EX-13 4 a2237254zex-13.htm EX-13

Exhibit 13

 

Report of Financials

International Business Machines Corporation and Subsidiary Companies

 

MANAGEMENT DISCUSSION

 

Overview

18

Forward-Looking and Cautionary Statements

19

Management Discussion Snapshot

19

Description of Business

22

Year in Review

27

Prior Year in Review

48

Other Information

59

Looking Forward

59

Liquidity and Capital Resources

60

Critical Accounting Estimates

63

Currency Rate Fluctuations

66

Market Risk

66

Cybersecurity

67

Employees and Related Workforce

67

 

 

Report of Management

68

 

 

Report of Independent Registered Public Accounting Firm

69

 

 

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Earnings

70

Comprehensive Income

71

Financial Position

72

Cash Flows

73

Changes in Equity

74

 

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

A

Significant Accounting Policies

76

B

Accounting Changes

89

C

Acquisitions/Divestitures

91

D

Financial Instruments

95

E

Inventories

103

F

Financing Receivables

103

G

Property, Plant and Equipment

106

H

Investments and Sundry Assets

107

I

Intangible Assets Including Goodwill

107

J

Borrowings

108

K

Other Liabilities

111

L

Equity Activity

111

M

Contingencies and Commitments

115

N

Taxes

117

O

Revenue Recognition

120

P

Research, Development and Engineering

122

Q

Earnings Per Share of Common Stock

123

R

Rental Expense and Lease Commitments

124

S

Stock-Based Compensation

124

T

Retirement-Related Benefits

127

U

Segment Information

141

V

Subsequent Events

146

 

 

 

Five-Year Comparison of Selected Financial Data

147

 

 

 

Selected Quarterly Data

148

 

 

 

Performance Graphs

149

 

 

 

Stockholder Information

150

 

17


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

OVERVIEW

 

The financial section of the International Business Machines Corporation (IBM or the company) 2018 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 19, presents an overview of the key performance drivers in 2018.

 

·        Beginning with the “Year in Review” on page 27, 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 59, and “Liquidity and Capital Resources” on page 60, which includes a description of management’s definition and use of free cash flow.

 

·        The Consolidated Financial Statements are presented on pages 70 through 75. These statements provide an overview of the company’s income and cash flow performance and its financial position.

 

·        The Notes follow the Consolidated Financial Statements. Among other items, the Notes contain the company’s accounting policies (pages 76 to 88), acquisitions and divestitures (pages 91 to 94), certain contingencies and commitments (pages 115 to 117), revenue (pages 120 to 122) and retirement-related plans information (pages 127 to 141).

 

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

 

·        On December 22, 2017, the Tax Cuts and Jobs Act (U.S. tax reform) was enacted in the U.S. This Act resulted in the company recording a charge of $5.5 billion in the fourth-quarter 2017. For the full-year 2018, the company recorded additional charges of $2.0 billion, including $1.9 billion in the fourth quarter, primarily related to the election to include Global Intangible Low-Taxed Income (GILTI) in measuring deferred taxes. Refer to note N, “Taxes,” on pages 117 to 119 for additional information.

 

·        Effective January 1, 2018, the company adopted the Financial Accounting Standards Board (FASB) guidance on presentation of net periodic pension and nonpension postretirement benefit costs (net benefit cost). The guidance is primarily a change in financial statement presentation, but it did impact the consolidated and reportable segment gross profit margins and expense and other income. As a result, the company aligned its presentation of operating (non-GAAP) earnings to conform to the FASB presentation of these costs in the Consolidated Statement of Earnings. The periods presented in this Annual Report are reported on a comparable basis.

 

·        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 66 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, intangible asset amortization expense resulting from basis differences on equity method investments, retirement-related costs, discontinued operations and related tax impacts. Due to the unique, non-recurring nature of the enactment of U.S. tax reform, the company characterizes the one-time provisional charge recorded in the fourth quarter of 2017 and all 2018 adjustments to that charge as non-operating. Adjustments include true-ups, accounting elections, any changes to regulations, laws, audit adjustments, etc. that affect the recorded one-time charge. For acquisitions, operating (non-GAAP) 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, tax charges related to acquisition integration and pre-closing charges. For the 2019 operating (non-GAAP) earnings per share expectation, acquisition-related charges associated with the Red Hat, Inc. (Red Hat) acquisition exclude pre-closing charges, such as financing costs. These charges are excluded as they may be inconsistent in amount and timing from period to period and are dependent on the size, type and frequency of the company’s acquisitions. All other spending for acquired companies is included in both earnings from continuing operations and in operating (non-GAAP) earnings. Throughout the Management Discussion and Analysis, the impact of acquisitions over the prior 12-month period may be a driver of higher expense year to year. For retirement-related costs, the company characterizes certain items as operating and others as non-operating, consistent with GAAP. The company includes defined benefit plan and nonpension postretirement benefit plan service cost, multi-employer plan costs and the cost of defined contribution plans in operating earnings. Non-operating retirement-related costs include defined benefit plan and nonpension postretirement benefit plan amortization of prior service cost, interest cost, expected return on plan

 

18


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

assets, amortized actuarial gains/losses, the impacts of any plan curtailments/settlements, 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 2018 Form 10-K filed on February 26, 2019.

 

MANAGEMENT DISCUSSION SNAPSHOT

 

($ and shares in millions except per share amounts)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/Margin

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Revenue

 

$

79,591

 

$

79,139

 

0.6

%*

Gross profit margin

 

46.4

%

46.7

%**

(0.3

)pts.

Total expense and other (income)

 

$

25,594

 

$

25,543

**

0.2

%

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

 

32.2

%

32.3

%**

(0.1

)pts.

Income from continuing operations before income taxes

 

$

11,342

 

$

11,400

 

(0.5

)%

Provision for income taxes from continuing operations

 

$

2,619

+

$

5,642

+

(53.6

)%

Income from continuing operations

 

$

8,723

+

$

5,758

+

51.5

%

Income from continuing operations margin

 

11.0

%

7.3

%

3.7

pts.

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

 

$

5

 

$

(5

)

NM

 

Net income

 

$

8,728

+

$

5,753

+

51.7

%

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

9.51

+

$

6.14

+

54.9

%

Consolidated earnings per share — assuming dilution

 

$

9.52

+

$

6.14

+

55.0

%

Weighted-average shares outstanding

 

 

 

 

 

 

 

Assuming dilution

 

916.3

 

937.4

 

(2.2

)%

Assets++

 

$

123,382

 

$

125,356

 

(1.6

)%

Liabilities++

 

$

106,452

 

$

107,631

 

(1.1

)%

Equity++

 

$

16,929

 

$

17,725

 

(4.5

)%

 


*

0.0 percent adjusted for currency.

**

Recast to reflect adoption of FASB guidance on presentation of net periodic pension and nonpension postretirement benefit costs.

+

Includes charges of $2.0 billion or $2.23 of diluted earnings per share in 2018 and $5.5 billion or $5.84 of diluted earnings per share in 2017 associated with U.S. tax reform.

++

At December 31

NM — Not meaningful

 

19


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

The following table provides the company’s operating (non-GAAP) earnings for 2018 and 2017.

 

($ in millions except per share amounts)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

For the year ended December 31:

 

2018

 

2017

 

Percent Change

 

Net income as reported

 

$

8,728

+

$

5,753

+

51.7

%

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

 

5

 

(5

)

NM

 

Income from continuing operations

 

$

8,723

+

$

5,758

+

51.5

%

Non-operating adjustments (net of tax)

 

 

 

 

 

 

 

Acquisition-related charges

 

649

 

718

 

(9.7

)

Non-operating retirement-related costs/(income)

 

1,248

 

856

**

45.9

 

U.S. tax reform charge

 

2,037

 

5,475

 

NM

 

Operating (non-GAAP) earnings*

 

$

12,657

 

$

12,807

**

(1.2

)%

Diluted operating (non-GAAP) earnings per share

 

$

13.81

 

$

13.66

**

1.1

%

 


*

See page 41 for a more detailed reconciliation of net income to operating (non-GAAP) earnings.

**

Recast to reflect adoption of FASB guidance on presentation of net periodic pension and nonpension postretirement benefit costs.

+

Includes charges of $2.0 billion in 2018 and $5.5 billion in 2017 associated with U.S. tax reform.

NM — Not meaningful

 

In 2018, the company reported $79.6 billion in revenue and $8.7 billion in income from continuing operations, which included charges of $2.0 billion associated with U.S. tax reform. Operating (non-GAAP) earnings were $12.7 billion, which excludes the tax reform charges. Diluted earnings per share from continuing operations were $9.51 as reported and $13.81 on an operating (non-GAAP) basis. The company generated $15.2 billion in cash from operations, $11.9 billion in free cash flow and delivered shareholder returns of $10.1 billion in gross common stock repurchases and dividends.

 

Total consolidated revenue in 2018 increased 0.6 percent as reported and was flat adjusted for currency compared to the prior year. Cognitive Solutions increased 0.2 percent as reported and was essentially flat adjusted for currency. Solutions Software grew 0.8 percent as reported (essentially flat adjusted for currency), while Transaction Processing Software declined 1.2 percent as reported (2 percent adjusted for currency). Global Business Services (GBS) increased 2.9 percent as reported and 2 percent adjusted for currency led by growth in Consulting. Technology Services & Cloud Platforms (TS&CP) grew 0.5 percent as reported and was flat adjusted for currency, with growth in Infrastructure Services and Integration Software offset by declines in Technical Support Services. Within TS&CP, there was continued strong growth in cloud revenue which increased 23 percent year to year as reported and adjusted for currency. Systems decreased 2 percent as reported and adjusted for currency, with IBM Z declining year to year reflecting product cycle dynamics. Storage Systems also decreased in a competitive environment with ongoing pricing pressures, while Power Systems grew as reported and adjusted for currency, with strong performance in Power9-based processors and Linux throughout the year.

