EX-13 9 a2230222zex-13.htm EX-13

Exhibit 13

 

Report of Financials

International Business Machines Corporation and Subsidiary Companies

 

MANAGEMENT DISCUSSION

 

Overview

26

Forward-Looking and Cautionary Statements

27

Management Discussion Snapshot

27

Description of Business

30

Year in Review

36

Prior Year in Review

56

Other Information

67

Looking Forward

67

Liquidity and Capital Resources

68

Critical Accounting Estimates

71

Currency Rate Fluctuations

74

Market Risk

74

Cybersecurity

75

Employees and Related Workforce

76

Global Financing

76

 

 

Report of Management

82

 

 

Report of Independent Registered Public Accounting Firm

83

 

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Earnings

84

Comprehensive Income

85

Financial Position

86

Cash Flows

87

Changes in Equity

88

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

A Significant Accounting Policies

90

B Accounting Changes

99

C Acquisitions/Divestitures

101

D Financial Instruments

107

E Inventories

114

F Financing Receivables

114

G Property, Plant and Equipment

118

H Investments and Sundry Assets

119

I Intangible Assets Including Goodwill

119

J Borrowings

120

K Other Liabilities

123

L Equity Activity

123

M Contingencies and Commitments

127

N Taxes

129

O Research, Development and Engineering

132

P Earnings Per Share of Common Stock

132

Q Rental Expense and Lease Commitments

133

R Stock-Based Compensation

133

S Retirement-Related Benefits

136

T Segment Information

150

U Subsequent Events

154

 

 

Five-Year Comparison of Selected Financial Data

155

 

 

Selected Quarterly Data

156

 

 

Performance Graph

157

 

 

Board of Directors and Senior Leadership

158

 

 

Stockholder Information

159

 

25



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

OVERVIEW

 

The financial section of the International Business Machines Corporation (IBM or the company) 2016 Annual Report includes the Management Discussion, the Consolidated Financial Statements and the Notes to Consolidated Financial Statements. This Overview is designed to provide the reader with some perspective regarding the information contained in the financial section.

 

Organization of Information

 

·          The Management Discussion is designed to provide readers with an overview of the business and a narrative on the company’s financial results and certain factors that may affect its future prospects from the perspective of the company’s management. The “Management Discussion Snapshot,” beginning on page 27, presents an overview of the key performance drivers in 2016.

 

·          Beginning with the “Year in Review” on page 36, the Management Discussion contains the results of operations for each reportable segment of the business and a discussion of the company’s financial position and cash flows. Other key sections within the Management Discussion include: “Looking Forward” on page 67, and “Liquidity and Capital Resources” on page 68, which includes a description of management’s definition and use of free cash flow.

 

·          Global Financing is a reportable segment that is measured as a stand-alone entity. A separate “Global Financing” section is included in the Management Discussion beginning on page 76.

 

·          The Consolidated Financial Statements are presented on pages 84 through 89. These statements provide an overview of the company’s income and cash flow performance and its financial position.

 

·          Subsequent to the company’s press release and Form 8-K filing on January 19, 2017, announcing 2016 fourth-quarter and full-year financial results, the company revised the classification of certain financing receivables on a full-year basis increasing net cash provided by operating activities and net cash used in investing activities in the amount of $441 million. As adjusted, net cash provided by operating activities for the three months and twelve months ended December 31, 2016 is $3,968 million and $16,958 million, respectively, and, net cash used in investing activities is $3,687 million and $10,976 million for the same periods. There was no impact to total GAAP cash flows or free cash flow.

 

·          The Notes follow the Consolidated Financial Statements. Among other items, the Notes contain the company’s accounting policies (pages 90 to 99), acquisitions and divestitures (pages 101 to 106), detailed information on specific items within the financial statements, certain contingencies and commitments (pages 127 to 129) and retirement-related plans information (pages 136 to 150).

 

·          The Consolidated Financial Statements and the Notes have been prepared in accordance with accounting principles generally accepted in the United States (GAAP).

 

·          In October 2014, the company announced a definitive agreement to divest its Microelectronics business. The assets and liabilities of the Microelectronics business were reported as held for sale at December 31, 2014 and the operating results of the Microelectronics business have been reported as discontinued operations. The transaction closed on July 1, 2015.

 

·          In January 2016, the company made a number of changes to its organizational structure and management system. These changes impacted the company’s reportable segments, but did not impact the company’s Consolidated Financial Statements. Refer to Note T, “Segment Information,” on pages 150 to 154 for additional information on the changes in reportable segments. The company’s reportable segments are: Cognitive Solutions, Global Business Services, Technology Services & Cloud Platforms, Systems, and Global Financing. The company filed a recast 2015 Annual Report in a Form 8-K on June 13, 2016 to recast its historical segment information to reflect these changes.

 

·          The references to “adjusted for currency” or “at constant currency” in the Management Discussion do not include operational impacts that could result from fluctuations in foreign currency rates. When the company refers to growth rates at constant currency or adjusts such growth rates for currency, it is done so that certain financial results can be viewed without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons of its business performance. Financial results adjusted for currency are calculated by translating current period activity in local currency using the comparable prior year period’s currency conversion rate. This approach is used for countries where the functional currency is the local currency. Generally, when the dollar either strengthens or weakens against other currencies, the growth at constant currency rates or adjusting for currency will be higher or lower than growth reported at actual exchange rates. See “Currency Rate Fluctuations” on page 74 for additional information.

 

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

 

Operating (non-GAAP) Earnings

 

In an effort to provide better transparency into the operational results of the business, the company separates business results into operating and non-operating categories. Operating earnings from continuing operations is a non-GAAP measure that excludes the effects of certain acquisition-related charges, retirement-related costs, discontinued operations and related tax impacts. For acquisitions, operating earnings exclude the amortization of purchased intangible assets and acquisition-related charges such as in-process research and development, transaction costs, applicable restructuring and related expenses and tax charges related to acquisition integration. These charges are excluded as they may be inconsistent in amount and timing from period to period and are dependent on the size, type and

 

26



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

frequency of the company’s acquisitions. For retirement-related costs, the company characterizes certain items as operating and others as non-operating. The company includes defined benefit plan and nonpension postretirement benefit plan service cost, amortization of prior service cost and the cost of defined contribution plans in operating earnings. Non-operating retirement-related cost includes defined benefit plan and nonpension postretirement benefit plan interest cost, expected return on plan assets, amortized actuarial gains/losses, the impacts of any plan curtailments/settlements and multi-employer plan costs, pension insolvency costs and other costs. Non-operating retirement-related costs are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance and the company considers these costs to be outside of the operational performance of the business.

 

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

 

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. Any forward-looking statement in this Annual Report speaks only as of the date on which it is made; the company assumes no obligation to update or revise any such statements. Forward-looking statements are based on the company’s current assumptions regarding future business and financial performance; these statements, by their nature, address matters that are uncertain to different degrees. Forward-looking 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 2016 Form 10-K filed on February 28, 2017.

 

MANAGEMENT DISCUSSION SNAPSHOT

 

($ and shares in millions except per share amounts)

 

 

 

 

 

 

 

Yr.- to -Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Revenue

 

$

79,919

 

$

81,741

 

(2.2

)%*

Gross profit margin

 

47.9

%

49.8

%

(1.9

)pts.

Total expense and other (income)

 

$

25,964

 

$

24,740

 

4.9

%

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

 

32.5

%

30.3

%

2.2

pts.

Income from continuing operations before income taxes

 

$

12,330

 

$

15,945

 

(22.7

)%

Provision for income taxes from continuing operations

 

$

449

 

$

2,581

 

(82.6

)%

Income from continuing operations

 

$

11,881

 

$

13,364

 

(11.1

)%

Income from continuing operations margin

 

14.9

%

16.3

%

(1.5

)pts.

Loss from discontinued operations, net of tax

 

$

(9

)

$

(174

)

(95.1

)%

Net income

 

$

11,872

 

$

13,190

 

(10.0

)%

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

12.39

 

$

13.60

 

(8.9

)%

Consolidated earnings per share—assuming dilution

 

$

12.38

 

$

13.42

 

(7.7

)%

Weighted-average shares outstanding

 

 

 

 

 

 

 

Assuming dilution

 

958.7

 

982.7

 

(2.4

)%

Assets**

 

$

117,470

 

$

110,495

 

6.3

%

Liabilities**

 

$

99,078

 

$

96,071

 

3.1

%

Equity**

 

$

18,392

 

$

14,424

 

27.5

%

 


*                 (1.6) percent adjusted for currency

**          At December 31

 

27


 

 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

The following table provides the company’s (non-GAAP) operating earnings for 2016 and 2015

 

($ in millions except per share amounts)

 

 

 

 

 

 

 

Yr.-to -Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Net income as reported

 

$

11,872

 

$

13,190

 

(10.0

)%

Loss from discontinued operations, net of tax

 

(9

)

(174

)

(95.1

)

Income from continuing operations

 

$

11,881

 

$

13,364

 

(11.1

)%

Non-operating adjustments (net of tax)

 

 

 

 

 

 

 

Acquisition-related charges

 

735

 

562

 

30.9

 

Non-operating retirement-related costs/(income)

 

415

 

734

 

(43.5

)

Operating (non-GAAP) earnings*

 

$

13,031

 

$

14,659

 

(11.1

)%

Diluted operating (non-GAAP) earnings per share

 

$

13.59

 

$

14.92

 

(8.9

)%

 


* See pages 48 and 49 for a more detailed reconciliation of net income to operating earnings.

 

In 2016, the company reported $79.9 billion in revenue, $11.9 billion in income from continuing operations and $13.0 billion in operating (non-GAAP) earnings, resulting in diluted earnings per share from continuing operations of $12.39 as reported and $13.59 on an operating (non-GAAP) basis. The results of continuing operations exclude a net loss from discontinued operations of $9 million in 2016 and $174 million in 2015 related to the divestiture of the Microelectronics business. On a consolidated basis, net income in 2016 was $11.9 billion, with diluted earnings per share of $12.38. The company generated $17.0 billion in cash from operations and $11.6 billion in free cash flow and shareholder returns of $8.8 billion in gross common stock repurchases and dividends.

 

There are significant opportunities and shifts occurring in the IT industry, and the company believes that to be successful with enterprise clients, it needs to bring together cognitive technologies on cloud platforms that create industry-based solutions to solve real-world problems. In 2016, the company continued to:

 

·             Deliver strong results in the strategic imperatives;

 

·             Make progress in building new businesses and creating new markets;

 

·             Deliver innovation in the more traditional businesses and monetize core technologies; and

 

·             Return capital to shareholders.

 

Total consolidated revenue in 2016 decreased 2.2 percent as reported and 1.6 percent year to year adjusted for currency. Annuity revenue increased as reported and adjusted for currency while transactional revenue declined year to year. In addition, acquisitions completed in the past 12 months contributed to revenue growth.

