Exhibit 13

REPORT OF FINANCIALS

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

MANAGEMENT DISCUSSION

Road Map		12
Forward-Looking and Cautionary Statements		13
Management Discussion Snapshot		14
Description of Business		15
Year in Review		22
Prior Year in Review		37
Discontinued Operations		41
Other Information		41
Looking Forward		41
Liquidity and Capital Resources		43
Critical Accounting Estimates		45
Currency Rate Fluctuations		47
Market Risk		47
Financing Risks		48
Employees and Related Workforce		48
Global Financing		49

REPORT OF MANAGEMENT		54

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

CONSOLIDATED FINANCIAL STATEMENTS

Earnings		56
Financial Position		57
Cash Flows		58
Stockholders’ Equity		59

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A	Significant Accounting Policies	62
B	Accounting Changes	71
C	Acquisitions/Divestitures	73
D	Financial Instruments (excluding derivatives)	78
E	Inventories	79
F	Financing Receivables	79
G	Plant, Rental Machines and Other Property	79
H	Investments and Sundry Assets	80
I	Intangible Assets Including Goodwill	80
J	Securitization of Receivables	81
K	Borrowings	81
L	Derivatives and Hedging Transactions	83
M	Other Liabilities	87
N	Stockholders’ Equity Activity	88
O	Contingencies and Commitments	89
P	Taxes	92
Q	Research, Development and Engineering	93
R	2005 Actions	93
S	Earnings Per Share of Common Stock	95
T	Rental Expense and Lease Commitments	96
U	Stock-Based Compensation	96
V	Retirement-Related Benefits	100
W	Segment Information	111
X	Subsequent Events	115

FIVE-YEAR COMPARISON OF SELECTED FINANCIAL DATA		116

SELECTED QUARTERLY DATA		117

PERFORMANCE GRAPHS		118

BOARD OF DIRECTORS AND SENIOR EXECUTIVE OFFICERS		120

STOCKHOLDER INFORMATION		121

MANAGEMENT DISCUSSION

INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

ROAD MAP

The financial section of the International Business Machines Corporation (IBM or the company) 2006 Annual Report, consisting of this Management Discussion, the Consolidated Financial Statements that follow and the notes related thereto, comprises 108 pages of information. This Road Map is designed to provide the reader 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 innovative, efficient and competitive through the use of business insight and information technology (IT) solutions; and, providing long-term value to shareholders. In addition to these goals, the company is committed to its employees and the communities in which it operates.

In support of these objectives, the business model has been developed over time through strategic investments in capabilities and technologies that have the best long-term growth and profitability prospects based on the value they deliver to clients.

The company’s strategy is to focus on the high-growth, high-value segments of the IT industry. The company’s broad capabilities include services, software, hardware, fundamental research, financing and the component technologies used to build larger systems. These global capabilities are combined to provide business insight and solutions in the enterprise computing space.

The business model is flexible, and allows for periodic rebalancing. In 2006, 13 acquisitions were completed, all focused on expanding the company’s software and services capabilities, at an aggregate cost of approximately $4.8 billion. In January 2007, the company announced its intent to form a joint venture with Ricoh Company based on the company’s Printing Systems business.

The business model, supported by the company’s long-term financial model, enables the company to deliver consistently strong earnings, cash flows and high returns on invested capital in changing economic environments.

TRANSPARENCY

Transparency is a primary goal of successful financial reporting. The following are the key elements found 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, 2006.

• 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 14 to 15, 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 its broad capabilities. The sections on “Description of the Business” on page 15, “Results of Continuing Operations” on page 22, “Financial Position” on page 32, and “Looking Forward” on page 41, 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 29 to 32.

• 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 49 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.

• Effective December 31, 2006, the company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment to FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires that the funded status of the company’s pension and nonpension postretirement benefit plans be recognized as an asset or a liability in the Consolidated Statement of Financial Position, the recognition of any changes in that funded status in the year in which the changes occur and the recognition of previously unrecognized gains/(losses), prior service costs/(credits) and transition assets as a component of Accumulated gains and (losses) not affecting retained earnings in the Consolidated Statement of Stockholder’s Equity. The adoption of SFAS No. 158 had a significant non-cash impact on the company’s reported financial position and stockholders' reducing equity by $9.5 billion, net of tax. The adoption of SFAS No. 158 had no impact on the company’s existing debt covenants, credit ratings

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

or financial flexibility. See note V, “Retirement-Related Benefits” on pages 100 to 111 for additional information, including the incremental effect on the Consolidated Statement of Financial Position.

• 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 77 and 78. As a result of this divestiture, the company’s reported financial results do not include any activity in 2006 and include four months of activity for the Personal Computing Division in 2005 as compared to 12 months in 2004. This lack of comparable periods has a material impact on the company’s reported revenue growth. Therefore, in the Management Discussion, within the “Year in Review” section on pages 22 to 25 and the “Prior Year in Review” section on pages 37 and 38, the company has presented an analysis of revenue both on an as-reported basis and on a basis that excludes the revenue from the divested Personal Computing business from both the 2005 and 2004 periods. The company believes that the analysis that excludes the Personal Computing revenue is a better indicator of the company’s operational revenue performance on an ongoing basis.

• IBM made changes to its management system effective as of the first quarter of 2006. In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” these changes impacted the company’s reportable segments and resulted in the reclassification of certain revenue and cost within its Consolidated Statement of Earnings from previously reported information. See note W, “Segment Information” on page 111 for additional information on the changes in reportable segments. These changes did not impact IBM’s total revenue, cost, expense, net income, earnings per share, Consolidated Statement of Financial Position or Consolidated Statement of Cash Flows from previously reported information. The Consolidated Statement of Earnings on page 56 reflects these changes for all periods presented.

• The reference to constant currency in the Management Discussion is made so that certain financial results can be viewed without the impacts of changing foreign currency exchange rates and therefore facilitates a comparative view of business growth. See “Currency Rate Fluctuations” on page 47 for additional information.

• Within the financial tables in this Annual Report, certain columns and rows may not add due to the use of rounded numbers for disclosure purposes. Percentages reported in the financial tables throughout this Annual Report are calculated from the underlying whole-dollar numbers.

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 111 to 115.

• Pages 56 through 61 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 Among other things, the notes contain the company’s accounting policies (pages 62 to 71), acquisitions and divestitures (pages 73 to 78), detailed information on specific items within the financial statements, certain contingencies and commitments (pages 89 to 92), and the results of each IBM segment (pages 111 to 115).

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 41 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 Securities and Exchange Commission (SEC), including the company’s 2006 Form 10-K filed on February 27, 2007.

MANAGEMENT DISCUSSION SNAPSHOT

(Dollars and shares in millions except per share amounts)

									YR. TO YR.
									PERCENT/
									MARGIN
FOR THE YEAR ENDED DECEMBER 31:	2006				2005				CHANGE
Revenue	$	91,424			$	91,134			0.3*	%
Gross profit margin	41.9			%	40.1			%	1.8	pts.
Total expense and other income	$	24,978			$	24,306			2.8	%
Total expense and other income to revenue ratio	27.3			%	26.7			%	0.7	pts.
Income from continuing operations before income taxes	$	13,317			$	12,226			8.9	%
Provision for income taxes	$	3,901			$	4,232			(7.8	)%
Income from continuing operations	$	9,416			$	7,994			17.8	%
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$		6.06		$		4.91		23.4	%
Discontinued operations	0.05				(0.01			)	NM
Cumulative effect of change in accounting principle	—				(0.02			)	NM
Total	$	6.11			$	4.87			25.5	%
Weighted-average shares outstanding: Diluted		1,553.5				1,627.6			(4.6	)%
Assets**	$	103,234			$	105,748			(2.4	)%
Liabilities**	$	74,728			$	72,650			2.9	%
Equity**	$	28,506			$	33,098			(13.9	)%

* Flat when adjusted for currency.

** At December 31.

NM—Not meaningful

CONTINUING OPERATIONS

The company’s 2006 performance was the result of a series of actions taken over the last several years to steadily transform the company. The company has divested of businesses that are commoditizing, while investing in targeted acquisitions to continue to build capabilities in higher value areas. The company has also been focused on increasing productivity, to expand margins and improve efficiency. In addition, it has accelerated its move to become a globally integrated company. These actions have resulted in a more balanced mix of businesses and a stronger, more competitive and sustainable global business. The company’s 2006 financial results reflect this improved business model.

