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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 2008 versus 2007 reportable segment results. The analysis of 2007 versus 2006 reportable segment results can be found in “Prior year in review - Continuing Operations.”

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

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Percent/
Margin Change
Yr.-to-Yr. Percent Change Adjusted for Currency
Revenue:        
Global Technology Services $39,264 $36,103 8.8% 5.8%
Gross margin 32.6% 29.9% 2.7 pts.  
Global Business Services 19,628 18,041 8.8% 5.1%
Gross margin 26.7% 23.5% 3.2 pts.  
Software 22,089 19,982 10.5% 8.2%
Gross margin 85.4% 85.2% 0.2 pts.  
Systems and Technology 19,287 21,317 (9.5)% (10.8)%
Gross margin 38.1% 39.7% (1.7) pts.  
Global Financing 2,559 2,502 2.3% 0.3%
Gross margin 51.3% 46.7% 4.6 pts.  
Other 803 842 (4.6)% (5.9)%
Gross margin 13.4% 4.4% 9.1 pts.  
Total revenue $103,630 $98,786 4.9% 2.3%
Gross profit $45,661 $41,729 9.4%  
Gross margin 44.1% 42.2% 1.8 pts.  

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

  Revenue
 
Pre-Tax Income*
For the year ended December 31: 2008 2007 2008 2007

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

Global Technology Services 38.2% 36.9% 26.3% 23.5%
Global Business Services 19.1 18.4 15.3 13.6
Total Global Services 57.3 55.3 41.6 37.1
Software 21.5 20.4 40.4 39.6
Systems and Technology 18.8 21.8 8.8 14.2
Global Financing 2.5 2.6 9.2 9.1
Total 100.0% 100.0% 100.0% 100.0%

In 2008, Global Services and Software increased as a percentage of total segment revenue and total segment pre-tax income. Global Services increased its revenue and profit contribution by 2.0 points and 4.5 points, respectively, while the Software business increased by 1.1 points and 0.8 points, respectively. These improvements reflect the company’s portfolio actions and targeted investment strategies — both aimed at market segments that present the best long-term opportunities.

Global Services

The Global Services segments, Global Technology Services (GTS) and Global Business Services (GBS), had combined revenue of $58,891 million, an increase of 8.8 percent (6 percent adjusted for currency) in 2008 when compared to 2007. Revenue performance was broad based across the segments, lines of business and geographic units, driven primarily by a strong annuity base and growth in short-term signings.

In 2008, total Global Services signings increased 2 percent year to year to $57,182 million ($49,738 million adjusted for currency, flat year to year). Short-term signings were $26,831 million, an increase of 8 percent (5 percent adjusted for currency) versus 2007. Short-term signings increased in both the growth markets and the major markets. Long-term signings were $30,351 million, a decrease of 3 percent (5 percent adjusted for currency) compared to 2007. Long-term signings declined in both the major and growth markets. The total Global Services backlog decreased $2 billion from the prior year to an estimated $117 billion at December 31, 2008.

The Global Services segments leveraged very strong margin performance and delivered combined pre-tax profit of $7,288 million in 2008, an improvement of 29.6 percent versus 2007. The services business contributed approximately 42 percent of the company’s segment pre-tax profit in 2008. Through its transformation initiatives, the Global Services business has focused on higher value offerings with a more flexible labor model that can adapt to changing market environments.

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Global Services Revenue: $58,891 $54,144 8.8%
Global Technology Services $39,264 $36,103 8.8%
Strategic Outsourcing 20,183 18,701 7.9
Integrated Technology Services 9,283 8,438 10.0
Business Transformation Outsourcing 2,550 2,294 11.2
Maintenance 7,250 6,670 8.7
Global Business Services $19,628 $18,041 8.8%

Global Technology Services revenue increased 8.8 percent (6 percent adjusted for currency) in 2008 versus 2007 with strong performance across all lines of business. Total signings in GTS increased 1 percent (flat adjusted for currency) led by short-term signings growth of 5 percent (4 percent adjusted for currency). Long-term signings decreased 1 percent (2 percent adjusted for currency).

Strategic Outsourcing (SO) revenue was up 7.9 percent (5 percent adjusted for currency) with growth in all geographies, driven by prior year’s signings and continued growth in the base accounts. SO signings in 2008 increased 3 percent (1 percent adjusted for currency) when compared to 2007. Signings were very strong in the fourth quarter (up 20 percent), as clients focused on the value of the SO offerings in the current environment. The initiatives around standardization, global integration and improved efficiency are driving improvements in quality and customer satisfaction which are reflected in the signings performance and in improved profitability.

Information Technology Services (ITS) revenue increased 10.0 percent (7 percent adjusted for currency) in 2008 versus 2007 led by growth in key infrastructure offerings such as Green Data Cen­ter and Converged Communications. ITS infrastructure offerings deliver high-value, standardized, asset-based services that leverage the company’s services, hardware and software capabilities, providing clients end-to-end solutions and processes that transform their businesses. ITS signings increased 5 percent (4 percent adjusted for currency) in 2008.

