Report of Financials

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Report of Management		12
Report of Independent Registered Public Accounting Firm		13

Management Discussion
Road Map		14
Forward-Looking and Cautionary Statements		15
Management Discussion Snapshot		15
Description of Business		17
Year in Review		22
Prior Year in Review		34
Looking Forward		36
Employees and Related Workforce		43
Global Financing		43

Consolidated Financial Statements
Earnings		48
Financial Position		49
Cash Flows		50
Stockholders’ Equity		51

Notes to Consolidated Financial Statements
A	Significant Accounting Policies	54
B	Accounting Changes	61
C	Acquisitions/Divestitures	63
D	Financial Instruments (excluding derivatives)	67
E	Inventories	68
F	Financing Receivables	68
G	Plant, Rental Machines and Other Property	68
H	Investments and Sundry Assets	68
I	Intangible Assets Including Goodwill	68
J	Securitization of Receivables	70
K	Borrowings	70
L	Derivatives and Hedging Transactions	71
M	Other Liabilities	74
N	Stockholders’ Equity Activity	75
O	Contingencies and Commitments	76
P	Taxes	79
Q	Research, Development and Engineering	80
R	2005 Actions	80
S	Earnings Per Share of Common Stock	82
T	Rental Expense and Lease Commitments	83
U	Stock-Based Compensation	83
V	Retirement-Related Benefits	85
W	Segment Information	95
X	Subsequent Events	100

Five-Year Comparison of Selected Financial Data		101

Selected Quarterly Data		102

Board of Directors and Senior Executive Officers		103

Stockholder Information		104

Report of Management

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Management Responsibility for Financial Information

Responsibility for the integrity and objectivity of the financial information presented in this Annual Report rests with IBM management. The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, applying certain estimates and judgments as required.

IBM maintains an effective internal control structure. It consists, in part, of organizational arrangements with clearly defined lines of responsibility and delegation of authority, and comprehensive systems and control procedures. An important element of the control environment is an ongoing internal audit program. Our system also contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.

To assure the effective administration of internal controls, we carefully select and train our employees, develop and disseminate written policies and procedures, provide appropriate communication channels, and foster an environment conducive to the effective functioning of controls. We believe that it is essential for the company to conduct its business affairs in accordance with the highest ethical standards, as set forth in the IBM Business Conduct Guidelines. These guidelines, translated into numerous languages, are distributed to employees throughout the world, and reemphasized through internal programs to assure that they are understood and followed.

PricewaterhouseCoopers LLP, an independent registered public accounting firm, is retained to audit IBM’s consolidated financial statements and management’s assessment of the effectiveness of the internal control over financial reporting. Its accompanying report is based on audits conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States).

The Audit Committee of the Board of Directors is composed solely of independent, non-management directors, and is responsible for recommending to the Board the independent registered public accounting firm to be retained for the coming year, subject to stockholder ratification. The Audit Committee meets periodically and privately with the independent registered public accounting firm, with the company’s internal auditors, as well as with IBM management, to review accounting, auditing, internal control structure and financial reporting matters.

Management's Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting of the company. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

The company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of December 31, 2005. Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.

SAMUEL J. PALMISANO

Chairman of the Board,

President and Chief Executive Officer

February 28, 2006

MARK LOUGHRIDGE

Senior Vice President,

Chief Financial Officer

February 28, 2006

Report of Independent Registered Public Accounting Firm

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF INTERNATIONAL BUSINESS MACHINES CORPORATION:

We have completed integrated audits of International Business Machines Corporation’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits and the report of other auditors, are presented below.

Consolidated Financial Statements

In our opinion, based on our audits and the report of other auditors, the accompanying consolidated financial statements appearing on pages 48 through 100 present fairly, in all material respects, the financial position of International Business Machines Corporation and its subsidiary companies at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of the Company’s Business Consulting Services Reporting Unit (which includes the consulting practice acquired from us) for the years ended December 31, 2004 and 2003, which statements reflect total revenues of 14.3 percent and 14.5 percent of the related consolidated totals in the years ended December 31, 2004 and 2003, respectively. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for the Company’s Business Consulting Services Reporting Unit, is based solely on the report of the other auditors. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.

As discussed in notes A and U to the financial statements, the Company changed the manner in which it accounts for stock-based awards exchanged for employee services as of January 1, 2005.

Internal Control Over Financial Reporting

Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing on page 12, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

PRICEWATERHOUSECOOPERS LLP

New York, New York

February 28, 2006

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Road Map

The financial section of the International Business Machines Corporation (IBM and/or the company) 2005 Annual Report, consisting of this Management Discussion, the Consolidated Financial Statements that follow and the notes related thereto, comprises 89 pages of information. This Road Map is designed to provide you with some perspective regarding the information contained in the financial section.

IBM’s Business Model

The company’s business model is built to support two principal goals: helping clients succeed in delivering business value by becoming more efficient and competitive through the use of business insight and information technology (IT) solutions; and providing long-term value to shareholders. In support of these objectives, the business model has been developed over time through strategic investments in services and technologies that have the best long-term growth and profitability prospects based on the value they deliver to clients. In addition, the company is committed to its employees and the communities in which it operates.

The model is designed to allow for flexibility and periodic rebalancing. In 2005, 16 acquisitions were completed, primarily in software and services, at an aggregate cost of approximately $2 billion, and the company completed the sale of its Personal Computing business to Lenovo Group Limited (Lenovo).

The company’s portfolio of capabilities ranges from services that include Business Performance Transformation Services to software, hardware, fundamental research, financing and the component technologies used to build larger systems. These capabilities are combined to provide business insight and solutions in the enterprise computing space.

In terms of financial performance, the company has continued to focus on its participation in the high-growth, high-profit segments of the IT industry that will enable the company to deliver consistently strong earnings, high returns on invested capital and excellent cash flows. The company’s business model is based on a balanced portfolio of services, systems and technology and software maintaining a broad range of capabilities that will allow the company to compete effectively and grow in key markets even during changing economic environments. This strategy results in less volatile returns overall, as the portfolio has an effective segmentation of businesses that drive transactional revenue and profits, as well as businesses that drive annuity-based revenue and profits. The strength of the business model is not any single component–it is the company’s ability to generate consistent financial performance with balanced contributions across the portfolio.

In terms of marketplace performance–i.e., the ability to deliver client value–it is important to understand that the fundamental strength of this business model is not found in the breadth of the portfolio alone, but in the way the company creates business solutions from among its capabilities and relationships.

Strategically, the company has exited commoditized businesses, increased its concentration in higher-value businesses and created a more balanced portfolio. The company integrates across its portfolio to create solution offerings for its global client-base, driving profit and cash growth over the long term.

Transparency

Transparency is a primary goal of successful financial reporting. The following are the key elements you will find in this year’s Annual Report.

• The company, in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, conducted an evaluation of its internal control over financial reporting and concluded that the internal control over financial reporting was effective as of December 31, 2005.

• The Management Discussion is designed to provide readers with a view of the company’s results and certain factors that may affect future prospects from the perspective of the company’s management. Within the “Management Discussion Snapshot,” on pages 15 to 17 the key messages and details will give readers the ability to quickly assess the most important drivers of performance within this brief overview.

• The Management Discussion reflects the company’s continued and improving strength in providing client- and industry-specific solutions utilizing the broad capabilities of its portfolio. The sections on “Description of the Business” on page 17, “Results of Continuing Operations” on page 22, “Financial Position” on page 30, and “Looking Forward” on page 36, are all written from the perspective of the consolidated entity. Detailed analysis for each of the company’s segments is also included and appears on pages 27 to 30.

• Global Financing is a business segment within the company that is measured as if it were a standalone entity. A separate “Global Financing” section beginning on page 43 is not included in the consolidated perspective that is referred to above. This section is separately presented given this segment’s unique impact on the company’s financial condition and leverage.

• The company divested its Personal Computing business to Lenovo on April 30, 2005. The details of this significant transaction are discussed in note C, “Acquisitions/Divestitures,” on pages 66 and 67. As a result of this divestiture, the company’s reported financial results include four months of activity for the Personal Computing business in 2005 as compared to 12 months in 2004. This lack of comparable periods has a material impact on the company’s reported revenue results. Therefore, in the Management Discussion, within the “Year in Review” section on pages 22 to 25, the company has presented an analysis of revenue both on an as-reported basis and on a basis that excludes the revenues from the divested Personal Computing business from both the 2005 and 2004 periods. The company believes that the analysis that excludes the Personal Computing revenues is a better indicator of the company’s operational revenue performance in 2005 as compared to 2004.

• The selected reference to constant currency in the Management Discussion is made so that the financial results can be viewed without the impacts of changing

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

foreign currency exchange rates and therefore facilitates a comparative view of business growth. The percentages reported in the financial tables throughout the Management Discussion are calculated from the underlying whole-dollar numbers. See “Currency Rate Fluctuations” on page 42 for additional information.

Helpful Hints

ORGANIZATION OF INFORMATION

• This Management Discussion section provides the reader of the financial statements with a narrative on the company’s financial results. It contains the results of operations for each segment of the business, followed by a description of the company’s financial position, as well as certain employee data. It is useful to read the Management Discussion in conjunction with note W, “Segment Information,” on pages 95 through 99.

• Pages 48 through 53 include the Consolidated Financial Statements. These statements provide an overview of the company’s income and cash flow performance and its financial position.

• The notes follow the Consolidated Financial Statements. Among other things, the notes contain the company’s accounting policies (pages 54 to 61), detailed information on specific items within the financial statements, certain contingencies and commitments (pages 76 through 78), and the results of each IBM segment (pages 95 through 99).

2004 Annual Report

Effective January 1, 2005, the company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”). The company elected to adopt the modified retrospective application method provided by SFAS 123(R). This method permits the restatement of historical financial statement amounts. See note A, “Significant Accounting Policies,” on pages 58 and 59 and note U, “Stock-Based Compensation,” on pages 83 to 85 for additional information.

In addition, as a result of the divestiture of the Personal Computing business in 2005, the company revised its operating segments in the second quarter. See note W, “Segment Information,” on page 95 for additional information. Accordingly, as a result of these actions, the company filed a restated 2004 Annual Report with the Securities and Exchange Commission (SEC) on Form 8-K on July 27, 2005.

Discontinued Operations

On December 31, 2002, the company sold its hard disk drive (HDD) business to Hitachi, Ltd. (Hitachi). The HDD business was accounted for as a discontinued operation under generally accepted accounting principles (GAAP) which requires that the income statement and cash flow information be reformatted to separate the divested business from the company’s continuing operations. See page 36 for additional information.

Forward-Looking and Cautionary Statements

Certain statements contained in this Annual Report may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to be materially different, as discussed more fully elsewhere in this Annual Report and in the company’s filings with the SEC, including the company’s 2005 Form 10-K filed on February 28, 2006.

Management Discussion Snapshot

(Dollars and shares in millions except per share amounts)

							YR. TO YR.
							PERCENT/
							MARGIN
FOR THE YEAR ENDED DECEMBER 31:	2005			2004			CHANGE

Revenue	$	91,134		$	96,293		(5.4	)%*
Gross profit margin	40.1		%	36.9		%	3.2	pts.
Total expense and other income	$	24,306		$	24,900		(2.4	)%
Total expense and other income to revenue ratio	26.7		%	25.9		%	0.8	pts.
Income from continuing operations before income taxes	$	12,226		$	10,669		14.6	%
Provision for income taxes	$	4,232		$	3,172		33.4	%
Income from continuing operations	$	7,994		$	7,497		6.6	%
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$	4.91		$	4.39		11.8	%
Discontinued operations	(0.01		)	(0.01		)	45.0	%
Cumulative effect of of change in accounting principle⁺⁺	(0.02		)	—			NM
Total	$	4.87	⁺	$	4.38		11.2	%
Weighted-average shares outstanding:
Diluted	1,627.6			1,707.2			(4.7	)%
Assets**	$	105,748		$	111,003		(4.7	)%
Liabilities**	$	72,650		$	79,315		(8.4	)%
Equity**	$	33,098		$	31,688		4.4	%

* (5.8) percent adjusted for currency.

** At December 31

+ Does not total due to rounding.

++ Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information.

NM–Not Meaningful

Continuing Operations

In 2005, the company delivered solid growth in earnings and cash generation–balanced across its portfolio–and executed a series of actions to improve productivity and to reallocate resources to the faster growing areas of the business.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

The company’s reported results include the Personal Computing business for four months in 2005 versus 12 months in 2004.

Total revenue, as reported, declined 5.4 percent versus 2004; excluding the Personal Computing business external revenue from both years, total revenue increased 3.2 percent (2.8 percent adjusted for currency). Pre-tax income from continuing operations grew 14.6 percent, while diluted earnings per share from continuing operations increased 11.8 percent compared to 2004. Net cash provided by operating activities was $14,914 million. The company’s financial performance in 2005 was driven by a combination of segment performance, portfolio actions and execution of the company’s productivity initiatives.