The company divested its Personal Computing business on April 30, 2005. Therefore, the company’s reported results for 2006 do not include any activity for the Personal Computing Division, while the results for 2005 include four months of activity.

Total revenue, as reported, increased 0.3 percent versus 2005; excluding the Personal Computing business external revenue from 2005, total 2006 revenue increased 3.6 percent (3.2 percent adjusted for currency). Pre-tax income from continuing operations grew 8.9 percent, while diluted earnings per share from continuing operations increased 23.4 percent compared to 2005. Income from continuing operations increased 17.8 percent compared to 2005, benefiting from an improved effective tax rate year to year. Net cash provided by operating activities was $15,019 million.

The increase in revenue, excluding the Personal Computing business, in 2006 as compared to 2005, was primarily due to:

• Improved demand in the software business, driven by Key Branded Middleware products, with positive contributions from key acquisitions;

• Increased demand in the hardware business driven by Microelectronics, System z and Storage; growth in System x and Retail Store Solutions; and

• Continued growth in emerging countries (up 21 percent) and solid performance in the Americas and Europe/Middle East/Africa geographies.

The increase in income from continuing operations before income taxes in 2006 as compared to 2005 was primarily due to:

• Revenue growth in the Software segment as discussed above;

• Continued execution of the company’s productivity initiatives driving improved Global Services gross margins; and

• Revenue growth and continued operational improvement in the Microelectronics business.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

The consolidated gross profit margin increased 1.8 points to 41.9 percent versus 2005. An improvement in the Hardware margin (1.9 points) contributed 0.6 points to the overall margin improvement. This increase was driven by the sale and resulting absence of the lower margin Personal Computing business. In addition, the Global Services margin improved 1.5 points versus 2005 to 27.5 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 ongoing productivity initiatives. The Software margin increased slightly. The Global Financing margin declined 4.4 points versus 2005 to 50.3 percent primarily driven by higher borrowing costs. This decline had an immaterial impact on the company’s overall margin due to the size of the segment.

Total expense and other income increased 2.8 percent in 2006 versus 2005. The increase was primarily due to the company’s investments in acquisitions and investments the company is making in its software and services businesses and emerging markets.

The provision for income taxes resulted in an effective tax rate of 29.3 percent for 2006, compared with the 2005 effective tax rate of 34.6 percent. The 5.3 point decrease in the 2006 effective tax rate was primarily attributable to the net effect of several items. In 2006, the tax rate was favorably impacted by the absence of the foreign earnings repatriation-related tax charge recorded in the third quarter of 2005 (4.3 points) as well as a benefit from the fourth-quarter 2006 settlement of the U.S. Federal income tax audit for the years 2001 through 2003 ( 3.0 points). These benefits were partially offset by a one-time tax cost associated with the 2006 intercompany transfer of certain intellectual property (4.3 points). The remaining items were individually insignificant.

Total Assets declined approximately $2.5 billion ($6.2 billion adjusted for currency) primarily due to lower prepaid pension assets ($10.0 billion) and a decrease in Cash and cash equivalents ($4.5 billion). These decreases were partially offset by increases in Goodwill ($3.4 billion), long-term deferred tax assets ($2.0 billion), Marketable securities ($1.9 billion), trade receivables ($1.2 billion), financing receivables ($1.8 billion) and Intangible assets ($0.5 billion).

The increase in total Liabilities of $2.1 billion (down $0.4 billion adjusted for currency) was primarily driven by Compensation and benefits ($1.3 billion), Deferred income ($1.3 billion) and Accounts payable ($0.6 billion). These increases were partially offset by decreases in long-term deferred tax liabilities ($1.0 billion) and restructuring liabilities ($0.4 billion). Total debt of $22.7 billion was essentially flat versus 2005.

The decrease in Stockholders’ Equity was primarily driven by retirement-related charges ($7.6 billion) and net common stock transactions ($5.4 billion), partially offset by increased Retained earnings ($7.7 billion). The retirement-related driven decrease in Stockholder’s Equity and the decrease in prepaid pension assets were as a result of the company’s adoption of SFAS No. 158. See note V, “Retirement- Related Benefits” on pages 100 to 111 for additional information.

Global Services signings were $49 billion in 2006 as compared to $47 billion in 2005. The Global Services backlog is estimated to be $116 billion at December 31, 2006, versus $111 billion at December 31, 2005.

For additional information, see the “Year in Review” section on pages 22 through 36.

Looking forward, the company’s long-term financial model objective is to generate 10 to 12 percent earnings per share growth over the long term 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 89 to 92.

DESCRIPTION OF BUSINESS

Please refer to IBM’s Annual Report on Form 10-K filed on February 27, 2007, with the SEC for a more detailed version of this Description of Business, especially Item 1A. entitled “Risk Factors.”

IBM is a globally integrated innovation company, serving the needs of enterprises and institutions worldwide. The company seeks to be a partner in its clients’ success by enabling their own capacity to innovate, so that they may differentiate themselves for competitive advantage in a globalized economy. 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. To help clients achieve growth, effectiveness, efficiency and the realization of greater value through innovation, IBM draws upon the world’s leading systems, software and services capabilities.

IBM’S STRATEGY

The company has divested low growth commoditizing product lines and acquired higher value opportunities to leverage IBM’s infrastructure.

In IBM’s view, the future of business is being shaped by the forces of global integration and innovation. They are foundational and intimately related to one another. A globally integrated enterprise is a new institutional form that shapes its strategy, management and operations globally, based on economics, expertise and open business environments. It is optimized for innovation in a worldwide economy and society that are increasingly integrated and specialized. IBM’s strategic moves over the past several years—from divestitures and acquisitions, to areas of focus for innovation, to the transformation of its core lines of business—have been shaped by this vision.

IBM’s strategic priorities to pursue this vision include:

• Offering enterprises in the global economy innovative, high-value solutions based on IBM’s ability to integrate technology and business model innovation to deliver measurable results for IBM and its clients;

• Leading in the delivery of business value by providing business and information technology consulting and implementation services; building, running and maintaining cross-industry and industry-specific business process services; leveraging leadership technology and engineering services; and accelerating increased business value through Service Oriented Architectures (SOA) and Information on Demand;

• Leading in the delivery of advanced infrastructure through enterprise SOA and infrastructure software and services; increased share leadership in servers; driving to leadership in storage; and leading the transition to standardized services offerings; and

• Making IBM the premier Globally Integrated Enterprise—lowering costs and increasing effectiveness by integrating the company’s decision making at the point of client contact (“lowering IBM’s center of gravity”); moving work to where it can best be performed; focusing IBM’s resources to create the greatest value; and excelling in business collaboration.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

Microelectronics. Semiconductor design and manufacturing of customized products including microprocessors, application specific integrated circuits and standard products for IBM systems and external clients.

Engineering and Technology Services (E&TS). System and component design services, strategic outsourcing of clients’ design teams, and technology and manufacturing consulting services.

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 systems, software and solutions.

FINANCING

Commercial Financing. Short-term inventory and accounts receivable financing to dealers and remarketers of IT products.

Client Financing. Lease and loan financing to external and internal clients for terms generally between two and seven years.

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

Software

Information Management Software. Advanced database, content management and information integration software that helps companies integrate, manage and gain value from their business information.

Lotus Software. Collaboration, messaging and social networking software that enables businesses to communicate, collaborate and increase productivity.

Rational Software. Software and process automation tools that help clients manage the business process of software and systems delivery.

Tivoli Software. Software for infrastructure management, including security and storage management that will help organizations better manage their IT infrastructure to more effectively deliver IT services.

WebSphere Software. Provides the foundation for Web-enabled applications and is a key product set in deploying a Service Oriented Architecture. Management of a wide variety of business processes using open standards to interconnect applications, data and operating systems.

Product Lifecycle Management (PLM). Software that enables clients to improve their product development processes and their ability to use product-related information across their businesses.

Operating Systems. Software engines that manage the fundamental processes that make computers run.

Services

Business Process Services (BPS). A range of offerings from standardized processing platforms and Business Process Outsourcing (BPO) through Business Transformation Outsourcing (BTO) that delivers improved business results to clients through the strategic change and/or operation of the client’s business processes, applications and infrastructure.