Business Transformation Outsourcing (BTO) revenue increased 11.2 percent (12 percent adjusted for currency) with growth in all geographies, led by Asia Pacific. The Daksh business, which is focused on business process outsourcing, delivered strong growth. BTO signings decreased 18 percent (14 percent adjusted for currency) in 2008 compared to 2007.

Maintenance revenue increased 8.7 percent (5 percent adjusted for currency) with growth in availability services on both IBM and non-IBM IT equipment.

Global Business Services revenue increased 8.8 percent (5 percent adjusted for currency) in 2008, with balanced growth across all three geographies. Revenue performance was led by growth in Application Management Services (12.5 percent) and Core Consulting (6.1 percent). Total signings in GBS increased 2 percent (decreased 1 percent adjusted for currency), led by a 10 percent (6 percent adjusted for currency) growth in short-term signings. Short-term signings growth was driven by offerings that enable clients to reduce cost and conserve capital. In the second half of the year, signings for transformational and compliance offerings also increased. Long-term signings decreased 14 percent (16 percent adjusted for currency) year over year.

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Global Services Gross Profit:      
Global Technology Services:      
Gross profit $12,802 $10,800 18.5%
Gross profit margin 32.6% 29.9% 2.7 pts.
Global Business Services:      
Gross profit $5,238 $4,240 23.5%
Gross profit margin 26.7% 23.5% 3.2 pts.

GTS gross profit increased 18.5 percent compared to 2007, with gross profit margin improving 2.7 points. All lines of business delivered gross margin expansion year over year driven by a combination of a mix to higher value offerings and an improved cost structure. Segment pre-tax profit increased 29.5 percent to $4,607 million with a pre-tax margin of 11.3 percent, an increase of 1.9 points versus 2007. GTS has delivered six consecutive quarters of double-digit pre-tax profit growth. The margin improvement was driven primarily by a delivery structure that maximizes utilization and flexibility, a mix to higher value offerings, lower retirement-related costs and improved productivity.

GBS gross profit increased 23.5 percent to $5,238 million in 2008 when compared to 2007, and the gross profit margin improved 3.2 points. Segment pre-tax profit increased 29.9 percent to $2,681 million with a pre-tax margin of 13.0 percent, an improvement of 2.2 points year over year. This was the third straight year of profit growth greater than 20 percent in GBS and demonstrates the results of a strong operating discipline and the benefits of a globally integrated operating model. The margin expansion was driven by improved utilization, cost and expense management, stable pricing and lower retirement-related costs.

Global Services signings

The tables below present Global Services signings as reported and adjusted for currency. Signings at actual currency rates provide investors a better view of how these signings will convert to services revenue and provide better comparability to other companies in the industry who report signings using actual rates.

At actual currency rates
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Global Technology Services Signings:      
Long term $24,446 $24,576 (0.5)%
Short term 10,247 9,776 4.8
Total $34,693 $34,352 1.0%
Global Business Services Signings:      
Long term $5,905 $6,847 (13.8)%
Short term 16,584 15,094 9.9
Total $22,488 $21,941 2.5%
Adjusted for currency
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Global Technology Services Signings:      
Long term $21,220 $21,550 (1.5)%
Short term 8,920 8,604 3.7
Total $30,141 $30,154 0.0%
Global business Services Signings:      
Long term $5,333 $6,330 (15.8)%
Short term 14,264 13,411 6.4
Total $19,597 $19,741 (0.7)%

Global Services signings are management’s initial estimate of the revenue value of a client’s commitment under a Global Services contract. Signings are used by management to assess period performance of Global Services management. There are no third-party standards or requirements governing the calculation of signings. The calculation used by management includes an approximation of currency and involves estimates and judgments to gauge the extent of a client’s commitment, including the type and duration of the agreement, and the presence of termination charges or wind-down costs. For example, for long-term contracts that require significant up-front investment by the company, the portions of these contracts that constitute a signing are those periods in which there is a significant economic impact on the client if the commitment is not achieved, usually through a termination charge or the client incurring significant wind-down costs as a result of the termination. For short-term contracts that do not require significant up-front investments, a signing is usually equal to the full contract revenue value. Long-term contracts represent SO and BTO contracts as well as GBS contracts with the U.S. Federal government and its agencies and Application Management Services (AMS) for custom and legacy applications. Short-term contracts represent the remaining GBS offerings of Consulting and Systems Integration, AMS for packaged applications and ITS contracts.

Signings include SO, BTO, ITS and GBS contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new revenue value. Maintenance is not included in signings as maintenance contracts tend to be more steady state, where revenues equal renewals.

