless certain conditions are met. The credit facilities also include a covenant on the company’s consolidated net interest expense ratio, which cannot be less than 2.20 to 1.0, as well as a cross default provision with respect to other defaulted indebtedness of at least $500 million.

 

42


 


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The company is in compliance with all of its significant debt covenants and provides periodic certifications to its lenders. The failure to comply with its debt covenants could constitute an event of default with respect to the debt to which such provisions apply. If certain events of default were to occur, the principal and interest on the debt to which such event of default applied would become immediately due and payable.

 

Pre-swap annual contractual maturities of long-term debt outstanding at September 30, 2017, are as follows:

 

(Dollars in millions)

 

Total

 

2017 (for Q4)

 

$

468

 

2018

 

5,140

 

2019

 

7,034

 

2020

 

6,155

 

2021

 

5,155

 

2022 and beyond

 

21,569

 

Total

 

$

45,522

 

 

Interest on Debt

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Cost of financing

 

$

496

 

$

432

 

Interest expense

 

485

 

523

 

Net investment derivative activity

 

(34

)

(51

)

Interest capitalized

 

(1

)

3

 

Total interest paid and accrued

 

$

947

 

$

907

 

 

Lines of Credit

 

In 2016, the company increased the size of its five-year Credit Agreement (the “Credit Agreement”) from $10 billion to $10.25 billion and extended the term by one year to November 10, 2021. The Credit Agreement permits the company and its Subsidiary Borrowers to borrow up to $10.25 billion on a revolving basis. Borrowings of the Subsidiary Borrowers will be unconditionally backed by the company. The company may also, upon the agreement of either existing lenders, or of the additional banks not currently party to the Credit Agreement, increase the commitments under the Credit Agreement up to an additional $1.75 billion. Subject to certain terms of the Credit Agreement, the company and Subsidiary Borrowers may borrow, prepay and reborrow amounts under the Credit Agreement at any time during the Credit Agreement term. Interest rates on borrowings under the Credit Agreement will be based on prevailing market interest rates, as further described in the Credit Agreement. The Credit Agreement contains customary representations and warranties, covenants, events of default, and indemnification provisions. The company believes that circumstances that might give rise to breach of these covenants or an event of default, as specified in the Credit Agreement, are remote. As of September 30, 2017, there were no borrowings by the company, or its subsidiaries, under the Credit Agreement.

 

The company also has other committed lines of credit in some of the geographies which are not significant in the aggregate. Interest rates and other terms of borrowing under these lines of credit vary from country to country, depending on local market conditions.

 

On July 20, 2017, the company and IBM Credit LLC, (the Borrowers), entered into a $2.5 billion 364-Day Credit Agreement, and a $2.5 billion Three-Year Credit Agreement (the New Credit Agreements, and together with the Credit Agreement, the Credit Facilities). IBM also entered into the Third Amendment to its Credit Agreement. The New Credit Agreements permit the Borrowers to borrow up to an aggregate of $5 billion on a revolving basis. Neither Borrower is a guarantor or co-obligor of the other Borrower under the New Credit Agreements. Subject to certain conditions stated in the New Credit Agreements, the Borrowers may borrow, prepay and re-borrow amounts under the New Credit Agreements at any time during the term of the New Credit Agreements. Funds borrowed may be used for the general corporate purposes of the Borrowers. Interest rates on borrowings under the New Credit Agreements will be based on prevailing market interest rates, as further described in the New Credit Agreements. The New Credit Agreements contain customary representations and warranties, covenants, events of default, and indemnification provisions. The Amendment to the Credit Agreement adds and restates various provisions in order to provide the company with the opportunity in 2018 to request that the lenders extend the termination date of the Credit Agreement to July 20, 2023.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

12. Contingencies:  As a company with a substantial employee population and with clients in more than 175 countries, IBM is involved, either as plaintiff or defendant, in a variety of ongoing claims, demands, suits, investigations, tax matters and proceedings that arise from time to time in the ordinary course of its business. The company is a leader in the information technology industry and, as such, has been and will continue to be subject to claims challenging its IP rights and associated products and offerings, including claims of copyright and patent infringement and violations of trade secrets and other IP rights. In addition, the company enforces its own IP against infringement, through license negotiations, lawsuits or otherwise. Also, as is typical for companies of IBM’s scope and scale, the company is party to actions and proceedings in various jurisdictions involving a wide range of labor and employment issues (including matters related to contested employment decisions, country-specific labor and employment laws, and the company’s pension, retirement and other benefit plans), as well as actions with respect to contracts, product liability, securities, foreign operations, competition law and environmental matters. These actions may be commenced by a number of different parties, including competitors, clients, current or former employees, government and regulatory agencies, stockholders and representatives of the locations in which the company does business. Some of the actions to which the company is party may involve particularly complex technical issues, and some actions may raise novel questions under the laws of the various jurisdictions in which these matters arise.

 

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 recorded liabilities, including any changes to such liabilities for the quarter ended September 30, 2017 were not material to the Consolidated Financial Statements.

 

In accordance with the relevant accounting guidance, the company provides disclosures of matters for which the likelihood of material loss is at least reasonably possible. In addition, the company also discloses matters based on its consideration of other matters and qualitative factors, including the experience of other companies in the industry, and investor, customer and employee relations considerations.

 

With respect to certain of the claims, suits, investigations and proceedings discussed herein, the company believes at this time that the likelihood of any material loss is remote, given, for example, the procedural status, court rulings, and/or the strength of the company’s defenses in those matters. With respect to the remaining claims, suits, investigations and proceedings discussed in this note, except as specifically discussed herein, the company is unable to provide estimates of reasonably possible losses or range of losses, including losses in excess of amounts accrued, if any, for the following reasons. Claims, suits, investigations and proceedings are inherently uncertain, and it is not possible to predict the ultimate outcome of these matters. It is the company’s experience that damage amounts claimed in litigation against it are unreliable and unrelated to possible outcomes, and as such are not meaningful indicators of the company’s potential liability. Further, the company is unable to provide such an estimate due to a number of other factors with respect to these claims, suits, investigations and proceedings, including considerations of the procedural status of the matter in question, the presence of complex or novel legal theories, and/or the ongoing discovery and development of information important to the matters. The company reviews claims, suits, investigations and proceedings at least quarterly, and decisions are made with respect to recording or adjusting provisions and disclosing reasonably possible losses or range of losses (individually or in the aggregate), to reflect the impact and status of settlement discussions, discovery, procedural and substantive rulings, reviews by counsel and other information pertinent to a particular matter.

 

Whether any losses, damages or remedies finally determined in any claim, suit, investigation or proceeding could reasonably have a material effect on the company’s business, financial condition, results of operations or cash flows 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 in the Consolidated Financial Statements; and the unique facts and circumstances of the particular matter that may give rise to additional factors. While the company will continue to defend itself vigorously, 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.

 

The following is a summary of the more significant legal matters involving the company.

 

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 (SCO v. IBM). The company removed the case to Federal Court in Utah. Plaintiff is an alleged 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 Dynix and contribution of code to Linux and the company has asserted counterclaims. On September 14, 2007, plaintiff filed for bankruptcy protection, and all proceedings in this case were stayed. The court in another suit, the SCO Group, Inc. v. Novell, Inc., held a trial in March 2010. The jury found that Novell is the owner of UNIX and UnixWare copyrights; the judge subsequently ruled that SCO is obligated to recognize

 

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Notes to Consolidated Financial Statements — (continued)

 

Novell’s waiver of SCO’s claims against IBM and Sequent for breach of UNIX license agreements. On August 30, 2011, the Tenth Circuit Court of Appeals affirmed the district court’s ruling and denied SCO’s appeal of this matter. In June 2013, the Federal Court in Utah granted SCO’s motion to reopen the SCO v. IBM case. In February 2016, the Federal Court ruled in favor of IBM on all of SCO’s remaining claims, and SCO appealed. On October 30, 2017, the Tenth Circuit Court of Appeals affirmed the dismissal of all but one of SCO’s remaining claims, which was remanded to the Federal Court in Utah.

 

On May 13, 2010, IBM and the State of Indiana (acting on behalf of the Indiana Family and Social Services Administration) sued one another in a dispute over a 2006 contract regarding the modernization of social service program processing in Indiana. After six weeks of trial, on July 18, 2012, the Indiana Superior Court in Marion County rejected the State’s claims in their entirety and awarded IBM $52 million plus interest and costs. On February 13, 2014, the Indiana Court of Appeals reversed portions of the trial judge’s findings, found IBM in material breach, and ordered the case remanded to the trial judge to determine the State’s damages, if any. The Indiana Court of Appeals also affirmed approximately $50 million of the trial court’s award of damages to IBM. On March 22, 2016, the Indiana Supreme Court affirmed the outcome of the Indiana Court of Appeals and remanded the case to the Indiana Superior Court. On August 7, 2017, the Indiana Superior Court awarded the State $128 million, which it then offset against IBM’s previously affirmed award of $50 million, resulting in a $78 million award to the State, plus interest. IBM appealed to the Indiana Court of Appeals and the matter remains pending.

 

On March 9, 2017, the Commonwealth of Pennsylvania’s Department of Labor and Industry sued IBM in Pennsylvania state court regarding a 2006 contract for the development of a custom software system to manage the Commonwealth’s unemployment insurance benefits programs. The matter is pending in a Pennsylvania court.

 

On October 29, 2013, Bridgestone Americas, Inc. (Bridgestone) sued IBM regarding a 2009 contract for the implementation of an SAP-based, enterprise-wide order management system. IBM counterclaimed against Bridgestone and its parent, Bridgestone Corp. The case is pending in the Middle District of Tennessee.

 

On April 16, 2014, Iusacell SA de C.V. (Iusacell) sued IBM, claiming that IBM made fraudulent misrepresentations that induced Iusacell to enter into an agreement with IBM Mexico. Iusacell claimed damages for lost profits. Iusacell’s complaint related to a contractual dispute in Mexico, which was the subject of a pending arbitration proceeding in Mexico initiated by IBM Mexico against Iusacell for breach of the underlying agreement.  On August 31, 2017, the parties entered into an agreement releasing all claims against each other, resolving both the lawsuit and the arbitration proceeding.

 

IBM United Kingdom Limited (IBM UK) initiated legal proceedings in May 2010 before the High Court in London against the IBM UK Pensions Trust (the UK Trust) and two representative beneficiaries of the UK Trust membership. IBM UK sought a declaration that it acted lawfully both in notifying the Trustee of the UK Trust that it was closing its UK defined benefit plans to future accruals for most participants and in implementing the company’s new retirement policy. In April 2014, the High Court acknowledged that the changes made to its UK defined benefit plans were within IBM’s discretion, but ruled that IBM breached its implied duty of good faith both in implementing these changes and in the manner in which it consulted with employees. Proceedings to determine remedies were held in July 2014, and in February 2015 the High Court held that for IBM to make changes to accruals under the plan would require a new consultation of the participants, but other changes (including to early retirement policy) would not require such consultation. IBM UK appealed both the breach and remedies judgments. In August 2017, the Appeal Court reversed the High Court, holding that IBM UK was not in breach of its implied duties of good faith and that the changes made to the plans were lawful. The time to appeal has expired and the Appeal Court judgment is final. In addition, IBM UK is a defendant in approximately 290 individual actions brought since early 2010 by participants of the defined benefits plans who left IBM UK. These actions, which allege constructive dismissal and age discrimination, are pending before the Employment Tribunal in Southampton UK.

 

In early 2012, IBM notified the SEC of an investigation by the Polish Central Anti-Corruption Bureau involving allegations of illegal activity by a former IBM Poland employee in connection with sales to the Polish government. IBM cooperated with the SEC and Polish authorities in this matter. In April 2013, IBM learned that the U.S. Department of Justice (DOJ) was also investigating allegations related to the Poland matter, as well as allegations relating to transactions in Argentina, Bangladesh and Ukraine. The DOJ was seeking information regarding the company’s global FCPA compliance program and its public sector business. The company cooperated with the DOJ in this matter. In June 2017, the DOJ and the SEC each informed IBM that based on the information to date, they closed their respective investigations into these matters without pursuing any enforcement action against the company.

 

In May 2015, a putative class action was commenced in the United States District Court for the Southern District of New York related to the company’s October 2014 announcement that it was divesting its global commercial semiconductor technology business, alleging violations of the Employee Retirement Income Security Act (“ERISA”). The company,

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

management’s Retirement Plans Committee, and three current or former IBM executives were named as defendants. On September 7, 2016, the Court granted the company’s motion to dismiss the plaintiffs’ claims. On October 21, 2016, the plaintiffs filed an amended complaint, dropping the company as a defendant. On September 29, 2017, the Court granted the defendants’ motion to dismiss. Plaintiffs have filed a notice of appeal to the Second Circuit Court of Appeals and the matter remains pending.

 

In August 2015, IBM learned that the SEC is conducting an investigation relating to revenue recognition with respect to the accounting treatment of certain transactions in the U.S., UK and Ireland. The company is cooperating with the SEC in 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, assessments or remediations at or in the vicinity of several current or former operating sites globally pursuant to permits, administrative orders or agreements with country, state or local environmental agencies, and is involved in lawsuits and claims concerning certain current or former operating sites.

 

The company is also subject to ongoing tax examinations and governmental assessments in various jurisdictions. Along with many other U.S. companies doing business in Brazil, the company is involved in various challenges with Brazilian tax authorities regarding non-income tax assessments and non-income tax litigation matters. The total potential amount related to all these matters for all applicable years is approximately $1.1 billion. The company believes it will prevail on these matters and that this amount is not a meaningful indicator of liability.

 

13. Commitments: The company’s extended lines of credit to third-party entities include unused amounts of $8,016 million and $6,542 million at September 30, 2017 and December 31, 2016, respectively. A portion of these amounts was available to the company’s business partners to support their working capital needs. In addition, the company has committed to provide future financing to its clients in connection with client purchase agreements for approximately $3,063 million and $2,463 million at September 30, 2017 and December 31, 2016, respectively.

 

The company has applied the guidance 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 intellectual property (IP) rights, specified environmental matters, third-party performance of nonfinancial contractual obligations and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, the procedures of which typically allow the company to challenge the other party’s claims. While typically indemnification provisions do not include a contractual maximum on the company’s payment, the company’s obligations under these agreements may be limited in terms of time and/or nature of claim, 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 have not had a material effect on the company’s business, financial condition or results of operations.

 

In addition, the company guarantees certain loans and financial commitments. The maximum potential future payment under these financial guarantees was $21 million and $34 million at September 30, 2017 and December 31, 2016, respectively. The fair value of the guarantees recognized in the Consolidated Statement of Financial Position is not material.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Changes in the company’s warranty liability for standard warranties and deferred income for extended warranty are presented in the following tables.

 

Standard Warranty Liability

 

(Dollars in millions)

 

2017

 

2016

 

Balance at January 1

 

$

156

 

$

181

 

Current period accruals

 

107

 

107

 

Accrual adjustments to reflect actual experience

 

(3

)

4

 

Charges incurred

 

(126

)

(132

)

Balance at September 30

 

$

134

 

$

160

 

 

Extended Warranty Liability

 

(Dollars in millions)

 

2017

 

2016

 

Aggregate deferred revenue at January 1

 

$

531

 

$

538

 

Revenue deferred for new extended warranty contracts

 

175

 

176

 

Amortization of deferred revenue

 

(198

)

(198

)

Other*

 

24

 

12

 

Aggregate deferred revenue at September 30

 

$

533

 

$

528

 

Current portion

 

$

258

 

$

287

 

Noncurrent portion

 

$

275

 

$

241

 

 


* Other primarily consists of foreign currency translation adjustments.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

14. Earnings Per Share of Common Stock: The following tables provide the computation of basic and diluted earnings per share of common stock for the three and nine months ended September 30, 2017 and 2016.

