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Dear IBM Investor:

Virginia M. Rometty, President and Chief Executive Officer

I am pleased to report that in 2012, IBM achieved record operating earnings per share, record free cash flow and record profit margins, with revenues that were flat at constant currency. Operating earnings per share were up 13 percent, putting us well on track to our 2015 Road Map objective of at least $20 of operating earnings per share. Importantly, we continued to deliver value to you, our owners.

This performance is a testament to our strategic position and capabilities, the discipline of our management systems, and the dedication and expertise of more than 430,000 IBMers around the world. Importantly, it reflects the impact of a distinct choice we have made about IBM’s business and technology model.

IBM is an innovation company. Both in what we do and in how we do it, we pursue continuous transformation—always remixing to higher value in our portfolio and skills, in the capabilities we deliver to our clients and in our own operations and management practices.

This is not the only path to success in our industry, and it is not the easiest one. But it is ours. In this letter, I will report on our 2012 results, and then put them in context of our model of continuous transformation.

Results in 2012

Earnings per share: Diluted operating earnings per share in 2012 were $15.25, a new record. This marked 10 straight years of double-digit EPS growth.

Margins: IBM’s operating pre-tax income margin rose for the 10th consecutive year—to 22.2 percent, up 12 points since 2000.

Cash flow: IBM has consistently generated strong cash flow, a key indicator of real business performance. In 2012 our free cash flow was $18.2 billion, a record for IBM and $12 billion higher than a decade ago. We ended 2012 with $11.1 billion of cash and marketable securities.

Revenue and income: Our revenue in 2012 was $104.5 billion, down 2 percent as reported and flat at constant currency. We grew operating net income by 8 percent, to $17.6 billion, our highest ever.

Investment and return to shareholders: In 2012 we invested $3.7 billion for 11 acquisitions in key areas of software and services; $4.3 billion in net capital expenditures; and $6.3 billion in R&D. We were able to return $15.8 billion to you—$12 billion through share repurchases and $3.8 billion through dividends. Last year’s dividend increase was 13 percent, marking the 17th year in a row in which we have raised our dividend, and the 97th consecutive year in which we have paid one.

Since 2000, we have added $14.6 billion to IBM’s operating pre-tax profit base, and increased our pre-tax income 1.7 times, our operating earnings per share 3.6 times and our free cash flow 1.7 times. Cumulatively, we have generated about $150 billion of free cash flow.

IBM’s Model: Continuous Transformation

In an industry characterized by a relentless cycle of innovation and commoditization, one model for success is that of the commodity player—winning through low price, efficiency and economies of scale. Ours is a different choice: the path of innovation, reinvention and shift to higher value.

We remix to higher value: We do so in our portfolio, in our organic R&D investment, and through targeted acquisitions and divestitures.

  • We remix our research and development: Two decades ago, 70 percent of our researchers were working in materials science, hardware and related technology. Even the one-in-ten working in software were focused on operating systems and compilers. Today, 60 percent are in fields that support our key growth initiatives, such as the 400 mathematicians developing algorithms for business analytics, as well as a diverse group of specialists that include medical doctors, computational biologists, experts in natural language processing, and weather and climate forecasters. Since the beginning of 2010, we have spent $19 billion on R&D, and in 2012 IBM earned the most U.S. patents for the 20th straight year, with a record total of 6,478.
  • We acquire new capabilities: Organizations run into trouble when they look to fulfill a new strategy or provide the basis for transformation through acquisitions. We practice a disciplined approach that asks three questions: Does it build on or extend a capability IBM already has? Does the company have scalable intellectual property? Can it take advantage of our reach into 170 countries? Our balanced formula has built a strong track record since 2000, with more than 140 acquisitions.
  • We divest nonstrategic assets: Always moving to the future isn’t just about what you invent. It also involves choices about when to move on. Over the past decade we have divested almost $15 billion of annual revenue—businesses that no longer fit our strategy. If we had not done so, we would be a larger company today, but with lower margins and capabilities less essential to our clients.

2012 Performance

($ in billions except per share amounts)
For the year ended December 31: 2012
Operating earnings per share $ 15.25
Revenue $104.50
Operating net income $ 17.60
Free cash flow $ 18.20
Returned to shareholders $ 15.80

We make markets: We create new markets by category, by geography and by client.

