Management Discussion

International Business Machines Corporation and Subsidiary Companies

OVERVIEW

The financial section of the International Business Machines Corporation (IBM or the company) 2019 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 our financial results and certain factors that may affect our future prospects from the perspective of management. The “Management Discussion Snapshot” presents an overview of the key performance drivers in 2019.

●

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

●	The Consolidated Financial Statements provide an overview of income and cash flow performance and financial position.

●	The Notes follow the Consolidated Financial Statements. Among other items, the Notes contain our accounting policies, revenue information, acquisitions and divestitures, certain commitments and contingencies and retirement-related plans information.

●

On July 9, 2019, IBM acquired 100 percent of the outstanding shares of Red Hat, Inc. (Red Hat). Red Hat is reported within the Cloud & Cognitive Software segment, in Cloud & Data Platforms. The consolidated financial results at and as of the year ended December 31, 2019 reflect the impacts of the acquisition on IBM; including: recognition of goodwill, intangible assets and related amortization and deferred tax liabilities, along with other purchase accounting adjustments including a deferred revenue fair value adjustment. The Consolidated Income Statement for the year ended December 31, 2019 includes impacts from these purchase accounting adjustments, higher interest expense, transaction-related costs and other acquisition-related activities. Refer to note E, “Acquisitions & Divestitures” for additional information.

●

Effective the first quarter of 2019, we made a number of changes to our organizational structure and management system. As a result of these changes, we revised our reportable segments. There was no change to the Consolidated Financial Statements. Refer to note D, “Segments” for additional information on our reportable segments. The periods presented in this Annual Report are reported on a comparable basis. We provided recast historical segment information reflecting these changes in a Form 8-K dated April 4, 2019.

●

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 we refer to growth rates at constant currency or adjust 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 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” for additional information.

●	To provide better transparency on the recurring performance of the ongoing business, the company provides revenue growth rates excluding divested businesses and at constant currency. These divested businesses are included in the company’s Other segment.

●	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, supplementally, management 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 and discontinued operations and their related tax impacts. Due to the unique, non-recurring nature of the enactment of the U.S. Tax Cuts and Jobs Act (U.S. tax reform), management characterizes the one-time provisional charge recorded in the fourth quarter of 2017 and adjustments to that charge as non-operating. Adjustments, among others, include true-ups, accounting elections, any changes to regulations, laws and audit adjustments 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 retention, restructuring and related expenses, tax charges related to acquisition integration and 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 significantly impacted by 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, the impact of acquisitions over the prior 12-month period may be a driver of higher expense year to year. For retirement-related costs, management characterizes certain items as operating and others as non-operating, consistent with GAAP. We include defined benefit plan and nonpension postretirement benefit plan service costs, 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 costs, interest cost, expected return on plan assets, amortized actuarial gains/losses, the impacts of any

Management Discussion

International Business Machines Corporation and Subsidiary Companies

plan curtailments/settlements and 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, management believes that supplementally 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. Our reportable segment financial results reflect pre-tax operating earnings from continuing operations, consistent with our management and measurement system. In addition, these non-GAAP measures provide a perspective consistent with areas of interest we routinely receive from investors and analysts.

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; IBM assumes no obligation to update or revise any such statements except as required by law. Forward-looking statements are based on IBM’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 IBM’s 2019 Form 10-K filed on February 25, 2020.

MANAGEMENT DISCUSSION SNAPSHOT


							Yr.-to-Yr.
($ and shares in millions except per share amounts)							Percent/Margin
For the year ended December 31:	2019			2018			Change**
Revenue	$	77,147		$	79,591		(3.1)	%*
Gross profit margin		47.3	%		46.4	%	0.9	pts.
Total expense and other (income)	$	26,322		$	25,594		2.8	%
Income from continuing operations before income taxes	$	10,166		$	11,342		(10.4)	%
Provision for income taxes from continuing operations	$	731		$	2,619	+	(72.1)	%
Income from continuing operations	$	9,435		$	8,723	+	8.2	%
Income from continuing operations margin		12.2	%		11.0	%	1.3	pts.
Net income	$	9,431		$	8,728	+	8.1	%
Earnings per share from continuing operations–assuming dilution	$	10.57		$	9.51	+	11.1	%
Weighted-average shares outstanding–assuming dilution		892.8			916.3		(2.6)	%
Assets++	$	152,186		$	123,382		23.3	%
Liabilities++	$	131,202		$	106,452		23.2	%
Equity++	$	20,985		$	16,929		24.0	%

* (1.0) percent adjusted for currency; 0.2 percent excluding divested businesses and adjusted for currency.

** 2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.

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

++ At December 31

The following table provides the company’s operating (non-GAAP) earnings for 2019 and 2018. See page 46 for additional information.


($ in millions except per share amounts)						Yr.-to-Yr.
For the year ended December 31:	2019		2018			Percent Change*
Net income as reported	$	9,431	$	8,728	**	8.1	%
Income/(loss) from discontinued operations, net of tax		(4)		5		NM
Income from continuing operations	$	9,435	$	8,723	**	8.2	%
Non-operating adjustments (net of tax)
Acquisition-related charges		1,343		649		107.0
Non-operating retirement-related costs/(income)		512		1,248		(58.9)
U.S. tax reform charge		146		2,037		(92.8)
Operating (non-GAAP) earnings	$	11,436	$	12,657		(9.6)	%
Diluted operating (non-GAAP) earnings per share	$	12.81	$	13.81		(7.2)	%

* 2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.

** Includes charges of $2.0 billion in 2018 associated with U.S. tax reform.

NM–Not meaningful

Management Discussion

International Business Machines Corporation and Subsidiary Companies

In 2019, we reported $77.1 billion in revenue, $9.4 billion in income from continuing operations and operating (non-GAAP) earnings of $11.4 billion, resulting in diluted earnings per share from continuing operations of $10.57 as reported and $12.81 on an operating (non-GAAP) basis. We also generated $14.8 billion in cash from operations, $11.9 billion in free cash flow and delivered shareholder returns of $7.1 billion in dividends and gross common stock repurchases. These results reflect solid performance in key high-value areas as we continued to strengthen our foundation for the next chapter of our clients’ digital reinventions. During 2019, we completed the acquisition of Red Hat and have started to benefit from the synergies of IBM and Red Hat together. We continued to bring new innovations to the market, launching the new z15, delivering new high-end storage and modernizing and containerizing our software portfolio. We have expanded our services offerings and skills for the cloud journey and the reach of our Watson/AI offerings. We also divested select businesses as we continue to prioritize our investments and optimize our portfolio for this next chapter in cloud.

Total consolidated revenue decreased 3.1 percent as reported and 1 percent adjusted for currency compared to the prior year. Excluding divested businesses, revenue increased 0.2 percent adjusted for currency. Cloud & Cognitive Software increased 4.5 percent as reported and 6 percent adjusted for currency, with strong results from the contribution of Red Hat beginning in the third quarter. Cloud & Data Platforms, which includes Red Hat, grew 10.4 percent as reported (12 percent adjusted for currency), Cognitive Applications increased 2.3 percent as reported (4 percent adjusted for currency), while Transaction Processing Platforms declined 0.5 percent as reported but grew 1 percent adjusted for currency. Global Business Services (GBS) grew 0.2 percent as reported and 2 percent adjusted for currency led by Consulting which grew 3.7 percent (6 percent adjusted for currency) with year-to-year improvement in each quarter of 2019. Global Technology Services (GTS) decreased 6.1 percent as reported and 4 percent adjusted for currency with declines in Infrastructure & Cloud Services and Technology Support Services. Performance in Infrastructure & Cloud Services was impacted by lower in-period revenue from client business volumes, while the decline in Technology Support Services was primarily due to transitions in the hardware product cycle. As we continued to take actions to accelerate the shift to the higher value segments of the market opportunity, there was solid growth in the cloud offerings within GTS. Systems decreased 5.3 percent year to year as reported and 4 percent adjusted for currency. IBM Z decreased 1.1 percent (flat adjusted for currency) reflecting product cycle dynamics. There was a year-to-year decline through the first three quarters of the year at the end of the z14 product cycle, but strong growth in the fourth quarter after shipment of the new z15 mainframe began in the last week of September. Storage Systems declined 8.9 percent as reported (8 percent adjusted for currency) with improved year-to-year performance in the second half of the year and growth in the fourth quarter led by high-end products. Power Systems declined 13.5 percent (12 percent adjusted for currency) compared with strong performance in the prior year. Across the segments, total IBM cloud revenue of $21.2 billion in 2019 grew 11 percent as reported and 13 percent adjusted for currency and represented 27 percent of our total 2019 revenue.