 

In 2018, the company delivered solid strategic imperatives revenue growth, generating $39.8 billion of revenue and growing 9 percent as reported and adjusted for currency, with double-digit growth in cloud and security. Cloud revenue of $19.2 billion increased 12 percent as reported and adjusted for currency, with as-a-Service revenue up 22 percent as reported and adjusted for currency. The annual exit run rate for as-a-Service revenue increased to $12.2 billion in 2018 compared to $10.3 billion in 2017.

 

From a geographic perspective, Americas revenue declined 1.7 percent year to year as reported (1 percent adjusted for currency) with a decline in the U.S. of 2.4 percent. Europe/Middle East/Africa (EMEA) increased 4.5 percent (1 percent adjusted for currency). Asia Pacific was essentially flat year to year as reported and adjusted for currency.

 

The consolidated gross margin of 46.4 percent decreased 0.3 points year to year and reflects the impacts of portfolio mix and investment, partially offset by benefits from productivity and improving services margins through the year. The operating (non-GAAP) gross margin of 46.9 percent decreased 0.4 points versus the prior year primarily driven by the same factors.

 

20


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Total expense and other (income) increased 0.2 percent in 2018 compared to the prior year. The year-to-year performance was driven by decline in intellectual property (IP) income (2 points) and a higher level of workforce rebalancing charges (1 point), offset by continued focus on efficiency resulting in lower spending (3 points). Total operating (non-GAAP) expense and other (income) decreased 0.4 percent year to year, driven primarily by the same factors.

 

Pre-tax income from continuing operations of $11.3 billion decreased 0.5 percent and the pre-tax margin was 14.3 percent, a decrease of 0.2 points versus 2017. The continuing operations effective tax rate for 2018 was 23.1 percent, including charges of $2.0 billion associated with U.S. tax reform. This is compared to an effective tax rate of 49.5 percent in 2017 which included a $5.5 billion charge associated with U.S. tax reform. Without these impacts, the continuing operations tax rate for 2018 would have been 5.4 percent, compared to a 2017 rate of 1.5 percent. Net income of $8.7 billion increased 51.7 percent year to year as a result of the lower tax reform charges in 2018. Operating (non-GAAP) pre-tax income from continuing operations of $13.7 billion was flat year to year and the operating (non-GAAP) pre-tax margin from continuing operations decreased 0.1 points to 17.3 percent. Operating (non-GAAP) income from continuing operations of $12.7 billion decreased 1.2 percent with an operating (non-GAAP) income margin from continuing operations of 15.9 percent, down 0.3 points year to year. The operating (non-GAAP) effective tax rate from continuing operations in 2018 was 7.9 percent, compared to 6.8 percent in the prior year.

 

Diluted earnings per share from continuing operations of $9.51 in 2018 increased 54.9 percent year to year, which included lower year-to-year charges associated with U.S. tax reform. Operating (non-GAAP) diluted earnings per share of $13.81 increased 1.1 percent versus 2017. In 2018, the company repurchased 32.9 million shares of its common stock at a cost of $4.4 billion and had $3.3 billion remaining in the current share repurchase authorization at December 31, 2018.

 

At December 31, 2018, the balance sheet remains strong and the company continues to be committed to maintaining a strong investment grade rating. Cash, restricted cash and marketable securities at December 31, 2018 were $12.2 billion, a decrease of $0.6 billion from December 31, 2017. Key drivers in the balance sheet and total cash flows were:

 

Total assets decreased $2.0 billion (increased $1.2 billion adjusted for currency) from December 31, 2017 driven by:

 

·             A decline in receivables of $1.6 billion ($0.6 billion adjusted for currency) driven by a decline in trade receivables of $1.5 billion, and

 

·             A decrease in net intangibles and goodwill of $1.2 billion ($0.6 billion adjusted for currency) resulting from currency impacts and intangibles amortization; partially offset by

 

·             An increase in deferred costs of $1.0 billion ($1.2 billion adjusted for currency) driven primarily by capitalized sales commissions costs due to the adoption of the new revenue standard.

 

Total liabilities decreased $1.2 billion (increased $1.3 billion adjusted for currency) from December 31, 2017 driven by:

 

·             Decreases in total debt ($1.0 billion), deferred income ($0.7 billion) and compensation and benefits ($0.5 billion); partially offset by

 

·             Increases in taxes ($1.1 billion).

 

Total equity of $16.9 billion decreased $0.8 billion from December 31, 2017 as a result of:

 

·             Decreases from dividends ($5.7 billion) and treasury stock ($4.6 billion) primarily due to share repurchases; partially offset by

 

·             Increases from net income ($8.7 billion) and the transition adjustment related to the adoption of the new revenue standard ($0.6 billion).

 

The company generated $15.2 billion in cash flow provided by operating activities, a decrease of $1.5 billion compared to 2017, driven primarily by a decrease in cash provided by financing receivables ($0.8 billion), a decrease in cash sourced from sales cycle working capital ($0.2 billion) and an increase in cash income tax payments ($0.1 billion). Net cash used in investing activities of $4.9 billion was $2.2 billion lower than the prior year, primarily driven by decreases in cash used for net non-operating receivables ($1.5 billion) and lower net purchases of marketable securities and other investments ($0.5 billion). Net cash used in financing activities of $10.5 billion increased $4.1 billion compared to 2017, driven primarily by a decrease in net cash sourced from debt transactions ($3.7 billion), with a lower level of issuances and a higher level of maturities in the current year.

 

In January 2019, the company disclosed that it is expecting GAAP earnings per share from continuing operations of at least $12.45 and operating (non-GAAP) earnings of at least $13.90 per diluted share for 2019. The company expects free cash flow to be approximately $12 billion in 2019. Free cash flow realization is expected to be approximately 100 percent of GAAP net income. Refer to page 61 in the Liquidity and Capital Resources section for additional information on this non-GAAP measure. Refer to the Looking Forward section on pages 59 and 60 for additional information on the company’s expectations.

 

21


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

DESCRIPTION OF BUSINESS

 

Please refer to IBM’s Annual Report on Form 10-K filed with the SEC on February 26, 2019 for Item 1A. entitled “Risk Factors.”

 

The company creates value for clients by providing integrated solutions and products that leverage: data, information technology, deep expertise in industries and business processes, with trust and security 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, digital and cognitive offerings, and enterprise systems and software which are all bolstered by one of the world’s leading research organizations.

 

IBM Strategy

 

IBM’s strategy is wholly focused on the needs of its clients. IBM is a technology company, but first and foremost it is an enterprise company. IBM serves enterprises of all sizes, and IBM’s longest-standing clients are leaders in their industries — the world’s leading financial services institutions, airlines, manufacturers, consumer goods and retail companies. IBM’s mission is to help its clients transform their companies and lead in their industries.

 

One of the biggest priorities for IBM clients is to derive competitive advantage through insights and the latest digital technologies. Better insight about the wants and needs of their customers will help them distinguish themselves in the marketplace. Data-driven insight will also influence how they design and produce their own products, as well as help them identify opportunities in new markets.

 

However, most companies are harnessing only a small percent of the valuable data they collect. As IBM clients embark on the next chapter of their digital journey, the proper collection, use, safeguarding and management of data is of paramount importance. Choosing the right digital technologies to analyze the data is also necessary.

 

IBM helps clients harness the power of their data through technologies like AI, analytics and blockchain; on a hybrid cloud that connects data across traditional and new environments; with services that put a client’s data and insight to use in and for their business. Underpinning all of this, IBM safeguards client data with world-class technologies and approaches to security.

 

By reinventing themselves digitally around insight, clients become what IBM calls Cognitive Enterprises.

 

What IBM Brings to Clients

 

Businesses are choosing IBM because they want to partner with a company that can uniquely integrate three core capabilities:

 

1.         They want the most innovative technology, like AI, blockchain, cybersecurity and quantum delivered in a hybrid cloud environment.

 

2.         They want industry expertise — from a partner that deeply understands their industry and can apply innovation to their business processes to drive transformation and competitive advantage.

 

3.         And, finally, they want a total commitment to trust and security. Clients want to partner with a company that will protect their valuable data and insights, and one that develops and deploys new innovations with a commitment to do so responsibly.

 

IBM is unique in that it can integrate all three core capabilities for clients.

 

Innovative Technology

 

IBM has a long history of bringing innovative technology to the world. For 26 years, IBM has led the world in U.S. patents; six IBMers are Nobel Laureates; and IBM engineers have developed innumerable first-of-its-kind products and services. Current examples of IBM’s innovative technology include:

 

·             Analytics and AI: IBM’s long-standing leadership in managing and extracting insights from data starts with a portfolio of analytics and database offerings. A few years ago, IBM brought AI into the mainstream with the Watson platform, which to date has been the foundation of many Enterprise AI implementations in production. Recently, IBM augmented its Watson platform with a set of AI tools that enable clients to trace the origins of the data their AI models use, explain what is behind their recommendations and ensure that bias has not crept into results. These innovations are making AI more consumable by everyday users — not just data scientists.

 

·             Security: Businesses built around data require an unparalleled level of data security. IBM is the leader in information security for enterprises — with leadership in both security software and services. Security is embedded inside all of IBM’s products and services. For example, IBM Z offers pervasive security by building data encryption directly in its computing processor. In addition, IBM’s Services businesses are world class in embedding security into the solutions they build and run for IBM clients.