  • We make markets by category: Our software and services businesses today look very different from just a few years ago, offering new solution categories like MobileFirst, Social Business and Smarter Commerce. In our hardware business, momentum is building for our new PureSystems family, which launched the new category of workload-optimized systems. PureSystems has seen more than 2,300 installations in more than 70 countries in just two quarters.
  • We make markets by geography: We are achieving strong results in the world’s growth markets, working closely with businesses, institutions and governments as they seek to modernize their infrastructures and societies. We opened 144 new branches in these markets in 2012. We also continue remixing to more profitable opportunities in these countries, through Smarter Planet solutions such as Smarter Transportation, Smarter Finance and Smarter Cities.
  • We make markets by client: We unlock new opportunity within our existing client base by creating capabilities for a new generation of IT buyers—from chief marketing officer to chief financial officer to the head of human resources and more. I discuss this in greater depth below.

We reinvent core franchises: Our System z enterprise server, introduced in 2012, is just the latest reinvention of the mainframe, and it drove System z’s largest capacity shipment ever during the fourth quarter—with more than half of that growth coming from Linux workloads. Core software platforms such as WebSphere have been entirely transformed. And Information Technology Services, which was once a significant reseller of others’ technology—generating good revenue but low margins—has shifted significantly to high-value services such as data center energy efficiency, security, and business continuity and recovery. This has contributed to a 6-point pre-tax income margin improvement in services since 2000.

We remix our skills and expertise: An innovation model means continuously remixing and deepening our expertise. For example, over the past three years we have increased our skill base in analytics by more than 8,100 experts. We have also added nearly 9,500 sellers in key areas of industry expertise—such as healthcare, energy, telecom and banking, as well as emerging sectors such as metals and mining. This year, IBM Global Business Services and IBM Research will launch the IBM Client Experience Lab, as well as joint GBS and Software practices in social business and mobility—including a tripling of our skill base in social and mobile technologies and doubling our skill base in Smarter Commerce.

We reinvent the enterprise itself: We have been highly disciplined about driving productivity—through the adoption of common, shared operations and systems; the streamlining of enterprise‑wide processes; and the leveraging of global skills—all in the service of global integration. And we are now taking the next step, becoming a Smarter Enterprise:

  • In part, this means applying analytics to every part of our business—changing how we manage risk, drive efficiency, increase marketing effectiveness and infuse business insight across the company.
  • In part, it means using social technologies to identify IBM experts and enable them to deliver their knowledge and leverage our entire portfolio to create a seamless, software-value client experience.

This ongoing transformation gives us confidence that we will achieve our goal of $8 billion in productivity savings over the course of our 2015 Road Map. Sixty percent of our productivity savings are reinvested in the business.

Revenue Increase for IBM Growth Initiatives in 2012

For the year ended December 31: 2012
Smarter Planet 25%
Business Analytics 13%
Cloud 80%
Growth Markets 7%*
* at constant currency

We use our strong cash flow strategically: Our cash flow generation fuels reinvestment in the business—in R&D, capital expenditures and acquisitions. At the same time, we deliver consistently strong returns to you, our owners.

A New Era of Computing

To sustain an innovation model in our industry, a company must do more than accommodate major technology shifts. It must lead them. IBM has done this repeatedly over the past century—not only pioneering new technology models, but capturing significant economic value.

Today, another new wave is sweeping in—powered by Big Data, analytics, mobile, social and cloud. We anticipated this several years ago with our point of view on building a Smarter Planet—a world that was becoming instrumented, interconnected and intelligent. Now, the IT environment is moving from monolithic applications to dynamic services; from structured data at rest to unstructured data in motion; from PCs to unprecedented numbers and kinds of devices; from stable to unpredictable workloads; from static infrastructure to cloud services; and from proprietary standards to open innovation.

This shift plays strongly to IBM’s historic position in enterprise computing. So we are, as we have so often done in the past, reshaping our investment, innovation and market strategies to lead.

We see three defining characteristics of this new era—what we call Smarter Computing:

1. Smarter Computing is designed for Big Data. Every two days, as much data is now generated as in all of human history up to 2003. This is “Big Data,” and it constitutes a vast new natural resource that can revolutionize industries and societies—with the right technology, capable of analyzing and extracting value and insight from it. This is one reason IBM’s analytics business is growing so strongly, as we work with clients to drive intelligence into every aspect of their operations. Indeed, we have raised our 2015 Road Map target for Business Analytics from $16 billion to $20 billion of revenue. We are also rapidly advancing the marketplace applications for our breakthrough “cognitive” computing system, Watson, which is already demonstrating its potential to transform healthcare and finance. We will introduce our first commercial Watson offerings this year.

To sustain an innovation model in our industry, a company must do more than accommodate major technology shifts.