 

The 2016 results reflect the success the company is having in its strategic imperatives and the investments made to drive that shift. The company had continued strong revenue growth in cloud, analytics and engagement, which together grew 13 percent year to year as reported and 14 percent adjusted for currency. In 2016, the strategic imperatives generated $32.8 billion in revenue, which represented 41 percent of the company’s revenue, an increase of 6 points from 2015. Total Cloud revenue of $13.7 billion increased 35 percent both as reported and adjusted for currency, with cloud as-a-Service revenue up 55 percent as reported and 57 percent adjusted for currency. The company exited 2016 with an annual run rate for cloud as-a-Service revenue of $8.6 billion, up from $5.3 billion at the end of 2015. Analytics revenue of $19.5 billion increased 9 percent as reported and adjusted for currency. Mobile revenue increased 34 percent year to year as reported (35 percent adjusted for currency) and Security revenue increased 13 percent as reported (14 percent adjusted for currency).

 

From a segment perspective, Cognitive Solutions revenue increased 1.9 percent as reported and 3 percent adjusted for currency with growth in Solutions Software, led by an increase in Analytics and Security revenue; partially offset by a decline in Transaction Processing Software. Global Business Services (GBS) revenue decreased 2.7 percent as reported and 3 percent adjusted for currency primarily driven by a decline in Consulting revenue. Revenue performance continued to be impacted by the company’s shift away from traditional businesses, such as ERP implementations. GBS strategic imperatives revenue had double-digit growth year to year as reported and adjusted for currency. Technology Services & Cloud Platforms revenue increased 0.6 percent as reported and 1 percent adjusted for currency led by growth in Infrastructure Services as the company assists clients in modernizing and transforming their infrastructures. Technology Services & Cloud Platforms strategic imperatives revenue was up 39 percent (40 percent adjusted for currency) year to year. Systems revenue decreased 19.2 percent (19 percent adjusted for currency) with z Systems down 27.1 percent (27 percent adjusted for currency) and Power Systems down 27.1 percent (27 percent adjusted for currency).

 

28



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

From a geographic perspective, Americas revenue decreased 2.5 percent as reported (1 percent adjusted for currency) with the U.S. down 0.9 percent. Europe/Middle East/Africa (EMEA) revenue decreased 5.0 percent as reported (2 percent adjusted for currency). Asia Pacific revenue increased 2.6 percent as reported, but decreased 1 percent adjusted for currency with Japan up 10.5 percent as reported, but down 1 percent adjusted for currency.

 

The consolidated gross profit margin of 47.9 percent decreased 1.9 points year to year and reflects the impact of the company’s investments, including acquisitions, and mix in as-a-Service which is not yet at scale. The operating (non-GAAP) gross margin of 48.9 percent decreased 1.9 points compared to 2015 driven primarily by the same factors.

 

Total expense and other (income) increased 4.9 percent in 2016 compared to the prior year. Total operating (non-GAAP) expense and other (income) increased 5.6 percent compared to 2015. The key year-to-year drivers were:

 

 

 

Total

 

Operating

 

 

 

Consolidated

 

(non-GAAP)

 

· Currency*

 

2 points

 

2 points

 

· Acquisitions**

 

5 points

 

4 points

 

· Base

 

(2) points

 

0 points

 

 


*                 Reflects impacts of translation and hedging programs

**          Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges.

 

The increase in expense was driven primarily by the impact of acquisitions completed in the prior 12 months and an impact from currency. Base expense performance reflects a higher level of intellectual property (IP) income ($950 million) year to year driven primarily by the company’s software licensing arrangements. Base expense also includes charges in 2016 for actions taken to accelerate the transformation of the company’s workforce and shift its skill base, as well as increased investments in the strategic areas of cognitive, security and cloud. This included a higher level of workforce rebalancing charges ($451 million) year to year and real estate capacity charges ($291 million) related to the workforce transformation. The company continued to invest at a high level in 2016 and remixed skills in support of the strategic imperatives.

 

Pre-tax income from continuing operations of $12.3 billion decreased 22.7 percent year to year and the pre-tax margin was 15.4 percent, a decrease of 4.1 points versus 2015. The continuing operations effective tax rate for 2016 was 3.6 percent, a decrease of 12.5 points versus 2015. The tax rate in 2016 was primarily the result of a refund ($1.0 billion) of previously paid non-U.S. taxes plus interest in the first quarter of 2016. Income from continuing operations of $11.9 billion decreased 11.1 percent and the net income margin was 14.9 percent, a decrease of 1.5 points versus 2015. Losses from discontinued operations, net of tax, were $9 million in 2016 compared to $174 million in 2015. Net income of $11.9 billion decreased 10.0 percent year to year. Operating (non-GAAP) pre-tax income from continuing operations of $13.9 billion decreased 21.3 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations decreased 4.2 points to 17.4 percent. Operating (non-GAAP) income from continuing operations of $13.0 billion decreased 11.1 percent and the operating (non-GAAP) income margin from continuing operations of 16.3 percent decreased 1.6 points. The operating (non-GAAP) effective tax rate from continuing operations in 2016 was 6.5 percent versus 17.2 percent in 2015.

 

Diluted earnings per share from continuing operations of $12.39 in 2016 decreased 8.9 percent year to year. In 2016, the company repurchased 23.3 million shares of its common stock at a cost of $3.5 billion and had $5.1 billion remaining in the share repurchase authorization at December 31, 2016. Operating (non-GAAP) diluted earnings per share of $13.59 decreased 8.9 percent versus 2015. Diluted earnings per share from discontinued operations was ($0.01) in 2016 compared to ($0.18) in 2015.

 

At December 31, 2016, the company continued to have the financial flexibility to support the business over the long term. Cash and marketable securities at December 31, 2016 were $8.5 billion, an increase of $0.3 billion from December 31, 2015. Key drivers in the balance sheet and total cash flows were:

 

Total assets increased $7.0 billion ($7.7 billion adjusted for currency) from December 31, 2015 driven by:

 

·             Increases in goodwill ($4.2 billion), retirement plan assets ($1.3 billion), net intangible assets ($1.2 billion), deferred taxes ($0.4 billion) and cash and marketable securities ($0.3 billion).

 

Total liabilities increased $3.0 billion ($3.9 billion adjusted for currency) from December 31, 2015 driven by:

 

·             Increases in total debt ($2.3 billion), retirement-related liabilities ($0.6 billion) and taxes ($0.4 billion).

 

Total equity of $18.4 billion increased $4.0 billion from December 31, 2015 as a result of:

 

·             Increases from net income ($11.9 billion) and stock-based compensation ($0.5 billion); partially offset by

 

·             Decreases from dividends ($5.3 billion) and share repurchases ($3.5 billion).

 

The company generated $17.0 billion in cash flow provided by operating activities, essentially flat compared to 2015, driven primarily by operational performance; offset by lower income tax payments. Net cash used in investing activities of $11.0 billion was $2.8 billion higher than 2015, primarily driven by an increase in cash used related to acquisitions ($2.3 billion). Net cash used in financing activities of $5.8 billion decreased $3.4 billion compared to the prior year, driven primarily by higher net debt issuances ($2.7 billion) and a decline in cash used for common share repurchases ($1.1 billion).

 

29



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

In January 2017, the company disclosed that it is expecting GAAP earnings per share from continuing operations of at least $11.95 and operating (non-GAAP) earnings of at least $13.80 per diluted share for 2017. The company expects 2017 free cash flow realization to be in excess of 90 percent of GAAP net income and free cash flow to be essentially flat year to year. Refer to page 69 in the Liquidity and Capital Resources section for additional information on this non-GAAP measure. Refer to the Looking Forward section on pages 67 and 68 for additional information on the company’s expectations.

 

DESCRIPTION OF BUSINESS

 

Please refer to IBM’s Annual Report on Form 10-K filed with the SEC on February 28, 2017 for Item 1A. entitled “Risk Factors.”

 

The company creates value for clients through integrated solutions and products that leverage: data, information technology, deep expertise in industries and business processes, and a broad ecosystem of partners and alliances. IBM solutions typically create value by enabling new capabilities for clients that transform their businesses and help them engage with their customers and employees in new ways. These solutions draw from an industry-leading portfolio of consulting and IT implementation services, cloud and cognitive offerings, and enterprise systems and software; all bolstered by one of the world’s leading research organizations.

 

Strategy

 

IBM has a history of continuous re-invention, transforming itself throughout its 100-plus year history. In the past five decades alone, IBM has ushered in the eras of the mainframe, the personal computer, IT services and enterprise software. In its current transformation, IBM is once again leading the reordering of the technology industry.

 

A number of years ago, the company declared its focus on the strategic forces behind the “digital” revolution; data, cloud and engagement, driven by mobile and social, and underpinned by security. Since 2010, IBM has invested approximately $40 billion in these areas, built out the IBM Cloud on a global scale and extended cognitive systems to numerous enterprises and industries. The company made 55 acquisitions and has formed partnerships with organizations that are leading players in key industries.

 

Because of this transformation, IBM today is much more than a hardware, software and services company; IBM is a cognitive solutions and cloud platform company, with a focus on industry capabilities and expertise:

 

Cognitive Solutions: With the highest level of intelligence that exists in technology systems, these solutions tackle challenges ranging from answering client inquiries to helping physicians fight cancer.

 

Cloud Platform: IBM Cloud is the leading cloud platform for the enterprise, providing what enterprises need for speed, agility and, combined with Watson, for cognitive capability.

 

Industry Focus: As IBM brings higher levels of value to its clients, as its offerings are being built for the needs of individual industries. Healthcare and Financial Services are two examples of the company’s initial cognitive focus.

 

Cognitive Solutions

 

Since IBM’s Watson was introduced in 2011, the company has been developing a new generation of cognitive systems that can see and analyze the massive amounts of data that have previously been invisible to computers and enterprises. IBM’s cognitive systems have the capability to inject a kind of thinking ability into every digitized object, process and service, and learn from interactions. IBM is on the forefront of deploying these systems and helping clients to embrace the cognitive era.

 

Cognitive systems are not programmed; like humans, they learn from experts and from every interaction, and they are uniquely able to find patterns in big data. They learn by using advanced algorithms to sense, predict and infer. Doing so, they augment human intelligence, allowing individuals to make faster and more informed decisions.

 

Since Watson’s debut, many technologies have entered the market under the banner of artificial intelligence. However, IBM’s approach to cognitive systems is quite unique:

 

·             Highly adaptable intelligence systems: Watson has broad applicability and can help clients tackle challenges ranging from oncology to customer support.

 

·             Protect and respect client data: Watson learns through data, both public data as well as clients’ private data. Clients choose whether their data or insights are shared. IBM respects the clients’ ownership and control of their own data.

 

·             Easy entry points: Watson’s open APIs offer easy on-ramps to experiment with speech, vision and other data.

