EX-13 4 a2181836zex-13.htm EXHIBIT 13

 

Report of Financials

 

International Business Machines Corporation and Subsidiary Companies

 

Management Discussion

 

Road Map

14

Forward-Looking and Cautionary Statements

15

Management Discussion Snapshot

16

Description of Business

17

Year in Review

23

Prior Year in Review

37

Discontinued Operations

42

Other Information

42

Looking Forward

42

Liquidity and Capital Resources

44

Critical Accounting Estimates

47

Currency Rate Fluctuations

49

Market Risk

49

Financing Risks

50

Employees and Related Workforce

50

Global Financing

50

 

 

Report of Management

56

Report of Independent Registered Public Accounting Firm

57

 

 

Consolidated Financial Statements

 

Earnings

58

Financial Position

59

Cash Flows

60

Stockholders’ Equity

61

 

 

Notes to Consolidated Financial Statements

 

A

Significant Accounting Policies

64

B

Accounting Changes

73

C

Acquisitions/Divestitures

76

D

Financial Instruments (excluding derivatives)

82

E

Inventories

83

F

Financing Receivables

83

G

Plant, Rental Machines and Other Property

84

H

Investments and Sundry Assets

84

I

Intangible Assets Including Goodwill

84

J

Borrowings

85

K

Derivatives and Hedging Transactions

88

L

Other Liabilities

91

M

Stockholders’ Equity Activity

92

N

Contingencies and Commitments

94

O

Taxes

97

P

Research, Development and Engineering

99

Q

2005 Actions

99

R

Earnings Per Share of Common Stock

101

S

Rental Expense and Lease Commitments

101

T

Stock-Based Compensation

102

U

Retirement-Related Benefits

105

V

Segment Information

116

W

Subsequent Events

119

 

 

Five-year Comparison of Selected Financial Data

120

Selected Quarterly Data

121

Performance Graphs

122

Board of Directors and Senior Executive Officers

123

Stockholder Information

124

 

13



 

Management Discussion

 

International Business Machines Corporation and Subsidiary Companies

 

Road Map

 

The financial section of the International Business Machines Corporation (IBM or the company) 2007 Annual Report, consisting of this Management Discussion, the Consolidated Financial Statements that follow and the notes related thereto, comprises 109 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. 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 global capabilities include services, software, hardware, fundamental research and financing. The broad mix of businesses and capabilities are combined to provide business insight and solutions for the company’s clients.

 

The business model is flexible, and allows for periodic change and rebalancing. The company has exited commoditizing businesses like personal computers and hard disk drives, and strengthened its position through strategic investments and acquisitions in emerging higher value segments like service oriented architecture (SOA) and Information on Demand. In addition, the company has transformed itself into a globally integrated enterprise which has improved overall productivity and is driving investment and participation in the world’s fastest growing markets. As a result, the company is a higher-performing enterprise today than it was several years ago.

 

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

 

Transparency

 

Transparency is a primary goal of successful financial reporting. The following are several key points for the reader of 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, 2007.

 

·      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 16 and 17, the key messages and details will give readers the ability to quickly assess the most important drivers of performance within this brief overview.

 

·      In the first quarter of 2007, the company changed the presentation of revenue and cost in the Consolidated Statement of Earnings to reflect the categories of Services, Sales and Financing. Previously, the presentation included Global Services, Hardware, Software, Global Financing and an Other category. In the past, these categories were aligned with the company’s reportable segment presentation of external revenue and cost. However, as the company moves toward delivering solutions which bring integrated software and services capabilities to its clients, the alignment between segments and categories will diverge. Therefore, there are situations where the Global Services segments could include software revenue, and conversely, the Software segment may have services revenue. The change was made to avoid possible confusion between the segment revenue and cost presentation and the required category presentation in the Consolidated Statement of Earnings. The change only impacts the format for the presentation of the company’s revenue and cost in the Consolidated Statement of Earnings and does not reflect any change in the company’s reportable segment results or in the company’s organizational structure. The periods presented in this Annual Report are reported on a comparable basis. The Management Discussion and Analysis of revenue and gross profit from continuing operations will focus on the segment view, as this is how the business is managed and is the best reflection of the company’s operating results and strategy.

 

·      On January 29, 2008, IBM International Group Capital LLC, an indirect, wholly owned subsidiary of the company, issued
$3.5 billion of 18-month floating rate notes. The proceeds will be utilized to reduce the 364-day bridge loan associated with the 2007 accelerated share repurchase (ASR). (See pages 31 and 32 for additional information.) In the Consolidated Statement of Financial Position included in the company’s press release and Form 8-K filing on January 17, 2008, the company classified the $3.5 billion related to the 364-day bridge loan as Short-term debt. As a result of this refinancing in January, and consistent with the

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

14



provisions of Statement of Financial Accounting Standards (SFAS) No. 6, “Classification of Short-Term Obligations Expected to Be Refinanced,” the company has classified this amount as Long-term debt in its Consolidated Statement of Financial Position on page 59.

 

·      Effective December 31, 2006, the company adopted the provisions of 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 2006 reported financial position and stockholder’s equity, 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 or financial flexibility. See note U, “Retirement-Related Benefits,” on pages 105 to 116 for additional information, including 2007 impacts.

 

·      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 81 and 82. As a result of this divestiture, the company’s reported financial results do not include any activity in 2007 and 2006, but includes 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. Therefore, in the Management Discussion, within the “Prior Year in Review” section on pages 38 to 41, the company has presented an analysis of revenue both on an as-reported basis and on a basis that excludes the revenues from the divested Personal Computing business from the 2005 period. The company believes that the analysis that excludes the Personal Computing revenues is a better indicator of operational revenue performance on an ongoing basis.

 

·      The reference to “adjusted for currency” in the Management Discussion is made so that certain financial results can be viewed without the impacts of fluctuating foreign currency exchange rates and therefore facilitates a comparative view of business performance. See “Currency Rate Fluctuations” on page 49 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.

 

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 V, “Segment Information,” on pages 116 to 119.

 

·      Global Financing is a reportable segment that is measured as if it were a standalone entity. A separate “Global Financing” section is included beginning on page 50. This section is separately presented given this segment’s unique impact on the company’s financial condition and leverage, and the information presented in this section is consistent with this separate company view.

 

·      Pages 58 through 63 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 items, the notes contain the company’s accounting policies (pages 64 to 73), acquisitions and divestitures (pages 76 to 82), detailed information on specific items within the financial statements, certain contingencies and commitments (pages 94 through 96), and the results of each reportable
segment (pages 116 to 119).

 

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 42 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 2007 Form 10-K filed on February 26, 2008.

 

15



 

Management Discussion Snapshot

 

 

 

 

 

 

 

YR.-TO-YR.

 

 

 

 

 

 

 

PERCENT/

 

($ and shares in millions except per share amounts)

 

 

 

 

 

MARGIN

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Revenue

 

$

98,786

 

$

91,424

 

8.1

%*

Gross profit margin

 

42.2

%

41.9

%

0.4

pts.

Total expense and other income

 

$

27,240

 

$

24,978

 

9.1

%

Total expense and other income to revenue ratio

 

27.6

%

27.3

%

0.3

pts.

Income from continuing operations before income taxes

 

$

14,489

 

$

13,317

 

8.8

%

Provision for income taxes

 

$

4,071

 

$

3,901

 

4.4

%

Income from continuing operations

 

$

10,418

 

$

9,416

 

10.6

%

Net income

 

$

10,418

 

$

9,492

 

9.7

%

Net income margin

 

10.5

%

10.4

%

0.2

pts.

Earnings per share of common stock:

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

Continuing operations

 

$

7.18

 

$

6.06

 

18.5

%

Discontinued operations

 

(0.00

)

0.05

 

NM

 

Total

 

$

7.18

 

$

6.11

 

17.5

%

Weighted-average shares outstanding:

 

 

 

 

 

 

 

Diluted

 

1,450.6

 

1,553.5

 

(6.6

)%

Assets**

 

$

120,431

 

$

103,234

 

16.7

%

Liabilities**

 

$

91,962

 

$

74,728

 

23.1

%

Equity**

 

$

28,470

 

$

28,506

 

(0.1

)%


* 4.2 percent adjusted for currency.

** At December 31.

NM — Not meaningful

 

Continuing Operations

 

The company’s performance in 2007 reflected the strength of its global model. Revenue increased in all geographies, with strong growth in emerging markets worldwide. The company capitalized on the opportunities in the global economies, generating 63 percent of its revenue outside the United States, in delivering full-year growth of 8.1 percent (4 percent adjusted for currency).

 

Gross profit margins improved reflecting a shift to higher value offerings and continued benefits from productivity initiatives and the transformation to a globally integrated enterprise. Pre-tax income from continuing operations grew 8.8 percent and net income from continuing operations increased 10.6 percent versus 2006. Diluted earnings per share improved 18.5 percent, reflecting the strong growth in net income and the benefits of the common stock repurchase program. In 2007, the company repurchased approximately $18.8 billion of its common stock, including a $12.5 billion ASR in the second quarter.

 

The increase in 2007 revenue, as compared to 2006, was primarily due to:

 

·      Strong performance from Global Technology Services and Global Business Services with growth in all business lines;

 

·      Continued strong demand in the Software business, driven by Key Branded Middleware products, with positive contributions from strategic acquisitions; and

 

·      Continued growth in emerging countries (Brazil, Russia, India and China: up 26 percent) and solid performance in all geographies, led by Asia Pacific.

 

The increase in income from continuing operations before income taxes in 2007 was primarily due to:

 

·      Revenue growth as discussed above; and

 

·      Gross profit margin improvements in the Global Services and Systems and Technology segments.

 

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public
Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

16



 

The consolidated gross profit margin increased 0.4 points versus 2006 to 42.2 percent. An improvement in the Systems and Technology margin (2.0 points) contributed 0.5 points to the overall margin improvement. This increase was primarily driven by higher margins in System z, System p and System x servers. The Software margin was flat at 85.2 percent, but contributed 0.2 points to the overall margin improvement due to the mix of revenue by segment. The Global Technology Services and Global Business Services margins increased 0.1 points and 0.4 points to 29.9 percent and 23.5 percent, respectively, versus the prior year. Although gross profit margins improved for Global Services, the increased Global Services revenue content contributed to a 0.2 point decline in the consolidated gross margin due to the mix impact. The Global Financing margin declined 3.5 points versus 2006 to 46.7 percent, causing a 0.1 point decline in the overall company margin.