Backlog includes SO, BTO, ITS, GBS and Maintenance. Backlog is intended to be a statement of overall work under contract and therefore does include Maintenance. Backlog estimates are subject to change and are affected by several factors, including terminations, changes in the scope of contracts, periodic revalidations, adjustments for revenue not materialized and currency assumptions used to approximate constant currency.

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

Software
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Software revenue: $22,089 $19,982 10.5%
Middleware $17,305 $15,505 11.6%
Key Branded Middleware 12,383 10,827 14.4
WebSphere Family     6.2
Information Management     24.5
Lotus     10.4
Tivoli     2.9
Rational     13.2
Other middleware 4,922 4,678 5.2
Operating systems 2,337 2,319 0.8
Product Lifecycle Management 960 1,051 (8.6)
Other 1,488 1,107 34.4

Software segment revenue of $22,089 million increased 10.5 percent (8 percent adjusted for currency) in 2008 led by growth in the Key Branded Middleware products and strong contributions from the annuity base and acquisitions. Clients continue to embed the company’s software in the fabric of their IT infrastructures.

Key Branded Middleware revenue increased 14.4 percent (12 percent adjusted for currency) and represented 56 percent of total Software segment revenue, an increase of 2 points from 2007. When adjusted for currency, growth in 2008 was led by Information Management, Rational and Lotus. Strategic acquisitions, including Cognos and Telelogic, have extended the segment’s middleware capabilities.

WebSphere Family revenue increased 6.2 percent (5 percent adjusted for currency) in 2008 and was led by growth in WebSphere Application Servers and WebSphere Business Integration software. In December 2008, the company completed the acquisition of ILOG, whose products help customers improve business decisions with optimization, visualization and business rules software. The WebSphere products provide the foundation for Web-enabled applications and are a key product set in deploying a client’s SOA. Information Management revenue increased 24.5 percent (22 percent adjusted for currency) in 2008 versus the prior year, reflecting the contribution from Cognos and strong demand for the distributed relational database products. Cognos’ performance management solution helps customers improve decision-making across the enterprise to optimize business performance.

Lotus revenue increased 10.4 percent (8 percent adjusted for currency) in 2008 led by growth in Lotus Notes products as customers continue to invest to improve their workforce efficiency. Lotus software is well established as a tool for providing improved workplace collaboration and productivity.

Tivoli revenue increased 2.9 percent (2 percent adjusted for currency) in 2008 when compared to 2007. Revenue performance was led by growth in Tivoli Security and Storage Management products. Tivoli software provides the advanced capabilities required to run large mission-critical environments. This includes security and storage software which helps customers improve utilization and reduce costs.

Rational revenue increased 13.2 percent (12 percent adjusted for currency) in 2008 driven primarily by Telelogic contributions. Telelogic’s suite of system programming tools complements Rational’s IT tool set, providing a common framework for software and systems delivery across a client’s enterprise.

Revenue from Other middleware products increased 5.2 percent (3 percent adjusted for currency) in 2008 versus the prior year. This software product set includes more mature products which provide a more stable flow of revenue.

Other software segment revenue increased 34.4 percent (31 percent adjusted for currency) versus 2007 reflecting continued growth in software-related services.

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Software gross profit:      
Gross profit $18,859 $17,015 10.8%
Gross profit margin 85.4% 85.2% 0.2 pts.

Software segment gross profit increased 10.8 percent to $18,859 million in 2008, driven primarily by the strong revenue growth. The large annuity base of this business continues to provide a predictable and growing profit stream. Gross profit margin was 85.4 percent in 2008, an increase of 0.2 points versus 2007. The company has been investing significantly in the software business with good results. The Software segment contributed $7,075 million of pre-tax profit in 2008, an increase of 17.9 percent versus 2007 while successfully integrating Cognos and Telelogic. Software contributed approximately 40 percent of the company’s segment pre-tax profit in 2008. The segment pre-tax profit margin increased 1.7 points to 28.5 percent. The pre-tax income and margin improvements have been driven primarily by revenue growth and increasing operational efficiencies.

Systems and Technology
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change

NM — Not meaningful

Systems and Technology revenue: $19,287 $21,317 (9.5)%
System z     12.5%
Legacy System i     (66.1)
Converged System p     11.2
System x     (16.9)
System Storage     (3.4)
Retail Store Solutions     (15.0)
Total Systems     (4.9)
Microelectronics OEM     (25.1)
Printing Systems     NM

Systems and Technology segment revenue decreased 9.5 percent (down 11 percent adjusted for currency) in 2008 versus 2007. In June 2007, the company divested its printing business. Systems and Technology revenue, excluding the divested printing business, decreased 7.8 percent (9 percent adjusted for currency) in 2008 versus 2007. Total Systems revenue decreased 4.9 percent (6 percent adjusted for currency) in 2008 versus 2007.

