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Management discussion
International Business Machines Corporation and Subsidiary Companies

Prior year in review

Continuing operations

The company’s performance in 2007 reflected the strength of its global model. Revenue increased in all geographies, with strong growth in emerging markets worldwide. The company capitalized on the opportunities in the global economies, generating 63 percent of its revenue outside the United States, in delivering full-year growth of 8.1 percent (4 percent adjusted for currency).

Gross profit margins improved reflecting a shift to higher value offerings, continued benefits from productivity initiatives and the transformation to a globally integrated enterprise. Pre-tax income from continuing operations grew 8.8 percent and net income from continuing operations increased 10.6 percent versus 2006. Diluted earnings per share improved 18.5 percent, reflecting the strong growth in net income and the benefits of the common stock repurchase program. In 2007, the company repurchased approximately $18.8 billion of its common stock, including a $12.5 billion accelerated share repurchase in the second quarter.

The increase in 2007 revenue was primarily due to:

  • Strong performance from Global Technology Services and Global Business Services with growth in all business lines;
  • Continued strong demand in the Software business, driven by Key Branded Middleware products, with strong contributions from strategic acquisitions; and
  • Continued growth in emerging countries (Brazil, Russia, India and China: up 26 percent) and solid performance in all geographies, led by Asia Pacific.

The increase in income from continuing operations before income taxes in 2007 was primarily due to the revenue growth and gross profit margin improvements in the Global Services and Systems and Technology segments.

The following is an analysis of the 2007 versus 2006 reportable segment results for Global Services, Systems and Technology and Software. The Global Financing segment analysis is included in the Global Financing section.

Global Services

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Global Services revenue: $54,144 $48,291 12.1%
Global Technology Services: $36,103 $32,322 11.7%
Strategic Outsourcing 18,701 17,044 9.7
Integrated Technology Services 8,438 7,448 13.3
Maintenance 6,670 5,986 11.4
Business Transformation Outsourcing 2,294 1,845 24.4
Global Business Services $18,041 $15,969 13.0%

The Global Services segments, GTS and GBS had combined revenue of $54,144 million, an increase of 12.1 percent (8 percent adjusted for currency) in 2007 when compared to 2006. Global Services signings at actual rates were $56.3 billion in 2007 as compared to $53.4 billion in 2006. The Global Services backlog was estimated to be $118 billion at December 31, 2007, versus $116 billion at December 31, 2006. The Global Services segments delivered combined pre-tax profit of $5,622 million, an increase of 12.6 percent.

GTS revenue increased 11.7 percent (7 percent adjusted for currency) in 2007 versus 2006. The strong performance reflected the extensive transformation which occurred in this business over the past few years. This transformation included revamping the entire ITS portfolio, continued improvement in SO delivery and a disciplined approach to driving new business in existing accounts. Total signings in GTS increased 7 percent (2 percent adjusted for currency). SO revenue was up 9.7 percent (5 percent adjusted for currency) with growth in all geographies, led by EMEA and Asia Pacific. Revenue growth benefited from prior-year signings, sales of new business in existing accounts, lower base contract erosion and good yield from 2007 signings. ITS revenue increased 13.3 percent (9 percent adjusted for currency). Revenue growth was driven primarily by increased signings and reflected the strength of the ITS portfolio worldwide. The revamped ITS portfolio includes ten Service Product Lines which complement hardware offerings from Systems and Technology and software offerings from the Software business. The acquisition of Internet Security Systems (ISS), in the fourth quarter of 2006, also contributed to the revenue growth. BTO revenue increased 24.4 percent (20 percent adjusted for currency), with double-digit growth in all geographies. Maintenance revenue increased 11.4 percent (7 percent adjusted for currency) driven primarily by increased availability services on non-IBM IT equipment. Services provided to InfoPrint Solutions, following the divestiture of the printer business in the second quarter of 2007, contributed 4 points of growth.

GBS revenue increased 13.0 percent (9 percent adjusted for currency) with balanced growth across all three geographies. Revenue performance was led by double-digit growth in application management services offerings and growth in all consulting service lines. Total signings in GBS increased 3 percent (1 percent adjusted for currency), led by growth in shorter term signings.

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Global Services Gross Profit:      
Global Technology Services:      
Gross profit $10,800 $9,623 12.2%
Gross profit margin 29.9% 29.8% 0.1 pts.
Global Business Services:      
Gross profit $4,240 $3,694 14.8%
Gross profit margin 23.5% 23.1% 0.4 pts.

GTS gross profit increased 12.2 percent with gross profit margin improving 0.1 points, driven primarily by margin expansion in SO, due to an improved cost structure, and ITS, which benefited from a mix to higher value offerings. Segment pre-tax profit increased 8.2 percent to $3,557 million with a pre-tax margin of 9.4 percent, a decline of 0.2 points. Increased investments in sales and delivery, acquisitions and workforce reduction charges were essentially offset by productivity improvements and effective expense management.