From a geographic perspective, Americas revenue declined 1.9 percent year to year as reported (1 percent adjusted for currency), but grew 1 percent excluding divested businesses and adjusted for currency. Europe/Middle East/Africa (EMEA) decreased 4.1 percent (flat adjusted for currency), but grew 1 percent excluding divested businesses and adjusted for currency. Asia Pacific declined 4.0 percent year to year as reported (3 percent adjusted for currency) and 2 percent excluding divested businesses and adjusted for currency.

The consolidated gross margin of 47.3 percent increased 0.9 points year to year, and the operating (non-GAAP) gross margin of 48.0 percent increased 1.1 points versus the prior year. The improved margins in 2019 reflect the actions we have taken to focus on higher value and portfolio optimization while also driving productivity and operational efficiency.

Total expense and other (income) increased 2.8 percent in 2019 compared to the prior year. The year-to-year performance was driven by higher spending including investment to deliver new innovations, Red Hat operational spending and interest expense from debt issuances to fund the acquisition (8 points), amortization of acquired intangible assets and other non-operating activity related to the Red Hat acquisition (3 points) and a decrease in intellectual property (IP) income (1 point), partially offset by lower non-operating retirement-related costs (4 points), gains from divestitures (3 points) and the impact of currency (3 points). Total operating (non-GAAP) expense and other (income) increased 4.1 percent year to year, driven primarily by the same factors excluding the non-operating retirement-related costs and the amortization of acquired intangible assets and other non-operating activity related to the Red Hat acquisition.

Pre-tax income from continuing operations of $10.2 billion decreased 10.4 percent and the pre-tax margin was 13.2 percent, a decrease of 1.1 points versus 2018. The second half of 2019 was impacted by the deferred revenue purchase accounting adjustment and Red Hat acquisition-related activity. The continuing operations effective tax rate for 2019 was 7.2 percent, a decrease of 15.9 points compared to 2018. The year-to-year change was primarily driven by a charge of $2.0 billion in 2018 for U.S. tax reform. Net income from continuing operations of $9.4 billion increased 8.2 percent and the net income from continuing operations margin was 12.2 percent, up 1.3 points year to year primarily due to the 2018 $2.0 billion charge for U.S. tax reform. Operating (non-GAAP) pre-tax income from continuing operations of $12.5 billion decreased 9.0 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations decreased 1.1 points to 16.2 percent. The operating (non-GAAP) tax rate for 2019 was 8.5 percent, an increase of 0.7 points compared to 2018. Operating (non-GAAP) income from continuing operations of $11.4 billion decreased 9.6 percent and the operating (non-GAAP) income margin from continuing operations of 14.8 percent was down 1.1 points year to year driven primarily by the Red Hat deferred revenue purchase accounting adjustment and acquisition-related activity.

Diluted earnings per share from continuing operations of $10.57 in 2019 increased 11.1 percent and operating (non-GAAP) diluted earnings per share of $12.81 decreased 7.2 percent versus 2018. In 2019, we repurchased 10.0 million shares of common stock at a cost of $1.3 billion before the share repurchase program was suspended at the time of the Red Hat closing.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

At December 31, 2019, we continued to have the financial flexibility to support the business. Cash, restricted cash and marketable securities at year end were $9.0 billion, a decrease of $3.2 billion from December 31, 2018 as we had built up our cash position in advance of the closing of the Red Hat acquisition. Goodwill and intangible assets increased $34.1 billion and total debt increased $17.1 billion since December 31, 2018, primarily due to the Red Hat acquisition. With strong cash flow from operating activities and free cash flow, and disciplined financial management, we significantly deleveraged in the second half of 2019.

Total assets increased $28.8 billion (increased $29.0 billion adjusted for currency) from December 31, 2018 primarily driven by:

●	Increases in goodwill of $22.0 billion and net intangible assets of $12.1 billion primarily associated with the acquisition of Red Hat; and

●	An increase in operating right-of-use assets of $5.0 billion resulting from the adoption of the new leasing standard on January 1, 2019; partially offset by

●	A decrease in financing receivables of $8.6 billion primarily due to the wind down of OEM IT commercial financing operations.

Total liabilities increased $24.7 billion (increased $25.0 billion adjusted for currency) from December 31, 2018 driven by:

●	An increase in total debt of $17.1 billion primarily driven by new issuances to finance the Red Hat acquisition; and

●	An increase in operating lease liabilities of $5.3 billion resulting from the adoption of the new leasing standard.

Total equity of $21.0 billion increased $4.1 billion from December 31, 2018 as a result of:

●	Increases from net income of $9.4 billion and retirement related plans of $1.4 billion; partially offset by

●	Decreases from dividends of $5.7 billion and gross share repurchases of $1.3 billion.

Cash provided by operating activities was $14.8 billion in 2019, a decrease of $0.5 billion compared to 2018, driven primarily by an increase in cash income tax payments ($0.3 billion), an increase in interest payments on debt ($0.3 billion) driven by incremental debt used to fund the acquisition of Red Hat, and performance-related declines within net income, including lower operating cash flows due to businesses divested in 2019; partially offset by an increase in cash provided by financing receivables ($0.8 billion).

Net cash used in investing activities of $26.9 billion was $22.0 billion higher than the prior year, primarily driven by an increase in net cash used for acquisitions ($32.5 billion) driven by the acquisition of Red Hat. This was partially offset by an increase in cash provided by net non-operating finance receivables ($7.2 billion) primarily driven by the wind down of the OEM IT commercial financing operations, a decrease in cash used for net capital expenditures ($1.3 billion) and an increase in cash provided by divestitures ($1.1 billion).

Financing activities were a net source of cash of $9.0 billion in 2019 compared to a net use of cash of $10.5 billion in 2018. The year-to-year increase in cash flow of $19.5 billion was driven by an increase in net cash sourced from debt transactions ($16.6 billion) primarily driven by net issuances to fund the Red Hat acquisition and a decrease in cash used for gross common stock repurchases ($3.1 billion).

In January 2020, the company disclosed that it is expecting GAAP earnings per share from continuing operations of at least $10.57 and operating (non-GAAP) earnings of at least $13.35 per diluted share for 2020. The company expects free cash flow to be approximately $12.5 billion in 2020. Refer to the Looking Forward section for additional information on the company’s expectations.

DESCRIPTION OF BUSINESS

Please refer to IBM’s Annual Report on Form 10-K filed with the SEC on February 25, 2020, for Item 1A. entitled “Risk Factors.”

We create 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 begins with our clients. IBM is distinguished as being first and foremost an Enterprise company, serving the world’s leaders in their industries.

Serving enterprises requires a distinct set of skills as our clients entrust us with building, integrating and running the world’s mission-critical systems. These are systems that cannot fail, systems that require the highest levels of privacy and security. They are built with our software and on our systems, designed and managed by IBM services. For example, we manage approximately ninety percent of the credit card transactions and half of the world’s wireless connections. We do this with an unparalleled commitment to our clients’ data security.

We are unique in bringing innovative technology and industry expertise on a foundation of trust and security as an integrated proposition to our clients. This integrated proposition allows us to deliver business impact that matters to our clients, impact that requires bringing together technologies such as hybrid cloud, data and AI insight with workflow and advanced industry skills. This integrated proposition helps our clients transform themselves from traditional businesses to what we call Cognitive Enterprises.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Furthermore, as technology becomes more central for business, as well as in our personal lives, trust matters more than ever. For decades we have followed core principles grounded in commitments to trust and transparency that guide our responsible development and deployment of new technologies. These values ground our business decisions, inspire our employees, and sustain our client relationships. We have 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. Our focus is not just on our direct client work, but extends to society at large, as we have been very active in areas such as education, sustainability and security. This is reinforced through a culture of inclusion and diversity. All of IBM treats this “responsible stewardship” as core to our mission.

A New Chapter in Technology

2019 ushered in Chapter 2 of our clients’ digital journeys in which the two predominant technology forces of our day–hybrid cloud and data/AI–are moving from “start-up” to “production at scale”. These two forces work together to help companies become what we call Cognitive Enterprises–companies that are powered by innovation, agility and data-driven intelligent decision making.

We describe below how IBM is leading the way in Chapter 2.

Hybrid Cloud

Chapter 1 marked the early stages of cloud with the rise of public cloud. This stage was focused on new end-user applications, including applications that have allowed consumers to check their bank balances, access social media, make online purchases and receive online support. While movement to public cloud has been strong, only twenty percent of workloads have been addressed in Chapter 1. Clients are merely at the beginning of a multi-stage journey.

Chapter 2 is about clients modernizing the remaining eighty percent of workloads, moving mission-critical workloads to the cloud and infusing AI deep into the decision-making of their businesses. These mission-critical workloads include core financial transaction systems, customer databases and Enterprise Resource Planning systems. Some of these workloads will gravitate to the public cloud in Chapter 2, while others will move to a private cloud or remain in traditional IT environments for security, compliance and/or performance reasons.