 

·             Trained in domain depth: Watson is trained to be an expert in industries and functional specialties. It augments the knowledge of professionals, giving them access to the insights of their best colleagues and the world’s leading experts.

 

·             Transformational services: IBM’s Cognitive Solutions and Watson Internet of Things (IoT) practices help clients build their cognitive strategies. GBS provides outcome-focused methodologies, domain skills and deep industry expertise.

 

30



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Cloud Platform

 

Cloud represents more than a new architecture for delivering infrastructure and applications as services; it is also a catalyst for innovation, speed and agility. Cloud enables companies to focus on differentiating their strategies, capabilities and business models rather than on the underlying technology.

 

The IBM Cloud brings a unique set of characteristics to clients:

 

·             It is a world-class cloud platform designed for enterprises, where security, reliability, scalability and performance are critical.

 

·             It is the industry-leading hybrid cloud, enabling clients to extend their existing IT investments, connecting valuable data and applications across public and private clouds.

 

·             It is a world-class cognitive cloud platform with IBM Watson services that developers can embed into their applications to create differentiating customer experiences and powerful insights.

 

The IBM Cloud has a strong global presence, with more than 50 cloud data centers around the world giving clients the flexibility to optimize the deployment of data and application, for performance, security and compliance.

 

The IBM Cloud is also continually expanding its base of advanced capabilities including cloud data services, cloud object storage, cloud video services, as well as Internet of Things, blockchain and analytics services. In 2016, IBM brought new cognitive solutions to professionals in marketing, commerce, supply chain and human resources, extending industry clouds to further differentiate its cloud offerings.

 

Industry Focus

 

To bring higher value to clients, IBM is providing solutions that are specific and tailored to challenges clients face in their industry, using the power of IBM’s advanced cognitive computing capabilities built on the IBM Cloud. In 2016, IBM deepened its commitment to delivering higher value in several key ways:

 

·             In the healthcare industry, IBM Watson Health combines the power of cloud and cognitive with value-based solutions to optimize performance, engage consumers, enable effective care and manage population health. Significant investment in the healthcare space, including the acquisition of Merge and Truven, has enabled the company to expand the scope of solutions aimed at solving some of the most pressing health challenges.

 

·             IBM continues to partner with financial services clients to build a robust infrastructure addressing increasingly complex and fast-changing demands. From preventing fraud to supporting cyber security efforts, IBM is becoming ever-more essential to the financial industry.

 

·             IBM offers analytics to help clients assess their risk and compliance against industry guidelines, and uses a cognitive approach to provide deeper and faster findings. In late 2016, the company acquired Promontory Financial Group, LLC (Promontory), one of the world’s leading regulatory consulting firms. Promontory is training Watson to be a market-leading expert in the regulatory field, which will allow the company to deliver services at new levels of efficiency and transparency.

 

·             IBM is committed to blockchain to provide a highly secure method of facilitating multi-step transactions, reducing the number of disputes and points of friction, including its participation in the Hyperledger Project. This cross-industry consortium is working to build the blockchain network in the cloud, doing for trusted transactions what the Internet did for information, and setting industry standards for years to come. Blockchain will enable financial institutions to settle securities in minutes instead of days; manufacturers to reduce product recalls by sharing production logs along their supply chain; and businesses of all types to more closely manage the flow of goods and payments. IBM is working with companies ranging from retailers, banks and shippers to apply this technology to transform their ecosystems through open standards and open platforms.

 

·             IBM’s Global Business Services consulting business, with broad expertise across industries and a strong global footprint and scale, provides a unique combination of technologies and services to help clients achieve their business outcomes.

 

31


 

 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Transforming Core Businesses

 

While the company is focused on cognitive solutions, cloud platform and industry, it is important to note cognitive, cloud and industry are being embedded across IBM’s offerings. These core businesses continue to run clients’ most critical business processes. IBM’s hardware systems are being designed from the ground up to power the cloud and cognitive systems of the future. The company’s technology services help clients move to the cloud, embedding cognitive capabilities tailored for their industry. The company’s software offerings are simultaneously being made available for the cloud as well as being connected to the cloud where our clients choose to keep them on premises. Additionally, cognitive capabilities are being added to these offerings to provide new levels of innovation. In short, all of IBM is transforming to support the way its clients are transforming.

 

Summary

 

Each transformation of IBM ushers in a new capability to the world. More than 50 years ago, IBM introduced the programmable era and transformed the world’s transactions through the mainframe. In the decades that followed, IBM commercialized the personal computer, created an industry around IT services and a software market around middleware. Each of these innovations remains essential to business and the world today.

 

The company’s current chapter is ushering in an entirely new era of human-computer interaction, embodied in cognitive solutions and the cloud platform for the needs of industries. The company is embarking on an era where it will create new capabilities at speeds and depth never previously witnessed.

 

Business Model

 

The company’s business model is built to support two principal goals: helping enterprise clients to become more innovative, efficient and competitive through the application of business insight and 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 superior long-term growth and profitability prospects based on the value they deliver to clients.

 

The company’s global capabilities as a cognitive solutions and cloud platform company include services, software, systems, fundamental research and related financing. The broad mix of businesses and capabilities are combined to provide integrated solutions and platforms to the company’s clients.

 

The business model is dynamic, adapting to the continuously changing industry and economic environment, including the company’s transformation into cloud and as-a-Service delivery models. The company continues to strengthen its position through strategic organic investments and acquisitions in higher-value areas, strengthening its industry expertise and applying advanced analytics across virtually all its offerings. In addition, the company is transforming into a more agile enterprise to drive innovation and speed, as well as helping to drive productivity, which supports investments for participation in markets with significant long-term opportunity.

 

This business model, supported by the company’s financial model, has enabled the company to deliver strong earnings, cash flows and returns to shareholders over the long term.

 

Business Segments and Capabilities

 

The company’s major operations consist of five business segments: Cognitive Solutions, Global Business Services, Technology Services & Cloud Platforms, Systems and Global Financing.

 

Cognitive Solutions comprises a broad portfolio of capabilities that help IBM’s clients to identify actionable new insights and inform decision-making for competitive advantage. Leveraging IBM’s research, technology and industry expertise, this business delivers a full spectrum of capabilities, from descriptive, predictive and prescriptive analytics to cognitive systems. Cognitive Solutions includes Watson, the first commercially available cognitive computing platform that has the ability to interact in natural language, process vast amounts of big data, and learn from interactions with people and computers. These solutions are provided through the most contemporary delivery methods including through cloud environments and “as-a-Service” models. Cognitive Solutions consists of Solutions Software and Transaction Processing Software.

 

Cognitive Solutions Capabilities

 

Solutions Software: provides the basis for many of the company’s strategic areas including analytics, security and social. IBM has established the world’s deepest portfolio of data and analytics solutions, including analytics and data management platforms, cloud data services, enterprise social software, talent management solutions, and solutions tailored by industry. Watson Platform, Watson Health and Watson Internet of Things capabilities are included in Solutions Software. IBM’s world-class security platform delivers integrated security intelligence across clients’ entire operations, including their cloud, applications, networks and data, helping them to prevent, detect and remediate potential threats.

 

32



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Transaction Processing Software: includes software that primarily runs mission-critical systems in industries such as banking, airlines and retail. Most of this software is on-premise and annuity in nature.

 

Global Business Services (GBS) provides clients with consulting, application management services and global process services. These professional services deliver business value and innovation to clients through solutions which leverage industry, technology and business process expertise. GBS is the digital reinvention partner for IBM clients, combining industry knowledge, functional expertise, and applications with the power of design, cognitive and cloud. The full portfolio of GBS services is backed by its globally integrated delivery network and integration with IBM solutions and services including Watson, cloud, blockchain, and Technology Services. To deepen its capabilities, in 2016 IBM acquired four consulting and design firms to enhance the GBS global network of 35 digital experience design studios. IBM also announced Watson IoT Consulting Solutions, a new practice that brings together IBM’s industry and technical expertise to help clients introduce IoT innovation into their businesses.

 

GBS Capabilities

 

Consulting: provides business consulting services focused on bringing to market solutions that help clients shape their digital blueprints and customer experiences, define their cognitive operating models, set their next-generation talent strategies and create new technology visions and architectures in a cloud-centric world.

 

Application Management: delivers system integration, application management, maintenance and support services for packaged software, as well as custom and legacy applications. Value is delivered through advanced capabilities in areas such as security and privacy, application testing and modernization, cloud application migration and automation.

 

Global Process Services: GBS’ business process outsourcing service line, delivers finance, procurement, HR, and industry-specific business processes. These services deliver improved business results to clients through the strategic change and/or operation of the client’s business processes, applications and infrastructure. GBS is redefining the efficiency and cost profiles of clients’ core processes through the application of the power of Watson, cognitive and deep analytics.

 

Technology Services & Cloud Platforms provides comprehensive IT infrastructure services creating business value for clients through integrated services that incorporate unique intellectual property within its global delivery model. By leveraging insights and experience drawn from IBM’s global scale, skills and technology, with applied innovation from IBM Research, clients gain access to leading edge, high-quality services with improved productivity, flexibility, cost and outcomes.

 

Technology Services & Cloud Platforms Capabilities

 

Infrastructure Services: delivers a portfolio of cloud, project-based, outsourcing and other managed services focused on clients’ enterprise IT infrastructure environments to enable digital transformation and deliver improved quality, flexibility, risk management and financial value. The portfolio includes a comprehensive set of hybrid cloud services and solutions to assist clients in building and running enterprise IT environments that utilize public and private clouds and traditional IT. The IBM Cloud Platform offers leading edge services to developers and IBM’s Cloud Infrastructure-as-a-Service covers a wide variety of workloads with unprecedented performance. These offerings integrate long-standing expertise in service management and technology with the ability to utilize the power of new technologies, including those from other IBM business segments. The portfolio is built around a key set of predictive and proactive solutions addressing systems, mobility, resiliency, networking, cloud and security. The company’s capabilities, including IBM Cloud, cognitive computing and hybrid cloud implementation, can help to deliver high-performance, end-to-end innovation and an improved ability to achieve business objectives.

 

Technical Support Services: delivers a comprehensive line of support services to maintain and improve the availability of clients’ IT infrastructures. These offerings include maintenance for IBM products and other technology platforms, as well as software and solution support.

 

Integration Software: delivers industry-leading hybrid cloud solutions that empower clients to achieve rapid innovation, hybrid integration, and process transformation with choice and consistency across public, dedicated and local cloud environments, leveraging IBM’s Bluemix Platform-as-a-Service solution. Integration Software offerings and capabilities help clients address the digital imperatives to create, connect and optimize their applications, data and infrastructure on their journey to become cognitive businesses.

 

33



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Systems provides clients with innovative infrastructure technologies to help meet the new requirements of hybrid cloud and cognitive workloads—from deploying advanced analytics, to moving to digital service delivery with the cloud, and securing mobile transaction processing. Approximately half of Systems Hardware’s server and storage sales transactions are through the company’s business partners, with the balance direct to end-user clients. IBM Systems also designs advanced semiconductor and systems technology in collaboration with IBM Research, primarily for use in the company’s systems.