 

·             Blockchain is an exciting technology that is just beginning to transform business processes. IBM’s platform has been rated number one by leading analyst firms such as Juniper Research and Everest Group. Blockchain technology enables multiple parties to conduct business with each other on a single, unified distributed system, eliminating the costly and time-consuming hand-offs of fragmented systems. IBM is deploying blockchain technology with clients to transform how global trade is transacted, how food safety is tracked and how supply chains are managed.

 

22


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

·             Cloud: Enterprise clients are in the very early stages of the move to cloud. IBM estimates that only 20 percent of workloads have moved to the cloud — with work ahead for the remaining 80 percent. The first part was to move business workloads that exist as a layer over core processes. The hard part is ahead: moving the mission-critical systems that run banking, retail, telecom and other industries. Some of these workloads will remain in traditional IT systems, some will move to a private cloud inside the safety of a client’s firewall, others will move to public clouds, and some will surge between all of these. Wherever a workload may reside, it will need to share its data across environments. All of this requires an approach that is open, highly interoperable between environments, and even interoperable between different public clouds. This is what IBM has long called hybrid cloud — and this describes the solution for the 80 percent of the workloads that is to come. With in-depth experience across all three environments, IBM brings the strongest hybrid cloud solution to the market for enterprises — which will be strengthened through the acquisition of Red Hat.

 

Industry Expertise

 

Changing a business requires in-depth understanding of how a business works and how technology can make it work differently.

 

IBM brings both industry expertise and innovative technology to clients through the IBM services and products businesses. This combination makes IBM unique and essential.

 

A few examples of this capability are highlighted below:

 

·             Global Business Services: the IBM GBS business is one of the world’s largest professional services businesses. Its mission is to help clients along the journey to becoming a Cognitive Enterprise.

 

·             Global Technology Services: the IBM GTS business runs some of the world’s largest data centers — and thereby some of the world’s most mission-critical workflows and franchises. GTS helps clients along their journey to the hybrid cloud — leveraging the best of their existing systems in the context of the regulatory, security and workflow of their industry.

 

·             Industry and Domain-Specific Solutions: augmenting IBM’s services businesses are software and solutions designed for specific industries and domains. For example:

 

Health: IBM has become a leader in applying advanced digital technologies to healthcare, including the application of AI and data analytics to the diagnosis and treatment of patients, bringing smart decisions to Health Care payers, and helping Life Sciences companies develop innovative products and services.

 

Financial Services: IBM is a leading provider in the Financial Services industry; with IBM’s Promontory Financial Group, a leading advisor in Financial Regulation and Compliance, IBM offers an advanced set of solutions for managing Risk and Compliance, a critical workflow in the Financial Services industry.

 

Trust and Security

 

Data and AI — together, they are both the opportunity and the issue of current times. They can make the world a better, healthier and more productive place; but only if businesses and consumers trust the companies putting data and AI to work.

 

IBM is a 107-year old business — and the reason it has been successful for so long is because it has earned the trust of its clients. IBM has not only followed guidelines around the responsible handling of data and the stewardship of new technology, but created them, published them, and invited others to adopt similar commitments. IBM’s principles make clear that:

 

·    The purpose of new technologies is to augment — not replace — human expertise;

 

·    Data and insights derived from AI belong to their owners and creators (not their IT partners); and,

 

·    New technologies must be transparent and explainable.

 

There are many companies in the IT industry who bring technology products to the marketplace. Many bring technology services to the marketplace. A few companies do both, but no one can do it as well as IBM when it comes to meeting the needs of clients. By bringing together technology and workflow, combining it with industry expertise, innovation and deployment, IBM helps clients and industries truly transform themselves.

 

This is what truly sets IBM apart.

 

Business Model

 

The company’s business model is built to support two principal goals: helping enterprise clients to move from one era to the next by bringing together innovative technology and industry expertise, and providing long-term value to shareholders. The business model has been developed over time through strategic investments in capabilities and technologies that have long-term growth and profitability prospects based on the value they deliver to clients.

 

The company’s global capabilities 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, broadening its industry expertise and integrating AI into more of what the company offers. 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

 

23


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

long-term opportunity. The company also regularly evaluates its portfolio and proactively maximizes shareholder value of non-strategic assets by bringing products to end of life, engaging in IP partnerships or executing divestitures.

 

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 primarily software 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 artificial intelligence. Cognitive Solutions includes Watson, the first enterprise AI platform that specializes in driving value and knowledge from the 80 percent of the world’s data that sits behind company firewalls. It enables businesses to reimagine their workflows across a variety of industries and professions and gives organizations complete control of their insights, data, training and IP.

 

Additionally, Cognitive Solutions includes the new Watson OpenScale technology — a first of a kind, open technology platform that addresses key challenges of AI adoption. It enables companies to manage AI transparently throughout the full AI lifecycle, irrespective of where their AI applications were built or in which environment they currently run.

 

IBM’s 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. IBM has established the world’s deepest portfolio of enterprise AI, including analytics and data management platforms, cloud data services, talent management solutions, and solutions tailored by industry. Watson Platform, Watson Health and Watson Internet of Things (IoT) are certain capabilities included in Solutions Software. IBM’s world-class security platform weaves in AI to deliver integrated security intelligence across clients’ entire operations, including their cloud, applications, networks and data, helping them to prevent, detect and remediate potential threats.

 

Transaction Processing Software: includes software that primarily runs mission-critical systems in industries such as banking, airlines and retail.

 

Global Business Services (GBS) provides clients with consulting, application management and business process services. These professional services deliver value and innovation to clients through solutions which leverage industry, technology and business strategy and process expertise. GBS is the digital reinvention partner for IBM clients, combining industry knowledge, functional expertise, and applications with the power of business design and cognitive and cloud technologies. The full portfolio of GBS services is backed by its globally integrated delivery network and integration with technologies, solutions and services from IBM units including IBM Watson, IBM Cloud, IBM Research, and Global Technology Services.

 

In 2018, focused on digital reinvention, GBS assisted clients on their journeys to becoming Cognitive Enterprises, helping them engage their customers with new digital value propositions, transform workflows using AI, and build hybrid, open cloud infrastructures. This was delivered by the operating model rolled out in 2017 — Digital Strategy and iX, Cognitive Process Transformation and Cloud Application Innovation, cross industry and globally.

 

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, unlock the potential in all data to improve decision-making, set their next-generation talent strategies and create new technology 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 (GPS): delivers finance, procurement, talent and engagement, and industry-specific business process outsourcing services. These services deliver improved business results to clients through a consult-to-operate model which includes the strategic change and/or operation of the client’s processes, applications and infrastructure. GBS is redefining process services for both growth and efficiency through the application of the power of cognitive technologies like Watson, as well as the IoT, blockchain and deep analytics.

 

Technology Services & Cloud Platforms (TS&CP) provides comprehensive IT infrastructure and platform services that create business value for clients. Clients gain access to leading-edge, high-quality services, flexibility and economic value. This is enabled through leverage of insights drawn from IBM’s decades of experience across thousands of engagements, the skills of practitioners, advanced technologies, applied innovation from IBM Research and global scale.

 

24


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

TS&CP Capabilities

 

Infrastructure Services: delivers a portfolio of project services, managed and outsourcing services and cloud-delivered services focused on clients’ enterprise IT infrastructure environments to enable digital transformation and deliver improved quality, flexibility and economic value. The portfolio includes a comprehensive set of hybrid cloud services and solutions to assist enterprise clients in building and running contemporary IT environments. These offerings integrate long-standing expertise in service management and technology with the ability to utilize the power of new technologies, drawn from across IBM’s businesses and ecosystem partners. The portfolio is built using the IBM Services Platform with Watson, designed to augment human intelligence with cognitive technologies, and addresses hybrid cloud, digital workplace, business resiliency, network, managed applications, cloud and security. The company’s capabilities, including IBM Cloud, cognitive computing and hybrid cloud implementation, provide high-performance, end-to-end innovation and an improved ability for clients to achieve business objectives.

 

Technical Support Services: delivers comprehensive 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 open source and vendor software and solution support, drawing on innovative technologies and leveraging the IBM Services Platform with Watson capabilities.

 

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 the IBM 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.

 

Systems provides clients with innovative infrastructure platforms to help meet the new requirements of hybrid cloud and enterprise AI workloads. More than one-third 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

 

Systems Hardware: includes IBM’s servers: IBM Z, Power Systems and Storage Systems.

 

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 IBM Z, a trusted enterprise platform for integrating data, transactions and insight, and Power Systems, a system designed from the ground up for big data and enterprise AI, optimized for hybrid cloud and Linux, and delivering open innovation with OpenPOWER.

 

Storage Systems: 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 flash storage, disk and tape storage solutions.

 

Operating Systems Software: IBM Z operating system environments include z/OS, a security-rich, high-performance enterprise operating system, as well as Linux. Power Systems offers a choice of AIX, IBM i 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 encompasses two primary businesses: financing, primarily conducted through IBM Credit LLC (IBM Credit), and remanufacturing and remarketing. IBM Credit is a wholly owned subsidiary of IBM that accesses the capital markets directly. IBM Credit, through its financing solutions, facilitates IBM clients’ acquisition of information technology systems, software and services in the areas where the company has expertise. The financing arrangements are predominantly for products or services that are critical to the end users’ business operations. The company conducts a comprehensive credit evaluation of its clients prior to extending financing. 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 associated with financing, credit and residual value, while generating strong returns on equity. Global Financing also maintains a long-term partnership with the company’s clients through various stages of the 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 working capital financing to suppliers, distributors and resellers of IBM and Original Equipment Manufacturer (OEM) products and services. The OEM portion will begin winding down starting in the second quarter of 2019 and continuing throughout the calendar year. Commercial Financing also 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.