The increase in revenue, excluding the Personal Computing business, in 2005 as compared to 2004 was primarily due to:

• Improving demand in the hardware business driven by pSeries and xSeries server products, as well as Storage products, Microelectronics and Engineering and Technology Services

• Improved demand in the software business, driven by key branded middleware products

• Continued growth in emerging countries (up 23 percent) and in Business Performance Transformation Services (up 28 percent)

The increase in income from continuing operations in 2005 as compared to 2004 was primarily due to:

• Moderate revenue growth in the Hardware and Software segments as discussed above

• Execution of the company’s restructuring and productivity initiatives, primarily focused on Global Services

• Improved demand and continued operational improvement in the Microelectronics business

In addition to improved earnings, in 2005, the company executed a series of important actions that benefited the company’s performance in the current year and strengthened its capabilities going forward. These actions included:

• Completion of the divestiture of the Personal Computing business to Lenovo

• Continuation of investment in acquisitions to strengthen the company’s on demand capabilities; in 2005, the company completed 16 acquisitions at a cost of approximately $2 billion

• Implementation of a large restructuring action to improve the company’s cost competitiveness

• Change of the company’s operating model in Europe–shifting resources and decision-making closer to the clients

• Redesign of the company’s U.S. pension plan, as well as taking actions in other countries; over the longer term, these actions will reduce volatility and provide a more competitive cost structure

• Repatriation of $9.5 billion of foreign earnings under the American Jobs Creation Act of 2004 improving the company’s geographic liquidity position

• Further extension of the company’s commitment to innovation and open standards

The consolidated gross profit margin increased 3.2 points to 40.1 percent versus 2004. An improvement in the Hardware margin (5.6 points) contributed 1.9 points to the overall margin improvement. This increase was primarily driven by the sale of the company’s Personal Computing business in the second quarter of 2005. In addition, the Global Services margin improved 1.7 points versus 2004 to 25.9 percent. This increase was driven by several factors: the restructuring actions taken in the second quarter of 2005 to improve cost competitiveness; improved utilization levels; and a better overall contract profile. The Software margin increased slightly and the Enterprise Investments/Other margin improved 6.3 points in 2005 to 46.5 percent, but these increases only slightly improved the overall company margin. The Global Financing margin declined 5.2 points versus 2004 to 54.7 percent primarily driven by a mix towards lower margin remarketing sales and increased interest cost. This decline had an immaterial impact on the company’s overall margin due to the size of the segment.

Total expense and other income declined 2.4 percent in 2005 versus 2004. The decline was primarily due to the gain associated with the sale of the company’s Personal Computing business, a gain from a legal settlement with Microsoft, partially offset by the incremental restructuring charges recorded in the second quarter.

Overall, retirement-related plan costs increased $993 million versus 2004, impacting both gross margin and expense. See note V, “Retirement-Related Benefits” on pages 85 to 95 and “Retirement-Related Benefits” on page 27 for additional information. In addition, stock-based compensation expense decreased $543 million versus 2004, impacting both gross margin and expense. See “Stock-Based Compensation,” on pages 26 and 27 for additional information.

The provision for income taxes resulted in an effective tax rate of 34.6 percent for 2005, compared with the 2004 effective tax rate of 29.7 percent. The 4.9 point increase in the effective tax rate in 2005 was primarily due to the third-quarter tax charge associated with the repatriation under the American Jobs Creation Act of 2004. See note P, “Taxes,” on page 80 for additional information concerning this repatriation tax charge.

With regard to the decrease in total Assets, the impact of currency was approximately $5.7 billion. Other asset changes primarily consisted of an increase in Cash and cash equivalents, an increase in Goodwill associated with 2005 acquisitions and increased Prepaid pension assets. These increases were partially offset by lower financing receivables and lower deferred tax assets.

The decrease in total Liabilities was primarily driven by the impact of currency, approximately $4.1 billion. In addition,

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Accounts payable declined approximately $1.1 billion due to the divestiture of the Personal Computing business. Total debt of $22.6 billion decreased $0.3 billion versus 2004.

Global Services signings were $47 billion in 2005 as compared to $43 billion in 2004. The Global Services backlog is estimated to be $111 billion at December 31, 2005, flat versus December 31, 2004. For additional information, see “Global Services Signings” on page 28.

For additional information, see the “Year in Review” section on pages 22 through 33.

Looking forward, the company’s longer-term financial model targets double-digit earnings per share growth through a combination of revenue growth, productivity-driven margin improvement and effective capital deployment for acquisitions and returns to shareholders through dividends and common stock repurchases. The company’s ability to meet these objectives depends on a number of factors, including those outlined on page 21 and on pages 76 to 78.

Description of Business

Please refer to IBM’s Annual Report on Form 10-K filed on February 28, 2006, with the SEC for a more detailed version of this Description of Business, especially Item 1A entitled “Risk Factors.”

IBM is an innovation company, serving the needs of enterprises and institutions worldwide. IBM seeks to deliver clients success by enabling their own capacity to innovate, so that they may differentiate their organizations to create a unique competitive advantage.

To help its clients achieve growth, productivity, efficiency, and the realization of greater value through innovation, IBM draws upon the world’s leading systems, software and services capabilities to turn enterprises of all sizes, in every major industry, into on demand businesses. An on demand business is an enterprise that is integrated end-to-end, and, with its business ecosystems of partners, suppliers and clients, is able to manage that extended network dynamically to address new opportunities, respond to changes in demand or threats to its business, enhance flexibility, speed execution and ultimately achieve profitable growth.

In IBM’s view, being on demand is the most comprehensive way to enable a company to innovate–and thus differentiate itself–consistently over time. IBM views enterprise innovation not only in terms of products and services, but across all dimensions of a business: its business processes, business model, management systems, culture and role in society.

IBM’s Strategy

IBM’s strategy is to pursue an innovation agenda with its clients, partners and in other relationships, and to continue refining its portfolio to achieve higher value. Through its understanding of where technology, client requirements and global business are headed, the company continually makes strategic decisions to maintain its leadership of this rapidly changing business by focusing on high-value innovation-based solutions and services while consistently generating high returns on invested capital for its shareholders. The company utilizes its entire portfolio–hardware, software, services, technology and research-to maintain its leadership. With those broad capabilities to enable enterprise innovation, the expertise and diversity of its global workforce and its large network of suppliers and business partners, IBM considers itself well-positioned to capitalize on the opportunities represented by the needs of its clients and current trends in economics and society. IBM believes these trends will have major effects on business, government, education, healthcare, transportation and most other fields of endeavor. These developments include, in part: the globalization of capabilities, skills, and markets; the increasingly interconnected nature of companies, industries and even economies; the growing influence of open-standards and open-source software; the rise in collaborative models of creation and development; the maturation and availability of semiconductor and wireless chip technology; the use of service-oriented architectures and Web services in software development; the growing number of service providers for a wider range of traditional and emerging business processes and functions; and the advances made by IBM and others in increasing computational speed, capacity and access.

To capitalize on the opportunities presented by these and other developments, and to avoid commoditization of its portfolio, IBM regularly reviews its businesses and invests in those that represent strategic growth opportunities, reallocating resources as needed; it acquires businesses that contribute strategically to its portfolio; it exits or divests itself of businesses that no longer support its strategy for innovation and higher value; and it seeks to improve productivity and drive efficiencies by integrating its global operations.

IBM’s strategic priorities for 2006 include:

• Capitalizing on technological, business and social trends and the need of enterprises to innovate in addressing those trends;

• Maintaining market-share leadership in systems, middle-ware software and services, as a platform to drive growth;

• Focusing investment and resources on emerging growth areas, including Business Performance Transformation Services and emerging countries;

• Continuing the global integration of IBM, driving productivity gains and higher value in service delivery;

• Furthering IBM’s leadership in innovation initiatives, including advanced semiconductor design and development, collaborative intellectual capital, business process expertise and integration, and advanced systems for supercomputing capability–including mainframes and “grid” networks;

• Acquiring businesses that contribute strategically to its portfolio, and exiting businesses that no longer support its strategy for innovation and higher value.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

IBM’s Capabilities

To execute its strategy, IBM’s business comprises three principal business segments:

• Systems and Financing

• Software

• Services

SYSTEMS AND FINANCING

SYSTEMS:

Servers. IBM systems using IBM operating systems (zSeries and iSeries), as well as AIX, the IBM UNIX operating system (pSeries) and the Microsoft Windows operating system (xSeries). All servers can also run Linux, a key open source operating system.

Storage. Data storage products, including disk, tape, optical and storage area networks.

Advanced Foundry. Integrated supply chain services and a full suite of semiconductor manufacturing services using either a client’s or IBM’s design.

Application Specific Integrated Circuit (ASICs). Manufacturing of customized semiconductor products for clients.

Standard products and custom microprocessors. Semiconductors designed and manufactured primarily based upon IBM’s PowerPC architecture.

Printing Systems. Production print solutions, on demand print-related solutions, enterprise workgroup print technologies, print management software, services and maintenance.

Retail Store Solutions. Point-of-sale retail checkout systems, software and solutions.

FINANCING:

Commercial financing. Short-term inventory and accounts receivable financing to dealers and remarketers of IT products. (Revenue reported as Global Financing.)

Client financing. Lease and loan financing to external and internal clients for terms generally between two and seven years. (Revenue reported as Global Financing.)

Remarketing. The sale and lease of used equipment (primarily sourced from the conclusion of lease transactions) to new or existing clients. (Revenue reported as Global Financing.)

SOFTWARE

DB2 INFORMATION MANAGEMENT SOFTWARE. Advanced database and content management software solutions that enable clients to leverage information on demand.

LOTUS SOFTWARE. Collaboration and messaging software that allows a company’s employees, clients, vendors and partners to engage in real-time and asynchronous communication and knowledge management.

RATIONAL SOFTWARE. Integrated tools designed to improve an organization’s software development processes and capabilities.

TIVOLI SOFTWARE. Software for infrastructure management, including security, change, configuration, job scheduling, storage capability, performance and availability.

WEBSPHERE SOFTWARE. Management of a wide variety of business processes using open standards to interconnect applications, data and operating systems.

SERVICES

BUSINESS PERFORMANCE TRANSFORMATION SERVICES (BPTS). Helps clients transform their spending on business processes, namely Selling, General and Administrative, and Research and Development. BPTS requires advanced technology and deep expertise in industry and/or specific functions like human resources, logistics, payroll, sales, customer services and procurement, to result in holistic improvement for the performance and success of a business, including efficiency of individual processes and their combined effort. BPTS solutions are delivered to clients by several of the company’s business areas: Business Transformation Outsourcing, Engineering and Technology Services, Strategy and Change Consulting and Business Performance Management. (Revenue reported in various segments.)

BUSINESS TRANSFORMATION OUTSOURCING (BTO). Delivers improved business results to clients through the continual strategic change and the operation and transformation of the client’s business processes, applications and infrastructure.

ENGINEERING & TECHNOLOGY SERVICES (E&TS). System and component design services, strategic outsourcing of clients’ design teams, and technology and manufacturing consulting services. (Revenue reported as Hardware segment.)

BUSINESS CONSULTING SERVICES (BCS). Delivery of value to clients through consulting services for client relationship management, financial management, human capital, business strategy and change, and supply-chain management, as well as application innovation and the transformation of business processes and operations.

BUSINESS PERFORMANCE MANAGEMENT (BPM). Enables companies to visualize end-to-end processes across business and IT systems, analyze execution in real time against goals, and make adjustments as needed. IBM offers consulting, services and middleware to simulate and monitor business processes, and provides clients with real-time analysis of the underlying IT systems carrying out those processes. (Revenue reported as Software segment.)

CENTER FOR BUSINESS OPTIMIZATION (CBO). Helps clients continually optimize their business performance by drawing upon massive amounts of real-time data, advanced analytical methods, business expertise and deep computing power.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

ON DEMAND INNOVATION SERVICES (ODIS). IBM Research scientists work with BCS consultants to analyze and solve clients’ most intractable business challenges. ODIS offers a number of cross-industry micropractices with deep expertise including mobile enablement and information mining.

STRATEGIC OUTSOURCING SERVICES (SO). Comprehensive IT services integrated with business insight working with clients to reduce costs and improve productivity through the outsourcing of processes and operations.

INTEGRATED TECHNOLOGY SERVICES (ITS). Design, implementation and maintenance of clients’ technology infrastructures.

APPLICATION MANAGEMENT SERVICES. Application development, management, maintenance and support services for packaged software, as well as custom and legacy applications.

E-BUSINESS HOSTING SERVICES. Solutions for the management of clients’ Web-based infrastructure and business applications, as well as a growing portfolio of industry-specific independent software vendor (ISV) solutions that are delivered as a service.

Business Segments

Organizationally, the company’s major operations comprise a Global Services segment; a Systems and Technology Group; a Software segment; a Global Financing segment; and an Enterprise Investments segment.

GLOBAL SERVICES is a critical component of the company’s strategy of providing insight and solutions to clients. While solutions often include industry-leading IBM software and hardware, other suppliers’ products are also used if a client solution requires it. Contracts for IBM services–commonly referred to as “signings”–can range from less than one year to ten years. Businesses generating short-term signings include ITS and the commercial content of Consulting and Systems Integration (C&SI). Long-term businesses include SO, BTO, and the federal content of C&SI.

SYSTEMS AND TECHNOLOGY GROUP provides IBM’s clients with business solutions requiring advanced computing power and storage capabilities. Approximately 60 percent of the Systems and Technology Group’s server and storage sales transactions are through business partners; approximately 40 percent are direct to end-user clients, more than half of which are through the Web at ibm.com. In addition, the group provides leading semiconductor technology and products, packaging solutions and engineering technology services to clients and for IBM’s own advanced technology needs. While appropriately not reported as external revenue, hardware is also deployed to support services solutions.

SOFTWARE consists primarily of middleware and operating systems software. Middleware software enables clients to integrate systems, processes and applications across their enterprises. Middleware is designed to be the underlying support for applications provided by ISVs, who build industry- or process-specific applications according to open industry standards. Operating systems are the engines that run computers. Approximately 45 percent of external Software revenue relates to one-time charge (OTC) arrangements, whereby the client pays one up-front payment for a perpetual license. The remaining annuity-based revenue consists of both maintenance revenue sold with OTC arrangements, as well as revenue from software sold on a monthly license charge (MLC) arrangement. Typically, arrangements for the sale of OTC software include one year of maintenance. The client can also purchase ongoing maintenance after the first year, which includes product upgrades and technical support.

GLOBAL FINANCING is described on pages 43 through 47.

