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MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2014(Edgar Glimpses Via Acquire Media NewsEdge) Snapshot Financial Results Summary: Yr. to Yr. Percent/ (Dollars in millions except per share amounts) Margin For the three months ended June 30: 2014 2013 Change Revenue $ 24,364 $ 24,924 (2.2) %* Gross profit margin 49.1 % 48.7 % 0.5 pts. Total expense and other (income) $ 6,804 $ 7,988 (14.8) % Total expense and other (income)-to-revenue ratio 27.9 % 32.0 % (4.1) pts. Provision for income taxes $ 1,034 $ 918 12.7 % Net income $ 4,137 $ 3,226 28.2 % Net income margin 17.0 % 12.9 % 4.0 pts. Earnings per share: Assuming dilution $ 4.12 $ 2.91 41.6 % Basic $ 4.14 $ 2.93 41.3 % Weighted-average shares outstanding: Assuming dilution 1,005.1 1,109.4 (9.4) % Basic 999.6 1,100.9 (9.2) % *2.5 percent decrease adjusted for currency Currency: The references to "adjusted for currency" or "at constant currency" in the Management Discussion do not include operational impacts that could result from fluctuations in foreign currency rates. Certain financial results are adjusted based on a simple mathematical model that translates current period results in local currency using the comparable prior year period's currency conversion rate. This approach is used for countries where the functional currency is the local country currency. This information is provided so that certain financial results can be viewed without the impact of fluctuations in foreign currency rates, thereby facilitating period-to-period comparisons of business performance. See "Currency Rate Fluctuations" on pages 75 and 76 for additional information. Operating (non-GAAP) Earnings: In an effort to provide better transparency into the operational results of the business, the company separates business results into operating and non-operating categories. Operating earnings is a non-GAAP measure that excludes the effects of certain acquisition-related charges and retirement-related costs, and their related tax impacts. For acquisitions, operating earnings exclude the amortization of purchased intangible assets and acquisition-related charges such as in-process research and development, transaction costs, applicable restructuring and related expenses and tax charges related to acquisition integration. For retirement-related costs, the company characterizes certain items as operating and others as non-operating. The company includes defined benefit plan and nonpension postretirement benefit plan service cost, amortization of prior service cost and the cost of defined contribution plans in operating earnings. Non-operating retirement-related cost includes defined benefit plan and nonpension postretirement benefit plan interest cost, expected return on plan assets, amortized actuarial gains/losses, the impacts of any plan curtailments/settlements and multi-employer plan costs, pension insolvency costs and other costs. Non-operating costs are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance and the company considers these costs to be outside the operational performance of the business. 46 -------------------------------------------------------------------------------- Management Discussion - (continued) Overall, the company believes that providing investors with a view of operating earnings as described above provides increased transparency and clarity into both the operational results of the business and the performance of the company's pension plans; improves visibility to management decisions and their impacts on operational performance; enables better comparisons to peer companies; and allows the company to provide a long-term strategic view of the business going forward. For its 2015 road map, the company is utilizing an operating view to establish its objectives and track its progress. The company's reportable segment financial results reflect operating earnings, consistent with the company's management and measurement system. The following table provides the company's (non-GAAP) operating earnings for the second quarter of 2014 and 2013. Yr. to Yr. (Dollars in millions except per share amounts) Percent For the three months ended June 30: 2014 2013 Change Net income as reported $ 4,137 $ 3,226 28.2 % Non-operating adjustments (net of tax): Acquisition-related charges 163 173 (6.0) Non-operating retirement-related costs/(income) 42 180 (76.8) Operating (non-GAAP) earnings* $ 4,341 $ 3,579 21.3 % Diluted operating (non-GAAP) earnings per share $ 4.32 $ 3.22 34.2 % * See pages 84 and 85 for a more detailed reconciliation of net income to operating earnings. Financial Performance Summary: In the second quarter of 2014, the company reported $24.4 billion in revenue and delivered diluted earnings per share of $4.12 as reported and $4.32 on an operating (non-GAAP) basis. The company generated $3.6 billion in cash from operations and $3.0 billion in free cash flow in the second quarter driving shareholder returns of $4.8 billion in gross common stock repurchases and dividends. The company's performance in the second quarter and the first half of 2014 reflected the stability of the overall business model as the company continued its transformation. From a portfolio perspective: † The company continued to drive double-digit revenue growth in the parts of the business that address the emerging trends in enterprise IT. † The core franchises were stable, where the company continues to drive innovation. † The company is dealing with secular shifts in parts of its hardware business. † The divested customer care business has had an impact as the company shifts to higher value. In the first quarter of 2014, the company announced a number of initiatives to support the shift to the strategic imperatives of data, cloud and systems of engagement. These included: † The launch of Bluemix, the company's cloud platform-as-a-service for the enterprise. † A $1.2 billion investment to globally expand SoftLayer cloud hubs. † A $1 billion investment to bring Watson's cognitive capabilities to the enterprise. In the second quarter of 2014, the company made progress implementing these initiatives including: † Bluemix becoming generally available in June. † New SoftLayer data centers were opened. † POWER8 began to ship, and the OpenPOWER consortium doubled its membership. † Substantially completing the divestiture of the customer care business. In July, the company announced additional actions to continue the shift to higher value, including: † An investment of $3 billion over the next five years in research and early stage development to create the next generation of semiconductor chip technologies that will fuel the systems required for cloud, big data and cognitive systems. 47-------------------------------------------------------------------------------- Management Discussion - (continued) † A strategic global partnership with Apple to provide a new level of business value from mobility for enterprise clients. The underlying theme of these actions - from the expansion of the cloud platforms and capacity, to the OpenPOWER consortium, to the partnership with Apple for enterprise mobility, to next generation chip technologies - is that the company is leveraging its unique strengths in innovation and enterprise capabilities to maintain its differentiation in the emerging areas of enterprise IT. While some of these actions impact results in the short term, they position the business better for the long term. In the second quarter, total consolidated revenue decreased 2.2 percent, 2.5 percent at constant currency. Adjusting for the divested customer care business, revenue decreased 1 percent at constant currency. From a segment perspective, Software revenue increased 1.0 percent (flat adjusted for currency), driven by middleware which increased 3.4 percent (3 percent adjusted for currency). The company is continuing to drive strong results in the strategic areas of mobile and security, as well as in some of the core franchises, including application servers and distributed databases. Global Services revenue declined 1.4 percent as reported and at constant currency; adjusting for the divested customer care business, Global Services