 

Total expense and other income increased 9.1 percent (5 percent adjusted for currency) in 2007 versus 2006. The increase was primarily due to increases in Selling, general and administrative (SG&A) expense and Interest expense. SG&A expense increased $1,801 million primarily due to acquisition related spending, as well as increased investments in emerging countries and the software and services businesses. Interest expense increased $333 million primarily due to higher debt associated with the financing of the ASR. In addition, Other (income) and expense declined $140 million in income year-to-year primarily due to higher losses on derivative instruments.

 

The effective tax rate for 2007 was 28.1 percent, compared with 29.3 percent in 2006.

 

Total assets increased $17,197 million ($12,957 million adjusted for currency) primarily due to increases in Cash and cash equivalents ($6,969 million), Prepaid pension assets ($6,788 million), total financing receivables ($2,729 million) and Goodwill ($1,431 million). These increases were partially offset by decreases in long-term deferred tax assets ($2,367 million) and short-term marketable securities ($1,479 million).

 

Total liabilities increased $17,234 million ($13,642 million adjusted for currency) driven primarily by increases in total debt ($12,592 million), tax liabilities ($1,492 million) and total deferred income ($1,773 million).

 

Stockholders’ equity of $28,470 million was essentially flat versus 2006. Increased Treasury stock ($17,649 million) from share repurchases, which included the ASR, was largely offset by increased Retained earnings ($8,208 million) driven by Net income, increased Common stock ($3,917 million) related to stock options and a decline in Accumulated gains and (losses) not affecting retained earnings ($5,487 million) primarily due to the effects of pension remeasurements.

 

The company generated $16,094 million in cash flow provided by operating activities, an increase of $1,075 million compared to 2006, primarily driven by increased Net income. Net cash used in investing activities of $4,675 million was $6,874 million lower than 2006 driven primarily by proceeds from disposition of short-term marketable securities and a reduction in cash used for acquisitions. Net cash used in financing activities of $4,740 million decreased $3,464 million versus 2006 driven by increased net proceeds from total debt ($12,233 million), partially offset by increased share repurchases ($10,744 million).

 

Global Services signings were $50 billion in 2007 as compared to $49 billion in 2006. The Global Services backlog is estimated to be $118 billion at December 31, 2007, versus $116 billion at December 31, 2006.

 

For additional information and details, see the “Year in Review” section on pages 23 to 37.

 

Description of Business

 

Please refer to IBM’s Annual Report on Form 10-K filed on February 26, 2008, with the SEC for a more detailed version of this Description of Business, especially Item 1A. entitled “Risk Factors.”

 

IBM is a globally integrated enterprise that targets the intersection of technology and effective business. The company seeks to be a partner in its clients’ success by enabling their own capacity for distinctive innovation. 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.

 

17



 

IBM’s Strategy

 

In IBM’s view, today’s networked economy has created a global business landscape and a mandate for business change. Integrated global economies have opened markets of new opportunity and new sources of skills. The Internet has enabled communication and collaboration across the world and brought with it a new computing model premised on continuous global connection. In that landscape, companies can distribute work and technology anywhere in the world.

 

Given these opportunities, IBM is working with its clients to develop new business designs and technical architectures that allow their businesses the flexibility required to compete in this new landscape. The business is also adjusting its footprint toward emerging geographies, tapping their double-digit growth, providing the technology infrastructure they need, and taking advantage of the talent pools they provide to better service the company’s clients.

 

IBM’s strategy addresses this new era and delivers value to its clients through three strategic priorities:

 

FOCUS ON OPEN TECHNOLOGIES AND HIGH-VALUE SOLUTIONS

 

The PC era has ended, representing a fundamental shift in the technology requirements of the company’s clients. IBM is well positioned to provide its enterprise clients the open technologies and high-value solutions they will need to compete.

 

·      IBM is leveraging its leadership position in the convergence of software and services, in SOA, in virtualization, in high-performance chips, in open and modular IT— continuing its shift from commoditizing segments to higher value segments with better profit opportunity.

 

·       The company continues to be a leading force in open source solutions to enable its clients to achieve higher levels of interoperability, cost efficiency and quality.

 

DELIVER INTEGRATION AND INNOVATION TO CLIENTS

 

Changes in the market have caused IBM’s clients to seek flexibility and innovation in everything from technical architecture to their business model. In response, IBM is focused on delivering integration and innovation to its clients — offering them technologies and services that support real value creation.

 

·      IBM has a long heritage of transforming the business operations of large enterprises and has earned the trust to be their innovation partner and global integrator.

 

·      The company has a deep set of global assets and capabilities it is applying to improve services profitability, both for its clients and for itself.

 

BECOME THE PREMIER GLOBALLY INTEGRATED ENTERPRISE

 

As global networks and technology capabilities change business economics, legacy business designs can quickly become noncompetitive. IBM believes a globally integrated enterprise, designed for this new landscape can compete effectively and will benefit from the opportunities offered.

 

·      To reshape its business for the global economy, IBM has replaced vertical hierarchies with horizontally integrated teams.

 

·      Across the business, the company has made significant investments in emerging markets, taking core processes and functions that were once managed regionally and shifting them to a globally integrated model.

 

Looking forward, IBM is confident it understands the economic shift of globalization, the evolution of the new computing model and the powerful role of innovation in this new landscape. Its unique capabilities are well adapted to help the company’s clients innovate and compete effectively in the new landscape.

 

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

18



GRAPHIC

 

Business Segments and Capabilities

 

The company’s major operations comprise a Global Technology Services segment; a Global Business Services segment; a Systems and Technology segment; a Software segment; and a Global Financing segment.

 

Global Services is a critical component of the company’s strategy of providing IT infrastructure and business 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 IT infrastructure services and business process services, delivering value through the company’s global scale, standardization and automation.

 

GTS Capabilities

 

Strategic Outsourcing Services. Comprehensive IT services integrated with business insight working with clients to reduce costs and improve productivity through the outsourcing of processes and operations.

 

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

 

Integrated Technology Services. 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.

 

GLOBAL BUSINESS SERVICES (GBS) segment primarily reflects professional services and application outsourcing services, delivering business value and innovation to clients through solutions which leverage industry- and business-process expertise.

 

GBS Capabilities

 

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

 

19



 

Application Management Services. Application development, management, maintenance and support services for packaged software, as well as custom and legacy applications. Delivering value through the company’s global resource capabilities, industry knowledge, and the standardization and automation of application development.

 

SYSTEMS AND TECHNOLOGY segment provides IBM’s clients with business solutions requiring advanced computing power and storage capabilities. Approximately 55 percent of the Systems and Technology’s server and storage sales transactions are through the company’s business partners; approximately 45 percent are direct to end-user clients, more than 40 percent of which are through the Internet at ibm.com. In addition, Systems and Technology 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, systems hardware is also deployed to support services solutions.

 

Systems and Technology Capabilities

 

Servers. IBM systems, which are typically connected to a network and provide the required infrastructure for business. These systems use both IBM and non-IBM operating systems and all IBM servers can also run Linux, a key open source operating system. (System z, System i, System p, System x and BladeCenter).

 

Storage. Information infrastructure products and solutions, which address critical client requirements for information retention and archiving, availability and virtualization, and security and compliance. The portfolio consists of a broad range of disk and tape storage systems and software.

 

Microelectronics. Semiconductor design and manufacturing for use in IBM systems and for sale to external clients.

 

Engineering and Technology Services. System and component design services, Blue Gene “supercomputer systems,” outsourcing of clients’ design teams and technology and manufacturing consulting services.

 

Retail Store Solutions. Point-of-sale retail systems (network connected cash registers) as well as solutions which connect them to other store systems (for example, inventory).

 

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 two-thirds of external software segment revenue is annuity-based, coming from recurring license charges and ongoing subscription and support from one-time charge (OTC) arrangements. The remaining one-third of external revenue relates to OTC arrangements, in which the client pays one up-front payment for a perpetual license. 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.

 

Software Capabilities

 

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

 

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

 

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.

 

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

 

Rational Software. Software tools that help clients manage their software development processes and capabilities.

 

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

 

GLOBAL FINANCING is described on pages 50 and 51.

 

Global Financing Capabilities

 

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.

 

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

20



 

IBM Worldwide Organizations

 

The following worldwide organizations play key roles in IBM’s delivery of value to its clients:

 

·      Sales and Distribution Organization

 

·      Research, Development and Intellectual Property

 

·      Integrated Operations

 

SALES AND DISTRIBUTION ORGANIZATION

 

The company’s Sales and Distribution organization manages a strong global footprint, with dedicated country based operating units focused on delivering client value. Within these units, client relationship professionals work with integrated teams of consultants, product specialists and delivery fulfillment teams to improve clients’ business performance. These teams deliver value by understanding the client’s business and needs, and then bring together capabilities from across IBM and an extensive network of Business Partners to develop and implement solutions for clients.

 

By combining global expertise with local experience, IBM’s geographic structure enables dedicated management focus for local clients, speed in addressing new market opportunities and timely investments in emerging opportunities. The geographic units align industry-skilled resources to serve clients’ agendas. IBM extends capabilities to mid-market client segments by leveraging industry skills with marketing, ibm.com and local Business Partner resources.

 

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

 

RESEARCH, DEVELOPMENT AND INTELLECTUAL PROPERTY

 

IBM’s research and development (R&D) operations differentiate the company from its competitors. IBM annually spends approximately $6 billion for R&D, focusing its investments in high-growth, high-value opportunities. In 2007, 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 2007 than any other company. This marks the 15th 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.