Wherever clients’ workloads reside, these environments must work together seamlessly to communicate, share data and share capacity. With enterprises having accumulated as many as fifteen public clouds, each with its own means of management, harmonizing these different clouds has become a necessity. Bringing these multiple public clouds, private cloud and traditional IT together is what we call hybrid cloud. Hybrid cloud defines the mission for Chapter 2 in IT.

We are a leader in hybrid cloud, and our mission in Chapter 2 is to bring our expertise and experience in building and managing mission-critical systems to lead our enterprise clients along this multi-stage journey.

Our public cloud is built on a foundation of open source software and enterprise grade infrastructure. It is the most open and secure public cloud, and it is built for the enterprise with Cloud Paks–enterprise-ready, containerized software solutions for applications, automation, data, integration and multi-cloud management.

To accelerate our clients’ success, we acquired Red Hat in 2019, further strengthening our leadership in hybrid cloud. Red Hat is the world’s leader in open source technology, including Enterprise Linux, the operating system of the cloud, as well as containers and OpenShift, technology platforms that create seamless integration between traditional and cloud environments. As the leader in open source, Red Hat brings capability that enables applications to be “written once and run anywhere”, in turn helping companies avoid lock-in to a single cloud provider, thereby taking advantage of the entire industry’s innovation. These technologies are central to the next era of computing.

Our systems and services play a large role in these hybrid cloud offerings as well. We have introduced new versions of our systems that work securely and seamlessly in the hybrid cloud, bringing mission-critical workloads into our clients’ digital journeys. Through our services, we play a large role in helping our clients map out their digital journeys, and then helping them build, manage and run the technology and the workflows.

This integrated value proposition of innovative technology and industry expertise built on trust and security, and now together with Red Hat, is helping our clients realize the full potential and competitive advantage of the hybrid cloud.

Data and AI

A new era of business reinvention is emerging as leading companies are moving from merely improving their processes to creating truly “intelligent workflows,” processes that are not only efficient at what they do, but intrinsically smart: capable of finding, connecting and analyzing data to uncover deep insights that can inform intelligent decisions. Data and AI, in concert with hybrid cloud, are making intelligent workflows possible.

We have been a pioneer of technologies and services that help clients collect, organize, and analyze their vast data stores and then operationalize AI across their business. Our long-running innovation in automation, data science, and natural language processing is helping clients manage their data as a strategic resource and deploy AI for greater insight and more accurate, trusted predictions.

Our data offerings help clients organize, collect, analyze and embed their data into their workflow. IBM software spans areas ranging from data management and discovery to reporting, governance, compliance and risk management. Our systems process our clients’ data with unparalleled speed, accuracy and security and our services help clients capture and embed the value of their data into their business.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Our IBM Watson AI system has been named by industry analysts as the worldwide market leader in AI for three consecutive years. Watson is not only a leading AI technology, but a leader in enterprise deployments in production and at scale. In addition to extracting deep insight from data, IBM Watson allows clients to trace the origins of the data that their AI models use, explain what is behind their recommendations and ensure that bias has not crept into results. Furthermore, IBM Watson is the only system that is built for the hybrid cloud, able to work on numerous public and private clouds. These innovations are making AI more consumable by everyday users, not just data scientists.

Creating intelligent workflows relies on our integrated proposition of technology, services and industry expertise, built on a foundation of trust and security. The way in which we bring these together is through an interactive process with our clients that we call the IBM Garage, a process of deep collaboration, co-creation and innovation.

* * * * *

We are in an era when our clients are embedding technology into their businesses in ways they have never done before. Technology is no longer merely a “tool”, it is at the center of their businesses, the source of their competitive advantage and the force behind their emerging business models.

In Chapter 2, IBM is bringing hybrid cloud and data/AI together to help our clients reinvent themselves as Cognitive Enterprises. The most challenging and complex work still lies ahead. With our strong commitment to responsible stewardship and our integrated value proposition, this makes us unique in helping our clients on their transformative digital journeys.

Business Model

Our business model is built to provide long-term value to stakeholders. We bring together innovative technology, industry expertise and a commitment to trust and transparency to help enterprise clients move from one era to the next. We provide integrated solutions and platforms, leveraging global capabilities that include services, software, systems, related financings and fundamental research. 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 business model is dynamic, adapting to the continuously changing industry and economic environment, including our shift to cloud delivery models. We continue to strengthen our position through strategic organic investments and acquisitions in higher-value areas, broadening our industry expertise and integrating AI into more of what we offer. In addition, we are transforming into a more agile enterprise to drive innovation and speed, as well as helping to drive productivity, which supports investments for participation in markets with significant long-term opportunity. We also regularly evaluate our portfolio and investments, proactively bringing products to end of life, engaging in IP partnerships and executing divestitures to optimize our portfolio.

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

Business Segments and Capabilities

Our major operations consist of five business segments: Cloud & Cognitive Software, Global Business Services, Global Technology Services, Systems and Global Financing.

Cloud & Cognitive Software brings together IBM’s software platforms and solutions, enabling us to deliver integrated and secure cloud, data and AI solutions to our clients. It includes all software, except operating system software reported in the Systems segment.

Cloud & Cognitive Software comprises three business areas–Cognitive Applications, Cloud & Data Platforms, and Transaction Processing Platforms.

Cloud & Cognitive Software Capabilities

Cognitive Applications: includes software that address vertical and domain-specific solutions, increasingly infused with AI, enabled by IBM’s Watson technology. Application areas such as health, financial services, Internet of Things (IoT) solutions, weather, and security software and services are among the offerings.

Cloud & Data Platforms: includes the company’s distributed middleware and data platform software, including Red Hat, which enables the operation of clients’ hybrid multi-cloud environments, whether on-premise or in public and private clouds. It also includes product areas such as Cloud Paks, WebSphere distributed, analytics platform software such as DB2 distributed, information integration, and enterprise content management, as well as IoT, Blockchain and AI/Watson platforms.

As clients increasingly move more of their mission-critical workloads to the cloud, their multi-cloud environments will be based on a foundation of Linux, with Kubernetes open-source software to deploy, manage and scale container-based applications. Red Hat, which provides the leading Linux operating system–Red Hat Enterprise Linux–and the leading hybrid cloud platform–Red Hat OpenShift–is at the center of this transformational shift among clients.

Transaction Processing Platforms: the software that supports client mission critical on-premise workloads in industries such as banking, airlines and retail. This includes transaction processing software such as Customer Information Control System and storage software, as well as the analytics and integration software running on IBM operating systems (e.g., DB2 and WebSphere running on z/OS).

Global Business Services provides clients with consulting, business process and application management 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

Management Discussion

International Business Machines Corporation and Subsidiary Companies

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 across IBM including IBM Research and Global Technology Services.

GBS assists clients on their journeys to becoming Cognitive Enterprises, helping them build business platform strategies and experiences, transform processes to intelligent workflows using AI and other exponential technologies, and build hybrid, open cloud infrastructures.

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 traditional 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.

Global Technology Services provides comprehensive IT infrastructure and platform services that create business value for clients. Clients gain access to leading-edge, high-quality services, and realize greater flexibility and economic value. This is enabled through 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.

GTS Capabilities

Infrastructure & Cloud Services: delivers a portfolio of project, managed, outsourcing and cloud-delivered services focused on clients’ enterprise IT infrastructure environments to enable digital transformation with improved quality, flexibility and economic value. The portfolio contains the IBM Cloud and a comprehensive set of hybrid cloud services and solutions that include resiliency, network and security capabilities to assist enterprise clients in building and running contemporary, software-defined IT environments. These offerings integrate long-standing expertise in service management and emerging technologies, drawn from across IBM’s businesses and ecosystem partners. The portfolio is built leveraging platforms, such as the IBM Services Platform with Watson, which augment human intelligence with cognitive technologies and address complex, hybrid cloud environments. IBM’s services capabilities integrate IBM Cloud, cognitive computing and multi-cloud management to provide clients with high-performance, end-to-end innovation and an improved ability to achieve business objectives.

Technology 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 cross-vendor software and solution support, drawing on innovative technologies and leveraging IBM Services Platform with Watson capabilities.

Systems provides clients with innovative infrastructure platforms to help meet the new requirements of hybrid multi-cloud and enterprise AI workloads. IBM Systems also designs advanced semiconductor and systems technology in collaboration with IBM Research, primarily for use in our systems.

Systems Capabilities

Systems Hardware: includes IBM’s servers 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 and LinuxONE, trusted enterprise platforms 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.