Consulting and Systems Integration (C&SI). Delivery of value to clients through consulting services for client relationship management, financial management, human capital, business strategy and change and supply chain management.

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). Services offerings that help clients access, manage and support their technology infrastructures, through a combination of skilled resources, software and IBM’s knowledge of business processes.

Maintenance. A number of support services from product maintenance through solution support to maintain and improve the availability of clients’ IT infrastructure.

Application Management Services (AMS). Application development, management, maintenance and support services for packaged software, as well as custom and legacy applications.

Applications on Demand (AoD). 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.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

BUSINESS SEGMENTS

Organizationally, the company’s major operations comprise a Global Technology Services segment; a Global Business Services segment; a Systems and Technology Group segment; a Software segment; and a Global Financing 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 over 10 years. Within Global Services there are two reportable segments: Global Technology Services and Global Business Services.

Global Technology Services (GTS) segment primarily reflects infrastructure services, delivering value through the company’s global scale, standardization and automation. It includes outsourcing services, Integrated Technology Services and Maintenance.

Global Business Services (GBS) segment primarily reflects professional services, delivering business value and innovation to clients through solutions which leverage industry and business process expertise. It includes consulting, systems integration and Application Management Services.

Systems and Technology Group provides IBM’s clients with business solutions requiring advanced computing power and storage capabilities. Approximately 55 percent of the Systems and Technology Group’s server and storage sales transactions are through business partners; approximately 45 percent are direct to end-user clients, more than half of which are through the internet 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 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 a standard software platform. IBM Middleware is designed to open standards which allows the efficient integration of disparate client applications that may have been built internally, or provided by package software vendors or system integrators. Operating systems are the software engines that run computers. In addition, Software includes Product Lifecycle Management software which primarily serves the Industrial sector. Approximately 25 percent of software transactions are sold through business partners. Also, 50 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 recurring license charge 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. While not reported as external revenue, software is also deployed to support services solutions.

Global Financing is described on pages 49 through 53.

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.

To facilitate its access to clients and local markets and to improve productivity, the Sales & Distribution organization utilizes geographic organizations in the Americas, Europe/Middle East/Africa (EMEA) and Asia Pacific geographies. This structure enables resources and decision making to be closer to the clients.

The majority of IBM’s revenue, excluding the company’s original equipment manufacturer (OEM) technology business, occurs in industries that are broadly grouped into six sectors:

• Financial Services: Banking, Financial Markets, Insurance

• Public: Education, Government, Healthcare, Life Sciences

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

• Distribution: Consumer Products, Retail, Travel and 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 focus on selling end-to-end solutions for large, complex business challenges.

Hardware and software brand specialists sell IBM products as parts of discrete technology decisions and as part of broader client solutions.

ibm.com provides fast, easy access to IBM’s product and business expertise via the Web and telephone. In addition, ibm.com 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). 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 $6 billion for R&D, focusing its investments in high-growth, high-value opportunities. In 2006, the company’s investment in R&D was approximately 15 percent of its combined hardware and software revenue. As a result of innovations in these and other areas, IBM was once again awarded more U.S. patents in 2006 than any other company. This marks the 14th 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 of approximately $1 billion annually. Some of IBM’s technological breakthroughs are used exclusively in IBM products, while others are licensed and may be used in either/both IBM products and/or the products of the licensee.

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 transactions is not readily apparent in the Consolidated Statement of Earnings, because income on cross-licensing arrangements is recorded only to the extent that cash is received. The value received for IP involving the sale of a business is included in the overall gain or loss from the divestiture, not in the separately presented IP income amounts on the Consolidated Statement of Earnings.

Integrated Supply Chain

Just as IBM works to transform its clients’ supply chains for greater efficiency and responsiveness to global market conditions, the company continues to derive business value from its own globally integrated supply chain, reinvented as a strategic advantage for the company to create value for clients and shareholders. IBM leverages its supply-chain expertise for clients through 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 $36 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, sales force productivity and processes, and these actions have improved client satisfaction when working with the company. Since 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. IBM is continuing to apply the supply-chain principles of product manufacturing and delivery 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.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

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 set of products and offerings is designed to provide more consistent results in both strong and weak economic environments. 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 2006, the company continued the global integration of its internal support 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. In addition to eliminating redundancies and overhead structures to drive productivity, this integration has 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. The company will continue to focus on global integration initiatives to improve productivity in its integrated supply chain, service delivery and internal support functions.

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. Examples include IBM’s leadership position in the design and fabrication of game processors; the design of smaller, faster and energy-efficient semiconductor devices; and the design of “grid” computing networks that allow computers to share processing power.

Through the Global Innovation Outlook (GIO), IBM has opened up its technical and business forecasting processes to include external leaders from business, academia, the public sector, nongovernmental organizations and other influential constituents of the world community. The GIO takes a deep look at some of the most pressing issues facing the world and works toward providing solutions to those needs. In 2006, IBM also announced that it will invest $100 million over the next two years to pursue 10 new businesses generated by InnovationJam, an on-line brainstorming session which brought together more than 150,000 people from 104 countries, including IBM employees, family members, universities, business partners and clients from 67 companies. Over two 72-hour sessions, participants posted more than 46,000 ideas as they explored IBM’s most advanced research technologies and considered their application to real-world problems and emerging business opportunities.

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’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, maintaining technology leadership and emerging growth countries such as China, Russia, India and Brazil.

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:	2006		2005		CHANGE		CURRENCY
Statement of Earnings Revenue Presentation:
Global Services	$	48,247	$	47,407	1.8	%	1.7	%
Hardware	22,499		24,343		(7.6	)	(8.3	)
Software	18,204		16,830		8.2		7.5
Global Financing	2,379		2,407		(1.1	)	(1.6	)
Other	94		147		(36.4	)	(33.4	)
Total	$	91,424	$	91,134	0.3	%	(0.0	)%

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2006		2005*		CHANGE		CURRENCY
Industry Sector:
Financial Services	$	25,181	$	24,186	4.1	%	3.8	%
Public	13,401		14,064		(4.7	)	(5.3	)
Industrial	11,535		11,699		(1.4	)	(1.6	)
Distribution	9,034		8,959		0.8		0.3
Communications	8,679		8,601		0.9		0.6
Small & Medium Business	16,981		17,597		(3.5	)	(3.8	)
OEM	3,856		3,271		17.9		17.9
Other	2,756		2,757		(0.1	)	0.0
Total	$	91,424	$	91,134	0.3	%	(0.0	)%

* Reclassified to conform with 2006 presentation.

(Dollars in millions)

							YR. TO YR.
							PERCENT
					YR. TO YR.		CHANGE
					PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2006		2005		CHANGE		CURRENCY
Geographies:
Americas	$	39,511	$	38,817	1.8	%	0.8	%
Europe/Middle East/Africa	30,491		30,428		0.2		(1.1	)
Asia Pacific	17,566		18,618		(5.7	)	(3.1	)
OEM	3,856		3,271		17.9		17.9
Total	$	91,424	$	91,134	0.3	%	(0.0	)%

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

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 77 and 78. As a result of this divestiture, the company’s reported financial results do not include any activity in 2006 and include four months of activity for the Personal Computing Division in 2005. This lack of comparable periods has a material impact on the company’s reported revenue growth. The company believes that a more appropriate analysis is one that excludes the revenue results of the Personal Computing Division in 2005 because it presents results on a comparable basis and provides a more meaningful focus on the company’s ongoing operational performance. Such discussion is presented on pages 24 and 25.

Total revenue, as reported, increased 0.3 percent versus 2005. In addition to the revenue presentation in the Consolidated Statement of Earnings, the company also measures revenue performance on both an industry sector and geographic basis.

As reported revenue performance by industry sector was mixed in 2006 when compared to 2005. Revenue in the Financial Services sector increased 4.1 percent versus the year-ago period, driven by Banking, which increased 7.2 percent. The Public sector revenue decline of 4.7 percent was attributable to decreased revenue in the Government (3.2 percent) and Education (25.1 percent) industries. The Industrial sector revenue decline (1.4 percent) was driven by Automotive (5.5 percent), partially offset by increased revenue in Chemical and Petroleum (12.4 percent). Revenue in the Distribution sector increased (0.8 percent) with growth in Consumer Products (5.3 percent) and the Retail industry (2.4 percent), partially offset by decreased revenue in Travel and Transportation (4.5 percent). The Communications sector revenue increase (0.9 percent) was driven by increased revenue in Utilities (9.3 percent). Revenue from Small and Medium Business decreased 3.5 percent in 2006 when compared to 2005, with revenue declines in all geographic markets. This sector was impacted most significantly by the loss of the Personal Computing business revenue.