 

INTEGRATED OPERATIONS

 

IBM’s ability to deliver differentiating innovation to its clients is being greatly enhanced by the company’s global integration which is simultaneously giving the company better economics and deeper capabilities, while eliminating redundancies that were built up over fifty years as a growing multinational enterprise. The company operates in 170 countries, with approximately 69 percent of its employees outside the U.S. As a globally integrated enterprise, the company organizes work based on the right costs, the right skills and the right business environment, integrating deeply with its partners, suppliers and clients. Being global is about gaining access to talent and skills and then scaling them globally to develop new, distinctive capabilities. The company’s integrated operations enable IBM to be the most efficient, responsive and globally integrated enterprise — able to instantly leverage its expertise and capabilities — anywhere, at any time. Although bound by a common mission and principles, Integrated Operations is comprised of three distinct units, each with very specific objectives closely aligned with the IBM businesses they support.

 

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 operate clients’ end-to-end supply-chain processes, from procurement to logistics.

 

21


 

IBM spends approximately $38 billion annually through its supply chain, procuring materials and services around the world. The company’s supply, manufacturing and logistics and customer fulfillment operations are integrated in one operating unit that has reduced inventories, improved response to marketplace opportunities and external risks and converted fixed to variable costs. Simplifying and streamlining internal processes has improved operations, sales force productivity and processes, and these actions have improved client satisfaction.

 

Integrated Technology Delivery

 

Integrated Technology Delivery (ITD) brings together all of the company’s worldwide service delivery capabilities for Strategic Outsourcing with strong local and regional management teams supported by a set of global competencies. ITD leverages the company’s global scale and advanced technology to deliver standardized solutions that are automated, repeatable and globally integrated. Through the company’s global position, clients gain cost advantages, access to industry-leading skills and access to IBM’s scale and overall flexibility. ITD manages the world’s largest privately-owned IT infrastructure with employees in over 30 countries supporting over 400 data centers.

 

Integrated Managed Business Process Delivery

 

Integrated Managed Business Process Delivery (IMBPD) provides highly efficient, world-class delivery capabilities in IBM’s business process delivery operations, which include Business Transformation Outsourcing, Business Process Outsourcing, Business Process Services and Application on Demand. IMBPD has employees and delivery centers in over 40 countries worldwide.

 

Key Business Drivers

 

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

 

ECONOMIC ENVIRONMENT AND CORPORATE SPENDING BUDGETS

 

Global demand for systems, software and services is a key driver of the company’s business and financial performance. 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- and industry-specific solutions, business performance and open standards.

 

INTERNAL BUSINESS TRANSFORMATION AND GLOBAL INTEGRATION INITIATIVES

 

IBM is committed to its transformation to a globally integrated enterprise. The company continues to drive greater productivity, flexibility and cost savings by transforming and globally integrating its own business processes and functions. 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.

 

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 cocreation relationships with developers, other companies and other institutions. Examples include IBM’s leadership positions in the design of smaller, faster and energy-efficient semiconductor devices; systems virtualization, Green Data Centers and the design of “grid” computing networks that allow computers to share processing power.

 

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 worldwide.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

22



 

Year in Review

 

Results of Continuing Operations

 

SEGMENT DETAILS

 

The following is an analysis of the 2007 versus 2006 reportable segment results. The analysis of 2006 versus 2005 reportable segment results is on pages 39 to 41.

 

The following table presents each reportable segment’s external revenue and gross margin results.

 

 

 

 

 

 

 

YR.-TO-YR.

 

YR.-TO-YR.

 

 

 

 

 

 

 

PERCENT/

 

PERCENT CHANGE

 

($ in millions)

 

 

 

 

 

MARGIN

 

ADJUSTED

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

FOR CURRENCY

 

Revenue:

 

 

 

 

 

 

 

 

 

Global Technology Services

 

$

36,103

 

$

32,322

 

11.7

%

7.4

%

Gross margin

 

29.9

%

29.8

%

0.1

pts.

 

 

Global Business Services

 

18,041

 

15,969

 

13.0

%

9.0

%

Gross margin

 

23.5

%

23.1

%

0.4

pts.

 

 

Systems and Technology

 

21,317

 

21,970

 

(3.0

)%

(5.8

)%

Gross margin

 

39.7

%

37.7

%

2.0

pts.

 

 

Software

 

19,982

 

18,161

 

10.0

%

5.6

%

Gross margin

 

85.2

%

85.2

%

(0.0

)pts.

 

 

Global Financing

 

2,502

 

2,365

 

5.8

%

2.2

%

Gross margin

 

46.7

%

50.3

%

(3.5

)pts.

 

 

Other

 

842

 

637

 

32.1

%

29.5

%

Gross margin

 

4.4

%

5.7

%

(1.4

)pts.

 

 

Total revenue

 

$

98,786

 

$

91,424

 

8.1

%

4.2

%

Gross profit

 

$

41,729

 

$

38,295

 

9.0

%

 

 

Gross margin

 

42.2

%

41.9

%

0.4

pts.

 

 

 

The following table presents each reportable segment’s external revenue as a percentage of total segment revenue and each reportable segment’s pre-tax income as a percentage of total segment pre-tax income.

 

 

 

REVENUE

 

PRE-TAX INCOME*

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

2007

 

2006

 

Global Technology Services

 

36.9

%

35.6

%

23.5

%

24.0

%

Global Business Services

 

18.4

 

17.6

 

13.6

 

12.5

 

Total Global Services

 

55.3

 

53.2

 

37.1

 

36.5

 

Systems and Technology

 

21.8

 

24.2

 

14.2

 

12.7

 

Global Financing

 

2.6

 

2.6

 

9.1

 

10.6

 

Total Systems and Technology/Financing

 

24.3

 

26.8

 

23.3

 

23.3

 

Software

 

20.4

 

20.0

 

39.6

 

40.1

 

Total

 

100.0

%

100.0

%

100.0

%

100.0

%


* Segment pre-tax income includes transactions between segments that are intended to reflect an arm’s-length transfer price.

 

23



 

Global Services

 

The company’s Global Services segments, Global Technology Services and Global Business Services had a combined revenue of $54,144 million, an increase of 12.1 percent (8 percent adjusted for currency) in 2007 when compared to 2006. The Global Services segments delivered combined pre-tax profit of $5,622 million, an increase of 12.6 percent versus the prior year. The company has made considerable progress implementing its strategies across the Global Services offerings. These actions have resulted in improved financial performance with strong and balanced contribution across all geographies and business lines.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Global Services revenue:

 

$

54,144

 

$

48,291

 

12.1

%

Global Technology Services

 

$

36,103

 

$

32,322

 

11.7

%

Strategic Outsourcing

 

18,701

 

17,044

 

9.7

 

Integrated Technology Services

 

8,438

 

7,448

 

13.3

 

Business Transformation Outsourcing

 

2,294

 

1,845

 

24.4

 

Maintenance

 

6,670

 

5,986

 

11.4

 

Global Business Services

 

$

18,041

 

$

15,969

 

13.0

%

 

Global Technology Services (GTS) revenue increased 11.7 percent (7 percent adjusted for currency) in 2007 versus 2006. The strong performance reflects the extensive transformation which has occurred in this business over the past few years. This transformation included revamping the entire Integrated Technology Services (ITS) portfolio, continued improvement in Strategic Outsourcing (SO) delivery and a disciplined approach to driving new business in existing accounts. Total signings in GTS increased 2 percent, with shorter term signings growth of 4 percent and 1 percent growth in longer term signings.

 

SO revenue was up 9.7 percent (5 percent adjusted for currency) with growth in all geographies, led by Europe/Middle East/Africa (EMEA) and Asia Pacific. Revenue growth benefited from prior-year signings, sales of new business in existing accounts, lower base contract erosion and good yield from 2007 signings. SO signings in 2007 decreased 1 percent when compared to 2006.

 

ITS revenue increased 13.3 percent (9 percent adjusted for currency) in 2007 versus 2006. Revenue growth was driven primarily by increased signings and reflects the strength of the ITS portfolio worldwide. The revamped ITS portfolio includes 10 Service Product Lines which complement hardware offerings from Systems and Technology and software offerings from the Software business. The acquisition of Internet Security Systems (ISS), in the fourth quarter of 2006, also contributed to the revenue growth this year. ITS signings increased 4 percent in 2007, with good performance in the key offerings, including Green Data Center, Server Management Services and SOA.

 

Business Transformation Outsourcing (BTO) revenue increased 24.4 percent (20 percent adjusted for currency), with double-digit growth in all geographies. BTO signings increased 17 percent year over year.

 

Maintenance revenue increased 11.4 percent (7 percent adjusted for currency) driven primarily by increased availability services on non-IBM IT equipment. Services provided to InfoPrint Solutions, following the divestiture of the printer business in the second quarter, contributed 4 points of growth.

 

Global Business Services (GBS) revenue increased 13.0 percent (9 percent adjusted for currency) in 2007, with balanced growth across all three geographies. Revenue performance was led by double-digit growth in application management services offerings and growth in all consulting service lines. Total signings in GBS increased 1 percent, led by 5 percent growth in shorter term signings. Longer term signings decreased 7 percent year over year.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Global Services gross profit:

 

 

 

 

 

 

 

Global Technology Services:

 

 

 

 

 

 

 

Gross profit

 

$

10,800

 

$

9,623

 

12.2

%

Gross profit margin

 

29.9

%

29.8

%

0.1

pts.

Global Business Services:

 

 

 

 

 

 

 

Gross profit

 

$

4,240

 

$

3,694

 

14.8

%

Gross profit margin

 

23.5

%

23.1

%

0.4

pts.

 

GTS gross profit increased 12.2 percent compared to 2006, with gross profit margin improving 0.1 points, driven primarily by margin expansion in SO due to an improved cost structure and ITS, which benefited from a mix to higher value offerings. Segment pre-tax profit increased 8.2 percent to $3.6 billion with a pre-tax margin of 9.4 percent, a decline of 0.2 points versus 2006. Increased investments in sales and delivery, acquisitions and restructuring charges were essentially offset by productivity improvements and effective expense management.