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.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

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 we have expertise. The financing arrangements are predominantly for products or services that are critical to the end users’ business operations. Global Financing 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 IBM’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 we have expertise. Internal financing is predominantly in support of Global Technology Services’ 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. Beginning in the second quarter of 2019 and continuing throughout the year, we wound down the portion of our commercial financing operations which provides short-term working capital solutions for Original Equipment Manufacturer (OEM) IT suppliers, distributors and resellers. This wind down is consistent with IBM’s capital allocation strategy and high-value focus. Commercial Financing also includes internal activity where Global Financing factors a selected portion of IBM’s accounts receivable primarily for cash management purposes, at arm’s-length rates. This program was suspended in the second quarter of 2019.

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 and 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 Global Technology Services. 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 operates in more than 175 countries with a broad distribution of revenue. To manage this global footprint, Global Markets leads our dedicated country-based IBM operations in order to serve clients, develop markets, and ultimately, ensure IBM is led through a client lens.

These integrated teams serve our clients locally, complemented by digital capabilities, global talent and resources, and an extensive partner ecosystem. These country teams have client relationship managers at their center, who integrate teams of IBM consultants, solution specialists, delivery professionals and business partners on behalf of clients. Their mission is to provide insights and innovation and co-create with clients to help them address their most pressing business challenges and opportunities.

In this way, we serve as a trusted partner to clients, establishing and maintaining relationships that deliver long-term value based on industry expertise, innovative technologies and an ability to deliver mission critical capabilities to an enterprise at scale.

Research, Development and Intellectual Property

Our research and development (R&D) operations differentiate us from our competitors. In 2019, we invested approximately 8 percent of total revenue for R&D, focusing on high-growth, high-value opportunities. IBM Research works with clients and our business units through global labs on near-and mid-term innovations. It delivers many new technologies to our portfolio every year and helps clients address their most difficult challenges. IBM Research scientists are conducting pioneering work in artificial intelligence, quantum computing, security, cloud, systems and more–applying these technologies across industries including financial services, healthcare, manufacturing and automotive.

In 2019, for the 27th consecutive year, IBM was awarded more U.S. patents than any other company. IBM’s 9,262 patents awarded in 2019 represent a diverse range of inventions in strategic growth areas for the company, including more than 4,500 patents related to work in artificial intelligence, cloud, cybersecurity and quantum computing.

We actively continue to seek IP protection for our innovations, while increasing emphasis on other initiatives designed to leverage our IP leadership. Some of our 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 our business model, we license certain of our IP 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 IBM both upon licensing, and with any ongoing royalty arrangements between it and the licensee. While our various proprietary IP rights are important to our success, we believe our 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.

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 2019 versus 2018 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.


							Yr.-to-Yr.		Yr.-to-Yr.
							Percent/		Percent Change
($ in millions)							Margin		Adjusted for
For the year ended December 31:	2019			2018			Change		Currency
Revenue
Cloud & Cognitive Software	$	23,200		$	22,209	*	4.5	%**	6.2	%
Gross margin		76.7	%		77.6	%*	(0.9)	pts.**
Global Business Services		16,634			16,595	*	0.2	%	2.4	%
Gross margin		27.7	%		26.8	%*	0.9	pts.
Global Technology Services		27,361			29,146	*	(6.1)	%	(3.7)	%
Gross margin		34.8	%		34.4	%*	0.3	pts.
Systems		7,604			8,034		(5.3)	%	(4.1)	%
Gross margin		53.1	%		49.8	%	3.2	pts.
Global Financing		1,400			1,590		(11.9)	%	(10.0)	%
Gross margin		35.6	%		29.1	%	6.4	pts.
Other		948			2,018	*	(53.0)	%	(51.7)	%
Gross margin		4.7	%		37.8	%*	(33.1)	pts.
Total consolidated revenue	$	77,147		$	79,591		(3.1)	%+	(1.0)	%

Total consolidated gross profit	$	36,488		$	36,936		(1.2)	%**
Total consolidated gross margin		47.3	%		46.4	%	0.9	pts.
Non-operating adjustments
Amortization of acquired intangible assets		534			372		43.8	%
Acquisition-related charges		13			—		NM
Operating (non-GAAP) gross profit	$	37,035		$	37,307		(0.7)	%**
Operating (non-GAAP) gross margin		48.0	%		46.9	%	1.1	pts.

* Recast to reflect segment changes.

** 2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.

+ 0.2 percent excluding divested businesses and adjusted for currency.

NM–Not meaningful

Cloud & Cognitive Software

aaw
							Yr.-to-Yr.
					Yr.-to-Yr.		Percent Change
($ in millions)					Percent		Adjusted for
For the year ended December 31:	2019		2018*		Change **		Currency**
Cloud & Cognitive Software external revenue	$	23,200	$	22,209	4.5	%	6.2	%
Cognitive Applications	$	5,765	$	5,633	2.3	%	3.9	%
Cloud & Data Platforms		9,499		8,603	10.4		12.3
Transaction Processing Platforms		7,936		7,974	(0.5)		1.4

* Recast to reflect segment changes.

** 2019 results were impacted by Red Hat purchase accounting.

Cloud & Cognitive Software revenue of $23,200 million increased 4.5 percent as reported (6 percent adjusted for currency) in 2019 compared to the prior year. There was strong growth in Cloud & Data Platforms, as reported and at constant currency, driven primarily by the acquisition of Red Hat in the third quarter of 2019. Red Hat had continued strong performance since the acquisition, in Red Hat Enterprise Linux (RHEL), application development and emerging technologies, led by OpenShift and Ansible. Red Hat and IBM are driving synergies with strong adoption of Cloud Paks since their introduction, expansion of our combined client base and more than 2,000 clients using our hybrid cloud platform. Cognitive Applications also grew as reported and at constant currency. Transaction Processing Platforms declined year to year as reported, but grew 1 percent adjusted for currency driven by strong fourth-quarter performance.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Cognitive Applications revenue of $5,765 million grew 2.3 percent as reported (4 percent adjusted for currency) compared to the prior year, driven by double-digit growth as reported and adjusted for currency in Security, and growth in industry verticals such as IoT. The Security performance included continued strong results in threat management software and services offerings. Within IoT, we had good revenue performance across the portfolio as we continued to invest in new offerings and industry-specific solutions.

Cloud & Data Platforms revenue of $9,499 million increased 10.4 percent as reported (12 percent adjusted for currency) compared to the prior year. Performance was driven by the addition of RHEL and OpenShift and the continued execution of the combined Red Hat and IBM hybrid strategy.

Transaction Processing Platforms revenue of $7,936 million decreased 0.5 percent as reported, but grew 1 percent adjusted for currency in 2019, compared to the prior year. Revenue performance reflects the ongoing investment in IBM platforms, and the timing of larger transactions that are tied to client business volumes and buying cycles.

Within Cloud & Cognitive Software, cloud revenue of $4.2 billion grew 40 percent as reported and 42 percent adjusted for currency year to year, reflecting the acquisition of Red Hat and client adoption of our hybrid cloud offerings.

aaw
							Yr.-to-Yr.
							Percent/
($ in millions)							Margin
For the year ended December 31:	2019			2018*			Change**
Cloud & Cognitive Software
External gross profit	$	17,790		$	17,224		3.3	%
External gross profit margin		76.7	%		77.6	%	(0.9)	pts.
Pre-tax income	$	7,952		$	8,882		(10.5)	%
Pre-tax margin		30.6	%		35.0	%	(4.4)	pts.

* Recast to reflect segment changes.

** 2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.

The Cloud & Cognitive Software gross profit margin decreased 0.9 points to 76.7 percent in 2019 compared to the prior year. The gross profit margin decline was driven by the purchase price accounting impacts from the Red Hat acquisition.

Pre-tax income of $7,952 million decreased 10.5 percent compared to the prior year with a pre-tax margin decline of 4.4 points to 30.6 percent which reflects the acquisition of Red Hat, ongoing investments in key strategic areas and lower income from IP partnership agreements.

Global Business Services


								Yr.-to-Yr.
						Yr.-to-Yr.		Percent Change
($ in millions)						Percent		Adjusted for
For the year ended December 31:	2019		2018			Change		Currency
Global Business Services external revenue	$	16,634	$	16,595	*	0.2	%	2.4	%
Consulting	$	7,993	$	7,705		3.7	%	5.6	%
Application Management		7,646		7,852		(2.6)		(0.3)
Global Process Services		995		1,037	*	(4.1)		(1.3)

* Recast to reflect segment changes.

GBS revenue of $16,634 million increased 0.2 percent as reported and 2 percent adjusted for currency in 2019 compared to the prior year. The strong growth in Consulting reflected GBS’ ability to bring together our industry specific expertise and innovative technology portfolio to help clients with their digital reinventions. Our performance reflects continued investment in offerings and capabilities to help advise clients and move their applications to hybrid multi-cloud environments. In the second half, we saw an acceleration in new Red Hat engagements.