The following geographic, regional and country-specific revenue performance excludes OEM revenue, which is presented separately.

From a geographic perspective, as reported revenue performance was mixed in 2006 compared to 2005, with growth in the Americas and EMEA, being offset by a decrease in Asia Pacific.

Americas’ revenue increased 1.8 percent (1 percent adjusted for currency) in 2006 versus the year-ago period. Revenue increased in all regions with the U.S. up 1.0 percent, Canada 2.4 percent (decreased 4 percent adjusted for currency) and Latin America 8.6 percent (3 percent adjusted for currency).

EMEA revenue increased a modest 0.2 percent on an as reported basis (declined 1 percent adjusted for currency) in 2006 when compared to 2005. In the major countries, the U.K. increased 0.5 percent (decreased 1 percent adjusted for currency), France increased 1.6 percent (flat adjusted for currency), Italy increased 1.6 percent (flat adjusted for currency) and Spain increased 2.1 percent (flat adjusted for currency). These increases were largely offset by lower revenue in Germany of 2.8 percent (4 percent adjusted for currency) in 2006 versus the year-ago period.

Asia Pacific revenue declined 5.7 percent (3 percent adjusted for currency) year over year. Japan, which represents over 50 percent of the Asia Pacific revenue base, declined 10.1 percent (5 percent adjusted for currency). Partially offsetting the Japan decline were revenue increases in Korea 12.6 percent and India 22.9 percent.

The emerging countries of Brazil, India, Russia and China together grew 9.9 percent (5 percent adjusted for currency), as the company continues to invest to build capabilities in these countries. Brazil grew 15.4 percent (4 percent adjusted for currency), India increased 22.9 percent (26 percent adjusted for currency) and Russia increased 13.9 percent (14 percent adjusted for currency). China declined 0.3 percent (2 percent adjusted for currency) in 2006 as this country’s performance was significantly impacted by the Personal Computing divestiture.

OEM revenue increased 17.9 percent (18 percent adjusted for currency) in 2006 driven by strong demand for game processors in the Microelectronics business.

Revenue Excluding Divested Personal Computing Business

(Dollars in millions)

									YR. TO YR.
									PERCENT
							YR. TO YR.		CHANGE
							PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE		CURRENCY
Statement of Earnings Revenue Presentation:
Global Services	$		48,247	$		47,407	1.8	%	1.7	%
Hardware	22,499			21,468			4.8		3.9
Software	18,204			16,830			8.2		7.5
Global Financing	2,379			2,407			(1.1	)	(1.6	)
Other	94			147			(36.4	)	(33.4	)
Total	$	91,424		$	88,259		3.6	%	3.2	%

(Dollars in millions)

									YR. TO YR.
									PERCENT
							YR. TO YR.		CHANGE
							PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2006			2005*			CHANGE		CURRENCY
Industry Sector:
Financial Services	$		25,181	$		23,916	5.3	%	4.9	%
Public	13,401			13,599			(1.5	)	(2.1	)
Industrial	11,535			11,470			0.6		0.4
Distribution	9,034			8,836			2.3		1.7
Communications	8,679			8,468			2.5		2.1
Small & Medium Business	16,981			16,018			6.0		5.7
OEM	3,856			3,271			17.9		17.9
Other	2,756			2,681			2.8		2.9
Total	$	91,424		$	88,259		3.6	%	3.2	%

* Reclassified to conform with 2006 presentation.

(Dollars in millions)

									YR. TO YR.
									PERCENT
							YR. TO YR.		CHANGE
							PERCENT		CONSTANT
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE		CURRENCY
Geographies:
Americas	$		39,511	$		37,725	4.7	%	3.7	%
Europe/Middle East/Africa	30,491			29,549			3.2		1.8
Asia Pacific	17,566			17,714			(0.8	)	1.8
OEM	3,856			3,271			17.9		17.9
Total	$	91,424		$	88,259		3.6	%	3.2	%

Total revenue, excluding the divested Personal Computing business, increased 3.6 percent (3.2 percent adjusted for currency) versus 2005.

Revenue across all industry sectors increased in 2006 when compared to 2005, except for the Public sector. Financial Services sector revenue increased 5.3 percent driven by Banking (8.5 percent). Public sector revenue decreased 1.5 percent driven by a 15.0 percent decline in the Education industry. Industrial sector revenue increased 0.6 percent driven by Chemical and Petroleum (16.3 percent), partially offset by decreased revenue from Automotive (4.2 percent). Distribution sector revenue increased 2.3 percent driven by Consumer Products (8.0 percent) and Retail (3.2 percent) industries, partially offset by decreased revenue in Travel and Transportation (3.2 percent). Communications sector revenue increased 2.5 percent on the strength of increased Utilities revenue (11.7 percent). Small and Medium Business increased 6.0 percent in 2006 versus 2005 with growth in all geographic markets and enabled by growth in the company’s ibm.com channel.

The following geographic, regional and country-specific revenue performance and the table above excludes OEM revenue, which is presented separately.

Adjusted for currency, revenue increased in all geographic markets in 2006 when compared with 2005, with the strongest growth coming from the Americas.

Americas revenue grew 4.7 percent as reported (4 percent adjusted for currency), with growth in all regions. From a product

perspective, the increased revenue was driven by software. Latin America led the regions with growth of 14.4 percent (9 percent adjusted for currency). Brazil grew 18.9 percent (8 percent adjusted for currency). The U.S. increased 3.6 percent and Canada grew 6.5 percent (flat adjusted for currency).

EMEA revenue increased 3.2 percent (2 percent adjusted for currency) in 2006 when compared with 2005, with revenue growth in all the major countries, except Germany. Revenue increased in the U.K. 3.0 percent (1 percent adjusted for currency), France 4.0 percent (2 percent adjusted for currency), Spain 4.1 percent (2 percent adjusted for currency) and Italy 3.6 percent (2 percent adjusted for currency). Germany declined a modest 0.3 percent as reported (2 percent adjusted for currency) in 2006 when compared to 2005. Russia grew 21.1 percent (21 percent adjusted for currency).

Asia Pacific revenue declined 0.8 percent (increased 2 percent adjusted for currency) in 2006 versus the prior year. Although Japan revenue declined 7.5 percent (2 percent adjusted for currency), its performance improved sequentially throughout 2006 and returned to growth in the fourth quarter. Partially offsetting the revenue decline in Japan was growth in other Asia Pacific regions. China grew 15.8 percent (14 percent adjusted for currency), Korea grew 14.2 percent (6 percent adjusted for currency) and India increased 38.5 percent (42 percent adjusted for currency).

For the year, the company benefited from solid contributions from the emerging countries of Brazil, India, Russia and China. Collectively, revenue from these four countries increased 20.5 percent (16 percent adjusted for currency) in 2006 versus 2005.

OEM revenue increased 17.9 percent (18 percent adjusted for currency) in 2006 versus 2005 driven by strong game processor demand in the Microelectronics business.

Total Global Services revenue increased 1.8 percent in 2006 versus 2005. The increase was driven by GTS (2.4 percent) and GBS (0.4 percent). The increase in GTS was driven by Strategic Outsourcing (3.2 percent) and BTO (17.2 percent), partially offset by a decline in ITS revenue of 1.8 percent.

Overall, Hardware revenue declined as reported in 2006 compared to 2005 due to the divestiture of the Personal Computing business. Systems and Technology Group revenue increased 4.7 percent as System z revenue increased 7.8 percent and MIPS (millions of instructions per second) volumes increased 11 percent versus 2005. System Storage revenue increased 6.4 percent as Total disk grew 7.8 percent driven by midrange disk (16.5 percent), while tape products revenue increased 3.1 percent. Microelectronics revenue increased 21.9 percent driven by strong demand in games processors and networking components. System x increased 3.7 percent compared to 2005 driven by increased revenue for servers (5.3 percent) and Blades (22.3 percent). Retail Stores Solutions revenue increased 21.4 percent versus 2005. These increases were partially offset by declines in System i servers (15.0) percent, System p servers (1.1 percent), Printing Systems (7.6 percent) and E&TS (16.2 percent).