 

Transformation actions executed by GBS over the past two years have resulted in profitable growth. GBS gross profit increased 14.8 percent to $4.2 billion in 2007 when compared to 2006, and the gross profit margin improved 0.4 points. Segment pre-tax profit increased 21.0 percent to $2.1 billion with a pre-tax margin of 10.7 percent, an improvement of 0.9 points year over year. The margin expansion has been driven primarily by revenue growth, ongoing productivity and utilization initiatives and expense management.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

24



 

Global Services Signings

 

In 2007, total Global Services signings increased 1 percent year to year to $49,895 million. Shorter term signings were $22,014 million, an increase of 5 percent year to year. Longer term signings decreased 1 percent to $27,880 million, however, the average duration of longer term contracts signed in 2007 was 1.1 years shorter than contracts signed in 2006. Therefore, while longer term signings were essentially flat year to year, the annualized revenue expected from these signings is higher versus the prior year. GTS signings were $30,154 million and GBS signings were $19,741 million in 2007. The total Global Services backlog increased $2 billion from the prior year to an estimated $118 billion.

 

($ in millions)

 

 

 

 

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

Global Technology Services Signings

 

 

 

 

 

Longer term

 

$

21,550

 

$

21,337

 

Shorter term

 

8,604

 

8,271

 

Total

 

$

30,154

 

$

29,608

 

Global Business Services Signings

 

 

 

 

 

Longer term

 

$

6,330

 

$

6,838

 

Shorter term

 

13,411

 

12,727

 

Total

 

$

19,741

 

$

19,565

 

 

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 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 upfront investments, a signing is usually equal to the full contract value. Longer term contracts represent SO and BTO contracts as well as GBS contracts with the
U.S. Federal government and its agencies and Application Management Services (AMS) for custom and legacy applications. Shorter term contracts represent the remaining GBS offerings of Consulting and Systems Integration, AMS for packaged applications and ITS contracts. These amounts have been adjusted to exclude the impact of year-to-year currency changes.

 

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 revenues equal renewals.

 

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 coincidental to an acquisition or divestiture.

 

Systems and Technology

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Systems and Technology revenue:

 

$

21,317

 

$

21,970

 

(3.0

)%

System z

 

 

 

 

 

(11.2

)

System i

 

 

 

 

 

(10.6

)

System p

 

 

 

 

 

8.8

 

System x

 

 

 

 

 

7.0

 

System Storage

 

 

 

 

 

5.1

 

Microelectronics

 

 

 

 

 

(11.8

)

Engineering & Technology Services

 

 

 

 

 

6.5

 

Retail Store Solutions

 

 

 

 

 

14.5

 

Printing Systems

 

 

 

 

 

(63.1

)

 

Systems and Technology revenue decreased 3.0 percent (6 percent adjusted for currency) in 2007 versus 2006. On June 1, 2007, the company completed the divestiture of its printing business to Ricoh. This resulted in the loss of approximately $600 million of Systems and Technology revenue in 2007 when compared to 2006. See note C, “Acquisitions/Divestitures,” on pages 80 and 81 for additional information regarding this divestiture. Systems and Technology revenue, excluding the printing business, was flat (declined 3 percent adjusted for currency) in 2007 versus 2006.

 

25



 

System z revenue decreased 11.2 percent (15 percent adjusted for currency) year to year. System z MIPS (millions of instructions per second) shipments increased 3 percent in 2007 versus 2006. System z revenue declined in the second half of 2007 following a long and successful technology cycle of over two-and-a-half years. The expected announcement and availability of the next generation mainframe is late February 2008.

 

System i revenue decreased 10.6 percent (14 percent adjusted for currency) in 2007 versus 2006. Although System i revenue declined year over year, fourth-quarter 2007 revenue increased 2 percent with growth in POWER6 servers which were introduced late in the third quarter of 2007.

 

System p revenue increased 8.8 percent (5 percent adjusted for currency) in 2007 versus 2006. The increase was primarily driven by strength in mid-range POWER5+ and POWER6 servers, which increased 23 percent in 2007 versus the prior year. System p revenue increased in all geographies, with particular strength in Asia Pacific. In the first quarter of 2008, the company will announce and ship POWER6 technology in System p’s entry segment.

 

System x revenue increased 7.0 percent (3 percent adjusted for currency) in 2007 versus 2006. Revenue performance was driven by System x server products which grew 8 percent and System x blades which increased 16 percent in 2007 versus 2006. The new x86 servers with quad-core processors and BladeCenter-S for the Small and Medium Business sector shipped in the fourth quarter and were well received in the market place.

 

System Storage revenue increased 5.1 percent (2 percent adjusted for currency) in 2007 versus 2006. The increase was primarily driven by 13 percent growth in tape products, while external disk products increased 1 percent in 2007. Enterprise tape products had strong double-digit revenue growth, while Midrange tape products had mid single-digit revenue growth. The company completed the acquisition of XIV in late December, which will further strengthen its storage portfolio in the long term. This acquisition positions the company to grow in emerging opportunities like Web 2.0 applications, digital archives and digital media.

 

Microelectronics revenue decreased 11.8 percent in 2007 versus 2006, driven by reduced demand for game processors. The Microelectronics OEM business has minimal impact to the company’s overall net income, but this business continues to deliver key technology to the systems business, which is the fundamental objective of the company’s investment.

 

Retail Store Solutions revenue increased 14.5 percent (11 percent adjusted for currency) in 2007 versus 2006, primarily due to the continued roll out of new programmable point-of-sale solutions to large retail clients.

 

Printing Systems revenue decreased as a result of the divestiture of the business. The 2007 results include five months of revenue while the 2006 results include 12 months of revenue.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Systems and Technology gross profit:

 

 

 

 

 

 

 

Gross profit

 

$

8,468

 

$

8,284

 

2.2

%

Gross profit margin

 

39.7

%

37.7

%

2.0

pts.

 

The increase in Systems and Technology gross profit dollars for 2007 versus 2006 was primarily due to higher gross profit margins in System z, System p and System x servers. The Systems and Technology gross profit margin increased 2.0 points to 39.7 percent in 2007. System p performance contributed 1.3 points to the overall margin improvement, while System z and System x contributed 0.7 points and 0.4 points, respectively. These increases were partially offset by lower gross margins in System i of 0.2 points and System Storage 0.2 points.

 

Systems and Technology pre-tax margin expanded 2.1 points to 9.6 percent in 2007, reflecting a strong combination of operational cost management and the value that virtualization is driving in the enterprise space.

 

Software

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006*

 

CHANGE

 

Software revenue:

 

$

19,982

 

$

18,161

 

10.0

%

Middleware

 

$

15,505

 

$

13,891

 

11.6

%

Key Branded Middleware

 

10,827

 

9,373

 

15.5

 

WebSphere Family

 

 

 

 

 

19.1

 

Information Management

 

 

 

 

 

14.7

 

Lotus

 

 

 

 

 

8.7

 

Tivoli

 

 

 

 

 

18.0

 

Rational

 

 

 

 

 

13.7

 

Other Middleware

 

4,678

 

4,518

 

3.5

 

Operating Systems

 

2,319

 

2,273

 

2.0

 

Product Lifecycle Management

 

1,051

 

1,123

 

(6.4

)

Other

 

1,107

 

874

 

26.7

 


* Reclassified to conform with 2007 presentation.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

26



 

Software segment revenue of $19,982 million increased 10.0 percent (6 percent adjusted for currency) in 2007 reflecting strong demand for the key branded middleware products. Revenue performance was led by double-digit growth in the Financial Services, Public and Small and Medium Business sectors. Clients are using IBM middleware to effectively improve their operating leverage and business efficiency.

 

Revenue from Key Branded Middleware, which includes WebSphere, Information Management, Lotus, Tivoli and Rational products, was $10.8 billion, up 15.5 percent (11 percent adjusted for currency) and increased 3 points to 54 percent of total software segment revenue. The company has invested heavily in these products, through internal investments and targeted acquisitions, and expects the majority of its software revenue growth to come from this portion of the product portfolio.

 

Revenue from the WebSphere Family of products increased 19.1 percent (14 percent adjusted for currency) and was led by double-digit growth in WebSphere Application Servers and WebSphere Business Integration software. The strong revenue performance reflects the industry’s adoption of SOA. The WebSphere products provide the foundation for Web-enabled applications and are a key product set in deploying a client’s SOA.

 

Information Management revenue increased 14.7 percent (10 percent adjusted for currency) in 2007 versus the prior year. Information Management software enables clients to leverage Information on Demand. The acquisition of FileNet, in the fourth quarter of 2006, contributed strong revenue growth throughout the year. The Cognos acquisition, completed in the first quarter of 2008, will provide a strong entry in the Business Intelligence marketplace and is expected to provide synergies in software, services, servers and storage.

 

Lotus revenue increased 8.7 percent (4 percent adjusted for currency) in 2007 driven by the Notes/Domino family of products. Lotus software is well established as a tool for providing improved workplace collaboration and productivity. Lotus Connections, released in the second quarter, has been rapidly adapted by customers. The latest version of Lotus Notes, Lotus Notes 8.0, was delivered in the third quarter of 2007.

 

Revenue from Tivoli software, infrastructure software that enables clients to centrally manage networks including security and storage capability, increased 18.0 percent (13 percent adjusted for currency) with double-digit growth in each segment of the portfolio, Systems Management, Security and Storage. The acquisitions of MRO, in the fourth quarter of 2006, and Vallent and Consul, in the first quarter of 2007, also contributed to the brand’s revenue growth.

 

Rational revenue increased 13.7 percent (9 percent adjusted for currency) in 2007 which reflected strong customer acceptance of the integrated product set. Rational provides integrated tools to improve the software development process for clients. The closing of the Telelogic acquisition is conditioned upon satisfactory completion of regulatory reviews in the European Union. Telelogic’s suite of system programming tools complements Rational’s IT tool set, providing a complete tooling solution across a client’s enterprise.

 

Revenue from Other middleware products increased 3.5 percent (flat adjusted for currency) in 2007 versus the prior year. This software product set includes more mature products which provide a more stable flow of revenue.

 

Operating Systems revenue increased 2.0 percent (decreased 2 percent adjusted for currency) in 2007 versus 2006.

 

Product Lifecycle Management (PLM) revenue decreased 6.4 percent (11 percent adjusted for currency) in 2007 driven by declines in the Small and Medium Business sector. PLM software helps companies improve their product development processes and their ability to use product-related information across their businesses.