Consulting revenue of $7,993 million increased 3.7 percent as reported and 6 percent adjusted for currency compared to the prior year. This strong performance was driven primarily by growth in offerings that enable each phase of our clients’ digital journey. These offerings include cognitive technology and data platform services, application modernization and next-generation enterprise applications and offerings that use AI to help clients unlock new opportunities and realize productivity improvements.

Application Management revenue of $7,646 million decreased 2.6 percent as reported, but was flat adjusted for currency. We had growth in offerings that help clients develop and manage cloud applications and modernize and automate their application portfolio, offset by continued decline in the more traditional application management engagements. With the acquisition of Red Hat, we continued to integrate OpenShift as clients’ preferred cloud-native application development platform.

Global Process Services revenue of $995 million decreased 4.1 percent as reported (1 percent adjusted for currency) as demand has been shifting away from traditional Business Process Outsourcing (BPO) offerings to new business platforms around intelligent workflows.

Within GBS, cloud revenue of $5.2 billion grew 10 percent as reported and 13 percent adjusted for currency, reflecting the growth in cloud consulting engagements and cloud application development.

Management Discussion

International Business Machines Corporation and Subsidiary Companies


							Yr.-to-Yr.
							Percent/
($ in millions)							Margin
For the year ended December 31:	2019			2018*			Change
Global Business Services
External gross profit	$	4,606		$	4,448		3.5	%
External gross profit margin		27.7	%		26.8	%	0.9	pts.
Pre-tax income	$	1,666		$	1,629		2.2	%
Pre-tax margin		9.9	%		9.6	%	0.2	pts.

* Recast to reflect segment changes.

The GBS profit margin increased 0.9 points to 27.7 percent and pre-tax income of $1,666 million increased 2.2 percent year to year. The pre-tax margin of 9.9 percent increased slightly year to year. The year-to-year improvements in margins and pre-tax income were driven by the continued mix shift to higher-value offerings, the yield from delivery productivity improvements and a currency benefit from leveraging the global delivery resource model. We continued to invest in our services offerings and skills necessary to assist our clients on their cloud journey.

Global Technology Services


								Yr.-to-Yr.
						Yr.-to-Yr.		Percent Change
($ in millions)						Percent		Adjusted for
For the year ended December 31:	2019		2018			Change		Currency
Global Technology Services external revenue	$	27,361	$	29,146	*	(6.1)	%	(3.7)	%
Infrastructure & Cloud Services	$	20,736	$	22,185	*	(6.5)	%	(4.1)	%
Technology Support Services		6,625		6,961		(4.8)		(2.2)

* Recast to reflect segment changes.

GTS revenue of $27,361 million decreased 6.1 percent as reported (4 percent adjusted for currency) in 2019 compared to the prior year. We had continued growth in cloud services that help clients move and manage workloads. However, performance reflected lower client business volumes in more traditional labor-based managed services. We continue to take actions to accelerate the shift to higher-value segments of the market and are introducing new managed services offerings for public and private cloud, in areas like cybersecurity, data management and hybrid orchestration. We are investing in joint services offerings integrating GTS and GBS, and deploying joint go-to-market capabilities, as clients demand solutions that merge applications and infrastructure. Although lower business volumes impacted full-year revenue and profit in 2019, we ended the year with growth in cloud signings and a solid pipeline of future deals that will deliver productivity to our clients.

Infrastructure & Cloud Services revenue of $20,736 million decreased 6.5 percent as reported (4 percent adjusted for currency) compared to the prior year. Revenue was impacted by our customers’ own business volumes which were lower year to year in certain offerings. Clients are modernizing their core infrastructures to hybrid multi-cloud infrastructures. GTS is continuing to invest in cloud capabilities, introduce new managed services offerings and build out its cloud data center footprint to capture this opportunity. Growth in cloud signings reflects our re-alignment of GTS offerings to help our clients on their journey to cloud, infusing offerings with IP and leveraging Red Hat’s capabilities.

Technology Support Services (TSS) revenue of $6,625 million decreased 4.8 percent as reported (2 percent adjusted for currency) in 2019, partially driven by dynamics in the hardware product cycles.

Within GTS, cloud revenue of $8.6 billion grew 8 percent as reported and 10 percent adjusted for currency.


							Yr.-to-Yr.
							Percent/
($ in millions)							Margin
For the year ended December 31:	2019			2018*			Change
Global Technology Services
External total gross profit	$	9,515		$	10,035		(5.2)	%
External total gross profit margin		34.8	%		34.4	%	0.3	pts.
Pre-tax income	$	1,645		$	1,781		(7.6)	%
Pre-tax margin		5.8	%		5.9	%	(0.2)	pts.

* Recast to reflect segment changes.

The GTS gross profit margin increased 0.3 points year to year to 34.8 percent, due to the benefits of workforce actions and the continued scale out of our public cloud. We continued to take structural actions to improve our cost competitiveness and are accelerating the use of AI and automation in delivery operations, including leveraging Red Hat’s Ansible platform. Pre-tax income of $1,645 million decreased 7.6 percent, driven primarily by the decline in revenue and gross profit, and a higher level of workforce rebalancing charges in the current year. Pre-tax margin of 5.8 percent was essentially flat year to year, with the 2019 pre-tax margin reflecting benefits from structural and workforce actions.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Services Backlog and Signings


							Yr.-to-Yr.
					Yr.-to-Yr.		Percent Change
($ in billions)					Percent		Adjusted for
At December 31:	2019		2018		Change		Currency
Total backlog	$	112.4	$	116.1	(3.1)	%	(2.7)	%

The estimated total services backlog at December 31, 2019 was $112 billion, a decrease of 3.1 percent as reported (3 percent adjusted for currency).

Total services backlog includes Infrastructure & Cloud Services, Security Services, Consulting, Global Process Services, Application Management and 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 & Cloud Services, Security Services, Consulting, Global Process Services and Application Management contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. 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.


							Yr.-to-Yr.
					Yr.-to-Yr.		Percent Change
($ in millions)					Percent		Adjusted for
For the year ended December 31:	2019		2018		Change		Currency
Total signings	$	40,741	$	44,700	(8.9)	%	(6.9)	%

Systems


							Yr.-to-Yr.
					Yr.-to-Yr.		Percent Change
($ in millions)					Percent		Adjusted for
For the year ended December 31:	2019		2018		Change		Currency
Systems external revenue	$	7,604	$	8,034	(5.3)	%	(4.1)	%
Systems Hardware	$	5,918	$	6,363	(7.0)	%	(5.9)	%
IBM Z					(1.1)		(0.3)
Power Systems					(13.5)		(12.1)
Storage Systems					(8.9)		(7.6)
Operating Systems Software		1,686		1,671	0.9		2.6

Systems revenue of $7,604 million decreased 5.3 percent year to year as reported (4 percent adjusted for currency). Systems Hardware revenue of $5,918 million declined 7.0 percent as reported (6 percent adjusted for currency), driven primarily by declines in Power Systems and Storage Systems. Operating Systems Software revenue of $1,686 million grew 0.9 percent as reported (3 percent adjusted for currency) compared to the prior year.

Within Systems Hardware, IBM Z revenue decreased 1.1 percent as reported but was essentially flat adjusted for currency, reflecting the mainframe product cycles. Revenue declined through the first three quarters due to the end of the z14 product cycle, but there was strong growth in the fourth quarter driven by z15 shipments. The z15’s strong performance demonstrates client demand for technology that offers improved data privacy and resiliency in the hybrid cloud environment. The z15

Management Discussion

International Business Machines Corporation and Subsidiary Companies

mainframe’s capabilities extend the platform’s differentiation with encryption everywhere, cloud-native development and instant recovery. In October, we announced OpenShift for IBM Z, bringing together the industry’s most comprehensive enterprise container and Kubernetes platform with the enterprise server platforms of IBM Z and LinuxONE. IBM Z continues to deliver a high-value, secure and scalable platform for our clients.

Power Systems revenue decreased 13.5 percent as reported (12 percent adjusted for currency) year to year, due to the strong performance during the second half of 2018 driven by Linux and the introduction of the POWER9-based architecture in our mid-range and high-end products.

Storage Systems revenue decreased 8.9 percent as reported (8 percent adjusted for currency) year to year, with improvements in year-to-year performance in the fourth quarter of 2019, driven primarily by the launch of the next generation high-end storage system DS8900 in November.

Within Systems, cloud revenue of $2.9 billion declined 4 percent as reported and 3 percent adjusted for currency.


							Yr.-to-Yr.
							Percent/
($ in millions)							Margin
For the year ended December 31:	2019			2018			Change
Systems
External Systems Hardware gross profit	$	2,622		$	2,590		1.2	%
External Systems Hardware gross profit margin		44.3	%		40.7	%	3.6	pts.
External Operating Systems Software gross profit	$	1,412		$	1,412		0.0	%
External Operating Systems Software gross profit margin		83.8	%		84.5	%	(0.7)	pts.
External total gross profit	$	4,034		$	4,002		0.8	%
External total gross profit margin		53.1	%		49.8	%	3.2	pts.
Pre-tax income	$	701		$	904		(22.4)	%
Pre-tax margin		8.4	%		10.2	%	(1.8)	pts.

The Systems gross profit margin increased 3.2 points to 53.1 percent in 2019 compared to the prior year. The increase was driven by actions taken in 2018 to better position the cost structure over the longer term, a mix to IBM Z hardware and operating systems and margin improvement in Storage Systems.

Pre-tax income of $701 million declined 22.4 percent and pre-tax margin of 8.4 percent decreased 1.8 points year to year driven by the declines in Power Systems and Storage Systems revenue and the continued investment in innovation across the Systems portfolio, mitigated by the benefit from the new hardware launches in the second-half 2019.

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 both the IBM and OEM IT 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.

Results of Operations


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
External revenue	$	1,400	$	1,590	(11.9)	%
Internal revenue		1,232		1,610	(23.5)
Total revenue	$	2,632	$	3,200	(17.8)	%
Pre-tax income	$	1,055	$	1,361	(22.5)	%

In 2019, Global Financing delivered external revenue of $1,400 million and total revenue of $2,632 million, with a decrease in gross margin of 2.7 points to 58.8 percent. Total pre-tax income of $1,055 million decreased 22.5 percent compared to 2018 and return on equity decreased 5.0 points to 25.8 percent.

Global Financing total revenue decreased 17.8 percent compared to the prior year. This was due to a decrease in internal revenue of 23.5 percent, driven by decreases in internal used equipment sales (down 27.4 percent to $862 million) and internal financing (down 12.6 percent to $370 million). External revenue declined 11.9 percent due to decreases in external financing (down 8.5 percent to $1,120 million) and external used equipment sales (down 23.4 percent to $281 million).

Management Discussion

International Business Machines Corporation and Subsidiary Companies

The decrease in internal financing revenue was due to lower average asset balances, partially offset by higher asset yields. The decrease in external financing revenue reflects the wind down of the OEM IT commercial financing operations.

Sales of used equipment represented 43.4 percent and 48.5 percent of Global Financing’s revenue for the years ended December 31, 2019 and 2018, respectively. The decrease in 2019 was due to a lower volume of internal used equipment sales. The gross profit margin on used sales was 52.2 percent and 54.2 percent for the years ended December 31, 2019 and 2018, respectively. The decrease in the gross profit margin was driven by lower margins on internal used equipment sales.

Global Financing pre-tax income decreased 22.5 percent year to year primarily driven by a decrease in gross profit ($422 million), partially offset by a decrease in total expense ($115 million), which was mainly driven by a decline in IBM shared expenses in line with the segment’s performance, a lower provision for credit losses and a gain from the sale of certain commercial financing capabilities in the first quarter of 2019.

The decrease in return on equity from 2018 to 2019 was primarily due to lower net income. Refer to page 45 for the details of the after-tax income and return on equity calculations.

Geographic Revenue

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


									Yr.-to-Yr.
									Percent Change
							Yr.-to-Yr.		Excluding Divested
					Yr.-to-Yr.		Percent Change		Businesses And
($ in millions)					Percent		Adjusted for		Adjusted for
For the year ended December 31:	2019		2018		Change		Currency		Currency
Total revenue	$	77,147	$	79,591	(3.1)	%	(1.0)	%	0.2	%
Americas	$	36,274	$	36,994	(1.9)	%	(1.1)	%	0.8	%
Europe/Middle East/Africa		24,443		25,491	(4.1)		0.4		1.3
Asia Pacific		16,430		17,106	(4.0)		(3.0)		(2.5)

Total revenue of $77,147 million in 2019 decreased 3.1 percent year to year as reported (1 percent adjusted for currency), but increased 0.2 percent excluding divested businesses and adjusted for currency.

Americas revenue decreased 1.9 percent as reported (1 percent adjusted for currency), but grew 1 percent excluding divested businesses and adjusted for currency. Within North America, the U.S. decreased 2.4 percent and Canada increased 4.0 percent as reported (6 percent adjusted for currency). Latin America declined as reported but grew adjusted for currency. Within Latin America, Brazil declined 4.8 percent as reported, but was flat adjusted for currency.

EMEA revenue decreased 4.1 percent as reported, but was essentially flat adjusted for currency and increased 1 percent excluding divested businesses and adjusted for currency. As reported, the U.K., France and Italy decreased 2.9 percent, 4.1 percent and 1.3 percent, respectively, but grew 1 percent, 1 percent and 4 percent, respectively, adjusted for currency. Germany decreased 7.9 percent as reported and 3 percent adjusted for currency. The Middle East and Africa region decreased 3.5 percent as reported and 2 percent adjusted for currency.

Asia Pacific revenue decreased 4.0 percent as reported (3 percent adjusted for currency) and 2 percent excluding divested businesses and adjusted for currency. Japan increased 2.3 percent as reported and 1 percent adjusted for currency. Australia decreased 17.3 percent as reported and 11 percent adjusted for currency. China decreased 13.4 percent as reported and 11 percent adjusted for currency and India decreased 8.1 percent as reported and 5 percent adjusted for currency.

Total Expense and Other (Income)


							Yr.-to-Yr.
							Percent/
($ in millions)							Margin
For the year ended December 31:	2019			2018			Change*
Total consolidated expense and other (income)	$	26,322		$	25,594		2.8	%
Non-operating adjustments
Amortization of acquired intangible assets		(764)			(437)		74.8
Acquisition-related charges		(409)			(16)		NM
Non-operating retirement-related (costs)/income		(615)			(1,572)		(60.9)
Operating (non-GAAP) expense and other (income)	$	24,533		$	23,569		4.1	%
Total consolidated expense-to-revenue ratio		34.1	%		32.2	%	2.0	pts.
Operating (non-GAAP) expense-to-revenue ratio		31.8	%		29.6	%	2.2	pts.

* 2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.

NM–Not meaningful

The following Red Hat-related expenses were included in 2019 total consolidated expense and other (income), with no corresponding expense in the prior-year: Red Hat operational spending, interest expense from debt issuances to fund the acquisition and other acquisition-related activity, including: amortization of acquired intangible assets, retention and legal and advisory fees associated with the transaction.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Total expense and other (income) increased 2.8 percent in 2019 versus the prior year primarily driven by higher spending including Red Hat operational spending and investments in software and systems innovation, higher interest expense, non-operating acquisition-related activity associated with the Red Hat transaction and lower IP income, partially offset by lower non-operating retirement-related costs, divesture-related activity (gains on divestitures and lower spending) and the effects of currency. Total operating (non-GAAP) expense and other (income) increased 4.1 percent year to year, driven primarily by the factors above excluding the higher non-operating acquisition related activity and lower non-operating retirement-related costs described above.

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

Selling, General and Administrative Expense


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Selling, general and administrative expense
Selling, general and administrative–other	$	17,099	$	16,438	4.0	%
Advertising and promotional expense		1,647		1,466	12.3
Workforce rebalancing charges		555		598	(7.2)
Amortization of acquired intangible assets		762		435	74.9
Stock-based compensation		453		361	25.2
Bad debt expense		89		67	32.5
Total consolidated selling, general and administrative expense	$	20,604	$	19,366	6.4	%
Non-operating adjustments
Amortization of acquired intangible assets		(762)		(435)	74.9
Acquisition-related charges		(282)		(15)	NM
Operating (non-GAAP) selling, general and administrative expense	$	19,560	$	18,915	3.4	%

NM–Not meaningful

Total selling, general and administrative (SG&A) expense increased 6.4 percent in 2019 versus 2018, driven primarily by the following factors:

●	Higher spending (5 points) driven by Red Hat spending (5 points); and

●	Higher acquisition-related charges and amortization of acquired intangible assets associated with the Red Hat acquisition (3 points); partially offset by

●	The effects of currency (2 points).

Operating (non-GAAP) expense increased 3.4 percent year to year primarily driven by the same factors excluding the acquisition-related charges and amortization of acquired intangible assets associated with the Red Hat transaction.

Bad debt expense increased $22 million in 2019 compared to 2018. The receivables provision coverage was 1.7 percent at December 31, 2019, an increase of 10 basis points from December 31, 2018.

Research, Development and Engineering Expense


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Total consolidated research, development and engineering	$	5,989	$	5,379	11.3	%
Non-operating adjustment
Acquisition-related charges		(53)		—	NM
Operating (non-GAAP) research, development and engineering	$	5,936	$	5,379	10.4	%

NM–Not meaningful

Research, development and engineering (RD&E) expense was 7.8 percent of revenue in 2019 and 6.8 percent of revenue in 2018.