revenue increased 1 percent at constant currency. Global Technology Services (GTS) revenue decreased 1.3 percent as reported and at constant currency; adjusting for the divested customer care business, GTS revenue increased 2 percent at constant currency from growth in cloud offerings and large outsourcing contracts signed in 2013. Global Business Services decreased 1.6 percent (2 percent adjusted for currency), with strong growth in the practices that address the digital front office, however performance in the traditional packaged application implementation offerings lagged. Systems and Technology revenue decreased 11.4 percent (12 percent adjusted for currency) but improved significantly sequentially compared to the first quarter of 2014 driven by System z mainframe, System x and Storage. From a geographic perspective, revenue in the growth markets declined 6.8 percent as reported and 4 percent adjusted for currency, a 1 point sequential improvement from the first quarter at constant currency. Within the growth markets, the BRIC countries decreased 1.9 percent as reported, but increased 1 percent at constant currency; a 7 point improvement from the first quarter 2014. The consolidated gross profit margin increased 0.5 points versus the second quarter of 2013 to 49.1 percent. The operating (non-GAAP) gross margin of 49.8 percent increased 0.1 points year to year. The improvement in gross margin was driven by margin expansion in Global Technology Services and an improved mix toward Software, partially offset by margin declines in Global Business Services and Systems and Technology. Operating (non-GAAP) gross profit of $12.1 billion declined approximately $250 million year to year driven entirely by Systems and Technology; excluding Systems and Technology, gross profit was flat year to year in the second quarter, including a $70 million impact from the divested customer care business, and while the company continues to transition to emerging areas where the profit and margins will benefit from scale. Total expense and other (income) decreased 14.8 percent in the second quarter of 2014 compared to the prior year. Total operating (non-GAAP) expense and other (income) decreased 14.0 percent year to year. The year-to-year drivers were approximately: Total Operating Consolidated (non-GAAP) Currency* 1 pt. 1 pt. Acquisitions ** 2 pts. 2 pts. Base expense (18) pts. (17) pts. * Reflects impacts of translation and hedging programs. ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges. There was one significant item that had an impact on total expense and other (income) year to year. Workforce rebalancing charges in the second quarter of 2013 were $1.0 billion compared to $11 million in the current year. Adjusting for the workforce rebalancing charges, operating (non-GAAP) base expense would have improved by 5 points compared to the 17 point impact highlighted above. The 5 point improvement is a better indication of the productivity in the base expense. Additionally, in the second quarter of 2014 the company recorded a pre-tax gain of $121 million related to the divestiture of the customer care business. Within base expense, the company is continuing to shift its spending to drive the strategic 48 -------------------------------------------------------------------------------- Management Discussion - (continued) imperatives and differentiated offerings. The substantial investments being made in cloud, which includes Bluemix and new data centers, in Watson and in chip innovation are examples of this. Pre-tax income increased 24.8 percent year to year and the pre-tax margin was 21.2 percent, an increase of 4.6 points versus the second quarter of 2013. Net income increased 28.2 percent and the net income margin was 17.0 percent, an increase of 4.0 points year to year. The effective tax rate for the second quarter was 20.0 percent, a decrease of 2.1 points year to year. Operating (non-GAAP) pre-tax income increased 18.3 percent year to year and the operating (non-GAAP) pre-tax margin was 22.3 percent, an increase of 3.9 points year to year. Operating (non-GAAP) net income increased 21.3 percent and the operating (non-GAAP) net income margin of 17.8 percent increased 3.5 points compared to the prior year. The operating (non-GAAP) effective tax rate was 20.0 percent versus 22.0 percent in the second quarter of 2013.The pre-tax income and net income margin improvements include the impact of the charge in the second quarter of 2013 of $1 billion for workforce rebalancing. Diluted earnings per share of $4.12 increased 41.6 percent versus the prior year. Operating (non-GAAP) diluted earnings per share of $4.32 increased 34.2 percent versus the second quarter of 2013. In the second quarter, the company repurchased 16.6 million shares of its common stock. The company generated $3,579 million in cash flow provided by operating activities, an increase of $405 million compared to the second quarter of 2013, driven primarily by lower uses of cash for receivables and lower cash tax payments. Net cash used in investing activities of $1,000 million increased $137 million compared to the prior year, primarily due to lower proceeds received from net sales of short-term marketable securities. Net cash used in financing activities of $2,260 million decreased $1,067 million compared to the prior year, primarily due to higher net cash proceeds from total debt. In July 2014, the company stated that it is expecting GAAP earnings per share of at least $17.00 and operating (non-GAAP) earnings of at least $18.00 per diluted share for the full year 2014. The company has also stated that its earnings per share expectation does not include the expected gain from the divestiture of its System x server business to Lenovo due to the uncertainty of the timing and the amount. The gain will ultimately be reflected in the company's results, and the company will provide an update later in the year. 49-------------------------------------------------------------------------------- Management Discussion - (continued) Financial Results Summary: Yr. to Yr. Percent/ (Dollars in millions except per share amounts) Margin For the six months ended June 30: 2014 2013 Change Revenue $ 46,848 $ 48,332 (3.1) %* Gross profit margin 48.1 % 47.2 % 0.9 pts. Total expense and other (income) $ 14,367 $ 15,060 (4.6) % Total expense and other (income)-to-revenue ratio 30.7 % 31.2 % (0.5) pts. Provision for income taxes $ 1,630 $ 1,492 9.3 % Net income $ 6,521 $ 6,258 4.2 % Net income margin 13.9 % 12.9 % 1.0 pts. Earnings per share: Assuming dilution $ 6.37 $ 5.60 13.8 % Basic $ 6.41 $ 5.65 13.5 % Weighted-average shares outstanding: Assuming dilution 1,023.5 1,116.7 (8.4) % Basic 1,017.4 1,107.3 (8.1) % 6/30/14 12/31/13 Assets $ 124,314 $ 126,223 (1.5) % Liabilities $ 106,801 $ 103,294 3.4 % Equity $ 17,513 $ 22,929 (23.6) % *2.4 percent decrease adjusted for currency The following table provides the company's (non-GAAP) operating earnings for the first six months of 2014 and 2013. Yr. to Yr. (Dollars in millions except per share amounts) Percent For the six months ended June 30: 2014 2013 Change Net income as reported $ 6,521 $ 6,258 4.2 % Non-operating adjustments (net of tax): Acquisition-related charges 324 313 3.5 Non-operating retirement-related costs/(income) 140 384 (63.6) Operating (non-GAAP) earnings* $ 6,985 $ 6,955 0.4 % Diluted operating (non-GAAP) earnings per share $ 6.82 $ 6.23 9.5 % * See pages 84 and 85 for a more detailed reconciliation of net income to operating earnings. Financial Performance Summary: In the first six months of 2014, the company reported revenue of $46.8 billion, expanded margins and delivered diluted earnings per share of $6.37 as reported and $6.82 on an operating (non-GAAP) basis while shifting investment to key areas. The company generated $6.9 billion in cash from operations and $3.6 billion in free cash flow in the first six months of 2014 driving shareholder returns of $13.9 billion in gross common stock repurchases and dividends. Total consolidated revenue decreased 3.1 percent (2 percent adjusted for currency) compared to the first six months of 2013. Adjusting for the divested customer care business, revenue decreased 1 percent