ENTERPRISE INVESTMENTS develops and provides industry-specific IT solutions supporting the Hardware, Software and Global Services segments of the company. Primary product lines include product life cycle management software and document processing technologies. Product life cycle management software primarily serves the Industrial sector and helps clients manage the development and manufacturing of their products. Document processor products service the Financial Services sector and include products that enable electronic banking.

IBM Worldwide Organizations

The following three company-wide organizations play key roles in IBM’s delivery of value to its clients:

• Sales & Distribution Organization and related sales channels

• Research, Development and Intellectual Property

• Integrated Supply Chain

SALES & DISTRIBUTION ORGANIZATION

With a comprehensive knowledge of IBM’s business and infrastructure solutions, as well as the products, technologies and services IBM and its Business Partners offer, the company’s global client teams gain a deep understanding of each client’s organizational, infrastructure and industry-specific needs to determine the best approach for addressing their critical business and IT challenges. These professionals work in integrated teams with IBM consultants and technology representatives, combining their deep skills and expertise to deliver high-value solutions that address clients’ pain points and innovational aspirations.

The majority of IBM’s business, excluding the company’s original equipment manufacturer (OEM) technology business, occurs in industries that are broadly grouped into six sectors. The company’s go-to-market strategies and sales and distribution activities are organized around these sectors:

• Financial Services: Banking, Financial Markets, Insurance

• Public: Education, Government, Healthcare and Life Sciences

• Industrial: Aerospace and Defense, Automotive, Chemical and Petroleum, Electronics

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

• Distribution: Consumer Products, Retail, Travel, Transportation

• Communications: Telecommunications, Media and Entertainment, Energy and Utilities

• Small and Medium Business: Mainly companies with less than 1,000 employees

INTERNAL ROUTES-TO-MARKET

Services consultants focused on selling end-to-end solutions for large, complex business challenges.

Hardware and software brand specialists Selling IBM products as parts of discrete technology decisions, and focusing on mid-sized clients interested in purchasing “turnkey” solutions, such as those in the IBM Express Portfolio.

ibm.com provides fast, easy access to IBM’s product and business expertise via the Web and telephone. Identifies business opportunities for all of IBM’s routes to market and provides online and telephone sales of standard hardware, software, services and financing for all size companies.

BUSINESS PARTNERS ROUTES-TO-MARKET

Global/major independent software vendors. ISVs deliver business process or industry-specific applications and, in doing so, often influence the sale of IBM hardware, middleware and services.

Global/major systems integrators (SIS). SIS identify business problems and design solutions when IBM Global services is not the preferred systems integrator; they also sell computing infrastructures from IBM and its competitors.

Regional ISVs and SIS. SIS identify the business problems, and ISVs deliver business process or industry-specific applications to medium-sized and large businesses requiring IBM computing infrastructure offerings.

Solutions providers, resellers and distributors. Resellers sell IBM platforms and value-added services as part of a discrete technology platform decision to clients wanting third-party assistance.

RESEARCH, DEVELOPMENT AND INTELLECTUAL PROPERTY

IBM’s research and development (R&D) operations differentiate IBM from its competitors. IBM annually spends approximately $5–$6 billion for R&D, including capitalized software costs, focusing its investments in high-growth opportunities. As a result of innovations in these and other areas, IBM was once again awarded more U.S. patents in 2005 than any other company. This marks the 13th year in a row that IBM achieved this distinction.

In addition to producing world-class hardware and software products, IBM innovations are a major differentiator in providing solutions for the company’s clients through its growing services activities. The company’s investments in R&D also result in intellectual property (IP) income. Some of IBM’s technological breakthroughs are used exclusively in IBM products, while others are used by the company’s licensees for their products when that new technology is not strategic to IBM’s business goals. A third group is both used internally and licensed externally.

In addition to these IP income sources, the company also generates value from its patent portfolio through cross-licensing arrangements and IP licensed in divestiture transactions. The value of these other two sources is not readily apparent in the financial results and Consolidated Statement of Earnings, because income on cross-licensing arrangements is recorded only to the extent that cash is received. The value received by IBM for IP involving the sale of a business is included in the overall gain or loss from the divestiture, not in the separately displayed IP income amounts in financial results and Consolidated Statement of Earnings.

INTEGRATED SUPPLY CHAIN

Just as IBM works to transform its clients’ supply chains for greater efficiency and responsiveness to market conditions, the company continues to see business value as it establishes its globally integrated supply chain as an on demand business, transforming this function into a strategic advantage for the company and, ultimately, improved delivery and outcomes for its clients. Leveraging this experience, in June 2005, IBM launched its supply-chain business transformation outsourcing service to optimize and help run clients’ end-to-end supply chain processes, from procurement to logistics.

IBM spends approximately $38 billion annually through its supply chain, procuring materials and services around the world. The company’s supply, manufacturing and logistics and customer fulfillment operations are integrated in one operating unit that has reduced inventories, improved response to marketplace opportunities and external risks and converted fixed to variable costs. Simplifying and streamlining internal processes has improved operations and sales force productivity and processes and thereby the experiences of the company’s clients when working with IBM. Because some of the cost savings this unit generates are passed along to clients, they will not always result in a visible gross margin improvement in the company’s Consolidated Statement of Earnings. While these efforts are largely concerned with product manufacturing and delivery, IBM is also applying supply-chain principles to service delivery across its solutions and services lines of business.

In addition to its own manufacturing operations, the company uses a number of contract manufacturing (CM) companies around the world to manufacture IBM-designed products. The use of CM companies is intended to generate cost efficiencies and reduce time-to-market for certain IBM products. Some of the company’s relationships with CM companies are exclusive. The company has key relationships with Sanmina-SCI for the manufacture of some Intel-based products and with Solectron for a significant portion of the manufacturing operations of

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Global Asset Recovery Services–an operation of Global Financing that restores end-of-lease personal computers and other IT equipment for resale.

Key Business Drivers

The following are some of the key drivers of the company’s business.

ECONOMIC ENVIRONMENT AND CORPORATE SPENDING BUDGETS

If overall demand for systems, software and services changes, whether due to general economic conditions or a shift in corporate buying patterns, sales performance could be impacted. IBM’s diverse portfolio of products and offerings is designed to gain market share in strong and weak economic climates. The company accomplishes this by not only having a mix of offerings with long-term cash and income streams, as well as cyclical transaction-based sales, but also by continually developing competitive products and solutions and effectively managing a skilled resource base. IBM continues to transform itself to take advantage of shifting demand trends, focusing on client- or industry-specific solutions, business performance and open standards.

INTERNAL BUSINESS TRANSFORMATION AND GLOBAL INTEGRATION INITIATIVES

IBM continues to drive greater productivity, flexibility and cost savings by transforming and globally integrating its own business processes and functions. In 2005, the company realigned its operations and organizational structure in Europe to give sales and delivery teams greater authority, accountability and flexibility to make decisions and to execute more effectively on behalf of our clients. Additionally, in 2005, many of the company’s corporate functions–such as Legal, Finance, Human Resources, Information Technology, and Real Estate Site Operations–which had been previously replicated for many of the individual countries where IBM operates were integrated so that they could be managed and their resources optimized on a global scale. In addition to eliminating redundancies and overhead structures to drive productivity, this integration improved IBM’s capacity to innovate by providing greater clarity of key priorities around shared goals and objectives and led to a sharper focus for the company on learning, development and knowledge sharing.

INNOVATION INITIATIVES

IBM invests to improve its ability to help its clients innovate. Investment may occur in the research and development of new products and services, as well as in the establishment of new collaborative and co-creation relationships with developers, other companies, and other institutions. To deliver value that helps clients differentiate themselves for competitive advantage, IBM has been moving away from commoditized categories of the IT industry and into areas in which it can differentiate itself through innovation and by leveraging its investments in R&D. Examples include IBM’s leadership position in the design and fabrication of ASICs; the design of smaller, faster and energy-efficient semiconductor devices; the design of “grid” computing networks that allow computers to share processing power; the transformation and integration of business processes; and the company’s efforts to advance open technology standards and to engage with governments, academia, think tanks and nongovernmental organizations on emerging trends in technology, society and culture. In the highly competitive IT industry, with large diversified competitors, as well as smaller and nimble single-technology competitors, IBM’s ability to continue its cutting-edge innovation is critical to maintaining and increasing market share. IBM is managing this risk by more closely linking its R&D organizations to industry-specific and client-specific needs, as discussed in “Description of Business–IBM Worldwide Organizations” on pages 19 to 21.

OPEN STANDARDS

The broad adoption of open standards is essential to the computing model for an on demand business and is a significant driver of collaborative innovation across all industries. Without interoperability among all manner of computing platforms, the integration of any client’s internal systems, applications and processes remains a monumental and expensive task. The broad-based acceptance of open standards–rather than closed, proprietary architectures–also allows the computing infrastructure to more easily absorb (and thus benefit from) new technical innovations. IBM is committed to fostering open standards because they are vital to the On Demand Operating Environment, and because their acceptance will expand growth opportunities across the entire business services and IT industry. There are a number of competitors in the IT industry with significant resources and investments who are committed to closed and proprietary platforms as a way to lock clients into a particular architecture. This competition will result in increased pricing pressure and/or IP claims and proceedings. IBM’s support of open standards is evidenced by the enabling of its products to support open standards such as Linux, and the development of Rational software development tools, which can be used to develop and upgrade other companies' software products.

INVESTING IN GROWTH OPPORTUNITIES

The company is continuing to refocus its business on the higher value segments of enterprise computing–providing technology and transformation services to clients’ businesses. Consistent with that focus, the company continues to significantly invest in growth opportunities as a way to drive revenue growth and market share gains. Areas of investment include strategic acquisitions, primarily in software and services, focused client- and industry-specific solutions, BPTS, key technologies and emerging growth countries such as China, Russia, India and Brazil.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Year in Review

Results of Continuing Operations

REVENUE

(Dollars in millions)

									YR. TO YR.
									PERCENT
							YR. TO YR.		CHANGE
							PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005			2004			CHANGE		CURRENCY

Statement of Earnings Revenue Presentation:
Global Services	$		47,357	$	46,213		2.5	%	2.1	%
Hardware	24,314			31,154			(22.0	)	(22.2	)
Software	15,753			15,094			4.4		3.7
Global Financing	2,407			2,608			(7.7	)	(8.4	)
Enterprise Investments/Other	1,303			1,224			6.5		7.0
Total	$	91,134		$		96,293	(5.4	)%	(5.8	)%

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005		2004*		CHANGE		CURRENCY

Industry Sector:
Financial Services	$	24,059	$	24,479	(1.7	)%	(1.8	)%
Public	14,020		14,769		(5.1	)	(5.5	)
Industrial	11,666		12,610		(7.5	)	(7.7	)
Distribution	8,844		8,831		0.1		(0.2	)
Communications	8,589		8,888		(3.4	)	(3.8	)
Small & Medium	17,969		20,793		(13.6	)	(13.7	)
OEM	3,271		2,885		13.4		13.4
Other	2,716		3,038		(10.6	)	(16.8	)
Total	$	91,134	$	96,293	(5.4	)%	(5.8	)%

* Reclassified to conform with 2005 presentation.

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005		2004		CHANGE		CURRENCY

Geographies:
Americas	$	38,817	$	40,064	(3.1	)%	(4.4	)%
Europe/Middle East/Africa	30,428		32,068		(5.1	)	(4.1	)
Asia Pacific	18,618		21,276		(12.5	)	(12.7	)
OEM	3,271		2,885		13.4		13.4
Total	$	91,134	$	96,293	(5.4	)%	(5.8	)%

On April 30, 2005, the company sold its Personal Computing business. Accordingly, the company’s reported revenue results include four months of revenue for the company’s Personal Computing business in 2005 versus 12 months in 2004. The company has presented a discussion on changes in reported revenues along with a discussion of revenue results excluding the divested Personal Computing business. A significant driver of the changes in revenues, on an as-reported basis, is the incomparable periods for which the Personal Computing business results are included in the as-reported results. The company believes that a more appropriate discussion is one that excludes the revenue results of the Personal Computing business in both 2005 and 2004 because it presents results on a comparable basis and provides a more meaningful discussion which focuses on the company’s ongoing operational performance. Such discussion is presented on pages 24 and 25.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

As-reported revenues across all industry sectors declined, except for the Distribution sector, which was essentially flat, due to the sale of the company’s Personal Computing business. The Financial Services revenue decrease was driven by Financial Markets (12.2 percent) partially offset by increases in Insurance (1.9 percent) and Banking (0.5 percent). The Public sector revenue decline was driven by Education (31.0 percent), Life Sciences (19.1 percent) and Government (2.0 percent), partially offset by increased revenue in Healthcare (13.1 percent). The Distribution sector revenue increase was driven by Travel and Transportation (11.0 percent) and Consumer Products (2.6 percent), partially offset by lower revenue in Retail Industry (7.5 percent). The decrease in Communications sector revenue was driven by Media and Entertainment (11.5 percent), Utilities (5.4 percent) and Telecommunications (1.1 percent).

America’s revenue decline was driven by the sale of the company’s Personal Computing business. The U.S. declined 5 percent, while Canada increased 5 percent (declined 3 percent adjusted for currency) and Latin America increased 8 percent (declined 2 percent adjusted for currency).

Revenue in Europe declined across most major countries driven by the sale of the company’s Personal Computing business. Of the major countries, Germany declined 12 percent (11 percent adjusted for currency), France declined 7 percent (6 percent adjusted for currency), Italy declined 11 percent (10 percent adjusted for currency), the U.K. declined 1 percent (flat adjusted for currency) and Spain declined 1 percent (flat adjusted for currency).

Japan, which represents about 60 percent of the Asia Pacific revenue base, declined 13 percent (11 percent adjusted for currency) in 2005 versus 2004. In addition, ASEAN revenue declined 3 percent (3 percent adjusted for currency) and China declined 19 percent (20 percent adjusted for currency), while India revenue increased 10 percent (8 percent adjusted for currency).