 

Systems Capabilities

 

Servers: a range of high-performance systems designed to address computing capacity, security and performance needs of businesses, hyperscale cloud service providers and scientific computing organizations. The portfolio includes z Systems, a trusted enterprise platform for integrating data, transactions and insight, and Power Systems, a system designed from the ground up for big data and analytics, optimized for scale-out cloud and Linux, and delivering open innovation with OpenPOWER.

 

The company is a founding member of the OpenPOWER foundation, a group of industry-leading companies developing high-performance compute technologies and solutions based on the IBM POWER architecture.

 

Storage: data storage products and solutions that allow clients to retain and manage rapidly growing, complex volumes of digital information and to fuel data-centric cognitive applications. These solutions address critical client requirements for information retention and archiving, security, compliance and storage optimization including data deduplication, availability and virtualization. The portfolio consists of a broad range of software-defined storage solutions, flash storage, disk and tape storage solutions.

 

Operating Systems Software: The company’s z/OS is a security-rich, scalable, high-performance enterprise operating system for z Systems. Power Systems offers a choice of AIX or Linux operating systems. These operating systems leverage POWER architecture to deliver secure, reliable and high- performing enterprise-class workloads across a breadth of server offerings.

 

Global Financing facilitates IBM clients’ acquisition of information technology systems, software and services by providing financing solutions in the areas where the company has the expertise. The financing arrangements are predominantly for products or services that are critical to the end users’ business operations. These financing contracts are entered into after a comprehensive credit evaluation and are secured by legal contracts. As a captive financier, Global Financing has the benefit of both deep knowledge of its client base and a clear insight into the products and services financed. These factors allow the business to effectively manage two of the major risks, credit and residual value, associated with financing while generating strong returns on equity. Global Financing also maintains a long-term partnership with the companies’ clients through various stages of IT asset life cycle—from initial purchase and technology upgrades to asset disposition decisions.

 

Global Financing Capabilities

 

Client Financing: lease, installment payment plan and loan financing to end users and internal clients for terms up to seven years. Assets financed are primarily new and used IT hardware, software and services where the company has expertise. Internal financing is predominantly in support of Technology Services & Cloud Platforms’ long-term client service contracts. All internal financing arrangements are at arm’s-length rates and are based upon market conditions.

 

Commercial Financing: short-term inventory and accounts receivable financing to suppliers, distributors and remarketers of IBM and OEM products. This includes internal activity where Global Financing factors a selected portion of the company’s accounts receivable primarily for cash management purposes, at arm’s-length rates.

 

Remanufacturing and Remarketing: assets include used equipment returned from lease transactions, or used and surplus equipment acquired internally or externally. These assets may be refurbished or upgraded and sold or leased to new or existing clients both externally or internally. Externally remarketed equipment revenue represents sales or leases to clients and resellers. Internally remarketed equipment revenue primarily represents used equipment that is sold internally to Systems and Technology Services & Cloud Platforms. Systems may also sell the equipment that it purchases from Global Financing to external clients.

 

34



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

IBM Worldwide Organizations

 

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

 

·      Global Markets (formerly Sales and Distribution)

 

·      Research, Development and Intellectual Property

 

·      Integrated Supply Chain

 

Global Markets

 

IBM has a global presence, operating in more than 175 countries with a broad-based geographic distribution of revenue. The company’s Global Markets organization manages IBM’s global footprint, working closely with dedicated country-based operating units to serve clients locally. These country teams have client relationship managers who lead integrated teams of consultants, solution specialists and delivery professionals to enable clients’ growth and innovation. These local teams develop deep relationships with their clients to bring together capabilities from IBM and its network of Business Partners to develop and implement solutions.

 

By complementing local expertise with global experience and digital capabilities, IBM builds broad-based client relationships. This local management focus fosters speed in addressing new markets and making investments in emerging opportunities. The Global Markets organization serves clients with expertise in their industry as well as through the products and services that IBM and partners supply. IBM is also expanding its reach to smaller clients through digital marketing, digital marketplaces, inside sales and local Business Partner resources.

 

IBM continues to invest to capture opportunities in key growth markets around the world—India, China and Southeast Asia; Eastern Europe; the Middle East and Africa; and Latin America. Major IBM markets include the G7 countries of Canada, France, Germany, Italy, Japan, the United States (U.S.) and the United Kingdom (U.K.), as well as Austria, the Bahamas, Belgium, the Caribbean, Cyprus, Denmark, Finland, Greece, Iceland, Ireland, Israel, Malta, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland.

 

Research, Development and Intellectual Property

 

IBM’s research and development (R&D) operations differentiate the company from its competitors. IBM annually invests 6 to 7 percent of total revenue for R&D, focusing on high-growth, high-value opportunities. IBM Research works with clients and the company’s business units through global labs on near-term and midterm innovations. It contributes many new technologies to IBM’s portfolio every year and helps clients address their most difficult challenges. IBM Research scientists are conducting pioneering work in artificial intelligence, analytics, security, nanotechnology, cloud computing, blockchain, quantum computing, silicon and post-silicon computing architectures, data-centric systems and more—applying these technologies across industries including healthcare, Internet of Things, education and financial services.

 

In 2016, IBM was awarded more U.S. patents than any other company for the 24th consecutive year. IBM’s 8,088 patents awarded in 2016 represent a diverse range of inventions in artificial intelligence and cognitive computing, cognitive health, cloud, cybersecurity and other strategic growth areas for the company.

 

The company continues to actively seek intellectual property (IP) protection for its innovations, while increasing emphasis on other initiatives designed to leverage its IP leadership. Some of IBM’s technological breakthroughs are used exclusively in IBM products, while others are licensed and may be used in IBM products and/or the products of the licensee. As part of its business model, the company licenses certain of its intellectual property, which is high-value technology, but may be in more mature markets. The licensee drives the future development of the IP and ultimately expands the customer base. This generates IP income for the company both upon licensing, and with ongoing royalty arrangements between it and the licensee. While the company’s various proprietary IP rights are important to its success, IBM believes its business as a whole is not materially dependent on any particular patent or license, or any particular group of patents or licenses. IBM owns or is licensed under a number of patents, which vary in duration, relating to its products.

 

Integrated Supply Chain

 

IBM has an extensive integrated supply chain, procuring materials and services globally. Additionally, growth in client spend managed by IBM’s procurement organization continues to demonstrate clients’ faith that IBM can reduce clients’ cost through the transformation of source-to-pay operations. The supply, manufacturing and logistics operations are seamlessly integrated and have optimized inventories over time. Simplifying and streamlining internal processes has improved sales force productivity and operational effectiveness and efficiency. Supply chain resiliency enables IBM to reduce its risk during marketplace changes.

 

The company continues to derive business value from its own globally integrated supply chain providing a strategic advantage for the company to create value for clients. 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. Utilizing analytics, mobile, cloud and social—with numerous projects, has allowed the integrated supply chain to drive positive business outcomes for the company and its clients.

 

35


 

 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

YEAR IN REVIEW

 

Results of Continuing Operations

 

Segment Details

 

The following is an analysis of the 2016 versus 2015 reportable segment results. The table below presents each reportable segment’s external revenue and gross margin results. Segment pre-tax income includes transactions between segments that are intended to reflect an arm’s-length transfer price and excludes certain unallocated corporate items.

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent

 

 

 

 

 

 

 

Percent/

 

Change

 

 

 

 

 

 

 

Margin

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Revenue

 

 

 

 

 

 

 

 

 

Cognitive Solutions

 

$

18,187

 

$

17,841

 

1.9

%

2.7

%

Gross margin

 

81.9

%

85.1

%

(3.3

)pts.

 

 

Global Business Services

 

16,700

 

17,166

 

(2.7

)%

(2.5

)%

Gross margin

 

27.0

%

28.2

%

(1.2

)pts.

 

 

Technology Services & Cloud Platforms

 

35,337

 

35,142

 

0.6

%

1.4

%

Gross margin

 

41.9

%

42.7

%

(0.8

)pts.

 

 

Systems

 

7,714

 

9,547

 

(19.2

)%

(18.9

)%

Gross margin

 

55.7

%

55.8

%

(0.1

)pts.

 

 

Global Financing

 

1,692

 

1,840

 

(8.0

)%

(6.9

)%

Gross margin

 

38.7

%

45.6

%

(6.9

)pts.

 

 

Other

 

289

 

206

 

40.4

%

41.3

%

Gross margin

 

(293.9

)%

(253.0

)%

(41.0

)pts.

 

 

Total consolidated revenue

 

$

79,919

 

$

81,741

 

(2.2

)%

(1.6

)%

 

 

 

 

 

 

 

 

 

 

Total consolidated gross profit

 

$

38,294

 

$

40,684

 

(5.9

)%

 

 

Total consolidated gross margin

 

47.9

%

49.8

%

(1.9

)pts.

 

 

Non-operating adjustments

 

 

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

494

 

373

 

32.6

%

 

 

Retirement-related costs/(income)

 

316

 

469

 

(32.7

)%

 

 

Operating (non-GAAP) gross profit

 

$

39,104

 

$

41,526

 

(5.8

)%

 

 

Operating (non-GAAP) gross margin

 

48.9

%

50.8

%

(1.9

)pts.

 

 

 

Cognitive Solutions

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.- to -Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Cognitive Solutions external revenue

 

$

18,187

 

$

17,841

 

1.9

%

2.7

%

Solutions Software

 

$

12,589

 

$

12,021

 

4.7

%

5.5

%

Transaction Processing Software

 

5,598

 

5,819

 

(3.8

)

(3.1

)

 

 

 

 

 

 

 

 

 

 

 

Cognitive Solutions revenue of $18,187 million grew 1.9 percent as reported and 3 percent adjusted for currency in 2016 compared to the prior year. On an as reported and constant currency basis, growth in Solutions Software, which addresses many of the company’s strategic areas, was partially offset by declines in Transaction Processing Software.

 

Solutions Software revenue of $12,589 million grew 4.7 percent as reported (6 percent adjusted for currency) compared to the prior year. This growth was led by analytics and security offerings. Analytics, which is the largest portion of the Solutions Software portfolio, continued to grow in key areas including Watson offerings such as Watson Health. Security also contributed to year-to-year growth, as the company continues to invest to build its security platform. There was strong Software-as-a-Service (SaaS) performance during the year with double-digit growth in revenue as reported and adjusted for currency. In 2016, five acquisitions, including The Weather Company and Truven, added substantial new capabilities to the Solutions Software portfolio.

 

Throughout the year, the Watson platform, which underpins the company’s cognitive strategy, continued to gain momentum, as the company expanded cognitive capabilities in the IBM Cloud.