 

Other software segment revenue increased 26.7 percent (22 percent adjusted for currency) versus 2006 reflecting growth in software-related services, such as consulting and education.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Software gross profit:

 

 

 

 

 

 

 

Gross profit

 

$

17,015

 

$

15,471

 

10.0

%

Gross profit margin

 

85.2

%

85.2

%

0.0

pts.

 

Software segment gross profit increased 10.0 percent to $17.0 billion in 2007, driven primarily by strong revenue growth. Gross profit margin was 85.2 percent in 2007, flat versus the prior year.

 

The Software segment contributed $6.0 billion of pre-tax profit in 2007, an increase of 9.3 percent versus 2006. The segment pre-tax profit margin of 26.8 percent was essentially flat (declined 0.1 pt) versus the prior year, reflecting the integration of acquired businesses.

 

Global Financing

 

See page 51 for an analysis of Global Financing’s revenue and gross profit.

 

Geographic Revenue

 

In addition to the revenue presentation by reportable segment, the company also measures revenue performance on a geographic basis.

 

27



 

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

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Geographies:

 

 

 

 

 

 

 

Americas

 

$

41,122

 

$

39,511

 

4.1

%

EMEA

 

34,699

 

30,491

 

13.8

 

Asia Pacific

 

19,501

 

17,566

 

11.0

 

OEM

 

3,465

 

3,856

 

(10.1

)

Total

 

$

98,786

 

$

91,424

 

8.1

%

 

From a geographic perspective, revenue increased in all geographies in 2007 when compared to 2006. Adjusted for currency, revenue growth was led by Asia Pacific and steady performance throughout the year in EMEA.

 

Americas’ revenue increased 4.1 percent (3 percent adjusted for currency) in 2007. Revenue increased in all regions with the U.S. up 2.9 percent, Canada 8.4 percent (2 percent adjusted for currency) and Latin America 8.6 percent (2 percent adjusted for currency).

 

EMEA revenue increased 13.8 percent (5 percent adjusted for currency) in 2007 when compared to 2006. Within the European market, IT spending grew at a moderate rate, and the company’s mid single-digit revenue growth rates throughout 2007 reflected that environment. In the major countries, Spain’s revenue grew 21.7 percent (11 percent adjusted for currency), while Germany’s revenue increased 14.6 percent (5 percent adjusted for currency) and the U.K.’s revenue increased 11.3 percent (3 percent adjusted for currency). France’s revenue increased 10.2 percent (1 percent adjusted for currency) and Italy’s revenue grew 8.7 percent (decreased 1 percent adjusted for currency).

 

Asia Pacific revenue increased 11.0 percent (8 percent adjusted for currency) year over year. Growth was led by strong performance in the India, Greater China, Australia/New Zealand, ASEAN and Korea regions, where the economies remain strong, with combined revenue growth of 23.8 percent (17 percent adjusted for currency). Japan revenue, which represents 49 percent of the Asia Pacific revenue base, was flat (increased 1 percent adjusted for currency) in 2007 when compared to 2006, reflecting a slower economy.

 

Across the geographies, the emerging BRIC countries of Brazil, Russia, India, and China together grew 26.3 percent (18 percent adjusted for currency), reflecting the investments made to build capabilities and capture opportunities in these countries. Brazil’s revenue increased 14.3 percent (1 percent adjusted for currency), while Russia’s revenue grew 30.3 percent (30 percent adjusted for currency). India’s revenue increased 37.9 percent (26 percent adjusted for currency) and China’s revenue increased 32.5 percent (29 percent adjusted for currency). In addition to the BRIC markets, the company has also had strong revenue growth in other nations where there is strong demand for business and IT infrastructure solutions.

 

Revenue growth rates, as reported, were impacted in 2007 as a result of the divestiture of the printing business on June 1, 2007. Revenue, excluding the printing business in both years, increased as follows compared to 2006:

 

·      Americas — 5.2%

·      EMEA — 14.5%

·      Asia Pacific — 11.8%

·      IBM Consolidated — 8.9%

 

The company believes that the analysis that excludes the printing business revenues is a better indicator of operational performance on an ongoing basis.

 

OEM revenue decreased 10.1 percent (10 percent adjusted for currency) in 2007 when compared to 2006, driven by a slowdown in demand for game processors.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

 

28



 

Total Expense and Other Income

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Total expense and other income

 

$

27,240

 

$

24,978

 

9.1

%

Expense to Revenue

 

27.6

%

27.3

%

0.3

pts.

 

Total expense and other income increased 9.1 percent (5 percent adjusted for currency) in 2007 versus 2006. Overall, the increase was primarily due to increased Selling, general and administrative (SG&A) expense and Interest expense. SG&A expense increased $1,801 million primarily due to acquisition related spending, as well as increased investments in emerging countries and the software and services businesses. Interest expense increased $333 million primarily due to higher debt associated with the financing of the ASR agreements. In addition, Other (income) and expense declined $140 million in income primarily due to higher losses on derivative instruments. The expense-to-revenue ratio increased 0.3 points to 27.6 percent in 2007, as revenue increased 8.1 percent and expense increased 9.1 percent in 2007 versus 2006. For additional information regarding the increase in Total expense and other income, see the following analyses by category:

 

Selling, General and Administrative

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006*

 

CHANGE

 

Selling, general and administrative — base

 

$

19,078

 

$

17,457

 

9.3

%

Advertising and promotional expense

 

1,242

 

1,195

 

3.9

 

Workforce reductions — ongoing

 

318

 

272

 

16.6

 

Amortization expense — acquired intangibles

 

234

 

220

 

6.7

 

Retirement-related expense

 

607

 

587

 

3.5

 

Stock-based compensation

 

480

 

541

 

(11.3

)

Bad debt expense

 

100

 

(13

)

NM

 

Total

 

$

22,060

 

$

20,259

 

8.9

%


* Reclassified to conform with 2007 presentation as the Restructuring category ($33 million in 2007 and $15 million in 2006) was combined into the SG&A — base category.

NM — Not meaningful

 

Total SG&A expense increased 8.9 percent (6 percent adjusted for currency). The increase was primarily driven by acquisition related spending (3 points), the effects of currency (3 points) and investments in the software and services businesses, as well as emerging markets. These investments reflect the continuing business mix shift to higher value offerings which require higher operating expenses. The returns on these investments are reflected in the momentum in key branded middleware offerings, growth in emerging markets and improved Global Services revenue. In addition, Bad debt expense increased $113 million primarily due to an increase in the provision for doubtful accounts. The reserve coverage for receivables at year end was 1.5 percent, essentially flat versus year-end 2006. Workforce reductions — ongoing increased as a result of actions taken to address cost issues in GTS, primarily in SO, during the second quarter of 2007.

 

Other (Income) and Expense

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006*

 

CHANGE

 

Foreign currency transaction gains

 

$

(143

)

$

(130

)

10.1

%

Losses on derivative instruments

 

382

 

135

 

183.5

 

Interest income

 

(565

)

(536

)

5.3

 

Net gains from securities and investments assets

 

(68

)

(40

)

68.5

 

Net realized gains from certain real estate activities

 

(18

)

(41

)

(56.0

)

Other

 

(214

)

(154

)

39.3

 

Total

 

$

(626

)

$

(766

)

(18.3

)%


* Reclassified to conform with 2007 presentation deleting 2006 categories for restructuring $(7) million and $(45) million for Lenovo/Microsoft gains and combining these items in the Other category for both years.

 

Other (income) and expense was income of $626 million and $766 million in 2007 and 2006, respectively. The decrease in income was primarily due to higher losses on derivative instruments. The company hedges its major cross-border cash flows to mitigate the effect of currency volatility in the year-over-year results. The impact of these hedging programs is primarily reflected in Other (income) and expense, as well as cost of goods sold. This year, losses from derivatives, as a result of currency movements, resulted in $247 million of year-to-year impact to Other (income) and expense. This decrease in income was partially offset by a gain from the divestiture of the printing business in the second quarter and sales of Lenovo stock in the first and second quarters of 2007 (see note C, “Acquisitions/Divestitures,” on pages 80 and 81 for additional information).

 

Research, Development and Engineering

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Research, development and engineering:

 

 

 

 

 

 

 

Total

 

$

6,153

 

$

6,107

 

0.8

%

 

29



 

The increase in Research, development and engineering (RD&E) expense was primarily driven by acquisitions and investments to maintain technology leadership across the product offerings. Software spending increased $339 million partially offset by lower Systems and Technology spending of $204 million in 2007 versus 2006. Retirement-related expense increased $13 million in 2007 versus 2006, while stock-based compensation expense decreased $21 million year over year.

 

Intellectual Property and Custom Development Income

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Sales and other transfers of intellectual property

 

$

138

 

$

167

 

(17.7

)%

Licensing/royalty-based fees

 

368

 

352

 

4.6

 

Custom development income

 

452

 

381

 

18.8

 

Total

 

$

958

 

$

900

 

6.4

%

 

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 2007 and 2006.

 

Interest Expense

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Interest expense:

 

 

 

 

 

 

 

Total

 

$

611

 

$

278

 

119.6

%

 

The increase in Interest expense was primarily due to the increase in debt to finance the ASR agreements. See note M, “Stockholders’ Equity,” on pages 92 and 93 for additional information regarding this transaction. Interest expense is presented in Cost of Financing in the Consolidated Statement of Earnings only if the related external borrowings are to support the Global Financing external business. See page 54 for additional information regarding Global Financing debt and interest expense.

 

Stock-Based Compensation

 

Total pre-tax stock-based compensation cost of $713 million decreased $134 million compared to 2006. The decrease was principally the result of a reduction in the level of stock option grants ($159 million), offset by an increase related to restricted and performance-based stock units ($25 million). The effects of stock-based compensation cost related to the divestiture of the printing business (a decrease of $1 million) were included in Other (income) and expense in the Consolidated Statement of Earnings. The year-to-year reductions in pre-tax stock-based compensation cost were reflected in the following categories: Cost ($50 million); SG&A expense ($61 million); RD&E expense ($21 million) and Other (income) and expense ($1 million).

 

There was no significant capitalized stock-based compensation cost at December 31, 2007 and 2006.