In the current economic environment, clients are focused on reducing the cost of running their IT infrastructure. Virtualization, which provides the capability to run multiple workloads on a single server, is a key enabler of efficiency. System z is the leading platform for virtualization as it is able to support thousands of images and operate fully utilized. The company’s POWER architecture supports hundreds of partitions, often driving utilization rates of over 60 percent. Both of these platforms leverage the entire system, from the company’s custom semiconductors through the software stack, to achieve these high levels of efficiency and lower cost of ownership. The distributed computing model, which utilizes many small servers, cannot offer the same level of efficiency and value.

System z revenue increased 12.5 percent (11 percent adjusted for currency) in 2008 versus 2007. System z revenue growth was particularly strong in the Americas (up 19 percent), as well as in the Financial Services and Industrial sectors globally. Clients in emerging markets also leveraged this platform’s stability and efficiency during 2008. MIPS (millions of instructions per second) shipments increased 25 percent in 2008 versus 2007, posting double-digit growth in each quarter, reflecting strength in both traditional and specialty workloads. Specialty MIPS increased 68 percent in 2008, as clients exploit the capabilities of System z to bring new Linux and Java applications to this highly efficient and cost effective platform.

Converged System p revenue increased 11.2 percent (11 percent adjusted for currency) in 2008 versus 2007, reflecting solid demand for the energy efficiencies and multi-operating system capabilities of POWER6 technology. Clients are concluding that POWER6 technology is the right solution for a multitude of workloads. The revenue growth was primarily driven by midrange servers which increased 32 percent and high-end servers which increased 3 percent in 2008 versus 2007.

Legacy System i revenue decreased 66.1 percent (67 percent adjusted for currency) in 2008 versus 2007, as the company continues to transition the System i customer base to the converged POWER platform within System p.

System x revenue decreased 16.9 percent (19 percent adjusted for currency) in 2008 versus 2007. System x server revenue declined 15 percent and blades revenue decreased 3 percent, in 2008 versus 2007, respectively. The decline in server revenue reflects a significant slowdown in the x86 market, especially in the second half of 2008, as clients are virtualizing and consolidating workloads onto more efficient platforms such as POWER and mainframe.

System Storage revenue decreased 3.4 percent (5 percent adjusted for currency) in 2008 versus 2007. Total disk revenue was essentially flat in 2008 versus 2007. Enterprise Disk revenue increased 2 percent primarily due to increased demand for the DS8000 product, while midrange disk revenue declined 15 percent. Tape revenue declined 10 percent in 2008 primarily due to reduced demand and clients deciding to purchase additional media to expand the utilization of their existing devices.

Microelectronics OEM revenue decreased 25.1 percent (25 percent adjusted for currency) in 2008 versus 2007. The primary mission of this business is to provide leadership technology for the systems business, as demonstrated during 2008 in the new System z10 mainframe and POWER6 systems.

Retail Stores Solutions revenue decreased 15.0 percent (16 percent adjusted for currency) in 2008 versus 2007, reflecting weakness in the retail sector and a compare to a strong 2007, when a new programmable point-of-sale solution was being delivered to large clients.

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Systems and Technology Gross Profit:      
Gross profit $7,341 $8,468 (13.3)%
Gross profit margin 38.1% 39.7% (1.7) pts.

Overall, gross margin decreased by 1.7 points versus the prior year. This decrease was primarily driven by margin declines in System z, System x and Microelectronics OEM which impacted the overall margin by 1.6 points, 1.3 points and 1.2 points, respectively. Partially offsetting these margin declines was a revenue mix benefit of 2.7 points due to the increased revenue in System z and converged System p.

Systems and Technology segment pre-tax margin declined 2.0 points to 7.7 percent in 2008 reflecting the lower revenue and gross profit margin in 2008 versus 2007.

Global Financing

See “Results of Operations” in “Global Financing” for an analysis of Global Financing’s segment results.

Geographic revenue

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

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Total revenue: $103,630 $98,786 4.9%
Geographies: $100,939 $95,320 5.9%
Americas 42,807 41,122 4.1
Europe/Middle East/Africa 37,020 34,699 6.7
Asia Pacific 21,111 19,501 8.3
OEM $2,691 $3,465 (22.4)%

Geographic revenue increased 5.9 percent (3 percent adjusted for currency) to $100,939 million in 2008 when compared to 2007. Revenue increased in all geographies in 2008, and adjusted for currency, revenue growth was strongest in the Americas followed by Europe and Asia Pacific. Revenue from the company’s growth markets organization increased 9.8 percent (10 percent adjusted for currency) while growth in the more established major markets was 5.1 percent (2 percent adjusted for currency).

Americas revenue increased 4.1 percent (4 percent adjusted for currency) in 2008. Revenue increased in all regions with the U.S. up 2.9 percent, Canada 5.6 percent (6 percent adjusted for currency) and Latin America 13.9 percent (11 percent adjusted for currency).