Personal Computing Division had no revenue in 2006 versus four months of revenue in 2005. See note C, “Acquisitions/Divestitures,” on pages 77 and 78 for additional information.

Software revenue increased 8.2 percent in 2006 versus 2005 driven by growth in the company’s Key Branded Middleware offerings (17.1 percent), partially offset by lower Operating Systems revenue (6.3 percent). The Key Branded Middleware growth was driven by strong performance in the WebSphere family of products (23.3 percent) and Tivoli (26.3 percent). All five brands in Key Branded Middleware had double-digit revenue growth in 2006 versus 2005 with the exception of Rational which grew 4.4 percent.

Global Financing revenue decreased 1.1 percent in 2006 versus 2005 due to lower remarketing equipment sales, partially offset by an increase in financing revenue. See pages 49 through 53 for additional information regarding Global Financing.

Gross Profit

					YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006		2005		CHANGE
Consolidated Gross
Profit Margins:
Global Services	27.5	%	26.0	%	1.5	pts.
Hardware	37.0		35.1		1.9
Software	85.2		84.9		0.3
Global Financing	50.3		54.7		(4.4	)
Other	(13.2	)	45.2		(58.4	)
Total	41.9	%	40.1	%	1.8	pts.

The increase in the overall Global Services gross profit margin was primarily due to benefits from the company’s productivity initiatives and cost efficiencies, including improved utilization. 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. The absence of the Personal Computing business contributed 3.5 points to the increase in the 2006 hardware margin. This increase was partially offset by a 2.7 point decline in the Systems and Technology Group margin in 2006 versus 2005.

The decrease in Global Financing gross profit margin was primarily driven by lower financing margins due to higher borrowing costs related to the external interest rate environment.

In addition, an increase in retirement-related plan costs of approximately $235 million partially offset by a decrease in stock-based compensation costs of approximately $114 million compared to 2005 also impacted overall segment margins. See “Segment Details” discussion on pages 29 to 32 for further details on gross profit.

Expense

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Total expense and other income	$	24,978		$	24,306		2.8	%
Expense to Revenue (E/R)	27.3		%	26.7		%	0.7	pts.

Total expense and other income increased 2.8 percent (2.4 percent adjusted for currency) in 2006 versus 2005. Overall, the increase was primarily due to increased Research, development and engineering expense driven by acquisitions and lower Other (income) and expense driven by the gain associated with the sale of the Personal Computing business and the Microsoft settlement in 2005. These increases were partially offset by lower Selling, general and administrative expense due primarily to the restructuring charges recorded in the second quarter of 2005. The expense-to-revenue ratio increased 0.7 points to 27.3 percent in 2006, as revenue increased 0.3 percent and expense increased 2.8 percent in 2006 versus 2005. For additional information regarding the increase in Total expense and other income, see the following analyses by category:

SELLING, GENERAL AND ADMINISTRATIVE

(Dollars in millions)

									YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006				2005*				CHANGE
Selling, general and administrative expense:
Selling, general and administrative—base	$		17,459		$		16,620		5.0	%
Advertising and promotional expense	1,195				1,284				(6.9	)
Workforce reductions—ongoing	289				289				0.4
Restructuring	(7			)	1,482				NM
Amortization expense—acquired intangibles	208				218				(4.5	)
Retirement-related expense	587				846				(30.6	)
Stock-based compensation	541				606				(10.7	)
Bad debt expense	(13			)	(31			)	(57.2	)
Total	$	20,259			$	21,314			(4.9%	)

* Reclassified to conform with 2006 presentation.

NM—Not meaningful

Total Selling, general and administrative (SG&A) expense decreased 4.9 percent (5.3 percent adjusted for currency). The decrease was primarily driven by the restructuring charges recorded in the second quarter of 2005. See note R, “2005 Actions” on pages 93 and 94 for additional information. In addition, retirement-related expense and stock-based compensation expense (see “Retirement-Related Benefits” and “Stock-Based Compensation” on pages 27 and 28 for additional information) decreased in 2006 versus 2005. These decreases were partially offset by increased operational expenses (SG&A-base) as a result of strategic acquisitions and investments the company is making in its software and services businesses as well as emerging countries. The returns on these investments are reflected in the revenue growth in the company’s key middleware brands and emerging countries during 2006 and strong services signings in the fourth quarter.

OTHER (INCOME) AND EXPENSE

(Dollars in millions)

									YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006				2005*				CHANGE
Other (income) and expense:
Foreign currency transaction (gains)/losses	$		(130	)	$		218		NM
Losses on derivative instruments	135				4				NM
Interest income	(536			)	(307			)	74.8	%
Net gains from securities and investments assets	(40			)	(111			)	(63.9	)
Net realized gains from certain real estate activities	(41			)	(179			)	(77.2	)
Restructuring	(7			)	230				NM
Lenovo/Microsoft gains	(45			)	(1,883			)	(97.6	)
Other	(102			)	(93			)	9.6
Total	$	(766		)	$	(2,122		)	(63.9%	)

* Reclassified to conform with 2006 presentation.

NM—Not meaningful

Other (income) and expense was net income of $766 million and $2,122 million in 2006 and 2005, respectively. The decrease in net income was primarily driven by the gain on the sale of the company’s Personal Computing business recorded in 2005. The pre-tax gain associated with this transaction was $1,108 million. See note C, “Acquisitions/Divestitures” on pages 77 and 78 for additional information. In addition, the company settled certain antitrust issues with the Microsoft Corporation in 2005 and the gain from this settlement was $775 million. The company also had lower income from certain real estate activities, as 2005 had unusually high gains from a few large real estate transactions. These decreases in income were partially offset by additional Interest income generated by the company in 2006; foreign currency transaction gains in 2006 versus losses in 2005 and real estate related restructuring charges recorded in the second quarter of 2005. See note R, “2005 Actions” on pages 93 and 94 for additional information. The Losses on derivative instruments relate to losses on certain hedge contracts offset by settlement of foreign currency receivables and payables. See “Currency Rate Fluctuations,” on page 47 for additional discussion of currency impacts on the company’s financial results.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

RESEARCH, DEVELOPMENT AND ENGINEERING

(Dollars in millions)

					YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006		2005		CHANGE
Research, development and engineering:
Total	$	6,107	$	5,842	4.5	%

The increase in Research, development and engineering (RD&E) was primarily driven by acquisitions and the company’s investments to maintain its technology leadership across the product offerings. Software spending increased $210 million and Systems and Technology spending increased $92 million in 2006 versus 2005. These increases were partially offset by the
year-to-year reduction in the Personal Computing Division of $52 million due to the divestiture of that business in the prior year. Retirement-related expense increased $32 million in 2006 versus 2005, partially offset by lower stock-based compensation expense of $18 million.

INTELLECTUAL PROPERTY AND CUSTOM DEVELOPMENT INCOME

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Intellectual property and custom development income:
Sales and other transfers of intellectual property	$		167	$		236	(29.1	)%
Licensing/royalty-based fees	352			367			(4.1	)
Custom development income	381			345			10.5
Total	$	900		$	948		(5.0	)%

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. There were no significant IP transactions in 2006 and 2005.

INTEREST EXPENSE

(Dollars in millions)

					YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006		2005		CHANGE
Interest expense:
Total	$	278	$	220	26.6	%

The increase in Interest expense was primarily driven by higher effective interest rates in 2006 versus 2005. Interest expense is presented in Cost of Global Financing in the Consolidated Statement of Earnings only if the related external borrowings are to support the Global Financing external business. See page 52 for additional information regarding Global Financing debt and interest expense.

Stock-Based Compensation

Total pre-tax stock-based compensation expense of $846 million decreased $189 million compared to 2005. The decrease was principally the result of: (1) a reduction in the level and fair value of stock option grants ($284 million), (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 No. 123(R) ($18 million), offset by (3) increased expense for performance-based stock units ($34 million) resulting from changes in the probabilities of achieving performance metrics and (4) an increase in the level of restricted stock units ($78 million). The effects on pre-tax stock-based compensation expense of the 2005 sale of the Personal Computing business were recorded in Other (income) and expense above and in the Consolidated Statement of Earnings for the year ended December 31, 2005. The year-to-year reductions in pre-tax compensation expense were reflected in the following categories: Cost ($114 million); Selling, general and administrative expense ($65 million); Research, development and engineering ($18 million) and an increase in Other (income) and expense ($8 million).

There was no significant capitalized stock-based compensation expense at December 31, 2006 and 2005.

See note U, “Stock-Based Compensation,” on page 96 to 100 for additional information on the company’s stock-based incentive awards.

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 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)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005*			CHANGE
Retirement-related plans cost:
Defined benefit and contribution pension plans cost	$		2,040	$		1,726	18.2	%
Nonpension postretirement plans costs	388			379			2.4
Plan amendments/curtailments	—			332			NM
Total	$	2,428		$	2,437		(0.4%	)

* Reclassified to conform with 2006 presentation.

NM—Not meaningful

Overall, retirement-related plan costs decreased $9 million versus 2005. The 2005 retirement-related plan costs included $332 million related to unique items: a curtailment charge of $267 million recorded in the fourth quarter as a result of U.S. pension plan amendments and a $65 million charge recorded in the second quarter related to the

company’s restructuring actions. These non-recurring charges were recorded in SG&A ($318 million) and Other (income) and expense ($14 million). This decrease year to year in retirement-related plan costs was essentially offset by an increase in the recognition of previously deferred actuarial losses in accordance with SFAS No. 87,“Employers’ Accounting for Pensions.”

Retirement-related expense within SG&A decreased $262 million year to year: a $318 million decrease as a result of the prior year charges discussed above, offset by recurring plan cost increases of $56 million versus 2005. Other (income) and expense decreased $14 million as discussed above. Increases year to year in Cost and RD&E expense of approximately $235 million and $32 million, respectively, were a result of recurring plan cost increases. See note V, “Retirement-Related Benefits,” on pages 100 to 111 for additional information of the company’s benefit plans including a description of the plans, plan financial information and assumptions.

Acquired Intangible Asset Amortization

The company has been investing in targeted acquisitions primarily within its Software and Global Services segments to increase its capabilities in higher value market segments. The following table presents the total acquired intangible asset amortization included in the Consolidated Statement of Earnings. See note I, “Intangible Assets Including Goodwill,” on pages 80 and 81 for additional information.

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Cost:
Software	$		81	$		118	(30.9	)%
Global Services	23			27			(15.3	)
Hardware	3			4			(16.7	)
Selling, general and administrative expense	208			218			(4.5	)
Total	$	316		$	367		(13.9	)%

Income Taxes

The provision for income taxes resulted in an effective tax rate of 29.3 percent for 2006, compared with the 2005 effective tax rate of 34.6 percent. The 5.3 point decrease in the 2006 effective tax rate was primarily attributable to the net effect of several items. In 2006, the tax rate was favorably impacted by the absence of the foreign earnings repatriation-related tax charge recorded in the third quarter of 2005 (4.3 points) as well as a benefit from the fourth-quarter 2006 settlement of the U.S. federal income tax audit for the years 2001 through 2003 ( 3.0 points). These benefits were partially offset by a one-time tax cost associated with the 2006 intercompany transfer of certain intellectual property (4.3 points). The remaining items were individually insignificant.

Earnings Per Share

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

										YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006				2005					CHANGE
Earnings per share of common stock:
Assuming dilution:
Continuing operations	$			6.06	$			4.91		23.4	%
Discontinued operations	0.05				(0.01				)	NM
Cumulative effect of change in accounting principle*	—				(0.02				)	NM
Total	$			6.11	$			4.87		25.5	%
Basic:
Continuing operations	$		6.15		$		4.99			23.2	%
Discontinued operations	0.05				(0.02				)	NM
Cumulative effect of change in accounting principle*	—				(0.02				)	NM
Total	$	6.20			$	4.96				25.0	%
Weighted-average shares outstanding (in millions):
Assuming dilution	1,553.5				1,627.6					(4.6	)%
Basic	1,530.8				1,600.6					(4.4	)%

* Reflects implementation of FASB Interpretation No. 47. See note B, “Accounting Changes,” on page 72 for additional information.

NM—Not meaningful

Actual shares outstanding at December 31, 2006 and December 31,2005 were 1,506.5 million and 1,574.0 million, respectively. The average number of common shares outstanding assuming dilution was lower by 74.1 million shares in 2006 versus 2005. The decrease was primarily the result of the company’s common share repurchase program. See note N, “Stockholders’ Equity Activity,” on page 88 for additional information regarding the common share activities. Also see note S, “Earnings Per Share of Common Stock,” on page 95.

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

SEGMENT DETAILS

The following is an analysis of the 2006 versus 2005 reportable segment results. The analysis of 2005 versus 2004 reportable segment results is on pages 39 and 40.

The following table presents each reportable segment’s external revenue as a percentage of total external segment revenue, excluding the Personal Computing business.

FOR THE YEAR ENDED DECEMBER 31:	2006		2005
Global Technology Services	35.6	%	36.0	%
Global Business Services	17.6		18.2
Total Global Services	53.2		54.1
Hardware	24.2		23.9
Global Financing	2.6		2.7
Total Hardware/Financing	26.8		26.7
Software	20.0		19.2
Total	100.0	%	100.0	%

The table below presents each reportable segment’s pre-tax income as a percentage of total reportable segment pre-tax income, excluding the Personal Computing business and the 2005 restructuring charges. Segment pre-tax income includes transactions between the segments that are intended to reflect an arms-length transfer price.

FOR THE YEAR ENDED DECEMBER 31:	2006		2005
Global Technology Services	24.0	%	25.5	%
Global Business Services	12.5		9.5
Total Global Services	36.5		35.0
Hardware	12.7		15.4
Global Financing	10.6		12.2
Total Hardware/Financing	23.3		27.6
Software	40.1		37.4
Total	100.0	%	100.0	%

Global Services

The company’s two services segments, Global Technology Services and Global Business Services had revenue of $48,291 million, an increase of 1.9 percent (2 percent adjusted for currency) in 2006 versus 2005. Revenue growth and the profile of the services business improved throughout 2006.

(Dollars in millions)

						YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005		CHANGE
Global Services segment revenue:	$		48,291	$	47,407	1.9	%

Global Technology Services	$		32,322	$	31,501	2.6	%
Strategic Outsourcing	17,044			16,522		3.2
Integrated Technology Services	7,448			7,538		(1.2	)
Business Transformation Outsourcing	1,845			1,573		17.2
Maintenance	5,986			5,868		2.0
Global Business Services	$	15,969		$	15,906	0.4	%

Global Technology Services revenue increased 2.6 percent (2 percent adjusted for currency) in 2006 versus the prior year period. Total signings in GTS increased 1 percent in 2006 when compared to 2005, with shorter term signings increasing 5 percent while longer term signings were flat.

Revenue from Strategic Outsourcing was up 3.2 percent (3 percent adjusted for currency) due primarily to signings growth in 2005 and a continued focus on increasing services into existing accounts. Signings in 2006 increased 7 percent when compared to 2005.

Integrated Technology Services revenue decreased 1.2 percent (2 percent adjusted for currency) in 2006 versus 2005. The rate of revenue growth in ITS improved during the second half of 2006 reflecting progress from the changes implemented throughout 2006 to improve the ITS business, including streamlining offerings and aligning skills to address higher growth and higher value areas. The acquisition of Internet Security Systems Inc. (ISS), added to the company’s capabilities in security and intrusion protection, and contributed to improved performance in the fourth quarter. ITS signings increased 5 percent in 2006 over the year-ago period.

Business Transformation Outsourcing revenue increased 17.2 percent (17 percent adjusted for currency) in 2006 when compared to 2005. The rate of growth in BTO was negatively impacted by a significant contract renegotiation in 2006 which will continue through the first quarter of 2007. While BTO signings in 2006 decreased 33 percent versus 2005, the company continues to see opportunity within this business, particularly in Finance and Accounting, Human Resources and Procurement.

Maintenance revenue increased 2.0 percent (2 percent adjusted for currency) driven by increased availability services on
non-IBM IT equipment, primarily in the Americas and Asia Pacific geographies.

The GTS segment pre-tax margin was 9.6 percent in 2006, an increase of 1.9 points versus 2005. The improvement was primarily the result of the incremental restructuring charges recorded in the second quarter of 2005 and the continued focus on productivity initiatives. The company is continuing to make investments in sales, delivery and business development skills across the entire set of GTS offerings, as well as investing in strategic outsourcing infrastructure and BTO capabilities.