 

See note T, “Stock-Based Compensation,” on pages 102 to 105 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 plan participants.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Defined benefit and contribution pension plans cost

 

$

2,198

 

$

2,040

 

7.7

%

Nonpension postretirement plans costs

 

399

 

388

 

2.8

 

Total

 

$

2,597

 

$

2,428

 

7.0

%

 

Overall, retirement-related plan costs increased $169 million versus 2006.

 

The increase in retirement-related plan costs was driven primarily as a result of changes in retirement plan assumptions as well as the impact of changes in foreign currency.

 

Retirement-related plan costs increased approximately $131 million in Cost, $21 million in SG&A expense, $13 million in RD&E expense and $5 million in Other (income) and expense year to year. See note U, “Retirement-Related Benefits,” on pages 105 to 116 for additional information on the company’s benefit plans including a description of the plans, plan financial information and assumptions.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

30



 

Acquired Intangible Asset Amortization

 

The company has been investing in targeted acquisitions primarily in 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 84 and 85 for additional information.

 

($ in millions)

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006*

 

CHANGE

 

Cost:

 

 

 

 

 

 

 

Software

 

$

91

 

$

81

 

12.6

%

Services

 

42

 

12

 

252.7

 

Hardware

 

 

3

 

NM

 

Selling, general and administrative expense

 

234

 

220

 

6.7

 

Total

 

$

367

 

$

316

 

16.3

%


* Reclassified to conform with 2007 presentation of Services and Selling, general and administrative expense categories.

NM — Not meaningful

 

Income Taxes

 

The effective tax rate for 2007 was 28.1 percent, compared with 29.3 percent in 2006. The 1.2 point decrease was primarily driven by the absence of the one-time tax cost associated with the intercompany transfer of certain intellectual property in the fourth quarter of 2006 (4.3 points) and the absence of the benefit from the settlement of the U.S. federal income tax audit for the years 2001 through 2003, also in the fourth quarter of 2006 (3.0 points). The company also benefitted in 2007 from a more favorable mix of income in lower tax rate jurisdictions and increased capital loss and state credit benefits, offset by a reduction in certain tax incentives.

 

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, convertible notes and shares which may be required to settle ASR agreements.

 

 

 

 

 

 

 

YR.-TO-YR.

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

CHANGE

 

Earnings per share of common stock:

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

Continuing operations

 

$

7.18

 

$

6.06

 

18.5

%

Discontinued operations

 

(0.00

)

0.05

 

NM

 

Total

 

$

7.18

 

$

6.11

 

17.5

%

Basic:

 

 

 

 

 

 

 

Continuing operations

 

$

7.32

 

$

6.15

 

19.0

%

Discontinued operations

 

(0.00

)

0.05

 

NM

 

Total

 

$

7.32

 

$

6.20

 

18.1

%

Weighted-average shares outstanding (in millions):

 

 

 

 

 

 

 

Assuming dilution

 

1,450.6

 

1,553.5

 

(6.6

)%

Basic

 

1,423.0

 

1,530.8

 

(7.0

)%


NM — Not meaningful

 

Actual shares outstanding at December 31, 2007 and December 31, 2006 were 1,385.2 million and 1,506.5 million, respectively. The average number of common shares outstanding assuming dilution was 103.0 million shares lower in 2007 versus 2006. The decrease was primarily the result of the company’s common share repurchase program. See note M, “Stockholders’ Equity Activity,” on pages 92 and 93 for additional information regarding common share activities. Also see note R, “Earnings Per Share of Common Stock,” on page 101.

 

FINANCIAL POSITION

 

Dynamics

 

The assets and debt associated with the Global Financing business are a significant part of the company’s financial position. The financial position amounts appearing below and on pages 32 to 35 are the consolidated amounts including Global Financing. The amounts appearing in the separate Global Financing section are supplementary data presented to facilitate an understanding of the Global Financing business.

 

In 2007, the company repurchased $18.8 billion of its outstanding common stock, of which $12.5 billion was the initial purchase price of the shares repurchased through ASR agreements. Under the agreements, which were executed on May 25, 2007, the company repurchased 118.8 million shares from three banks for an initial price of $105.18 per share. The banks were expected to purchase an equivalent number of shares in the open market in the nine month period following May 25, 2007. As discussed in note M, “Stockholders’ Equity Activity,” on pages 92 and 93, the initial price of the ASR is

 

31



 

subject to an adjustment based on the volume weighted average price of the shares during this period and this adjustment will be recorded in Stockholders’ equity in the Consolidated Statement of Financial Position on each of the settlement dates. The first settlement occurred on September 6, 2007, resulting in a settlement payment by the company of $151.8 million; the second settlement occurred on December 5, 2007, resulting in a settlement payment by the company of $253.1 million. The final settlement is expected to occur in March 2008.

 

The ASR transaction was guaranteed by the company and was executed through IBM International Group (IIG), a wholly owned foreign subsidiary of the company. The formation of IIG enabled the company to create a centralized foreign holding subsidiary to own most of its non-U.S. operations. IIG funded the repurchases with $1 billion in cash and an $11.5 billion, 364-day bridge loan with a number of financial institutions. The bridge loan was guaranteed by the company and carries an interest rate of the LIBOR plus 10 basis points. Principal and interest on IIG debt will be paid by IIG with cash generated by its non-U.S. operating subsidiaries. The execution of the ASR enabled the company to achieve a substantial share reduction, a lower cost of capital and an effective use of non-U.S. cash.

 

In the second half of 2007, IBM International Group Capital LLC (IIGC), an indirect, wholly owned subsidiary of the company, issued $4.1 billion in long-term debt and $2.8 billion in commercial paper. These proceeds were utilized to refinance the bridge loan associated with the ASR. In addition, approximately $750 million of the original amount has been repaid. At December 31, 2007, the outstanding balance of the bridge loan was $3.9 billion.

 

In addition, on January 29, 2008, IIGC issued $3.5 billion of 18-month floating rate notes. The proceeds will be utilized to further reduce the bridge loan associated with the ASR.

 

Consistent with retirement and postretirement plan accounting standards, the company remeasures the funded status of its plans at December 31. The funded status is measured as the difference between the fair value of the plan assets and the benefit obligation. The funded status is recognized in the Consolidated Statement of Financial Position. (See note A, “Significant Accounting Policies,” on pages 69 and 70 for additional information). At December 31, 2007, as a result of the company’s plan contributions, returns on plan assets and changes in certain retirement plan assumptions, the overall net funded status improved $7.2 billion from December 31, 2006 to a net over-funded position of $3.3 billion. This change is primarily reflected in Prepaid pension assets in the Consolidated Statement of financial position which increased $6.8 billion from the prior year-end balance.

 

In addition, Stockholders’ equity improved $4.7 billion as a result of changes from pension remeasurements and current year activity within Accumulated gains and (losses) not affecting retained earnings. See note U, “Retirement-Related Benefits,” on pages 105 to 116 for additional information.

 

Working Capital

 

($ in millions)

 

 

 

 

 

AT DECEMBER 31:

 

2007

 

2006

 

Current assets

 

$

53,177

 

$

44,660

 

Current liabilities

 

44,310

 

40,091

 

Working capital

 

$

8,867

 

$

4,569

 

Current ratio

 

1.20

 

1.11

 

 

Working capital increased $4,298 million compared to the prior year primarily as a result of a net increase in Current assets. The key drivers are described below:

 

Current assets increased $8,517 million due to:

 

·      An increase of $5,490 million in Cash and cash equivalents and Marketable securities including a $299 million currency impact. See Cash Flow analysis on page 33.

 

·      An increase of $1,941 million in short-term receivables driven by:

 

– increase of $460 million in financing receivables due to asset growth in commercial financing and client loans; and

 

– approximately $1,325 million currency impact.

 

·      An increase of $1,351 million in Prepaid expenses and other current assets primarily resulting from:

 

– an increase of $335 million in derivative assets primarily due to changes in foreign currency rates for certain cash flow hedges;

 

– an increase of $164 million due to prepaid software for services contracts ($94 million) and maintenance agreements ($70 million);

 

an increase of $170 million in prepaid taxes;

 

an increase of $128 million in deferred services arrangements transition costs; and

 

– approximately $158 million currency impact.

 

Current liabilities increased $4,220 million as a result of:

 

·      An increase of $3,333 million in Short-term debt primarily driven by increases in commercial paper;

 

·      An increase of $1,215 million in Deferred income mainly driven by Software ($502 million) and Global Technology Services ($543 million);

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

 

32


 

·      An increase of $528 million in Other accrued liabilities primarily due to an increase in derivative liabilities as a result of changes in foreign currency rates for hedges of net investment; partially offset by

 

·      A decrease of $997 million in Taxes payable primarily due to the adoption of FASB Interpretation Number (FIN) 48, “Accounting for Uncertainty in Income Taxes” (FIN 48); consistent with the provisions of FIN 48, $2,066 million of income tax liabilities on January 1, 2007 was reclassified from current to noncurrent liabilities; this was offset by current year income tax activity.

 

Cash Flow

 

The company’s cash flow from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 60, is summarized in the following table. These amounts include the cash flows associated with the Global Financing business. See pages 52 through 55.

 

($ in millions)

 

 

 

 

 

FOR THE YEAR ENDED DECEMBER 31:

 

2007

 

2006

 

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

 

 

 

 

 

Operating activities

 

$

16,094

 

$

15,019

 

Investing activities

 

(4,675

)

(11,549

)

Financing activities

 

(4,740

)

(8,204

)

Effect of exchange rate changes on cash and cash equivalents

 

294

 

201

 

Net cash used in discontinued operations — operating activities

 

(5

)

(12

)

Net change in cash and cash equivalents

 

$

6,969

 

$

(4,546

)

 

Net cash from operating activities for 2007 increased $1,075 million as compared to 2006 driven by the following key factors:

 

·      An increase in net income of $925 million;

 

·      A decrease in cash related to deferred income taxes of $984 million primarily due to the impact of pension activity;

 

·      Retirement-related cash flows increased $622 million primarily due to lower pension funding of $795 million year to year;

 

·      Growth in accounts receivable drove a use of cash of $896 million; this was driven by Global Financing receivables ($1,045 million) as a result of asset growth;

 

·      Other assets/other liabilities drove an increase in cash of $1,587 million primarily resulting from:

 

      an increase in cash from tax liabilities of $1,185 million mainly driven by an increase in income tax provisions and reserves; and

 

      an increase in cash from deferred income of $398 million primarily due to prepayment of future services to be provided to Infoprint.

 

Net cash used in investing activities decreased $6,874 million on a year-to-year basis driven by:

 

·      The net impact of the purchases and sales of marketable securities and other investments resulted in an increase in cash of $4,006 million;

 

·      A decrease of $2,790 million utlized for acquisitions (see note C, “Acquisitions/Divestitures,” on pages 76 to 78 for additional information); and

 

·      An increase of $310 million received from divestitures driven by the printing business transaction;

 

Partially offset by:

 

·      An increase in net capital spending of $231 million resulting from:

 

      an increase of $160 million primarily driven by Global Technology Services to support the outsourcing business; and

 

      an increase of $71 million in capitalized software development expenditures.

 

Net cash used in financing activities decreased $3,464 million compared to 2006 as a result of:

 

·      An increase of $12,233 million in net cash proceeds from debt transactions primarily from issuances in support of the ASR; and

 

·      An increase of $2,438 million due to higher other common stock transactions mainly due to stock option exercises;

 

Partially offset by:

 

·      Higher common stock repurchases of $10,744 million driven by the ASR; and

 

·      Higher dividend payments of $464 million as a result of the increase in the common stock dividend from $1.10 to $1.50 per share.

 

Within total debt, on a net basis, the company had $12,112 million in net cash proceeds from new debt versus $121 million in net cash used in 2006 to retire debt. The net proceeds from new debt in 2007 was comprised of: $21,744 million of new debt issuances and $1,674 million in net short-term borrowings, partially offset by $11,306 million in cash payments to settle debt. See note J, “Borrowings,” on pages 85 to 88 for a listing of the company’s debt securities.

 

Noncurrent Assets and Liabilities

 

($ in millions)

 

 

 

 

 

AT DECEMBER 31:

 

2007

 

2006

 

Noncurrent assets

 

$

67,254

 

$

58,574

 

Long-term debt

 

$

23,039

 

$

13,780

 

Noncurrent liabilities (excluding debt)

 

$

24,612

 

$

20,857

 

 

33



 

The increase in Noncurrent assets of $8,680 million compared to the prior year-end balance was primarily driven by:

 

·      An increase of $6,788 million ($505 million due to currency) in Prepaid pension assets primarily resulting from an increase in overfunded pension plans reflecting year-end remeasurements;

 

·      An increase of $1,535 million ($526 million due to currency) in Long-term financing receivables mainly due to increased Global Financing volumes;

 

·      An increase of $1,431 million ($347 million due to currency) in Goodwill driven by acquisitions in 2007; and

 

·      An increase of $642 million in Plant, rental machines and other property (net) effectively all due to currency effects.

 

These increases were partially offset by:

 

·      A decrease of $1,621 million in Investments and sundry assets primarily resulting from:

 

      a decrease of $2,367 million in noncurrent deferred tax assets primarily related to the pension remeasurements;

 

      growth of $243 million in noncurrent deferred transition costs driven by an increase in long-term services arrangements with clients; and

 

      $170 million due to increased investments in long-term marketable securities.

 

Long-term debt increased $9,259 million due to new borrowings in 2007 primarily to finance the ASR agreements. See note M, “Stockholders’ Equity Activity,” on pages 92 and 93 for detailed discussion.

 

Other Noncurrent liabilities, excluding debt, increased $3,755 million primarily driven by:

 

·      An increase in noncurrent tax reserves of $2,107 million as a result of a reclassification from current ($2,066 million) related to FIN 48 implementation and current year activity;

 

·      Growth of $558 million in noncurrent deferred income mainly driven by Global Technology Services;

 

·      An increase of $399 million in noncurrent deferred tax liabilities primarily due to pension remeasurement; and

 

·      An increase of $298 million in long-term derivative liabilities due to changes in foreign currency rates for hedge of net investments.

 

Debt

 

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

 

($ in millions)

 

 

 

 

 

AT DECEMBER 31:

 

2007

 

2006

 

Total company debt

 

$

35,274

 

$

22,682

 

Total Global Financing segment debt

 

$

24,532

 

$

22,287

 

Debt to support external clients

 

21,072

 

18,990

 

Debt to support internal clients

 

3,460

 

3,297

 

 

The Global Financing business provides funding predominantly for the company’s external client assets as well as for assets under contract by other IBM units. These assets, primarily for Global Services, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their nature, these Global Services assets are leveraged with the balance of the Global Financing asset base. The debt analysis above is further detailed in the Global Financing section on page 54.

 

Non-Global Financing debt increased $10,348 million and the debt-to-capital ratio at December 31, 2007 was 30.0 percent. Non-Global Financing debt increased versus 2006 primarily due to the financing of the ASR agreements in the second quarter of 2007. The debt-to-capital ratio was 46.7 percent at June 30, 2007. A reduction of $1,034 million in non-Global Financing debt and an increase of $11,554 million in equity has reduced the ratio from the half-year point. See note M, “Stockholders’ Equity Activity,” on pages 92 and 93 for detailed information.

 

Equity

 

($ in millions)

 

 

 

 

 

AT DECEMBER 31:

 

2007

 

2006

 

Stockholders’ equity:

 

 

 

 

 

Total

 

$

28,470

 

$

28,506

 

 

The company’s consolidated Stockholders’ equity decreased $36 million in 2007 as a result of several key factors:

 

·      A decrease related to net stock transactions of $13,732 million, driven by common stock repurchases which resulted in an increase in Treasury stock in 2007.

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

 

34



 

This reduction was offset by:

 

·      An increase of $8,208 million in retained earnings primarily driven by net income of $10,418 million, partially offset by dividends ($2,147 million); and

 

·      An increase of $5,487 million in Accumulated gains and (losses) not affecting retained earnings primarily resulting from the non-cash equity impacts related to an increase in overfunded pension plans reflecting year-end remeasurements.

 

Consolidated Fourth-Quarter Results

 

 

 

 

 

 

 

YR.-TO-YR.

 

 

 

 

 

 

 

PERCENT/

 

($ and shares in millions except per share amounts)

 

 

 

 

 

MARGIN

 

FOR THE FOURTH QUARTER:

 

2007

 

2006

 

CHANGE

 

Revenue

 

$

28,866

 

$

26,257

 

9.9

%*

Gross profit margin

 

44.9

%

44.6

%

0.4

pts.

Total expense and other income

 

$

7,481

 

$

6,887

 

8.6

%

Total expense and other income-to-revenue ratio

 

25.9

%

26.2

%

(0.3

)pts.

Income from continuing operations before income taxes

 

$

5,489

 

$

4,814

 

14.0

%

Provision for income taxes

 

$

1,537

 

$

1,350

 

13.9

%

Income from continuing operations

 

$

3,951

 

$

3,464

 

14.1

%

Income from discontinued operations

 

$

1

 

$

76

 

NM

 

Net income

 

$

3,952

 

$

3,541

 

11.6

%

Net income margin

 

13.7

%

13.5

%

0.2

pts.

Earnings per share of common stock:

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

Continuing operations

 

$

2.80

 

$

2.26

 

23.9

%

Discontinued operations

 

0.00

 

0.05

 

NM

 

Total

 

$

2.80

 

$

2.31

 

21.2

%

Weighted-average shares outstanding:

 

 

 

 

 

 

 

Assuming dilution

 

1,412.9

 

1,532.5

 

(7.8

)%


* 4.2 percent adjusted for currency.

NM — Not meaningful

 

CONTINUING OPERATIONS

 

In the fourth quarter, the company increased Income from continuing operations by 14.1 percent ($487 million) to $4.0 billion versus the fourth quarter of 2006. Diluted earnings per share from continuing operations of $2.80 increased 23.9 percent versus the prior year.

 

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

 

·      The strength of the company’s global business model — led by strong performance in Asia Pacific and emerging country markets, plus continued solid performance in Europe;

 

·      Double-digit revenue growth in the Services and Software segments; and

 

·      Margin expansion led by the Systems and Technology and Software segments.

 

Total revenue in the fourth quarter of $28.9 billion increased 9.9 percent as reported (4 percent adjusted for currency). Revenue growth was led by the Global Services and Software segments and, on a geographic basis, by Asia Pacific, EMEA and the emerging countries.

 

The two services segments together had $14.9 billion of revenue in the fourth quarter, an increase of 16.5 percent (10 percent adjusted for currency) year to year, with double-digit revenue growth across all lines of business. Total signings for Global Services in the fourth quarter were $15.4 billion, a decrease of 13 percent versus the fourth quarter of 2006. Longer term signings decreased 25 percent compared to a very strong fourth quarter in 2006. Shorter term signings increased 8 percent. GTS revenue increased 16.4 percent (10 percent adjusted for currency), with double-digit growth across all business lines, geographies and sectors. GTS signings decreased 9 percent in the fourth quarter, with longer term signings decreasing 14 percent, partially offset by a 6 percent increase in shorter term signings. SO revenue increased 14.5 percent, driven primarily by prior-year signings, the continued sales of new business in existing accounts and good yield from current-year signings. SO signings decreased 26 percent versus fourth-quarter 2006. ITS revenue increased 11.4 percent, with growth in all geographies, led by EMEA and Asia Pacific. ITS signings increased 6 percent versus fourth-quarter 2006, led by double-digit growth in the Americas. BTO revenue increased 56.5 percent with double-digit growth in all geographies and continued strength in the Daksh business, which increased over 40 percent year to year. BTO signings increased 147 percent year to year. Maintenance revenue increased 16.2 percent and included services provided to InfoPrint Solutions, which contributed 7 points of growth in the quarter. GTS gross profit in the quarter increased 17.2 percent, with gross profit margin improving 0.2 points, primarily driven by margin expansion in SO and ITS. The GTS segment fourth-quarter pre-tax margin improved 0.9 points to 10.2 percent from fourth-quarter 2006. The margin improvement was driven primarily by an improved cost structure in SO, a mix to higher value products in ITS and good

 

35



 

expense management. GBS revenue increased 16.8 percent (10 percent adjusted for currency) with growth in all geographies and sectors. Revenue performance was led by growth in AMS offerings and double-digit growth across all consulting service lines. GBS signings decreased 20 percent, driven by a 48-percent decline in longer term signings when compared to a very strong fourth quarter of 2006. Shorter term signings increased 9 percent to $3.9 billion for the quarter, the highest level of shorter term signings achieved in any quarter in this business. GBS gross profit increased 9.0 percent in the quarter, with a gross margin decline of 1.7 points due to higher employee bonus compensation costs. The GBS segment contributed $0.6 billion of pre-tax profit in the quarter, an increase of 9.2 percent versus the fourth quarter of 2006. Pre-tax profit margin declined 0.5 points to 11.3 percent driven primarily by the impact of higher employee bonus compensation in the quarter, partially offset by improved expense productivity.