at constant currency. The company has a set of offerings that address the strategic areas of data, cloud and the way clients are engaging with their customers. The company's business model is to deliver double-digit revenue growth for these areas - with high software content. Results in the first half of 2014 were consistent with that part of the model. Business analytics revenue increased 7 percent on a large base, and cloud revenue was up over 50 percent, with the "delivered as a service" business doubling again. Security revenue increased over 20 percent, and mobile revenue more than doubled year to year. Combined, revenue in the strategic imperatives was up double-digits, with approximately half of the content in software. The company also continues to innovate in its core franchises. These include the longer term services business, the recurring software business and the mainframe business with its large capacity clients. The model for the core franchises is stable revenue, and the first half of 2014 results reflect that the company is on track. In the transactional businesses that are shifting to higher value, the portfolio is continuing to evolve - the company is investing in capabilities in some areas, while divesting businesses that do not 50 -------------------------------------------------------------------------------- Management Discussion - (continued) support the shift to higher value. In the first half of 2014, the company substantially completed the divestiture of the customer care business - and announced the sale of its industry standard x86 server business to Lenovo. These transactions impact the company's revenue performance, but position the business for the long term. The company continues to drive these shifts. For example, in the first half of the year: † Bluemix went live, new SoftLayer cloud hubs were added and investment is being ramped up to commercialize Watson. † POWER8 was introduced for big data and cloud at the entry level and the OpenPOWER consortium doubled its membership. † The company committed $3 billion in spending over the next five years to drive chip innovation, while launching a global new partnership with Apple to extend the company's position in the enterprise mobile space. From a segment perspective, Software revenue increased 1.3 percent (1 percent adjusted for currency) year to year driven by middleware which increased 3.3 percent (3 percent adjusted for currency). Global Services revenue declined 1.7 percent (1 percent adjusted for currency). Adjusted for the divested customer care business, Global Services revenue increased 1 percent at constant currency. Global Technology Services (GTS) declined 2.1 percent (1 percent adjusted for currency); adjusting for the divested customer care business, GTS revenue increased 2 percent at constant currency. Global Business Services revenue decreased 0.8 percent as reported, flat adjusted for currency. Systems and Technology revenue decreased 16.6 percent (17 percent adjusted for currency) from a combination of secular and cyclical challenges in the hardware business. System z mainframe revenue decreased 16.4 percent (17 percent adjusted for currency). Global Financing revenue increased 3.1 percent (5 percent adjusted for currency). On a geographic basis, revenue in the growth markets declined 8.7 percent (5 percent adjusted for currency) and the major markets declined 0.9 percent (1 percent adjusted for currency). The consolidated gross margin increased 0.9 points versus the first six months of 2013 to 48.1 percent. The operating (non-GAAP) gross margin increased 0.5 points to 48.7 percent compared to the prior year. The improvement in gross margin in the first six months was driven by margin improvement in GTS and an improved mix toward Software, partially offset by a margin decline in Systems and Technology. Total expense and other (income) decreased 4.6 percent in the first six months of 2014 compared to the prior year. Total operating (non-GAAP) expense and other (income) decreased 3.8 percent compared to the first six months of 2013. The key drivers of the year-to-year change in total expense and other (income) were approximately: Total Operating Consolidated (non-GAAP) Currency * 1 pt. 1 pt. Acquisitions** 2 pts. 2 pts. Base expense (7) pts. (6) pts. * Reflects impacts of translation and hedging programs. ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges. There were two significant items that had an impact on total expense and other (income) year to year. Workforce rebalancing charges for the first six months of 2014 were $883 million compared to $1,030 million in the prior year. In addition, the company recorded a pre-tax gain of $219 million in the first half of 2014 related to the divestiture of the customer care outsourcing business. Pre-tax income grew 5.2 percent year to year and the pre-tax margin was 17.4 percent, an increase of 1.4 points year to year. Net income increased 4.2 percent and the net income margin was 13.9 percent, an increase of 1.0 points year to year. The effective tax rate for the first six months was 20.0 percent, compared with 19.2 percent in the prior year. Operating (non-GAAP) pre-tax income increased 0.7 percent year to year and the operating (non-GAAP) pre-tax margin expanded 0.7 points to 18.6 percent versus the prior year. Operating (non-GAAP) net income increased 0.4 percent and the operating (non-GAAP) net income margin of 14.9 percent increased 0.5 points.The operating (non-GAAP) effective tax rate for the first six months was 20.0 percent versus 19.8 percent in 2013. 51 -------------------------------------------------------------------------------- Management Discussion - (continued) Diluted earnings per share of $6.37 increased 13.8 percent compared to the prior year. Operating (non-GAAP) diluted earnings per share of $6.82 increased 9.5 percent year to year in the first six months. In the first six months of 2014, the company repurchased 61.8 million shares of its common stock. At June 30, 2014, the company's balance sheet and liquidity position remained strong and well positioned to support the business over the long term. Cash and marketable securities at quarter end were $9,721 million, a decrease of $1,345 million from December 31, 2013. Key drivers in the balance sheet and total cash flows are: Total assets decreased $1,909 million ($2,470 million adjusted for currency) from December 31, 2013 driven by: † Decreases in total receivables ($2,375 million) and cash and cash equivalents ($1,000 million); partially offset by † Increased prepaid pension assets ($1,343 million). Total liabilities increased $3,507 million ($3,203 million adjusted for currency) from December 31, 2013 driven by: † Increases in total debt ($6,752 million); partially offset by † Decreases in taxes payable ($2,298 million) and accounts payable ($1,191 million). Total equity of $17,513 million decreased $5,417 million from December 31, 2013 as a result of: † Increased treasury stock ($11,659 million) driven by share repurchases; partially offset by † Higher retained earnings ($4,441 million), decreased losses in accumulated other comprehensive income/(loss) ($1,232 million) and higher common stock ($570 million). The company generated $6,905 million in cash flow provided by operating activities, a decrease of $292 million compared to the first six months of 2013, driven primarily by a higher level of cash tax payments ($1,188 million), partially offset by increased cash provided by receivables ($955 million). Net cash used in investing activities of $965 million was $911 million lower than the first six months of 2013, primarily due to an increase in cash provided by net sales of marketable securities and other instruments ($782 million). Net cash used in financing activities of $6,933 million increased $890 million compared to the prior year, driven primarily by increased cash used for gross common stock purchases ($5,683 million), partially offset by higher net cash proceeds from total debt ($5,139 million). 