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MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 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 September 30: 2014 2013** Change Revenue $ 22,397 $ 23,338 (4.0) %* Gross profit margin 48.6 % 49.0 % (0.4) pts. Total expense and other (income) $ 6,513 $ 6,458 0.9 % Total expense and other (income)-to-revenue ratio 29.1 % 27.7 % 1.4 pts. Provision for income taxes from continuing operations $ 906 $ 832 8.8 % Income from continuing operations $ 3,455 $ 4,139 (16.5) % Income from continuing operations margin 15.4 % 17.7 % (2.3) pts. Loss from discontinued operations, net of tax $ (3,437) $ (98) nm % Net income $ 18 $ 4,041 (99.6) % Earnings per share from continuing operations: Assuming dilution $ 3.46 $ 3.77 (8.2) % Basic $ 3.48 $ 3.79 (8.2) % Consolidated earnings per share - assuming dilution $ 0.02 $ 3.68 (99.5) % Weighted-average shares outstanding: Assuming dilution 997.7 1,098.8 (9.2) % Basic 991.8 1,090.9 (9.1) % * 3.6 percent decrease adjusted for currency ** Reclassified to reflect discontinued operations presentation. nm - not meaningful 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 page 77 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 from continuing operations is a non-GAAP measure that excludes the effects of certain acquisition-related charges and retirement-related costs, and their related tax impacts. Operating earnings from continuing operations excludes discontinued operations. 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. 48 -------------------------------------------------------------------------------- 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. 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 third quarter of 2014 and 2013. Yr. to Yr. (Dollars in millions except per share amounts) Percent For the three months ended September 30: 2014 2013** Change Net income as reported $ 18 $ 4,041 (99.6) % Loss from discontinued operations, net of tax (3,437) (98) nm Income from continuing operations $ 3,455 $ 4,139 (16.5) % Non-operating adjustments (net of tax): Acquisition-related charges 159 166 (3.8) Non-operating retirement-related costs/(income) 57 181 (68.4) Operating (non-GAAP) earnings* $ 3,671 $ 4,485 (18.2) % Diluted operating (non-GAAP) earnings per share $ 3.68 $ 4.08 (9.8) % * See page 86 for a more detailed reconciliation of net income to operating earnings. ** Reclassified to reflect discontinued operations presentation. nm - not meaningful Financial Performance Summary: In the third quarter of 2014, the company reported $22.4 billion in revenue and delivered diluted earnings per share from continuing operations of $3.46 as reported and $3.68 on an operating (non-GAAP) basis. The results of continuing operations exclude a net loss from discontinued operations of $3.4 billion related to the announced divestiture of the company's Microelectronics business (see pages 37 and 38 for additional information on the transaction). On a consolidated basis, net income in the third quarter was $18 million, with diluted earnings per share of $0.02. The company generated $3.9 billion in cash from operations and $2.2 billion in free cash flow in the third quarter driving shareholder returns of $2.8 billion in gross common stock repurchases and dividends. The financial results in the third quarter fell short of the company's expectations driven by three primary factors. First, Software revenue was weaker than expected resulting from some sales execution issues. In addition, the company has made it easier for clients to manage their software capacity across new and more traditional workloads as clients invest in the company's platform over the longer term. Second, the company did not get the productivity required in the Global Services business which impacted both profit and margin in the quarter. Third, the environment, including currency, impacted the results. Currency rates moved sharply in September, which resulted in some impact in the third quarter, and the company expects currency to have a larger impact going forward. Additionally, overall, the company experienced delays in client decision-making in September, which had a particular impact in the quarter given the skew of the company's transactional business. For some time now, the company has been clear about its strategic direction and its actions to address the market shifts around data, cloud and engagement. Throughout 2014, the company has been launching initiatives and making significant investments to drive this shift. The company has been successful, with strong revenue growth in its strategic imperatives, and that continued in the third quarter with the strategic imperatives again delivering double-digit revenue growth. However, some of the fundamental shifts in the industry are happening faster than the company planned. As a result, the company is putting in place a series of actions to accelerate its transformation: † First, the company is continuing to remix to higher value. The company took a bold step in its transformation with the announced divestiture of the Microelectronics business to GLOBALFOUNDRIES. The agreement leverages the strengths of each company - IBM's semiconductor and material science research, development capabilities and leadership in high end systems, and GLOBALFOUNDRIES' leadership in advanced technology manufacturing at scale and commitment to delivering future semiconductor technologies. With GLOBALFOUNDRIES operating at scale, the company will receive supply at market-based pricing for the long term, and the company will exit a 49-------------------------------------------------------------------------------- Management Discussion - (continued) business that was not only capital intensive but also operating at a loss. In January, the company announced the sale of its industry standard server business to Lenovo, and on October 1, 2014, the company completed the initial closing of this transaction. In 2013, this was a $4.6 billion business with effectively no annual profit. With the transaction, the company and Lenovo have formed a strategic alliance which includes an agreement for Lenovo to resell selected IBM storage and software products. To ensure a smooth transition for its clients, the company will provide related maintenance on Lenovo's behalf. The company will continue to remix its portfolio, by investing in higher value areas and making decisions on businesses that no longer support its high value strategy. † Second, the company is implementing changes that will make it easier for clients to consume its capabilities and innovations and increase its agility. The company is creating vertically integrated units to address key growth areas. Similar