The company continued to invest in growth initiatives in its emerging countries. Revenue growth in these emerging countries is driven by client investment to build out their infrastructures, especially in the Financial Services sector. Overall revenue in these countries declined 2 percent (9 percent adjusted for currency). The declines were driven by the sale of the company’s Personal Computing business. China declined 19 percent (20 adjusted for currency), while Brazil’s revenue grew 21 percent (1 percent adjusted for currency), India’s revenue grew 10 percent (8 percent adjusted for currency) and Russia’s revenue increased 2 percent (2 percent adjusted for currency).

OEM revenue increased in 2005 versus 2004 primarily due to improved manufacturing yields for game processors driven by the ramp up of production for these processors in the second half of 2005. In addition, E&TS revenue continued to show strong revenue growth.

REVENUE EXCLUDING DIVESTED PERSONAL COMPUTING BUSINESS REVENUE

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005		2004		CHANGE		CURRENCY

Statement of Earnings Revenue Presentation:
Global Services	$	47,357	$	46,213	2.5	%	2.1	%
Hardware	21,439		20,417		5.0		4.9
Software	15,753		15,094		4.4		3.7
Global Financing	2,407		2,608		(7.7	)	(8.4	)
Enterprise Investments/Other	1,303		1,224		6.5		7.0
Total	$	88,259	$	85,556	3.2	%	2.8	%

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005		2004		CHANGE		CURRENCY

Industry Sector:
Financial Services	$	23,789	$	23,393	1.7	%	1.7	%
Public	13,556		12,858		5.4		5.0
Industrial	11,437		11,702		(2.3	)	(2.4	)
Distribution	8,722		8,309		5.0		4.7
Communications	8,458		8,391		0.8		0.5
Small & Medium	16,387		15,393		6.5		6.4
OEM	3,271		2,885		13.4		13.4
Other	2,639		2,625		0.5		(6.6	)
Total	$	88,259	$	85,556	3.2	%	2.8	%

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2005		2004		CHANGE		CURRENCY

Geographies:
Americas	$	37,725	$	35,904	5.1	%	3.7	%
Europe/Middle East/Africa	29,549		28,889		2.3		3.6
Asia Pacific	17,714		17,878		(0.9	)	(1.1	)
OEM	3,271		2,885		13.4		13.4
Total	$	88,259	$	85,556	3.2	%	2.8	%

Revenue from Small & Medium Business increased 6.5 percent in 2005 versus 2004. The Small & Medium Business increase was led by the Americas, where clients continued to focus on cost, efficiency and business value in their IT decisions. Clients value the IBM solutions, including the Express offerings that the company takes to market through its strong network of business partners and ISVs. The Financial Services revenue increase was driven by Banking (3.8 percent) and Insurance (7.3 percent) as these clients continue to focus on back office efficiencies. These increases were partially offset by lower revenue from Financial Markets (10.5 percent). The Public sector revenue increase was primarily driven by Healthcare (19.7 percent) as the company launched new solutions to improve healthcare productivity, quality and lower costs, increasing growth at both new and existing accounts and Government (4.5 percent). The Distribution sector revenue increase was driven by Travel and Transportation (16.2 percent) and Consumer Products (11.4 percent), partially offset by a decline in Retail (4.5 percent). Communications sector revenue increased slightly driven by Telecommunications (2.6 percent), partially offset by declines in Media & Entertainment (6.5 percent) and Utilities (0.5 percent).

America’s performance, adjusted for currency, was driven by revenue growth across all key brands and regions. The U.S. grew 3 percent, Canada grew 7 percent and Latin America grew 11 percent in 2005 versus 2004. Overall demand remains positive, as clients invest to improve the competitiveness of their infrastructure and provide differentiated advantage in the marketplace.

Revenue performance in Europe was mixed. Of the major countries, without the benefit of currency, the U.K., France and Spain increased 7 percent, 2 percent and 5 percent, respectively, while Germany and Italy declined 6 percent and 7 percent, respectively, in an environment that continues to be challenging. The company successfully executed its restructuring actions, and its new operating model, with a more streamlined management system, is now in place. These changes will allow the company to compete more effectively in these markets.

Asia Pacific had the weakest results of the major geographies in 2005. Japan, which represents about 60 percent of the Asia Pacific revenue base, declined 5 percent adjusted for currency in 2005 versus 2004. The company continues to drive actions to improve execution, and expects improved revenue performance in 2006. Mitigating the declines in Japan, China revenue grew 8 percent and ASEAN revenue grew 20 percent with strong results, led by India (55 percent).

The company continued to invest in growth initiatives in its emerging countries. Revenue growth in these emerging countries is driven by client investment to build out their infrastructures, especially in the Financial Services sector. Overall revenue in these countries grew 23 percent (14 percent adjusted for currency) in 2005 versus 2004 without the Personal Computing business. Russia grew 29 percent (29 percent adjusted for currency); India was up 59 percent (55 percent adjusted for currency); Brazil increased 29 percent (7 percent adjusted for currency) and China was up 9 percent (8 percent adjusted for currency). The company expects to continue to shift investment to these areas to address these important markets.

The increase in Global Services revenue was primarily driven by BCS and SO, however all Global Services categories had revenue growth versus 2004. Global Services signings were $47.1 billion in 2005, an increase of 9.5 percent versus 2004. The company continued to have strong revenue growth in its businesses that address the BPTS opportunity, up 28 percent versus 2004.

Overall, Hardware revenue declined as reported in 2005 compared to 2004 due to the divestiture of the Personal Computing business. Systems and Technology Group revenue increased as pSeries servers, xSeries servers, iSeries servers, Storage Systems, Microelectronics and E&TS had revenue growth versus 2004. pSeries revenue increased as clients continued to recognize the strength and leadership of the POWER5+ architecture. xSeries servers revenue was driven by the company’s strong momentum in Blades. iSeries revenue grew slightly and was affected in the fourth quarter as demand fell off as clients anticipated the first quarter 2006 announcement of the new POWER5+ based product. Storage Systems revenue growth was driven by Total Disk products, as enterprise and mid-range disk products both had strong revenue growth. Tape products revenue also increased in 2005 versus 2004. Microelectronics revenue increased due to improved manufacturing yields and volumes for game processors. E&TS revenue continued to be strong in 2005 versus 2004. These increases were partially offset by declines in zSeries server revenue, Retail Stores Solutions and Printer Systems. Although zSeries server

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

revenue declined, MIPS (millions of instructions per second) volumes increased 7 percent in 2005 versus 2004.

Personal Computing Division revenue decreased as a result of the company divesting its Personal Computing business to Lenovo. The 2005 results have four months of revenue versus 12 months of revenue in 2004. See note C, “Acquisitions/Divestitures,” on pages 66 to 67 for additional information.

Software revenue increased in 2005 versus 2004 driven by growth in the company’s key branded Middleware offerings, partially offset by lower Operating Systems revenue. The Middleware revenue growth was driven by Tivoli software offerings, the WebSphere family of products and Lotus software offerings.

Global Financing revenue declined due to a continued decline in the income-generating asset base and yields. See pages 43 through 47 for additional information regarding Global Financing.

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

FOR THE YEAR ENDED DECEMBER 31:	2005		2004
Global Services	52.0	%	48.0	%
Hardware	26.7		32.3
Software	17.3		15.7
Global Financing	2.6		2.7
Enterprise Investments/Other	1.4		1.3
Total	100.0	%	100.0	%

GROSS PROFIT

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Gross Profit Margin:
Global Services	25.9	%	24.2	%	1.7	pts.
Hardware	35.1		29.5		5.6
Software	87.5		87.2		0.3
Global Financing	54.7		59.9		(5.2	)
Enterprise Investments/Other	46.5		40.2		6.3
Total	40.1	%	36.9	%	3.2	pts.

The increase in Global Services gross profit margin was primarily due to benefits from the restructuring actions taken in the second quarter of 2005, improved utilization/productivity and a better overall contract profile. The increase in Hardware margin was primarily due to the divestiture of the Personal Computing business (which had a lower gross profit margin than the other hardware businesses) in the second quarter of 2005. This sale contributed 3.8 points to the increase in the 2005 margin. Microelectronics' margins increased due to improving yields.

The decrease in Global Financing gross profit margin was driven by declining financing margins primarily due to the changing interest rate environment and a mix towards lower margin remarketing sales.

The cost savings generated by the company’s continuing focus on supply-chain initiatives also contributed to the overall margin improvement and permitted the company to improve price competitiveness in key markets. In addition, an increase in retirement-related plan costs of approximately $648 million partially offset by a decrease in stock-based compensation costs of approximately $133 million compared to 2004 also impacted overall segment margins. See “Segment Details” discussion on pages 27 to 30 for further details on gross profit.

EXPENSE

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			YR. TO YR. CHANGE
Total expense and other income	$	24,306		$	24,900		(2.4	)%
Expense to Revenue (E/R)	26.7		%	25.9		%	0.8	pts.

Total expense and other income decreased 2.4 percent (2.9 percent adjusted for currency) in 2005 versus 2004. Overall, the decrease was primarily due to the gain associated with the divestiture of the Personal Computing business ($1,108 million), a gain from a legal settlement with Microsoft ($775 million) partially offset by incremental restructuring charges ($1,706 million) recorded in the second quarter of 2005. The expense-to-revenue ratio increased 0.8 points to 26.7 percent in 2005, as revenue declined 5.4 percent and expense declined 2.4 percent in 2005 versus 2004. For additional information regarding the decrease in Total expense and other income, see the following analyses by category:

SELLING, GENERAL AND ADMINISTRATIVE (SG&A)

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004*		YR. TO YR. CHANGE
Selling, general and administrative expense:
Selling, general and administrative–base	$	16,845		$	16,690	0.9	%
Advertising and promotional expense	1,284			1,335		(3.8	)
Workforce reductions–ongoing	289			397		(27.2	)
Restructuring	1,475			—		NM
Retirement-related expense	846			610		38.7
Stock-based compensation	606			914		(33.7	)
Bad debt expense	(31		)	133		(123.3	)
Total	$	21,314		$	20,079	6.1	%

* Reclassified to conform with 2005 presentation.

NM–Not Meaningful

Total SG&A expense increased 6.1 percent (5.7 percent adjusted for currency). The increase was primarily driven by the restructuring charges recorded in the second quarter of 2005. See note R, “2005 Actions” on pages 80 and 81 for additional information. In addition, retirement-related expenses increased in 2005. See the “Retirement-Related Benefits” caption on page 27 for additional information. These increases were partially offset by lower operational expenses as a result of the restructuring

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

actions and the Personal Computing business divestiture, lower stock-based compensation expense (see “Stock-Based Compensation” caption below for additional information) and lower ongoing workforce reductions. In addition, Bad debt expense declined primarily due to decreased specific reserve requirements, an overall reduction in the financing asset portfolio (see Global Financing Receivables and Allowances on page 45 for additional information), the improvement in economic conditions and improved credit quality.

OTHER (INCOME) AND EXPENSE

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004*			YR. TO YR. CHANGE
Other (income) and expense:
Foreign currency transaction losses	$	170		$	381		(55.4	)%
Interest income	(307		)	(180		)	70.6
Net realized gains on sales of securities and other investments	(111		)	(59		)	88.1
Net realized (gains)/losses from certain real estate activities	(179		)	(71		)	152.1
Restructuring	231			—			NM
Lenovo/Microsoft gains	(1,883		)	—			NM
Other	(43		)	(94		)	(54.3	)
Total	$	(2,122	)	$	(23	)	NM

* Reclassified to conform with 2005 presentation.

NM–Not Meaningful

Other (income) and expense was income of $2,122 million and $23 million in 2005 and 2004, respectively. The increase was primarily driven by the gain on the sale of the company’s Personal Computing business. The pre-tax gain associated with this transaction was $1,108 million. See note C, “Acquisitions/Divestitures” on pages 66 to 67 for additional information. In addition, the company settled certain antitrust issues with the Microsoft Corporation and the gain from this settlement was $775 million; additional Interest income generated by the company in 2005; and lower foreign currency transaction losses which relate to losses on certain hedge contracts offset by settlement of foreign currency receivables and payables. See “Currency Rate Fluctuations,” on page 42 for additional discussion of currency impacts on the company’s financial results. The company also had additional gains from the sale of certain real estate transactions in 2005 versus 2004. These gains were partially offset by real-estate related restructuring charges recorded in the second quarter of 2005. See note R, “2005 Actions” on pages 80 and 81 for additional information.

RESEARCH, DEVELOPMENT AND ENGINEERING

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Research, development and engineering:
Total	$	5,842	$	5,874	(0.6	)%

The decline in Research, development and engineering (RD&E) was driven by the sale of the company’s Personal Computing business in the second quarter of 2005 ($93 million) and lower spending in Microelectronics ($93 million) and Software ($25 million). These decreases were partially offset by increased spending in Systems and Technology for server products ($171 million). Included in RD&E expense was increased retirement-related expense of $95 million and a decrease of $94 million for stock-based compensation expense in 2005 versus 2004.

INTELLECTUAL PROPERTY AND CUSTOM DEVELOPMENT INCOME

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Intellectual property and custom development income:
Sales and other transfers of intellectual property	$	236	$	466	(49.4	)%
Licensing/royalty-based fees	367		393		(6.6	)
Custom development income	345		310		11.3
Total	$	948	$	1,169	(19.0	)%

The decrease in Sales and other transfers of intellectual property was primarily due to Applied Micro Circuits Corporation’s (AMCC) acquisition of the company’s IP associated with its embedded PowerPC 4xx standard products for $208 million in 2004.The timing and amount of Sales and other transfers of IP may vary significantly from period to period depending upon timing of divestitures, industry consolidation, economic conditions and the timing of new patents and know-how development.

INTEREST EXPENSE

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Interest expense:
Total	$	220	$	139	58.6	%

The increase in Interest expense was primarily driven by higher average non-Global Financing debt and higher effective interest rates in 2005 versus 2004. Interest expense is presented in Cost of Global Financing in the Consolidated Statement of Earnings only if the related external borrowings are to support the Global Financing external business. See pages 46 and 47 for additional information regarding Global Financing debt and interest expense.

STOCK-BASED COMPENSATION

Total pre-tax stock-based compensation expense of $1,035 million decreased $543 million compared to 2004. This decrease was principally the result of changes in the company’s equity programs, primarily driven by: (1) a reduction in the level and fair value of stock option grants ($306 million) and (2) changes to the terms of the company’s employee stock purchase plan, which rendered it non-compensatory in the second quarter of 2005 in accordance with the provisions of SFAS 123(R) ($186 million). The year-to-year reductions in pre-tax compensation expense were reflected in the following categories: Cost ($133 million); Selling,

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

general and administrative expense ($308 million); Research, development and engineering expense ($94 million); and, Other (income) and expense ($8 million). See note U, “Stock-Based Compensation,” on pages 83 to 85 for additional information.

RETIREMENT-RELATED BENEFITS

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

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Retirement-related plans cost:
Defined benefit and contribution pension plans cost	$	2,058	$	1,072	92.0	%
Nonpension postretirement plans costs	379		372		1.9
Total	$	2,437	$	1,444	68.8	%

Overall, retirement-related plan costs increased $993 million versus 2004. The 2005 increase was driven by the amortization of deferred charges, as well as changes in the discount rates, a key assumption underlying the valuation of the plans. During 2005, the company recognized approximately $1,100 million of previously deferred actuarial losses (as a result of the amortization of assumption changes) which contributed approximately $700 million of the increase in retirement-related expense in 2005. In addition, on December 31, 2004, the company lowered the discount rate assumption in a number of countries which increased pre-tax expense by approximately $300 million in 2005. Additionally, during 2005, the company recorded a curtailment charge of $267 million in the fourth quarter as a result of U.S. pension plan amendments, as well as a $65 million charge in the second quarter related to the restructuring actions. Offsetting the year-to-year effects of these one-time charges recorded in 2005 was a one-time charge of $320 million recorded in 2004 for the partial settlement of certain legal claims against the U.S. pension plan.

The $993 million year-to-year increase impacted Cost, SG&A RD&E and Other (income) and expense by approximately $648 million, $236 million, $95 million and $14 million, respectively. See V, “Retirement-Related Benefits,” on pages 85 to 95 for a detailed discussion of the company’s benefit plans including a description the plans, accounting policies, plan financial information and assumptions.

INCOME TAXES

The provision for income taxes resulted in an effective tax rate of 34.6 percent for 2005, compared with the 2004 effective tax rate of 29.7 percent. The 4.9 point increase in the effective tax rate in 2005 was primarily due to the third-quarter 2005 tax charge associated with the repatriation of $9.5 billion under the American Jobs Creation Act of 2004. See note P, “Taxes,” on page 80 for additional information concerning this repatriation tax charge.

WEIGHTED-AVERAGE COMMON SHARES

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			YR. TO YR. CHANGE
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$	4.91		$	4.39		11.8	%
Discontinued operations	(0.01		)	(0.01		)	45.0
Cumulative effect of of change in accounting principle**	(0.02		)	—			NM
Total	$	4.87	*	$	4.38		11.2	%

Basic:
Continuing operations	$	4.99		$	4.48		11.4	%
Discontinued operations	(0.02		)	(0.01		)	44.6
Cumulative effect of change in accounting principle**	(0.02		)	—			NM
Total	$	4.96	*	$	4.47		11.0	%

Weighted-average shares outstanding (in millions):
Assuming dilution	1,627.6			1,707.2			(4.7	)%
Basic	1,600.6			1,675.0			(4.4	)

* Does not total due to rounding.

** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information.

NM–Not Meaningful

The average number of common shares outstanding assuming dilution was lower by 79.6 million shares in 2005 versus 2004.

The decrease was primarily the result of the company’s common share repurchase program. See note N, “Stockholders’ Equity Activity,” on pages 75 and 76 for additional information regarding the common share activities. Also see note S, “Earnings Per Share of Common Stock,” on page 82.

Segment Details

The following is an analysis of the 2005 versus 2004 external segment results. The analysis of 2004 versus 2003 external segment results is on pages 34 to 36.

GLOBAL SERVICES

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Global Services Revenue:	$	47,357	$	46,213	2.5	%
Strategic Outsourcing	$	19,766	$	19,309	2.4	%
Business Consulting Services	14,185		13,767		3.0
Integrated Technology Services	7,538		7,441		1.3
Maintenance	5,868		5,696		3.0

Global Services revenue increased 2.5 percent (2.1 percent adjusted for currency) in 2005 versus 2004. Although SO revenue continued to grow, it experienced a slowdown in its revenue

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

growth rate due to the impact of high levels of backlog erosion experienced in 2004 and the cumulative effect of lower signings, starting in 2004 through the first quarter of 2005. SO revenue growth was driven by the Americas (2 percent) and EMEA (6 percent), with a decline year to year in Asia Pacific (2 percent).

BCS revenue increased in 2005 versus 2004 led by growth in the Americas (7 percent) and EMEA (5 percent), partially offset by declines in Asia Pacific (6 percent). BCS signings were up 19 percent over last year, with Consulting and Systems Integration up 3 percent and Business Transformation Outsourcing up 126 percent. The company’s Consulting and Systems Integration business had many areas of growth, with strong performance in the Strategy and Change and Supply Chain Management practices. This overall growth was mitigated by weakness year to year in Japan, Germany, and the company’s Federal Business in the U.S. However, across all practices, the company drove improved resource utilization and pricing trends remained stable to improving. The company is taking actions to improve its growth in Consulting and Systems Integration. The company is increasing the level of dedicated sales resources to drive its Business and Web Services and System Oriented Architecture (SOA) solutions, further investing in resources to address mid-market opportunities, increasing the level of brand resources in Asia Pacific and leveraging its global end-to-end design, build, and run capabilities.

The company’s BTO business continued its strong year-to-year growth. BTO is an important offering to address the BPTS opportunity. Other elements include the Strategy and Change practice, E&TS, and Business Performance Software. For the year, BPTS revenue was $4 billion dollars, up 28 percent year to year.

ITS signings were down 7 percent in 2005 versus 2004. The ITS business is more dependent upon short-term signings for revenue growth and signings declines in the third and fourth quarter impacted the overall revenue growth rate for 2005. The company began to rebalance its ITS offerings portfolio and shift its business development and delivery capabilities and skills to higher growth areas in the third quarter of 2005. The initial portfolio rebalancing work is completed. The company is adding business development skills and the sales coverage model has been aligned to the revised portfolio.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			YR. TO YR. CHANGE
Global Services:
Gross profit	$	12,287		$	11,175		9.9	%
Gross profit margin	25.9		%	24.2		%	1.7	pts.

Global Services gross profit dollars increased primarily due to the corresponding increase in revenue and improved gross profit margins across all categories of Global Services. The gross profit margin improvement was primarily due to benefits from the second quarter 2005 restructuring and productivity initiatives (see note R, “2005 Actions,” on pages 80 and 81 for additional information), improved utilization levels, primarily within BCS, and a better overall contract profile versus the prior year. In addition, since Global Services is primarily a resource-based business, the resulting Global Services margins were impacted more by pension expense increases, partially mitigated by lower stock-based compensation expense.

GLOBAL SERVICES SIGNINGS

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		2003
Longer-term*	$	27,180	$	22,857	$	34,608
Shorter-term*	19,901		20,146		20,854
Total	$	47,081	$	43,003	$	55,462

* Longer-term signings include SO and BTO contracts, as well as the U.S. federal government contracts within BCS. Shorter-term signings include ITS and all other BCS contracts. These amounts have been adjusted to exclude the impact of year to year currency changes.

In 2005, total Global Services signings increased 9 percent year to year, driven by a 19 percent increase in longer-term signings, while shorter-term signings were essentially flat.

Global Services signings are management’s initial estimate of the value of a client’s commitment under a Global Services contract. Signings are used by management to assess period performance of Global Services management. 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. For example, for longer-term contracts that require significant up-front investment by the company, the portions of these contracts that are counted as a signing are those periods in which there is a significant economic impact on the client if the commitment is not achieved, usually through a termination charge or the client incurring significant wind-down costs as a result of the termination. For shorter-term contracts that do not require significant up-front investments, a signing is usually equal to the full contract value.

Signings includes SO, BCS and ITS contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. Maintenance is not included in signings as maintenance contracts tend to be more steady-state, where revenues equal renewals, and therefore, the company does not think they are as useful a predictor of future performance.

Backlog includes SO, BCS, ITS, and Maintenance. Backlog is intended to be a statement of overall work under contract and therefore does include Maintenance. 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 currency assumptions used to approximate constant currency.

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 coincident to an acquisition.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

HARDWARE

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004		YR. TO YR. CHANGE
Hardware Revenue:	$	23,857	$	30,710	(22.3	)%
Systems and Technology
Group	$	20,981	$	19,973	5.0	%
zSeries					(7.6	)
iSeries					0.8
pSeries					14.6
xSeries					5.9
Storage Systems					15.3
Microelectronics					15.6
Engineering & Technology Services					39.2
Retail Store Solutions					(23.0	)
Printer Systems					(8.6	)
Personal Computing Division	2,876		10,737		NM

NM–Not Meaningful

Systems and Technology Group revenue increased 5.0 percent (5 percent adjusted for currency) in 2005 versus 2004. pSeries server revenue increased with double digit growth in all geographies as clients continue to recognize the strength and leadership of the POWER architecture. In early October, the company announced a new POWER5+ processor that includes the industry’s first Quad Core Module, which puts four processor cores on a single piece of ceramic. Additional new pSeries products will be delivered in 2006. The company expects to gain share in the UNIX market when the 2005 external results are reported. iSeries server revenue increased driven by broad demand for the company’s POWER5 based offerings. Demand in the fourth quarter of 2005 fell off as clients anticipated the first quarter 2006 announcement of the new POWER5+ based products. In 2005, iSeries added over 2,500 new clients, reflecting a continued commitment to the platform from ISVs, resellers and clients. Within xSeries, server revenue increased 7 percent despite strong competitive pressures driving lower prices, particularly in Europe and Asia. The company’s momentum in Blades remains strong with revenue growth of 65 percent in 2005 versus 2004. The company expects to maintain its market leadership position in Bladecenter. Although zSeries server revenue declined versus 2004, MIPS volumes grew 7 percent in 2005. The MIPS growth was driven by the company’s new System z9 which began shipping in late September 2005. The zSeries clients continue to add new workloads to this platform as they build their on demand infrastructure. These new workloads have accelerated Java and Linux adoption on the zSeries platform.

Total Storage revenue growth was driven by total Disk revenue growth of 19 percent, while tape grew 9 percent in 2005 versus 2004. Within External disk, mid-range disk and enterprise products both had strong revenue growth of approximately 24 percent in 2005 versus 2004. The company believes it gained market share in external disk and extended its market leadership in tape.

Microelectronics revenue increased due to improved manufacturing yields and volumes for game processors. The fourth quarter of 2005 was the first full quarter of production for these processors. Partially offsetting this increase was a softening of demand for some of the company’s older technology. E&TS revenue continued to show strong growth as it represents a unique opportunity for the company to leverage its deep capabilities, expertise and assets in engineering design to benefit client engineering and R&D processes. E&TS is a key component of the company’s businesses that address the BPTS opportunity.

Retail Stores Solutions revenue decreased primarily due to a number of large transactions in 2004 and demand from these clients declined in 2005. Printer Systems revenue decreased due primarily to lower hardware and maintenance sales.

Personal Computing Division revenue decreased as a result of the company divesting its Personal Computing business to Lenovo on April 30, 2005. The 2005 results have four months of revenue versus 12 months in 2004. See note C, “Acquisitions/ Divestitures,” on pages 66 and 67 for additional information.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			YR. TO YR. CHANGE
Hardware:
Gross profit	$	8,718		$	9,505		(8.3	)%
Gross profit margin	36.5		%	31.0		%	5.5	pts.

The decrease in gross profit dollars for 2005 versus 2004 was primarily due to the sale of the company’s Personal Computing business. The increase in gross profit margin was also primarily due to the divestiture of the Personal Computing business (which had a lower gross profit margin than the other hardware products) in the second quarter of 2005. This divestiture contributed 3.8 points of the improvement in the Hardware margin.

Systems and Technology Group gross profit margins declined 1.2 points to 40.4 percent in 2005 versus 2004. Microelectronics margins improved and contributed 0.6 points of improvement as manufacturing yields and volumes increased on game processors. In addition, margin improvements in pSeries contributed 0.5 points to the overall margin. These improvements were more than offset by lower margins in Storage Systems which impacted the overall margin by 1.1 points primarily due to intensified competition resulting in product discounting and the mix to mid-range disk and tape products. In addition, zSeries servers, xSeries and iSeries servers had lower margins which impacted the overall margin by 0.8 points, 0.2 points and 0.2 points, respectively.

Differences between the Hardware segment gross profit margin and gross profit dollar amounts above and the amounts reported on page 25 (and derived from page 48) primarily relate to the impact of certain hedging transactions (see “Anticipated Royalties and Cost Transactions” on page 72). The recorded amounts for these transactions are considered unallocated corporate amounts for purposes of measuring the segment’s gross margin performance and therefore are not included in the segment results above.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

SOFTWARE

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005		2004*		YR. TO YR. CHANGE
Software Revenue:	$	15,753	$	15,094	4.4	%
Middleware	$	12,552	$	11,968	4.9	%
WebSphere family					10.2
Information Management					8.2
Lotus					9.7
Tivoli					11.5
Rational					3.6
Other middleware					(1.4	)
Operating systems	2,426		2,474		(2.0	)
Other	775		652		18.8

* Reclassified to conform with 2005 presentation.