Global Business Services revenue increased 0.4 percent (1 percent adjusted for currency) in 2006 versus 2005. The rate of year-over-year revenue growth in GBS increased in the second half of 2006 reflecting progress made on actions taken throughout the year that focused on operational transformation and profitable growth initiatives. Total signings in GBS increased 10 percent in 2006. Shorter term signings were up 6 percent; with particular strength in the larger, higher value-add engagements during the second half of the year. Longer term signings increased 17 percent, driven by the Application Management business.

The GBS segment pre-tax margin was 9.8 percent in 2006, an improvement of 5.3 points versus 2005. In addition to the benefits received from the incremental restructuring charges recorded in the second quarter of 2005 (2.6 points of improvement), the margin improvement was driven by improved utilization, better contract management and delivery and stable-to-improved pricing.

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Global Services:
Gross profit	$	13,317		$	12,314		8.1	%
Gross profit margin	27.6		%	26.0		%	1.6	pts.

Global Services gross profit dollars increased primarily due to the benefits from productivity initiatives and cost efficiencies, including benefits resulting from the company’s targeted restructuring action in the second quarter of 2005. Gross profit margin improvement was achieved in each of the services lines of business.

GLOBAL SERVICES SIGNINGS

In 2006, total Global Services signings increased 4 percent year to year to $49,174 million, driven by a 6 percent increase in shorter term signings and a 4 percent increase in longer term signings. Global Technology Services signings were $29,608 million and Global Business Services signings were $19,565 million in 2006. The company’s total Global Services backlog increased to an estimated $116 billion from the 2005 estimated backlog of $111 billion.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2006				2005
Global Technology Services Signings
Longer term*	$			21,337	$			21,355
Shorter term*	8,271				7,886
Total	$			29,608	$			29,242
Global Business Services Signings
Longer term*	$		6,838		$		5,824
Shorter term*	12,727				12,015
Total	$	19,565			$	17,839

* Longer term contracts are generally 7 to 10 years in length and represent SO and BTO contracts as well as GBS contracts with the U.S. Federal government and its agencies and AMS for custom and legacy applications. Shorter term are contracts generally three to nine months in length and represent the remaining GBS offerings of Consulting and Systems Integration, AMS packaged applications and ITS contracts. These amounts have been adjusted to exclude the impact of year-to-year currency changes.

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 is an approximation of constant currency, and 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 include SO, BTO, ITS and GBS 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 revenue equal renewals, and therefore, the company does not think they are as useful a predictor of future performance.

Backlog includes SO, BTO, ITS, GBS, 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.

Hardware

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Hardware segment revenue:	$		21,970	$		23,857	(7.9%	)
Systems and Technology
Group	$	21,970		$	20,981		4.7	%
System z							7.8
System i							(15.0	)
System p							(1.1	)
System x							3.7
System Storage							6.4
Microelectronics							21.9
Engineering & Technology Services							(16.2	)
Retail Store Solutions							21.4
Printing Systems							(7.6	)
Personal Computing Division	—			2,876			NM

NM—Not meaningful

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

Systems and Technology Group revenue increased 4.7 percent (4 percent adjusted for currency) in 2006 versus 2005. System z revenue increased reflecting continued strong customer acceptance of both specialty engines for Linux and Java workloads and traditional mainframe workloads. MIPS shipments increased 11 percent versus 2005. System x revenue increased driven by increased server revenue (5.3 percent) and System x blades growth of 22.3 percent. IBM BladeCenter offers clients unique power and cooling capabilities and the flexibility to efficiently handle various workloads. In addition to the company’s System x blades, the company offers POWER blades and blades utilizing the Cell Broadband Engine. Total blade growth, including System p blades, was 24.6 percent in 2006 versus 2005. Although System p revenue declined for the year, high-end server revenue increased 9.4 percent. In the third quarter the company completed its transition to POWER5+ and expanded the implementation of POWER Quadcore technology to all POWER-based entry level System p products. These transitions allowed the company to sustain the price/performance and virtualization leadership position that has made the company the number one UNIX vendor worldwide. System i revenue declined as the company completed its transition to POWER5+ in the third quarter, however clients continued to leverage their existing capacity.

System Storage revenue growth was driven by Total disk growth of 7.8 percent, while tape grew 3.1 percent in 2006 versus 2005. Within Total disk, mid-range disk revenue increased 16.5 percent and storage area network products increased 10.6 percent, while enterprise products revenue declined 6.7 percent in 2006 versus 2005. The revenue increase in tape products was primarily driven by the new tape security offering which includes unique encryption capabilities.

Microelectronics revenue increased due to strong demand in the game processor business and networking components.

Retail Stores Solutions revenue increased primarily due to clients replacing older technology in favor of integrated retail solutions. Printing Systems revenue decreased due primarily to lower maintenance revenue as a result of a declining install base and lower sales of hardware products.

Personal Computing Division revenue decreased as a result of the company divesting its Personal Computing business to Lenovo on April 30, 2005. The 2006 results do not include any revenue while the 2005 results include four months of revenue. See note C, “Acquisitions/Divestitures,” on pages 77 and 78 for additional information.

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Hardware:
Gross profit	$	8,284		$	8,718		(5.0	)%
Gross profit margin	37.7		%	36.5		%	1.2	pts.

The decrease in gross profit dollars for 2006 versus 2005 was primarily due to the absence of the 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 3.5 points of the improvement in the Hardware margin.

Systems and Technology Group gross profit margins declined 2.7 points to 37.7 percent in 2006 versus 2005. The decline in gross profit margin was driven by revenue mix towards lower margin products in 2006 versus 2005 (2.5 points) and pricing pressure in the company’s low- and mid-range server brands.

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 56) primarily relate to the impact of certain cost hedging transactions (see “Anticipated Royalties and Cost Transactions” on page 84) as well as the ongoing warranty costs associated with the divested Personal Computing business. 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.

Software

(Dollars in millions)

						YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005*		CHANGE
Software segment revenue:	$		18,161	$	16,830	7.9	%
Middleware	$	13,891		$	12,552	10.7	%
Key Branded Middleware	9,369			8,004		17.1
WebSphere family						23.3
Information Management						14.0
Lotus						12.0
Tivoli						26.3
Rational						4.4
Other middleware	4,522			4,548		(0.6	)
Operating systems	2,273			2,426		(6.3	)
Product Lifecycle
Management	1,123			1,077		4.2
Other	873			775		12.7

* Reclassified to conform with 2005 presentation.

Software revenue increased 7.9 percent (7 percent adjusted for currency) in 2006 versus 2005 reflecting strong demand for the company’s industry-leading middleware capabilities. The revenue growth was driven from both organic sources and the company’s targeted acquisitions. The company’s leadership in technology and innovation has allowed it to continue to capitalize on industry trends such as SOA and Information on Demand.

Key Branded Middleware is made up of five key brands which provide an integrated suite for the company’s customers. All five brands grew in 2006, reflecting continued momentum and benefit from the company’s sales and development investments along with additional benefit from acquisitions.

Revenue from the WebSphere family of products increased 23.3 percent (22 percent adjusted for currency) and was led by double-digit growth in WebSphere Application Servers (25.3 percent) and WebSphere Business Integration (22.7 percent) software versus 2005. WebSphere provides the foundation for Web-enabled applications and is a key product set in deploying SOA.

Information Management software helps companies integrate, manage and gain value from their business information. For the year, revenue increased 14.0 percent (13 percent adjusted for currency). Growth was driven by the company’s “Information on Demand” portfolio of software products. The acquisition of File Net Corporation, during the fourth quarter of 2006, also contributed to the growth when compared to the year-ago period.

Lotus revenue increased 12.0 percent (11 percent adjusted for currency) driven by the Notes/Domino family of collaboration products. The company’s Lotus products provide clients with collaborative solutions which enable the integration of people, data and business processes as part of the company’s On Demand and SOA offerings. Customer loyalty to Lotus products remains strong.

Tivoli revenue increased 26.3 percent (25 percent adjusted for currency) with double-digit growth in each of its key segments: Systems Management (24.5 percent), Security (40.8 percent) and Storage (27.4 percent). The acquisitions of Micromuse, Inc. in the first quarter and MRO Software, Inc. in the fourth quarter added to the company’s capabilities in the Tivoli brand and contributed to the revenue growth.