 

36



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

The company broadened the reach of Watson, with new capabilities, partnerships and engagement to accelerate adoption. Focus continues on scaling Watson Health and bringing real world benefits to researchers and clinicians. Watson IoT is growing and clients are using the power of Watson across the immense data pool created by the Internet of Things. The company is expanding its industry differentiation and focus on building industry verticals including the acquisition of Promontory in the fourth quarter.

 

Transaction Processing Software revenue of $5,598 million declined 3.8 percent as reported (3 percent adjusted for currency) compared to the prior year. Most of this software is on-premise and annuity in nature which is not a growing part of the software opportunity.

 

Within Cognitive Solutions, total 2016 strategic imperatives revenue of $11.7 billion grew 7 percent as reported (8 percent adjusted for currency) year to year. Cloud revenue of $2.1 billion grew 53 percent as reported (54 percent adjusted for currency), with an as-a-Service exit run rate of $1.8 billion.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

For the year ended

 

 

 

 

 

Margin

 

December 31:

 

2016

 

2015

 

Change

 

Cognitive Solutions

 

 

 

 

 

 

 

External gross profit

 

$

14,890

 

$

15,189

 

(2.0

)%

External gross profit margin

 

81.9

%

85.1

%

(3.3

)pts.

Pre-tax income

 

$

6,352

 

$

7,245

 

(12.3

)%

Pre-tax margin

 

30.5

%

36.1

%

(5.6

)pts.

 

Cognitive Solutions gross profit margin decreased 3.3 points to 81.9 percent in 2016. Pre-tax income of $6,352 million decreased 12.3 percent compared to the prior year with a pre-tax margin decline of 5.6 points to 30.5 percent. This overall margin performance for the year reflects impacts of the company’s continued investment into strategic areas, including acquisition content, and the mix toward the SaaS business which is not yet at scale, partially offset by the impact of IP partnership agreements entered into during the year.

 

Global Business Services

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Global Business Services external revenue

 

$

16,700

 

$

17,166

 

(2.7

)%

(2.5

)%

Consulting

 

$

7,332

 

$

7,678

 

(4.5

)%

(4.8

)%

Global Process Services

 

1,388

 

1,435

 

(3.3

)

(2.0

)

Application Management

 

7,980

 

8,053

 

(0.9

)

(0.5

)

 

Global Business Services revenue of $16,700 million decreased 2.7 percent as reported and 3 percent adjusted for currency in 2016 compared to the prior year. Digital practices, which made up more than half of GBS revenue in 2016, grew strong double digits as reported and adjusted for currency including double-digit growth in cloud, analytics and mobile. This growth was more than offset by declines in the more traditional areas that the company is shifting away from, such as large ERP implementations.

 

Consulting revenue of $7,332 million declined 4.5 percent as reported (5 percent adjusted for currency). Global Process Services (GPS) revenue of $1,388 million decreased 3.3 percent as reported (2 percent adjusted for currency) compared to the prior year. Application Management revenue of $7,980 million decreased 0.9 percent as reported (flat adjusted for currency).

 

Within GBS, total 2016 strategic imperatives revenue of $8.9 billion grew 16 percent as reported and adjusted for currency year to year. Cloud revenue of $3.0 billion grew 68 percent as reported (66 percent adjusted for currency), with an as-a-Service exit run rate of $1.1 billion.

 

The company continues to aggressively shift the business to the strategic imperatives, or digital practices in GBS. The IBM Interactive Experience, the largest global digital agency, now has more than 30 studios worldwide. The company continues to respond to clients looking to create new business models with cognitive technologies. There was continued revenue growth in 2016, both as reported and adjusted for currency, in enterprise mobility solutions that are helping clients redesign workflows with specific industry content. The company’s growing collection of MobileFirst for iOS applications can now be integrated with a broad set of Watson technologies to increase productivity. The company is scaling the industry’s first cognitive consulting practice which draws on the expertise of consulting professionals spanning machine learning, advanced analytics, data science and development. During 2016, six acquisitions added substantial new capabilities in digital design, cloud consulting and other skill areas.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

For the year ended

 

 

 

 

 

Margin

 

December 31:

 

2016

 

2015

 

Change

 

Global Business Services

 

 

 

 

 

 

 

External gross profit

 

$

4,501

 

$

4,837

 

(6.9

)%

External gross profit margin

 

27.0

%

28.2

%

(1.2

)pts.

Pre-tax income

 

$

1,732

 

$

2,602

 

(33.4

)%

Pre-tax margin

 

10.1

%

14.7

%

(4.6

)pts.

 

37



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

GBS gross profit margin decreased 1.2 points to 27.0 percent compared to the prior year, with declines in Consulting and GPS. Overall, this reflects the company’s investments to grow the digital practices, additional spending in certain accounts to deliver on client commitments, and price and profit pressure in more traditional engagements. These dynamics are also reflected in the pre-tax margin for the year. In 2016, pre-tax income of $1,732 million decreased 33.4 percent and the pre-tax margin declined 4.6 points to 10.1 percent.

 

The company continues to invest and shift resources to higher value services around digital and cognitive. The company is investing in enablement, hiring top talent and bringing in new skills through acquisitions and focusing on integrating and scaling these new skills. While this impacts near-term profit, this investment has added important capabilities as the company continues to expand the digital practices.

 

Technology Services & Cloud Platforms

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Technology Services & Cloud Platforms external revenue

 

$

35,337

 

$

35,142

 

0.6

%

1.4

%

Infrastructure Services

 

$

23,543

 

$

23,075

 

2.0

%

2.7

%

Technical Support Services

 

7,272

 

7,426

 

(2.1

)

(1.0

)

Integration Software

 

4,521

 

4,641

 

(2.6

)

(1.5

)

 

Technology Services & Cloud Platforms revenue of $35,337 million grew 0.6 percent as reported and 1 percent adjusted for currency in 2016 compared to the prior year. As the business shifts from systems integration to services integration, there is continuing momentum in new offerings. Infrastructure Services revenue grew as reported and adjusted for currency, partially offset by declines in Technical Support Services and Integration Software. In 2016, four acquisitions have expanded capabilities and strengthened the company’s portfolio.

 

Infrastructure Services revenue of $23,543 million grew 2.0 percent as reported (3 percent adjusted for currency) compared to the prior year. Technical Support Services revenue of $7,272 million decreased 2.1 percent as reported (1 percent adjusted for currency). Integration Software revenue of $4,521 million decreased 2.6 percent as reported (1 percent adjusted for currency) in 2016 compared to the prior year.

 

In Infrastructure Services, clients continue to turn to the company as the trusted partner to modernize and transform their most critical IT systems and navigate the complexities of the hybrid cloud environment. The company’s hybrid cloud strategy is resonating with clients as they move to enterprise-grade cloud solutions that are secure, agile and leverage the data and investments in their core systems. Enterprise workloads on the company’s public cloud continue to scale, contributing to growth in as-a-Service content. The company continues to expand its cloud infrastructure and now has 50 cloud centers around the world, enabling low latency connectivity to cloud infrastructure.

 

Although revenue declined year to year, Technical Support Services continues to generate substantial revenue and profit. There was year-to-year revenue growth as reported and adjusted for currency in multi-vendor services, which is leveraging the company’s global scale and deep technical skills.

 

In Integration Software, there was revenue growth in Connect products that integrate applications, data and processes for on-premise and cloud environments. There was also a continued shift of the portfolio to an as-a-Service model through IBM’s Bluemix cloud platform which continues to scale across a broad catalog of high value services.

 

Within Technology Services & Cloud Platforms, total 2016 strategic imperatives revenue of $8.7 billion grew 39 percent as reported (40 percent adjusted for currency) year to year. Cloud revenue of $5.9 billion grew 49 percent as reported (50 percent adjusted for currency), with an as-a-Service exit run rate of $5.8 billion.

 

38


 

 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

For the year ended

 

 

 

 

 

Margin

 

December 31:

 

2016

 

2015*

 

Change

 

Technology Services & Cloud Platforms

 

 

 

 

 

 

 

External Technology Services gross profit

 

$

10,969

 

$

11,008

 

(0.4

)%

External Technology Services gross profit margin

 

35.6

%

36.1

%

(0.5

)pts.

External Integration Software gross profit

 

$

3,830

 

$

4,005

 

(4.4

)%

External Integration Software gross profit margin

 

84.7

%

86.3

%

(1.6

)pts.

External total gross profit

 

$

14,800

 

$

15,014

 

(1.4

)%

External total gross profit margin

 

41.9

%

42.7

%

(0.8

)pts.

Pre-tax income

 

$

4,707

 

$

5,669

 

(17.0

)%

Pre-tax margin

 

13.1

%

15.8

%

(2.8

)pts.

 


*          Recast to conform with 2016 presentation

 

Technology Services & Cloud Platforms gross profit margin decreased 0.8 points to 41.9 percent in 2016 compared to the prior year. While partially due to mix within the segment, there was improvement in the Infrastructure Services margin offset by declines in Technical Support Services and Integration Software. The margin improvement in Infrastructure Services reflects the benefits from delivery transformation and ongoing productivity actions related to automation, process optimization and leveraging the company’s scale, technology and talent. The company is investing in cognitive capabilities to further improve its delivery model and drive efficiencies. The Technical Support Services margin decline reflects the mix to multi-vendor support offerings. The Integration Software margin declined as the shift of the portfolio to an as-a-Service model continues.

 

Pre-tax income of $4,707 million decreased 17.0 percent and pre-tax margin declined 2.8 points year to year to 13.1 percent. The pre-tax margin reflects the dynamics impacting gross profit and the continued investments to build out the cloud platform, partially offset by the impact of IP partnership agreements entered into during the year.

 

Services Backlog and Signings

 

($ in billions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

At December 31:

 

2016

 

2015

 

Change

 

Currency

 

Total backlog

 

$

118.7

 

$

122.6

 

(3.2

)%

(1.8

)%

 

The estimated total services backlog at December 31, 2016 was $119 billion, a decrease of 3.2 percent as reported, and 2 percent adjusted for currency, with an increase in GTS more than offset by a decline in GBS as reported and adjusted for currency, compared to the December 31, 2015 balance.

 

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

 

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

 

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

 

Contract portfolios purchased in an acquisition are treated as positive backlog adjustments provided those contracts meet the company’s requirements for initial signings. A new signing will be recognized if a new services agreement is signed incidental or coincidental to an acquisition or divestiture.