52-------------------------------------------------------------------------------- Management Discussion - (continued) Second Quarter and First Six Months in Review Results of Operations Segment Details The following is an analysis of the second quarter and first six months of 2014 versus the second quarter and first six months of 2013 reportable segment external revenue and gross margin results. Segment pre-tax income includes transactions between the segments that are intended to reflect an arm's-length transfer price and excludes certain unallocated corporate items. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent/Margin Adjusted For For the three months ended June 30: 2014 2013 Change Currency Revenue: Global Technology Services $ 9,414 $ 9,536 (1.3) % (1.3) % Gross margin 38.4 % 37.8 % 0.6 pts. Global Business Services 4,534 4,606 (1.6) % (1.7) % Gross margin 30.0 % 31.2 % (1.2) pts. Software 6,488 6,423 1.0 % 0.2 % Gross margin 88.8 % 88.8 % 0.0 pts. Systems and Technology 3,331 3,758 (11.4) % (11.6) % Gross margin 33.9 % 36.7 % (2.8) pts. Global Financing 504 487 3.5 % 4.5 % Gross margin 54.8 % 46.3 % 8.5 pts. Other 93 115 (19.1) % (18.9) % Gross margin (179.7) % (190.5) % 10.8 pts. Total consolidated revenue $ 24,364 $ 24,924 (2.2) % (2.5) % Total consolidated gross profit $ 11,975 $ 12,132 (1.3) % Total consolidated gross margin 49.1 % 48.7 % 0.5 pts. Non-operating adjustments: Amortization of acquired intangible assets 105 90 17.2 % Acquisition-related charges - 1 (100.0) Retirement-related costs/(income) 45 156 (71.0) Operating (non-GAAP) gross profit $ 12,126 $ 12,379 (2.0) % Operating (non-GAAP) gross margin 49.8 % 49.7 % 0.1 pts. 53 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent/Margin Adjusted For For the six months ended June 30: 2014 2013 Change Currency Revenue: Global Technology Services $ 18,744 $ 19,140 (2.1) % (0.9) % Gross margin 38.2 % 37.3 % 0.9 pts. Global Business Services 9,017 9,091 (0.8) % 0.1 % Gross margin 30.0 % 29.9 % 0.1 pts. Software 12,149 11,995 1.3 % 1.1 % Gross margin 88.2 % 88.1 % 0.1 pts. Systems and Technology 5,722 6,864 (16.6) % (16.7) % Gross margin 31.0 % 34.7 % (3.7) pts. Global Financing 1,016 985 3.1 % 5.3 % Gross margin 50.4 % 46.0 % 4.4 pts. Other 200 257 (22.0) % (21.1) % Gross margin (171.1) % (172.8) % 1.7 pts. Total consolidated revenue $ 46,848 $ 48,332 (3.1) % (2.4) % Total consolidated gross profit $ 22,518 $ 22,810 (1.3) % Total consolidated gross margin 48.1 % 47.2 % 0.9 pts. Non-operating adjustments: Amortization of acquired intangible assets 209 184 13.9 % Acquisition-related charges - 3 (100.0) Retirement-related costs/(income) 98 320 (69.5) Operating (non-GAAP) gross profit $ 22,825 $ 23,316 (2.1) % Operating (non-GAAP) gross margin 48.7 % 48.2 % 0.5 pts. Global Services In the second quarter of 2014, the Global Services segments, Global Technology Services (GTS) and Global Business Services (GBS), delivered revenue of $13,948 million, a decrease of 1.4 percent (1 percent adjusted for currency) compared to the prior year. Normalizing for the divestiture of the customer care business, Global Services revenue increased 0.8 percent (1 percent adjusted for currency). Adjusted for the divestiture, this is the fourth consecutive quarter of constant currency growth in total Global Services. Pre-tax income in the second quarter increased 25.5 percent and the pre-tax margin increased 4.1 points to 18.7 percent. Total outsourcing revenue of $6,204 million decreased 4.6 percent (5 percent adjusted for currency) when compared to the prior year, but increased 0.1 percent (flat adjusted for currency) when normalized for the divestiture. Total transactional revenue of $5,990 million increased 2.2 percent (2 percent adjusted for currency). In the first six months of 2014, total Global Services revenue was $27,761 million, a decrease of 1.7 percent (1 percent adjusted for currency) year to year. Normalizing for the divestiture of the customer care business, Global Services revenue increased 0.2 percent (1 percent adjusted for currency). Total outsourcing revenue of $12,419 million decreased 5.2 percent (4 percent adjusted for currency), while adjusted for the divestiture, it decreased 1.3 percent and was flat on a constant currency basis. Total transactional revenue of $11,868 million increased 2.5 percent (3 percent adjusted for currency). 54-------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended June 30: 2014 2013 Change Currency Global Services external revenue: $ 13,948 $ 14,142 (1.4) % (1.4) % Global Technology Services $ 9,414 $ 9,536 (1.3) % (1.3) % Outsourcing 5,265 5,471 (3.8) (3.9) Integrated Technology Services 2,395 2,287 4.7 4.9 Maintenance 1,754 1,777 (1.3) (1.0) Global Business Services $ 4,534 $ 4,606 (1.6) % (1.7) % Outsourcing 939 1,032 (9.0) (8.8) Consulting and Systems Integration 3,595 3,574 0.6 0.3 Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the six months ended June 30: 2014 2013 Change Currency Global Services external revenue: $ 27,761 $ 28,231 (1.7) % (0.6) % Global Technology Services $ 18,744 $ 19,140 (2.1) % (0.9) % Outsourcing 10,546 11,029 (4.4) (3.4) Integrated Technology Services 4,724 4,564 3.5 4.8 Maintenance 3,475 3,547 (2.0) (0.6) Global Business Services $ 9,017 $ 9,091 (0.8) % 0.1 % Outsourcing 1,873 2,073 (9.7) (8.2) Consulting and Systems Integration 7,144 7,017 1.8 2.6 Global Technology Services revenue of $9,414 million decreased 1.3 percent (1 percent adjusted for currency) in the second quarter of 2014. Normalizing for the divestiture of the customer care business, revenue increased 2.0 percent (2 percent adjusted for currency). GTS revenue decreased 2.1 percent (1 percent adjusted for currency) to $18,744 million in the first six months of 2014. However, adjusted for the divestiture, it increased 0.7 percent (2 percent adjusted for currency). Within GTS, the Softlayer platform contributed about 1 point of constant currency growth in the quarter. The company is expanding its global cloud footprint, opening a datacenter in Hong Kong during the second quarter, followed by another in London in July. Additional capacity will be brought on during the second half of this year. GTS Outsourcing, one of the company's core franchises, continued to show improvement. Normalizing for the customer care divestiture, revenue for the quarter increased 2.0 percent (2 percent adjusted for currency) compared to the prior year and grew on a constant currency basis for the second consecutive quarter. The revenue growth was driven by the new contracts brought on during 2013. Global Business Services revenue of $4,534 million decreased 1.6 percent (2 percent adjusted for currency) in the second quarter of 2014 and decreased 0.8 percent (flat adjusted for currency) for the first six months of the year. Consulting and Systems Integration (C&SI) revenue grew 0.6 percent (flat adjusted for currency) in the second quarter. There was strong double digit growth in the practices that address the digital front office, particularly in cloud, analytics and mobile. This was offset by declines in traditional packaged application implementations. As the Digital Front Office offerings become a larger part of the portfolio, they will contribute more meaningfully to revenue performance. In July, the company announced a strategic partnership with Apple to deliver a new class of "enterprise ready" MobileFirst business applications for iOS. With this partnership, the company's consultants and other client-facing specialists will help expand mobile device productivity, enabling Big Data and analytics at the point of contact. Consistent with last quarter's performance, Application Outsourcing revenue decreased 9.0 percent (9 percent adjusted for currency) in the second quarter. Performance continues to reflect pricing pressure and client contract renegotiations, as well as a reduction in elective projects. 