Europe/Middle East/Africa (EMEA) revenue increased 6.7 percent (3 percent adjusted for currency) in 2008 when compared to 2007. The majority of major market countries performed well led by Spain which grew 12.0 percent (5 percent adjusted for currency), Germany increased 10.8 percent (4 percent adjusted for currency) and France increased 9.0 percent (2 percent adjusted for currency). Italy increased 5.8 percent (decreased 1 percent adjusted for currency) while the U.K. decreased 4.9 percent (increased 4 percent adjusted for currency).

Asia Pacific revenue increased 8.3 percent (2 percent adjusted for currency) year over year. Revenue increased in the India, South Korea, ASEAN, Australia/New Zealand and China regions with combined growth of 8.1 percent (9 percent adjusted for currency). Japan revenue, which represented 49 percent of the Asia Pacific revenue base, increased 8.5 percent as reported, but decreased 5 percent adjusted for currency in 2008 when compared to 2007.

Across the geographies, aggregate revenue from the countries comprising the company’s growth markets organization increased 9.8 percent (10 percent adjusted for currency) in 2008 and represented approximately 18 percent of the company’s total geographic revenue. The company has continued to invest to capture new infrastructure spending in the growth markets. Adjusted for currency, growth in these markets was 8 points higher than in the major markets. The BRIC countries, a subset of the growth markets, together grew 17.6 percent (15 percent adjusted for currency), with growth in India of 25.8 percent (33 percent adjusted for currency), Brazil 18.3 percent (13 percent adjusted for currency), China 14.7 percent (8 percent adjusted for currency) and Russia 11.0 percent (11 percent adjusted for currency).

OEM revenue decreased 22.4 percent (23 percent adjusted for currency) in 2008 when compared to 2007, driven by reduced demand in the Microelectronics OEM business.

Total Expense and Other Income
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Total expense and other income $28,945 $27,240 6.3%
Expense to Revenue 27.9% 27.6% 0.4 pts.

The key drivers year to year in total expense and other income were approximately:

  • Operational expense, -1 point
  • Acquisitions, +5 points
  • Currency, +2 points

In 2008, the company continued to focus on productivity improvements in its more established markets and increased its investments in the growth markets. Within selling, general and administrative expense (SG&A), total sales and marketing expense increased 4 percent year to year (2 percent adjusted for currency). Sales and marketing expense in the growth markets increased 13 percent (13 percent adjusted for currency), as compared to major markets where sales and marketing expense increased 3 percent (1 percent adjusted for currency) year to year. On a consolidated basis, general and administrative expenses, which are indirect expenses incurred in the business, increased 2 percent (flat at constant currency) year to year.

Selling, General and Administrative
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Selling, general and administrative — base $20,006 $19,078 4.9%
Advertising and promotional expense 1,259 1,242 1.4
Workforce reductions — ongoing 706 318 121.8
Amortization expense — acquired intangibles 306 234 30.5
Retirement-related expense 319 607 (47.3)
Stock-based compensation 484 480 0.8
Bad debt expense 306 100 205.1
Total $23,386 $22,060 6.0%

Total SG&A expense increased 6.0 percent (4 percent adjusted for currency) in 2008 versus 2007. The increase in SG&A was primarily due to acquisition-related spending, predominantly for Cognos and Telelogic, which accounted for 5 points of the increase, while the effects of currency accounted for 2 points. Workforce reductions — ongoing expense increased $387 million primarily due to charges recorded in the fourth quarter reflecting workforce actions in Japan ($120 million) and other ongoing skills rebalancing that is a regular element of the company’s business model. In addition, bad debt expense increased $206 million primarily driven by additional specific accounts receivable reserves reflecting the current economic environment in many industries. The company’s accounts receivable provision coverage at year end is 2.0 percent, an increase of 50 basis points from year-end 2007. These increases were partially offset by lower retirement-related expense of $287 million.

Other (Income) and Expense
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change

* Reclassified to conform with 2008 presentation.

NM — Not meaningful

Foreign currency transaction losses* $330 $45 NM
(Gains)/losses on derivative instruments* (27) 194 (114.1)%
Interest income (343) (565) (39.3)
Net gains from securities and investment assets (52) (68) (22.6)
Net realized gains from certain real estate activities (26) (18) 45.0
Other (179) (214) (16.5)
Total $(298) $(626) (52.4)%

Other (income) and expense was income of $298 million and $626 million in 2008 and 2007, respectively. The decrease in income was primarily driven by higher foreign currency transaction losses ($285 million) and lower interest income reflecting lower cash balances and the current interest rate environment ($222 million). These decreases were partially offset by a gain on derivative instruments which primarily hedge foreign currency risks ($221 million). Included within the foreign currency hedging activity, the company hedges its major cross-border cash flows to mitigate the effect of currency volatility in its global cash planning, which also reduces volatility in the year-over-year results. The impact of these hedging programs is primarily reflected in other (income) and expense, as well as cost of goods sold. The impact of losses from these cash flow hedges reflected in other (income) and expense was $186 million, a decrease of $24 million year to year.

Research, Development and Engineering
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Research, development and engineering      
Total $6,337 $6,153 3.0%

The increase in research, development and engineering (RD&E) expense was primarily driven by acquisitions and investments to maintain technology leadership across the company’s offerings. Software spending increased $262 million, partially offset by lower spending in Systems and Technology ($54 million) and other unit spending ($74 million), while stock-based compensation expense decreased $9 million versus 2007.

Intellectual Property and Custom Development Income
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Sales and other transfers of intellectual property $138 $138 (00.0)%
Licensing/royalty-based fees 514 368 39.7
Custom development income 501 452 10.9
Total $1,153 $958 20.4%

The timing and amount of sales and other transfers of IP may vary significantly from period to period depending upon timing of divestitures, industry consolidation, economic conditions and the timing of new patents and know-how development. While IP income increased 20.4 percent in 2008, there were no significant individual IP transactions in 2008 or 2007. The improvement year to year was primarily driven by the Systems and Technology business.

Interest Expense
($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Interest expense      
Total $673 $611 10.3%

The increase in interest expense was primarily due to the increase in debt in 2007 associated with the financing of the accelerated share repurchase agreements, partially offset by lower interest rates in 2008. See note N, “Stockholders’ Equity,” for additional information regarding the accelerated share repurchase. Interest expense is presented in cost of financing in the Consolidated Statement of Earnings if the related external borrowings are to support the Global Financing external business. See Global Financing for additional information regarding Global Financing debt and interest expense. Overall interest expense for 2008 was $1,477 million, an increase of $46 million versus 2007.

Stock-Based Compensation

Total pre-tax stock-based compensation cost of $659 million decreased $54 million compared to 2007. The decrease was principally the result of a reduction in the level of stock option grants ($203 million), offset by an increase related to restricted and performance-based share units ($149 million). The year-to-year change was reflected in the following categories: reductions in cost ($50 million) and RD&E expense ($9 million), and increases in SG&A expense ($4 million) and other (income) and expense ($1 million).

See note T, “Stock-Based Compensation,” for additional information on the company’s stock-based incentive awards.

Retirement-Related Benefits

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

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change
Defined benefit and contribution pension plans cost $1,053 $2,198 (52.1)%
Nonpension postretirement plans costs 363 399 (9.0)
Total $1,416 $2,597 (45.5)%

Overall, retirement-related plan costs decreased $1,181 million versus 2007 primarily as a result of pension plan redesign efforts and a lower level of recognized actuarial losses.

Effective January 1, 2008, benefit accruals ceased in the IBM Personal Pension Plan, a U.S. defined benefit plan. This decrease was partially offset by an increase in defined contribution plans, primarily in the U.S. See note U, “Retirement-Related Benefits,” for additional information on these plan changes and all the factors driving the year-to-year change in total cost.

Retirement-related plan costs decreased approximately $771 million in cost, $287 million in SG&A expense, $117 million in RD&E expense and $5 million in other (income) and expense year to year.

Acquired Intangible Asset Amortization

The company has been investing in targeted acquisitions to increase its capabilities in higher value businesses. The following table presents the total acquired intangible asset amortization included in the Consol­idated Statement of Earnings. See note J, “Intangible Assets Including Goodwill,” for additional information.

($ in millions)
For the year ended December 31: 2008 2007* Yr.-to-Yr. Change

* Reclassified to conform with 2008 presentation disclosing the two services segments separately.

NM — Not meaningful

Cost:      
Software (Sales) $173 $91 89.2%
Global Technology Services (Services) 32 41 (21.0)
Global Business Services (Services) 0 1 (67.0)
Systems and Technology (Sales) 8 0 NM
Selling, general and administrative expense 306 234 30.5
Total $520 $367 41.5%
Income Taxes

The effective tax rate for 2008 was 26.2 percent, compared with 28.1 percent in 2007. The 1.9 point decrease was primarily driven by the 2008 net increase in the utilization of foreign and state tax credits (2.9 points), the benefit associated with the second quarter 2008 agreement reached with the U.S. Internal Revenue Service (IRS) regarding claims for certain tax incentives (1.7 points) and the benefit related to certain issues associated with newly published U.S. tax regulations (1.2 points). These benefits were partially offset by several items including the net impact related to the completion of the U.S. federal income tax examination for the years 2004 and 2005 including the associated income tax reserve redeterminations (0.5 points), the second quarter 2008 tax cost associated with the intercompany transfer of certain intellectual property (2.8 points) and lower capital loss utilization in 2008 (0.7 points). The remaining items were individually insignificant.

Earnings Per Share

Basic earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted-average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, share awards, convertible notes and shares which may be required to settle accelerated share repurchase (ASR) agreements.