Software revenue increased 4.4 percent (3.7 percent adjusted for currency) in 2005 versus 2004 as the software market remains highly competitive. The company believes it gained market share in all five key middleware brands in 2005 and held market share in Total Middleware.

The WebSphere family of products revenue increased with growth in WebSphere Application Servers (15 percent) and WebSphere Portals (12 percent) software versus 2004. The WebSphere family provides the foundation technologies for clients implementing business processes and applications in a Services Oriented Architecture (SOA). As clients’ interest in SOA has increased, so has the demand for highly scalable, robust infrastructure platforms, such as WebSphere.

Information Management software revenue increased driven by growth in content management and information integration product sets.

Lotus software revenue increased as clients continue to demonstrate strong response to the Domino Version 7 product line, as well as very high interest in Workplace software. Workplace software more than doubled its revenue in 2005 versus 2004.

Tivoli software revenue increased with strong growth in storage software as clients’ adoption of the company’s virtualization technologies continued to gain traction. Tivoli systems management and security software offerings also had good revenue growth in 2005 versus 2004. The security products revenue was driven by the company’s new SOA Security offerings which were well received in the second half of 2005.

Rational software revenue increased in 2005 versus 2004, however, late in the fourth quarter of 2005, client buying deferrals prevented stronger performance.

Revenue from Other Middleware products, including host software products such as compilers, certain tools and Other Storage and Printer software declined versus 2004.

Operating Systems software revenue declined in 2005 versus 2004, primarily due to lower zSeries and pSeries revenue, partially offset by increased iSeries and xSeries revenue.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			YR. TO YR. CHANGE
Software:
Gross profit	$	13,781		$	13,161		4.7	%
Gross profit margin	87.5		%	87.2		%	0.3	pts.

The increase in the Software gross profit dollars and gross profit margin was primarily driven by growth in software revenue and reduced external royalty costs.

GLOBAL FINANCING

See page 44 for a discussion of Global Financing’s revenue and gross profit.

ENTERPRISE INVESTMENTS

Revenue from Enterprise Investments increased 1.9 percent to $1,203 million (1.6 percent adjusted for currency) in 2005 versus 2004. The revenue increase was attributable to higher product life-cycle management software revenue primarily for Industrial (5 percent) and Small & Medium Business clients (2 percent).

Gross profit dollars increased 8.0 percent to $563 million in 2005 versus 2004. The gross profit margin increased 2.6 points to 46.8 percent in 2005 versus 2004. The increase in gross profit dollars and gross profit margin in 2005 was primarily driven by the increased product life-cycle management software revenue.

Financial Position

DYNAMICS

The assets and debt associated with the company’s Global Financing business are a significant part of the company’s financial position. The financial position amounts appearing below and on pages 31 and 32 are the company’s consolidated amounts including Global Financing. However, to the extent the Global Financing business is a major driver of the consolidated financial position, this narrative section will refer to the separate Global Financing section in this Management Discussion on pages 43 through 47. The amounts appearing in the separate Global Financing section are supplementary data presented to facilitate an understanding of the company’s Global Financing business.

WORKING CAPITAL

(Dollars in millions)

AT DECEMBER 31:	2005		2004
Current assets	$	45,661	$	47,143
Current liabilities	35,152		39,786
Working capital	$	10,509	$	7,357
Current ratio	1.30		1.18

Current assets decreased $1,482 million due to declines of $3,708 million in short-term receivables primarily driven by declines of: $1,100 million in financing receivables as collections exceeded new originations, approximately $300 million in trade receivables due to the divestiture of the Personal Computing business, approximately $375 million in non-client receivables

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

primarily driven by the final payment received from Hitachi for the purchase of the HDD business, and $1,637 million due to the effects of currency; and a decrease of $475 million in inventories primarily driven by the Personal Computing divestiture and reductions in the Systems and Technology Group server brands. These declines were partially offset by the $3,116 million increase (approximately $3,905 million before negative currency impact of $789 million) in Cash and cash equivalents and Marketable securities (see the Cash Flow analysis below).

Current liabilities decreased $4,634 million primarily due to declines of: $2,095 million in Accounts payable of which approximately $1,100 million was due to the Personal Computing divestiture and $332 million due to the effects of currency; $1,303 million in other accruals driven primarily by a decline in derivative liabilities due to year-to-year changes in foreign currency rates; and $883 million in Short-term debt primarily due to the settlement of $2,300 million in commercial paper debt, partially offset by new debt issuances of approximately $1,500 million to facilitate foreign earnings repatriation actions.

CASH FLOW

The company’s cash flow from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 50, are summarized in the table below. These amounts include the cash flows associated with the company’s Global Financing business. See pages 43 through 47.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2005				2004
Net cash provided by/(used in) continuing operations:
Operating activities	$	14,914			$	15,349
Investing activities	(4,423			)	(5,346			)
Financing activities	(7,147			)	(7,562			)
Effect of exchange rate changes on cash and cash equivalents	(789			)	405
Net cash used in discontinued operations*	(40			)	(83			)
Net change in cash and cash equivalents	$		2,515		$		2,763

* Does not include $319 million in 2005 of net proceeds from the sale of the HDD business. $51 million is included in Operating activities from continuing operations and $268 million is included in Investing activities from continuing operations.

Net cash from operating activities for the year ended December 31, 2005 decreased $435 million as compared to 2004. The decrease was primarily driven by an increase in restructuring payments of $1,012 million and an increase in pension funding in the United States of approximately $1,015 million, partially offset by the $775 million legal settlement payment from Microsoft and $493 million due to improved management of inventory primarily in the Systems and Technology Group.

Net cash used in investing activities decreased $923 million on a year-to-year basis driven by: a $907 million improvement in divestiture-related cash due to the divestiture of the Personal Computing business and disposition of a portion of Lenovo shares (approximately $662 million) and the final net payment received from Hitachi for the purchase of the HDD business (approximately $268 million); a $218 million decline in net capital spending and $256 million in lower cash spending for acquisitions; however, the company did expend $1,482 million in net cash on acquisitions in 2005. These declines were partially offset by a $458 million increase in marketable securities and other investments.

The decrease in net cash used in financing activities of $415 million was primarily the result of an increase in net cash inflows related to debt of approximately $1,636 million, partially offset by higher net payments for common stock activity of $1,145 million and higher dividend payments of $76 million. Within total debt, on a net basis, in 2005, the company had $609 million in net cash proceeds from new debt versus $1,027 million used to retire debt in 2004. The net cash proceeds of $609 million in 2005 comprise $4,363 million of cash proceeds from new debt partially offset by $3,522 million of cash payments to settle debt and by $232 million in short-term repayments. The higher payments for common stock were driven by increases of approximately $594 million in cash payments to repurchase stock and decreases of approximately $551 million in cash received for stock issued under the company’s stock option plan and employee stock purchase plan.

NON-CURRENT ASSETS AND LIABILITIES

(Dollars in millions)

AT DECEMBER 31:	2005		2004
Non-current assets	$	60,087	$	63,860
Long-term debt	$	15,425	$	14,828
Non-current liabilities (excluding debt)	$	22,073	$	24,701

The decrease in Non-current assets of $3,773 million was primarily driven by declines of: $2,141 million in Investments and sundry assets; $1,419 million in Plant, rental machines, and other property-net which was driven by the effects of currency (approximately $562 million) and asset sales; and $1,322 million in Long-term financing receivables (see page 45). The decline in Investments and sundry assets was mainly due to a $2,839 million decrease ($252 million due to the effects of currency) in deferred tax assets driven by the utilization of income tax credit carryforwards and U.S. and non-US. pension activity, partially offset by increases of $314 million in deferred transition costs driven by growth in services arrangements with clients, $155 million in alliance investments primarily due to the company’s equity interest in Lenovo, and $112 million in non-current derivative assets due to the appreciation of the U.S. dollar against certain foreign currencies. These declines were partially offset by increases of $1,004 million in Goodwill driven by the company’s acquisitions and $231 million (approximately $1,220 million before negative currency impact of $989 million) in Prepaid pension assets due primarily to the $1,700 million funding of the IBM Personal Pension Plan (PPP) in the first quarter of 2005.

Long-term debt increased $597 million due to new debt issuances. The company continually monitors its liquidity profile and interest rates, and manages its short- and long-term debt portfolios accordingly.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Other non-current liabilities decreased $2,628 million due to decreases of $2,104 million in Retirement and nonpension postretirement obligations of which approximately $1,137 million was due to the effects of currency and the remaining $967 million was attributable to the favorable funded status of primarily non-U.S. pension plans as discussed on page 93; and $524 million in other accruals primarily due to the effects of currency.

DEBT

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

(Dollars in millions)

AT DECEMBER 31:	2005			2004
Total company debt	$	22,641		$	22,927
Non-Global Financing debt*	$	2,142		$	607
Non-Global Financing debt/capitalization	6.7		%	2.1		%

* Non-Global Financing debt is the company’s total external debt less the Global Financing debt described in the Global Financing balance sheet on page 44.

Non-Global Financing debt increased $1,535 million and the debt-to-capital ratio at December 31, 2005 was within acceptable levels at 6.7 percent. Non-Global Financing debt increased versus 2004 primarily to facilitate the company’s repatriation actions under the American Jobs Creation Act of 2004. The increase relates to short-term debt issuances.

EQUITY

(Dollars in millions)

AT DECEMBER 31:	2005		2004
Stockholders’ equity:
Total	$	33,098	$	31,688

The company’s total consolidated Stockholders’equity increased $1,410 million during 2005 primarily due to an increase in the company’s retained earnings driven by net income, partially offset by the company’s ongoing stock repurchase program and higher dividend payments.

OFF-BALANCE SHEET ARRANGEMENTS

In the ordinary course of business, the company entered into off-balance sheet arrangements as defined by the SEC Financial Reporting Release 67 (FRR-67), “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.”

None of these off-balance sheet arrangements either has, or is reasonably likely to have, a material current or future effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. See page 39 for the company’s contractual obligations and note O, “Contingencies and Commitments,” on page 78, for detailed information about the company’s guarantees, financial commitments and indemnification arrangements. The company does not have retained interests in assets transferred to unconsolidated entities (see note J, “Securitization of Receivables,” on page 70) or other material off-balance sheet interests or instruments.

Consolidated Fourth Quarter Results

(Dollars and shares in millions except per share amounts)

FOR FOURTH QUARTER:	2005				2004				YR. TO YR. CHANGE
Revenue	$	24,427			$	27,671			(11.7	)%*
Gross profit margin	44.1			%	38.8			%	5.3	pts.
Total expense and other income	$	6,197			$	6,690			(7.4	)%
Total expense and other income-to-revenue ratio	25.4			%	24.2			%	1.2	pts.
Income from continuing operations before income taxes	$	4,568			$	4,048			12.8	%
Provision for income taxes	$	1,348			$	1,206			11.6	%
Income from continuing operations	$	3,220			$	2,842			13.3	%
Income/(loss) from discontinued operations	$	3			$	(15		)	NM
Cumulative effect of change in accounting principle**	$	(36		)	$	—			NM
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$	2.01			$	1.68			19.6	%
Discontinued operations	—				(0.01			)	NM
Cumulative effect of of change in accounting principle**	(0.02			)	—				NM

Total	$		1.99		$		1.67		19.2	%

Weighted-average shares outstanding:
Assuming dilution	1,604.8				1,692.1				(5.2	)%

* (8.5) percent adjusted for currency.

** Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information.

NM–Not Meaningful

CONTINUING OPERATIONS

In the fourth quarter, the company increased Income from continuing operations by $378 million or 13.3 percent versus the fourth quarter of 2004. Diluted earnings per share from continuing operations of $2.01 increased 19.6 percent versus the prior year.

The company’s performance in the fourth quarter was driven by several factors:

• Strong results in the hardware business, driven by Storage products, Microelectronics and zSeries and pSeries servers.

• Increased demand for the company’s key branded middleware software products and improved profitability in that segment.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

• Improved margins in Global Services driven primarily by benefits from the company’s restructuring, productivity initiatives and a better overall contract profile.

Total revenue in the fourth quarter declined 11.7 percent as reported (8.5 percent decline adjusted for currency). The company’s revenue profile was significantly impacted by the divestiture of the Personal Computing business in the second quarter of 2005–excluding the Personal Computing business, the company’s fourth-quarter 2004 total revenue was $24,703 million. When compared to this revised amount, total revenue in the fourth-quarter 2005 decreased 1.1 percent (increased 2.5 percent adjusted for currency) driven by a decline in Global Services.

The following is an analysis of the external segment results.

Global Services revenue decreased 4.9 percent (0.9 percent adjusted for currency). The decline was driven primarily by weakness in short-term signings and a decrease in SO revenue. Short-term signings were down 4 percent and flat in the fourth quarter and third quarter of 2005, respectively, when compared with the same periods in 2004. Total SO signings declined 32 percent this quarter and revenue was down 5.3 percent. SO revenue continues to be impacted by the high levels of backlog erosion experienced in 2004 and the cumulative effect of lower signings starting in 2004 through the first quarter of 2005. ITS revenue, excluding Maintenance, was down 5.4 percent and signings also declined this quarter by 10 percent. BCS revenue decreased 6.1 percent driven by declines in Asia Pacific and Italy, while revenue in the Americas grew versus 2004. BCS signings increased by 23 percent, driven by the Americas and Europe, with significant growth (144 percent) in long-term Business Transformation Outsourcing signings. Profitability improved in Global Services as both gross margin (3.1 points) and segment pre-tax (2.4 points) margin increased versus the fourth quarter of 2004. Margin improvements were primarily driven by the company’s second-quarter restructuring actions, improved resource utilization and a better contract profile. Global Services signings for the quarter were $11.5 billion.