to the action taken with Watson earlier in 2014, the company is creating a dedicated business unit for Cloud, and other integrated units to address growth areas like security and smarter commerce. These actions will enable more focused investment, and will improve integration and speed in bringing solutions to the market and to the company's clients. To provide more flexibility to clients in the way that they purchase the company's software, the company is accelerating investments to make its software more directly consumable through digital channels. As a result, the company will have an end-to-end digital sales and marketing channel which will improve its reach. † Third, the company is taking additional actions to simplify its structure and accelerate productivity. For example, to improve productivity in Global Services while providing greater value and innovation to clients, the company will accelerate the use of automation in its data centers and be more aggressive in the use of its global delivery skills and intellectual property across the service lines. These actions will have an impact on the company's financial model. In the near term, revenue will be down but margin will improve, as the divestitures announced and closed in 2014 represented approximately $7 billion of annual 2013 revenue and pre-tax losses of approximately $500 million. These actions also allow spending and capital to be reinvested to areas that will accelerate the transformation and allow for continued strong returns to shareholders through dividends and share repurchases. All of these actions are consistent with the company's strategic direction, and while there are impacts in the short term, they improve the company's position for the long term. In the third quarter, total consolidated revenue decreased 4.0 percent, 3.6 percent at constant currency. Adjusting for the divested customer care business, revenue decreased 2 percent at constant currency. From a segment perspective, Global Services revenue declined 2.7 percent (2 percent adjusted for currency); adjusting for the divested customer care business, Global Services revenue was flat at constant currency. Global Technology Services (GTS) revenue decreased 2.9 percent (2 percent adjusted for currency); adjusting for the divested customer care business, GTS revenue increased 1 percent at constant currency driven by the large outsourcing contracts signed in 2013. Global Business Services (GBS) decreased 2.2 percent (1 percent adjusted for currency). Software revenue decreased 1.6 percent (2 percent adjusted for currency), with middleware essentially flat (down 1 percent adjusted for currency). Systems and Technology revenue decreased 15.0 percent (15 percent adjusted for currency) and reflected the product cycle impact in System z and declines in Power Systems, Storage and System x. From a geographic perspective, revenue in the major markets declined 3.4 percent as reported and 3 percent adjusted for currency, a 2 point sequential deceleration from the second quarter at constant currency. Revenue in the growth markets declined 5.6 percent as reported and 5 percent adjusted for currency, a 1 point sequential deceleration from the second quarter at constant currency. Within the growth markets, the BRIC countries (Brazil, Russia, India and China) decreased 6.9 percent as reported and 7 percent at constant currency. The consolidated gross profit margin decreased 0.4 points versus the third quarter of 2013 to 48.6 percent. The operating (non-GAAP) gross margin of 49.2 percent decreased 0.9 points year to year driven primarily by weak hardware performance and insufficient productivity in services. The Systems & Technology gross margin declined 5.9 points year to year due to a combination of lower margins across the brands and a mix away from the higher margin System z due to the product cycle. GTS realized savings from the workforce rebalancing action taken earlier in 2014 and continues to make investments in capacity and skills. However, GTS did not deliver planned base productivity and the transition of some new contracts took 50 -------------------------------------------------------------------------------- Management Discussion - (continued) longer than expected. In GBS, the company had strong growth with good margin performance in the strategic imperatives, however, in the more traditional back office implementations the company continues to see price pressure. Total expense and other (income) increased 0.9 percent in the third quarter of 2014 compared to the prior year. Total operating (non-GAAP) expense and other (income) increased 2.3 percent year to year. The company has been shifting its spending to drive the strategic imperatives and differentiated offerings. With the actions being taken, the shift in base spending will accelerate. The year-to-year drivers were approximately: Total Operating Consolidated (non-GAAP) Currency* 1 pt. 1 pt. Acquisitions ** 2 pts. 2 pts. Base expense (1) pt. 0 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 items that had an impact on total expense and other (income) year to year. Bad debt expense increased $72 million year to year in the third quarter. The company has a performance-based compensation structure, and as a result of the business not performing as expected, the accrual for 2014 performance-based compensation in the third quarter is down relative to the first half of 2014. However, the reduction in the third quarter of 2014 was not as substantial as the reduction in the third-quarter of 2013. As a result, performance-based compensation across both cost and expense was up approximately $230 million year to year. Pre-tax income from continuing operations of $4,361 million decreased 12.3 percent year to year and the pre-tax margin was 19.5 percent, a decrease of 1.8 points versus the third quarter of 2013. The continuing operations effective tax rate for the third quarter was 20.8 percent, an increase of 4.0 points year to year. Income from continuing operations of $3,455 million decreased 16.5 percent year to year and the loss from discontinued operations, net of tax, was $3,437 million in the third quarter of 2014 compared to $98 million in the third quarter of 2013. Net income of $18 million decreased $4,023 million year to year. Operating (non-GAAP) pre-tax income from continuing operations decreased 14.9 percent year to year and the operating (non-GAAP) pre-tax margin was 20.7 percent, a decrease of 2.6 points year to year. Operating (non-GAAP) income from continuing operations decreased 18.2 percent and the operating (non-GAAP) income margin of 16.4 percent decreased 2.8 points compared to the prior year. The operating (non-GAAP) effective tax rate from continuing operations was 20.8 percent versus 17.6 percent in the third quarter of 2013. Diluted earnings per share from continuing operations of $3.46 decreased 8.2 percent year to year. Operating (non-GAAP) diluted earnings per share of $3.68 decreased 9.8 percent versus the third quarter of 2013. Diluted earnings per share from discontinued operations was ($3.44) compared to ($0.09) in the third quarter of 2013. In the third quarter, the company repurchased 9.1 million shares of its common stock. The company generated $3,904 million in cash flow provided by operating activities, an increase of $145 million compared to the third quarter of 2013, driven primarily by lower workforce rebalancing payments ($431 million), partially offset by a higher level of cash tax payments ($332 million). Net cash used in investing activities of $800 million decreased $1,748 million compared to the prior year, primarily due to decreased spending for acquisitions ($2,336 million). Net cash used in financing activities of $2,820 million increased $1,993 million compared to the prior year, primarily due to lower net debt issuances. In summary, the company is taking actions to make it easier for clients to do business with it, including creating vertically integrated units to address key growth areas and making its software more consumable through digital channels. Additional actions are being taken to drive more productivity and increase the agility of the company. While the company is continuing to invest to shift to higher value areas, it is also aggressively moving away from the businesses that do not fit its strategic portfolio. The sale of the industry standard server business and the announced divestiture of the Microelectronics business are the two most recent examples. All of these actions support the company's shift to higher value. For the full year 2013, the company reported $14.94 in diluted earnings per share. Reclassified to reflect discontinued operations, full-year 2013 diluted earnings per share from continuing operations was $15.30, and diluted earnings per share 51 -------------------------------------------------------------------------------- Management Discussion - (continued) from discontinued operations was $(0.36). The loss from discontinued operations, net of tax, in 2013 was $398 million. Operating (non-GAAP) earnings per share, on a continuing operations basis, was $16.64 for the full year 2013 versus the previously reported $16.28. See page 88 for a detailed reconciliation of 2013 reclassified net income to operating earnings. In October 2014, the company stated that it is expecting GAAP earnings per share from continuing operations to be flat to down 2 percent for the full year 2014 compared to $15.30 in the prior year. The company also stated that it expects operating (non-GAAP) earnings, on a continuing operations basis, to be down 2 percent to down 4 percent for the full year 2014 compared to $16.64 in the prior year. See the Looking Forward section on page 76 for additional information regarding the company's expectations. Financial Results Summary: Yr. to Yr. Percent/ (Dollars in millions except per share amounts) Margin For the nine months ended September 30: 2014 2013** Change Revenue $ 68,680 $ 70,982 (3.2) %* Gross profit margin 48.8 % 48.4 % 0.5 pts. Total expense and other (income) $ 20,654 $ 21,205 (2.6) % Total expense and other (income)-to-revenue ratio 30.1 % 29.9 % 0.2 pts. Provision for income taxes from continuing operations $ 2,655 $ 2,478 7.1 % Income from continuing operations $ 10,237 $ 10,665 (4.0) % Income margin from continuing operations 14.9 % 15.0 % (0.1) pts. Loss from discontinued operations, net of tax $ (3,698) $ (366) nm % Net income $ 6,539 $ 10,299 (36.5) % Earnings per share from continuing operations: Assuming dilution $ 10.09 $ 9.60 5.1 % Basic $ 10.15 $ 9.68 4.9 % Consolidated earning per share - assuming dilution $ 6.44 $ 9.27 (30.5) % Weighted-average shares outstanding: Assuming dilution 1,014.9 1,110.7 (8.6) % Basic 1,008.9 1,101.8 (8.4) % 9/30/14 12/31/13 Assets $ 118,911 $ 126,223 (5.8) % Liabilities $ 104,515 $ 103,294 1.2 % Equity $ 14,395 $ 22,929 (37.2) % * 2.7 percent decrease adjusted for currency ** Reclassified to reflect discontinued operations presentation. nm - not meaningful The following table provides the company's (non-GAAP) operating earnings for the first nine months of 2014 and 2013. Yr. to Yr. (Dollars in millions except per share amounts) Percent For the nine months ended September 30: 2014 2013** Change Net income as reported $ 6,539 $ 10,299 (36.5) % Loss from discontinued operations, net of tax (3,698) (366) nm Income from continuing operations $ 10,237 $ 10,665 (4.0) % Non-operating adjustments (net of tax): Acquisition-related charges 483 479 1.0 Non-operating retirement-related costs/(income) 197 564 (65.1) Operating (non-GAAP) earnings* $ 10,917 $ 11,708 (6.8) % Diluted operating (non-GAAP) earnings per share $ 10.76 $ 10.54 2.1 % * See page 87 for a more detailed reconciliation of net income to operating earnings. ** Reclassified to reflect discontinued operations presentation. nm - not meaningful 52 -------------------------------------------------------------------------------- Management Discussion - (continued) Financial Performance Summary: In the first nine months of 2014, the company reported revenue of $68.7 billion, income from continuing operations of $10,237 million and diluted earnings per share from continuing operations of $10.09 as reported and $10.76 on an operating (non-GAAP) basis. The results of continuing operations exclude a net loss from discontinued operations of $3,698 million in the first nine months of 2014 and $366 million in the first nine months of 2013. The company generated $10.8 billion in cash from operations and $5.8 billion in free cash flow in the first nine months of 2014 driving shareholder returns of $16.7 billion in gross common stock repurchases and dividends. Total consolidated revenue decreased 3.2 percent (3 percent adjusted for currency) compared to the first nine months of 2013. Adjusting for the divested customer care business, revenue decreased 2 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. Revenue in the strategic imperatives was up double digits in the first nine months of 2014 with approximately half of the content in software. Business analytics revenue increased 8 percent with the strongest growth coming from GBS. This is a large business for the company with revenues in 2013 of nearly $16 billion. The company has a broad analytics portfolio that helps clients to extract value from their data. Cloud revenue was up over 50 percent year to year. The delivered as-a-service component was up over 80 percent and exited the third quarter with an annual run rate of $3.1 billion. The company's cloud portfolio supports the full scope of enterprise client cloud requirements, including solutions for private, hybrid and public clouds. In engagement, mobile revenue more than doubled year to year, social offerings returned to growth, with double-digit growth in the third quarter, and security revenue was up over 20 percent. This was the 8thconsecutive quarter of double-digit growth in security. The company continues to launch initiatives and make significant investments to drive the shift toward the strategic imperatives. For example: † Earlier in 2014, the company created a Watson unit and committed $1 billion to bring Watson's cognitive capabilities to the enterprise, and † The company launched Bluemix; is globally expanding SoftLayer's cloud data centers; and, formed a partnership with Apple for enterprise mobility. From a segment perspective, Software revenue was flat year to year as reported and at constant currency. Middleware revenue increased 2.1 percent (2 percent adjusted for currency). Global Services revenue declined 2.0 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 2.3 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 1.3 percent as reported, flat adjusted for currency. Systems and Technology revenue decreased 16.0 percent (16 percent adjusted for currency). On a geographic basis, revenue in the growth markets declined 7.7 percent (5 percent adjusted for currency) and the major markets declined 1.7 percent (2 percent adjusted for currency). The consolidated gross margin of 48.8 percent improved 0.5 points year to year. The operating (non-GAAP) gross margin of 49.5 percent was flat compared to the prior year. An improved mix toward Software was offset by a margin decline in Systems and Technology. Total expense and other (income) decreased 2.6 percent in the first nine months of 2014 compared to the prior year. Total operating (non-GAAP) expense and other (income) decreased 1.5 percent compared to the first nine 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 (5) pts. (4) 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. 53 -------------------------------------------------------------------------------- Management Discussion - (continued) There were several significant items that had an impact on total expense and other (income) year to year. Workforce rebalancing charges for the first nine months of 2014 were $894 million compared to $1,015 million in the prior year. In addition, the company recorded pre-tax gains of $365 million in the first nine months of 2014 related to divestitures, including $212 million related to the divestiture of the customer care outsourcing business. Bad debt expense increased $148 million year to year driven by specific provision additions. The receivables provision coverage was 2.2 percent at September 30, 2014, an increase of 60 basis points from December 31, 2013 and 60 basis points from September 30, 2013. Pre-tax income from continuing operations decreased 1.9 percent year to year and the pre-tax margin was 18.8 percent, an increase of 0.3 points year to year. The effective tax rate for the first nine months was 20.6 percent, compared with 18.9 percent in the prior year. Income from continuing operations of $10,237 million decreased 4.0 percent and the net income margin was 14.9 percent, a decrease of 0.1 points year to year. Loss from discontinued operations, net of tax, was $3,698 million in the first nine months of 2014 compared to $366 million in the first nine months of 2013. Net income of $6,539 million decreased $3,760 million year to year. Operating (non-GAAP) pre-tax income from continuing operations decreased 5.4 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations declined 0.5 points to 20.0 percent versus the prior year. Operating (non-GAAP) income from continuing operations of $10,917 million decreased 6.8 percent and the operating (non-GAAP) income margin from continuing operations of 15.9 percent decreased 0.6 points. The operating (non-GAAP) effective tax rate from continuing operations for the first nine months was 20.6 percent versus 19.5 percent in 2013. Diluted earnings per share from continuing operations of $10.09 increased 5.1 percent compared to the prior year. Operating (non-GAAP) diluted earnings per share of $10.76 increased 2.1 percent year to year in the first nine months. In the first nine months of 2014, the company repurchased 70.9 million shares of its common stock. At September 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 $9,565 million, a decrease of $1,501 million from December 31, 2013. Key drivers in the balance sheet and total cash flows are: Total assets decreased $7,312 million ($4,029 million adjusted for currency) from December 31, 2013 driven by: † Decreases in total receivables ($5,596 million), property, plant and equipment ($2,753 million) driven primarily by the impairment of the long-lived semiconductor assets ($2,353 million), and cash and cash equivalents ($1,155 million); partially offset by † Increased prepaid pension assets ($1,892 million). Total liabilities increased $1,222 million ($3,905 million adjusted for currency) from December 31, 2013 driven by: † Increases in total debt ($5,979 million) and accruals related to the Microelectronics divestiture ($2,337 million); partially offset by † Decreases in current taxes payable ($2,158 million), deferred income ($1,635 million) and accounts payable ($1,606 million). Total equity of $14,395 million decreased $8,534 million from December 31, 2013 as a result of: † Increased treasury stock ($13,374 million) driven by share repurchases; partially offset by † Higher retained earnings ($3,362 million), higher common stock ($852 million) and decreased losses in accumulated other comprehensive income/(loss) ($623 million). The company generated $10,809 million in cash flow provided by operating activities, a decrease of $148 million compared to the first nine months of 2013, driven primarily by a higher level of cash tax payments ($1,521 million), partially offset by increased cash provided by receivables ($868 million). Net cash used in investing activities of $1,765 million was $2,659 million lower than the first nine months of 2013, primarily due to a decrease in cash used for acquisitions ($1,912 million). Net cash used in financing activities of $9,753 million increased $2,883 million compared to the prior year, driven primarily by increased cash used for gross common stock purchases ($5,485 million), partially offset by higher net cash proceeds from total debt ($3,022 million). 