($ in millions)
For the year ended December 31: 2008 2007 Yr.-to-Yr. Change

NM — Not meaningful

Earnings per share of common stock:      
Assuming dilution:      
Continuing operations $8.93 $7.18 24.4%
Discontinued operations (0.00) NM
Total $8.93 $7.18 24.4%
Basic:      
Continuing operations $9.07 $7.32 23.9%
Discontinued operations (0.00) NM
Total $9.07 $7.32 23.9%
Weighted-average shares outstanding (in millions):      
Assuming dilution 1,381.8 1,450.6 (4.7)%
Basic 1,359.8 1,423.0 (4.4)%

Actual shares outstanding at December 31, 2008 and December 31, 2007 were 1,339.1 million and 1,385.2 million, respectively. The average number of common shares outstanding assuming dilution was 68.8 million shares lower in 2008 versus 2007. The decrease was primarily the result of the company’s common stock repurchase program. See note N, “Stockholders’ Equity Activity,” for additional information regarding common stock activities. Also see note R, “Earnings Per Share of Common Stock.”

Financial position

Dynamics

At December 31, 2008, the company’s balance sheet and liquidity position remain strong. Cash on hand at year-end was $12,741 million. Total debt of $33,926 million decreased $1,349 million from prior year-end levels. The commercial paper balance at December 31 was $468 million, down $5,363 million from December 31, 2007. In 2008, the company generated $18,812 million in cash from operations, an increase of $2,718 million compared to 2007. The company has consistently generated strong cash flow from operations and continues to have access to additional sources of liquidity through the capital markets and its $10 billion global credit facility.

Consistent with retirement and postretirement plan accounting standards, the company remeasures the funded status of its plans at December 31. The funded status is measured as the difference between the fair value of the plan assets and the benefit obligation and is recognized in the Consolidated Statement of Financial Position. At December 31, 2008, primarily as a result of the returns on plan assets, coupled with changes in certain plan assumptions and plan contributions, the overall net funded position decreased $21,793 million from December 31, 2007 to a net under-funded position of $18,485 million. This change is primarily reflected in prepaid pension assets and retirement and nonpension postretirement benefit obligations which decreased $15,816 million and increased $5,871 million respectively from year-end 2007 levels. Due to the extreme volatility in the equity markets in 2008, the return on IBM Personal Pension Plan assets declined 15 percent, compared to a 14 percent increase in 2007. The company’s asset return in the non-U.S. plans declined approximately 21 percent. Within the company’s defined benefit plans, the net funded status declined in 2008 due to the volatility in the financial markets. At December 31, 2008, the company’s qualified defined benefit plans worldwide were 93 percent funded, with the U.S. qualified Personal Pension Plan 97 percent funded.

In addition, stockholders’ equity decreased $15,004 million, net of tax, primarily as a result of changes from pension remeasurements and current year activity within accumulated gains and (losses) not affecting retained earnings. This is a non-cash impact to equity and does not affect the company’s access to capital markets or its ability to meet its obligations.

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

Working Capital
($ in millions)
At December 31: 2008 2007
Current assets $49,004 $53,177
Current liabilities 42,435 44,310
Working capital $6,568 $8,867
Current ratio 1.15 1.20

Working capital decreased $2,299 million compared to the prior year primarily as a result of a net decrease in current assets. The key drivers are described below:

Current assets decreased $4,174 million due to:

  • A decrease of $3,239 million in cash and cash equivalents and marketable securities (See Cash Flow analysis below);
  • A decrease of $1,235 million in short-term receivables driven by currency impacts of $1,202 million;

Partially offset by:

  • An increase of $409 million in prepaid expenses and other current assets primarily resulting from:
    • – an increase of $353 million in prepaid taxes;
    • – an increase of $238 million in derivative assets primarily due to changes in foreign currency rates for certain economic hedges; and
    • – approximately $189 million negative currency impact.

Current liabilities decreased $1,875 million as a result of:

  • A decrease of $1,041 million (including $260 million of negative impact due to currency) in accounts payable primarily due to lower purchasing volumes;
  • A decrease of $999 million in short-term debt primarily driven by the reduction in commercial paper balances; and
  • A decrease of $930 million (including $222 million negative currency impact) in taxes payable;

Partially offset by:

  • An increase of $679 million in other accrued liabilities primarily due to:
    • – an increase of $502 million in derivative liabilities as a result of changes in foreign currency rates;
    • – an increase of $329 million in workforce reduction accruals; and
    • – approximately $172 million negative currency impact.
  • An increase of $436 million (net of a $288 million negative currency impact) in deferred income mainly driven by Software ($285 million) and Global Services ($139 million).
Cash Flow

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

($ in millions)
For the year ended December 31: 2008 2007
Net cash provided by/(used in) continuing operations:    
Operating activities $18,812 $16,094
Investing activities (9,285) (4,675)
Financing activities (11,834) (4,740)
Effect of exchange rate changes on cash and cash equivalents 58 294
Net cash used in discontinued operations — operating activities (5)
Net change in cash and cash equivalents $(2,250) $6,969

Net cash from operating activities for 2008 increased $2,718 million as compared to 2007 driven by the following key factors:

  • An increase in net income of $1,916 million;
  • Decreases in accounts receivable drove an increase in cash of $1,682 million, driven by Global Financing receivables ($1,280 million) and non-Global Financing receivables ($402 million) primarily resulting from reduced fourth-quarter 2008 revenue and improved collections; and
  • A decrease year to year in retirement-related plan funding of $426 million;

Partially offset by:

  • Accounts payable drove a use of cash of $718 million; and
  • A decrease in cash of $284 million driven by growth in inventory.