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Total signings

 

$

44,645

 

$

46,432

 

(3.8

)%

(2.7

)%

 

39



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Systems

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Systems external revenue

 

$

7,714

 

$

9,547

 

(19.2

)%

(18.9

)%

Systems Hardware

 

$

5,926

 

$

7,574

 

(21.8

)%

(21.6

)%

z Systems

 

 

 

 

 

(27.1

)

(26.8

)

Power Systems

 

 

 

 

 

(27.1

)

(26.8

)

Storage Systems

 

 

 

 

 

(10.0

)

(10.0

)

Operating Systems Software

 

1,788

 

1,973

 

(9.4

)

(8.7

)

 

Systems revenue of $7,714 million decreased 19.2 percent as reported (19 percent adjusted for currency) in 2016 compared to the prior year reflecting market shifts and product cycle dynamics. Systems Hardware revenue of $5,926 million decreased 21.8 percent as reported (22 percent adjusted for currency) year to year. Operating Systems Software revenue of $1,788 million decreased 9.4 percent as reported (9 percent adjusted for currency) compared to the prior year.

 

Within Systems Hardware, z Systems revenue decreased 27.1 percent as reported (27 percent adjusted for currency) year to year reflecting product cycle dynamics. However, eight quarters into the z13 cycle at the end of 2016, the company continues to add new clients to the platform, drive innovation and introduce new technologies. During 2016, 29 new clients were added, with a total of 80 since introduction of the z13, validating its value and ongoing commitment to the company’s platform. Throughout the year, the company continued to optimize z Systems to drive new workloads such as blockchain and instant payments. The acquisition of EZSource, which helps clients modify applications for their digital transformation while supporting agility and hybrid cloud, also drove innovation in the z Systems platform.

 

Power Systems revenue decreased 27.1 percent as reported (27 percent adjusted for currency) year to year reflecting the underlying dynamics of a declining market for UNIX, where IBM continues to be the market leader, partially offset by growth in the expanding Linux market. During the year, there was success with HANA where the company is bringing in new clients. The UNIX market remains a high-value space for clients, and in 2016 new midrange and high-end systems were introduced. These systems are designed for hybrid cloud computing and flexible consumption models to transform on-premise IT to the cloud. In Power, the company is shifting to Linux while continuing to serve the UNIX space, but this is a long transition.

 

Storage Systems revenue decreased by 10.0 percent as reported and adjusted for currency year to year reflecting the weakness in the traditional disk storage market. In 2016, the company introduced new products and transitioned to a full suite of flash array offerings to improve its competitive position, and this portfolio grew revenue in the fourth quarter of the year as reported and adjusted for currency. While not reported within the Systems segment, Software-Defined Storage had revenue growth as reported and adjusted for currency in 2016.

 

Within Systems, total 2016 strategic imperatives revenue of $3.4 billion decreased 15 percent as reported and adjusted for currency year to year. Cloud revenue of $2.7 billion decreased 11 percent as reported and adjusted for currency as a result of a strong 2015 with the mainframe cycle.

 

40



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

For the year ended

 

 

 

 

 

Margin

 

December 31:

 

2016

 

2015*

 

Change

 

Systems

 

 

 

 

 

 

 

External Systems Hardware gross Profit

 

$

2,720

 

$

3,536

 

(23.1

)%

External Systems Hardware gross profit margin

 

45.9

%

46.7

%

(0.8

)pts.

External Operating Systems Software gross profit

 

$

1,577

 

$

1,790

 

(11.9

)%

External Operating Systems Software gross profit margin

 

88.2

%

90.7

%

(2.5

)pts.

External total gross Profit

 

$

4,298

 

$

5,326

 

(19.3

)%

External total gross Profit margin

 

55.7

%

55.8

%

(0.1

)pts.

Pre-tax income

 

$

933

 

$

1,722

 

(45.8

)%

Pre-tax margin

 

11.0

%

16.7

%

(5.7

)pts.

 


*          Recast to conform with 2016 presentation

 

The Systems gross profit margin decreased 0.1 points to 55.7 percent in 2016 compared to the prior year with declines in Power and Storage partially offset by expansion in z Systems margins. Pre-tax income of $933 million decreased 45.8 percent and the pre-tax margin declined 5.7 points year to year to 11.0 percent, consistent with the product cycle and portfolio transition dynamics impacting revenue and profit.

 

The company has reinvented its core systems for work in a new era of computing. It has optimized systems to drive new types of workloads and is expanding its footprint, building new capabilities and solving new types of problems for its clients. While facing some shifting market dynamics and product transitions, the Systems portfolio remains optimized to address the demands of the cognitive era and cloud computing.

 

Global Financing

 

See pages 76 through 81 for an analysis of Global Financing’s segment results.

 

Total Software

 

Under the company’s new segment structure, total software no longer exists as a segment. Given the focus on IBM’s software revenue performance, the company continued to report total software revenue performance through 2016. The company’s software revenue is reported discretely within the Cognitive Solutions, Technology Services & Cloud Platforms and Systems segments and can be added together to calculate total software. The company has a broad software portfolio, from solutions that provide cognitive, analytics and security solutions, to core transaction processing, to connecting on-premises data and processes to private and public cloud environments. This software is open, running on IBM and non-IBM environments.

 

Total software revenue, which includes Cognitive Solutions, Integration Software and Operating Systems Software, of $24,496 million increased 0.2 percent as reported and 1 percent adjusted for currency in 2016 compared to 2015. From a business area perspective, there was growth in Cognitive Solutions as reported and adjusted for currency, while Integration Software and Operating Systems Software were down year to year as reported and adjusted for currency. Across software, annuity revenue grew year to year as reported and adjusted for currency led by SaaS offerings. Transactional revenue declined as reported and adjusted for currency.

 

Geographic Revenue

 

In addition to the revenue presentation by reportable segment, the company also measures revenue performance on a geographic basis. The following geographic, regional and country-specific revenue performance excludes OEM revenue.

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

 

 

Percent

 

 

 

 

 

 

 

Yr.-to -Yr.

 

Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Currency

 

Total revenue

 

$

79,919

 

$

81,741

 

(2.2

)%

(1.6

)%

Geographies

 

$

79,594

 

$

81,430

 

(2.3

)%

(1.6

)%

Americas

 

37,513

 

38,486

 

(2.5

)

(1.4

)

Europe/Middle East/Africa

 

24,769

 

26,073

 

(5.0

)

(2.1

)

Asia Pacific

 

17,313

 

16,871

 

2.6

 

(1.2

)

 

41



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Total geographic revenue of $79,594 million in 2016 decreased 2.3 percent as reported and 2 percent adjusted for currency compared to the prior year.

 

Americas revenue of $37,513 million decreased 2.5 percent as reported and 1 percent adjusted for currency with declines in North America and Latin America as reported and adjusted for currency. Within North America, the U.S. decreased 0.9 percent and Canada decreased 6.2 percent (3 percent adjusted for currency). In Latin America, Brazil decreased 10.5 percent (7 percent adjusted for currency) and Mexico decreased 14.5 percent (7 percent adjusted for currency).

 

EMEA revenue of $24,769 million decreased 5.0 percent as reported and 2 percent adjusted for currency. Within EMEA, revenue declined in the UK, Germany and France, as reported and adjusted for currency, while revenue grew in Italy as reported and adjusted for currency. The UK decreased 12.8 percent (1 percent adjusted for currency). Germany decreased 5.1 percent (5 percent adjusted for currency). Revenue declined in France 3.4 percent (3 percent adjusted for currency). Italy increased 4.0 percent (4 percent adjusted for currency) year to year. The Middle East and Africa region grew 0.6 percent (3 percent adjusted for currency), while there was a decline in the Central and Eastern European region as reported and adjusted for currency including a year-to-year decline in Russia of 27.1 percent.

 

Asia Pacific revenue of $17,313 million grew 2.6 percent as reported, but declined 1 percent adjusted for currency. Japan grew 10.5 percent as reported, but declined 1 percent adjusted for currency. India grew 5.2 percent as reported and 10 percent adjusted for currency. China decreased 2.4 percent as reported, but was flat on an adjusted for currency basis. Australia decreased 9.7 percent (8 percent adjusted for currency).

 

Total Expense and Other (Income)

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

For the year ended

 

 

 

 

 

Margin

 

December 31:

 

2016

 

2015

 

Change

 

Total consolidated expense and other (income)

 

$

25,964

 

$

24,740

 

4.9

%

Non-operating adjustments

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

(503

)

(304

)

65.7

 

Acquisition-related charges

 

(5

)

(26

)

(81.0

)

Non-operating retirement-related (costs)/income

 

(282

)

(581

)

(51.4

)

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

 

$

25,174

 

$

23,830

 

5.6

%

Total consolidated expense-to-revenue ratio

 

32.5

%

30.3

%

2.2

pts.

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

 

31.5

%

29.2

%

2.3

pts.

 

The key drivers of the year-to-year change in total expense and other (income) were approximately:

 

 

 

Total

 

Operating

 

 

Consolidated

 

(non-GAAP)

·Currency*

 

2 points

 

2 points

·Acquisitions**

 

5 points

 

4 points

·Base

 

(2) points

 

0 points

 


*          Reflects impacts of translation and hedging programs

** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges.

 

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

 

42


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Selling, General and Administrative

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Selling, general and administrative expense

 

 

 

 

 

 

 

Selling, general and administrative—other

 

$

16,971

 

$

16,643

 

2.0

%

Advertising and promotional expense

 

1,327

 

1,290

 

2.8

 

Workforce rebalancing charges

 

1,038

 

587

 

76.7

 

Retirement-related costs

 

742

 

1,052

 

(29.5

)

Amortization of acquired intangible assets

 

503

 

304

 

65.7

 

Stock-based compensation

 

401

 

322

 

24.3

 

Bad debt expense

 

87

 

231

 

(62.3

)

Total consolidated selling, general and administrative expense

 

$

21,069

 

$

20,430

 

3.1

%

Non-operating adjustments

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

(503

)

(304

)

65.7

 

Acquisition-related charges

 

2

 

(21

)

NM

 

Non-operating retirement- related (costs)/income

 

(253

)

(533

)

(52.6

)

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

 

$

20,315

 

$

19,573

 

3.8

%

 

NM—Not meaningful

 

Total selling, general and administrative (SG&A) expense increased 3.1 percent in 2016 versus 2015, driven primarily by the following factors:

 

·             Acquisition-related spending (4 points); and

 

·             Higher workforce rebalancing charges (2 points); partially offset by

 

·             The effects of currency (1 point); and

 

·             A year-to-year decrease in charges for pension obligations related to litigation in Spain (1 point).

 

Operating (non-GAAP) expense increased 3.8 percent year to year driven primarily by the same factors excluding the year-to-year decrease in charges for pension obligations related to litigation which is not reflected in operating (non-GAAP) expense.

 

Bad debt expense decreased $144 million in 2016 compared to 2015. The receivables provision coverage was 2.0 percent at December 31, 2016, a decrease of 60 basis points from December 31, 2015 due to write-offs of previously reserved receivables in 2016.

 

Research, Development and Engineering

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Total consolidated research, development and engineering

 

$

5,751

 

$

5,247

 

9.6

%

Non-operating adjustment

 

 

 

 

 

 

 

Non-operating retirement-related (costs)/income

 

(29

)

(48

)

(38.6

)

Operating (non-GAAP) research, development and engineering

 

$

5,722

 

$

5,200

 

10.1

%

 

Research, development and engineering (RD&E) expense was 7.2 percent of revenue in 2016 and 6.4 percent of revenue in 2015.