54-------------------------------------------------------------------------------- Management Discussion - (continued) Third Quarter and First Nine Months in Review Results of Continuing Operations Segment Details The following is an analysis of the third quarter and first nine months of 2014 versus the third quarter and first nine 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 September 30: 2014 2013* Change Currency Revenue: Global Technology Services $ 9,218 $ 9,494 (2.9) % (2.2) % Gross margin 38.5 % 39.0 % (0.5) pts. Global Business Services 4,459 4,558 (2.2) % (1.4) % Gross margin 31.3 % 32.9 % (1.6) pts. Software 5,708 5,798 (1.6) % (1.7) % Gross margin 87.6 % 88.0 % (0.4) pts. Systems and Technology 2,434 2,864 (15.0) % (14.8) % Gross margin 33.9 % 39.9 % (5.9) pts. Global Financing 487 502 (3.2) % (3.1) % Gross margin 47.8 % 47.2 % 0.7 pts. Other 92 122 (24.3) % (24.2) % Gross margin (143.8) % (211.6) % (67.8) pts. Total consolidated revenue $ 22,397 $ 23,338 (4.0) % (3.6) % Total consolidated gross profit $ 10,874 $ 11,429 (4.9) % Total consolidated gross margin 48.6 % 49.0 % (0.4) pts. Non-operating adjustments: Amortization of acquired intangible assets 106 101 4.6 % Acquisition-related charges - 1 (100.0) Retirement-related costs/(income) 43 154 (72.2) Operating (non-GAAP) gross profit $ 11,023 $ 11,686 (5.7) % Operating (non-GAAP) gross margin 49.2 % 50.1 % (0.9) pts. * Reclassified to reflect discontinued operations presentation. 55 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent/Margin Adjusted For For the nine months ended September 30: 2014 2013* Change Currency Revenue: Global Technology Services $ 27,962 $ 28,634 (2.3) % (1.3) % Gross margin 38.3 % 37.9 % 0.4 pts. Global Business Services 13,476 13,649 (1.3) % (0.4) % Gross margin 30.4 % 30.9 % (0.5) pts. Software 17,857 17,792 0.4 % 0.2 % Gross margin 88.0 % 88.0 % 0.0 pts. Systems and Technology 7,590 9,041 (16.0) % (16.0) % Gross margin 36.3 % 40.2 % (3.9) pts. Global Financing 1,502 1,488 1.0 % 2.5 % Gross margin 49.6 % 46.4 % 3.2 pts. Other 292 378 (22.8) % (22.1) % Gross margin (162.5) % (185.3) % (22.8) pts. Total consolidated revenue $ 68,680 $ 70,982 (3.2) % (2.7) % Total consolidated gross profit $ 33,545 $ 34,347 (2.3) % Total consolidated gross margin 48.8 % 48.4 % 0.5 pts. Non-operating adjustments: Amortization of acquired intangible assets 315 285 10.6 % Acquisition-related charges - 4 (100.0) Retirement-related costs/(income) 141 474 (70.4) Operating (non-GAAP) gross profit $ 34,001 $ 35,110 (3.2) % Operating (non-GAAP) gross margin 49.5 % 49.5 % 0.0 pts. * Reclassified to reflect discontinued operations presentation. Global Services In the third quarter of 2014, the Global Services segments, Global Technology Services (GTS) and Global Business Services (GBS), delivered revenue of $13,677 million, a decrease of 2.7 percent (2 percent adjusted for currency) compared to the prior year. Normalizing for the divestiture of the customer care business, Global Services revenue decreased 0.5 percent (flat adjusted for currency). Pre-tax income in the third quarter decreased 12.6 percent and the pre-tax margin decreased 1.9 points to 17.7 percent. Total outsourcing revenue of $6,059 million decreased 5.2 percent (4 percent adjusted for currency) when compared to the prior year, and decreased 0.5 percent (flat adjusted for currency) when normalized for the divestiture. Total transactional revenue of $5,874 million decreased 0.3 percent (flat adjusted for currency). In the first nine months of 2014, total Global Services revenue was $41,438 million, a decrease of 2.0 percent (1 percent adjusted for currency) year to year. Normalizing for the divestiture of the customer care business, Global Services revenue decreased 0.1 percent, but increased 1 percent adjusted for currency. Total outsourcing revenue of $18,478 million decreased 5.2 percent (4 percent adjusted for currency), adjusted for the divestiture, revenue decreased 1.1 percent and was flat on a constant currency basis. Total transactional revenue of $17,742 million increased 1.5 percent (2 percent adjusted for currency). 56 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended September 30: 2014 2013 Change Currency Global Services external revenue: $ 13,677 $ 14,052 (2.7) % (2.0) % Global Technology Services $ 9,218 $ 9,494 (2.9) % (2.2) % Outsourcing 5,115 5,377 (4.9) (4.2) Integrated Technology Services 2,359 2,353 0.3 1.2 Maintenance 1,743 1,764 (1.2) (0.7) Global Business Services $ 4,459 $ 4,558 (2.2) % (1.4) % Outsourcing 944 1,016 (7.1) (6.1) Consulting and Systems Integration 3,515 3,542 (0.8) (0.1) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the nine months ended September 30: 2014 2013 Change Currency Global Services external revenue: $ 41,438 $ 42,283 (2.0) % (1.0) % Global Technology Services $ 27,962 $ 28,634 (2.3) % (1.3) % Outsourcing 15,661 16,407 (4.5) (3.6) Integrated Technology Services 7,083 6,917 2.4 3.6 Maintenance 5,218 5,311 (1.7) (0.6) Global Business Services $ 13,476 $ 13,649 (1.3) % (0.4) % Outsourcing 2,817 3,089 (8.8) (7.5) Consulting and Systems Integration 10,659 10,560 0.9 1.7 Global Technology Services revenue of $9,218 million decreased 2.9 percent (2 percent adjusted for currency) in the third quarter of 2014. Normalizing for the divestiture of the customer care business, revenue increased 0.3 percent (1 percent adjusted for currency). GTS revenue decreased 2.3 percent (1 percent adjusted for currency) to $27,962 million in the first nine months of 2014. However, adjusted for the divestiture, revenue increased 0.5 percent (2 percent adjusted for currency). Within GTS, SoftLayer continues to attract new workloads to the platform as its footprint expands. In the third quarter, cloud data centers were opened in London and Toronto, as well as two federal datacenters outside of Dallas and Washington D.C. Cloud capacity was also added in Singapore. GTS Outsourcing grew 0.8 percent (2 percent adjusted for currency) in the third quarter when normalized for the customer care divestiture. That growth was driven by performance from the substantial new contracts brought on during 2013. Global Business Services revenue of $4,459 million decreased 2.2 percent (1 percent adjusted for currency) in the third quarter of 2014 and decreased 1.3 percent (flat adjusted for currency) for the first nine months of the year. Consulting and Systems Integration (C&SI) revenue declined 0.8 percent (flat adjusted for currency) in the third quarter. There was strong double digit growth in the practices that are highly differentiated in the marketplace which address cloud, analytics, mobile and social. This was offset by declines in the areas that are becoming less differentiated such as the more traditional back office implementations. As announced in July, the company has formed a strategic partnership with Apple to deliver a new class of "enterprise ready" MobileFirst business applications for iOS combining mobility and analytics. In the fourth quarter of 2014, the first dozen applications are expected to be launched. Application Outsourcing revenue decreased 7.1 percent (6 percent adjusted for currency) in the third quarter, reflecting modest sequential improvement compared to the second quarter of this year. Performance continues to be impacted by pricing pressure and client renegotiations, as well as a reduction in elective projects. 