 

 

 

For the Three Months Ended

 

 

 

September 30, 2017

 

September 30, 2016

 

Number of shares on which basic earnings per share is calculated:

 

 

 

 

 

Weighted-average shares outstanding during period

 

929,437,441

 

953,995,828

 

Add — Incremental shares under stock-based compensation plans

 

2,236,234

 

2,357,365

 

Add — Incremental shares associated with contingently issuable shares

 

1,553,754

 

964,091

 

Number of shares on which diluted earnings per share is calculated

 

933,227,429

 

957,317,284

 

 

 

 

 

 

 

Income from continuing operations (millions)

 

$

2,726

 

$

2,854

 

Loss from discontinued operations, net of tax (millions)

 

0

 

(1

)

Net income on which basic earnings per share is calculated (millions)

 

$

2,726

 

$

2,853

 

Income from continuing operations (millions)

 

$

2,726

 

$

2,854

 

Net income applicable to contingently issuable shares (millions)

 

0

 

 

Income from continuing operations on which diluted earnings per share is calculated (millions)

 

$

2,726

 

$

2,854

 

Loss from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)

 

0

 

(1

)

Net income on which diluted earnings per share is calculated (millions)

 

$

2,726

 

$

2,853

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

Assuming dilution

 

 

 

 

 

Continuing operations

 

$

2.92

 

$

2.98

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

2.92

 

$

2.98

 

Basic

 

 

 

 

 

Continuing operations

 

$

2.93

 

$

2.99

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

2.93

 

$

2.99

 

 

Stock options to purchase 399,844 shares and 29,033 shares were outstanding as of September 30, 2017 and 2016, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price during the respective period was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

 

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Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

For the Nine Months Ended

 

 

 

September 30, 2017

 

September 30, 2016

 

Number of shares on which basic earnings per share is calculated:

 

 

 

 

 

Weighted-average shares outstanding during period

 

935,600,777

 

957,693,385

 

Add — Incremental shares under stock compensation plans

 

3,213,758

 

2,258,854

 

Add — Incremental shares associated with contingently issuable shares

 

1,394,930

 

771,943

 

Number of shares on which diluted earnings per share is calculated

 

940,209,466

 

960,724,182

 

 

 

 

 

 

 

Income from continuing operations (millions)

 

$

6,811

 

$

7,375

 

Loss from discontinued operations, net of tax (millions)

 

(3

)

(4

)

Net income on which basic earnings per share is calculated (millions)

 

$

6,807

 

$

7,371

 

Income from continuing operations (millions)

 

$

6,811

 

$

7,375

 

Net income applicable to contingently issuable shares (millions)

 

(2

)

 

Income from continuing operations on which diluted earnings per share is calculated (millions)

 

$

6,809

 

$

7,375

 

Loss from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)

 

(3

)

(4

)

Net income on which diluted earnings per share is calculated (millions)

 

$

6,806

 

$

7,371

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

Assuming dilution

 

 

 

 

 

Continuing operations

 

$

7.24

 

$

7.67

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

7.24

 

$

7.67

 

Basic

 

 

 

 

 

Continuing operations

 

$

7.28

 

$

7.70

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

7.28

 

$

7.70

 

 

Stock options to purchase 146,795 shares and 533,089 shares (average of first, second and third quarter share amounts) were outstanding as of September 30, 2017 and 2016, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price during the respective periods was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

 

15. Subsequent Events: On October 31, 2017, the company announced that the Board of Directors approved a quarterly dividend of $1.50 per common share. The dividend is payable December 9, 2017 to shareholders of record on November 10, 2017.

 

On October 31, 2017, the company announced that the Board of Directors authorized $3.0 billion in additional funds for use in the company’s stock repurchase program.

 

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Table of Contents

 

Item 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017

 

Snapshot

 

Financial Results Summary — Three Months Ended September 30:

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars and shares in millions except per share amounts)

 

 

 

 

 

Margin

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Revenue

 

$

19,153

 

$

19,226

 

(0.4

)%*

Gross profit margin

 

45.9

%

46.9

%

(0.9

)pts.

Total expense and other (income)

 

$

5,735

 

$

5,751

 

(0.3

)%

Total expense and other (income)-to-revenue ratio

 

29.9

%

29.9

%

0.0

pts.

Income from continuing operations, before income taxes

 

$

3,065

 

$

3,263

 

(6.1

)%

Provision for income taxes from continuing operations

 

$

339

 

$

409

 

(17.1

)%

Income from continuing operations

 

$

2,726

 

$

2,854

 

(4.5

)%

Income from continuing operations margin

 

14.2

%

14.8

%

(0.6

)pts.

Loss from discontinued operations, net of tax

 

$

0

 

$

(1

)

(79.3

)%

Net income

 

$

2,726

 

$

2,853

 

(4.5

)%

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

2.92

 

$

2.98

 

(2.0

)%

Basic

 

$

2.93

 

$

2.99

 

(2.0

)%

Consolidated earnings per share - assuming dilution

 

$

2.92

 

$

2.98

 

(2.0

)%

Weighted-average shares outstanding:

 

 

 

 

 

 

 

Assuming dilution

 

933.2

 

957.3

 

(2.5

)%

Basic

 

929.4

 

954.0

 

(2.6

)%

 


*   (1.0) percent adjusted for currency.

 

Organization of Information:

 

In October 2014, the company announced a definitive agreement to divest its Microelectronics business and manufacturing operations. The operating results of the Microelectronics business are reported as discontinued operations. The transaction closed on July 1, 2015.

 

Currency:

 

The references to “adjusted for currency” or “at constant currency” in the Management Discussion do not include operational impacts that could result from fluctuations in foreign currency rates. When the company refers to growth rates at constant currency or adjusts such growth rates for currency, it is done so that certain financial results can be viewed without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons of its business performance. Financial results adjusted for currency are calculated by translating current period activity in local currency using the comparable prior year period’s currency conversion rate. This approach is used for countries where the functional currency is the local currency. Generally, when the dollar either strengthens or weakens against other currencies, the growth at constant currency rates or adjusting for currency will be higher or lower than growth reported at actual exchange rates. See “Currency Rate Fluctuations” on page 81 for additional information.

 

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Table of Contents

 

Management Discussion — (continued)

 

Operating (non-GAAP) Earnings:

 

In an effort to provide better transparency into the operational results of the business, the company separates business results into operating and non-operating categories. Operating earnings from continuing operations is a non-GAAP measure that excludes the effects of certain acquisition-related charges, intangible asset amortization expense resulting from basis differences on equity method investments, retirement-related costs, discontinued operations and related tax impacts. For acquisitions, operating earnings exclude the amortization of purchased intangible assets and acquisition-related charges such as in-process research and development, transaction costs, applicable restructuring and related expenses and tax charges related to acquisition integration. These charges are excluded as they may be inconsistent in amount and timing from period to period and are dependent on the size, type and frequency of the company’s acquisitions. All other spending for acquired companies is included in both earnings from continuing operations and in operating (non-GAAP) earnings. Throughout the Management Discussion & Analysis, the impact of acquisitions over the prior 12-month period may be a driver of higher expenses year to year.  For retirement-related costs, the company characterizes certain items as operating and others as non-operating. The company includes defined benefit plan and nonpension postretirement benefit plan service cost, amortization of prior service cost and the cost of defined contribution plans in operating earnings. Non-operating retirement-related cost includes defined benefit plan and nonpension postretirement benefit plan interest cost, expected return on plan assets, amortized actuarial gains/losses, the impacts of any plan curtailments/settlements and multi-employer plan costs, pension insolvency costs and other costs. Non-operating retirement-related costs are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance and the company considers these costs to be outside of the operational performance of the business.

 

Overall, the company believes that providing investors with a view of operating earnings as described above provides increased transparency and clarity into both the operational results of the business and the performance of the company’s pension plans; improves visibility to management decisions and their impacts on operational performance; enables better comparisons to peer companies; and allows the company to provide a long-term strategic view of the business going forward. The company’s reportable segment financial results reflect operating earnings from continuing operations, consistent with the company’s management and measurement system.

 

The following table provides the company’s (non-GAAP) operating earnings for the third quarter of 2017 and 2016.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions except per share amounts)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Net income as reported

 

$

2,726

 

$

2,853

 

(4.5

)%

Loss from discontinued operations, net of tax

 

0

 

(1

)

(79.3

)

Income from continuing operations

 

$

2,726

 

$

2,854

 

(4.5

)%

Non-operating adjustments (net of tax):

 

 

 

 

 

 

 

Acquisition-related charges

 

159

 

197

 

(19.1

)

Non-operating retirement-related costs/(income)

 

193

 

99

 

96.1

 

Operating (non-GAAP) earnings*

 

$

3,079

 

$

3,149

 

(2.2

)%

Diluted operating (non-GAAP) earnings per share

 

$

3.30

 

$

3.29

 

0.3

%

 


*   See page 85 for a more detailed reconciliation of net income to operating earnings.

 

Financial Performance Summary — Three Months Ended September 30:

 

In the third quarter of 2017, the company reported $19.2 billion in revenue, $2.7 billion in income from continuing operations and $3.1 billion in operating (non-GAAP) earnings, resulting in diluted earnings per share from continuing operations of $2.92 as reported and $3.30 on an operating (non-GAAP) basis. The company generated $3.6 billion in cash from operations and $2.5 billion in free cash flow in the third quarter of 2017 and shareholder returns of $2.3 billion in gross common stock repurchases and dividends.

 

Total consolidated revenue decreased 0.4 percent year to year as reported and 1.0 percent adjusted for currency in the third quarter of 2017, with sequential improvement of 4.3 points as reported and 2.3 points adjusted for currency from the second-quarter year-to-year rates. The Cognitive Solutions segment and the Systems segment both had revenue growth year to year in the third quarter as reported and adjusted for currency. The year-to-year effect of currency in the third quarter (0.6 points help) improved from the second quarter impact (1.4 points hurt).

 

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Table of Contents

 

Management Discussion — (continued)

 

The company is embedding cloud and cognitive capabilities across the business and the strategic imperatives are a signpost of the progress being made in helping enterprise clients extract value from data and become digital businesses. In the third quarter of 2017, the company continued to deliver solid revenue growth in its strategic imperatives - cloud, analytics, mobile, security and social, which together generated $8.8 billion of revenue and grew 11 percent as reported and 10 percent adjusted for currency, with double-digit growth in cloud and security. Strategic imperatives growth in the third quarter largely represented organic growth as the acquisitive content has leveled on a year-to-year basis. Total Cloud revenue of $4.1 billion increased 20 percent as reported and adjusted for currency, with as-a-Service revenue up 25 percent (24 percent adjusted for currency). The annual exit run rate for as-a-Service revenue increased to $9.4 billion in the third quarter of 2017 compared to $7.5 billion in the third quarter of 2016. Analytics revenue of $5.0 billion increased 5 percent both as reported and adjusted for currency. Mobile revenue increased 7 percent as reported and adjusted for currency and Security revenue increased 51 percent (49 percent adjusted for currency), driven by security software solutions and strong demand for the pervasive encryption capabilities in the new z14 mainframe.

 

From a segment perspective, in the third quarter, Cognitive Solutions revenue increased 3.9 percent as reported and 3 percent adjusted for currency with growth in Solutions Software and Transaction Processing Software as reported and adjusted for currency. Performance in the third quarter included growth in annuity revenue, including as-a-Service solutions, as well as growth in software transactional performance. Global Business Services (GBS) revenue decreased 2.3 percent as reported and 2 percent adjusted for currency, primarily driven by declines in both Application Management and Global Process Services, partially offset by growth in Consulting. The GBS business continued to shift resources and move into the high-value strategic areas of digital, cloud and analytics. GBS strategic imperatives revenue increased 10 percent (11 percent adjusted for currency) year to year. Technology Services & Cloud Platforms revenue decreased 3.3 percent as reported and 4 percent adjusted for currency, primarily driven by a decline in Infrastructure Services. However, within Technology Services & Cloud Platforms, strategic imperatives revenue was up 12 percent as reported and adjusted for currency year to year, driven by hybrid cloud services, security and mobile. Systems revenue increased 10.4 percent as reported and 10 percent adjusted for currency driven by strong contribution from the new z14 mainframe and continued growth in Storage Systems.

 

From a geographic perspective, Americas revenue decreased 2.0 percent (2 percent adjusted for currency) year to year, with the U.S. down 2.6 percent and Latin America down 1.5 percent (2 percent adjusted for currency). Canada was up 2.1 percent as reported, but down 2 percent adjusted for currency. Europe/Middle East/Africa (EMEA) revenue increased 2.4 percent as reported, but decreased 1 percent adjusted for currency, with growth in France, Germany and Spain and a decline in the UK. Asia Pacific revenue decreased 1.2 percent as reported, but increased 2 percent adjusted for currency. Within Asia Pacific, Japan decreased 4.0 percent as reported, but increased 4 percent adjusted for currency, and China increased 3.9 percent (4 percent adjusted for currency).

 

The consolidated gross profit margin of 45.9 percent decreased 0.9 points year to year driven by continued investments, mix and higher retirement-related costs, partially offset by benefits from productivity. The operating (non-GAAP) gross margin of 47.6 percent decreased 0.4 points compared to the prior year driven primarily by the same factors, excluding the impact of higher non-operating retirement-related costs. The consolidated gross margin and the operating (non-GAAP) gross margin both improved 0.4 points compared to the second-quarter 2017 gross margins.

 

Total expense and other (income) decreased 0.3 percent in the third quarter of 2017 compared to the prior year. The year-to-year decrease was primarily the result of lower operational spending (4 points), largely offset by lower intellectual property income (4 points) and spending related to acquisitions completed in the prior 12 months. The expense dynamics reflect continued efficiency in the underlying spending offset by continued investment to build and reinvent new solutions and platforms. Total operating (non-GAAP) expense and other (income) decreased 0.8 percent year to year driven primarily by the same factors.

 

Pre-tax income from continuing operations of $3.1 billion in the third quarter of 2017 decreased 6.1 percent year to year and the pre-tax margin was 16.0 percent, a decrease of 1.0 points compared to the third quarter of 2016. The continuing operations effective tax rate for the third quarter of 2017 was 11.0 percent, a decrease of 1.5 points compared to the third quarter of 2016, driven by an increase in foreign tax credits, partially offset by a benefit related to tax audit activity in the prior year period. Income from continuing operations of $2.7 billion decreased 4.5 percent and the net income margin was 14.2 percent, a decrease of 0.6 points. Losses from discontinued operations, net of tax, were $0.2 million in the third quarter of 2017 and $1.0 million in the third quarter of 2016. Net income of $2.7 billion decreased 4.5 percent year to year. Operating (non-GAAP) pre-tax income from continuing operations of $3.6 billion decreased 1.7 percent year to year. Operating (non-GAAP) pre-tax margin from continuing operations decreased 0.2 points to 18.8 percent. Operating (non-GAAP) income from continuing operations of $3.1 billion decreased 2.2 percent and the operating (non-GAAP) income

 

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Management Discussion — (continued)

 

margin from continuing operations of 16.1 percent decreased 0.3 points. The operating (non-GAAP) effective tax rate from continuing operations in the third quarter of 2017 was 14.7 percent versus 14.2 percent in the prior year.

 

Diluted earnings per share from continuing operations of $2.92 in the third quarter of 2017 decreased 2.0 percent year to year. In the third quarter of 2017, the company repurchased 6.6 million shares of its common stock at a cost of $0.9 billion and had $1.5 billion remaining in the share repurchase authorization at September 30, 2017. Operating (non-GAAP) diluted earnings per share of $3.30 increased 0.3 percent versus the third quarter of 2016.

 

The company generated $3.6 billion in cash flow from operating activities in the third quarter of 2017, a decrease of $0.5 billion compared to the third quarter of 2016. Net cash used in investing activities of $1.9 billion was $1.0 billion higher than the prior year, primarily driven by a reduction in cash sourced from non-operating finance receivables ($0.4 billion) and an increase in cash used from net purchases of marketable securities and other investments ($0.4 billion). Net cash used in financing activities of $2.8 billion decreased $1.4 billion compared to the prior year, primarily driven by higher net debt issuances ($1.6 billion).

 

In January 2017, the company disclosed that it expected GAAP earnings per share from continuing operations of at least $11.95 and operating (non-GAAP) earnings of at least $13.80 per diluted share for 2017. The company also disclosed that it expected 2017 free cash flow to be consistent with 2016. Refer to page 82 in the Liquidity and Capital Resources section for additional information on this non-GAAP measure. In October 2017, the company disclosed that it continues to maintain these expectations. Refer to the Looking Forward section on pages 80 and 81 for additional information on the company’s expectations.

 

Financial Results Summary - Nine Months Ended September 30:

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars and shares in millions except per share amounts)

 

 

 

 

 

Margin

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Revenue

 

$

56,597

 

$

58,149

 

(2.7

)%*

Gross profit margin

 

44.8

%

47.1

%

(2.3

)pts.

Total expense and other (income)

 

$

18,434

 

$

20,056

 

(8.1

)%

Total expense and other (income)-to-revenue ratio

 

32.6

%

34.5

%

(1.9

)pts.

Income from continuing operations, before income taxes

 

$

6,931

 

$

7,345

 

(5.6

)%

Provision for/(benefit from) income taxes from continuing operations

 

$

120

 

$

(31

)

nm

%

Income from continuing operations

 

$

6,811

 

$

7,375

 

(7.7

)%

Income from continuing operations margin

 

12.0

%

12.7

%

(0.6

)pts.

Loss from discontinued operations, net of tax

 

$

(3

)

$

(4

)

(17.5

)%

Net income

 

$

6,807

 

$

7,371

 

(7.6

)%

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

7.24

 

$

7.67

 

(5.6

)%

Basic

 

$

7.28

 

$

7.70

 

(5.5

)%

Consolidated earnings per share - assuming dilution

 

$

7.24

 

$

7.67

 

(5.6

)%

Weighted-average shares outstanding:

 

 

 

 

 

 

 

Assuming dilution

 

940.2

 

960.7

 

(2.1

)%

Basic

 

935.6

 

957.7

 

(2.3

)%

 

 

 

 

 

 

 

 

 

 

 

9/30/17

 

12/31/16

 

 

 

Assets

 

$

121,636

 

$

117,470

 

3.5

%

Liabilities

 

$

101,879

 

$

99,078

 

2.8

%

Equity

 

$

19,757

 

$

18,392

 

7.4

%

 


* (2.2) percent adjusted for currency

 

nm - not meaningful

 

The following table provides the company’s (non-GAAP) operating earnings for the first nine months of 2017 and 2016.

 

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Management Discussion — (continued)

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions except per share amounts)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Net income as reported

 

$

6,807

 

$

7,371

 

(7.6

)%

Loss from discontinued operations, net of tax

 

(3

)

(4

)

(17.5

)

Income from continuing operations

 

$

6,811

 

$

7,375

 

(7.7

)%

Non-operating adjustments (net of tax):

 

 

 

 

 

 

 

Acquisition-related charges

 

537

 

542

 

(0.7

)

Non-operating retirement-related costs/(income)

 

777

 

338

 

129.9

 

Operating (non-GAAP) earnings*

 

$

8,125

 

$

8,255

 

(1.6

)%

Diluted operating (non-GAAP) earnings per share

 

$

8.64

 

$

8.59

 

0.6

%

 


*   See page 86 for a more detailed reconciliation of net income to operating earnings.

 

Financial Performance Summary — Nine Months Ended September 30:

 

In the first nine months of 2017, the company reported $56.6 billion in revenue, and delivered $6.8 billion in income from continuing operations, resulting in diluted earnings per share from continuing operations of $7.24 as reported and $8.64 on an operating (non-GAAP) basis. The company generated $11.0 billion in cash from operations and $6.2 billion in free cash flow in the first nine months of 2017 and shareholder returns of $7.8 billion in gross common stock repurchases and dividends.

 

Total consolidated revenue decreased 2.7 percent year to year as reported and 2.2 percent adjusted for currency in the first nine months of 2017.

 

In the first nine months of 2017, the company’s strategic imperatives revenue grew 9 percent year to year as reported and 10 percent adjusted for currency. Total Cloud revenue of $11.6 billion was up 22 percent year to year as reported and 23 percent adjusted for currency, with as-a-Service revenue up 36 percent (37 percent adjusted for currency). Analytics revenue of $14.5 billion increased 5 percent as reported and 6 percent adjusted for currency. Mobile revenue was up 17 percent year to year (19 percent adjusted for currency) and Security revenue increased 21 percent as reported and adjusted for currency.

 

From a segment perspective, for the first nine months, Cognitive Solutions revenue increased 1.0 percent as reported and 1 percent adjusted for currency. On an as reported and adjusted for currency basis, Solutions Software increased year to year, while Transaction Processing Software declined. GBS revenue decreased 3.0 percent as reported and 2 percent adjusted for currency with declines in Application Management , Consulting and Global Process Services. GBS strategic imperatives revenue increased 10 percent (11 percent adjusted for currency) year to year. Technology Services & Cloud Platforms revenue decreased 3.7 percent as reported and 3 percent adjusted for currency, primarily driven by Infrastructure Services which declined 4.4 percent (4 percent adjusted for currency). Technology Services & Cloud Platforms strategic imperatives revenue was up 20 percent (21 percent adjusted for currency) year to year, led by hybrid cloud services. Systems revenue decreased 6.2 percent as reported (6 percent adjusted for currency) with declines in z Systems and Power Systems, both due to product refresh cycle dynamics, partially offset by growth in Storage Systems.

 

From a geographic perspective, Americas revenue decreased 1.8 percent (2 percent adjusted for currency) year to year with the U.S. down 3.0 percent, partially offset by growth in Latin America (4.5 percent as reported, 1 percent adjusted for currency). EMEA revenue decreased 4.7 percent (3 percent adjusted for currency) driven primarily by declines in the UK and Germany. Asia Pacific revenue decreased 1.9 percent (1 percent adjusted for currency), with Japan down 1.8 percent as reported, but up 2 percent adjusted for currency.

 

The consolidated gross margin of 44.8 percent decreased 2.3 points year to year and reflects investments, mix and higher retirement-related costs, partially offset by benefits from productivity. The operating (non-GAAP) gross margin of 46.5 percent decreased 1.7 points versus the prior year primarily driven by the same factors, excluding the impact of higher non-operational retirement-related costs.

 

Total expense and other (income) decreased $1.6 billion or 8.1 percent in the first nine months of 2017 compared to the prior year. The year-to-year decrease was primarily the result of continued focus on efficiency in spending and reduced expenses for workforce transformation. This included a lower level of workforce rebalancing charges (4 points), a prior-year charge for real estate actions (2 points) and lower operational spending (2 points). In addition, the effects of currency (1 point) contributed to the year-to-year decline. The year-to-year decrease in expense and other (income) was partially offset by

 

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Table of Contents

 

Management Discussion — (continued)

 

spending related to acquisitions (2 points) completed in the prior 12 months. Total operating (non-GAAP) expense and other (income) decreased 9.9 percent year to year, driven primarily by the same factors.

 

Pre-tax income from continuing operations of $6.9 billion decreased 5.6 percent and the pre-tax margin was 12.2 percent, a decrease of 0.4 points versus the first nine months of 2016. The continuing operations effective tax rate for the first nine months of 2017 was 1.7 percent compared to (0.4) percent in the prior year. The tax rate in the first nine months of 2017 benefitted from discrete tax items, including the first-quarter intra-entity transfer of assets ($0.6 billion) and certain second-quarter discrete items. The prior year negative tax rate was primarily the result of a refund ($1.2 billion) of previously paid non-U.S. taxes plus interest in the first quarter of 2016. Income from continuing operations of $6.8 billion decreased 7.7 percent and the net income margin was 12.0 percent, a decrease of 0.6 points compared to the first nine months of 2016. Losses from discontinued operations, net of tax, were $3.5 million in the first nine months of 2017 and $4.2 million in the prior-year period. Net income of $6.8 billion decreased 7.6 percent year to year. Operating (non-GAAP) pre-tax income from continuing operations of $8.7 billion increased 2.5 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations increased 0.8 points to 15.5 percent. Operating (non-GAAP) income from continuing operations of $8.1 billion decreased 1.6 percent and the operating (non-GAAP) income margin from continuing operations of 14.4 percent increased 0.2 points. The operating (non-GAAP) effective tax rate from continuing operations in the first nine months of 2017 was 7.1 percent versus 3.2 percent in the first nine months of 2016.

 

Diluted earnings per share from continuing operations of $7.24 decreased 5.6 percent year to year. In the first nine months of 2017, the company repurchased 22.9 million shares of its common stock and had $1.5 billion remaining in the current share repurchase authorization at September 30, 2017. Operating (non-GAAP) diluted earnings per share of $8.64 increased 0.6 percent versus the prior year.

 

At September 30, 2017, the balance sheet remains strong, and with the newly reorganized financing entity, IBM Credit LLC, the company is better positioned to support the business over the long term. Cash and marketable securities at quarter end were $11.5 billion, an increase of $3.0 billion from December 31, 2016. Key drivers in the balance sheet and total cash flows were:

 

Total assets increased $4.2 billion (decreased $0.4 billion adjusted for currency) from December 31, 2016 driven by:

 

·                  Increases in cash and marketable securities ($3.0 billion), deferred taxes ($2.1 billion), retirement plan assets ($1.5 billion) and goodwill ($0.6 billion); partially offset by

·                  Decreases in total receivables ($2.7 billion) and intangible assets ($0.7 billion).

 

Total liabilities increased $2.8 billion (decreased $1.5 billion adjusted for currency) from December 31, 2016 driven by:

 

·                  Increases in total debt ($3.5 billion); partially offset by

 

·                  Decreases in accounts payable ($0.8 billion).

 

Total equity of $19.8 billion increased $1.4 billion from December 31, 2016 as a result of:

 

·                  Increases from net income ($6.8 billion), retirement-related ($1.4 billion) and equity translation adjustments ($0.8 billion); partially offset by

 

·                  Decreases from dividends ($4.1 billion) and share repurchases ($3.7 billion).

 

The company generated $11.0 billion in cash flow provided by operating activities, a decrease of $2.1 billion compared to the first nine months of 2016, driven primarily by the prior-year tax refund and a decrease in cash provided by financing receivables. Net cash used in investing activities of $3.3 billion was $4.0 billion lower than the prior year, primarily driven by a decrease in cash used for acquisitions ($5.0 billion). Net cash used in financing activities of $5.5 billion increased $0.9 billion compared to the first nine months of 2016, driven primarily by increased gross common share repurchases ($1.0 billion).

 

55



Table of Contents

 

Management Discussion — (continued)

 

Third Quarter and First Nine Months in Review

 

Results of Continuing Operations

 

Segment Details

 

The following is an analysis of the third quarter and first nine months of 2017 versus the third quarter and first nine months of 2016 reportable segment external revenue and gross margin results. Segment pre-tax income includes transactions between the segments that are intended to reflect an arm’s-length transfer price and excludes certain unallocated corporate items.

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent/Margin

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Revenue:

 

 

 

 

 

 

 

 

 

Cognitive Solutions

 

$

4,400

 

$

4,235

 

3.9

%

3.0

%

Gross margin

 

78.7

%

80.4

%

(1.7

)pts.

 

 

Global Business Services

 

4,093

 

4,191

 

(2.3

)%

(2.2

)%

Gross margin

 

27.3

%

28.8

%

(1.5

)pts.

 

 

Technology Services & Cloud Platforms

 

8,457

 

8,748

 

(3.3

)%

(4.1

)%

Gross margin

 

41.1

%

42.0

%

(1.0

)pts.

 

 

Systems

 

1,721

 

1,558

 

10.4

%

9.6

%

Gross margin

 

53.6

%

51.1

%

2.6

pts.

 

 

Global Financing

 

427

 

412

 

3.7

%

2.8

%

Gross margin

 

25.2

%

37.8

%

(12.6

)pts.

 

 

Other

 

56

 

81

 

(31.8

)%

(32.8

)%

Gross margin

 

(511.4

)%

(279.2

)%

(232.2

)pts.

 

 

Total consolidated revenue

 

$

19,153

 

$

19,226

 

(0.4

)%

(1.0

)%

Total consolidated gross profit

 

$

8,800

 

$

9,013

 

(2.4

)%

 

 

Total consolidated gross margin

 

45.9

%

46.9

%

(0.9

)pts.

 

 

Non-operating adjustments:

 

 

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

114

 

129

 

(12.2

)%

 

 

Retirement-related costs/(income)

 

203

 

79

 

158.7

%

 

 

Operating (non-GAAP) gross profit

 

$

9,116

 

$

9,221

 

(1.1

)%

 

 

Operating (non-GAAP) gross margin

 

47.6

%

48.0

%

(0.4

)pts.

 

 

 

56



Table of Contents

 

Management Discussion — (continued)

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent/Margin

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Revenue:

 

 

 

 

 

 

 

 

 

Cognitive Solutions

 

$

13,021

 

$

12,889

 

1.0

%

1.3

%

Gross margin

 

78.4

%

81.5

%

(3.1

)pts.

 

 

Global Business Services

 

12,196

 

12,578

 

(3.0

)%

(1.9

)%

Gross margin

 

25.3

%

27.0

%

(1.7

)pts.

 

 

Technology Services & Cloud Platforms

 

25,079

 

26,029

 

(3.7

)%

(3.3

)%

Gross margin

 

40.2

%

41.5

%

(1.3

)pts.

 

 

Systems

 

4,863

 

5,184

 

(6.2

)%

(5.9

)%

Gross margin

 

51.5

%

55.1

%

(3.6

)pts.

 

 

Global Financing

 

1,246

 

1,245

 

0.1

%

(0.4

)%

Gross margin

 

29.2

%

39.6

%

(10.4

)pts.

 

 

Other

 

192

 

223

 

(14.2

)%

(14.3

)%

Gross margin

 

(456.0

)%

(295.2

)%

(160.8

)pts.

 

 

Total consolidated revenue

 

$

56,597

 

$

58,149

 

(2.7

)%

(2.2

)%

Total consolidated gross profit

 

$

25,365

 

$

27,401

 

(7.4

)%

 

 

Total consolidated gross margin

 

44.8

%

47.1

%

(2.3

)pts.

 

 

Non-operating adjustments:

 

 

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

349

 

371

 

(5.7

)%

 

 

Retirement-related costs/(income)

 

591

 

238

 

148.2

%

 

 

Operating (non-GAAP) gross profit

 

$

26,305

 

$

28,010

 

(6.1

)%

 

 

Operating (non-GAAP) gross margin

 

46.5

%

48.2

%

(1.7

)pts.

 

 

 

Cognitive Solutions

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Cognitive Solutions external revenue:

 

$

4,400

 

$

4,235

 

3.9

%

3.0

%

Solutions Software

 

$

3,029

 

$

2,919

 

3.8

%

2.9

%

Transaction Processing Software

 

1,371

 

1,316

 

4.2

 

3.2

 

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Cognitive Solutions external revenue:

 

$

13,021

 

$

12,889

 

1.0

%

1.3

%

Solutions Software

 

$

9,015

 

$

8,842

 

2.0

%

2.3

%

Transaction Processing Software

 

4,006

 

4,048

 

(1.0

)

(0.8

)

 

Cognitive Solutions revenue of $4,400 million grew 3.9 percent as reported and 3 percent adjusted for currency in the third quarter of 2017 compared to the prior year with growth in both Solutions Software and Transaction Processing Software. For the first nine months of the year, Cognitive Solutions revenue of $13,021 million grew 1.0 percent as reported and 1 percent adjusted for currency with growth in Solutions Software, partially offset by declines in Transaction Processing Software both as reported and adjusted for currency.

 

Cognitive Solutions third-quarter annuity revenue grew as reported and adjusted for currency including strong Software-as-a-Service (SaaS) performance with continued double-digit revenue growth as reported and adjusted for currency. There was growth, as reported and adjusted for currency, in software services which support solutions offerings through industry and product expertise. Transactional revenue also grew this quarter as reported and adjusted for currency compared to the

 

57



Table of Contents

 

Management Discussion — (continued)

 

prior year as clients commit to the platform long term. Within the segment, third-quarter revenue growth was driven by organic performance as acquisitive content has leveled on a year-to-year basis.

 

In the third quarter, Solutions Software revenue of $3,029 million grew 3.8 percent as reported (3 percent adjusted for currency) compared to the prior year. Transaction Processing Software revenue of $1,371 million grew 4.2 percent as reported (3 percent adjusted for currency) compared to the third quarter of 2016. Within Solutions Software, third quarter year-to-year growth was led by offerings in security and analytics. Security software grew double digits as reported and adjusted for currency year to year in the third quarter with strong performance across the portfolio as cognitive capabilities continue to be embedded into these offerings. Analytics revenue growth was broad-based as the company continues to reinvent these offerings. With new offerings and new clients added to the platform this quarter, Internet of Things (IoT) revenue grew double digits in the third quarter both as reported and adjusted for currency. Within Transaction Processing Software, the year-to-year growth reflects clients’ ongoing long-term commitment and the value the company’s platform provides to them. This portfolio predominately runs on-premise mission critical workloads running on z Systems in industries such as banking, airlines and retail.

 

Cognitive Solutions total third-quarter strategic imperatives revenue of $2.9 billion grew 5 percent year to year as reported and adjusted for currency. Cloud revenue of $0.6 billion grew 10 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $2.0 billion. For the first nine months of the year, total strategic imperatives revenue of $8.5 billion grew 4 percent as reported and adjusted for currency year to year. Cloud revenue of $1.8 billion grew 24 percent as reported and adjusted for currency.

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Cognitive Solutions:

 

 

 

 

 

 

 

External gross profit

 

$

3,465

 

$

3,407

 

1.7

%

External gross profit margin

 

78.7

%

80.4

%

(1.7

)pts.

Pre-tax income

 

$

1,649

 

$

1,574

 

4.8

%

Pre-tax margin

 

32.8

%

32.1

%

0.7

pts.

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Cognitive Solutions:

 

 

 

 

 

 

 

External gross profit

 

$

10,207

 

$

10,509

 

(2.9

)%

External gross profit margin

 

78.4

%

81.5

%

(3.1

)pts.

Pre-tax income

 

$

4,539

 

$

4,039

 

12.4

%

Pre-tax margin

 

30.2

%

27.3

%

3.0

pts.

 

Cognitive Solutions gross profit margin decreased 1.7 points to 78.7 percent in the third quarter of 2017 compared to the prior year. For the first nine months of the year, gross profit margin decreased 3.1 points to 78.4 percent. The gross profit margin decline year to year is driven by continued investment and an increasing mix toward SaaS.

 

In the third quarter, pre-tax income of $1,649 million increased 4.8 percent compared to the prior year with a pre-tax margin improvement of 0.7 points to 32.8 percent. For the first nine months of the year, pre-tax income of $4,539 million increased 12.4 percent compared to the prior year with a pre-tax margin improvement of 3.0 points to 30.2 percent. The company continues to embed cognitive into offerings, scale platforms and build high value vertical solutions. The year-to-year benefit in the nine-month period also reflects a lower level of charges related to workforce rebalancing and real estate actions year to year.

 

58



Table of Contents

 

Management Discussion — (continued)

 

Global Business Services

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Global Business Services external revenue:

 

$

4,093

 

$

4,191

 

(2.3

)%

(2.2

)%

Consulting

 

$

1,803

 

$

1,799

 

0.2

%

0.9

%

Global Process Services

 

314

 

354

 

(11.3

)

(11.9

)

Application Management

 

1,976

 

2,038

 

(3.0

)

(3.2

)

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Global Business Services external revenue:

 

$

12,196

 

$

12,578

 

(3.0

)%

(1.9

)%

Consulting

 

$

5,394

 

$

5,520

 

(2.3

)%

(0.9

)%

Global Process Services

 

948

 

1,048

 

(9.6

)

(9.2

)

Application Management

 

5,855

 

6,011

 

(2.6

)

(1.6

)

 

 Global Business Services revenue of $4,093 million decreased 2.3 percent as reported and 2 percent adjusted for currency in the third quarter of 2017 compared to the prior year. The company continues to transform this business and shift its practices to where there is opportunity, which is around digital, cognitive, cloud and automation. GBS signings grew for the third consecutive quarter as reported and adjusted for currency, and strategic imperatives revenue grew double digits year to year as reported and adjusted for currency. However, this growth continues to be more than offset by declines in the more traditional areas that the company is shifting away from. For the first nine months of the year, Global Business Services revenue of $12,196 million decreased 3.0 percent as reported and 2 percent adjusted for currency.