55 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent/ (Dollars in millions) Margin For the three months ended June 30: 2014 2013 Change Global Technology Services: External gross profit $ 3,618 $ 3,607 0.3 % External gross profit margin 38.4 % 37.8 % 0.6 pts. Pre-tax income $ 1,850 $ 1,514 22.2 % Pre-tax margin 19.2 % 15.4 % 3.7 pts. Global Business Services: External gross profit $ 1,360 $ 1,436 (5.3) % External gross profit margin 30.0 % 31.2 % (1.2) pts. Pre-tax income $ 832 $ 623 33.7 % Pre-tax margin 17.8 % 13.0 % 4.8 pts. Yr. to Yr. Percent/ (Dollars in millions) Margin For the six months ended June 30: 2014 2013 Change Global Technology Services: External gross profit $ 7,157 $ 7,137 0.3 % External gross profit margin 38.2 % 37.3 % 0.9 pts. Pre-tax income $ 3,196 $ 3,099 3.1 % Pre-tax margin 16.6 % 15.7 % 0.9 pts. Global Business Services: External gross profit $ 2,702 $ 2,719 (0.6) % External gross profit margin 30.0 % 29.9 % 0.1 pts. Pre-tax income $ 1,461 $ 1,326 10.2 % Pre-tax margin 15.7 % 14.0 % 1.7 pts. GTS gross profit margin improved 0.6 points and 0.9 points in the second quarter and first six months of 2014, respectively. In the second quarter, pre-tax income increased 22.2 percent to $1,850 million and the pre-tax margin expanded 3.7 points to 19.2 percent compared to the prior year. The improvement in profit was driven by several factors. First, the company continues to make investments in key growth areas such as mobile, security and cloud. These investments result in a differentiated set of capabilities that complement clients' system of record and are a good example of how the company continues to evolve its core franchises. Second, the results reflect a pre-tax gain of $121 million related to the customer care divestiture, partially offset by the profit lost from the divested business. Third, the benefit from prior workforce rebalancing actions, and fourth, the prior year second quarter results included a workforce rebalancing charge of $352 million. In the first six months of 2014, pre-tax income increased 3.1 percent to $3,196 million and pre-tax margin expanded 0.9 points to 16.6 percent compared to the prior year. GBS gross profit margin decreased 1.2 points in the second quarter, but increased 0.1 points for the first six months of 2014 compared to the prior year. Pre-tax income increased 33.7 percent to $832 million and the pre-tax margin expanded 4.8 points to 17.8 percent in the second quarter. Second quarter profit reflects both the year-to-year benefit ($231 million) in workforce rebalancing charges and the impact of lower revenue on a relatively fixed cost base. In the first six months of 2014, pre-tax income increased 10.2 percent to $1,461 million and pre-tax margin expanded 1.7 points to 15.7 percent compared to the prior year. Global Services Backlog The estimated Global Services backlog at June 30, 2014 was $136 billion, a decrease of 3.2 percent (5 percent adjusted for currency) compared to the June 30, 2013 balance. This includes a backlog reduction in January 2014 of $3.8 billion associated with the customer care divestiture. Adjusting for the divestiture, backlog was down 0.5 percent (3 percent adjusted for currency) year to year. The estimated transactional backlog at June 30, 2014 increased 3.1 percent (1 percent adjusted for currency) from the June 30, 2013 levels. The estimated outsourcing backlog decreased 6.3 percent (8 percent adjusted for currency) including the backlog reduction from the customer care divestiture. Adjusting for the divestiture, the estimated outsourcing backlog decreased 2.1 percent (4 percent adjusted for currency) compared to the June 30, 2013 balance. 56 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change At June 30, At June 30, Percent Adjusted For (Dollars in billions) 2014 2013 Change Currency Backlog: Total backlog $ 136.0 $ 140.5 (3.2) % (5.1) % adjusted for customer care (0.5) % (2.5) % Outsourcing backlog $ 84.6 $ 90.3 (6.3) % (8.3) % adjusted for customer care (2.1) % (4.2) % Total Global Services backlog includes GTS Outsourcing, ITS, GBS Outsourcing, Consulting and Systems Integration and Maintenance. Outsourcing backlog includes GTS Outsourcing and GBS Outsourcing. Transactional backlog includes ITS and Consulting and Systems Integration. Total 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 adjustments for currency. Global Services signings are management's initial estimate of the value of a client's commitment under a Global Services contract. There are no third-party standards or requirements governing the calculation of signings. The calculation used by management involves estimates and judgments to gauge the extent of a client's commitment, including the type and duration of the agreement, and the presence of termination charges or wind-down costs. Signings include GTS Outsourcing, ITS, GBS Outsourcing and Consulting and Systems Integration contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. Maintenance is not included in signings as maintenance contracts tend to be more steady state, where revenues equal renewals. Contract portfolios purchased in an acquisition are treated as positive backlog adjustments provided those contracts meet the company's requirements for initial signings. A new signing will be recognized if a new services agreement is signed incidental or coincidental to an acquisition or divestiture. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended June 30: 2014 2013 Change Currency Total signings: $ 10,992 $ 16,418 (33.1) % (32.9) % Outsourcing signings $ 4,787 $ 8,901 (46.2) % (45.9) % Transactional signings 6,204 7,517 (17.5) % (17.4) % Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the six months ended June 30: 2014 2013 Change Currency Total signings: $ 22,145 $ 33,349 (33.6) % (32.9) % Outsourcing signings $ 10,275 $ 19,634 (47.7) % (46.9) % Transactional signings 11,870 13,715 (13.5) % (12.9) % 57 -------------------------------------------------------------------------------- Management Discussion - (continued) Software Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended June 30: 2014 2013 Change Currency Software external revenue: $ 6,488 $ 6,423 1.0 % 0.2 % Middleware: $ 5,500 $ 5,320 3.4 % 2.6 % Key branded middleware: 4,324 4,302 0.5 (0.3) WebSphere Family 5.5 4.6 Information Management (1.1) (1.9) Workforce Solutions (7.1) (8.0) Tivoli 3.6 2.6 Rational (9.3) (10.0) Other middleware 1,176 1,018 15.5 14.6 Operating systems 530 606 (12.5) (13.3) Other 458 496 (7.7) (8.4) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the six months ended June 30: 2014 2013 Change Currency Software external revenue: $ 12,149 $ 11,995 1.3 % 1.1 % Middleware: $ 10,196 $ 9,868 3.3 % 3.1 % Key branded middleware: 7,980 7,806 2.2 2.0 WebSphere Family 8.4 8.1 Information Management 0.0 (0.2) Workforce Solutions (5.9) (6.3) Tivoli 4.9 4.5 Rational (4.8) (4.8) Other middleware 2,215 2,062 7.4 7.2 Operating systems 1,049 1,184 (11.4) (11.4) Other 905 943 (4.0) (3.9) Software revenue of $6,488 million increased 1.0 percent (flat adjusted for currency) in the second quarter and increased 1.3 percent (1 percent adjusted for currency) to $12,149 million in the first six months of 2014, respectively. In the second quarter, middleware grew 3.4 percent (3 percent adjusted for currency) while operating systems were down 12.5 percent (13 percent adjusted for currency). Across the software brands, Software-as-a Service (SaaS) offerings are growing rapidly and in the second quarter increased by approximately 40 percent on a year-to-year basis. Key branded middleware revenue, which accounted for 67 percent of total Software revenue in the second quarter of 2014, increased 0.5 percent (flat adjusted for currency) compared to a strong quarter in the prior year. There was good growth in several strategic areas - cloud, big data and analytics, mobile and security. In the first six months of 2014, key branded middleware grew 2.2 percent (2 percent adjusted for currency) and accounted for 66 percent of total Software revenue. WebSphere revenue increased 5.5 percent (5 percent adjusted for currency) and 8.4 percent (8 percent adjusted for currency) in the second quarter and first six months of 2014 year to year, respectively. The performance in the second quarter was led by application server, commerce and mobile solutions. Both on-premise and SaaS offerings contributed to WebSphere growth, with the majority of this growth coming from on-premise solutions. The application server business delivered strong growth, with an increase in demand for on-premise software that was driven by mobile and analytics workloads. Strong growth continues in MobileFirst, leveraging over 5,000 mobile experts and the company's expanding capabilities. Supporting the partnership with Apple, the Software Group will develop unique enterprise cloud services native for iOS, to deliver the full enterprise-class mobile experience from analytics, to cloud storage and data security. Information Management revenue decreased 1.1 percent (2 percent adjusted for currency) in the second quarter and was flat, both as reported and on a constant currency basis, in the first six months of 2014 compared to the prior year. In the second quarter, relational database continued to grow, although some product areas in the brand were faced with tough 58-------------------------------------------------------------------------------- Management Discussion - (continued) comparisons to strong performance in the prior year. Tivoli revenue increased 3.6 percent (3 percent adjusted for currency) in the second quarter and 4.9 percent (4 percent adjusted for currency) in the first six months of 2014 compared to the prior year periods. Revenue growth in the quarter was driven by security software, marking its eleventh consecutive quarter of growth with most of those quarters increasing by double digits. That includes every quarter since the company acquired Q1Labs and built a security division around that acquisition, supplemented by additional analytics capabilities. Workforce Solutions revenue decreased 7.1 percent (8 percent adjusted for currency) in the second quarter and 5.9 percent (6 percent adjusted for currency) in the first six months of 2014 year to year, respectively. Performance in both periods has been impacted by the transition from on-premise Notes to SaaS offerings. Rational revenue decreased 9.3 percent (10 percent adjusted for currency) year to year in the second quarter and decreased 4.8 percent (5 percent adjusted for currency) in the six months of 2014. Across software, the company is transitioning its portfolio to capture growth areas and continues to drive innovation in its core franchises. It is growing and building capabilities in emerging areas like SaaS, mobile and security and also in more traditional areas such as application server and relational database, as new growth areas drive the need for on-premise capabilities. In the second quarter the Software business faced a tough comparison to strong performance in the prior year. The company expects year-to-year revenue growth to accelerate in the second half of the year. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the three months ended June 30: 2014 2013 Change Software: External gross profit $ 5,760 $ 5,703 1.0 % External gross profit margin 88.8 % 88.8 % 0.0 pts. Pre-tax income $ 2,683 $ 2,443 9.8 % Pre-tax margin 36.5 % 34.1 % 2.4 pts. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the six months ended June 30: 2014 2013 Change Software: External gross profit $ 10,716 $ 10,562 1.5 % External gross profit margin 88.2 % 88.1 % 0.1 pts. Pre-tax income $ 4,601 $ 4,457 3.2 % Pre-tax margin 33.0 % 32.9 % 0.2 pts. Software gross profit margins of 88.8 percent in the second quarter and 88.2 percent for the first six months of 2014 were essentially flat compared to the prior year periods. Software pre-tax income of $2,683 million in the second quarter of 2014 increased 9.8 percent year to year, with a pre-tax margin of 36.5 percent, an improvement of 2.4 points. Second-quarter profit growth reflects a year-to-year reduction in workforce rebalancing charges of $214 million. Segment pre-tax income for the first six months of 2014 increased 3.2 percent to $4,601 million with a pre-tax margin of 33.0 percent, up 0.2 points. 59 -------------------------------------------------------------------------------- Management Discussion - (continued) Systems and Technology Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended June 30: 2014 2013 Change Currency Systems and Technology external revenue: $ 3,331 $ 3,758 (11.4) % (11.6) % System z (0.9) % (1.2) % Power Systems (28.3) (28.7) System x (3.1) (3.2) Storage (12.3) (12.8) Total Systems (10.5) (10.8) Microelectronics OEM (17.6) (17.6) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the six months ended June 30: 2014 2013 Change Currency Systems and Technology external revenue: $ 5,722 $ 6,864 (16.6) % (16.7) % System z (16.4) % (16.8) % Power Systems (25.4) (25.4) System x (10.4) (10.1) Storage (17.1) (17.4) Total Systems (16.6) (16.7) Microelectronics OEM (16.8) (16.8) Systems and Technology (STG) revenue decreased 11.4 percent (12 percent adjusted for currency) and 16.6 percent (17 percent adjusted for currency) in the second quarter and first six months of 2014, respectively, versus the same periods in 2013. The second quarter year-to-year revenue performance improved compared to the first quarter rate and was driven by System z mainframe, as well as sequential improvements in System x and Storage. The improved revenue performance, together with actions taken to align the structure of the business to the demand profile, resulted in progress in stabilizing profit. System z revenue decreased 0.9 percent (1 percent adjusted for currency) and 16.4 percent (17 percent adjusted for currency) in the second quarter and first six months of 2014, respectively, compared to the prior year periods. MIPS (millions of instructions per second) shipments were flat year to year in the second quarter of 2014 and down 8 percent in the first six months of the year. The second quarter results, which included some large deals in the financial sector in China, the United States and Brazil, reflect significant performance in the seventh quarter of the product cycle since announcement. Comparing the current mainframe cycle to date with the prior cycle, the company has shipped 25 percent more MIPS, and the revenue and gross profit are each about 98 percent of the previous cycle, net of currency. The System z platform is one of the company's core franchises, benefitting from IT trends. The value proposition for System z becomes stronger as the scale of data and transactions grow, as well as the need for security of that data and those transactions. Power Systems revenue decreased 28.3 percent (29 percent adjusted for currency) and 25.4 percent (25 percent adjusted for currency) in the second quarter and first six months of 2014, respectively, compared to the prior year periods. This performance reflects fundamental changes in the business and the company has taken actions to align its structure to the demand profile, while investing to address opportunities for the future. In June 2014, entry-level POWER8 was launched and had a good start compared to previous cycles. The entry-level is only a small portion of the Power business and, over the remainder of the year, POWER8 will be introduced into the mid-range and high-end segments. Also during the second quarter, the company expanded its OpenPOWER consortium and doubled the number of alliance members. At the end of June, the company had a globally diverse membership, with 36 members across ten countries, throughout the stack from chip designers, to hardware component OEMs, to system vendors and to middleware and software providers. Within the alliance, members have access to high end technology, as the Power architecture is available for open development and to integrate new designs into their hardware platforms. System x revenue decreased 3.1 percent (3 percent adjusted for currency) and 10.4 percent (10 percent adjusted for currency) in the second quarter and first six months of 2014, respectively, compared to the prior year periods. While second 60-------------------------------------------------------------------------------- Management Discussion - (continued) quarter revenue was down on a year-to-year basis, there was improvement in the rate compared to the first quarter of 2014 when revenue was down 18 percent versus the prior year. Storage revenue decreased 12.3 percent (13 percent adjusted for currency) and 17.1 percent (17 percent adjusted for currency) in the second quarter and first six months of 2014, respectively, compared to the prior year periods. The second quarter year-to-year rate was a sequential improvement compared to the 23 percent decrease in the first quarter of this year. The second quarter included strong growth in Flash Systems, as revenue doubled over last year, and in the Storwize portfolio which was up double digits compared to the prior year. However, this growth was more than offset by weakness in high-end disk and the continued wind-down of the OEM business. There were a number of product launches in the second quarter including the V7000 update to the Storwize portfolio and flash-enabled DS8K. Microelectronics OEM revenue decreased 17.6 percent (18 percent adjusted for currency) and 16.8 percent (17 percent adjusted for currency) in the second quarter and first six months of 2014 versus the comparable periods of 2013, respectively. Yr. to Yr. Percent/ (Dollars in millions) Margin For the three months ended June 30: 2014 2013 Change Systems and Technology: External gross profit $ 1,128 $ 1,379 (18.2) % External gross profit margin 33.9 % 36.7 % (2.8) pts. Pre-tax income $ 25 $ (141) 117.9 % Pre-tax margin 0.7 % (3.6) % 4.3 pts. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the six months ended June 30: 2014 2013 Change System and Technology: External gross profit $ 1,773 $ 2,382 (25.6) % External gross profit margin 31.0 % 34.7 % (3.7) pts. Pre-tax income $ (635) $ (546) 16.3 % Pre-tax margin (10.4) % (7.7) % (2.8) pts. Systems and Technology's gross profit margin decreased 2.8 points in the second quarter of 2014 versus the prior year. The decrease was driven by lower margins in Power Systems (1.1 points), Storage (0.9 points), Microelectronics (0.8 points) and System x (0.8 points), partially offset by an improvement due to revenue mix (0.4 points). Gross profit margin for the first six months of 2014 decreased 3.7 points compared to the first six months of 2013. The decrease was driven by lower margins in Power Systems (1.3 points), Microelectronics (1.0 points) and Storage (0.9 points), and a decline due to revenue mix (0.7 points). Systems and Technology's pre-tax income increased $166 million to $25 million in the second quarter and its pre-tax loss increased $89 million to $635 million for the first six months of 2014 compared to prior year periods. Pre-tax margin increased 4.3 points in the second quarter and decreased 2.8 points in the first six months versus the prior year periods. Second-quarter performance reflects a year-to-year reduction in workforce rebalancing charges of $202 million. The company's focus for STG in 2014 is to stabilize the profit base and, after the first half of the year, the company is on track. The company will continue to make investments in this business to remain a leader in high-performance, high-end systems. In July, the company announced it will invest $3 billion over the next five years to tackle the challenges of the "post-silicon" era, demonstrating its commitment to innovation and to leading in the new era of enterprise IT. Global Financing See pages 77 to 83 for a discussion of Global Financing's segment results. 61 -------------------------------------------------------------------------------- Management Discussion - (continued) 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 excludes OEM revenue, which is discussed separately. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended June 30: 2014 2013 Change Currency Total Revenue $ 24,364 $ 24,924 (2.2) % (2.5) % Geographies: $ 23,931 $ 24,385 (1.9) % (2.1) % Americas 10,643 10,709 (0.6) 0.8 Europe/Middle East/Africa (EMEA) 7,948 7,839 1.4 (3.1) Asia Pacific 5,340 5,838 (8.5) (6.2) Major markets (0.3) % (1.5) % Growth markets (6.8) % (4.2) % BRIC countries (1.9) % 1.1 % Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the six months ended June 30: 2014 2013 Change Currency Total Revenue $ 46,848 $ 48,332 (3.1) % (2.4) % Geographies: $ 46,060 $ 47,367 (2.8) % (2.1) % Americas 20,239 20,751 (2.5) (0.6) Europe/Middle East/Africa (EMEA) 15,526 15,117 2.7 (1.3) Asia Pacific 10,295 11,499 (10.5) (5.9) Major markets (0.9) % (1.3) % Growth markets (8.7) % (4.6) % BRIC countries (6.4) % (2.3) % Total geographic revenue of $23,931 million decreased 1.9 percent (2 percent adjusted for currency) in the second quarter of 2014 compared to the prior year. In total, major market countries decreased 0.3 percent (1 percent adjusted for currency) and growth market countries decreased 6.8 percent (4 percent adjusted for currency) in the second quarter of 2014. In the growth markets, on a constant currency basis, revenue grew at a double-digit rate in Latin America, while the Asia Pacific countries declined at a double-digit rate. China showed significant improvement compared to the last three quarters, although the balance of the Asia Pacific growth markets remains challenged. Within the BRIC countries of Brazil, Russia, India and China, combined revenue decreased 1.9 percent, but increased 1 percent on a constant currency basis in the second quarter. This constant currency growth rate represents a 7 point sequential improvement from the first quarter rate. It was driven by Brazil, India and China, with each country up between 9 and 10 points quarter to quarter on a constant currency basis. In the second quarter, Brazil grew 16.9 percent (22 percent adjusted for currency) driven by large deals in the financial sector. India decreased 4.1 percent as reported, but grew 3 percent adjusted for currency. China decreased 11.2 percent (11 percent adjusted for currency) effectively halving the rate of decline from the past three quarters. Russia declined 12.0 percent (9 percent adjusted for currency) on a year-to-year basis. Overall, adjusted for currency, the growth markets had a modest sequential improvement of 1 point compared to the first quarter of 2014. Americas revenue decreased 0.6 percent, but increased 1 percent adjusted for currency compared to the second quarter of 2013. On a constant currency basis, this represents a 3 point improvement from the first quarter rate. The improvement in the Americas was driven by strong System z mainframe performance. Within the major markets, the U.S. was down 0.8 percent year to year, an improvement of 3 points compared to the first quarter, and Canada was down 9.6 percent (4 percent adjusted for currency). The Latin America growth markets increased 8.0 percent as reported (14 percent adjusted for currency) driven by the strong performance in Brazil. 62-------------------------------------------------------------------------------- Management Discussion - (continued) EMEA revenue increased 1.4 percent (decreased 3 percent adjusted for currency) year to year in the second quarter of 2014. Within the major markets, there was continued growth in Germany and Italy, with Germany increasing 10.7 percent (5 percent adjusted for currency) and Italy increasing 7.0 percent (2 percent adjusted for currency) compared to the second quarter of 2013. However, the UK decreased 6.0 percent (14 percent adjusted for currency) and France decreased 5.1 percent (9 percent adjusted for currency). The EMEA growth markets decreased 4.7 percent (4 percent adjusted for currency) driven by declines in the Eastern European countries. Asia Pacific second quarter revenue decreased 8.5 percent (6 percent adjusted for currency) year over year. Japan decreased 1.6 percent as reported, but increased 2 percent on a constant currency basis. Adjusted for currency, this was the seventh consecutive quarter of revenue growth in Japan. This constant currency growth in Japan was more than offset by the Asia Pacific growth market countries which decreased 12.6 percent (11 percent adjusted for currency) compared to the second quarter of 2013. Total geographic revenue of $46,060 million for the first six months of 2014 decreased 2.8 percent (2 percent adjusted for currency) compared to the prior year. Major markets decreased 0.9 percent (1 percent adjusted for currency) and the growth market countries decreased 8.7 percent (5 percent adjusted for currency) for the first six months of the year. Within the BRIC countries, combined revenue was down year to year 6.4 percent (2 percent adjusted for currency) driven by China which decreased 15.0 percent (15 percent adjusted for currency). While the company had strength in Latin America during the first half of the year, declines in some of the larger growth markets, such as China, Australia and Korea, impacted the overall performance in the growth markets. Americas revenue for the first six months of 2014 decreased 2.5 percent (1 percent adjusted for currency) compared to the prior year. The major market countries were down 3.2 percent (2 percent adjusted for currency), partially offset by an increase in the Latin America growth markets of 2.8 percent (11 percent adjusted for currency). Within the major market countries, the U.S. was down 2.2 percent and Canada was down 9.6 percent (2 percent adjusted for currency). Within the Latin America growth market countries, Brazil increased 8.6 percent (17 percent adjusted for currency). Mexico decreased 4.5 percent (2 percent adjusted for currency). Europe/Middle East/Africa (EMEA) revenue increased 2.7 percent (decreased 1 percent adjusted for currency) for the first six months of 2014 compared to the prior year. The major market countries increased 3.5 percent (decreased 1 percent adjusted for currency), while the growth market countries decreased 3.4 percent (2 percent adjusted for currency). In the major market countries, Germany increased 11.8 percent (7 percent adjusted for currency), Italy increased 8.2 percent (4 percent adjusted for currency), the UK decreased 3.0 percent (10 percent adjusted for currency) and France decreased 4.0 percent (8 percent adjusted for currency). Asia Pacific revenue decreased 10.5 percent (6 percent adjusted for currency) year to year for the first six months of 2014. Japan decreased 4.8 percent as reported, but increased 2 percent on a constant currency basis. The Asia Pacific growth markets decreased 14.1 percent (11 percent adjusted for currency). OEM revenue decreased 19.5 percent (19 percent adjusted for currency) and decreased 18.3 percent (18 percent adjusted for currency) year to year in the second quarter and first six months of 2014, respectively, driven by the Microelectronics OEM business. 63 -------------------------------------------------------------------------------- Management Discussion - (continued) Expense Total Expense and Other (Income) Yr. to Yr. (Dollars in millions) Percent For the three months ended June 30: 2014 2013 Change Total consolidated expense and other (income) $ 6,804 $ 7,988 (14.8) % Non-operating adjustments: Amortization of acquired intangible assets (94) (88) 7.4 Acquisition-related charges (4) (3) 19.2 Non-operating retirement-related (costs)/income (7) (106) (93.5)Operating (non-GAAP) expense and other (income) $ 6,699 $ 7,791 (14.0) % Total consolidated expense-to-revenue ratio 27.9 % 32.0 % (4.1) pts. Operating (non-GAAP) expense-to-revenue ratio 27.5 % 31.3 % (3.8) pts. Yr. to Yr. (Dollars in millions) Percent For the six months ended June 30: 2014 2013 Change Total consolidated expense and other (income) $ 14,367 $ 15,060 (4.6) % Non-operating adjustments: Amortization of acquired intangible assets (186) (177) 4.7 Acquisition-related charges (10) (13) (21.6) Non-operating retirement-related (costs)/income (77) (226) (65.8) Operating (non-GAAP) expense and other (income) $ 14,094 $ 14,644 (3.8) % Total consolidated expense-to-revenue ratio 30.7 % 31.2 % (0.5) pts. Operating (non-GAAP) expense-to-revenue ratio 30.1 % 30.3 % (0.2) pts. Total expense and other (income) decreased 14.8 percent in the second quarter and decreased 4.6 percent in the first six months of 2014 compared to the prior year periods. Total operating (non-GAAP) expense and other (income) decreased 14.0 percent in the second quarter and decreased 3.8 percent in the first six months of 2014 compared to the second quarter and first six months of 2013, respectively. The key drivers of the year-to-year change in total expense and other (income) were approximately: Total Consolidated Operating (non-GAAP) For the three and six months ended June 30, 2014: Three Months Six Months Three Months Six Months Currency* 1 pt. 1 pt. 1 pt. 1 pt. Acquisitions** 2 pts. 2 pts. 2 pts. 2 pts. Base expense (18) pts. (7) pts. (17) pts. (6) pts. * Reflects impacts of translation and hedging programs. ** Includes acquisitions completed in prior 12-month period; operating (non-GAAP) is net of non-operating acquisition-related charges. For additional information regarding total expense and other (income) for both expense presentations, see the following analyses by category. 64-------------------------------------------------------------------------------- Management Discussion - (continued) Selling, general and administrative expense Yr. to Yr. (Dollars in millions) Percent For the three months ended June 30: 2014 2013 Change Selling, general and administrative expense: Selling, general and administrative - other $ 4,813 $ 4,850 (0.8) % Advertising and promotional expense 347 348 (0.4) Workforce rebalancing charges 11 1,011 (98.9) Retirement-related costs 171 244 (29.8) Amortization of acquired intangible assets 94 88 7.4 Stock-based compensation 100 115 (13.3) Bad debt expense 67 24 181.1 Total consolidated selling, general and administrative expense $ 5,603 $ 6,680 (16.1) % Non-operating adjustments: Amortization of acquired intangibles assets (94) (88) 7.4 Acquisition-related charges (4) (3) 30.8 Non-operating retirement-related (costs)/income (27) (93) (71.1) Operating (non-GAAP) selling, general and administrative expense $ 5,478 $ 6,496 (15.7) % Yr. to Yr. (Dollars in millions) Percent For the six months ended June 30: 2014 2013 Change Selling, general and administrative expense: Selling, general and administrative - other $ 9,425 $ 9,609 (1.9) % Advertising and promotional expense 685 671 2.0 Workforce rebalancing charges 883 1,030 (14.3) Retirement-related costs 403 509 (20.8) Amortization of acquired intangible assets 186 177 4.7 Stock-based compensation 188 214 (12.0) Bad debt expense 122 47 161.3 Total consolidated selling, general and administrative expense $ 11,892 $ 12,257 (3.0) % Non-operating adjustments: Amortization of acquired intangibles assets (186) (177) 4.7 Acquisition-related charges (10) (6) 72.9 Non-operating retirement-related (costs)/income (114) (197) (42.0) Operating (non-GAAP) selling, general and administrative expense $ 11,583 $ 11,878 (2.5) % Total Selling, general and administrative (SG&A) expense decreased 16.1 percent (16 percent adjusted for currency) in the second quarter of 2014 versus the second quarter of 2013. The decrease was primarily driven by lower base expense (18 points), partially offset by acquisition-related spending (2 points). Operating (non-GAAP) SG&A expense decreased 15.7 percent (16 percent adjusted for currency) primarily driven by lower base expense (17 points), partially offset by acquisition-related spending (2 points). Base expense includes workforce rebalancing charges in the second quarter of 2013 of $1,011 million. Normalized for the workforce rebalancing charges, operating (non-GAAP) SG&A base expense decreased 2 points year to year compared to the 17 point decrease above. Bad debt expense increased $43 million year to year driven by specific provision additions. SG&A expense decreased 3.0 percent (2 percent adjusted for currency) in the first six months of 2014 versus the first six months of 2013. The decrease was primarily driven by lower base expense (4 points) and the effects of currency (1 point), partially offset by acquisition-related spending (2 points). Operating (non-GAAP) SG&A expense decreased 2.5 percent (2 percent adjusted for currency) primarily driven by lower base expense (3 points) and the effects of currency (1 point), partially offset by acquisition-related spending (2 points). Workforce rebalancing charges in the first six months of 2014 were $883 million, a decrease of $147 million year to year, which resulted in a 1 point year-to-year improvement in the operating (non-GAAP) SG&A base performance. Normalized for the workforce rebalancing charges in both six-month periods, operating (non-GAAP) SG&A base expense decreased 2 points year to year compared to the 3 point decrease above. Bad debt expense increased $75 million year to year driven by specific provision additions. The receivables provision coverage 65-------------------------------------------------------------------------------- |