 

Systems and Technology segment revenue was $6.8 billion, a decrease of 3.9 percent as reported (8 percent adjusted for currency), when compared to the fourth quarter of 2006; excluding the divested printer business, revenue was essentially flat (decreased 4 percent adjusted for currency). System z revenue decreased 15.1 percent, with revenue declines in the U.S. and EMEA, partially offset by double-digit revenue growth in Asia Pacific. This was the tenth quarter of a long and successful technology cycle for System z; MIPS shipments decreased 4 percent year to year. System i revenue increased 2.0 percent driven primarily by growth in POWER6 servers. System p revenue grew 9.5 percent, with growth in all geographies led by double-digit growth in Asia Pacific. This was the sixth consecutive quarter of revenue growth for System p, driven primarily by POWER6 servers. System x revenue increased 4.3 percent with growth in server products (6 percent) and blades (31 percent). Performance in the quarter reflected strong acceptance of the new BladeCenter-S, which was introduced at the end of the quarter, and strong demand for the new high-end Quad-Core processor servers. Systems Storage revenue increased 10.8 percent, driven by growth in tape products of 22 percent and external disk products of 7 percent. Retail Store Solutions revenue increased 5.9 percent. Microelectronics revenue declined 15.2 percent driven by a slowdown in demand for game processors. Segment gross margin at 45.7 percent, improved 3.9 points versus the fourth quarter of 2006 with margin improvement in every system brand, except System i. Systems and Technology segment pre-tax profit increased 17.8 percent to $1.4 billion. Pre-tax margin improved 3.8 points to 19.4 percent, driven primarily by operational cost management, a mix to higher end models within the brands and the value of the new POWER6 products in the market.

 

Software segment revenue of $6.3 billion, increased 11.6 percent (6 percent adjusted for currency), reflecting strong execution in closing transactions in the quarter and continued strong demand for the key branded middleware products. Revenue growth this quarter was primarily organic, as the company wrapped around prior year acquisitions. Revenue from key branded middleware increased 15.4 percent (9 percent adjusted for currency) and represented 58 percent of total software revenue. Revenue from the WebSphere Family of products grew 22.8 percent in the quarter, with strong performance tied to the industry’s adoption of services-oriented architecture. Information Management revenue increased 11.4 percent. The FileNet acquisition, now in its second year, contributed to the revenue growth. Lotus revenue increased 6.7 percent compared to a very strong fourth quarter of 2006. This is the thirteenth consecutive quarter of growth from Lotus software. Lotus Connections, which was released in June 2007, has been rapidly adopted by customers. Tivoli software revenue increased 19.0 percent with double-digit growth in Systems Management, Security and Storage products. Rational revenue increased 22.2 percent in the quarter, as the company’s largest customers embraced this integrated product set. Software gross profit increased 12.4 percent in the quarter, with margin improvement of 0.6 points. In addition to the strong revenue and gross profit performance in the fourth quarter, the Software segment delivered pre-tax profit of $2.4 billion, an increase of 20.8 percent. The pre-tax margin of 34.9 percent increased 2.6 points, reflecting the strong revenue growth with a relatively fixed cost base.

 

Global Financing revenue increased 7.7 percent (2 percent adjusted for currency), driven primarily by increased sales of used equipment.

 

From a geographic perspective, revenue increased in all geographies, led by strong performance in Asia Pacific, EMEA and the emerging countries. Americas’ revenue was $11.7 billion, an increase of 4.8 percent as reported (2 percent adjusted for currency). EMEA revenue increased 16.2 percent (6 percent adjusted for currency) to $10.8 billion. Revenue increased in most of the major countries, when adjusted for currency, led by Spain which was up 15 percent. Asia Pacific revenue increased 14.7 percent (9 percent adjusted for currency) to $5.5 billion, led by growth in the India, Greater China, Australia/New Zealand, ASEAN and Korea regions. Collectively, these regions increased 20.3 percent, adjusted for currency, versus the fourth quarter of 2006. The emerging BRIC countries of Brazil, Russia, India and China together grew 29.4 percent (18 percent

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

36



 

adjusted for currency). In addition to the BRIC markets, there are many other nations with a similar profile that have demonstrated rapidly growing markets with strong demand for business and IT infrastructure solutions. In December 2007, the company announced a new organization and management structure aimed at continuing to capture these opportunities.

 

Total expense and other income increased 8.6 percent compared to the fourth quarter of 2006. Total expense and other income to revenue ratio improved 0.3 points to 25.9 percent. Selling, general and administrative expense increased 7.0 percent (3 percent adjusted for currency), primarily driven by currency, continuing investments in key markets and acquisitions and increased accounts receivable provisions. Interest expense was $214 million, an increase of $144 million versus the fourth quarter of 2006. The higher level of interest expense was primarily driven by the increased debt utilized to fund the ASR agreements in the second quarter. Other (income) and expense was $98 million of income, a reduction of $52 million (34.5 percent) versus the fourth quarter of 2006. A reduction in gains on real estate transactions and losses from foreign currency transactions were partially offset by increased interest income due to higher cash balances.

 

The company’s effective tax rate in the fourth-quarter 2007 was 28.0 percent, flat when compared to the fourth-quarter 2006 rate.

 

Share repurchases totaled approximately $0.5 billion in the fourth quarter, including $0.3 billion related to the settlement of the ASR agreements (see note M, “Stockholders Equity Activity,” on pages 92 and 93). The weighted-average number of diluted common shares outstanding in the fourth quarter of 2007 was 1,412.9 million compared with 1,532.5 million in the fourth quarter of 2006.

 

The company generated $5,151 million in cash flow provided by operating activities, driven primarily by net income. Net cash from investing activities was a source of cash of $1,098 million in fourth quarter of 2007 versus a use of cash of $5,634 million in the fourth quarter of 2006, resulting primarily from the disposition of higher levels of short term marketable securities.

 

Prior Year in Review

 

 

 

 

 

 

 

YR.-TO-YR.

 

 

 

 

 

 

 

PERCENT/

 

($ and shares in millions except per share amounts)

 

 

 

 

 

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

%

Income/(loss) from discontinued operations

 

$

76

 

$

(24

)

NM

 

Income before cumulative effect of change in accounting principle

 

$

9,492

 

$

7,970

 

19.1

%

Cumulative effect of change in accounting principle, net of tax**

 

$

 

$

(36

)

NM

 

Net income

 

$

9,492

 

$

7,934

 

19.6

%

Net income margin

 

10.4

%

8.7

%

1.7

pts.

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:

 

 

 

 

 

 

 

Assuming dilution

 

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 adjusted for currency.

** Reflects implementation of FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” See note B, “Accounting Changes,” on page 75 for additional information.

At December 31.

NM — Not meaningful

 

37



 

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 reflected this improved business model.

 

The company divested its Personal Computing business on April 30, 2005. Therefore, the reported results for 2006 did not include any activity for the Personal Computing Division, while the results for 2005 included four months of activity. This lack of comparable periods had a material impact on the company’s reported revenue growth.

 

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 a 5.3 point improvement in the effective tax rate year to year.

 

The increased 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 Systems and Technology business driven by Microelectronics, System z and Storage; growth in System x and Retail Store Solutions; and

 

·      Continued growth in the emerging countries, Brazil, Russia, India and China, (up 21 percent) and solid performance in the Americas and EMEA geographies.

 

The increased 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.

 

Total revenue, as reported, increased 0.3 percent (flat adjusted for currency) versus 2005. 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 decreased revenue in Asia Pacific.

 

Americas’ revenue increased 1.8 percent (1 percent adjusted for currency) in 2006 versus 2005 and 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 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). Revenue in Germany declined 2.8 percent (4 percent adjusted for currency) year to year.

 

Asia Pacific revenue declined 5.7 percent (3 percent adjusted for currency) year over year. Japan, which represented over 50 percent of the Asia Pacific revenue base, declined 10.1 percent (5 percent adjusted for currency). The Japan revenue decline was partially offset by increased revenue in Korea (12.6 percent) and India (22.9 percent).

 

The emerging countries of Brazil, Russia, India and China together grew 9.9 percent (5 percent adjusted for currency) as the company continued to invest to build capabilities in these countries. Brazil grew 15.4 percent (4 percent adjusted for currency), Russia increased 13.9 percent (14 percent adjusted for currency) and India increased 22.9 percent (26 percent adjusted for currency). China declined 0.3 percent (2 percent adjusted for currency) as 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.

 

The company believes that a more appropriate revenue 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.

 

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

 

Management Discussion

 

14

Road Map

 

14

Forward-Looking and Cautionary Statements

 

15

Management Discussion Snapshot

 

16

Description of Business

 

17

Year in Review

 

23

Prior Year in Review

 

37

Discontinued Operations

 

42

Other Information

 

42

Global Financing

 

50

Report of Management

 

56

Report of Independent Registered Public Accounting Firm

 

57

Consolidated Statements

 

58

Notes

 

64

 

 

38



 

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, Russia, India 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.

 

The following is an analysis of the reportable segment results for Global Services, Systems and Technology and Software. The Global Financing segment analysis is included in the Global Financing section on page 51.

 

GLOBAL SERVICES

 

($ in millions)