 

In the third quarter, Consulting revenue of $1,803 million increased 0.2 percent as reported (1 percent adjusted for currency) with continued improvement on a sequential basis led by the company’s digital strategy and iX platform. The Consulting backlog returned to growth as reported and adjusted for currency in the third quarter versus the prior year. Global Process Services (GPS) revenue of $314 million decreased 11.3 percent as reported (12 percent adjusted for currency) compared to the prior year. Application Management revenue of $1,976 million decreased 3.0 percent as reported (3 percent adjusted for currency). The company continues to help clients implement new cloud-centric architectures in their critical applications. Overall performance was impacted by areas of this business that are not as differentiated and are experiencing pricing pressure.

 

Third-quarter 2017 GBS strategic imperatives revenue of $2.5 billion grew 10 percent as reported (11 percent adjusted for currency) year to year. Cloud revenue of $1.0 billion grew 35 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $1.2 billion. For the first nine months of the year, total strategic imperatives revenue of $7.2 billion grew 10 percent as reported (11 percent adjusted for currency) year to year. Cloud revenue of $2.9 billion grew 41 percent as reported (43 percent adjusted for currency).

 

59



Table of Contents

 

Management Discussion — (continued)

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Global Business Services:

 

 

 

 

 

 

 

External gross profit

 

$

1,117

 

$

1,206

 

(7.4

)%

External gross profit margin

 

27.3

%

28.8

%

(1.5

)pts.

Pre-tax income

 

$

453

 

$

544

 

(16.8

)%

Pre-tax margin

 

10.8

%

12.7

%

(1.9

)pts.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Global Business Services:

 

 

 

 

 

 

 

External gross profit

 

$

3,083

 

$

3,393

 

(9.2

)%

External gross profit margin

 

25.3

%

27.0

%

(1.7

)pts.

Pre-tax income

 

$

1,065

 

$

1,210

 

(12.0

)%

Pre-tax margin

 

8.5

%

9.4

%

(0.8

)pts.

 

 

 

 

 

 

 

 

 

GBS third quarter gross profit margin decreased 1.5 points to 27.3 percent year to year with a decline similar to the second quarter 2017. In the third quarter of 2017, pre-tax income of $453 million decreased 16.8 percent year to year. The pre-tax margin declined 1.9 points to 10.8 percent, however it improved more than 3 points sequentially compared to the second quarter 2017. For the first nine months of the year, pre-tax income of $1,065 million decreased 12.0 percent and the pre-tax margin declined 0.8 points to 8.5 percent. Pre-tax income performance for the first nine months of 2017 includes a lower level of charges related to workforce rebalancing and real estate actions as compared to the prior year.

 

The GBS margin has been impacted by investments to drive transformation and reflects pricing and profit pressure in the more traditional IT services. The company will continue to focus on improving productivity with a streamlined practice model and new project management approaches. As it grows its practices around cloud, analytics and mobility services, the company will continue to invest in skills necessary to drive this transformation.

 

Technology Services & Cloud Platforms

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Technology Services & Cloud Platforms external revenue:

 

$

8,457

 

$

8,748

 

(3.3

)%

(4.1

)%

Infrastructure Services

 

$

5,665

 

$

5,901

 

(4.0

)%

(4.8

)%

Technical Support Services

 

1,801

 

1,831

 

(1.6

)

(2.1

)

Integration Software

 

990

 

1,016

 

(2.6

)

(3.4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Technology Services & Cloud Platforms external revenue:

 

$

25,079

 

$

26,029

 

(3.7

)%

(3.3

)%

Infrastructure Services

 

$

16,695

 

$

17,458

 

(4.4

)%

(3.9

)%

Technical Support Services

 

5,357

 

5,446

 

(1.6

)

(1.5

)

Integration Software

 

3,027

 

3,126

 

(3.2

)

(2.7

)

 

 

 

 

 

 

 

 

 

 

 

Technology Services & Cloud Platforms revenue of $8,457 million decreased 3.3 percent as reported and 4 percent adjusted for currency in the third quarter of 2017 compared to the prior year. In the third quarter, there were declines across

 

60



Table of Contents

 

Management Discussion — (continued)

 

all lines of business, however there was double-digit growth as reported and adjusted for currency in strategic imperatives revenue. Global Technology Services (GTS) signings also grew more than 25 percent year to year. For the first nine months of the year, Technology Services and Cloud Platforms revenue of $25,079 million decreased 3.7 percent as reported and 3 percent adjusted for currency.

 

In the third quarter, Infrastructure Services revenue of $5,665 million declined 4.0 percent as reported (5 percent adjusted for currency) compared to the prior year. This decline reflects the continued impact associated with contract conclusions at the end of 2016 and the shift away from certain lower value work within this business. The full year-to-year benefit from certain larger contracts signed in second-quarter 2017 are not yet providing offsetting growth. However, in the third quarter, there was strong signings performance both as reported and adjusted for currency as clients contract to implement hybrid cloud environments.

 

Technical Support Services third-quarter revenue of $1,801 million decreased 1.6 percent as reported (2 percent adjusted for currency) year to year. Within this line of business, the company is focused on growing its multi-vendor support services which provide clients with a single source of expertise and visibility across different vendor solutions. Integration Software third quarter revenue of $990 million decreased 2.6 percent as reported (3 percent adjusted for currency) compared to the prior year. There was continued growth in SaaS across the portfolio as the company helps clients implement hybrid cloud environments. This growth was offset by declines in areas such as on premise DevOps and IT service management.

 

Technology Services & Cloud Platforms third-quarter 2017 strategic imperatives revenue of $2.6 billion grew 12 percent year to year as reported and adjusted for currency. Cloud revenue of $1.8 billion grew 16 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $6.2 billion. For the first nine months of the year, total strategic imperatives revenue of $7.4 billion grew 20 percent as reported (21 percent adjusted for currency) year to year. Cloud revenue of $5.1 billion grew 24 percent as reported (25 percent adjusted for currency).

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Technology Services & Cloud Platforms:

 

 

 

 

 

 

 

External Technology Services gross profit

 

$

2,667

 

$

2,825

 

(5.6

)%

External Technology Services gross profit margin

 

35.7

%

36.5

%

(0.8

)pts.

External Integration Software gross profit

 

$

805

 

$

851

 

(5.4

)%

External Integration Software gross profit margin

 

81.3

%

83.8

%

(2.4

)pts.

External total gross profit

 

$

3,473

 

$

3,676

 

(5.5

)%

External total gross profit margin

 

41.1

%

42.0

%

(1.0

)pts.

Pre-tax income

 

$

1,192

 

$

1,288

 

(7.5

)%

Pre-tax margin

 

13.8

%

14.4

%

(0.6

)pts.

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Technology Services & Cloud Platforms:

 

 

 

 

 

 

 

External Technology Services gross profit

 

$

7,630

 

$

8,176

 

(6.7

)%

External Technology Services gross profit margin

 

34.6

%

35.7

%

(1.1

)pts.

External Integration Software gross profit

 

$

2,450

 

$

2,630

 

(6.9

)%

External Integration Software gross profit margin

 

80.9

%

84.2

%

(3.2

)pts.

External total gross profit

 

$

10,080

 

$

10,806

 

(6.7

)%

External total gross profit margin

 

40.2

%

41.5

%

(1.3

)pts.

Pre-tax income

 

$

2,888

 

$

2,825

 

2.2

%

Pre-tax margin

 

11.3

%

10.6

%

0.6

pts.

 

Technology Services & Cloud Platforms gross profit margin decreased 1.0 points year to year in the third quarter to 41.1 percent and pre-tax income of $1,192 million decreased 7.5 percent. The pre-tax margin declined 0.6 points year to year to 13.8 percent, but improved sequentially by 2 points compared to the second quarter of 2017.  For the first nine months of the year, pre-tax income of $2,888 million increased 2.2 percent and the pre-tax margin improved 0.6 points to 11.3 percent. The

 

61



Table of Contents

 

Management Discussion — (continued)

 

year-to-year performance in the nine months of 2017 compared to the prior year includes a lower level of charges related to workforce and real estate actions.

 

The company continues to yield savings from prior-year workforce transformation, is focused on delivering productivity to clients, and continues to invest to expand its cloud infrastructure which is currently impacting margin. With over sixty cloud centers across nineteen countries, the IBM Cloud provides clients with flexibility in how and where they store their data.

 

Services Backlog and Signings

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

 

 

At September 30,

 

At September 30,

 

Percent

 

Adjusted For

 

(Dollars in billions)

 

2017

 

2016

 

Change

 

Currency

 

Total backlog

 

$

119.3

 

$

121.3

 

(1.6

)%

(2.1

)%

 

The estimated total services backlog at September 30, 2017 was $119 billion, a decrease of 1.6 percent as reported and 2 percent adjusted for currency with modest growth in GTS as reported (essentially flat adjusted for currency) and a decrease in GBS year to year as reported and adjusted for currency.

 

Total services backlog includes Infrastructure Services, Consulting, Global Process Services, Application Management and Technical Support Services. Total backlog is intended to be a statement of overall work under contract for these businesses and therefore includes Technical Support Services. It does not include as-a-Service offerings that have flexibility in contractual commitment terms. Backlog estimates are subject to change and are affected by several factors, including terminations, changes in the scope of contracts, periodic revalidations, adjustments for revenue not materialized and adjustments for currency.

 

Services signings are management’s initial estimate of the value of a client’s commitment under a services contract. There are no third-party standards or requirements governing the calculation of signings. The calculation used by management involves estimates and judgments to gauge the extent of a client’s commitment, including the type and duration of the agreement, and the presence of termination charges or wind-down costs.

 

Signings include Infrastructure Services, Consulting, Global Process Services and Application Management contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. Technical Support Services is not included in signings as maintenance contracts tend to be more steady state, where revenues equal renewals.

 

Contract portfolios purchased in an acquisition are treated as 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.

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Total signings

 

$

10,385

 

$

8,955

 

16.0

%

14.8

%

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Total signings

 

$

29,178

 

$

30,031

 

(2.8

)%

(1.8

)%

 

62



Table of Contents

 

Management Discussion — (continued)

 

Systems

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Systems external revenue:

 

$

1,721

 

$

1,558

 

10.4

%

9.6

%

Systems Hardware

 

$

1,301

 

$

1,128

 

15.3

%

14.4

%

z Systems

 

 

 

 

 

63.8

 

61.9

 

Power Systems

 

 

 

 

 

(7.2

)

(7.8

)

Storage Systems

 

 

 

 

 

4.9

 

4.3

 

Operating Systems Software

 

420

 

430

 

(2.3

)

(2.9

)

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Systems external revenue:

 

$

4,863

 

$

5,184

 

(6.2

)%

(5.9

)%

Systems Hardware

 

$

3,629

 

$

3,852

 

(5.8

)%

(5.5

)%

z Systems

 

 

 

 

 

(13.4

)

(13.3

)

Power Systems

 

 

 

 

 

(12.7

)

(12.6

)

Storage Systems

 

 

 

 

 

6.1

 

6.6

 

Operating Systems Software

 

1,234

 

1,332

 

(7.4

)

(7.1

)

 

Systems revenue of $1,721 million grew 10.4 percent year to year as reported (10 percent adjusted for currency) in the third quarter of 2017 driven by a combination of strong z14 market acceptance and the third consecutive quarter of growth as reported and adjusted for currency in Storage Systems. Systems Hardware revenue of $1,301 million grew 15.3 percent as reported (14 percent adjusted for currency) with the growth in z Systems and Storage partially offset by a decrease in Power Systems as reported and adjusted for currency. Operating Systems Software revenue of $420 million decreased 2.3 percent as reported (3 percent adjusted for currency) compared to the prior year. For the first nine months of 2017, Systems revenue of $4,863 million decreased 6.2 percent as reported (6 percent adjusted for currency) with declines in both Systems Hardware and Operating Systems Software, both as reported and adjusted for currency.

 

Within Systems Hardware, third quarter z Systems revenue grew 63.8 percent as reported (62 percent adjusted for currency) year to year driven by the successful launch of the z14 mainframe in mid-September 2017. This success is due to strong demand for technology that helps address the growing threat of global data breaches and the need for clients to operate within regulated environments. The z14 mainframe has unprecedented encryption capabilities that are widely appealing and the company has already experienced good traction across a broad mix of industries and geographies in the quarter.

 

Power Systems third quarter revenue decreased 7.2 percent as reported (8 percent adjusted for currency) year to year. This reflects the company’s continued shift to a growing Linux market while continuing to serve a high value, but declining UNIX market. Linux had continued revenue growth as reported and adjusted for currency in the third quarter. Although there was growth in UNIX high-end systems this quarter, overall UNIX declined as reported and adjusted for currency.

 

Storage Systems third quarter revenue increased by 4.9 percent as reported (4 percent adjusted for currency) year to year with growth as reported and adjusted for currency across the major hardware product areas. There was continued growth as reported and adjusted for currency in all-flash array offerings in line with this high-growth market.

 

Third-quarter Systems strategic imperatives revenue of $0.9 billion grew 26 percent year to year as reported (25 percent adjusted for currency). Cloud revenue of $0.7 billion grew 24 percent as reported (23 percent adjusted for currency). For the first nine months of the year, total strategic imperatives revenue of $2.2 billion decreased 3 percent as reported and adjusted for currency year to year, primarily a reflection of product cycle dynamics. Cloud revenue of $1.7 billion decreased 5 percent as reported and adjusted for currency.

 

63



Table of Contents

 

Management Discussion — (continued)

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Systems:

 

 

 

 

 

 

 

External Systems Hardware gross profit

 

$

557

 

$

416

 

33.8

%

External Systems Hardware gross profit margin

 

42.9

%

36.9

%

5.9

pts.

External Operating Systems Software gross profit

 

$

366

 

$

380

 

(3.7

)%

External Operating Systems Software gross profit margin

 

87.0

%

88.3

%

(1.2

)pts.

External total gross profit

 

$

923

 

$

796

 

16.0

%

External total gross profit margin

 

53.6

%

51.1

%

2.6

pts.

Pre-tax income/(loss)

 

$

339

 

$

136

 

149.7

%

Pre-tax margin

 

17.4

%

7.8

%

9.6

pts.

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Systems:

 

 

 

 

 

 

 

External Systems Hardware gross profit

 

$

1,432

 

$

1,676

 

(14.6

)%

External Systems Hardware gross profit margin

 

39.5

%

43.5

%

(4.0

)pts.

External Operating Systems Software gross profit

 

$

1,074

 

$

1,182

 

(9.2

)%

External Operating Systems Software gross profit margin

 

87.0

%

88.7

%

(1.7

)pts.

External total gross profit

 

$

2,506

 

$

2,858

 

(12.3

)%

External total gross profit margin

 

51.5

%

55.1

%

(3.6

)pts.

Pre-tax income/(loss)

 

$

227

 

$

354

 

(35.9

)%

Pre-tax margin

 

4.2

%

6.1

%

(1.9

)pts.

 

The Systems gross profit margin increased 2.6 points to 53.6 percent in the third quarter of 2017 compared to the prior year, with sequential improvement compared to the second quarter of 2017. The overall increase year-to-year was driven by product mix primarily toward the high-margin z Systems. There was also margin improvement in z Systems and Storage Systems, with Power Systems essentially flat year to year. For the first nine months of the year, the Systems gross profit margin decreased 3.6 points to 51.5 percent compared to the prior year, with margin declines across all hardware brands and Operating Systems Software, as well as an impact from mix.

 

In the third quarter of 2017, pre-tax income of $339 million grew 149.7 percent and pre-tax margin increased 9.6 points year to year to 17.4 percent driven by the strong performance in z Systems. For the first nine months of the year, pre-tax income of $227 million decreased 35.9 percent compared to the prior year which also included a higher level of charges related to workforce rebalancing and real estate actions. The company remains focused on continually reinventing this portfolio to address new workloads.

 

Global Financing

 

Global Financing is a reportable segment that is measured as a stand-alone entity. Global Financing facilitates IBM clients’ acquisition of information technology systems, software and services by providing financing solutions in the areas where the company has the expertise, while generating strong returns on equity. Global Financing also optimizes the recovery of residual values by selling assets sourced from end of lease, leasing used equipment to new clients, or extending lease arrangements with current clients. Sales of equipment include equipment returned at the end of a lease, surplus internal equipment and used equipment purchased externally. Residual value is a risk unique to the financing business and management of this risk is dependent upon the ability to accurately project future equipment values at lease inception. Global Financing has insight into product plans and cycles for the IBM products under lease. Based upon this product information, Global Financing continually monitors projections of future equipment values and compares them with the residual values reflected in the portfolio.