Net cash used in investing activities increased $4,611 million on a year-to-year basis driven by:

Partially offset by:

  • The net impact of the purchases and sales of marketable securities and other investments resulted in an increase in cash of $642 million; and
  • A decrease in net capital spending of $431 million resulting from:
    • – a decrease of $272 million primarily driven by lower spending by Global Technology Services and Systems and Technology; and
    • – a decrease of $159 million in capitalized software development expenditures.

Net cash used in financing activities increased $7,095 million compared to 2007 as a result of:

  • An increase of $14,556 million in cash used to retire debt, net of cash proceeds, primarily driven by higher proceeds in 2007 due to the issuance of debt for the ASR and a decline in commercial paper in 2008;
  • Higher dividend payments of $438 million; and
  • A decrease of $350 million in cash received due to lower other common stock transactions primarily due to stock option exercises;

Partially offset by:

  • Lower common stock repurchases of $8,249 million.

Within total debt, on a net basis, the company utilized $2,444 million in net cash to retire debt versus $12,112 million in net cash proceeds in 2007. The net cash used to retire debt in 2008 was comprised of: $10,248 million in cash payments to settle debt and net payments of $6,025 million in short-term borrowings, partially offset by $13,829 million of new debt issuances. See note K, “Borrowings,” for a listing of the company’s debt securities.

Noncurrent Assets and Liabilities
($ in millions)
At December 31: 2008 2007
Noncurrent assets $60,520 $67,254
Long-term debt $22,689 $23,039
Noncurrent liabilities (excluding debt) $30,934 $24,612

The decrease in noncurrent assets of $6,733 million compared to the prior year-end balance was primarily driven by:

  • A decrease of $15,816 million in prepaid pension assets primarily resulting from pension remeasurements;
  • A decrease of $777 million in plant, rental machines and other property mainly due to currency impact ($576 million) and lower capital spending primarily in Global Technology Services; and
  • A decrease of $420 million in long-term financing receivables mainly due to currency impact;

Partially offset by:

  • An increase in deferred tax assets of $5,757 million primarily due to pension remeasurements; and
  • An increase in goodwill of $3,941 million (net of a $1,529 million negative currency impact) and an increase of $771 million (net of a $160 million negative currency impact) in intangible assets-net primarily driven by the Cognos and Telelogic acquisitions.

Long-term debt decreased $350 million primarily due to reclasses to short-term debt as certain instruments approached maturity; offset by new debt issuances.

Other noncurrent liabilities, excluding debt, increased $6,322 million primarily driven by:

  • An increase of $5,871 million in retirement and nonpension postretirement benefit obligations primarily driven by pension remeasurement; and
  • An increase in noncurrent tax reserves of $1,450 million related to unrecognized tax benefits;

Partially offset by:

  • A decrease of $794 million in noncurrent deferred tax liabilities primarily due to pension remeasurement; and
  • A decrease of $154 million in restructuring liabilities mainly driven by the reclass to current liabilities.
Debt

The company’s funding requirements are continually monitored and strategies are executed to manage the overall asset and liability profile.

($ in millions)
At December 31: 2008 2007
Total company debt $33,926 $35,274
Total Global Financing segment debt: $24,360 $24,532
Debt to support external clients 20,892 21,072
Debt to support internal clients 3,468 3,460

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

Total debt decreased $1,177 million in 2008 versus 2007, primarily due to reductions in commercial paper. The debt-to-capital ratio at December 31, 2008 was 49.0 percent, an increase of 19.0 points from December 31, 2007, primarily due to the reduction in equity driven by the pension remeasurements.

Equity
($ in millions)
At December 31: 2008 2007
Stockholders’ equity    
Total $13,465 $28,470

The company’s consolidated stockholders’ equity decreased $15,004 million in 2008 as a result of several key factors:

  • A decrease of $18,431 million in accumulated gains and (losses) not affecting retained earnings resulted from non-cash equity impacts, primarily from pension remeasurement and other retirement-related activities ($14,856 million), and a decrease in foreign currency translation adjustments ($3,552 million); and
  • A decrease related to net stock transactions of $6,286 million, driven by common stock repurchases;

Partially offset by:

  • An increase of $9,713 million in retained earnings primarily driven by net income of $12,334 million, partially offset by dividends ($2,585 million).
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