2. Smarter Computing is built on software-defined environment. To handle today’s volume, velocity and variety of data, enterprise data centers must become more dynamic and flexible. One way to think about this is to imagine entire IT infrastructures that are as programmable as individual systems. This new model is known as the “software-defined environment,” and cloud computing is its first manifestation. However, it will not be the last. This new model optimizes the entire computing “stack”—compute, storage and network resources—so that it can adapt to the type of work required. Hardware built for these new environments will be of significant business value—exemplified by IBM’s systems today. From System z, to Power Systems, to storage, to our new PureSystems family, IBM systems are software-defined.

3. Smarter Computing is open. Only through open standards and platforms can enterprises support an expanding universe of heterogeneous data, devices and services, and engage in today’s rich innovation ecosystems. The challenge is how to turn open approaches into successful business. IBM helped do so with Linux, Eclipse and Apache, supporting their growth into standards with vital industry ecosystems, and then developing high-value IBM business on top of them. Today, we are repeating this strategy through a number of collaborations such as OpenStack, a new open source cloud platform; Hadoop, an open source platform for Big Data; and several promising open source hardware projects.

Taken together, computing that is open, software-defined, and designed for Big Data constitutes a profound shift in information technology. And as in prior such shifts, it will create new markets and new clients. We are pursuing them aggressively.

New Clients, New Markets

As I mentioned, to capture the opportunities opened up by this new era of technology, IBM is engaging with new kinds of clients as we make new markets in Big Data/analytics, cloud for the enterprise, emerging economies and Smarter Planet. Indeed, from a business perspective, Smarter Planet is a platform for a growing array of new markets—such as Smarter Commerce, Smarter Cities and Social Business—and these new markets take concrete shape through the engagement and enablement of a new generation of IT clients. Today, we are working around the world and across multiple industries with many new leaders.

Perhaps the most active among them in embracing the new era of technology have been chief marketing officers, who are looking to reinvent the practice of marketing—for example, by understanding and enabling customers as individuals, rather than “segments.” This helped our Global Business Services Smarter Commerce signings grow by nearly 200 percent in 2012—reaching $2 billion.

At the same time, chief procurement officers are expected to increase their annual investment in Supplier Intelligence by 30 percent through 2015, as they reshape their global supply chains. And leaders of human resources are investing in analytics to build smarter workforces and social enterprises. One analyst has ranked IBM as number one in enterprise social business for the past three years.

“Front-office” transformation has the potential to fuel the biggest wave of business technology investment since the era of enterprise resource planning.

City mayors are deploying Intelligent Operations Centers to transform public services in Davao, Philippines; Rio de Janeiro, Brazil; and Miami-Dade County, Florida. And urban transportation managers, such as those in Singapore and Eindhoven, Netherlands, are reducing urban congestion by offering drivers alternate route recommendations in exchange for their cars’ data on braking, acceleration and location.

This list could go on. “Front-office” transformation has the potential to fuel the biggest wave of business technology investment since the era of enterprise resource planning (ERP). And that creates a powerful set of conditions for the tens of thousands of business advisors and industry experts embedded in the world’s greatest engine of technical innovation.

In sum, our strong strategic positioning, solid balance sheet, recurring revenue, robust profit streams, global reach—and especially our institutional capacity for innovation and continuous transformation—give us confidence that we will continue to provide differentiating value to our clients, employees, partners and communities—and therefore to you, our owners. “Generating Higher Value at IBM” summarizes how.

On Being Essential

In closing, let me say a few words on the deeper meaning of this model of continuous transformation to higher value, at this particular moment in history.

As I have noted, an innovation model does not present an easy path, especially in an industry as fast-changing as ours. But once you are clear on your choice, it shapes everything you do: your business strategy, how you recruit talent, how you develop skills, how you invent, how you run the company. And for IBM, it means something more.

It speaks to IBMers’ aspiration to be essential to each of our vital constituencies—our clients, our communities, our partners, our investors, and one another. We see this as our purpose as an enterprise—to serve their plans for success, their need to transform and their own unique sense of purpose.

The era opening before us offers a historic opportunity for both businesses and societies to pursue this higher purpose. A vast new natural resource is being unleashed—promising to do for our century what steam, electricity and fossil fuels did for the Industrial Age. The economic and societal potential of this new gusher of data is incalculable. It is the opportunity of our lifetime—and IBMers are determined to seize it.

It is in this spirit that I express my deep pride in the worldwide IBM team for bringing us to where we are, and my gratitude to you, our shareholders, for your unwavering support. I hope you share our excitement about your company’s performance and the way in which IBMers are building a smarter planet and a brighter future.

Virginia M. Rometty, CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER