IBM’s business strategy and operations are designed to support the company’s long-term financial model and objectives — including double-digit earnings-per-share growth.

Our revenue model is based on the IT industry’s historical growth pattern, the new opportunities described in this document and our ability to capture or maintain leading share positions in the markets we select.

The same on demand principles that have yielded efficiencies and enhanced capabilities in our integrated supply chain are being applied throughout our internal operations. Margin improvements will also come from a continued focus on high-value offerings and by fully leveraging IBM’s global operations.

We use our cash to support internal growth opportunities with capital expenditures and research and development, to acquire new capabilities, to open new market opportunities, and to repurchase stock.

We maintain low financial leverage on IBM’s non-financing business and a substantial cash balance. This gives us the financial flexibility to act on opportunities and to manage through periods of economic stress.

IBM has delivered consistently high return on invested capital (ROIC). Our management discipline and strategy have produced sustained ROIC results well above those of the S&P 500 average. In fact, over the last five years, IBM’s total ROIC ranged between 5 and 15 percentage points above that of the S&P 500 and well above our weighted average cost of capital. While IBM’s total return on invested capital includes our Global Financing business, a more appropriate measure of our ROIC excludes Global Financing. In 2004, our ROIC increased to 29 percent, excluding our Global Financing business and a one-time pension settlement charge.^* Most companies can deliver impressive return on invested capital for one year. The key is delivering impressive ROIC on a sustained basis.

Our financial management strategy is based on IBM’s growth objectives. Our strong balance sheet and cash flows support continual investment, which generates revenue and earnings-per-share (EPS) growth. Our disciplined use of capital drives high annual return on invested capital, which in turn generates strong cash flows. And those cash flows are reinvested in the business or returned to investors through consistent dividends and share repurchases.

IBM is expanding in the high-value markets for IT-intensive business consulting and business transformation services. Business Performance Transformation Services generated more than $3 billion in revenues in 2004, up approximately 45 percent over the previous year.

IBM revenues from emerging markets in China, Russia, India and Brazil together grew more than 25 percent in 2004, to more than $4 billion. Our revenues from IBM’s Small and Medium Business organization grew more than 8 percent in 2004, and account for more than a fifth of our revenues today.

We are leveraging IBM’s leadership positions in IT services, enterprise middleware and enterprise hardware, and combining them with the capabilities of our business partners and independent software vendors.

• IBM Global Services is the worldwide leader in IT services, with more than twice the revenue of its nearest rival. IBM is ranked number one in IT outsourcing, application management and e-business hosting.
  
  
• IBM is the number one server provider in the world.
  
  
• In 2004, IBM increased market share for its zSeries, pSeries and xSeries servers, including its innovative line of blade servers.
  
  
• In 2004, IBM gained share in several key product segments of its software business, and held share in middleware overall. IBM’s WebSphere platform grew 14 percent in revenues in 2004. Revenue from our Rational brand, acquired in February 2003, grew by 15 percent.

We don’t just deliver On Demand Business to our clients, we apply it ourselves. As we’ve discussed, increased responsiveness, flexibility and ongoing efficiencies have now been built into our management systems — leading to significant cost savings and, as a result, more robust margins.

In addition, we are adopting business performance transformation ourselves to lower the costs of producing the services, hardware and software we provide clients, enabling increased investment to grow sales. Some of our business partners are also our vendors, helping us transform our processes and integrate them across the company.

Furthermore, after several years of creating advanced, custom, on demand transformation solutions for many clients, we’re now able to reuse some of the intellectual capital we’ve generated and thereby increase our margins. IBM is actively pursuing this asset-based services model for our clients and for our own operations. The revenue and profit potential are attractive relative to purely labor-based services models.

IBM has historically generated strong cash flows. This comes from our consistent profitability, disciplined working capital management and investment decisions that generate high annual return on invested capital.

Our mix of businesses helps us to sustain our cash flows year-to-year. Approximately 45 percent of our revenue and more than half of our gross profit come from annuity-like businesses, such as software licenses and long-term services contracts. Some have seen this as a pursuit of stable, recurring revenue streams for their own sake. We, however, see it as the result of a major shift in IBM’s business model over the last decade — moving from that of an enterprise built primarily on individual transactions to one in which our most important work is managing deep, strategic, long-term relationships. We believe this shift will continue as our business performance transformation revenues grow.

The cash generated from the business is first invested to sustain and grow the business — through internal investments such as capital expenditures and research and development.

Our investments are designed to exceed substantially the company’s cost of capital. Next, we invest in acquisitions, with a primary focus on increasing our capability and expanding our market opportunities. Cash is then returned to our shareholders through stock repurchases and dividends.

Over the past five years, IBM’s businesses have generated $59.4 billion in cash available for investment and for distribution to shareholders. Approximately half of this was reinvested in our business through net capital expenditures and strategic acquisitions.

Our strategy is to maintain a strong balance sheet with a significant cash balance and low debt levels on everything but our financing business, where debt is an appropriate form of the capital base. This gives IBM the financial flexibility to take advantage of any business opportunity or to deal with economic difficulties the company may face. When borrowing is necessary, we have substantial credit lines and access to the capital markets to meet our requirements. Cash flows are used to reduce debt levels once the borrowing is no longer required.

Our model for return to shareholders has allowed us to provide consistent dividend returns and make significant stock repurchases while maintaining financial flexibility so the company can move quickly and dynamically when opportunities arise.

IBM began a regular series of dividend payouts in 1916, a time when such payouts were arguably the only tangible indicator of a company’s financial health. After 89 years, IBM has achieved a number of milestones in delivering shareholder value:

• Dividend payouts for each of the last 357 fiscal quarters.
  
  
• Year-to-year increases in dividends per share in 64 of the past 89 years.
  
  
• $8.8 billion paid in dividends to shareholders over the past 10 years.

Today, our dividends are set by our board of directors and are consistent with our profit growth, stock repurchase and financial flexibility objectives.

Share repurchases complement our dividends with substantial additional payouts to investors in most years, yet they give the company financial flexibility to make alternative use of its cash flow for acquisition investments or other needs. Repurchasing shares also supports our financial model by reducing the number of shares outstanding and increasing our earnings-per-share rate of growth. Since 1995, IBM has returned $59.8 billion to investors through share repurchase.

As a reflection of the total value of our company, IBM’s market capitalization since 1997 grew at a compound annual growth rate (CAGR) of 7.1 percent, from $100 billion to $162 billion by the end of 2004.

Another way to look at the value of our company is through our share price performance. While many factors can affect share price, it provides a single, comprehensive measure over time of investor confidence in how IBM runs its business, serves its clients, enables and develops its workforce, and manages its relationships and finances. IBM’s share price has grown at a CAGR of 9.5 percent from year-end 1997 through year-end 2004 — better than the S&P 500 (3.2 percent), the NASDAQ (4.8 percent) and the Dow Jones Industrial Average (4.5 percent) during the same time frame.