Systems & Technology Group revenue grew 6.3 percent (9.8 percent adjusted for currency). zSeries server revenue increased 5.5 percent, with strong MIPs growth of 28 percent year to year. zSeries growth continues to be driven by new workloads, such as Linux and Java. iSeries server revenue declined 18.2 percent as clients anticipated the early 2006 announcement of new POWER5+ products. pSeries server revenue grew 3.9 percent, driven by that brand’s POWER5+ product line refresh which began in the fourth quarter. xSeries servers grew volumes 13 percent, however, revenue was flat due to competitive pricing pressures. Blade Center product revenue grew 41.4 percent in the quarter. Storage products had a strong quarter with revenue growth of 23.6 percent, driven by total disk (32.2 percent) products. Microelectronics OEM revenue grew 48.1 percent year to year as 300-millimeter-based products, driven by game processors, grew over 250 percent versus the fourth quarter 2004.

Software revenue increased 0.3 percent (3.3 percent adjusted for currency). The WebSphere family of products grew 3.6 percent, while Information Management software increased 4.5 percent, driven by the company’s content management and information integration product sets. Lotus revenue grew 1.6 percent and Tivoli revenue increased 2.9 percent driven by a 17 percent growth in the brand’s storage software products. Rational software revenue declined 2.0 percent–performance was good in Asia Pacific and Europe, but some clients delayed buying decisions in the Americas. In addition to the revenue growth in the company’s key branded middleware, described above, the profitability of the software business improved as well, with the segment’s pre-tax margin growing by 5.7 points in the fourth quarter versus 2004.

Global Financing revenue declined 8.0 percent (5.6 percent adjusted for currency) driven primarily by lower client financing revenue due to a declining asset base, as well as lower external used equipment sales.

The company’s total gross profit margin increased 5.3 points in the fourth-quarter 2005 compared to the fourth-quarter 2004, which included the divested Personal Computing business. Excluding the Personal Computing business, the fourth-quarter 2004 gross profit margin was 41.9 percent, making the current quarter’s margin a 2.2 point improvement on a comparable basis.

Total expense and other income decreased 7.4 percent compared to the prior-year period. Selling, general and administrative expense decreased 3.4 percent year to year, driven primarily by the divestiture of the Personal Computing business and the company’s restructuring actions, offset by a $267 million curtailment charge related to the announced changes in the company’s U.S. defined benefit pension plans. RD&E expense decreased 3.6 percent, while Intellectual property and custom development income also decreased 23.7 percent year to year. Other income and expense was $334 million of income in the fourth quarter of 2005 versus $4 million of income in the same period last year. This improvement was driven by gains on certain real estate transactions (increase of $160 million) and the favorable impact of hedging programs (up approximately $150 million) versus the fourth quarter of 2004.

The company’s effective tax rate in the fourth-quarter 2005 was 29.5 percent compared with 29.8 percent in the fourth quarter of 2004. The nonrecurring pension curtailment charge reduced the fourth-quarter 2005 effective tax rate by 0.5 points.

In the fourth quarter, the company recorded a $36 million charge, net of tax, to reflect the cumulative effect of a change in accounting principle related to the adoption of FASB Interpretation No. 47. See note B, “Accounting Changes,” on pages 61 and 62 for additional information.

Share repurchases totaled approximately $1.0 billion in the fourth quarter. The weighted-average number of diluted common shares outstanding in the fourth-quarter 2005 was 1,604.8 million compared with 1,692.1 million in the same period of 2004.

The company generated an increase of $1,395 million in cash flow provided by operating activities. This increase reflects the effects of prior-year funding of the U.S. pension plan ($700 million) and improved inventory management ($327 million). Also, net cash used in financing activities decreased significantly–$2,417 million–primarily driven by a reduction in share repurchases in the quarter versus the fourth-quarter 2004.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

Prior Year in Review

(Dollars and shares in millions except per share amounts)

FOR THE YEAR ENDED DECEMBER 31:	2004			2003			YR. TO YR. CHANGE
Revenue	$	96,293		$	89,131		8.0	%*
Gross profit margin	36.9		%	36.5		%	0.4	pts.
Total expense and other income	$	24,900		$	23,130		7.7	%
Total expense and other income-to-revenue ratio	25.9		%	26.0		%	(0.1	)%
Income from continuing operations before income taxes	$	10,669		$	9,417		13.3	%
Provision for income taxes	$	3,172		$	2,829		12.1	%
Income from continuing operations	$	7,497		$	6,588		13.8	%
Loss from discontinued operations	$	18		$	30		(41.3	)%
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$	4.39		$	3.76		16.8	%
Discontinued operations	(0.01		)	(0.02		)	(39.8	)%
Total	$	4.38		$	3.74		17.1	%
Weighted-average shares outstanding:
Assuming dilution	1,707.2			1,752.8			(2.6	)%
Assets**	$	111,003		$	106,021		4.7	%
Liabilities**	$	79,315		$	76,490		3.7	%
Equity**	$	31,688		$	29,531		7.3	%

* 3.4 percent adjusted for currency.

** At December 31

Continuing Operations

In 2004, the company demonstrated that it could extend its leadership in a growth environment. The company delivered revenue growth of 8.0 percent and diluted earnings per share growth of 16.8 percent. The increase in the company’s Income from continuing operations and diluted earnings per share from continuing operations as compared to 2003 was primarily due to:

• Improving demand associated with the moderate expansion of the economy and continued market share gains for zSeries and xSeries server products

• Continued operational improvements in the Microelectronics business

• Continued demand growth in emerging countries

• Favorable impact of currency translation

The increase in revenue in 2004 as compared to 2003 was primarily due to:

• Improved demand in Global Services and key industry sectors

• Improving demand associated with the moderate expansion of the economy and continued market share gains for zSeries, xSeries and pSeries server products, as well as increased revenue for personal computers

• Continued demand growth in emerging countries (up over 25 percent) and in BPTS (up approximately 45 percent)

• Favorable impact of currency translation

Revenue from all industry sectors increased in 2004 when compared to 2003, reflecting the company’s broad capabilities and industry-specific solutions which combine technology and high-value services to solve a client’s business or IT problems. These solutions also provide for a longer-term relationship with the client, rather than a transaction-oriented sale. The Financial Services sector revenue growth of 9.3 percent was led by financial markets (15 percent), banking (9 percent) and insurance (8 percent). The Communications sector had revenue growth of 10.4 percent with growth in Telecommunications (15 percent), while the Distribution sector revenue growth was 7.5 percent, led by the retail industry (12 percent). The Small & Medium business sector revenue increased 8.3 percent as the company continued to roll out new products under the Express label that are designed and priced specifically for clients in the 100 to 1,000 employee segment.

Revenue across all geographies increased in 2004 when compared to 2003. In the Americas, U.S. (6 percent) and Canada (9 percent) revenue grew as did Latin America (12 percent), notably Brazil, which grew at 15 percent.

Within Europe/Middle East/Africa, Eastern Europe, the Nordic countries, Spain (7 percent) and France (3 percent) had revenue growth, while the U.K. (2 percent), Germany (3 percent) and Italy (8 percent) declined when adjusted for currency. Asia Pacific had strong growth in 2004, led by China, which grew at 25 percent, and the ASEAN region (17 percent), while Japan, which is about 60 percent of Asia Pacific’s revenue, also had growth of 5 percent. Collectively, as a result of the company’s targeted investments, the emerging countries of China, Russia (75 percent), India (45 percent) and Brazil had revenue growth over 25 percent in 2004 to over $4.0 billion in revenue.

OEM revenue increased in 2004 versus 2003 due primarily to continued strong growth in the company’s E&TS business and improved operational performance in the Microelectronics business.

The following is an analysis of external segment results.

GLOBAL SERVICES

Global Services revenue increased 8.4 percent (3.1 percent adjusted for currency). SO revenue grew 12.8 percent and continued to demonstrate its competitive advantage in delivering on demand solutions by leveraging both its business transformational skills and scale during 2004. Each geography continued year-to-year growth, with seven consecutive quarters of double-digit growth in Europe/Middle East/Africa, excluding currency benefits. Within SO, e-business Hosting Services, an offering that provides Web infrastructure and application management as an Internet-based service, continued its pattern of revenue growth. ITS revenue, which excludes Maintenance, increased 4.8 percent

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

driven by growth in Business Continuity and Recovery Services of 29 percent, partially offset by the reduction for sales of third-party hardware in Japan. BCS revenue increased 6.3 percent driven by strong growth in BTO. BCS continued to improve its revenue growth rate when adjusted for currency in every quarter of the year. Maintenance revenue increased 4.4 percent primarily driven by favorable impacts of currency movements.

HARDWARE

Systems and Technology Group revenue increased 7.9 percent (4.4 percent adjusted for currency). zSeries revenue increased

14.9 percent due to clients continuing to add new workloads on the zSeries platform as they build their on demand infrastructures, as well as taking advantage of the capabilities of the z990 server for consolidations. Mainframes remain the platform of choice for hosting mission-critical transactions, as well as for consolidations and infrastructure simplification. The total delivery of zSeries computing power as measured in MIPS increased 33 percent in 2004 versus 2003, offsetting price declines of 23 percent per MIP. xSeries server revenue increased (24 percent) due to strong growth in both high-end and 1&2 Way Servers. xSeries-related Blade-Center revenue had strong growth, up over 150 percent, as the company is leading and shaping the blade market. In the fourth quarter of 2004, the company saw strong demand for the new POWERBlade, which can run Windows, Linux and AIX on different servers in the BladeCenter. pSeries server revenue increased 7.3 percent, reflecting clients’ very strong acceptance of the POWER5 systems. The new pSeries high-end system started shipping in November 2004, marking the completion of a top-to-bottom refresh of the pSeries server product line in just three months. iSeries server revenue declined driven by lower sales as the transition to POWER5 is taking longer than in previous cycles, as clients must transition their operating environment to the new level.

Storage Systems revenue increased 1.6 percent due to increased demand for external midrange disk (13 percent) and tape products (9 percent). These increases were partially offset by decreases in high-end disk products (18 percent) as clients anticipated the shipment of the company’s new POWER5 high-end storage product which will ship in the first quarter of 2005. E&TS had strong revenue growth of 93 percent due to increased design and technical services contracts and Microelectronics revenue increased modestly (1 percent) as yields in the 300-millimeter plant improved.

Retail Store Solutions revenue increased 17.6 percent due to strong demand for the company’s products and the acquisition of Productivity Solutions Inc. in November 2003. This acquisition drove 6.9 points of the unit’s revenue growth in 2004. Printing Systems maintenance revenue declined due to lower annuity-based revenue on a declining installed base.

Personal Computing Division revenue increased 14.8 percent (10.5 percent adjusted for currency). The increase was driven by strong performance worldwide by the company’s ThinkPad mobile computer (22 percent). Desktop personal computer revenue increased (4 percent) in 2004 when compared to 2003 due primarily to favorable currency movements.

SOFTWARE

Software revenue increased 5.5 percent (0.6 percent adjusted for currency). Middleware revenue increased 6.5 percent (1.5 percent adjusted for currency). The WebSphere family of software offerings revenue increased 14 percent with growth in business integration software (14 percent), WebSphere Portal software (12 percent) and application servers (20 percent). Data Management revenue increased 7 percent with growth of 12 percent in DB2 Database software on both the host (13 percent) and distributed platforms (11 percent), DB2 Tools (8 percent), and distributed enterprise content management software (22 percent). Rational software revenue increased (16 percent) with growth across all product areas. Tivoli software revenue increased (15 percent), aided by the Candle acquisition, which was completed in the second quarter of 2004. Tivoli systems management, storage and security software all had revenue growth in 2004 versus 2003. Lotus software revenue increased 3 percent and Other Foundation middleware products revenue also increased 2 percent due to favorable currency movements.

Operating system software increased 0.9 percent due to growth in xSeries and pSeries, which correlates to the increases in the related server brands. zSeries operating system revenue declined 1 percent despite the growth in related hardware volumes due to ongoing software price performance delivered to enterprise clients. iSeries operating system software declined 6 percent in line with related hardware volumes. Overall, operating systems software revenue increased primarily as a result of favorable currency movements.

GLOBAL FINANCING

See page 44 for a discussion of Global Financing’s revenue and gross profit.

ENTERPRISE INVESTMENTS

Revenue from Enterprise Investments increased 10.7 percent (4.2 percent adjusted for currency). Revenue for product life-cycle management software increased primarily in the automotive and aerospace industries, partially offset by lower hardware revenue (48 percent), primarily for document processors.

Global Services gross profit margin was flat year to year at 24.2 percent due to continued investment in on demand infrastructure and business transformation capabilities, and less contribution from the higher margin Maintenance business. These declines were offset by improved profitability in BCS driven by improved utilization, reduced overhead structure and an improved labor mix.

The increase in Hardware margins of 0.8 points to 31.0 percent was primarily due to yield improvements in the Microelectronics business and margin improvements in zSeries servers, xSeries servers, storage products and personal computers, as well as the impact of certain hedging transactions (see “Anticipated Royalties and Cost Transactions” on page 72).

The Software margin at 87.2 percent increased 0.8 points due to growth in software revenue, as well as productivity improvements in the company’s support and distribution models.

The cost savings generated by the company’s supply-chain

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

initiatives also contributed to the company’s overall margin improvement, however, the company has passed a portion of the savings to clients to improve competitive leadership and gain market share in key industry sectors. In addition, an increase in retirement-related plan costs of approximately $490 million compared to 2003 impacted overall segment margins.