57 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent/ (Dollars in millions) MarginFor the three months ended September 30: 2014 2013 Change Global Technology Services: External gross profit $ 3,549 $ 3,705 (4.2) % External gross profit margin 38.5 % 39.0 % (0.5) pts. Pre-tax income $ 1,680 $ 1,895 (11.3) % Pre-tax margin 17.7 % 19.4 % (1.7) pts. Global Business Services: External gross profit $ 1,397 $ 1,501 (6.9) % External gross profit margin 31.3 % 32.9 % (1.6) pts. Pre-tax income $ 805 $ 948 (15.0) % Pre-tax margin 17.5 % 20.0 % (2.5) pts. Yr. to Yr. Percent/ (Dollars in millions) Margin For the nine months ended September 30: 2014 2013 Change Global Technology Services: External gross profit $ 10,706 $ 10,842 (1.3) % External gross profit margin 38.3 % 37.9 % 0.4 pts. Pre-tax income $ 4,876 $ 4,994 (2.4) % Pre-tax margin 17.0 % 17.0 % 0.0 pts. Global Business Services: External gross profit $ 4,100 $ 4,220 (2.8) % External gross profit margin 30.4 % 30.9 % (0.5) pts. Pre-tax income $ 2,266 $ 2,274 (0.3) % Pre-tax margin 16.3 % 16.0 % 0.3 pts. GTS gross profit margin decreased 0.5 points in the third quarter but increased 0.4 points for the first nine months of 2014 compared to prior year. In the third quarter, pre-tax income decreased 11.3 percent to $1,680 million and the pre-tax margin declined 1.7 points to 17.7 percent compared to the prior year. While benefits continue from the workforce rebalancing actions earlier this year, these benefits were more than offset in the third quarter. Investments across the portfolio in areas like new resiliency centers, additional security skills and the SoftLayer cloud hub expansion and the lost profit from the divested customer care business have contributed to this performance. Additionally, there was not sufficient productivity in the base, partially due to the large deals signed in 2013 which have lower margins in the early stages and where the transition was not executed as rapidly as expected. GBS gross profit margin decreased 1.6 and 0.5 points in the third quarter and first nine months of 2014, respectively, compared to the prior year. Pre-tax income decreased 15.0 percent to $805 million and the pre-tax margin declined 2.5 points to 17.5 percent in the third quarter. GBS also continued to benefit from the previous workforce rebalancing actions, but this was more than offset by other factors which included the impact of lower revenue on a relatively fixed cost base. In areas where the company has strong differentiation, such as solutions that address the strategic imperatives, there is good growth and gross margin performance. However, in the parts of the portfolio that are not as well differentiated, there is continued price and profit pressure. In these areas, the company will be more aggressive on the use of global delivery centers and in applying intellectual property for faster time to value for its clients and improved business results for the company. Global Services Backlog The estimated Global Services backlog at September 30, 2014 was $128 billion, a decrease of 9.3 percent (5 percent adjusted for currency) compared to the September 30, 2013 balance. This includes a backlog reduction in 2014 of $3.6 billion associated with the customer care divestiture. Adjusting for the divestiture, backlog was down 6.7 percent (2 percent adjusted for currency) year to year. The estimated transactional backlog at September 30, 2014 decreased 3.7 percent (flat adjusted for currency) from the September 30, 2013 levels. The estimated outsourcing backlog decreased 12.3 percent (8 percent adjusted for currency) including the backlog reduction from the customer care divestiture. Adjusting for the divestiture, the estimated outsourcing backlog decreased 8.2 percent (4 percent adjusted for currency) compared to the September 30, 2013 balance. 58 -------------------------------------------------------------------------------- Management Discussion - (continued) Yr. to Yr. Percent Yr. to Yr. Change At September 30, At September 30, Percent Adjusted For (Dollars in billions) 2014 2013 Change Currency Backlog: Total backlog $ 127.9 $ 141.1 (9.3) % (5.0) % adjusted for customer care (6.7) % (2.4) % Outsourcing backlog $ 79.0 $ 90.1 (12.3) % (7.8) % adjusted for customer care (8.2) % (3.6) % 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 September 30: 2014 2013 Change Currency Total signings: $ 11,049 $ 12,340 (10.5) % (9.5) % Outsourcing signings $ 5,032 $ 6,095 (17.4) % (16.8) % Transactional signings 6,017 6,245 (3.7) % (2.5) % Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the nine months ended September 30: 2014 2013 Change Currency Total signings: $ 33,194 $ 45,689 (27.3) % (26.6) % Outsourcing signings $ 15,307 $ 25,729 (40.5) % (39.8) % Transactional signings 17,887 19,960 (10.4) % (9.7) % 59 -------------------------------------------------------------------------------- Management Discussion - (continued) Software Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended September 30: 2014 2013 Change Currency Software external revenue: $ 5,708 $ 5,798 (1.6) % (1.7) % Middleware: $ 4,725 $ 4,745 (0.4) % (0.6) % Key branded middleware: 3,694 3,725 (0.8) (1.0) WebSphere Family 6.7 6.4 Information Management (4.9) (5.0) Workforce Solutions 1.4 0.6 Tivoli 2.5 2.5 Rational (12.3) (12.1) Other middleware 1,031 1,021 1.0 0.9 Operating systems 513 576 (11.0) (11.2) Other 470 476 (1.4) (1.2) Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the nine months ended September 30: 2014 2013 Change Currency Software external revenue: $ 17,857 $ 17,792 0.4 % 0.2 % Middleware: $ 14,921 $ 14,613 2.1 % 1.9 % Key branded middleware: 11,674 11,530 1.2 1.1 WebSphere Family 7.8 7.5 Information Management (1.6) (1.7) Workforce Solutions (3.5) (4.0) Tivoli 4.1 3.8 Rational (7.3) (7.2) Other middleware 3,246 3,083 5.3 5.1 Operating systems 1,562 1,760 (11.3) (11.4) Other 1,375 1,419 (3.1) (3.1) Software revenue of $5,708 million decreased 1.6 percent (2 percent adjusted for currency) in the third quarter and increased 0.4 percent (flat adjusted for currency) to $17,857 million in the first nine months of 2014, respectively. In the third quarter, middleware decreased 0.4 percent (1 percent adjusted for currency) while operating systems were down 11.0 percent (11 percent adjusted for currency). In the third quarter, the company did have solid growth in many of its solution areas, including security, mobile and cloud. In addition, across the software brands, Software-as-a-Service (SaaS) offerings were up nearly 50 percent versus the third quarter of 2013. However, overall software results did not meet the company's expectations. First, there were some sales execution issues. Second, given clients substantial investment in the IBM software platform, the company has been providing more flexibility on how clients deploy its software, and with economics that enable their mobile and social workloads on its platforms. This enables clients to better manage their capacity and commit to the company's platforms for the long term. This will drive higher utilization of the company's middleware as these mobile and social platforms drive additional on-premise workload. Key branded middleware revenue, which accounted for 65 percent of total Software revenue in the third quarter of 2014, decreased 0.8 percent (1 percent adjusted for currency) compared to the prior year. In the first nine months of 2014, key branded middleware grew 1.2 percent (1 percent adjusted for currency) and accounted for 65 percent of total Software revenue. WebSphere revenue increased 6.7 percent (6 percent adjusted for currency) and 7.8 percent (8 percent adjusted for currency) in the third quarter and first nine months of 2014 year to year, respectively. Performance in the third quarter was led by commerce, mobile solutions and business integration offerings. Both on-premise and SaaS offerings contributed to WebSphere growth, with the majority of this growth coming from on-premise solutions. In commerce, there was broad based growth with strong momentum in Commerce-as-a-Service which includes recent acquisitions like Silverpop and Aspera. Across software and services, the company's mobile business more than doubled from the prior year in the third quarter. 60 -------------------------------------------------------------------------------- Management Discussion - (continued) Information Management revenue decreased 4.9 percent (5 percent adjusted for currency) in the third quarter and decreased 1.6 percent (2 percent adjusted for currency) in the first nine months of 2014 compared to the prior year. In the third quarter, performance was impacted by sales execution challenges and some product transitions. Tivoli revenue increased 2.5 percent (3 percent adjusted for currency) in the third quarter and 4.1 percent (4 percent adjusted for currency) in the first nine months of 2014 compared to the prior year periods. Revenue growth in the quarter was driven by security and storage software. Security grew again at a double digit rate, marking its twelfth consecutive quarter of growth with most of those quarters increasing by double digits. Workforce Solutions revenue increased 1.4 percent (1 percent adjusted for currency) in the third quarter and decreased 3.5 percent (4 percent adjusted for currency) in the first nine months of 2014 year to year, respectively. Performance in the quarter included growth in social and collaboration solutions, mitigated by a decline in Notes. Rational revenue decreased 12.3 percent (12 percent adjusted for currency) year to year in the third quarter and decreased 7.3 percent (7 percent adjusted for currency) in the first nine months of 2014. In the third quarter, the brand faced a difficult comparison to strong performance in the prior year. Across software, the company is transitioning its portfolio to capture growth areas, while continuing to drive innovation in its core franchise. In addition, the company will be accelerating investment to make its software more consumable though digital channels. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the three months ended September 30: 2014 2013 Change Software: External gross profit $ 5,001 $ 5,101 (2.0) % External gross profit margin 87.6 % 88.0 % (0.4) pts. Pre-tax income $ 2,333 $ 2,410 (3.2) % Pre-tax margin 35.5 % 36.8 % (1.3) pts. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the nine months ended September 30: 2014 2013 Change Software: External gross profit $ 15,717 $ 15,663 0.3 % External gross profit margin 88.0 % 88.0 % 0.0 pts. Pre-tax income $ 6,935 $ 6,867 1.0 % Pre-tax margin 33.8 % 34.2 % (0.3) pts. The Software gross profit margin decreased 0.4 points to 87.6 percent in the third quarter and was flat at 88.0 percent for the first nine months of 2014 compared to the prior year periods. Software pre-tax income of $2,333 million in the third quarter of 2014 decreased 3.2 percent year to year, with a pre-tax margin of 35.5 percent, a decline of 1.3 points. Segment pre-tax income for the first nine months of 2014 increased 1.0 percent to $6,935 million with a pre-tax margin of 33.8 percent, down 0.3 points year to year. 61 -------------------------------------------------------------------------------- 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 September 30: 2014 2013* Change Currency Systems and Technology external revenue: $ 2,434 $ 2,864 (15.0) % (14.8) % System z (35.0) % (34.6) % Power Systems (12.2) (12.2) System x (9.6) (9.4) Storage (6.3) (5.9) * Reclassified to reflect discontinued operations presentation. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the nine months ended September 30: 2014 2013* Change Currency Systems and Technology external revenue: $ 7,590 $ 9,041 (16.0) % (16.0) % System z (22.0) % (22.2) % Power Systems (21.3) (21.3) System x (10.1) (9.9) Storage (13.7) (13.7) * Reclassified to reflect discontinued operations presentation. Systems and Technology (STG) revenue decreased 15.0 percent (15 percent adjusted for currency) and 16.0 percent (16 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, versus the same periods in 2013. This performance reflects year-to-year declines related to the product cycle of System z as well as declines in Power, Storage and System x. Although both Power and Storage declined compared to the prior year, both brands improved sequentially compared to the second quarter of 2014. The company continues to take significant actions within this business segment. Recently, the company completed the initial closing of the sale of its industry standard server (System x) business to Lenovo, reached an agreement to divest its Microelectronics business to GLOBALFOUNDRIES and introduced the first OpenPOWER based scale-out systems. System z revenue decreased 35.0 percent (35 percent adjusted for currency) and 22.0 percent (22 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. In the ninth quarter of the