 

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Table of Contents

 

Management Discussion — (continued)

 

Results of Operations

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

(Dollars in millions)

 

2017

 

2016

 

2017

 

2016

 

External revenue

 

$

427

 

$

412

 

$

1,246

 

$

1,245

 

Internal revenue

 

272

 

352

 

925

 

1,340

 

Total revenue

 

$

698

 

$

763

 

$

2,171

 

$

2,585

 

Pre-tax income

 

$

244

 

$

355

 

$

836

 

$

1,208

 

 

In the third quarter of 2017, Global Financing total revenue of $698 million decreased 8.5 percent compared to the prior year. This was due to a decline in internal revenue of 22.8 percent, driven by a decrease in internal used equipment sales (down 31.2 percent to $184 million), partially offset by an increase in internal financing (up 4.4 percent to $88 million). External revenue increased 3.7 percent as reported (2.8 percent adjusted for currency), due to an increase in external used equipment sales (up 31.6 percent to $141 million), partially offset by a decrease in external financing (down 6.1 percent to $286 million).

 

The decrease in total revenue in the first nine months of 2017 compared to the same period in 2016 was due to a decline in internal revenue of 30.9 percent, driven by a decrease in internal used equipment sales (down 39.9 percent to $662 million), partially offset by an increase in internal financing (up 10.1 percent to $263 million). External revenue was flat (down 0.4 percent adjusted for currency), with a decline in financing (down 6.3 percent to $877 million), partially offset by an increase in external used equipment sales (up 19.3 percent to $370 million).

 

The year-to-year increase in internal financing revenue in the third quarter of 2017 was due to higher average asset balances, partially offset by lower asset yields. The year-to-year increase in internal financing revenue in the first nine months of 2017 was due to higher average asset balances and higher asset yields. The decrease in external financing revenue in the third quarter of 2017, compared to the same period in 2016, was due to lower asset yields, partially offset by higher average asset balances. The decrease in external financing revenue in the first nine months of 2017, compared to the same period in 2016 was due to lower asset yields.

 

Total sales of used equipment represented 46.5 percent and 47.5 percent of Global Financing’s revenue in the third quarter and first nine months of 2017, respectively, and 49.1 percent and 54.6 percent in the third quarter and first nine months of 2016, respectively. The decreases in both periods were due to a lower volume of used equipment sales for internal transactions. The gross profit margin on used sales was 33.2 percent and 54.6 percent in the third quarter of 2017 and 2016, respectively, and 45.4 percent and 60.8 percent in the first nine months of 2017 and 2016, respectively. The decrease in the gross profit margin was driven by a shift in mix away from higher margin internal equipment sales and declines in internal sales margins.

 

Global Financing pre-tax income decreased 31.4 percent to $244 million in the third quarter of 2017, compared to the same period in 2016, due to lower gross profit ($118 million), partially offset by a decrease in total expenses ($6 million). Pre-tax income decreased 30.8 percent to $836 million in the first nine months of 2017, compared to the same period in 2016, due to lower gross profit ($426 million), partially offset by a decrease in total expense ($55 million), including a decrease in financing receivables provisions ($61 million), primarily due to higher Brazil reserve requirements in the prior year.

 

Global Financing return on equity was 23.8 percent and 24.6 percent for the three and nine months ended September 30, 2017, respectively, compared to 27.2 percent and 30.3 percent for the three and nine months ended September 30, 2016, respectively. The decrease in return on equity in the third quarter and first nine months of 2017 compared to the same periods of 2016, was due to the decrease in net income, partially offset by a decrease in equity. See page 84 for the details of the after-tax income and return on equity calculation.

 

Total unguaranteed residual value of leases was $668 million as of September 30, 2017. In addition to the unguaranteed residual value, on a limited basis, Global Financing will obtain guarantees of the future value of the equipment to be returned at end of lease. Third-party residual value guarantees increase the minimum lease payments as provided for by accounting standards that are utilized in determining the classification of a lease as a sales-type lease, direct financing lease or operating lease and provide protection against risk of loss arising from declines in equipment values for these assets. The aggregate asset values associated with the guarantees of sales-type leases were $79 million and $43 million for the financing

 

65



Table of Contents

 

Management Discussion — (continued)

 

transactions originated during the quarters ended September 30, 2017 and 2016, respectively and $186 million and $201 million for the nine months ended September 30, 2017 and 2016, respectively.

 

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.

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Total Revenue

 

$

19,153

 

$

19,226

 

(0.4

)%

(1.0

)%

Geographies:

 

$

19,063

 

$

19,159

 

(0.5

)%

(1.1

)%

Americas

 

8,887

 

9,070

 

(2.0

)

(2.5

)

Europe/Middle East/Africa (EMEA)

 

5,989

 

5,851

 

2.4

 

(1.4

)

Asia Pacific

 

4,187

 

4,238

 

(1.2

)

2.2

 

 

 

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr. to Yr.

 

Change

 

(Dollars in millions)

 

 

 

 

 

Percent

 

Adjusted For

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Currency

 

Total Revenue

 

$

56,597

 

$

58,149

 

(2.7

)%

(2.2

)%

Geographies:

 

$

56,343

 

$

57,932

 

(2.7

)%

(2.2

)%

Americas

 

26,727

 

27,229

 

(1.8

)

(2.3

)

Europe/Middle East/Africa (EMEA)

 

17,186

 

18,032

 

(4.7

)

(3.3

)

Asia Pacific

 

12,430

 

12,671

 

(1.9

)

(0.6

)

 

Total geographic revenue of $19,063 million decreased 0.5 percent as reported and 1 percent adjusted for currency in the third quarter of 2017 compared to the prior year. Americas revenue of $8,887 million decreased 2.0 percent as reported and 2 percent adjusted for currency. EMEA revenue of $5,989 million increased 2.4 percent as reported, but declined 1 percent adjusted for currency. Asia Pacific revenue of $4,187 million declined 1.2 percent as reported, but grew 2 percent adjusted for currency in the third quarter versus the prior year. Each of the three geographies had year-to-year revenue performance improvement (as reported and at constant currency) compared to the second-quarter 2017 year-to-year performance.

 

Within Americas, third-quarter revenue in the U.S. decreased 2.6 percent compared to the prior year. Canada increased 2.1 percent as reported but declined 2 percent year to year adjusted for currency. Latin America decreased 1.5 percent as reported and 2 percent adjusted for currency. Within Latin America, Brazil decreased 11.3 percent as reported and 13 percent adjusted for currency while Mexico increased 31.0 percent as reported and 27 percent adjusted for currency.

 

In the third quarter, within EMEA, the UK declined 9.3 percent (9 percent adjusted for currency). France increased 14.2 percent (8 percent adjusted for currency), Germany increased 8.4 percent (3 percent adjusted for currency), Spain increased 10.9 percent (5 percent adjusted for currency), Norway increased 30.0 percent (24 percent adjusted for currency) and Italy increased 7.3 percent (2 percent adjusted for currency) compared to the same period in the prior year. The Middle East and Africa region increased 3.1 percent as reported and 2 percent adjusted for currency.

 

Within Asia Pacific, Japan revenue decreased 4.0 percent as reported, but grew 4 percent adjusted for currency compared to the same period in the prior year. India grew 14.1 percent as reported (10 percent adjusted for currency) while Australia declined 7.8 percent (11 percent adjusted for currency). China revenue grew 3.9 percent as reported (4 percent adjusted for currency) and Taiwan grew 19.2 percent as reported (14 percent adjusted for currency).

 

Total geographic revenue of $56,343 million decreased 2.7 percent as reported and 2 percent adjusted for currency in the first nine months of 2017 compared to the prior year. Americas revenue of $26,727 million decreased 1.8 percent as reported and 2 percent adjusted for currency. EMEA revenue of $17,186 million decreased 4.7 percent as reported and 3 percent adjusted for currency. Asia Pacific revenue of $12,430 million decreased 1.9 percent as reported and 1 percent adjusted for currency.

 

66



Table of Contents

 

Management Discussion — (continued)

 

Within Americas, U.S. revenue decreased 3.0 percent compared to the first nine months of the prior year. Canada increased 0.9 percent as reported, which was essentially flat year to year on an adjusted for currency basis. Latin America increased 4.5 percent as reported and 1 percent adjusted for currency. Within Latin America, Brazil increased 5.7 percent as reported, but declined 2 percent adjusted for currency while Mexico increased 11.3 percent as reported and 13 percent adjusted for currency.

 

Within EMEA, the UK decreased 15.6 percent as reported and 8 percent adjusted for currency compared to the first nine months of the prior year. Germany decreased 4.7 percent as reported and 5 percent adjusted for currency. Switzerland decreased 12.3 percent as reported and 12 percent adjusted for currency. Spain increased 4.4 percent (5 percent adjusted for currency). The Central and Eastern European region declined 1.7 percent (2 percent adjusted for currency) and the Middle East and Africa region was essentially flat as reported, but down 2 percent adjusted for currency.

 

Within Asia Pacific, Japan declined 1.8 percent as reported, but grew 2 percent adjusted for currency compared to the first nine months of the prior year. Australia decreased 6.6 percent as reported and 9 percent adjusted for currency. China decreased 7.8 percent as reported and 6 percent adjusted for currency. India increased 8.9 percent as reported and 6 percent adjusted for currency. South Korea increased 5.4 percent as reported and 3 percent adjusted for currency.

 

Expense

 

Total Expense and Other (Income)

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Total consolidated expense and other (income)

 

$

5,735

 

$

5,751

 

(0.3

)%

Non-operating adjustments:

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

$

(125

)

$

(136

)

(8.1

)%

Acquisition-related charges

 

0

 

(4

)

(101.8

)

Non-operating retirement-related (costs)/income

 

(103

)

(60

)

71.9

 

Operating (non-GAAP) expense and other (income)

 

$

5,507

 

$

5,550

 

(0.8

)%

Total consolidated expense-to-revenue ratio

 

29.9

%

29.9

%

0.0

pts.

Operating (non-GAAP) expense-to-revenue ratio

 

28.8

%

28.9

%

(0.1

)pts.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Total consolidated expense and other (income)

 

$

18,434

 

$

20,056

 

(8.1

)%

Non-operating adjustments:

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

$

(382

)

$

(371

)

2.8

%

Acquisition-related charges

 

(19

)

(1

)

nm

 

Non-operating retirement-related (costs)/income

 

(474

)

(206

)

130.0

 

Operating (non-GAAP) expense and other (income)

 

$

17,559

 

$

19,478

 

(9.9

)%

Total consolidated expense-to-revenue ratio

 

32.6

%

34.5

%

(1.9

)pts.

Operating (non-GAAP) expense-to-revenue ratio

 

31.0

%

33.5

%

(2.5

)pts.

 

nm - not meaningful

 

For additional information regarding total expense and other (income) for both expense presentations, see the following analyses by category.

 

67



Table of Contents

 

Management Discussion — (continued)

 

Selling, General and Administrative Expense

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Selling, general and administrative expense:

 

 

 

 

 

 

 

Selling, general and administrative — other

 

$

3,898

 

$

3,983

 

(2.1

)%

Advertising and promotional expense

 

337

 

341

 

(1.4

)

Workforce rebalancing charges

 

17

 

25

 

(31.1

)

Retirement-related costs

 

175

 

174

 

0.7

 

Amortization of acquired intangible assets

 

125

 

136

 

(8.1

)

Stock-based compensation

 

88

 

105

 

(16.5

)

Bad debt expense

 

7

 

(32

)

nm

 

Total consolidated selling, general and administrative expense

 

$

4,648

 

$

4,732

 

(1.8

)%

Non-operating adjustments:

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

$

(125

)

$

(136

)

(8.1

)%

Acquisition-related charges

 

0

 

(3

)

nm

 

Non-operating retirement-related (costs)/income

 

(53

)

(53

)

(0.5

)

Operating (non-GAAP) selling, general and administrative expense

 

$

4,470

 

$

4,541

 

(1.6

)%

 

nm — not meaningful

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Selling, general and administrative expense:

 

 

 

 

 

 

 

Selling, general and administrative — other

 

$

12,293

 

$

12,697

 

(3.2

)%

Advertising and promotional expense

 

1,090

 

1,051

 

3.7

 

Workforce rebalancing charges

 

188

 

1,038

 

(81.9

)

Retirement-related costs

 

690

 

551

 

25.3

 

Amortization of acquired intangible assets

 

382

 

371

 

2.8

 

Stock-based compensation

 

277

 

295

 

(6.1

)

Bad debt expense

 

40

 

90

 

(56.0

)

Total consolidated selling, general and administrative expense

 

$

14,959

 

$

16,093

 

(7.0

)%

Non-operating adjustments:

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

$

(382

)

$

(371

)

2.8

%

Acquisition-related charges

 

(12

)

6

 

nm

 

Non-operating retirement-related (costs)/income

 

(326

)

(183

)

78.0

 

Operating (non-GAAP) selling, general and administrative expense

 

$

14,240

 

$

15,545

 

(8.4

)%

 

nm - not meaningful

 

Total selling, general and administrative (SG&A) expense decreased 1.8 percent in the third quarter of 2017 driven primarily by the following factors:

 

·                  Lower spending from increased focus on driving expense efficiency (3 points); partially offset by

 

·                  The effects of currency (1 point); and

 

·                  The impact of acquisitions completed in the prior 12-month period (1 point).

 

Operating (non-GAAP) expense decreased 1.6 percent year to year driven primarily by the same factors, excluding higher non-operating retirement-related costs net of the one-time non-operating UK gain.

 

SG&A expense decreased 7.0 percent in the first nine months of 2017 versus the first nine months of 2016 driven primarily by the following factors:

 

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Table of Contents

 

Management Discussion — (continued)

 

·                  Lower workforce rebalancing charges (5 points);

 

·                  Lower spending (2 points); and

 

·                  The effects of currency (1 point); partially offset by

 

·                  The impact of acquisitions completed in the prior 12-month period (1 point).

 

Operating (non-GAAP) expense decreased 8.4 percent year to year driven primarily by the same factors.

 

Third-quarter SG&A reflects a year-to-year impact of $105 million related to several commercial disputes and a benefit of $91 million resulting from the favorable resolution of pension-related litigation in the UK. Operating (non-GAAP) SG&A does not include the benefit from the pension litigation.

 

Bad debt expense decreased $51 million year to year in the first nine months of 2017, primarily driven by increased reserves in Brazil in the prior year. The receivables provision coverage was 1.9 percent at September 30, 2017, a decrease of 10 basis points compared to December 31, 2016 and a decrease of 100 basis points from September 30, 2016. The decrease year to year in the receivables provision coverage was due primarily to write-offs of previously reserved receivables in December 2016.

 

Research, Development and Engineering

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Total consolidated research, development and engineering expense

 

$

1,342

 

$

1,397

 

(3.9

)%

Non-operating adjustment:

 

 

 

 

 

 

 

Non-operating retirement-related (costs)/income

 

$

(51

)

$

(7

)

615.0

%

Operating (non-GAAP) research, development and engineering expense

 

$

1,291

 

$

1,390

 

(7.1

)%

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Total consolidated research, development and engineering expense

 

$

4,360

 

$

4,320

 

0.9

%

Non-operating adjustment:

 

 

 

 

 

 

 

Non-operating retirement-related (costs)/income

 

$

(148

)

$

(23

)

547.8

%

Operating (non-GAAP) research, development and engineering expense

 

$

4,212

 

$

4,297

 

(2.0

)%

 

Research, development and engineering (RD&E) expense was 7.0 percent and 7.7 percent of revenue in the third quarter and first nine months of 2017, respectively, compared to 7.3 percent and 7.4 percent in prior year periods, respectively. The company continues to invest in research and development as it builds new markets and maintains its leadership in enterprise IT.

 

RD&E expense in the third quarter of 2017 decreased 3.9 percent year to year primarily driven by:

 

·                  Lower spending, net of higher retirement-related costs (5 points); partially offset by

 

·                  The effects of currency (1 point).

 

Operating (non-GAAP) RD&E expense decreased 7.1 percent in the third quarter of 2017 compared to the prior year, driven primarily by the same factors, excluding higher non-operating retirement-related costs.

 

RD&E expense in the first nine months of 2017 increased 0.9 percent year to year primarily driven by:

 

·                  The impact of acquisitions completed in the prior 12-month period (2 points); partially offset by

 

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Table of Contents

 

Management Discussion — (continued)

 

·                  Lower spending, net of higher retirement-related costs.

 

Operating (non-GAAP) RD&E expense decreased 2.0 percent in the first nine months of 2017 compared to the prior year, driven primarily by the same factors, excluding higher non-operating retirement-related costs.

 

Intellectual Property and Custom Development Income

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016*

 

Change

 

Intellectual Property and Custom Development Income:

 

 

 

 

 

 

 

Licensing of intellectual property including royalty-based fees

 

$

236

 

$

474

 

(50.1

)%

Custom development income

 

62

 

53

 

16.4

 

Sales/other transfers of intellectual property

 

10

 

1

 

607.5

 

Total

 

$

308

 

$

528

 

(41.7

)%

 


* Reclassified to conform to 2017 presentation.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016*

 

Change

 

Intellectual Property and Custom Development Income:

 

 

 

 

 

 

 

Licensing of intellectual property including royalty-based fees

 

$

921

 

$

935

 

(1.5

)%

Custom development income

 

186

 

158

 

18.2

 

Sales/other transfers of intellectual property

 

11

 

17

 

(38.4

)

Total

 

$

1,118

 

$

1,110

 

0.7

%

 


* Reclassified to conform to 2017 presentation.