RD&E expense increased 11.3 percent in 2019 versus 2018 primarily driven by:

●	Higher spending (11 points) including investment in the z15 and Red Hat spending in the second half of 2019 (8 points); and

●	Higher acquisition-related charges associated with the Red Hat transaction (1 point); partially offset by

●	The effects of currency (1 point).

Operating (non-GAAP) expense increased 10.4 percent year to year primarily driven by the same factors excluding the acquisition-related charges associated with the Red Hat transaction.

Intellectual Property and Custom Development Income


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Licensing of intellectual property including royalty-based fees	$	367	$	723	(49.2)	%
Custom development income		246		275	(10.5)
Sales/other transfers of intellectual property		34		28	22.6
Total	$	648	$	1,026	(36.9)	%

Licensing of intellectual property including royalty-based fees decreased 49.2 percent in 2019 compared to 2018. This was primarily due to a decline in new partnership agreements compared to the prior year. 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.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

Other (Income) and Expense


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Other (income) and expense
Foreign currency transaction losses/(gains)	$	(279)	$	(427)	(34.6)	%
(Gains)/losses on derivative instruments		15		434	(96.6)
Interest income		(349)		(264)	32.2
Net (gains)/losses from securities and investment assets		(32)		(101)	(67.9)
Retirement-related costs/(income)		615		1,572	(60.9)
Other		(937)		(63)	NM
Total consolidated other (income) and expense	$	(968)	$	1,152	NM
Non-operating adjustments
Amortization of acquired intangible assets		(2)		(2)	50.0	%
Acquisition-related charges		154		0	NM
Non-operating retirement-related costs/(income)		(615)		(1,572)	(60.9)	%
Operating (non-GAAP) other (income) and expense	$	(1,431)	$	(422)	239.4	%

NM–Not meaningful

Total consolidated other (income) and expense was income of $968 million in 2019 compared to expense of $1,152 million in 2018. The year-to-year change was primarily driven by:

●	Lower non-operating retirement-related costs ($957 million). Refer to “Retirement-Related Plans” for additional information.

●	Higher gains from divestitures ($833 million) reflected in Other; and

●	Higher net exchange gains (including derivative instruments) ($272 million). The company’s hedging programs help mitigate currency impacts in the Consolidated Income Statement.

Operating (non-GAAP) other (income) and expense was $1,431 million of income in 2019 and increased $1,010 million compared to the prior-year period. The year-to-year change was primarily driven by the same factors excluding lower non-operating retirement-related costs.

Interest Expense


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Interest expense	$	1,344	$	723	85.9	%
Non-operating adjustment
Acquisition-related charges		(228)		—	NM
Operating (non-GAAP) interest expense	$	1,116	$	723	54.4	%

NM–Not meaningful

Interest expense increased $621 million compared to 2018. Interest expense is presented in cost of financing in the Consolidated Income Statement only if the related external borrowings are to support the Global Financing external business. Overall interest expense (excluding capitalized interest) in 2019 was $1,952 million, an increase of $473 million year to year, driven by a higher average debt balance and higher interest rates as we issued debt to finance the Red Hat acquisition.

Operating (non-GAAP) interest expense increased $393 million compared to the prior-year period. It excludes the Red Hat pre-closing debt financing costs.

Stock-Based Compensation

Pre-tax stock-based compensation cost of $679 million increased $169 million compared to 2018. This was primarily due to increases related to the issuances and conversions of stock-based compensation for Red Hat ($150 million) and issuance of restricted stock units ($27 million). Stock-based compensation cost, and the year-to-year change, was reflected in the following categories: Cost: $100 million, up $18 million; SG&A expense: $453 million, up $91 million; and RD&E expense: $126 million, up $60 million.

Retirement-Related Plans

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


					Yr.-to-Yr.
($ in millions)					Percent
For the year ended December 31:	2019		2018		Change
Retirement-related plans–cost
Service cost	$	385	$	431	(10.7)	%
Multi-employer plans		32		38	(16.9)
Cost of defined contribution plans		1,040		1,024	1.5
Total operating costs/(income)	$	1,457	$	1,494	(2.5)	%
Interest cost	$	2,929	$	2,726	7.4	%
Expected return on plan assets		(4,192)		(4,049)	3.5
Recognized actuarial losses		1,819		2,941	(38.2)
Amortization of prior service costs/(credits)		(9)		(73)	(87.6)
Curtailments/settlements		41		11	262.2
Other costs		28		16	76.2
Total non-operating costs/(income)	$	615	$	1,572	(60.9)	%
Total retirement-related plans–cost	$	2,072	$	3,066	(32.4)	%

Total pre-tax retirement-related plan cost decreased by $994 million compared to 2018, primarily driven by a decrease in recognized actuarial losses ($1,123 million), primarily due to the change in the amortization period in the U.S. Qualified Personal Pension Plan and higher expected return on plan assets ($143 million), partially offset by higher interest costs ($203 million).

Management Discussion

International Business Machines Corporation and Subsidiary Companies

As discussed in the “Operating (non-GAAP) Earnings” section, we characterize certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in 2019 were $1,457 million, a decrease of $37 million compared to 2018. Non-operating costs of $615 million in 2019 decreased $957 million year to year, driven primarily by the same factors as above.

Income Taxes

The continuing operations effective tax rate for 2019 was 7.2 percent, a decrease of 15.9 points versus the prior year. The decrease in the effective tax rate was primarily driven by the following factors:

●	A lower charge year to year of 16.5 points from the impacts of U.S. tax reform;

●	A charge in 2018 from intercompany payments of 3.4 points; partially offset by

●	A lower benefit year to year from audit settlements of 4.4 points.

The operating (non-GAAP) tax rate was 8.5 percent in 2019, an increase of 0.7 points versus 2018, principally driven by the same factors described above, excluding the impacts of U.S. tax reform.

For more information, see note G, “Taxes.”

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:	2019		2018			Change
Earnings per share of common stock from continuing operations
Assuming dilution	$	10.57	$	9.51	*	11.1	%
Basic	$	10.63	$	9.56	*	11.2	%
Diluted operating (non-GAAP)	$	12.81	$	13.81		(7.2)	%
Weighted-average shares outstanding (in millions)
Assuming dilution		892.8		916.3		(2.6)	%
Basic		887.2		912.0		(2.7)	%

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

Actual shares outstanding at December 31, 2019 and 2018 were 887.1 million and 892.5 million, respectively. The year-to-year decrease was primarily the result of the common stock repurchase program. The average number of common shares outstanding assuming dilution was 23.5 million shares lower in 2019 versus 2018.

Financial Position

Dynamics

At December 31, 2019, we continued to have the financial flexibility to support the business over the long term. Cash, restricted cash and marketable securities at year end were $9,009 million. We continued to manage the investment portfolio to meet our capital preservation and liquidity objectives.

Total assets increased $28,805 million since December 31, 2018. This was primarily due to an increase in goodwill and net intangible assets of $34,104 million, driven by the Red Hat acquisition and an increase of $4,996 million in right-of-use assets recorded as a result of the adoption of the new leasing standard in 2019. This was partially offset by a decline in net receivables of $7,312 million since year-end 2018 levels, primarily due to the wind down of OEM IT commercial financing operations which we announced in February 2019.

Total debt of $62,899 million increased $17,087 million from prior year-end levels primarily to fund the Red Hat acquisition. The commercial paper balance at December 31, 2019 was $304 million, a decrease of $2,691 million from the prior year end. Within total debt, $24,727 million is in support of the Global Financing business which is leveraged at a 9 to 1 ratio. During 2019, we completed bond issuances totaling $25,712 million, with terms ranging from 2 to 30 years, and interest rates ranging from 0.375 to 4.25 percent depending on maturity. We have reduced total debt $10,140 million since the end of the second quarter of 2019. We have consistently generated strong cash flow from operations and continue to have access to additional sources of liquidity through the capital markets and our credit facilities.

Consistent with accounting standards, the company remeasured the funded status of our retirement and postretirement plans at December 31. At December 31, 2019, the overall net underfunded position was $11,090 million, an improvement of $2,043 million from December 31, 2018 driven by higher returns on assets partially offset by lower discount rates and interest costs. At year end, our qualified defined benefit plans were well funded and the required contributions related to these plans and multi-employer plans are expected to be approximately $300 million in both 2020 and 2021. In 2019, the return on the U.S. Personal Pension Plan assets was 14.9 percent and the plan was 107 percent funded at December 31, 2019. Overall, global asset returns were 13.6 percent and the qualified defined benefit plans worldwide were 102 percent funded at December 31, 2019.

During 2019, we generated $14,770 million in cash from operations, a decrease of $477 million compared to 2018. Our free cash flow for 2019 was $11,909 million, an increase of $33 million versus the prior year. See pages 58 and 59 for additional information on free cash flow. We returned $7,068 million to shareholders in 2019, with $5,707 million in dividends and $1,361 million in gross share repurchases. In 2019, we

Management Discussion

International Business Machines Corporation and Subsidiary Companies

repurchased 10.0 million shares and had $2.0 billion remaining in share repurchase authorization at year end. We suspended our share repurchase program at the time of the Red Hat closing to focus on debt repayment. Our cash generation permits us 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:	2019		2018
Cash and cash equivalents	$	1,697	$	1,833
Net investment in sales-type and direct financing leases ⁽¹⁾		6,224		6,924
Equipment under operating leases–external clients ⁽²⁾		238		444
Client loans		12,884		12,802
Total client financing assets		19,346		20,170
Commercial financing receivables		3,820		11,838
Intercompany financing receivables ^{(3) (4)}		3,870		4,873
Total assets	$	29,568	$	41,320
Debt		24,727		31,227
Total equity	$	2,749	$	3,470

(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 in the Consolidated Balance Sheet.

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

At December 31, 2019, substantially all financing assets were IT-related assets, and approximately 62 percent of the total external portfolio was with investment-grade clients with no direct exposure to consumers, an increase of 7 points year to year. This investment-grade percentage is based on the credit ratings of the companies in the portfolio.

We have 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. Adjusting for the mitigation actions, the investment-grade content would increase to 67 percent, a decrease of 3 points year to year.

IBM Working Capital


($ in millions)
At December 31:	2019		2018
Current assets	$	38,420	$	49,146
Current liabilities		37,701		38,227
Working capital	$	718	$	10,918
Current ratio		1.02:1		1.29:1

Working capital decreased $10,200 million from the year-end 2018 position. The key changes are described below:

Current assets decreased $10,726 million ($10,477 million adjusted for currency) due to:

●

A decline in receivables of $6,769 million ($6,695 million adjusted for currency) driven by a decline in financing receivables of $8,197 million primarily due to the wind down of OEM IT commercial financing operations; partially offset by an increase in other receivables of $989 million primarily related to divestitures; and

●	A decrease of $3,213 million ($3,052 million adjusted for currency) in cash and cash equivalents, restricted cash, and marketable securities primarily due to retirement of debt.

Current liabilities decreased $526 million ($449 million adjusted for currency) as a result of:

●	A decrease in accounts payable of $1,662 million primarily due to the wind down of OEM IT commercial financing operations; and

●	A decrease in short-term debt of $1,410 million due to maturities of $12,649 million and a decrease in commercial paper of $2,691 million; partially offset by reclassifications of $7,592 million from long-term debt to reflect upcoming maturities and issuances of $6,334 million; offset by

●	An increase in operating lease liabilities of $1,380 million as a result of the adoption of the new leasing standard on January 1, 2019; and

●	An increase in deferred income of $861 million ($890 million adjusted for currency).

Receivables and Allowances

Roll Forward of Total IBM Receivables Allowance for Credit Losses

($ in millions)

January 1,

December 31,

2019

Additions*

Write-offs**

Other+

2019

639

(178)

554

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

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

+ Primarily represents translation adjustments.

The total IBM receivables provision coverage was 1.7 percent at December 31, 2019, an increase of 10 basis points compared to December 31, 2018. The increase was primarily driven by the overall decline in gross financing receivables. The majority of the write-offs during the year related to receivables which had been previously reserved.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

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:	2019			2018
Recorded investment⁽¹⁾	$	22,446		$	31,182
Specific allowance for credit losses		177			220
Unallocated allowance for credit losses		45			72
Total allowance for credit losses		221			292
Net financing receivables	$	22,224		$	30,890
Allowance for credit losses coverage		1.0	%		0.9	%

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

The percentage of Global Financing receivables reserved was 1.0 percent at December 31, 2019, compared to 0.9 percent at December 31, 2018. The decline in the allowance for credit losses was driven by write-offs of $64 million, primarily of receivables previously reserved, and net releases of $7 million as a result of lower average asset balances in client and commercial financing. See note K, “Financing Receivables,” for additional information.

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

($ in millions)

January 1,

Additions/

December 31,

2019

(Releases)*

Write-offs**

Other+

2019

292

(7)

(64)

221

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

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

+ Primarily represents translation adjustments.

Global Financing’s bad debt expense was a release of $7 million in 2019, compared to an addition of $14 million in 2018, due to lower specific reserves and a higher unallocated reserve release in 2019.

Noncurrent Assets and Liabilities


($ in millions)
At December 31:	2019		2018
Noncurrent assets	$	113,767	$	74,236
Long-term debt	$	54,102	$	35,605
Noncurrent liabilities (excluding debt)	$	39,398	$	32,621

The increase in noncurrent assets of $39,531 million ($39,470 million adjusted for currency) was driven by:

●	A net increase in goodwill and net intangible assets of $34,104 million ($34,058 million adjusted for currency) due to the acquisition of Red Hat; and

●	An increase in operating right-of-use assets of $4,996 million ($5,010 million adjusted for currency) as a result of the adoption of the new leasing standard on January 1, 2019; and

●	An increase in prepaid pension assets of $2,199 million ($2,152 million adjusted for currency) driven by higher returns on plan assets and plan remeasurements; partially offset by

●	A decrease in net property, plant and equipment of $782 million ($785 million adjusted for currency).

Long-term debt increased $18,497 million ($18,550 million adjusted for currency) primarily driven by:

●	Issuances of $26,081 million; partially offset by

●	Reclassifications to short-term debt of $7,592 million to reflect upcoming maturities.

Noncurrent liabilities (excluding debt) increased $6,778 million ($6,911 million adjusted for currency) primarily driven by:

●	An increase in long-term operating lease liabilities of $3,879 million ($3,893 million adjusted for currency) as a result of the adoption of the new leasing standard on January 1, 2019; and

●	An increase in other liabilities of $2,352 million ($2,320 million adjusted for currency), primarily driven by increases in deferred tax liabilities of $1,534 million and income tax reserves of $923 million.

Debt

Our funding requirements are continually monitored and we execute our strategies to manage the overall asset and liability profile. Additionally, we maintain sufficient flexibility to access global funding sources as needed.


($ in millions)
At December 31:	2019		2018
Total company debt	$	62,899	$	45,812
Total Global Financing segment debt	$	24,727	$	31,227
Debt to support external clients		21,487		27,536
Debt to support internal clients		3,239		3,690
Non-Global Financing debt		38,173		14,585

Total debt of $62,899 million increased $17,087 million from December 31, 2018, driven by issuances of $32,415 million; partially offset by debt maturities of $12,673 million and a decrease in commercial paper of $2,691 million.

Non-Global Financing debt of $38,173 million increased $23,587 million from prior year-end levels primarily driven by issuances to fund the Red Hat acquisition.

Global Financing debt of $24,727 million decreased $6,500 million from December 31, 2018, primarily due to the wind down of OEM IT commercial financing operations.

Global Financing provides financing predominantly for IBM’s external client assets, as well as for assets under contract by other IBM units. These assets, primarily for GTS, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their attributes, these GTS assets are leveraged with the balance of the Global Financing asset base.

Management Discussion

International Business Machines Corporation and Subsidiary Companies

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. The Global Financing debt-to-equity ratio remained at 9 to 1 at December 31, 2019.

As previously stated, we measure 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” and in note D, “Segments.” In the Consolidated Income Statement, the external debt-related interest expense supporting Global Financing’s internal financing to IBM is reclassified from cost of financing to interest expense.

Equity

Total equity increased by $4,055 million from December 31, 2018 as a result of net income of $9,431 million, a decline in accumulated other comprehensive losses of $893 million primarily due to retirement-related benefits plans, and an increase in common stock of $745 million; partially offset by decreases from dividends of $5,707 million, and an increase in treasury stock of $1,342 million mainly due to share repurchases.

Cash Flow

Our cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 71 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:	2019		2018
Net cash provided by/(used in) continuing operations
Operating activities	$	14,770	$	15,247
Investing activities		(26,936)		(4,913)
Financing activities		9,042		(10,469)
Effect of exchange rate changes on cash, cash equivalents and restricted cash		(167)		(495)
Net change in cash, cash equivalents and restricted cash	$	(3,290)	$	(630)

Net cash provided by operating activities decreased $477 million in 2019 driven by the following key factors:

●	An increase in cash income tax payments of $346 million;

●	An increase in interest payments on debt of approximately $300 million, driven by incremental debt used to fund the acquisition of Red Hat; and

●	Performance-related declines within net income, including lower operating cash flows due to businesses divested in 2019; partially offset by

●	An increase of $836 million in cash provided by financing receivables.