Rational revenue increased 4.4 percent (3 percent adjusted for currency) in 2006 versus 2005, in a slower growing market. Rational software provides customers with products that manage the business process of software and systems delivery.

Revenue from Other middleware products declined 0.6 percent (1 percent adjusted for currency) in 2006. This product set includes more mature products which provide a more stable flow of revenue.

Operating Systems revenue declined 6.3 percent (7 percent adjusted for currency) in 2006 versus 2005. Operating Systems are closely tied to the company’s server products. The decline in revenue was primarily driven by improved price performance in System z operating systems.

Product Lifecycle Management (PLM) revenue increased 4.2 percent (4 percent adjusted for currency) in 2006 versus 2005. This product set benefited from a number of large transactions in the second quarter of 2006.

(Dollars in millions)

							YR. TO YR.
FOR THE YEAR ENDED DECEMBER 31:	2006			2005			CHANGE
Software:
Gross profit	$	15,471		$	14,296		8.2	%
Gross profit margin	85.2		%	84.9		%	0.2	pts.

The increase in Software gross profit dollars and gross profit margin was primarily driven by the 7.9 percent growth in Software revenue.

The Software segment contributed $5.5 billion of pre-tax profit in 2006, an increase of 14.9 percent versus 2005. Pre-tax profit margins improved 1.5 points to 26.9%.

Global Financing

See pages 49 and 50 for a discussion of Global Financing’s revenue and gross profit.

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 33 and 34 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 49 through 53. 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:	2006			2005
Current assets	$		44,660	$		45,661
Current liabilities	40,091			35,152
Working capital	$	4,569		$	10,509
Current ratio	1.11			1.30

Working capital decreased $5,940 million compared to the prior year primarily as a result of an increase in Current liabilities. The key drivers are described below:

Current assets decreased $1,001 million due to:

• Decline of $3,030 million, net of a favorable $202 million currency impact, in Cash and cash equivalents and Marketable Securities due to current-year requirements in pension funding, share repurchase,

Management Discussion	12
Road Map	12
Forward-Looking and Cautionary Statements	13
Management Discussion Snapshot	14
Description of Business	15
Year in Review	22
Prior Year in Review	37
Discontinued Operations	41
Other Information	41
Global Financing	49

Report of Management	54

Report of Independent Registered Public Accounting Firm	55

Consolidated Statements	56

dividend payments, tax payments, acquisitions and capital spending. See Cash Flow analysis below.

• Increase of $2,420 million in short-term receivables driven by:

• increase of $769 million in trade receivables as a result of fourth quarter revenue growth;

• increase of $743 million in financing receivables due to asset growth in commercial financing and customer loans; and

• approximately $1,106 million favorable currency impact.

Current liabilities increased $4,939 million as a result of:

• Increase of $1,686 million in Short-term debt as the company increased commercial paper balances in support of the increased Global Financing asset base discussed above;

• Growth in Deferred income driven by Software ($557 million) and Global Services ($423 million);

• Increase of $1,270 million in Compensation and benefits primarily as a result of SFAS No. 158 implementation; the company is required to record as a current liability the amount of retirement-related benefit payments that will be paid in the coming year ($990 million) that are not covered by retirement plan assets; this would occur in unfunded or under-funded plans; and

• Increase of $615 million in Accounts payable of which $256 million was due to the effects of currency.

Cash Flow

The company’s cash flow from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 58, is summarized in the table below. These amounts include the cash flows associated with the company’s Global Financing business. See pages 49 through 53.

(Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2006			2005
Net cash provided by/(used in) continuing operations:
Operating activities	$	15,019		$		14,914
Investing activities	(11,549		)	(4,423			)
Financing activities	(8,204		)	(7,147			)
Effect of exchange rate changes on cash and cash equivalents	201			(789			)
Net cash used in discontinued operations—operating activities*	(12		)	(40			)
Net change in cash and cash equivalents	$	(4,546	)	$	2,515

* 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 2006 increased $105 million as compared to 2005 driven by the following key factors:

• Increase in net income of $1,559 million;

• Decrease in cash related to deferred income taxes, $461 million, due to the utilization of tax credit carryforwards in 2005;

• Decrease in net gains on asset sales, $1,350 million, driven by the gain related to the Personal Computing business divestiture in 2005;

• Pension assets and liabilities contributed an increase in cash of $878 million, primarily driven by lower pension funding of $549 million ($1,840 million funding of non-U.S. plans in 2006 versus $2,389 million total funding in 2005);

• Increase in cash driven by Accounts payable of $891 million primarily as a result of the Personal Computing business divestiture in 2005; and

• Growth in accounts receivable drove a use of cash of $2,731 million; this was driven by Global Financing receivables ($2,071 million) primarily due to asset growth in the second half of 2006; in addition, the Personal Computing business divestiture contributed to this year-to-year decrease in cash.

Net cash used in investing activities increased $7,126 million on a year-to-year basis driven by:

• Net purchases of marketable securities and other investments of $2,668 million;

• Increased spending of $2,316 million for acquisitions;

• Increase in net capital spending of $1,210 million as a result of a $521 million increase in capital expenditures primarily to support the SO business, and a $677 million decrease in real estate sales versus the prior year; and

• A decline in divestiture related cash proceeds of $932 million: $662 million related to the Personal Computing business divestiture and $268 million received from Hitachi representing the final proceeds related to the HDD business sale; both of these payments were received in 2005.

Net cash used in financing activities increased $1,057 million compared to 2005 as a result of:

• Higher dividend payments of $434 million as a result of the increase in the company’s quarterly common stock dividend from $0.20 to $0.30 per share; and

• Increase in net cash used to retire debt of $730 million.

Within total debt, on a net basis, the company utilized $121 million in net cash to retire debt versus $609 million in net proceeds from new debt in 2005. The net cash used in 2006 to retire debt was comprised of: $3,400 million in cash payments to retire debt offset by $1,444 million of new debt issuances and $1,834 million in net short-term borrowings. See note K, “Borrowings” on pages 81 to 83 for a listing of the company’s debt securities.

Non-Current Assets and Liabilities

(Dollars in millions)

AT DECEMBER 31:	2006		2005
Non-current assets	$	58,574	$	60,087
Long-term debt	$	13,780	$	15,425
Non-current liabilities (excluding debt)	$	20,857	$	22,073

The decrease in Non-current assets of $1,513 million compared to the prior year-end balance was primarily driven by:

• A decline of $9,996 million ($10,776 million excluding the effects of currency) in Prepaid pension assets primarily attributable to the implementation of SFAS No. 158 which requires that only overfunded plans ( fair value of plan assets exceed the benefit obligation) be recognized as a Prepaid pension asset for the excess amount.

The significant decline in Prepaid pension assets was offset by increases in other non-current asset categories as follows:

• Increase in Goodwill of $3,413 million and $539 million in Intangible assets-net, both driven by the company’s acquisitions in the current year;

• Growth of $440 million in long-term financing receivables due to increased Global Financing volumes;

• Increase of $3,408 million in Investments and sundry assets which was attributable to three key factors:

• increase of $2,048 million in non-current deferred tax assets primarily as a result of SFAS No. 158;

• growth of $451 million in deferred transition costs driven by an increase in long-term services arrangements with clients; and

• $345 million due to increased investments in long-term marketable securities.

Long-term debt decreased $1,644 million primarily due to a reclassification to short-term debt as these items approach maturity. The company continually monitors its liquidity profile and interest rates, and manages its short- and long-term debt portfolios accordingly.

Other non-current liabilities, excluding debt, decreased $1,216 million due to decreases of $951 million ($1,145 million before the effects of currency) in non-current deferred tax liabilities and $226 million ($858 million before the effects of currency) in Retirement and nonpension postretirement benefit obligations primarily due to the implementation of SFAS No. 158.

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:	2006			2005
Total company debt	$	22,682		$	22,641
Non-Global Financing debt*	$	395		$	2,142
Non-Global Financing debt/capitalization	1.5		%	6.7		%

* 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 50.

Non-Global Financing debt decreased $1,747 million and the debt-to-capital ratio at December 31, 2006 was at 1.5 percent. Non-Global Financing debt decreased versus 2005 as the company paid down debt, including debt used in 2005 to facilitate the company’s repatriation actions under the American Jobs Creation Act of 2004.

Equity

(Dollars in millions)

AT DECEMBER 31:

2006

2005