 

Licensing of intellectual property including royalty-based fees decreased 50.1 percent year to year in the third quarter of 2017 and decreased 1.5 percent in the first nine months of 2017 compared to the prior-year period. The company entered into new partnership agreements in the first nine months of 2017, which included two transactions with period income greater than $100 million. The company is licensing IP to partners who are allocating their skills to extend the value of assets that are high value, but may be in mature markets. The licensing of intellectual property for the first nine months of 2016 included three transactions with period income greater than $100 million. The timing and amount of licensing, sales or other transfers of IP may vary significantly from period to period depending upon the timing of licensing agreements, economic conditions, industry consolidation and the timing of new patents and know-how development.

 

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Table of Contents

 

Management Discussion — (continued)

 

Other (Income) and Expense

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Other (income) and expense:

 

 

 

 

 

 

 

Foreign currency transaction losses/(gains)

 

$

37

 

$

93

 

(60.3

)%

(Gains)/losses on derivative instruments

 

(29

)

(23

)

22.0

 

Interest income

 

(38

)

(22

)

72.7

 

Net (gains)/losses from securities and investment assets

 

(6

)

(5

)

20.9

 

Other

 

(79

)

(51

)

54.9

 

Total consolidated other (income) and expense

 

$

(114

)

$

(8

)

nm

%

Non-operating adjustment:

 

 

 

 

 

 

 

Acquisition-related charges

 

$

0

 

$

(2

)

(100.0

)%

Operating (non-GAAP) other (income) and expense

 

$

(114

)

$

(10

)

nm

%

 

nm - not meaningful

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Other (income) and expense:

 

 

 

 

 

 

 

Foreign currency transaction losses/(gains)

 

$

374

 

$

514

 

(27.2

)%

(Gains)/losses on derivative instruments

 

(351

)

(339

)

3.5

 

Interest income

 

(102

)

(76

)

35.5

 

Net (gains)/losses from securities and investment assets

 

(16

)

29

 

nm

 

Other

 

(123

)

153

 

nm

 

Total consolidated other (income) and expense

 

$

(218

)

$

281

 

nm

%

Non-operating adjustment:

 

 

 

 

 

 

 

Acquisition-related charges

 

$

(7

)

$

(7

)

(1.0

)%

Operating (non-GAAP) other (income) and expense

 

$

(225

)

$

274

 

nm

%

 

nm - not meaningful

 

Total consolidated other (income) and expense was income of $114 million in the third quarter of 2017 compared to income of $8 million in the third quarter of 2016. The increase in income of $106 million year to year was primarily driven by:

 

·                  Lower foreign currency transaction losses ($56 million);

 

·                  Higher gains on real estate transactions (reflected in Other in the table above) ($19 million); and

 

·                  Higher interest income ($16 million).

 

The consolidated other (income) and expense was income of $218 million in the first nine months of 2017 compared to expense of $281 million in the first nine months of 2016. The increase in income of $499 million year over year was primarily driven by:

 

·                  Real estate capacity charges (reflected in Other in the table above)  in the prior year related to workforce transformation ($328 million);

 

·                  Lower foreign currency transaction losses ($140 million);

 

·                  Reduced losses from securities and investment assets ($45 million), primarily related to the sale of Lenovo shares in the first quarter of 2016; and

 

·                  Higher interest income ($27 million); partially offset by

 

·                  Lower gains on divestitures ($42 million).

 

71



Table of Contents

 

Management Discussion — (continued)

 

Interest Expense

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Interest expense

 

$

168

 

$

158

 

6.4

%

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Interest expense

 

$

451

 

$

473

 

(4.6

)%

 

Interest expense increased $10 million year to year in the third quarter, but decreased $22 million in the first nine months of 2017. Interest expense is presented in cost of financing in the Consolidated Statement of Earnings if the related external borrowings are to support the Global Financing external business. Overall interest expense (excluding capitalized interest) for the third quarter and first nine months of 2017 was $335 million and $947 million, respectively, an increase of $29 million and $43 million, respectively, versus the comparable prior-year periods, primarily driven by higher average interest rates and higher average debt balance.

 

Retirement-Related Plans

 

The following tables provide the total pre-tax cost for all retirement-related plans. These amounts are included in the Consolidated Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the plan participants.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Retirement-related plans — cost:

 

 

 

 

 

 

 

Service cost

 

$

111

 

$

114

 

(2.5

)%

Amortization of prior service costs/(credits)

 

(22

)

(28

)

(21.3

)

Cost of defined contribution plans

 

258

 

262

 

(1.4

)

Total operating costs/(income)

 

$

347

 

$

347

 

(0.2

)%

Interest cost

 

$

746

 

$

826

 

(9.6

)%

Expected return on plan assets

 

(1,096

)

(1,392

)

(21.3

)

Recognized actuarial losses

 

728

 

692

 

5.2

 

Curtailments/settlements

 

2

 

4

 

(55.8

)

Multi-employer plan/other

 

(74

)

8

 

nm

 

Total non-operating costs/(income)

 

$

306

 

$

139

 

121.1

%

Total retirement-related plans — cost

 

$

653

 

$

486

 

34.4

%

 

nm - not meaningful

 

72



Table of Contents

 

Management Discussion — (continued)

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Retirement-related plans — cost:

 

 

 

 

 

 

 

Service cost

 

$

323

 

$

335

 

(3.6

)%

Amortization of prior service costs/(credits)

 

(66

)

(81

)

(18.5

)

Cost of defined contribution plans

 

776

 

802

 

(3.3

)

Total operating costs/(income)

 

$

1,033

 

$

1,056

 

(2.2

)%

Interest cost

 

$

2,215

 

$

2,483

 

(10.8

)%

Expected return on plan assets

 

(3,250

)

(4,190

)

(22.4

)

Recognized actuarial losses

 

2,143

 

2,069

 

3.5

 

Curtailments/settlements

 

3

 

19

 

(81.6

)

Multi-employer plans/other

 

(46

)

64

 

nm

 

Total non-operating costs/(income)

 

$

1,065

 

$

444

 

139.8

%

Total retirement-related plans — cost

 

$

2,097

 

$

1,500

 

39.8

%

 

nm - not meaningful

 

In the third quarter of 2017, total pre-tax retirement-related plan cost increased by $167 million compared to the third quarter of 2016, primarily driven by lower expected return on plan assets ($296 million) and an increase in recognized actuarial losses ($36 million); partially offset by lower interest costs ($79 million) and a reduction in other ($83 million), driven by the pension obligation adjustment recorded related to the UK pension litigation ($91 million). Total cost for the first nine months of 2017 increased by $597 million versus the first nine months of 2016, primarily driven by lower expected return on plan assets ($940 million) and an increase in recognized actuarial losses ($73 million); partially offset by lower interest costs ($268 million) and other costs ($109 million).

 

As discussed in the “Snapshot” on page 51, the company characterizes certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in the third quarter of 2017 were $347 million, flat compared to the third quarter of 2016. Non-operating costs of $306 million in the third quarter of 2017 increased $168 million year to year, driven primarily by lower expected return on plan assets ($296 million) and an increase in recognized actuarial losses ($36 million); partially offset by lower interest costs ($79 million) and other costs ($83 million). For the first nine months of 2017, operating retirement-related costs were $1,033 million, a decrease of $24 million compared to the first nine months of 2016, primarily driven by lower defined contribution plan costs ($26 million). Non-operating costs of $1,065 million increased $621 million in the first nine months of 2017 compared to the prior year, driven primarily by lower expected return on plan assets ($940 million) and an increase in recognized actuarial losses ($73 million); partially offset by lower interest costs ($268 million) and other costs ($109 million), driven by the third-quarter pension obligation adjustment in the UK.

 

Taxes

 

The continuing operations effective tax rate for the third quarter of 2017 was 11.0 percent, a decrease of 1.5 points compared to the third quarter of 2016. The continuing operations effective tax rate for the first nine months of 2017 was 1.7 percent, an increase of 2.2 points compared to the first nine months of 2016. The operating (non-GAAP) tax rate for the third quarter of 2017 was 14.7 percent, an increase of 0.5 points compared to the third quarter of 2016. The operating (non-GAAP) tax rate for the first nine months of 2017 was 7.1 percent, an increase of 3.9 points compared to the first nine months of 2016.

 

The change in the continuing operations effective tax rate for the third quarter of 2017 compared to 2016 was driven by an increase in foreign tax credits, partially offset by a prior year tax benefit related to foreign tax audit activity. The change in the operating (non-GAAP) tax rate for the third quarter was driven by the same factors.

 

The change in the continuing operations effective tax rate for the first nine months of 2017 compared to 2016 was primarily driven by the year-to-year benefits above, as well as a discrete tax benefit related to the intra-entity transfer recognized in the first quarter of 2017 and other net discrete period impacts in the first two quarters of 2017 primarily related to foreign tax audit activity. These benefits were more than offset by a prior year tax benefit related to the Japan tax matter (a refund of $1.0 billion plus interest of $0.2 billion). The change in the operating (non-GAAP) tax rate was driven by the same factors.

 

73



Table of Contents

 

Management Discussion — (continued)

 

With respect to major U.S. state and foreign taxing jurisdictions, the company is generally no longer subject to tax examinations for years prior to 2012. The company is no longer subject to income tax examination of its U.S. federal tax return for years prior to 2013. The open years contain matters that could be subject to differing interpretations of applicable tax laws and regulations as it relates to the amount and/or timing of income, deductions and tax credits. Although the outcome of tax audits is always uncertain, the company believes that adequate amounts of tax and interest have been provided for any adjustments that are expected to result for these years.

 

In the first quarter of 2016, the IRS commenced its audit of the company’s U.S. tax returns for 2013 and 2014. The company anticipates that this audit will be completed by the end of the first quarter of 2018.

 

The amount of unrecognized tax benefits at December 31, 2016 increased by $108 million in the third quarter of 2017 and increased by $466 million in the first nine months of 2017 to $4,206 million. The overall increase for the nine months ended September 30, 2017 was primarily related to potential U.S. audit matters. The total amount of unrecognized tax benefits that, if recognized, would favorably affect the effective tax rate was $3,107 million at September 30, 2017.

 

The company is involved in a number of income tax-related matters in India challenging tax assessments issued by the India Tax Authorities. As of September 30, 2017, the company has recorded $566 million as prepaid income taxes in India. A significant portion of this balance represents cash tax deposits paid over time to protect the company’s right to appeal various income tax assessments made by the Indian Tax Authorities. The company believes it will prevail on these matters.

 

Earnings Per Share

 

Basic earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent

 

For the three months ended September 30:

 

2017

 

2016

 

Change

 

Earnings per share of common stock from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

2.92

 

$

2.98

 

(2.0

)%

Basic

 

$

2.93

 

$

2.99

 

(2.0

)%

Diluted operating (non-GAAP)

 

$

3.30

 

$

3.29

 

0.3

%

Weighted-average shares outstanding: (in millions)

 

 

 

 

 

 

 

Assuming dilution

 

933.2

 

957.3

 

(2.5

)%

Basic

 

929.4

 

954.0

 

(2.6

)%

 

 

 

 

 

 

 

Yr. to Yr.

 

 

 

 

 

 

 

Percent

 

For the nine months ended September 30:

 

2017

 

2016

 

Change

 

Earnings per share of common stock from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

7.24

 

$

7.67

 

(5.6

)%

Basic

 

$

7.28

 

$

7.70

 

(5.5

)%

Diluted operating (non-GAAP)

 

$

8.64

 

$

8.59

 

0.6

%

Weighted-average shares outstanding: (in millions)

 

 

 

 

 

 

 

Assuming dilution

 

940.2

 

960.7

 

(2.1

)%

Basic

 

935.6

 

957.7

 

(2.3

)%

 

Actual shares outstanding at September 30, 2017 were 925.8 million. The weighted-average number of common shares outstanding assuming dilution during the third quarter and first nine months of 2017 were 24.1 million and 20.5 million shares lower than the same periods of 2016. The decrease was primarily the result of the common stock repurchase program.

 

74



Table of Contents

 

Management Discussion — (continued)

 

Financial Position

 

Dynamics

 

At September 30, 2017, the balance sheet remains strong, and with the newly reorganized financing entity, IBM Credit LLC, the company is better positioned to support the business over the long term. Cash and marketable securities at quarter end were $11,515 million. The company continues to manage the investment portfolio to meet its capital preservation and liquidity objectives. Total debt of $45,625 million increased $3,457 million from December 31, 2016, driven by new debt issuances of $9,336 million, partially offset by maturities of $6,259 million. Within total debt, $29,390 million, or approximately 64 percent, is in support of the Global Financing business. This includes IBM Credit LLC’s first public debt issuance of $3,000 million in September 2017. In the first nine months of 2017, the company generated $10,991 million in cash from operations. 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.

 

The assets and debt associated with the Global Financing business are a significant part of the company’s financial position. The financial position amounts appearing on pages 5 and 6 are the consolidated amounts including Global Financing.

 

Global Financing Financial Position Key Metrics:

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Cash and cash equivalents

 

$

1,919

 

$

1,844

 

Net investment in sales-type and direct financing leases

 

6,700

 

6,893

 

Equipment under operating leases — external clients (1)

 

504

 

548

 

Client loans

 

11,269

 

11,478

 

Total client financing assets

 

18,473

 

18,920

 

Commercial financing receivables

 

8,561

 

9,700

 

Intercompany financing receivables (2) (3)

 

4,897

 

4,959

 

Total assets

 

$

36,498

 

$

36,492

 

Debt

 

$

29,390

 

$

27,859

 

Total equity

 

$

3,278

 

$

3,812

 

 


(1)         Includes intercompany mark-up, priced on an arm’s-length basis, on products purchased from the company’s product divisions which is eliminated in IBM’s consolidated results.

(2)         Entire amount eliminated for purposes of IBM’s consolidated results and therefore does not appear on pages 5 and 6.

(3)         These assets, along with all other financing assets in this table, are leveraged at the value in the table using Global Financing debt.

 

At September 30, 2017, substantially all client and commercial financing assets were IT related assets, and approximately 52 percent of the total external portfolio was with investment grade clients with no direct exposure to consumers. The increase in investment grade year to year (2 points) was driven primarily by rating changes within the existing portfolio, not by changing the company’s approach to the market. This investment grade percentage is based on the credit ratings of the companies in the portfolio. Additionally, the company takes actions to transfer exposure to third parties. On that basis, the investment grade content would increase by 15 points to 67 percent, an increase of 2 points year to year.

 

The company has a long-standing practice of taking mitigation actions, in certain circumstances, to transfer credit risk to third parties, including credit insurance, financial guarantees, non-recourse borrowings, transfers of receivables recorded as true sales in accordance with accounting guidance or sales of equipment under operating lease.

 

75



Table of Contents

 

Management Discussion — (continued)

 

IBM Working Capital

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Current assets

 

$

44,742

 

$

43,888

 

Current liabilities

 

31,697

 

36,275

 

Working capital

 

$

13,045

 

$

7,613

 

 

 

 

 

 

 

Current ratio

 

1.41:1

 

1.21:1

 

 

Working capital increased $5,432 million from the year-end 2016 position. The key changes are described below:

 

Current assets increased $854 million (decreased $1,534 million adjusted for currency) due to:

 

·                  An increase in cash and cash equivalents of $3,089 million ($2,214 million adjusted for currency); partially offset by

 

·                  A decline in receivables of $2,118 million ($3,365 million adjusted for currency) primarily as a result of collections of higher year-end balances.

 

Current liabilities decreased $4,578 million ($6,173 million adjusted for currency) as a result of:

 

·                  A decrease in short-term debt of $3,214 million ($3,230 million adjusted for currency) primarily as a result of maturities of $6,258 million; partially offset by reclassifications of $3,670 million from long-term debt to reflect upcoming maturities and a decrease in commercial paper of $899 million; and

 

·                  A decrease in accounts payable of $767 million ($969 million adjusted for currency) reflecting declines from typically higher year-end balances.

 

Receivables and Allowances

 

Roll Forward of Total IBM Receivables Allowance for Credit Losses

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

January 1, 2017

 

Additions *

 

Write-offs **

 

Other***

 

September 30, 2017

 

$

776

 

$

37

 

$

(157

)

$

33

 

$

689

 

 


*                 Additions for Allowance for Credit Losses are charged to expense.

**          Refer to note A, “Significant Accounting Policies,” in the company’s 2016 Annual Report on pages 98 and 99 for additional information regarding allowance for credit loss write-offs.

***   Primarily represents translation adjustments.

 

The total IBM receivables provision coverage was 1.9 percent at September 30, 2017, a decrease of 10 basis points compared to December 31, 2016. The majority of the write-offs during the nine months ended September 30, 2017 related to Global Financing receivables, which had been previously reserved.

 

Global Financing Receivables and Allowances

 

The following table presents external financing receivables, excluding residual values, and the allowance for credit losses.

 

76



Table of Contents

 

Management Discussion — (continued)

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Gross financing receivables

 

$

26,405

 

$

28,043

 

Specific allowance for credit losses

 

258

 

335

 

Unallocated allowance for credit losses

 

96

 

103

 

Total allowance for credit losses

 

354

 

438

 

Net financing receivables

 

$

26,051

 

$

27,605

 

Allowance for credit losses coverage

 

1.3

%

1.6

%

 

The percentage of Global Financing receivables reserved decreased from 1.6 percent at December 31, 2016, to 1.3 percent at September 30, 2017. The decline was driven by the 2017 write-offs of $119 million of receivables previously reserved, partially offset by the overall decline in gross receivables. Specific reserves decreased 23 percent from $335 million at December 31, 2016, to $258 million at September 30, 2017. Unallocated reserves decreased 7 percent from $103 million at December 31, 2016, to $96 million at September 30, 2017.