Total expense and other income increased 7.7 percent (4.8 percent adjusted for currency) in 2004 versus 2003.

Total SG&A expense of $20,079 million increased 8.0 percent (4.6 percent adjusted for currency) versus $18,601 million in 2003. The increase was primarily driven by increased expense for retirement-related plan costs of approximately $515 million, which included a one-time charge of $320 million related to the partial settlement of certain legal claims against the company’s PPP, unfavorable currency translation of $626 million and provision for certain litigation-related expenses of $125 million in 2004. These increases were partially offset by lower workforce reductions of $122 million and lower Advertising and promotional expense of $71 million. In addition, bad debt expense declined $72 million due to lower reserve requirements associated with the improvement in economic conditions and improved credit quality, as well as the lower asset base of Global Financing’s receivables portfolio.

Other (income) and expense was income of $23 million in 2004 versus expense of $238 million in 2003. The improvement was primarily driven by increased gains from various asset sales including certain real estate transactions ($87 million) in 2004 versus 2003, additional Interest income ($28 million) generated by the company in 2004 and other nonrecurring gains/settlements of $121 million in 2004 compared to 2003.

Research, development and engineering (RD&E) expense of $5,874 million increased $560 million or 10.5 percent in 2004 versus 2003 primarily the result of increased spending in middleware software including new acquisitions (approximately $240 million). In addition, RD&E expense increased due to spending related to the POWER5 technology initiatives (approximately $140 million) and higher retirement-related plan costs (approximately $77 million).

Intellectual property and custom development income was flat in 2004 versus 2003 and Interest expense declined $6 million versus 2003 primarily due to lower effective interest rates in 2004.

The provision for income taxes resulted in an effective tax rate of 29.7 percent for 2004, compared with the 2003 effective tax rate of 30.0 percent. The 0.3 point decrease in the effective tax rate in 2004 was primarily due to the tax effect of the settlement of certain pension claims in the third quarter of 2004.

With regard to Assets, approximately $3.6 billion of the year-to-year increase relates to the impact of currency translation. The remaining increase primarily consists of an increase in Cash and cash equivalents, an increase in Goodwill associated with recent acquisitions and increased Prepaid pension assets. The increases were partially offset by lower financing receivables and lower deferred tax assets.

Global Financing debt decreased, but the company’s Global Financing debt-to-equity ratio was 7.0 to 1 for 2004 and 7.1 to 1 for 2003 which is within the company’s targeted range.

Discontinued Operations

On December 31, 2002, the company sold its HDD business to Hitachi for approximately $2 billion. The final cash payment of $399 million was received on December 30, 2005. In addition, the company paid Hitachi $80 million to settle warranty obligations during 2005. These transactions were consistent with the company’s previous estimates. The HDD business was accounted for as a discontinued operation whereby the results of operations and cash flows were removed from the company’s results from continuing operations for all periods presented.

The company incurred a loss from discontinued operations of $24 million in 2005, $18 million in 2004 and $30 million in 2003, net of tax. These losses were primarily due to additional costs associated with parts warranty as agreed upon by the company and Hitachi, under the terms of the agreement for the sale of the HDD business to Hitachi.

Looking Forward

The following key drivers impacting the company’s business are discussed on page 21:

• Economic environment and corporate spending budgets

• Internal business transformation and global integration initiatives

• Innovation initiatives

• Open standards

• Investing in growth opportunities

With respect to the economic environment, in 2005 the global economy slowed modestly following the recovery’s peak a year earlier. Looking forward, while uncertainties make it difficult to predict future developments, the company anticipates similar moderate growth for the economy and the traditional IT industry. Several factors-including increasing complexity, globalization and the pace of technology change-are driving clients to continue to transform their businesses. The deeper integration of technology into business models, processes and practices has created new long-term opportunities for the company. IBM is addressing these opportunities through its BPTS offerings. The company expects continued double-digit revenue growth in these offerings in 2006.

With respect to business transformation and the continual conversion of the company into an on demand business, the company’s supply chain initiatives are expected to allow continued flexibility to drive additional competitive advantages. Also, the company will leverage the actions taken in 2005 and continue to focus on increased productivity and efficiency to accelerate the globalization and transformation of its global business model.

Finally, with respect to technology, in 2005 the company has again been awarded more U.S. patents than any other company for the thirteenth year in a row. The company continues to focus internal development investments on high-growth opportunities and to broaden its ability to deliver industry-specific solutions.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

From a client-set perspective, the momentum in 2005 with respect to the Small & Medium Business sector should continue. The company anticipates improved growth in its industry sectors in 2006.

The company also will continue to selectively pursue acquisitions, primarily in the Global Services and Software segments, where it believes these acquisitions will expand its portfolio to meet clients’ needs.

In 2005, total Global Services signings increased 9 percent year to year, driven by a 19 percent increase in longer term signings, while shorter term signings were essentially flat. Backlog was flat versus December 31, 2004, at an estimated $111 billion. The company implemented several broad initiatives in the services business in 2005 including a restructuring action to improve cost competitiveness, implementation of Professional Marketplace to improve consulting resource utilization, addition of over 15,000 resources to the Global Resource Delivery Centers and rebalancing the Integrated Technology Services portfolio to focus on faster growing opportunities. Global Services pre-tax margin improved in 2005. The company expects to leverage these actions for continued improvement in 2006 in both revenue growth rates and higher margins.

The company’s Systems & Technology Group develops leading and often pioneering technologies that can be integrated with software and services to provide client solutions. IBM’s BlueGene supercomputer at the Lawrence Livermore National Laboratory earned its designation as the world’s fastest supercomputer with an astonishing 280-trillion-calculations-per-second performance. In 2005, IBM also won the U.S. National Medal of Technology in recognition of 40 years of broadly based semiconductor innovation. Our latest innovation, the revolutionary Cell microprocessor–developed in collaboration with Sony and Toshiba–boasts a staggering advantage, performing up to 40 times faster than conventional processors handling graphics-intensive applications in areas like gaming and consumer electronics, and has potential in adjacent markets like medical imaging or aerospace and defense. Moving forward, IBM technologies that advantage IBM in the data center systems market will be leveraged through the Systems & Technology Group’s new Technology Collaboration Solutions unit to help clients develop their own innovative products and to create incremental opportunity for IBM.

The key to the company’s continued growth in Software will be clients’ continued adoption of its on demand solutions. The key differentiating factor for the company is the strength and breadth of its middleware portfolio. Software is a key component of on demand solutions, and the company will continue to invest in this strategic area and strengthen its portfolio through acquisitions. An example is the company’s ability to respond to clients’ increasing interest in a SOA with its WebSphere product portfolio and key acquisitions, such as DataPower Technology, that expand the company’s capabilities to address this opportunity. In addition, the company will continue to build a strong partner ecosystem to drive growth.

The company expects 2006 pre-tax retirement-related plan expense to increase approximately $100-$200 million when compared to 2005. This expected increase is driven by year-end 2005 changes in key assumptions used to determine 2006 expense (approximately $600 million) and incremental amortization expense related to previously deferred losses (approximately $500 million), offset by expected savings generated from pension plan amendments (approximately $450-$500 million), better than expected 2005 return on asset performance (approximately $100 million), as well as the effects of one-time charges incurred in 2005 for the fourth-quarter pension curtailment charge ($267 million) and a charge related to the second-quarter 2005 restructuring actions ($65 million).

Specifically, given the declining interest rate environment, the company reduced its discount rate assumption for the PPP by 25 basis points to 5.5 percent on December 31, 2005. This change, along with similar changes to the discount rate for non-U.S. pension plans are expected to contribute an additional $400 million of expense in 2006. In addition, the company increased the interest crediting rate by 190 basis points to 5.0 percent which will result in an anticipated increase in expense of $200 million. The company will keep the expected long-term rate of return on PPP assets at 8 percent. The actual return on PPP plan assets in 2005 was 11 percent.

Pre-tax stock-based compensation expense declined $543 million in 2005, as compared to 2004. The company expects stock-based compensation expense to continue to decline in 2006, when compared to 2005, primarily as a result of changes in the company’s equity-based compensation programs. The anticipated decline, however, will not be at a rate consistent with the decline from 2004 to 2005, given the effect changes in the company’s employee stock purchase plan had on the 2004 to 2005 expense decrease.

The amount of IP and custom development income has been declining in recent years, down 19 percent in 2005. A moderate declining trend may continue as the company does not expect IP to be a contributor to growth. The overall level of IP is dependent on several factors: divestitures, industry consolidation, economic conditions and the timing of new patent development.

Income Taxes

In the normal course of business, the company expects that its effective tax rate will approximate 30 percent. The rate will change year to year based on nonrecurring events (such as the third-quarter 2005 repatriation charge as described in note P, “Taxes” on page 80), as well as recurring factors including the geographic mix of income before taxes, the timing and amount of foreign dividends, state and local taxes and the interaction of various global tax strategies.

During the period 2003-2005, the company’s cash tax rate declined from 18 percent to 16 percent. The company’s cash tax rate represents the amount of income taxes paid during the year over Income from continuing operations before income taxes.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

The cash tax rate differs from the company’s effective tax rate due to a number of variables including, but not limited to, certain items of income and expense that are recognized in different years for financial reporting purposes than for income tax purposes, differences in currency rates used in the translation of the non-U.S. income tax provision and income tax payments, and current-year cash tax payments or refunds that are related to prior years. The company anticipates that its cash tax rate will approximate the upper end of this range for the near term. However, once the company fully utilizes its alternative minimum tax credits or loss carry forwards, the possibility exists that the cash tax rate could increase.

Liquidity and Capital Resources

The company generates strong cash flow from operations, providing a source of funds ranging between $13.7 billion and $15.3 billion per year over the past five years. The company provides for additional liquidity through several sources; a sizable cash balance, access to global funding sources, a committed global credit facility and in 2004, the company converted a receivables securitization facility from an “uncommitted” to a “committed” facility, adding an additional source of liquidity. (See note J, “Securitization of Receivables” on page 70 for additional information). The table below provides a summary of these major sources of liquidity for the years ended December 31, 2001 through 2005.

CASH FLOW AND LIQUIDITY TRENDS

(Dollars in billions)

	2005		2004		2003		2002		2001
Net cash from operating activities	$	14.9	$	15.3	$	14.5	$	13.8	$	13.7
Cash and marketable securities	$	13.7	$	10.6	$	7.6	$	6.0	$	6.4
Size of global credit facilities	$	10.0	$	10.0	$	10.0	$	12.0	$	12.0
Trade receivables securitization facility	$	0.5	$	0.5	$	—	$	—	$	—

The major rating agencies’ ratings on the company’s debt securities at December 31, 2005 appear in the following table and remain unchanged over the past five years. The company has no 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 AND POOR’S	MOODY’S INVESTORS SERVICE	FITCH RATINGS
Senior long-term debt	A+	A1	AA-
Commercial paper	A-1	Prime-1	F1+

The company prepares its Consolidated Statement of Cash Flows in accordance with SFAS No. 95, “Statement of Cash Flows,” on page 50 and highlights causes and events underlying sources and uses of cash in that format on page 31. For purposes of running its business, the company manages, monitors and analyzes cash flows in a different format.

As discussed on page 43, one of the company’s two primary objectives of its Global Financing business is to generate strong return on equity. Increasing receivables is the basis for growth in a financing business. Accordingly, management considers Global Financing receivables as a profit-generating investment-not as working capital that should be minimized for efficiency. After classifying the Global Financing accounts receivables as an investment, the remaining net cash flow is viewed by the company as the Cash available for investment and for distribution to shareholders. With respect to the company’s cash flow analysis for internal management purposes (see the first table on page 39), Global Financing accounts receivables are combined with Global Financing debt to represent the Net Global Financing debt to accounts receivable (a profit-generating investment).

From the perspective of how management views cash flows, in 2005, net cash from operating activities, excluding Global Financing receivables, was $13.1 billion, an increase of $0.2 billion compared to 2004. This cash performance was driven primarily by the growth in net income from continuing operations and the company’s continued focus on working capital and supply chain management. The company returned over 100 percent of net income in 2005 to shareholders in dividend payments and share repurchases.

Over the past five years, the company generated over $60.8 billion in Cash available for investment and for distribution to shareholders. As a result, during the period the company invested $20.6 billion of net capital expenditures, invested $9.1 billion in strategic acquisitions, received $2.2 billion from divestitures and returned $34.1 billion to shareholders through dividends and share repurchases. The amount of prospective Returns to shareholders in the form of dividends and share repurchases will vary based upon several factors including affordability, namely each year’s operating results, capital expenditures, research and development, and acquisitions, as well as the factors discussed immediately following the first table on page 39.

The company’s Board of Directors meets quarterly to consider the dividend payment. The company expects to fund dividend payments through cash from operations.

Management Discussion

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

The table below represents the way in which management reviews its cash flow as described on page 38.

(Dollars in billions)

FOR THE YEAR ENDED DECEMBER 31:	2005			2004			2003			2002			2001
Net cash from operating activities (Continuing Operations):	$	14.9		$	15.3		$	14.5		$	13.8		$	13.7
Less:Global Financing accounts receivable	1.8			2.5			1.9			3.3			2.0
Net cash from operating activities (Continuing Operations), excluding Global Financing receivables	13.1			12.9			12.6			10.5			11.7
Investing Activities:
Capital expenditures, net	(3.5		)	(3.7		)	(3.9		)	(4.6		)	(4.9		)
Global Financing accounts receivable	1.8			2.5			1.9			3.3			2.0
Global Financing debt	(0.6		)	(1.7		)	(2.6		)	(3.1		)	(1.1		)
Net Global Financing debt to accounts receivable	1.3			0.7			(0.7		)	0.2			0.9
Acquisitions	(1.5		)	(1.7		)	(1.8		)	(3.2		)	(0.9		)
Divestitures