 

RD&E expense increased 9.6 percent in 2016 versus 2015 primarily driven by:

 

·             Higher expense due to acquisitions (7 points); and

 

·             Increased base spending (4 points); partially offset by

 

·             The effects of currency (1 point).

 

Operating (non-GAAP) RD&E expense increased 10.1 percent in 2016 compared to the prior year, driven primarily by the same factors.

 

Intellectual Property and Custom Development Income

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015*

 

Change

 

Licensing of intellectual property including royalty-based fees

 

$

1,390

 

$

407

 

241.8

%

Custom development income

 

214

 

262

 

(18.4

)

Sales/other transfers of intellectual property

 

27

 

13

 

113.4

 

Total

 

$

1,631

 

$

682

 

139.3

%

 


*          Reclassified to conform to 2016 presentation

 

Licensing of intellectual property including royalty-based fees increased in 2016 compared to the prior year period, primarily due to licensing of certain intellectual property in 2016 within the company’s Integration Software and Cognitive Solutions software portfolio, which included four transactions each with period income greater than $100 million. The company is licensing IP to partners who are allocating their skills to extend the value of assets that are high value, but may be in mature markets. There were no significant individual IP transactions in 2015. The

 

43



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

timing and amount of licensing, sales or other transfers of IP may vary significantly from period to period depending upon the timing of licensing agreements, economic conditions, industry consolidation and the timing of new patents and know-how development.

 

Other (Income) and Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Other (income) and expense

 

 

 

 

 

 

 

Foreign currency transaction losses/(gains)

 

$

(116

)

$

414

 

NM

 

(Gains)/losses on derivative instruments

 

260

 

(853

)

NM

 

Interest income

 

(108

)

(72

)

49.1

%

Net (gains)/losses from securities and investment assets

 

23

 

47

 

(50.5

)

Other

 

85

 

(260

)

NM

 

Total consolidated other (income) and expense

 

$

145

 

$

(724

)

NM

 

Non-operating adjustment

 

 

 

 

 

 

 

Acquisition-related charges

 

(7

)

(5

)

35.2

 

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

 

$

138

 

$

(729

)

NM

 

 

NM—Not meaningful

 

Total consolidated other (income) and expense was expense of $145 million in 2016 compared to income of $724 million in 2015. The decrease in income of $869 million year over year was primarily driven by:

 

·             Lower net exchange gains ($593 million); and

 

·             Real estate capacity charges related to the first-quarter 2016 workforce transformation ($291 million).

 

Interest Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Interest expense

 

 

 

 

 

 

 

Total

 

$

630

 

$

468

 

34.4

%

 

The increase in interest expense in 2016 versus 2015 was primarily driven by higher average debt levels and higher average interest rates. 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. Overall interest expense (excluding capitalized interest) in 2016 was $1,206 million, an increase of $197 million year to year.

 

Stock-Based Compensation

 

Pre-tax stock-based compensation cost of $544 million increased $76 million compared to 2015. This was due primarily to increases related to performance share units ($72 million) and the conversion of stock-based awards previously issued by acquired entities ($15 million); partially offset by decreases related to restricted stock units ($15 million). Stock-based compensation cost, and the year-to-year change, was reflected in the following categories: Cost: $88 million, down $13 million; SG&A expense: $401 million, up $78 million and RD&E expense: $55 million, up $5 million.

 

Retirement-Related Plans

 

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

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Retirement-related plans—cost

 

 

 

 

 

 

 

Service cost

 

$

443

 

$

484

 

(8.6

)%

Amortization of prior service costs/ (credits)

 

(107

)

(100

)

7.0

 

Cost of defined contribution plans

 

1,070

 

1,138

 

(6.0

)

Total operating costs/ (income)

 

$

1,405

 

$

1,522

 

(7.7

)%

Interest cost

 

$

3,300

 

$

3,316

 

(0.5

)%

Expected return on plan assets

 

(5,563

)

(5,879

)

(5.4

)

Recognized actuarial losses

 

2,751

 

3,283

 

(16.2

)

Curtailments/ settlements

 

(16

)

36

 

NM

 

Multi-employer plan/ other costs

 

126

 

293

 

(57.0

)

Total non-operating costs/(income)

 

$

598

 

$

1,050

 

(43.0

)%

Total retirement-related plans—cost

 

$

2,003

 

$

2,572

 

(22.1

)%

 

NM—Not meaningful

 

44



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

In 2016, total pre-tax retirement-related plan cost decreased by $569 million compared to 2015, primarily driven by a decrease in recognized actuarial losses ($532 million), a decrease in pension obligations related to litigation in Spain ($177 million) and lower defined contribution plans cost ($68 million); partially offset by lower expected return on plan assets ($316 million).

 

As discussed in the “Operating (non-GAAP) Earnings” section on pages 26 and 27, the company characterizes certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2016 were $1,405 million, a decrease of $117 million compared to 2015, primarily driven by lower defined contribution plans cost ($68 million) and lower service cost ($42 million). Non-operating costs of $598 million decreased $452 million in 2016 compared to the prior year, driven primarily by a decrease in recognized actuarial losses ($532 million) and a decrease in pension obligations related to litigation in Spain ($177 million); partially offset by lower expected return on plan assets ($316 million).

 

Income Taxes

 

The continuing operations effective tax rate for 2016 was 3.6 percent, a decrease of 12.5 points versus the prior year. The benefit resulting from the favorable resolution of a long standing tax matter related to the determination of certain foreign tax losses incurred by the company in Japan drove a 9.5 point reduction in the rate. Without that discrete item, the continuing operations effective tax rate for 2016 would have been 13.1 percent, with the remaining change in the rate year to year driven by the following factors:

 

·             The benefit resulting from the favorable resolution of a long-standing tax matter related to the utilization of certain foreign tax losses in Japan of 9.5 points; and

 

·             A benefit due to the year-to-year decrease in tax charges related to intercompany payments made by foreign subsidiaries and the intercompany licensing of certain IP of 5.7 points; and

 

·             A benefit due to the geographic mix of pre-tax earnings in 2016 of 0.3 points; partially offset by

 

·             A reduced benefit year to year related to audit settlements of 2.3 points; and

 

·             The decreased benefit year to year in the utilization of foreign tax credits of 0.6 points.

 

The continuing operations operating (non-GAAP) effective tax rate was 6.5 percent, a decrease of 10.7 points versus 2015 principally driven by the same factors described above. Without the Japan benefits, the continuing operations (non-GAAP) effective tax rate would have been 14.9 percent.

 

Earnings Per Share

 

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

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended

 

 

 

 

 

Percent

 

December 31:

 

2016

 

2015

 

Change

 

Earnings per share of common stock from continuing operations

 

 

 

 

 

 

 

Assuming dilution

 

$

12.39

 

$

13.60

 

(8.9

)%

Basic

 

$

12.44

 

$

13.66

 

(8.9

)%

Diluted operating (non-GAAP)

 

$

13.59

 

$

14.92

 

(8.9

)%

Weighted-average shares outstanding (in millions)

 

 

 

 

 

 

 

Assuming dilution

 

958.7

 

982.7

 

(2.4

)%

Basic

 

955.4

 

978.7

 

(2.4

)%

 

Actual shares outstanding at December 31, 2016 and 2015 were 945.9 million and 965.7 million, respectively. The average number of common shares outstanding assuming dilution was 24.0 million shares lower in 2016 versus 2015. The decrease was primarily the result of the common stock repurchase program.

 

Results of Discontinued Operations

 

The loss from discontinued operations, net of tax, was $9 million in 2016 and $174 million in 2015. The discontinued operations effective tax rate in 2016 was 21.7 percent compared to 40.3 percent in 2015.

 

45


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Financial Position

 

Dynamics

 

At December 31, 2016, the company continued to have the financial flexibility to support the business over the long term. Cash and marketable securities at year end were $8,527 million. During the year, the company continued to manage the investment portfolio to meet its capital preservation and liquidity objectives.

 

Total debt of $42,169 million increased $2,279 million from prior year-end levels. The commercial paper balance at December 31, 2016, was $899 million, an increase of $299 million from the prior year end. Within total debt, $27,859 million was in support of the Global Financing business which is leveraged at a 7.3 to 1 ratio. The company continues to have substantial flexibility in the debt markets. During 2016, the company completed bond issuances totaling $7,873 million, with terms ranging from 1.5 to 30 years, and interest rates ranging from 0.50 to 4.70 percent depending on maturity. The company has consistently generated strong cash flow from operations and continues to have access to additional sources of liquidity through the capital markets and its $10.25 billion global credit facility, with 100 percent of the facility available on a same day basis.

 

Consistent with accounting standards, the company remeasured the funded status of its retirement and postretirement plans at December 31. At December 31, 2016, the overall net underfunded position was $14,840 million, a decrease of $674 million from December 31, 2015 driven by asset returns partially offset by a decrease in discount rates. At year end, the company’s qualified defined benefit plans were well funded and the cash requirements related to these plans remain stable going forward at approximately $500 million per year through 2020. In 2016, the return on the U.S. Personal Pension Plan assets was 6.2 percent and the plan was 102 percent funded at December 31. Overall, global asset returns were 8.5 percent and the qualified defined benefit plans worldwide were 98 percent funded at December 31, 2016.

 

During 2016, the company generated $16,958 million in cash from operations, a decrease of $49 million compared to 2015. In addition, the company generated $11,574 million in free cash flow, a decrease of $1,501 million versus the prior year. See page 69 for additional information on free cash flow. The company returned $8,758 million to shareholders in 2016, with $5,256 million in dividends and $3,502 million in gross share repurchases. In 2016, the company repurchased 23.3 million shares and had $5.1 billion remaining in share repurchase authorization at year end. The company’s cash generation permits the company to invest and deploy capital to areas with the most attractive long-term opportunities.

 

The assets and debt associated with the Global Financing business are a significant part of the company’s financial position. The financial position amounts appearing on page 86 are the consolidated amounts including Global Financing. The amounts appearing in the separate Global Financing section, beginning on page 77, are supplementary data presented to facilitate an understanding of the Global Financing business.

 

Working Capital

 

($ in millions)

 

At December 31:

 

2016

 

2015

 

Current assets

 

$

43,888

 

$

42,504

 

Current liabilities

 

36,275

 

34,269

 

Working capital

 

$

7,613

 

$

8,235

 

Current ratio

 

1.21:1

 

1.24:1

 

 

Working capital decreased $622 million from the year-end 2015 position. The key changes are described below:

 

Current assets increased $1,383 million ($1,920 million adjusted for currency), as a result of:

 

·             An increase of $690 million ($1,013 million adjusted for currency) in receivables driven by trade receivables; and

 

·             An increase of $359 million ($457 million adjusted for currency) in prepaid expenses and other current assets; and

 

·             An increase of $332 million ($427 million adjusted for currency) in cash and marketable securities.