 

Roll Forward of Global Financing Receivables Allowance for Credit Losses

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

January 1, 2017

 

Additions *

 

Write-offs **

 

Other ***

 

September 30, 2017

 

$

438

 

$

14

 

$

(119

)

$

20

 

$

354

 

 


*                 Additions for Allowance for Credit Losses are charged to expense.

**          Refer to note A, “Significant Accounting Policies,” in the company’s 2016 Annual Report on pages 98 and 99 for additional information regarding allowance for credit loss write-offs.

***   Primarily represents translation adjustments.

 

Global Financing’s bad debt expense was a release of $1 million for the three months ended September 30, 2017, compared to a release of $2 million for the same period in 2016. Global Financing’s bad debt expense was $14 million for the nine months ended September 30, 2017, compared to $75 million for the same period in 2016, due to higher reserve requirements in Brazil in the prior year.

 

Noncurrent Assets and Liabilities

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Noncurrent assets

 

$

76,894

 

$

73,582

 

Long-term debt

 

$

41,327

 

$

34,655

 

Noncurrent liabilities (excluding debt)

 

$

28,856

 

$

28,147

 

 

The increase in noncurrent assets of $3,313 million ($1,153 million adjusted for currency) was driven by:

 

·                  An increase of $2,065 million in deferred taxes ($1,731 million adjusted for currency) driven by increases in the U.S. ($998 million) and the first-quarter 2017 intra-entity transfer, including the cumulative effect of adoption of the new FASB guidance ($827 million); and

 

·                  An increase in retirement plans assets of $1,487 million ($1,262 million adjusted for currency) driven by the expected returns on plan assets, partially offset by interest costs; partially offset by

 

·                  A decrease of $562 million in long-term financing receivables ($888 million adjusted for currency) reflecting seasonal reductions from higher year-end balances.

 

Long-term debt increased $6,671 million ($5,662 million adjusted for currency) from the year-end balance primarily driven by:

 

·                  Issuances of $9,124 million; partially offset by

 

·                  Reclassification to short-term debt of $3,670 million to reflect upcoming maturities.

 

77



Table of Contents

 

Management Discussion — (continued)

 

The increase in noncurrent liabilities (excluding debt) of $708 million (a decrease of $944 million adjusted for currency) was driven by:

 

·                  An increase in retirement and nonpension postretirement liabilities of $483 million (decreased $598 million adjusted for currency) driven by currency impacts and higher interest and service costs; partially offset by contributions.

 

Debt

 

The company’s funding requirements are continually monitored and strategies are executed to manage the overall asset and liability profile. Additionally, the company maintains sufficient flexibility to access global funding sources as needed.

 

 

 

At September 30,

 

At December 31,

 

(Dollars in millions)

 

2017

 

2016

 

Total company debt

 

$

45,625

 

$

42,169

 

Total Global Financing segment debt

 

$

29,390

 

$

27,859

 

Debt to support external clients

 

25,433

 

24,034

 

Debt to support internal clients

 

3,957

 

3,825

 

Non-Global Financing debt

 

$

16,235

 

$

14,309

 

 

Total debt of $45,625 million increased $3,457 million from December 31, 2016.

 

Global Financing provides financing predominantly for the company’s external client assets, as well as for assets under contract by other IBM units. These assets, primarily for Technology Services & Cloud Platforms, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their attributes, these Technology Services & Cloud Platforms assets are leveraged with the balance of the Global Financing asset base. The increase in debt is consistent with the company’s expectations at year-end 2016 to increase leverage in the Global Financing business.

 

Non-Global Financing debt of $16,235 million was up $1,926 million from December 31, 2016 and down $116 million from September 30, 2016.

 

Consolidated debt-to-capitalization ratio at September 30, 2017 was 69.8 percent versus 69.6 percent at December 31, 2016 and 71.2 percent at September 30, 2016.

 

Given the significant leverage, the company also presents a debt-to-capitalization ratio which excludes Global Financing debt and equity as management believes this is more representative of the company’s core business operations. This ratio can vary from period to period as the company manages its global cash and debt positions. “Core” debt-to-capitalization ratio (excluding Global Financing debt and equity) was 49.6 percent at September 30, 2017 compared to 49.5 percent at December 31, 2016 and 54.6 percent at September 30, 2016.

 

Global Financing debt-to-equity ratio

 

 

 

At September 30,

 

At December 31,

 

 

 

2017

 

2016

 

Global Financing debt-to-equity ratio

 

9.0

x

7.3

x

 

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 substantially match the term and currency underlying the financing receivable and are based on arm’s-length pricing.

 

Global Financing provides financing predominantly for the company’s external client assets, as well as for assets under contract by other IBM units. As previously stated, the company measures Global Financing as a stand-alone entity, and accordingly, interest expense relating to debt supporting Global Financing’s external client and internal business is included in the “Global Financing Results of Operations” on page 65 and in “Segment Information” on pages 29 and 30.

 

78



Table of Contents

 

Management Discussion — (continued)

 

In the company’s Consolidated Statement of Earnings, the external debt-related interest expense supporting Global Financing’s internal financing to the company is reclassified from cost of financing to interest expense.

 

Equity

 

Total equity increased by $1,365 million from December 31, 2016 as a result of an increase in retained earnings of $2,806 million, an increase in retirement-related amounts of $1,446 million and an increase of $794 million related to currency translation, partially offset by an increase in treasury stock of $3,762 million primarily due to common stock repurchases.

 

Cash Flow

 

The company’s cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 7, are summarized in the following table. These amounts include the cash flows associated with the Global Financing business.

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Net cash provided by/(used in) continuing operations:

 

 

 

 

 

Operating activities

 

$

10,991

 

$

13,105

* **

Investing activities

 

(3,278

)

(7,289

)*

Financing activities

 

(5,499

)

(4,619

)**

Effect of exchange rate changes on cash and cash equivalents

 

875

 

155

 

Net change in cash and cash equivalents

 

$

3,089

 

$

1,352

 

 


*   Revised classification of certain financing receivables. Refer to note 1, “Basis of Presentation,” for additional information.

** Reclassified to reflect adoption of the FASB guidance on share-based compensation.

 

Net cash provided by operating activities decreased by $2,114 million as compared to the first nine months of 2016 driven by the following factors:

 

·                  An increase in net income tax payments of $1,211 million, driven by the prior year Japan tax refund received;

 

·                  A decrease in cash provided by financing receivables of $868 million; and

 

·                  Performance-related declines within net income; partially offset by

 

·                  Working capital improvements of $1,009 million driven by strong cash collections.

 

Net cash used in investing activities decreased $4,011 million as compared to the first nine months of 2016 driven by:

 

·                  A decrease in net cash used related to acquisitions of $5,002 million.

 

Net cash used in financing activities increased $880 million as compared to the first nine months of 2016 driven by:

 

·                  An increase in common stock repurchases of $1,043 million; partially offset by

 

·                  An increase in net cash sourced from debt transactions of $422 million primarily driven by a higher level of issuances which exceeded higher maturities.

 

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Management Discussion — (continued)

 

Looking Forward

 

The company’s strategies, investments and actions are all taken with an objective of optimizing long-term performance. A long-term perspective ensures that the company is well-positioned to take advantage of the major shifts in technology, business and the global economy.

 

Within the IT industry, there are major shifts occurring—driven by cognitive, including data and analytics, cloud and changes in the ways individuals and enterprises are engaging. The company is bringing together its cognitive technologies on cloud platforms to create industry-based solutions in order to solve enterprise clients’ real problems. The company continues to address the higher value areas of enterprise IT and is amassing a unique set of capabilities and is differentiating itself from other technology providers as it moves into new spaces, and in some cases, creating entirely new markets. IBM is more than a hardware, software and services company; it has emerged as a cognitive solutions and cloud platform company, focused on industry differentiation. The company’s strategic imperatives represent revenue from its cloud, analytics, mobile, social and security solutions, across its segments, and are a signpost of progress in addressing these market shifts.

 

In 2017, the company is continuing to embed cognitive and cloud across the business, to build new platforms and solutions and reinvent core capabilities. This is fueling the shift toward strategic imperatives revenue. Consistent with the long-term model, over the course of 2017, the company has continued to acquire and integrate key capabilities, remix skills, invest in areas of growth and return value to shareholders. This is all taken into account in the full-year view. Overall, the company continues to expect GAAP earnings per share from continuing operations for 2017 to be at least $11.95. Excluding acquisition-related charges of $0.75 per share and non-operating retirement-related items of $1.10 per share, operating (non-GAAP) earnings per share is expected to be at least $13.80.

 

Overall, looking forward to the fourth quarter of 2017, as a result of the typical large transactional base in the fourth quarter, there is a range of possible scenarios. In 2016, the company increased revenue by $2.5 billion from third to fourth quarter. In 2017, the company expects stronger sequential performance than the typical third to fourth quarter increase, with potentially $300 million to $400 million more revenue, depending on currency, due in part to the mainframe cycle. The company’s GAAP and operating (non-GAAP) gross margins have shown good progression in recent quarters, driven by mix and some moderation in the headwinds from investment. In the fourth quarter of 2017, the company expects GAAP and operating (non-GAAP) gross margins to be consistent with the sequential improvement the company has experienced the last few years of an approximate 2.5 to 3.5 point increase in gross margins from third to fourth quarter. In expense, the company expects to continue to drive efficiency in spending, however with the weaker U.S. dollar, currency hedges are expected to have an impact. The company continues to have a strong pipeline of IP income opportunities. At mid-October spot rates, the currency impact to revenue growth for the fourth-quarter 2017 is expected to be approximately a three-point tailwind, which would result in a neutral to a one-point tailwind to full-year 2017.

 

Free cash flow realization, defined as free cash flow to income from continuing operations (GAAP), was 96 percent over the last twelve months and is again expected to be in line with the longer-term model of over 90 percent in 2017. The company continues to expect full year free cash flow to be relatively flat year to year, as the first half year-to-year headwind shifts to a tailwind driven by lower tax and workforce rebalancing payments in 2017. This also reflects the level of profit consistent with the company’s full year expectations of earnings per share.

 

The company’s tax rate reflects its mix of business, both country and product mix. The company continues to expect that the 2017 GAAP tax rate will be approximately 3 points lower than the operating (non-GAAP) tax rate expectation. Expectations for the operating (non-GAAP) tax rate are approximately 15 percent plus or minus three points, excluding discrete items. This range was widened in 2017 due to mix variables and tax reform discussions underway in the U.S, which could result in planning actions this year. The tax rates for the first nine months of 2017, excluding discrete items, were in line with the company’s January 2017 expectations. The company may have discrete tax items in the fourth quarter of 2017, however the amount and timing is unknown and any benefits may be mitigated by other actions. The rate will change year to year based on nonrecurring events, such as the settlement of income tax audits and changes in tax laws, as well as recurring factors including the geographic mix of income before taxes, the timing and amount of foreign dividend repatriation, state and local taxes and the effects of various global income tax strategies.

 

In January 2017, the company reorganized its client and commercial financing business as a wholly owned subsidiary, IBM Credit LLC. As announced, the financing business target leverage was increased from 7:1 to 9:1. The subsidiary began accessing the capital markets directly in September 2017, with its first public debt issuance. At September 30, 2017, this business continues to be leveraged at a debt-to-equity ratio of 9:1.

 

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Management Discussion — (continued)

 

The company expects 2017 pre-tax retirement-related plan cost to be approximately $2.9 billion, an increase of approximately $900 million compared to 2016. This estimate reflects current pension plan assumptions at December 31, 2016. Within total retirement-related plan cost, operating retirement-related plan cost is expected to be approximately $1.4 billion, approximately flat versus 2016. Non-operating retirement-related plan cost is expected to be approximately $1.5 billion, an increase of approximately $900 million compared to 2016, driven by lower income from expected return on assets. Contributions for all retirement-related plans are expected to be approximately $2.4 billion in 2017, approximately flat compared to 2016.

 

Currency Rate Fluctuations

 

Changes in the relative values of non-U.S. currencies to the U.S. dollar (USD) affect the company’s financial results and financial position. At September 30, 2017, currency changes resulted in assets and liabilities denominated in local currencies being translated into more dollars than at year-end 2016. The company uses financial hedging instruments to limit specific currency risks related to financing transactions and other foreign currency-based transactions.

 

During periods of sustained movements in currency, the marketplace and competition adjust to the changing rates. For example, when pricing offerings in the marketplace, the company may use some of the advantage from a weakening U.S. dollar to improve its position competitively, and price more aggressively to win the business, essentially passing on a portion of the currency advantage to its customers. Competition will frequently take the same action. Consequently, the company believes that some of the currency-based changes in cost impact the prices charged to clients. The company also maintains currency hedging programs for cash management purposes which temporarily mitigate, but do not eliminate, the volatility of currency impacts on the company’s financial results.

 

The company translates revenue, cost and expense in its non-U.S. operations at current exchange rates in the reported period. References to “adjusted for currency” or “constant currency” reflect adjustments based upon a simple mathematical formula. However, this constant currency methodology that the company utilizes to disclose this information does not incorporate any operational actions that management could take to mitigate fluctuating currency rates. Currency movements impacted the company’s year-to-year revenue and earnings per share growth in the first nine months of 2017. Based on the currency rate movements in the first nine months of 2017, total revenue decreased 2.7 percent as reported and decreased 2.2 percent at constant currency versus the first nine months of 2016. On an income from continuing operations before income tax basis, these translation impacts offset by the net impact of hedging activities resulted in a theoretical maximum (assuming no pricing or sourcing actions) decrease of approximately $10 million in the first nine months of 2017 on an as-reported basis and a decrease of $20 million on an operating (non-GAAP) basis. The same mathematical exercise resulted in an increase of approximately $50 million in the first nine months of 2016 on an as-reported basis and an increase of $75 million on an operating (non-GAAP) basis. The company views these amounts as a theoretical maximum impact to its as-reported financial results. Considering the operational responses mentioned above, movements of exchange rates, and the nature and timing of hedging instruments, it is difficult to predict future currency impacts on any particular period, but the company believes it could be substantially less than the theoretical maximum given the competitive pressure in the marketplace.

 

For non-U.S. subsidiaries and branches that operate in U.S. dollars or whose economic environment is highly inflationary, translation adjustments are reflected in results of operations. Generally, the company manages currency risk in these entities by linking prices and contracts to U.S. dollars.

 

The company continues to monitor the economic conditions in Venezuela. In mid-February 2016, changes to the currency exchange systems were announced which eliminated the SICAD exchange rate and replaced the SIMADI rate with DICOM, which is expected to be a floating exchange rate. The company recorded a pre-tax loss of $43 million in the first quarter of 2016 in other (income) and expense in the Consolidated Statement of Earnings as a result of the elimination of the SICAD and devaluation in the new exchange. Total pre-tax loss for the first nine months of 2017 was $9 million compared to $46 million in the first nine months of 2016. The company’s net assets denominated in local currency were $8 million at September 30, 2017. The company’s operations in Venezuela comprised less than 1 percent of total 2016 and 2015 revenue, respectively.

 

Liquidity and Capital Resources

 

In the company’s 2016 Annual Report, on pages 68 to 71, there is a discussion of the company’s liquidity including two tables that present five years of data. The table presented on page 68 includes net cash from operating activities, cash and marketable securities and the size of the company’s global credit facilities for each of the past five years. For the nine months

 

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Management Discussion — (continued)

 

ended, or as of, as applicable, September 30, 2017, those amounts are $11.0 billion for net cash from operating activities, $11.5 billion of cash and marketable securities and $10.25 billion in global credit facilities, respectively. On July 20, 2017, the company and IBM Credit entered into a $2.5 billion 364-day Credit Agreement and a $2.5 billion three-year Credit Agreement. These new agreements permit borrowings up to an aggregate of $5 billion on a revolving basis.

 

The major rating agencies’ ratings on the company’s debt securities at September 30, 2017 appear in the table below. The Fitch ratings were reaffirmed on September 30, 2016 and remain unchanged from December 31, 2016. On May 3, 2017, Moody’s Investors Service lowered its rating on the company’s senior long-term debt from Aa3 to A1, while reaffirming its rating on commercial paper. On May 5, 2017, Standard and Poor’s lowered its ratings on the company’s senior long-term debt to A+ from AA- and commercial paper to A-1 from A-1+. IBM remains a strong investment grade company with significant financial flexibility to execute its strategy and capital allocation plans. The company does not have “ratings trigger” provisions in its debt covenants or documentation, which would allow the holders to declare an event of default and seek to accelerate payments thereunder in the event of a change in credit rating. The company’s contractual agreements governing derivative instruments contain standard market clauses which can trigger the termination of the agreement if the company’s credit rating were to fall below investment grade. At September 30, 2017, the fair value of those instruments that were in a liability position was $352 million, before any applicable netting, and this position is subject to fluctuations in fair value period to period based on the level of the company’s outstanding instruments and market conditions. The company has no other contractual arrangements that, in the event of a change in credit rating, would result in a material adverse effect on its financial position or liquidity.