GBS gross profit increased 14.8 percent to $4,240 million and the gross profit margin improved 0.4 points. Segment pre-tax profit increased 21.0 percent to $2,064 million with a pre-tax margin of 10.7 percent, an improvement of 0.9 points. The margin expansion was driven primarily by revenue growth, ongoing productivity and utilization initiatives, and expense management.

Software

($ in millions)
For the year ended December 31: 2007 2006* Yr.-to-Yr. Change

* Reclassified to conform with 2007 presentation.

Software revenue: $19,982 $18,161 10.0%
Middleware: $15,505 $13,891 11.6%
Key Branded Middleware 10,827 9,373 15.5
WebSphere Family     19.1
Information Management     14.7
Lotus     8.7
Tivoli     18.0
Rational     13.7
Other middleware 4,678 4,518 3.5
Operating systems 2,319 2,273 2.0
Product Lifecycle Management 1,051 1,123 (6.4)
Other 1,107 874 26.7

Software segment revenue of $19,982 million increased 10.0 percent (6 percent adjusted for currency) in 2007 reflecting strong demand for the Key Branded Middleware products. Revenue performance was led by double-digit growth in the Financial Services, Public and Small and Medium Business sectors.

Key Branded Middleware revenue was $10,827 million, up 15.5 percent (11 percent adjusted for currency) and increased 3 points to 54 percent of total software segment revenue.

WebSphere Family revenue increased 19.1 percent (14 percent adjusted for currency) and was led by double-digit growth in WebSphere Application Servers and WebSphere Business Integration software. The strong revenue performance reflected the industry’s adoption of SOA. Information Management revenue increased 14.7 percent (10 percent adjusted for currency) in 2007 versus the prior year. The acquisition of FileNet, in the fourth quarter of 2006, contributed strong revenue growth throughout the year. Lotus revenue increased 8.7 percent (4 percent adjusted for currency) in 2007 driven by the Notes/Domino family of products. Lotus Connections, released in the second quarter of 2007, was rapidly adopted by customers. The latest version of Lotus Notes, Lotus Notes 8.0, was delivered in the third quarter of 2007. Revenue from Tivoli software increased 18.0 percent (13 percent adjusted for currency) with double-digit growth in each segment of the portfolio: Systems Management, Security and Storage. The acquisitions of MRO, in the fourth quarter of 2006, and Vallent and Consul, in the first quarter of 2007, also contributed to the brand’s revenue growth. Rational revenue increased 13.7 percent (9 percent adjusted for currency) in 2007 which reflected strong customer acceptance of its integrated product set.

Revenue from Other middleware products increased 3.5 percent (flat adjusted for currency) in 2007 versus the prior year. This software product set includes mature products which provide a more stable flow of revenue.

Operating systems revenue increased 2.0 percent (decreased 2 percent adjusted for currency) in 2007 versus 2006. Product Lifecycle Management (PLM) revenue decreased 6.4 percent (11 percent adjusted for currency) driven by declines in the Small and Medium Business sector. Other software segment revenue increased 26.7 percent (22 percent adjusted for currency) reflecting growth in software-related services, such as consulting and education.

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Software gross profit:      
Gross profit $17,015 $15,471 10.0%
Gross profit margin 85.2% 85.2% 0.0 pts.

Software segment gross profit increased 10.0 percent to $17,015 million in 2007, driven primarily by strong revenue growth. Gross profit margin was 85.2 percent in 2007, flat versus the prior year.

The Software segment contributed $6,002 million of pre-tax profit in 2007, an increase of 9.3 percent versus 2006. The segment pre-tax profit margin of 26.8 percent was essentially flat (declined 0.1 points) versus the prior year, reflecting the integration of acquired businesses.

Systems and Technology

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Systems and Technology revenue: $21,317 $21,970 (3.0)%
System z     (11.2)%
Legacy System i     (10.6)
Converged System p     8.8
System x     7.0
System Storage     5.1
Retail Store Solutions     14.5
Total Systems     2.8
Microelectronics OEM     (11.8)
Printing Systems     (63.1)

Systems and Technology segment revenue decreased 3.0 percent (6 percent adjusted for currency). On June 1, 2007, the company completed the divestiture of its printing business to Ricoh. This resulted in the loss of approximately $600 million of Systems and Technology revenue in 2007 when compared to 2006. Systems and Technology revenue, excluding the printing business, was flat (declined 3 percent adjusted for currency) in 2007 versus 2006. System z revenue decreased 11.2 percent (15 percent adjusted for currency). System z MIPS shipments increased 3 percent. System z revenue declined in the second half of 2007 following a long and successful technology cycle of over two-and-a-half years. Converged System p revenue increased 8.8 percent (5 percent adjusted for currency). The increase was primarily driven by strength in midrange POWER5+ and POWER6 servers, which increased 23 percent. Legacy System i revenue decreased 10.6 percent (14 percent adjusted for currency). Although legacy System i revenue declined year over year, fourth-quarter 2007 revenue increased 2 percent with growth in POWER6 servers which were introduced late in the third quarter of 2007. System x revenue increased 7.0 percent (3 percent adjusted for currency). Revenue performance was driven by System x server products which grew 8 percent and System x blades which increased 16 percent in 2007 versus 2006. System Storage revenue increased 5.1 percent (2 percent adjusted for currency). The increase was primarily driven by 13 percent growth in tape products, while external disk products increased 1 percent. Enterprise tape products had strong double-digit revenue growth, while midrange tape products had mid single-digit revenue growth. Retail Store Solutions revenue increased 14.5 percent (11 percent adjusted for currency) primarily due to the continued roll out of new programmable point-of-sale solutions to large retail clients.

Microelectronics OEM revenue decreased 11.8 percent driven by reduced demand for game processors. Printing Systems revenue decreased as a result of the divestiture of the business. The 2007 results included five months of revenue while the 2006 results included 12 months of revenue.

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Systems and Technology Gross Profit:      
Gross profit $8,468 $8,284 2.2%
Gross profit margin 39.7% 37.7% 2.0 pts.

The increase in Systems and Technology gross profit dollars was primarily due to higher gross profit margins in System z, converged System p and System x servers. The Systems and Technology gross profit margin increased 2.0 points to 39.7 percent. Converged System p performance contributed 1.3 points to the overall margin improvement, while System z and System x contributed 0.7 points and 0.4 points, respectively. These increases were partially offset by lower gross margins in legacy System i of 0.2 points and System Storage of 0.2 points.

Systems and Technology segment pre-tax margin expanded 2.1 points to 9.6 percent driven primarily by a strong combination of operational cost management and the value that virtualization has driven in the enterprise space.

Global Financing

See the Global Financing section for a discussion of the Global Financing segment.

Geographic Revenue

($ in millions)
For the year ended December 31: 2007 2006 Yr.-to-Yr. Change
Total revenue: $98,786 $91,424 8.1%
Geographies: $95,320 $87,564 8.9%
Americas 41,122 39,511 4.1
Europe/Middle East/Africa 34,699 30,491 13.8
Asia Pacific 19,501 17,566 11.0
OEM $3,465 $3,856 (10.1)%

From a geographic perspective, revenue increased in all geographies in 2007 when compared to 2006. Adjusted for currency, revenue growth was led by Asia Pacific and steady performance throughout the year in EMEA.

Americas revenue increased 4.1 percent (3 percent adjusted for currency) in 2007. Revenue increased in all regions with the U.S. up 2.9 percent, Canada 8.4 percent (2 percent adjusted for currency) and Latin America 8.6 percent (2 percent adjusted for currency).

EMEA revenue increased 13.8 percent (5 percent adjusted for currency) in 2007 when compared to 2006. Within the European market, IT spending grew at a moderate rate, and the company’s mid single-digit revenue growth rates throughout 2007 reflected that environment. Revenue increased in all major countries with Spain up 21.7 percent (11 percent adjusted for currency), Germany 14.6 percent (5 percent adjusted for currency), the U.K. 11.3 percent (3 percent adjusted for currency), France 10.2 percent (1 percent adjusted for currency) and Italy 8.7 percent (decreased 1 percent adjusted for currency).

Asia Pacific revenue increased 11.0 percent (8 percent adjusted for currency) year over year. Growth was led by strong performance in the India, Greater China, Australia/New Zealand, ASEAN and Korea regions, where the economies remain strong, with combined revenue growth of 23.8 percent (17 percent adjusted for currency). Japan revenue, which represented 49 percent of the Asia Pacific revenue base, was flat (increased 1 percent adjusted for currency) in 2007 when compared to 2006, reflecting a slower economy.

Across the geographies, the emerging BRIC countries of Brazil, Russia, India, and China together grew 26.3 percent (18 percent adjusted for currency), reflecting the investments made to build capabilities and capture opportunities in these countries. Brazil revenue increased 14.3 percent (1 percent adjusted for currency), Russia grew 30.3 percent (30 percent adjusted for currency), India increased 37.9 percent (26 percent adjusted for currency) and China increased 32.5 percent (29 percent adjusted for currency). In addition to the BRIC markets, the company also had strong revenue growth in other nations where there was strong demand for business and IT infrastructure solutions.