 

Current liabilities increased $2,006 million ($2,471 million adjusted for currency), as a result of:

 

·             An increase in short-term debt of $1,052 million ($1,033 million adjusted for currency); and

 

·             An increase in taxes of $388 million ($442 million adjusted for currency) primarily driven by the reclass from non-current liabilities based on the anticipated settlement of various U.S. and non U.S. tax audits; and

 

·             An increase in other accrued expenses and liabilities of $352 million ($571 million adjusted for currency); and

 

·             An increase in accounts payable of $181 million ($244 million adjusted for currency).

 

46



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Cash Flow

 

The company’s cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 87 are summarized in the table below. These amounts include the cash flows associated with the Global Financing business.

 

($ in millions)

 

For the year ended December 31:

 

2016

 

2015

 

Net cash provided by/(used in) continuing operations

 

 

 

 

 

Operating activities

 

$

16,958

 

$

17,008

 

Investing activities

 

(10,976

)

(8,159

)

Financing activities

 

(5,791

)

(9,166

)

Effect of exchange rate changes on cash and cash equivalents

 

(51

)

(473

)

Net change in cash and cash equivalents

 

$

140

 

$

(790

)

 

Net cash provided by operating activities decreased by $49 million in 2016 driven by the following key factors:

 

·             Performance-related declines within net income; offset by

 

·             A decline in cash income tax payments ($1,579 million).

 

Net cash used in investing activities increased $2,817 million driven by:

 

·             An increase in cash used related to acquisitions of $2,330 million.

 

Net cash used in financing activities decreased $3,375 million as compared to the prior year driven by the following factors:

 

·             An increase in net cash sourced from debt transactions of $2,744 million driven by a higher level of issuances in the current year; and

 

·             A decrease of $1,107 million of cash used for gross share repurchases; partially offset by

 

·             An increase in dividend payments of $358 million.

 

Noncurrent Assets and Liabilities

 

($ in millions)

 

At December 31:

 

2016

 

2015

 

Noncurrent assets

 

$

73,582

 

$

67,991

 

Long-term debt

 

$

34,655

 

$

33,428

 

Noncurrent liabilities (excluding debt)

 

$

28,147

 

$

28,374

 

 

The increase in noncurrent assets of $5,591 million ($5,788 million adjusted for currency) was driven by:

 

·             An increase in intangible assets and goodwill of $5,379 million ($5,420 million adjusted for currency) resulting from acquisitions during the year; and

 

·             An increase in prepaid pension assets of $1,301 million ($1,427 million adjusted for currency) primarily driven by the expected returns on plan assets partially offset by interest costs and plan remeasurements; partially offset by

 

·             A decrease of $993 million ($1,054 million adjusted for currency) in long-term financing receivables primarily due to lower volumes.

 

Long-term debt increased $1,227 million ($1,595 million adjusted for currency) driven by:

 

·             Bond issuances of $7,873 million; partially offset by

 

·             Reclassification of $6,239 million to short-term debt to reflect upcoming maturities.

 

Other noncurrent liabilities, excluding debt, decreased $227 million ($195 million adjusted for currency) primarily driven by:

 

·             A decrease of $622 million ($769 million adjusted for currency) in other liabilities driven by the reclass to current taxes based on the anticipated settlement of various U.S. and non U.S. tax audits; partially offset by

 

·             An increase in retirement and nonpension postretirement liabilities of $567 million ($706 million adjusted for currency) driven by plan remeasurements.

 

47



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

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:

 

2016

 

2015

 

Total company debt

 

$

42,169

 

$

39,890

 

Total Global Financing segment debt

 

$

27,859

 

$

27,205

 

Debt to support external clients

 

24,034

 

23,934

 

Debt to support internal clients

 

3,825

 

3,271

 

Non-Global Financing debt

 

14,309

 

12,684

 

 

Global Financing provides financing predominantly for the company’s external client assets, as well as for assets under contract by other IBM units. These assets, primarily for Technology Services & Cloud Platforms, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their attributes, these Technology Services & Cloud Platforms assets are leveraged with the balance of the Global Financing asset base. The debt analysis above is further detailed in the Global Financing section on page 80.

 

Consolidated debt-to-capitalization ratio at December 31, 2016 was 69.6 percent versus 73.4 percent at December 31, 2015.

 

Given the significant leverage, the company also presents a debt-to-capitalization ratio which excludes Global Financing debt and equity as management believes this is more representative of the company’s core business operations. This ratio can vary from period to period as the company manages its global cash and debt positions. “Core” debt-to-capitalization ratio (excluding Global Financing debt and equity) was 49.5 percent at December 31, 2016 compared to 54.3 percent at December 31, 2015.

 

Equity

 

Total equity increased by $3,968 million from December 31, 2015 as a result of an increase in retained earnings of $6,634 million, an increase in common stock of $673 million and lower accumulated other comprehensive losses of $209 million; partially offset by an increase in treasury stock of $3,532 million mainly due to gross common stock repurchases.

 

GAAP Reconciliation

 

The tables below provide a reconciliation of the company’s income statement results as reported under GAAP to its operating earnings presentation which is a non-GAAP measure. The company’s calculation of operating (non-GAAP) earnings, as presented, may differ from similarly titled measures reported by other companies. Please refer to the “Operating (non-GAAP) Earnings” section on pages 26 and 27 for the company’s rationale for presenting operating earnings information.

 

($ in millions except per share amount)

 

 

 

 

 

Acquisition-

 

Retirement-

 

 

 

 

 

 

 

Related

 

Related

 

Operating

 

For the year ended December 31, 2016:

 

GAAP

 

Adjustments

 

Adjustments

 

(non-GAAP)

 

Gross profit

 

$

38,294

 

$

494

 

$

316

 

$

39,104

 

Gross profit margin

 

47.9

%

0.6

pts.

0.4

 

48.9

%

SG&A

 

$

21,069

 

$

(501

)

$

(253

)

$

20,315

 

RD&E

 

5,751

 

 

(29

)

5,722

 

Other (income) and expense

 

145

 

(7

)

 

138

 

Total expense and other (income)

 

25,964

 

(508

)

(282

)

25,174

 

Pre-tax income from continuing operations

 

12,330

 

1,003

 

598

 

13,931

 

Pre-tax margin from continuing operations

 

15.4

%

1.3

pts.

0.7

pts.

17.4

%

Provision for income taxes*

 

$

449

 

$

268

 

$

183

 

$

900

 

Effective tax rate

 

3.6

%

1.7

pts.

1.2

pts.

6.5

%

Income from continuing operations

 

$

11,881

 

$

735

 

$

415

 

$

13,031

 

Income margin from continuing operations

 

14.9

%

0.9

pts.

0.5

pts.

16.3

%

Diluted earnings per share from continuing operations

 

$

12.39

 

$

0.77

 

$

0.43

 

$

13.59

 

 


*          The tax impact on operating (non-GAAP) pre-tax income is calculated under the same accounting principles applied to the GAAP pre-tax income which employs an annual effective tax rate method to the results.

 

48



 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

($ in millions except per share amount)

 

 

 

 

 

Acquisition-

 

Retirement-

 

 

 

 

 

 

 

Related

 

Related

 

Operating

 

For the year ended December 31, 2015:

 

GAAP

 

Adjustments

 

Adjustments

 

(non-GAAP)

 

Gross profit

 

$

40,684

 

$

373

 

$

469

 

$

41,526

 

Gross profit margin

 

49.8

%

0.5

Pts.

0.6

pts.

50.8

%

SG&A

 

$

20,430

 

$

(324

)

$

(533

)

$

19,573

 

RD&E

 

5,247

 

 

(48

)

5,200

 

Other (income) and expense

 

(724

)

(5

)

 

(729

)

Total expense and other (income)

 

24,740

 

(330

)

(581

)

23,830

 

Pre-tax income from continuing operations

 

15,945

 

703

 

1,050

 

17,697

 

Pre-tax margin from continuing operations

 

19.5

%

0.9

pts.

1.3.

pts.

21.6

%

Provision for income taxes*

 

$

2,581

 

$

141

 

$

316

 

$

3,037

 

Effective tax rate

 

16.2

%

0.2

pts.

0.9

pts.

17.2

%

Income from continuing operations

 

$

13,364

 

$

562

 

$

734

 

$

14,659

 

Income margin from continuing operations

 

16.3

%

0.7

pts.

0.9

pts.

17.9

%

Diluted earnings per share from continuing operations

 

$

13.60

 

$

0.57

 

$

0.75

 

$

14.92

 

 


*          The tax impact on operating (non-GAAP) pre-tax income is calculated under the same accounting principles applied to the GAAP pre-tax income which employs an annual effective tax rate method to the results.

 

Consolidated Fourth-Quarter Results

 

($ and shares in millions except per share amounts)

 

 

 

 

 

 

 

Yr.- to -Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the fourth quarter:

 

2016

 

2015

 

Change

 

Revenue

 

$

21,770

 

$

22,059

 

(1.3

)%*

Gross profit margin

 

50.0

%

51.7

%

(1.7

)pts.

Total expense and other (income)

 

$

5,907

 

$

6,308

 

(6.4

)%

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

 

27.1

%

28.6

%

(1.5

)pts.

Income from continuing operations before income taxes

 

$

4,986

 

$

5,098

 

(2.2

)%

Provision for income taxes from continuing operations

 

$

480

 

$

638

 

(24.7

)%

Income from continuing operations

 

$

4,505

 

$

4,460

 

1.0

%

Income from continuing operations margin

 

20.7

%

20.2

%

0.5

pts.

Income/(loss) from discontinued operations, net of tax

 

$

(4

)

$

3

 

NM

 

Net income

 

$

4,501

 

$

4,463

 

0.9

%

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

4.73

 

$

4.59

 

3.1

%

Consolidated earnings per share—assuming dilution

 

$

4.72

 

$

4.59

 

2.8

%

Weighted-average shares outstanding

 

 

 

 

 

 

 

Assuming dilution

 

952.7

 

972.8

 

(2.1

)%

 


*          (0.7) percent adjusted for currency

 

NM—Not meaningful

 

49


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

The following table provides the company’s operating (non-GAAP) earnings for the fourth quarter of 2016 and 2015.

 

($ in millions except per share amounts)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the fourth quarter:

 

2016

 

2015

 

Change

 

Net income as reported

 

$

4,501

 

$

4,463

 

0.9

%

Income/(loss) from discontinued operations, net of tax

 

(4

)

3

 

NM

 

Income from continuing operations

 

4,505

 

4,460

 

1.0

 

Non-operating adjustments (net of tax)

 

 

 

 

 

 

 

Acquisition-related charges

 

193

 

110

 

75.8

 

Non-operating retirement-related costs/(income)

 

77