 

25


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

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.

 

IBM Worldwide Organizations

 

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

 

·    Global Markets

 

·    Research, Development and Intellectual Property

 

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.

 

By complementing local expertise with global experience and digital capabilities, IBM builds deep and broad-based client relationships. This local management focus fosters speed in supporting clients, 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 continues to expand its reach to new and existing clients through digital marketplaces, digital sales and local Business Partner resources.

 

Research, Development and Intellectual Property

 

IBM’s research and development (R&D) operations differentiate the company from its competitors. IBM annually invests approximately 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 mid-term innovations. It delivers 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, quantum computing, blockchain, security, cloud, nanotechnology, silicon and post-silicon computing architectures and more — applying these technologies across industries including financial services, healthcare, blockchain and IoT.

 

In 2018, for the 26th consecutive year, IBM was awarded more U.S. patents than any other company. IBM’s 9,100 patents awarded in 2018 represent a diverse range of inventions in strategic growth areas for the company, including more than 3,000 patents related to work in artificial intelligence, cloud, cybersecurity and quantum computing.

 

The company actively continues to seek 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 assets, which constitute high-value technology, but may be applicable 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 any 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.

 

26


 

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 2018 versus 2017 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:

 

2018

 

2017

 

Change

 

Currency

 

Revenue

 

 

 

 

 

 

 

 

 

Cognitive Solutions

 

$

18,481

 

$

18,453

 

0.2

%

(0.4

)%

Gross margin

 

77.5

%

78.6

%*

(1.1

)pts.

 

 

Global Business Services

 

16,817

 

16,348

 

2.9

%

2.0

%

Gross margin

 

26.7

%

24.9

%*

1.7

pts.

 

 

Technology Services & Cloud Platforms

 

34,462

 

34,277

 

0.5

%

(0.1

)%

Gross margin

 

40.5

%

40.3

%*

0.2

pts

.

 

Systems

 

8,034

 

8,194

 

(2.0

)%

(2.3

)%

Gross margin

 

49.8

%

53.2

%*

(3.4

)pts.

 

 

Global Financing

 

1,590

 

1,696

 

(6.3

)%

(6.5

)%

Gross margin

 

29.1

%

29.3

%

(0.2

)pts.

 

 

Other

 

207

 

171

 

21.0

%

19.9

%

Gross margin

 

(140.7

)%

(173.9

)%*

33.2

pts.

 

 

Total consolidated revenue

 

$

79,591

 

$

79,139

 

0.6

%

0.0

%

 

 

 

 

 

 

 

 

 

 

Total consolidated gross profit

 

$

36,936

 

$

36,943

*

0.0

%

 

 

Total consolidated gross margin

 

46.4

%

46.7

%*

(0.3

)pts.

 

 

Non-operating adjustments

 

 

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

372

 

449

 

(17.2

)%

 

 

Retirement-related costs/(income)

 

 

*

%

 

 

Operating (non-GAAP) gross profit

 

$

37,307

 

$

37,392

*

(0.2

)%

 

 

Operating (non-GAAP) gross margin

 

46.9

%

47.2

%*

(0.4

)pts.

 

 

 


*  Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

27


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Cognitive Solutions

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Currency

 

Cognitive Solutions external revenue

 

$

18,481

 

$

18,453

 

0.2

%

(0.4

)%

Solutions Software

 

$

12,903

 

$

12,806

 

0.8

%

0.3

%

Transaction Processing Software

 

5,578

 

5,647

 

(1.2

)

(1.9

)

 

Cognitive Solutions revenue of $18,481 million was essentially flat as reported and adjusted for currency in 2018 compared to the prior year. On an as-reported and constant currency basis, there was growth in Solutions Software, while Transaction Processing Software declined year to year.

 

Solutions Software revenue of $12,903 million grew 0.8 percent as reported (essentially flat adjusted for currency) compared to the prior year, led by the company’s analytics and security platforms. Within analytics, the company had broad-based growth across the Db2 portfolio, including analytics appliances and increasing demand for IBM Cloud Private for Data, which accelerated in the fourth quarter of 2018. The company continued to have solid demand for integrated security and services solutions with strong growth in security intelligence and orchestration offerings. Across the industry verticals, Watson Health and Watson Media & Weather grew revenue as reported and adjusted for currency compared to the prior year. Certain Solutions Software offerings which address horizontal domains, specifically collaboration, commerce and talent, have been impacted by secular shifts in the market. In December 2018, the company announced its intent to divest its collaboration and on-premise marketing and commerce products to HCL. This transaction is expected to close by mid-year 2019.

 

Transaction Processing Software revenue of $5,578 million decreased 1.2 percent as reported (2 percent adjusted for currency) in 2018 compared to the prior year. There was improved revenue performance sequentially in the fourth quarter 2018 versus the third quarter 2018 reflecting clients’ commitment to the company’s platform for the long-term and the value it provides in managing mission-critical workloads and predictability in spending.

 

Cognitive Solutions total strategic imperatives revenue of $12.3 billion grew 3 percent as reported and 2 percent adjusted for currency year to year. Cloud revenue of $2.6 billion grew 2 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $2.0 billion.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Cognitive Solutions

 

 

 

 

 

 

 

External gross profit

 

$

14,319

 

$

14,503

 

(1.3

)%

External gross profit margin

 

77.5

%

78.6

%

(1.1

)pts.

Pre-tax income

 

$

7,154

 

$

6,795

 

5.3

%

Pre-tax margin

 

33.8

%

32.2

%

1.5

pts.

 


*  Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

Cognitive Solutions gross profit margin decreased 1.1 points to 77.5 percent in 2018 compared to the prior year. The gross profit margin decline was driven by an increasing mix toward SaaS and increased royalty cost associated with IP licensing agreements in 2018 compared to the prior year.

 

Pre-tax income of $7,154 million increased 5.3 percent compared to the prior year with a pre-tax margin improvement of 1.5 points to 33.8 percent, primarily driven by operational efficiencies and mix.

 

28


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Global Business Services

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Currency

 

Global Business Services external revenue

 

$

16,817

 

$

16,348

 

2.9

%

2.0

%

Consulting

 

$

7,705

 

$

7,262

 

6.1

%

5.1

%

Global Process Services

 

1,259

 

1,265

 

(0.5

)

(0.5

)

Application Management

 

7,852

 

7,821

 

0.4

 

(0.5

)

 

Global Business Services revenue of $16,817 million increased 2.9 percent as reported and 2 percent adjusted for currency in 2018 compared to the prior year. This performance reflects the progress the company has made to reposition this business, with strong growth in Consulting, led by key offerings in digital and cloud application, where the business is bringing together technology and industry expertise to help clients on their digital journey.

 

Consulting revenue of $7,705 million increased 6.1 percent as reported (5 percent adjusted for currency) compared to the prior year. The improvement was driven by the company’s digital strategy, including Digital Commerce and CRM offerings and accelerated growth in next generation enterprise applications, led by strong demand for consulting and implementation services. GPS revenue of $1,259 million was essentially flat year to year as reported and decreased 1 percent adjusted for currency. GPS performance improved during the second half of 2018 on a year-to-year basis as reported and adjusted for currency, as the business has been reinventing industry workflows by leveraging automation and infusing AI. In January 2019, the company announced the intent to divest its Seterus mortgage servicing platform business (reported within GPS), which is expected to close in the first quarter of 2019. Application Management revenue of $7,852 million was flat as reported and declined 1 percent adjusted for currency compared to 2017. The company continues to help clients move to the cloud with offerings such as Cloud Migration Factory and cloud application development. The business continued to decline in the more traditional application management engagements.

 

Within GBS, total strategic imperatives revenue of $10.8 billion grew 10 percent year to year as reported (9 percent adjusted for currency). Cloud revenue of $4.7 billion grew 19 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $2.1 billion.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Global Business Services

 

 

 

 

 

 

 

External gross profit

 

$

4,484

 

$

4,077

 

10.0

%

External gross profit margin

 

26.7

%

24.9

%

1.7

pts.

Pre-tax income

 

$

1,676

 

$

1,362

 

23.0

%

Pre-tax margin

 

9.8

%

8.2

%

1.6

pts.

 


*  Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

GBS gross profit margin increased 1.7 points to 26.7 percent year to year and pre-tax income of $1,676 million increased 23.0 percent year to year. The pre-tax margin increased 1.6 points to 9.8 percent. The year-to-year improvements in margins and pre-tax income are the result of the shift to higher-value offerings, realignment of resources to key skill areas, increased productivity and utilization as well as a benefit from currency, due to the company’s global delivery model.

 

29


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Technology Services & Cloud Platforms

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Currency

 

Technology Services & Cloud Platforms external revenue

 

$

34,462

 

$

34,277

 

0.5

%

(0.1

)%

Infrastructure Services

 

$

23,007

 

$

22,690

 

1.4

%

0.7

%

Technical Support Services

 

6,961

 

7,196

 

(3.3

)

(3.5

)

Integration Software

 

4,493

 

4,390

 

2.3

 

1.9

 

 

Technology Services & Cloud Platforms revenue of $34,462 million increased 0.5 percent as reported (flat adjusted for currency) in 2018 compared to the prior year, with growth in Infrastructure Services and Integration Software, offset by a decline in Technical Support Services. Cloud revenue grew double-digits as reported and adjusted for currency. New and existing clients are engaging IBM to manage their critical infrastructure and deliver innovation, including migrating their operations to an open hybrid cloud environment, while simultaneously achieving predictable spending.

 

Infrastructure Services revenue of $23,007 million increased 1.4 percent as reported (1 percent adjusted for currency) compared to the prior year. In Infrastructure Services, the business has prioritized the portfolio to deliver high-value solutions that bring productivity to clients and allow for expanding workloads, while exiting some lower-value offerings. Technical Support Services revenue of $6,961 million decreased 3.3 percent as reported (3 percent adjusted for currency) year to year. This business was impacted by the hardware product cycle dynamics in 2018, but continued to grow its multi-vendor services offerings which provide clients with an integrated approach by bringing expertise and access to different vendor solutions. Integration Software revenue of $4,493 million grew 2.3 percent as reported (2 percent adjusted for currency) compared to the prior year. There was strong double-digit growth year to year in SaaS offerings, with continued strong adoption of IBM Cloud Private, which helps clients modernize their traditional workloads and provides access to over 100 integrated IBM software offerings including blockchain, Watson, IoT and analytics.

 

Within Technology Services & Cloud Platforms, strategic imperatives revenue of $12.2 billion increased 18 percent year to year as reported and adjusted for currency. Cloud revenue of $8.8 billion grew 23 percent as reported and adjusted for currency, with an as-a-Service exit run rate of $8.0 billion.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Technology Services & Cloud Platforms

 

 

 

 

 

 

 

External Technology Services gross profit

 

$

10,307

 

$

10,215

 

0.9

%

External Technology Services gross profit margin

 

34.4

%

34.2

%

0.2

pts.

External Integration Software gross profit

 

$

3,651

 

$

3,587

 

1.8

%

External Integration Software gross profit margin

 

81.3

%

81.7

%

(0.4

)pts.

External total gross profit

 

$

13,958

 

$

13,802

 

1.1

%

External total gross profit margin

 

40.5

%

40.3

%

0.2

pts.

Pre-tax income

 

$

3,786

 

$

4,286

 

(11.7

)%

Pre-tax margin

 

10.7

%

12.3

%

(1.5

)pts.

 


*  Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

Technology Services & Cloud Platforms gross profit margin of 40.5 percent was essentially flat year to year. The 2018 margin reflects benefits from productivity initiatives, including automation of delivery processes infused with AI and global workforce optimization. Pre-tax income of $3,786 million decreased 11.7 percent. The pre-tax margin declined 1.5 points year to year to 10.7 percent, reflecting the company’s continued investment to expand its go-to-market capabilities and develop new offerings for the hybrid market.

 

30


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Services Backlog and Signings

 

($ in billions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

At December 31:

 

2018

 

2017

 

Change

 

Currency

 

Total backlog

 

$

116.1

 

$

121.0

 

(4.1

)%

(0.6

)%

 

The estimated total services backlog at December 31, 2018 was $116 billion, a decrease of 4.1 percent as reported (1 percent adjusted for currency).

 

Total services backlog includes Infrastructure Services, Consulting, Global Process Services, Application Management and Technical Support Services (TSS). Total backlog is intended to be a statement of overall work under contract which is either noncancellable, or which historically has very low likelihood of termination, given the criticality of certain services to the company’s clients. Total backlog does not include as-a-Service arrangements that allow for termination under 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, GPS and Application Management contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. TSS is generally not included in signings as the maintenance contracts tend to be more steady state, where revenues equal renewals. Certain longer-term TSS contracts that have characteristics similar to outsourcing contracts are included in signings.

 

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.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Currency

 

Total signings

 

$

44,700

 

$

42,869

 

4.3

%

4.9

%

 

Systems

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Currency

 

Systems external revenue

 

$

8,034

 

$

8,194

 

(2.0

)%

(2.3

)%

Systems Hardware

 

$

6,363

 

$

6,494

 

(2.0

)%

(2.3

)%

IBM Z

 

 

 

 

 

(5.4

)

(5.6

)

Power Systems

 

 

 

 

 

8.8

 

8.7

 

Storage Systems

 

 

 

 

 

(5.5

)

(5.9

)

Operating Systems Software

 

1,671

 

1,701

 

(1.7

)

(2.4

)

 

Systems revenue of $8,034 million decreased 2.0 percent year to year as reported (2 percent adjusted for currency) driven by strong IBM Z performance in the prior year and continuing price pressures impacting Storage Systems. Both hardware platforms were down year to year for the full year, as reported and adjusted for currency. This performance was partially offset by strong growth in Power Systems (which grew as reported and adjusted for currency in 2018). Systems Hardware revenue of $6,363 million declined 2.0 percent as reported (2 percent adjusted for currency). Operating Systems Software revenue of $1,671 million decreased 1.7 percent as reported (2 percent adjusted for currency) compared to the prior year.

 

31


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Within Systems Hardware, IBM Z revenue decreased 5.4 percent as reported (6 percent adjusted for currency) year to year, driven by the strong performance in 2017 of the z14 mainframe which was launched in the third quarter of 2017. The z14 continues to be one of the most successful programs within IBM Z history, and the company continued to grow the install base by adding new clients and new mission-critical workloads to the platform.

 

Power Systems revenue increased 8.8 percent as reported (9 percent adjusted for currency) year to year. As reported and adjusted for currency, there was double-digit revenue growth in both the low-end and high-end portfolio, mitigated by a decline in the midrange products. Overall performance was driven by Linux and continued strong adoption of the new POWER9-based architecture. In the fourth quarter of 2018, the business released the next-generation POWER9 processors in the high-end. These systems are designed for handling advanced analytics, cloud environments and data-intensive workloads in AI, HANA and UNIX markets. In 2018, the company delivered the most powerful commercially available supercomputers built with Power9 technology to the U.S. Department of Energy labs.

 

Storage Systems revenue decreased 5.5 percent as reported (6 percent adjusted for currency) year to year, with declines in midrange products, mitigated by continued strong growth in flash array offerings. The storage market remains very competitive, with ongoing pricing pressures. The company continues to introduce new innovative products with enhanced functionality into its products, such as the extension of the next-generation NVMe technology into its midrange products in December 2018. This technology is expected to be extended across the storage portfolio in the first half of 2019.

 

Within Systems, total strategic imperatives revenue of $4.5 billion grew 4 percent year to year as reported (3 percent adjusted for currency). Cloud revenue of $3.1 billion declined 10 percent as reported and adjusted for currency, reflecting IBM Z product cycle dynamics.

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Systems

 

 

 

 

 

 

 

External Systems Hardware gross profit

 

$

2,590

 

$

2,893

 

(10.5

)%

External Systems Hardware gross profit margin

 

40.7

%

44.6

%

(3.8

)pts.

External Operating Systems Software gross profit

 

$

1,412

 

$

1,469

 

(3.9

)%

External Operating Systems Software gross profit margin

 

84.5

%

86.4

%

(1.9

)pts.

External total gross profit

 

$

4,002

 

$

4,362

 

(8.2

)%

External total gross profit margin

 

49.8

%

53.2

%

(3.4

)pts.

Pre-tax income

 

$

904

 

$

1,128

 

(19.9

)%

Pre-tax margin

 

10.2

%

12.6

%

(2.4

)pts.

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

The Systems gross profit margin decreased 3.4 points to 49.8 percent in 2018 compared to the prior year. The overall decrease year to year was driven by the mix away from IBM Z and margin declines in Power Systems and Storage Systems.

 

Pre-tax income of $904 million declined 19.9 percent and pre-tax margin decreased 2.4 points year to year to 10.2 percent driven by the strong performance in IBM Z in the prior year, and the continued investment in innovation across the Systems portfolio.

 

Global Financing

 

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

 

32


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Results of Operations

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

External revenue

 

$

1,590

 

$

1,696

 

(6.3

)%

Internal revenue

 

1,610

 

1,471

 

9.5

 

Total revenue

 

$

3,200

 

$

3,168

 

1.0

%

Pre-tax income

 

$

1,361

 

$

1,278

*

6.5

%

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

In 2018, Global Financing delivered external revenue of $1,590 million and total revenue of $3,200 million, with an increase in gross margin of 1.0 points. Total pre-tax income of $1,361 million increased 6.5 percent compared to 2017 and return on equity decreased 2.0 points to 30.8 percent.

 

In 2018, Global Financing total revenue increased 1.0 percent compared to the prior year. This was due to an increase in internal revenue of 9.5 percent, driven by an increase in internal financing (up 17.6 percent to $424 million), and an increase in internal used equipment sales (up 6.8 percent to $1,187 million). External revenue declined 6.3 percent due to a decrease in external used equipment sales (down 30.8 percent to $366 million), partially offset by an increase in external financing (up 4.9 percent to $1,223 million).

 

The increase in external financing revenue was due to the increase in the average asset balances, partially offset by lower asset yields. The increase in internal financing revenue was primarily due to higher asset yields and average asset balances.

 

Total sales of used equipment represented 48.5 percent and 51.8 percent of Global Financing’s revenue for years ended December 31, 2018 and December 31, 2017, respectively. The decrease in 2018 was due to lower volume of external used equipment sales, partially offset by increases in internal transactions. The gross profit margin on used sales was 54.2 percent and 47.4 percent for years ended December 31, 2018 and December 31, 2017, respectively. The increase in the gross profit margin was driven by a shift toward higher margin internal equipment sales.

 

Global Financing pre-tax income increased 6.5 percent year to year primarily driven by an increase in gross profit ($52 million) and a decrease in total expense ($32 million).

 

The decrease in return on equity from 2017 to 2018 was primarily due to lower net income. Refer to page 40 for the details of the after-tax income and return on equity calculations.

 

Total unguaranteed residual value of leases, including operating leases, at December 31, 2018 and 2017 was $699 million and $724 million, respectively. In addition to the unguaranteed residual value, on a limited basis, Global Financing will obtain guarantees of the future value of the equipment to be returned at end of lease.

 

Third-party residual value guarantees increase the minimum lease payments as provided for by accounting standards that are utilized in determining the classification of a lease as a sales-type lease, direct financing lease or operating lease. The aggregate asset values associated with the guarantees of sales-type leases were $231 million and $716 million for the financing transactions originated during the years ended December 31, 2018 and December 31, 2017, respectively. In 2018, the residual value guarantee program resulted in the company recognizing approximately $148 million of revenue that would otherwise have been recognized in future periods as operating lease revenue. If the company had chosen to not participate in a residual value guarantee program in 2018 and prior years, the 2018 impact would be substantially mitigated by the effect of prior year asset values being recognized as operating lease revenue in the current year. The aggregate asset values associated with the guarantees of direct financing leases were $163 million and $154 million for the financing transactions originated during the years ended December 31, 2018 and 2017, respectively. The associated aggregate guaranteed future values at the scheduled end of lease were $18 million and $45 million for the financing transactions originated during the years ended December 31, 2018 and 2017, respectively. The cost of guarantees was $2 million and $4 million for the years ended December 31, 2018 and 2017, respectively.

 

Geographic Revenue

 

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

 

($ in millions)

 

 

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

Percent Change

 

 

 

 

 

 

 

Percent

 

Adjusted for

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Currency

 

Total revenue

 

$

79,591

 

$

79,139

 

0.6

%

0.0

%

Americas

 

$

36,994

 

$

37,641

 

(1.7

)%

(0.7

)%

Europe/Middle East/Africa

 

25,491

 

24,397

 

4.5

 

1.3

 

Asia Pacific

 

17,106

 

17,102

 

0.0

 

(0.4

)

 


*       Recast to conform to current period presentation.

 

Total revenue of $79,591 million in 2018 increased 0.6 percent as reported (flat adjusted for currency) compared to the prior year.

 

33


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Americas revenue decreased 1.7 percent year to year as reported (1 percent adjusted for currency) with a decline in North America, as reported and adjusted for currency, and a decline in Latin America as reported, but grew adjusted for currency. Within North America, the U.S. decreased 2.4 percent and Canada increased 1.4 percent (2 percent adjusted for currency). In Latin America, Brazil decreased 0.9 percent as reported, but grew 8 percent adjusted for currency, and Mexico increased 2.8 percent (4 percent adjusted for currency).

 

EMEA revenue increased 4.5 percent as reported and 1 percent adjusted for currency. Germany increased 8.0 percent (4 percent adjusted for currency) and the UK increased 6.2 percent (3 percent adjusted for currency). Spain increased 15.4 percent (11 percent adjusted for currency) and France grew 3.4 percent as reported, but declined 1 percent adjusted for currency. Italy increased 4.0 percent as reported (flat adjusted for currency).

 

Asia Pacific revenue was essentially flat year to year as reported and adjusted for currency. Japan increased 3.0 percent as reported (1 percent adjusted for currency). Australia grew 2.0 percent as reported (5 percent adjusted for currency). China decreased 7.8 percent (9 percent adjusted for currency) and India decreased 10.1 percent (6 percent adjusted for currency).

 

Total Expense and Other (Income)

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

 

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Total consolidated expense and other (income)

 

$

25,594

 

$

25,543

*

0.2

%

Non-operating adjustments

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

(437

)

(496

)

(11.9

)

Acquisition-related charges

 

(16

)

(52

)

(70.2

)

Non-operating retirement-related (costs)/income

 

(1,572

)

(1,341

)*

17.3

 

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

 

$

23,569

 

$

23,654

*

(0.4

)%

Total consolidated expense-to-revenue ratio

 

32.2

%

32.3

%*

(0.1

)pts.

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

 

29.6

%

29.9

%*

(0.3

)pts.

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

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

 

Selling, General and Administrative Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Selling, general and administrative expense

 

 

 

 

 

 

 

Selling, general and administrative — other

 

$

16,438

 

$

17,100

*

(3.9

)%

Advertising and promotional expense

 

1,466

 

1,445

 

1.5

 

Workforce rebalancing charges

 

598

 

199

 

202.2

 

Amortization of acquired intangible assets

 

435

 

496

 

(12.2

)

Stock-based compensation

 

361

 

384

 

(6.0

)

Bad debt expense

 

67

 

55

 

(20.9

)

Total consolidated selling, general and administrative expense

 

$

19,366

 

$

19,680

*

(1.6

)%

Non-operating adjustments

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

(435

)

(496

)

(12.2

)

Acquisition-related charges

 

(15

)

(13

)

17.6

 

Non-operating retirement-related (costs)/income

 

 

*

 

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

 

$

18,915

 

$

19,170

*

(1.3

)%

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

Total selling, general and administrative (SG&A) expense decreased 1.6 percent in 2018 versus 2017, driven primarily by the following factors:

 

·             Lower spending (4 points); partially offset by

 

·             Higher workforce rebalancing charges (2 points).

 

Operating (non-GAAP) SG&A expense decreased 1.3 percent year to year driven primarily by the same factors.

 

Bad debt expense increased $12 million in 2018 compared to 2017. The receivables provision coverage was 1.6 percent at December 31, 2018, unchanged from December 31, 2017.

 

34


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Research, Development and Engineering Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017*

 

Change

 

Total consolidated research, development and engineering

 

$

5,379

 

$

5,590

 

(3.8

)%

Non-operating adjustment

 

 

 

 

 

 

 

Non-operating retirement-related (costs)/income

 

 

 

 

Operating (non-GAAP) research, development and engineering

 

$

5,379

 

$

5,590

 

(3.8

)%

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

Research, development and engineering (RD&E) expense was 6.8 percent of revenue in 2018 and 7.1 percent of revenue in 2017.

 

RD&E expense decreased 3.8 percent in 2018 versus 2017 primarily driven by the company’s leveraging of development partnerships consistent with its IP licensing strategy and lower spending year to year.

 

Intellectual Property and Custom Development Income

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Licensing of intellectual property including royalty-based fees

 

$

723

 

$

1,193

 

(39.4

)%

Custom development income

 

275

 

252

 

9.3

 

Sales/other transfers of intellectual property

 

28

 

21

 

35.0

 

Total

 

$

1,026

 

$

1,466

 

(30.0

)%

 

Licensing of intellectual property including royalty-based fees decreased 39.4 percent in 2018 compared to 2017. The company entered into new partnership agreements in 2018, which included three transactions with period income greater than $100 million. There were also three transactions greater than $100 million in 2017. The company licenses IP to partners who allocate their skills to extend the value of assets that are high value, but may be in mature markets. The timing and amount of licensing, sales or other transfers of IP may vary significantly from period to period depending upon the timing of licensing agreements, economic conditions, industry consolidation and the timing of new patents and know-how development.

 

Other (Income) and Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Other (income) and expense

 

 

 

 

 

 

 

Foreign currency transaction losses/(gains)

 

$

(427

)

$

405

 

NM

 

(Gains)/losses on derivative instruments

 

434

 

(341

)

NM

 

Interest income

 

(264

)

(144

)

83.7

%

Net (gains)/losses from securities and investment assets

 

(101

)

(20

)

404.2

 

Retirement-related costs/(income)

 

1,572

 

1,341

*

17.3

%

Other

 

(63

)

(116

)

(46.0

)

Total consolidated other (income) and expense

 

$

1,152

 

$

1,125

*

2.5

%

Non-operating adjustments

 

 

 

 

 

 

 

Amortization of acquired intangible assets

 

(2

)

 

NM

 

Acquisition-related charges

 

0

 

(39

)

(99.2

)%

Non-operating retirement-related costs/(income)

 

(1,572

)

(1,341

)*

17.3

 

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

 

$

(422

)

$

(255

)

65.3

%

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

NM — Not meaningful

 

Total consolidated other (income) and expense was expense of $1,152 million in 2018 compared to $1,125 million in 2017. The increase in expense of $28 million year over year was primarily driven by:

 

·             Higher retirement-related costs ($232 million); partially offset by

 

·             Higher interest income ($120 million); and

 

·             Higher gains from securities and investment assets ($81 million).

 

Interest Expense

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Interest expense

 

 

 

 

 

 

 

Total

 

$

723

 

$

615

 

17.6

%

 

Interest expense increased $108 million compared to 2017. 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 2018 was $1,480 million, an increase of $207 million year to year, driven by higher average interest rates and higher average debt levels.

 

35


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Stock-Based Compensation

 

Pre-tax stock-based compensation cost of $510 million decreased $24 million compared to 2017. This was due primarily to decreases related to the conversion of stock-based awards previously issued by acquired entities ($4 million), performance share units ($7 million) and restricted stock units ($13 million). Stock-based compensation cost, and the year-to-year change, was reflected in the following categories: Cost: $82 million, down $9 million; SG&A expense: $361 million, down $23 million; and RD&E expense: $67 million, up $8 million.

 

Retirement-Related Plans

 

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

 

($ in millions)

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Retirement-related plans — cost

 

 

 

 

 

 

 

Service cost

 

$

431

 

$

429

 

0.4

%

Multi-employer plans

 

38

 

40

*

(5.4

)

Cost of defined contribution plans

 

1,024

 

1,046

 

(2.1

)

Total operating costs/ (income)

 

$

1,494

 

$

1,516

*

(1.5

)%

Interest cost

 

$

2,726

 

$

2,961

 

(7.9

)%

Expected return on plan assets

 

(4,049

)

(4,346

)

(6.8

)

Recognized actuarial losses

 

2,941

 

2,871

 

2.5

 

Amortization of prior service costs/(credits)

 

(73

)

(88

)*

(16.6

)

Curtailments/settlements

 

11

 

19

 

(39.9

)

Other costs

 

16

 

(76

)*

NM

 

Total non-operating costs/(income)

 

$

1,572

 

$

1,341

*

17.3

%

Total retirement-related plans — cost

 

$

3,066

 

$

2,857

 

7.3

%

 


*       Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

NM — Not meaningful

 

Total pre-tax retirement-related plan cost increased by $209 million compared to 2017, primarily driven by lower expected return on plan assets ($296 million), an increase in other costs ($93 million) related to benefits from pension litigation in the prior year and an increase in recognized actuarial losses ($70 million); partially offset by lower interest costs ($235 million).

 

As discussed in the “Operating (non-GAAP) Earnings” section on pages 18 and 19, the company characterizes certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2018 were $1,494 million, a decrease of $22 million compared to 2017, primarily driven by lower defined contribution plans cost ($22 million). Non-operating costs of $1,572 million increased $232 million in 2018 compared to 2017, driven primarily by lower expected return on plan assets ($296 million), an increase in other costs ($93 million) related to benefits from pension litigation in the prior year and an increase in recognized actuarial losses ($70 million); partially offset by lower interest costs ($235 million).

 

Income Taxes

 

The continuing operations effective tax rate for 2018 was 23.1 percent, a decrease of 26.4 points versus the prior year. In 2018, the accounting for impacts of U.S. tax reform was completed and the effects of measurement period adjustments were recognized as a net full-year 2018 charge of $2.0 billion (17.7 points). This is compared to a charge of $5.5 billion (48.0 points) in 2017 related to the impact of the enactment of U.S. tax reform, a year-to-year decrease of 30.4 points. Without these impacts, the continuing operations tax rate for 2018 would have been 5.4 percent, compared to a 2017 rate of 1.5 percent. The adjusted year-to-year increase of 3.9 points is primarily driven by the following factors:

 

·             A lower benefit year to year in the utilization of foreign tax credits of 5.9 points;

 

·             Benefits in 2017 related to an intra-entity asset transfer of 5.1 points and the tax write down of an investment of 1.7 points;

 

·             A year-to-year increase in tax charges related to intercompany payments of 1.3 points; partially offset by

 

·             Benefits in 2018 related to domestic and foreign audit activity (6.8 points), geographic mix of pre-tax earnings in 2018 (2.1 points) and the re-assessment of valuation allowances (1.2 points).

 

The continuing operations operating (non-GAAP) effective tax rate was 7.9 percent in 2018, an increase of 1.1 points versus 2017, principally driven by the same factors described above.

 

For more information on U.S. tax reform impacts, see note N, “Taxes,” on pages 117 to 119.

 

36


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Earnings Per Share

 

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

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2018

 

2017

 

Change

 

Earnings per share of common stock from continuing operations

 

 

 

 

 

 

 

Assuming dilution

 

$

9.51

*

$

6.14

*

54.9

%

Basic

 

$

9.56

 

$

6.17

 

54.9

%

Diluted operating (non-GAAP)

 

$

13.81

 

$

13.66

**

1.1

%

Weighted-average shares outstanding (in millions)

 

 

 

 

 

 

 

Assuming dilution

 

916.3

 

937.4

 

(2.2

)%

Basic

 

912.0

 

932.8

 

(2.2

)%

 


*       Includes a charge of $2.0 billion or $2.23 of diluted earnings per share in 2018 and $5.5 billion or $5.84 of diluted earnings per share in 2017 associated with U.S. tax reform.

**Recast to reflect adoption of the FASB guidance on presentation of net benefit cost.

 

Actual shares outstanding at December 31, 2018 and 2017 were 892.5 million and 922.2 million, respectively. The average number of common shares outstanding assuming dilution was 21.1 million shares lower in 2018 versus 2017. The decrease was primarily the result of the common stock repurchase program.

 

Financial Position

 

Dynamics

 

At December 31, 2018, the company continued to have the financial flexibility to support the business over the long term. Cash, restricted cash and marketable securities at year end were $12,222 million. During the year, the company continued to manage the investment portfolio to meet its capital preservation and liquidity objectives.

 

Total debt of $45,812 million decreased $1,012 million from prior year-end levels. The commercial paper balance at December 31, 2018, was $2,995 million, an increase of $1,499 million from the prior year end. Within total debt, $31,227 million is in support of the Global Financing business which is leveraged at a 9 to 1 ratio. The company continues to have substantial flexibility in the debt markets. During 2018, the company completed bond issuances totaling $4,000 million, with terms ranging from 2 to 5 years, and interest rates ranging from 2.65 to 3.60 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 Credit Facilities.

 

Consistent with accounting standards, the company remeasured the funded status of its retirement and postretirement plans at December 31. At December 31, 2018, the overall net underfunded position was $13,133 million, an increase of $243 million from December 31, 2017 driven by lower asset returns, partially offset by lower interest cost and an increase in discount rates. At year end, the company’s qualified defined benefit plans were well funded and the cash requirements related to these plans is expected to be approximately $400 million in 2019 and in the $350 million to $400 million range in 2020. In 2018, the return on the U.S. Personal Pension Plan assets was (1.8) percent and the plan was 104 percent funded at December 31. Overall, global asset returns were (1.9) percent and the qualified defined benefit plans worldwide were 99 percent funded at December 31, 2018.

 

During 2018, the company generated $15,247 million in cash from operations, a decrease of $1,477 million compared to 2017. In addition, the company generated $11,876 million in free cash flow, a decrease of $1,117 million versus the prior year. See page 61 for additional information on free cash flow. The company returned $10,109 million to shareholders in 2018, with $5,666 million in dividends and $4,443 million in gross share repurchases. In 2018, the company repurchased 32.9 million shares and had $3.3 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.

 

Global Financing Financial Position Key Metrics

 

($ in millions)

 

At December 31:

 

2018

 

2017

 

Cash and cash equivalents

 

$

1,833

 

$

2,696

 

Net investment in sales-type and direct financing leases (1)

 

6,924

 

7,253

 

Equipment under operating leases — external clients (2)

 

444

 

477

 

Client loans

 

12,802

 

12,450

 

Total client financing assets

 

20,170

 

20,180

 

Commercial financing receivables

 

11,838

 

11,590

 

Intercompany financing receivables (3) (4)

 

4,873

 

5,056

 

Total assets

 

$

41,320

 

$

41,096

 

Debt

 

31,227

 

31,434

 

Total equity

 

$

3,470

 

$

3,484

 

 


(1)    Includes deferred initial direct costs which are eliminated in IBM’s consolidated results.

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

(3)    Entire amount eliminated for purposes of IBM’s consolidated results and therefore does not appear on page 72.

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

 

37


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

At December 31, 2018, substantially all financing assets were IT-related assets, and approximately 55 percent of the total external portfolio was with investment grade clients with no direct exposure to consumers. This investment-grade percentage is based on the credit ratings of the companies in the portfolio. Additionally, the company takes actions to transfer exposure to third parties. On that basis, the investment-grade content would increase by 16 points to 71 percent, a slight increase year to year.

 

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

 

IBM Working Capital

 

($ in millions)

 

At December 31:

 

2018

 

2017

 

Current assets

 

$

49,146

 

$

49,735

 

Current liabilities

 

38,227

 

37,363

 

Working capital

 

$

10,918

 

$

12,373

 

Current ratio

 

1.29:1

 

1.33:1

 

 

Working capital decreased $1,454 million from the year-end 2017 position. The key changes are described below:

 

Current assets decreased $590 million (increased $1,009 million adjusted for currency) due to:

 

·             A decline in receivables of $1,067 million ($261 million adjusted for currency) driven by a decline in trade receivables of $1,496 million; partially offset by

 

·             An increase of $519 million ($598 million adjusted for currency) in prepaid expenses and other current assets primarily due to the reclassification of certain trade receivables due to the adoption of the new revenue standard.

 

Current liabilities increased $865 million ($2,076 million adjusted for currency) as a result of:

 

·             An increase in short-term debt of $3,220 million ($3,284 million adjusted for currency) primarily as a result of reclassifications of $7,252 million from long-term debt to reflect upcoming maturities and an increase in commercial paper of $1,499 million; partially offset by maturities of $5,586 million. The increase in short-term debt was partially offset by

 

·             A decrease in taxes payable of $1,173 million ($1,099 million adjusted for currency) principally driven by the resolution in the first-quarter 2018 of certain matters related to the ongoing U.S. tax audit of the company’s 2013-2014 tax returns; and

 

·             A decrease in other accrued expenses and liabilities of $569 million driven by currency-related decreases of $502 million; and

 

·             A decrease in deferred income of $387 million ($44 million adjusted for currency).

 

Receivables and Allowances

 

Roll Forward of Total IBM Receivables Allowance for Credit Losses

 

($ in millions)

 

January 1,

 

 

 

 

 

 

 

December 31,

 

2018

 

Additions*

 

Write-offs**

 

Other+

 

2018

 

$

668

 

$

66

 

$

(64

)

$

(31

)

$

639

 

 


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

**Refer to note A, “Significant Accounting Policies,” on pages 76 to 88 for additional information regarding Allowance for Credit Loss write-offs.

+       Primarily represents translation adjustments.

 

The total IBM receivables provision coverage was 1.6 percent at December 31, 2018, unchanged compared to December 31, 2017.

 

Global Financing Receivables and Allowances

 

The following table presents external Global Financing receivables excluding residual values, the allowance for credit losses and immaterial miscellaneous receivables:

 

($ in millions)

 

At December 31:

 

2018

 

2017

 

Recorded investment (1)

 

$

31,182

 

$

30,892

 

Specific allowance for credit losses

 

220

 

258

 

Unallocated allowance for credit losses

 

72

 

78

 

Total allowance for credit losses

 

292

 

336

 

Net financing receivables

 

$

30,890

 

$

30,556

 

Allowance for credit losses coverage

 

0.9

%

1.1

%

 


(1) Includes deferred initial direct costs which are eliminated in IBM’s consolidated results.

 

The percentage of Global Financing receivables reserved was 0.9 percent at December 31, 2018, compared to 1.1 percent at December 31, 2017. In 2018, write-offs of $41 million of receivables previously reserved resulted in a 14 percent reduction in the specific reserves, from $258 million at December 31, 2017, to $220 million at December 31, 2018. See note F, “Financing Receivables,” on pages 103 to 106 for additional information. Unallocated reserves decreased 10 percent from $78 million at December 31, 2017, to $72 million at December 31, 2018.

 

38


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Roll Forward of Global Financing Receivables Allowance for Credit Losses (included in Total IBM)

 

($ in millions)

 

January 1,

 

 

 

 

 

 

 

December 31,

 

2018

 

Additions*

 

Write-offs**

 

Other+

 

2018

 

$

336

 

$

14

 

$

(41

)

$

(17

)

$

292

 

 


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

**Refer to note A, “Significant Accounting Policies,” on pages 76 to 88 for additional information regarding Allowance for Credit Loss write-offs.

+       Primarily represents translation adjustments.

 

Global Financing’s bad debt expense was $14 million in 2018, compared to $17 million in 2017. The year-to-year decrease in bad debt expense was primarily due to lower specific reserve requirements in 2018.

 

Noncurrent Assets and Liabilities

 

($ in millions)

 

At December 31:

 

2018

 

2017

 

Noncurrent assets

 

$

74,236

 

$

75,621

 

Long-term debt

 

$

35,605

 

$

39,837

 

Noncurrent liabilities (excluding debt)

 

$

32,621

 

$

30,432

 

 

The decrease in noncurrent assets of $1,385 million (an increase of $177 million adjusted for currency) was driven by:

 

·             A decrease in net intangibles and goodwill of $1,178 million resulting from intangibles amortization and currency impacts of $553 million.

 

Long-term debt decreased $4,232 million ($3,994 million adjusted for currency) primarily driven by:

 

·             Reclassifications to short-term debt of $7,252 million to reflect upcoming maturities; and

 

·             Early retirement of long-term debt of $942 million; partially offset by

 

·             Issuances of $4,673 million.

 

Noncurrent liabilities (excluding debt) increased $2,189 million ($3,236 million adjusted for currency) primarily driven by:

 

·             An increase in other liabilities of $2,209 million, primarily driven by the company’s election to include GILTI in measuring deferred taxes ($1,927 million).

 

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:

 

2018

 

2017

 

Total company debt

 

$

45,812

 

$

46,824

 

Total Global Financing segment debt

 

$

31,227

 

$

31,434

 

Debt to support external clients

 

27,536

 

27,556

 

Debt to support internal clients

 

3,690

 

3,878

 

Non-Global Financing debt

 

14,585

 

15,390

 

 

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 TS&CP, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their attributes, these TS&CP assets are leveraged with the balance of the Global Financing asset base.

 

Non-Global Financing debt of $14,585 million declined $805 million from prior year-end levels.

 

At December 31:

 

2018

 

2017

 

Global Financing debt-to-equity ratio

 

9.0

x

9.0

x

 

The debt used to fund Global Financing assets is composed of intercompany loans and external debt. Total debt changes generally correspond with the level of client and commercial financing receivables, the level of cash and cash equivalents, the change in intercompany and external payables and the change in intercompany investment from IBM. The terms of the intercompany loans are set by the company to substantially match the term, currency and interest rate variability underlying the financing receivable and are based on arm’s-length pricing.

 

Global Financing provides financing predominantly for the company’s external client assets, as well as for assets under contract by other IBM units. As previously stated, the company measures Global Financing as a stand-alone entity, and accordingly, interest expense relating to debt supporting Global Financing’s external client and internal business is included in the “Global Financing Results of Operations” on page 33 and in note U, “Segment Information,” on pages 141 to 146. In the company’s Consolidated Statement of Earnings, the external debt-related interest expense supporting Global Financing’s internal financing to the company is reclassified from cost of financing to interest expense.

 

39


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

Equity

 

Total equity decreased by $795 million from December 31, 2017 primarily due to decreases from dividends ($5,666 million), and treasury stock ($4,564 million) primarily due to share repurchases; partially offset by increases from net income ($8,728 million) and transition adjustments related to the adoption of the new revenue standard ($580 million).

 

Cash Flow

 

The company’s cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 73 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:

 

2018

 

2017

 

Net cash provided by/(used in) continuing operations

 

 

 

 

 

Operating activities

 

$

15,247

 

$

16,724

 

Investing activities

 

(4,913

)

(7,081

)*

Financing activities

 

(10,469

)

(6,418

)

Effect of exchange rate changes on cash, cash equivalents and restricted cash

 

(495

)

937

 

Net change in cash, cash equivalents and restricted cash

 

$

(630

)

$

4,161

*

 


*       Recast to reflect adoption of the FASB guidance on restricted cash.

 

Net cash provided by operating activities decreased $1,477 million in 2018 driven by the following key factors:

 

·             A decrease in cash provided by financing receivables of $764 million driven by an increase in client financing receivables due to higher volumes;

 

·             A decrease in cash sourced from sales cycle working capital of $240 million; and

 

·             An increase in cash income tax payments of $148 million.

 

Net cash used in investing activities decreased $2,167 million driven by:

 

·             A decrease from net non-operating financing receivables of $1,525 million; and

 

·             A decrease in net purchases of marketable securities and other investments of $485 million.

 

Net cash used in financing activities increased $4,051 million driven by the following factors:

 

·             A decrease in net cash sourced from debt transactions of $3,746 million primarily driven by a lower level of issuances and a higher level of maturities in the current year.

 

Global Financing Return on Equity Calculation

 

($ in millions)

 

At December 31:

 

2018

 

2017+

 

Numerator

 

 

 

 

 

Global Financing after-tax income (1) *

 

$

1,065

 

$

1,114

 

Denominator

 

 

 

 

 

Average Global Financing equity (2) **

 

$

3,460

 

$

3,393

 

Global Financing return on equity (1)/(2)

 

30.8

%

32.8

%

 


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

**Average of the ending equity for Global Financing for the last five quarters.

+       Recast to reflect the adoption of the FASB guidance on presentation of net benefit cost.

 

40


 

Management Discussion

International Business Machines Corporation and Subsidiary Companies

 

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 18 and 19 for the company’s rationale for presenting operating earnings information.

 

($ in millions except per share amounts)

 

 

 

 

 

Acquisition-

 

Retirement-

 

 

 

 

 

 

 

 

 

Related

 

Related

 

Tax Reform

 

Operating

 

For the year ended December 31, 2018:

 

GAAP

 

Adjustments

 

Adjustments

 

Charges

 

(non-GAAP)

 

Gross profit

 

$

36,936

 

$

372

 

$

 

$

 

$

37,307

 

Gross profit margin

 

46.4

%

0.5

pts.

pts.

pts.

46.9

%

SG&A

 

$

19,366

 

$

(451

)

$

 

$

 

$

18,915

 

RD&E

 

5,379

 

 

 

 

5,379

 

Other (income) and expense

 

1,152

 

(2

)

(1,572

)

 

(422

)

Total expense and other (income)

 

25,594

 

(453

)

(1,572

)

 

23,569

 

Pre-tax income from continuing operations

 

11,342

 

824

 

1,572

 

 

13,739

 

Pre-tax margin from continuing operations

 

14.3

%

1.0

pts.

2.0

pts.

pts.

17.3

%

Provision for income taxes*

 

$

2,619

 

$

176

 

$

324

 

$

(2,037

)

$

1,082

 

Effective tax rate

 

23.1

%

(0.1

)pts.

(0.3

)pts.

(14.8

)pts.

7.9

%

Income from continuing operations

 

$

8,723

 

$

649

 

$

1,248

 

$

2,037

 

$

12,657

 

Income margin from continuing operations

 

11.0

%

0.8

pts.

1.6

pts.

2.6

pts.

15.9

%

Diluted earnings per share from continuing operations

 

$

9.51

 

$

0.71

 

$

1.36

 

$

2.23

 

$

13.81

 

 


*       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.

 

($ in millions except per share amounts)

 

 

 

 

 

Acquisition-

 

Retirement-

 

 

 

 

 

 

 

 

 

Related

 

Related

 

Tax Reform

 

Operating

 

For the year ended December 31, 2017:

 

GAAP**

 

Adjustments

 

Adjustments**

 

Charge

 

(non-GAAP)**

 

Gross profit

 

$

36,943

 

$

449

 

$

 

$

 

$

37,392

 

Gross profit margin

 

46.7

%

0.6

pts.

pts.

pts.

47.2

%

SG&A

 

$

19,680

 

$

(509

)

$

 

$

 

$

19,170

 

RD&E

 

5,590

 

 

 

 

5,590

 

Other (income) and expense

 

1,125

 

(39

)

(1,341

)

 

(255

)

Total expense and other (income)

 

25,543

 

(548

)

(1,341

)

 

23,654

 

Pre-tax income from continuing operations

 

11,400

 

997

 

1,341

 

 

13,738

 

Pre-tax margin from continuing operations

 

14.4

%

1.3

pts

1.7

pts.

pts.

17.4