Revenue growth rates, as reported, were impacted in 2007 as a result of the divestiture of the printing business on June 1, 2007. Revenue, excluding the printing business in both years, increased as follows compared to 2006:

  • Americas — 5.2%
  • EMEA — 14.5%
  • Asia Pacific — 11.8%
  • IBM Consolidated — 8.9%

OEM revenue decreased 10.1 percent (10 percent adjusted for currency) in 2007 when compared to 2006, driven by a slowdown in demand for game processors.

Total Expense and Other Income

Total expense and other income increased 9.1 percent (5 percent adjusted for currency) in 2007 versus 2006. The increase was primarily due to increased SG&A expense and interest expense. SG&A expense increased primarily due to acquisition related spending, as well as increased investments in emerging countries and the software and services businesses. Interest expense increased primarily due to higher debt levels associated with the financing of the ASR agreements. The expense-to-revenue ratio increased 0.3 points to 27.6 percent in 2007, as revenue increased 8.1 percent and expense increased 9.1 percent in 2007 versus 2006.

Total SG&A expense of $22,060 million increased 8.9 percent (6 percent adjusted for currency) versus 2006. The increase was primarily driven by acquisition-related spending (3 points), the effects of currency (3 points) and investments in the software and services businesses, as well as emerging markets. In addition, bad debt expense increased $113 million primarily due to an increase in the provision for doubtful accounts. The reserve coverage for receivables of 1.5 percent was essentially flat versus year-end 2006. Ongoing workforce reductions increased as a result of actions taken to address cost issues in GTS, primarily in SO, during the second quarter of 2007.

Other (income) and expense was income of $626 million and $766 million in 2007 and 2006, respectively. The decrease in income was primarily due to higher losses on derivative instruments. The company hedges its major cross-border cash flows to mitigate the effect of currency 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. Losses from derivatives, as a result of currency movements, resulted in $247 million of year-to-year impact to other (income) and expense. This decrease in income was partially offset by a gain from the divestiture of the printing business in the second quarter and sales of Lenovo stock in the first and second quarters of 2007.

RD&E expense of $6,153 million increased 0.8 percent primarily driven by acquisitions and investments to maintain technology leadership across the product offerings. Software spending increased $339 million partially offset by lower Systems and Technology spending of $204 million.

Intellectual property and custom development income of $958 million increased $58 million or 6.4 percent versus 2006. There were no significant IP transactions in 2007 and 2006.

Interest expense of $611 million increased $333 million, or 119.6 percent in 2007 primarily due to the higher debt associated with the financing of the ASR agreements.

Income Taxes

The provision for income taxes resulted in an effective tax rate of 28.1 percent for 2007, compared with the 2006 effective tax rate of 29.3 percent. The 1.2 point decrease was primarily driven by the absence of the one-time tax cost associated with the intercompany transfer of certain intellectual property in the fourth quarter of 2006 (4.3 points) and the absence of the benefit from the settlement of the U.S. federal income tax audit for the years 2001 through 2003, also in the fourth quarter of 2006 (3.0 points). The company also benefited in 2007 from a more favorable mix of income in lower tax rate jurisdictions and increased capital loss and state credit benefits, offset by a reduction in certain tax incentives.

Financial Position

Assets of $120,431 million increased $17,197 million ($12,957 million adjusted for currency) primarily due to increases in cash and cash equivalents ($6,969 million), prepaid pension assets ($6,788 million), total financing receivables ($2,729 million) and goodwill ($1,431 million). These increases were partially offset by decreases in long-term deferred tax assets ($2,367 million) and short-term marketable securities ($1,479 million).

Liabilities of $91,962 million increased $17,234 million ($13,642 million adjusted for currency) driven primarily by increases in total debt ($12,592 million), tax liabilities ($1,492 million) and total deferred income ($1,773 million).

Stockholders’ equity of $28,470 million was essentially flat versus 2006. Increased treasury stock ($17,649 million) from share repurchases, which included the ASR, was largely offset by increased retained earnings ($8,208 million) driven by net income, increased common stock ($3,917 million) related to stock options and a decline in accumulated gains and (losses) not affecting retained earnings ($5,487 million) primarily due to the effects of pension remeasurements.

The company generated $16,094 million in cash flow provided by operating activities, an increase of $1,075 million compared to 2006, primarily driven by increased net income. Net cash used in investing activities of $4,675 million was $6,874 million lower than 2006 driven primarily by proceeds from disposition of short-term marketable securities and a reduction in cash used for acquisitions. Net cash used in financing activities of $4,740 million decreased $3,464 million versus 2006 driven by increased net proceeds from total debt ($12,233 million), partially offset by increased share repurchases ($10,744 million).

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