 

 

 

STANDARD

 

MOODY’S

 

 

 

 

AND

 

INVESTORS

 

FITCH

IBM and IBM Credit LLC ratings:

 

POOR’S

 

SERVICE

 

RATINGS

Senior long-term debt

 

A+

 

A1

 

A+

Commercial paper

 

A-1

 

Prime-1

 

F1

 

The company prepares its Consolidated Statement of Cash Flows in accordance with applicable accounting standards for cash flow presentation on page 7 of this Form 10-Q and highlights causes and events underlying sources and uses of cash in that format on page 79. For the purpose of running its business, the company manages, monitors and analyzes cash flows in a different manner.

 

Management uses free cash flow as a measure to evaluate its operating results, plan share repurchase levels, make strategic investments and assess its ability and need to incur and service debt. The entire free cash flow amount is not necessarily available for discretionary expenditures. The company defines free cash flow as net cash from operating activities less the change in Global Financing receivables and net capital expenditures, including the investment in software. A key objective of the Global Financing business is to generate strong returns on equity, and increasing receivables is the basis for growth. Accordingly, management considers Global Financing receivables as a profit-generating investment, not as working capital that should be minimized for efficiency. Therefore, management includes presentations of both free cash flow and net cash from operating activities that exclude the effect of Global Financing receivables. Free cash flow guidance is derived using an estimate of profit, working capital and operational cash outflows. As previously noted, the company views Global Financing receivables as a profit-generating investment which it seeks to maximize and therefore it is not considered when formulating guidance for free cash flow. As a result the company does not estimate a GAAP Net Cash from Operations expectation metric.

 

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Management Discussion — (continued)

 

The following is management’s view of cash flows for the first nine months of 2017 and 2016 prepared in a manner

consistent with the description above.

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2017

 

2016

 

Net cash from operating activities per GAAP

 

$

10,991

 

$

13,105

* **

Less: change in Global Financing receivables

 

2,468

 

3,336

*

Net cash from operating activities, excluding Global Financing receivables

 

8,523

 

9,769

**

Capital expenditures, net

 

(2,347

)

(2,801

)

Free cash flow (FCF)

 

6,176

 

6,969

**

Acquisitions

 

(442

)

(5,445

)

Divestitures

 

35

 

35

 

Share repurchase

 

(3,674

)

(2,632

)

Common stock repurchases for tax withholdings

 

(153

)

(115

)**

Dividends

 

(4,119

)

(3,927

)

Non-Global Financing debt

 

1,896

 

3,365

 

Other (includes Global Financing receivables and Global Financing debt)

 

3,270

 

3,523

 

Change in cash, cash equivalents and short-term marketable securities

 

$

2,988

 

$

1,773

 

 


*   Revised classification of certain financing receivables.

** Reclassified to reflect adoption of the FASB guidance on share-based compensation.

 

In the first nine months of 2017, the company generated free cash flow of $6.2 billion, a decrease of $0.8 billion versus the prior year. The year-to-year decrease was driven primarily by a cash tax refund related to the Japan tax matter in the prior year. In addition, working capital contributed to the free cash flow performance in the first nine months of 2017. Net capital expenditures of $2.3 billion included investments to expand the company’s cloud and cognitive capabilities. In the first nine months of 2017, the company continued to focus its cash utilization on returning value to shareholders including $4.1 billion in dividends and $3.7 billion in gross common stock repurchases.

 

Events that could temporarily change the historical cash flow dynamics discussed previously and in the company’s 2016 Annual Report include significant changes in operating results, material changes in geographic sources of cash, unexpected adverse impacts from litigation, future pension funding requirements during periods of severe downturn in the capital markets or the timing of tax payments. Whether any litigation has such an adverse impact will depend on a number of variables, which are more completely described in note 12, “Contingencies,” in this Form 10-Q. With respect to pension funding, the company expects to make legally mandated pension plan contributions to certain non-U.S. plans of approximately $400 million in 2017. Contributions related to all retirement-related plans are expected to be approximately $2.4 billion in 2017. Financial market performance could increase the legally mandated minimum contributions in certain non-U.S. countries that require more frequent remeasurement of the funded status. The company is not quantifying any further impact from pension funding because it is not possible to predict future movements in the capital markets or pension plan funding regulations.

 

The company’s U.S. cash flows continue to be sufficient to fund its current domestic operations and obligations, including investing and financing activities such as dividends and debt service. The company’s U.S. operations generate substantial cash flows, and, in those circumstances where the company has additional cash requirements in the U.S., the company has several liquidity options available. These options may include the ability to borrow additional funds at reasonable interest rates, utilizing its Credit Facilities, repatriating certain foreign earnings and utilizing intercompany loans with certain foreign subsidiaries.

 

The company does earn a significant amount of its pre-tax income outside the U.S. The company’s policy is to indefinitely reinvest the undistributed earnings of its foreign subsidiaries, and accordingly, no provision for federal income taxes has been made on accumulated earnings of foreign subsidiaries. The company periodically repatriates a portion of these earnings to the extent that it does not incur an additional U.S. tax liability. Quantification of the deferred tax liability, if any, associated with indefinitely reinvested earnings is not practicable. While the company currently does not have a need to repatriate funds held by its foreign subsidiaries, if these funds are needed for operations and obligations in the U.S., the company could elect to repatriate these funds which could result in a reassessment of the company’s policy and increased tax expense.

 

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Table of Contents

 

Management Discussion — (continued)

 

Global Financing Return on Equity Calculation

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

(Dollars in millions)

 

2017

 

2016

 

2017

 

2016

 

Numerator

 

 

 

 

 

 

 

 

 

Global Financing after-tax income*

 

$

194

 

$

244

 

$

621

 

$

829

 

Annualized after-tax income (a)

 

$

776

 

$

977

 

$

828

 

$

1,106

 

Denominator

 

 

 

 

 

 

 

 

 

Average Global Financing equity (b)**

 

$

3,255

 

$

3,595

 

$

3,372

 

$

3,647

 

Global Financing return on equity (a)/(b)

 

23.8

%

27.2

%

24.6

%

30.3

%

 


*   Calculated based upon an estimated tax rate principally based on Global Financing’s geographic mix of earnings as IBM’s provision for income taxes is determined on a consolidated basis.

** Average of the ending equity for Global Financing for the last 2 quarters and 3 quarters, for the three months ended September 30, and for the nine months ended September 30, respectively.

 

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Table of Contents

 

Management Discussion — (continued)

 

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. Refer to the “Snapshot” section on page 51 for the company’s rationale for presenting operating earnings information.

 

(Dollars in millions except per share amounts)

 

 

 

Acquisition-related

 

Retirement-related

 

Operating

 

For the three months ended September 30, 2017

 

GAAP

 

adjustments

 

adjustments

 

(Non-GAAP)

 

Gross profit

 

$

8,800

 

$

114

 

$

203

 

$

9,116

 

Gross profit margin

 

45.9

%

0.6

pts.

1.1

pts.

47.6

%

S,G&A

 

$

4,648

 

$

(125

)

$

(53

)

$

4,470

 

R,D&E

 

1,342

 

 

(51

)

1,291

 

Other (income) and expense

 

(114

)

 

 

(114

)

Total expense and other (income)

 

5,735

 

(125

)

(103

)

5,507

 

Pre-tax income from continuing operations

 

3,065

 

238

 

306

 

3,609

 

Pre-tax margin from continuing operations

 

16.0

%

1.2

pts.

1.6

pts.

18.8

%

Provision for income taxes*

 

$

339

 

$

79

 

$

113

 

$

531

 

Effective tax rate

 

11.0

%

1.5

pts.

2.2

pts.

14.7

%

Income from continuing operations

 

$

2,726

 

$

159

 

$

193

 

$

3,079

 

Income margin from continuing operations

 

14.2

%

0.8

pts.

1.0

pts.

16.1

%

Diluted earnings per share from

 

 

 

 

 

 

 

 

 

continuing operations

 

$

2.92

 

$

0.17

 

$

0.21

 

$

3.30

 

 


*            The tax impact on operating (non-GAAP) pre-tax income from continuing operations 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.

 

(Dollars in millions except per share amounts)

 

 

 

Acquisition-related

 

Retirement-related

 

Operating

 

For the three months ended September 30, 2016

 

GAAP

 

adjustments

 

adjustments

 

(Non-GAAP)

 

Gross profit

 

$

9,013

 

$

129

 

$

79

 

$

9,221

 

Gross profit margin

 

46.9

%

0.7

pts.

0.4

pts.

48.0

%

S,G&A

 

$

4,732

 

$

(138

)

$

(53

)

$

4,541

 

R,D&E

 

1,397

 

 

(7

)

1,390

 

Other (income) and expense

 

(8

)

(2

)

 

(10

)

Total expense and other (income)

 

5,751

 

(140

)

(60

)

5,550

 

Pre-tax income from continuing operations

 

3,263

 

269

 

139

 

3,671

 

Pre-tax margin from continuing operations

 

17.0

%

1.4

pts.

0.7

pts.

19.1

%

Provision for income taxes*

 

$

409

 

$

73

 

$

40

 

$

521

 

Effective tax rate

 

12.5

%

1.1

pts.

0.6

pts.

14.2

%

Income from continuing operations

 

$

2,854

 

$

197

 

$

99

 

$

3,149

 

Income margin from continuing operations

 

14.8

%

1.0

pts.

0.5

pts.

16.4

%

Diluted earnings per share from

 

 

 

 

 

 

 

 

 

continuing operations

 

$

2.98

 

$

0.21

 

$

0.10

 

$

3.29

 

 


*            The tax impact on operating (non-GAAP) pre-tax income from continuing operations 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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Management Discussion — (continued)

 

(Dollars in millions except per share amounts)

 

 

 

Acquisition-related

 

Retirement-related

 

Operating

 

For the nine months ended September 30, 2017

 

GAAP

 

adjustments

 

adjustments

 

(Non-GAAP)

 

Gross profit

 

$

25,365

 

$

349

 

$

591

 

$

26,305

 

Gross profit margin

 

44.8

%

0.6

pts.

1.0

pts.

46.5

%

S,G&A

 

$

14,959

 

$

(393

)

$

(326

)

$

14,240

 

R,D&E

 

4,360

 

 

(148

)

4,212

 

Other (income) and expense

 

(218

)

(7

)

 

(225

)

Total expense and other (income)

 

18,434

 

(401

)

(474

)

17,559

 

Pre-tax income from continuing operations

 

6,931

 

750

 

1,065

 

8,746

 

Pre-tax margin from continuing operations

 

12.2

%

1.3

pts.

1.9

pts.

15.5

%

Provision for income taxes*

 

$

120

 

$

212

 

$

288

 

$

621

 

Effective tax rate

 

1.7

%

2.3

pts.

3.1

pts.

7.1

%

Income from continuing operations

 

$

6,811

 

$

537

 

$

777

 

$

8,125

 

Income margin from continuing operations

 

12.0

%

0.9

pts.

1.4

pts.

14.4

%

Diluted earnings per share from

 

 

 

 

 

 

 

 

 

continuing operations

 

$

7.24

 

$

0.57

 

$

0.83

 

$

8.64

 

 


*            The tax impact on operating (non-GAAP) pre-tax income from continuing operations 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.

 

(Dollars in millions except per share amounts)

 

 

 

Acquisition-related

 

Retirement-related

 

Operating

 

For the nine months ended September 30, 2016

 

GAAP

 

adjustments

 

adjustments

 

(Non-GAAP)

 

Gross profit

 

$

27,401

 

$

371

 

$

238

 

$

28,010

 

Gross profit margin

 

47.1

%

0.6

pts.

0.4

pts.

48.2

%

S,G&A

 

$

16,093

 

$

(365

)

$

(183

)

$

15,545

 

R,D&E

 

4,320

 

 

(23

)

4,297

 

Other (income) and expense

 

281

 

(7

)

 

274

 

Total expense and other (income)

 

20,056

 

(372

)

(206

)

19,478

 

Pre-tax income from continuing operations

 

7,345

 

743

 

444

 

8,532

 

Pre-tax margin from continuing operations

 

12.6

%

1.3

pts.

0.8

pts.

14.7

%

Provision for/(benefit from) income taxes*

 

$

(31

)

$

201

 

$

106

 

$

277

 

Effective tax rate

 

(0.4

)%

2.4

pts.

1.3

pts.

3.2

%

Income from continuing operations

 

$

7,375

 

$

542

 

$

338

 

$

8,255

 

Income margin from continuing operations

 

12.7

%

0.9

pts.

0.6

pts.

14.2

%

Diluted earnings per share from

 

 

 

 

 

 

 

 

 

continuing operations

 

$

7.67

 

$

0.57

 

$

0.35

 

$

8.59

 

 


*            The tax impact on operating (non-GAAP) pre-tax income from continuing operations 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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Management Discussion — (continued)

 

Forward-Looking and Cautionary Statements

 

Except for the historical information and discussions contained herein, statements contained in this Form 10-Q may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on the company’s current assumptions regarding future business and financial performance. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including the following: a downturn in the economic environment and client spending budgets; the company’s failure to meet growth and productivity objectives; a failure of the company’s innovation initiatives; risks from investing in growth opportunities; failure of the company’s intellectual property portfolio to prevent competitive offerings and the failure of the company to obtain necessary licenses; cybersecurity and data privacy considerations; fluctuations in financial results; impact of local legal, economic, political and health conditions; adverse effects from environmental matters, tax matters and the company’s pension plans; ineffective internal controls; the company’s use of accounting estimates; the company’s ability to attract and retain key personnel and its reliance on critical skills; impacts of relationships with critical suppliers; product quality issues; impacts of business with government clients; currency fluctuations and customer financing risks; impact of changes in market liquidity conditions and customer credit risk on receivables; reliance on third party distribution channels and ecosystems; the company’s ability to successfully manage acquisitions, alliances and dispositions; risks from legal proceedings; risk factors related to IBM securities; and other risks, uncertainties and factors discussed in the company’s Form 10-Qs, Form 10-K and in the company’s other filings with the U.S. Securities and Exchange Commission (SEC) or in materials incorporated therein or herein by reference. The company assumes no obligation to update or revise any forward-looking statements.

 

Item 4. Controls and Procedures

 

The company’s management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the company’s disclosure controls and procedures were effective as of the end of the period covered by this report. There has been no change in the company’s internal control over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.

 

Part II — Other Information

 

Item 1.  Legal Proceedings

 

Refer to note 12, “Contingencies,” on pages 44 to 46 of this Form 10-Q.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities

 

The following table provides information relating to the company’s repurchase of common stock for the third quarter of 2017.

 

 

 

 

 

 

 

Total Number

 

Approximate

 

 

 

 

 

 

 

of Shares

 

Dollar Value

 

 

 

 

 

 

 

Purchased as

 

of Shares that

 

 

 

Total Number

 

Average

 

Part of Publicly

 

May Yet Be

 

 

 

of Shares

 

Price Paid

 

Announced

 

Purchased Under

 

Period

 

Purchased

 

per Share

 

Program

 

The Program*

 

July 1, 2017 - July 31, 2017

 

1,403,534

 

$

149.09

 

1,403,534

 

$

2,191,734,677

 

 

 

 

 

 

 

 

 

 

 

August 1, 2017 - August 31, 2017

 

3,167,041

 

$

142.65

 

3,167,041

 

$

1,739,970,319

 

 

 

 

 

 

 

 

 

 

 

September 1, 2017 - September 30, 2017

 

1,982,071

 

$

144.56

 

1,982,071

 

$

1,453,447,857

 

 

 

 

 

 

 

 

 

 

 

Total

 

6,552,646

 

$

144.60

 

6,552,646

 

 

 

 


* On October 25, 2016, the Board of Directors authorized $3.0 billion in funds for use in the company’s common stock repurchase program. The company stated that it would repurchase shares on the open market or in private transactions depending on market conditions. The common stock repurchase program does not have an expiration date. This table does not include shares tendered to satisfy the exercise price in connection with cashless exercises of employee stock options or shares tendered to satisfy tax withholding obligations in connection with employee equity awards.

 

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Table of Contents

 

Item 6. Exhibits

 

Exhibit Number

 

4.1

 

Indenture dated as of October 1, 1993 between IBM and The Bank of New York Mellon, (as successor to The Chase Manhattan Bank (National Association)) as Trustee. *

 

 

 

4.2

 

First Supplemental Indenture to Indenture dated as of October 1, 1993 between IBM and The Bank of New York Mellon, (as successor to The Chase Manhattan Bank (National Association)) as Trustee, dated as of December 15, 1995. *

 

 

 

11

 

Statement re: computation of per share earnings.

 

 

 

 

 

The statement re computation of per share earnings is note [14], “Earnings Per Share of Common Stock,” in this Form 10-Q.

 

 

 

12

 

Statement re: computation of ratios.

 

 

 

31.1

 

Certification by principal executive officer pursuant to Rule 13A-14(a) or 15D-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification by principal financial officer pursuant to Rule 13A-14(a) or 15D-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification by principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification by principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

101.INS

 

XBRL Instance Document

 

 

 

101.SCH

 

XBRL Taxonomy Extension Schema Document

 

 

 

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document

 

 

 

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document

 

 

 

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document

 

 

 

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document

 


* Refiled by the company in electronic format in accordance with SEC Release Nos. 33-10322 and 34-80132 relating to exhibit hyperlinks, which became effective September 1, 2017.

 

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Table of Contents

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

International Business Machines Corporation

 

(Registrant)

 

 

 

 

 

 

 

 

Date:

October 31, 2017

 

 

 

 

 

By:

/s/  Robert F. Del Bene

 

 

      Robert F. Del Bene

 

 

Vice President and Controller

 

89