current product cycle, the company continues to innovate on this platform. For example, the company recently made available new analytics offerings for the mainframe to provide Real-Time Customer Insights. With this, the company added new analytics capabilities to the mainframe platform providing clients with the ability to integrate Hadoop big data. Power Systems revenue decreased 12.2 percent (12 percent adjusted for currency) and 21.3 percent (21 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. This represented a double digit sequential improvement in the year-to-year growth rate compared to the second quarter of this year. The company has repositioned Power Systems. In June, scale-out systems based on POWER8 were introduced and high-end POWER8 based enterprise systems were announced in October. These newly announced systems are highly scalable and can handle the most data intensive, mission critical applications in the industry. In addition, the company saw continued expansion of the OpenPOWER consortium, now with over 60 members. Through the efforts of the consortium members, the company has for the first time introduced a system built on the POWER8 processor that tightly integrates IBM and other OpenPOWER member technologies, including NVIDIA's GPU accelerator technology. System x revenue decreased 9.6 percent (9 percent adjusted for currency) and 10.1 percent (10 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. This is the final quarter before the System x divestiture. Storage revenue decreased 6.3 percent (6 percent adjusted for currency) and 13.7 percent (14 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. The third quarter year-to-year rate was a sequential improvement compared to the 12 percent decrease in the second quarter of this 62-------------------------------------------------------------------------------- Management Discussion - (continued) year. The third quarter again included strong contribution from Flash Systems and the Storwize portfolio. This was more than offset by weakness in high-end disk and the continued wind-down of the legacy OEM business. The company sees the value in the storage business shifting to software, and in the third quarter, storage software revenue grew. The company plans to continue to expand its software defined storage portfolio. Yr. to Yr. Percent/ (Dollars in millions) MarginFor the three months ended September 30: 2014 2013* Change Systems and Technology: External gross profit $ 826 $ 1,142 (27.7) % External gross profit margin 33.9 % 39.9 % (5.9) pts. Pre-tax income $ (99) $ (8) nm % Pre-tax margin (3.8) % (0.3) % (3.5) pts. * Reclassified to reflect discontinued operations presentation. nm - not meaningful Yr. to Yr. Percent/ (Dollars in millions) MarginFor the nine months ended September 30: 2014 2013* Change System and Technology: External gross profit $ 2,752 $ 3,633 (24.2) % External gross profit margin 36.3 % 40.2 % (3.9) pts. Pre-tax income $ (354) $ (133) 167.1 % Pre-tax margin (4.4) % (1.4) % (3.0) pts. * Reclassified to reflect discontinued operations presentation. Systems and Technology's gross profit margin decreased 5.9 points in the third quarter of 2014 versus the prior year. The decrease was driven by lower margins in System x (1.4 points), Power Systems (1.2 points), and Storage (1.1 points), and a decline due to mix (2.3 points), driven by a mix away from higher margin System z due to the product cycle. The gross profit margin for the first nine months of 2014 decreased 3.9 points compared to the first nine months of 2013. The decrease was driven by lower margins in Power Systems (1.4 points), Storage (1.0 points) and System x (0.7 points), and a decline due to revenue mix (1.3 points). Systems and Technology's pre-tax loss increased $91 million to $99 million in the third quarter and its pre-tax loss increased $222 million to $354 million for the first nine months of 2014 compared to prior year periods. Pre-tax margin decreased 3.5 points in the third quarter and decreased 3.0 points in the first nine months versus the prior year periods. Across the Systems and Technology business, the company has taken significant actions to reposition the portfolio and maintain its commitment to driving innovation in its high-end systems and storage. It has committed a $3 billion investment in the next era of chip technology as the company strengthens its semiconductor R&D and systems innovation, with future chip supply coming from an at-scale manufacturer. The company has repositioned Power Systems through creation of POWER8 systems which are built for cloud and big data, and it has also made available the POWER8 architecture through the OpenPOWER consortium to build an open eco-system and an IP offering. Storage is being repositioned to capture value through software defined environments, and the company has divested its low-end industry standard server business. Global Financing See pages 80 through 85 for a discussion of Global Financing's segment results. 63-------------------------------------------------------------------------------- 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. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the three months ended September 30: 2014 2013* Change Currency Total Revenue $ 22,397 $ 23,338 (4.0) % (3.6) % Geographies: $ 22,276 $ 23,186 (3.9) % (3.5) % Americas 10,081 10,305 (2.2) (1.3) Europe/Middle East/Africa (EMEA) 7,173 7,334 (2.2) (3.2) Asia Pacific 5,022 5,547 (9.5) (8.0) Major markets (3.4) % (3.0) % Growth markets (5.6) % (5.2) % BRIC countries (6.9) % (7.0) % * Reclassified to reflect discontinued operations presentation. Yr. to Yr. Percent Yr. to Yr. Change (Dollars in millions) Percent Adjusted For For the nine months ended September 30: 2014 2013* Change Currency Total Revenue $ 68,680 $ 70,982 (3.2) % (2.7) % Geographies: $ 68,336 $ 70,553 (3.1) % (2.6) % Americas 30,320 31,056 (2.4) (0.8) Europe/Middle East/Africa (EMEA) 22,699 22,451 1.1 (1.9) Asia Pacific 15,317 17,046 (10.1) (6.6) Major markets (1.7) % (1.9) % Growth markets (7.7) % (4.8) % BRIC countries (6.6) % (3.8) % * Reclassified to reflect discontinued operations presentation. Total geographic revenue of $22,276 million decreased 3.9 percent (3 percent adjusted for currency) in the third quarter of 2014 compared to the prior year. In total, major market countries decreased 3.4 percent (3 percent adjusted for currency) and growth market countries decreased 5.6 percent (5 percent adjusted for currency) in the third quarter of 2014. These results include the impact of the customer care divestiture which accounted for one point of the decline in the constant currency growth rates for both the major and growth markets. In the month of September, nearly all regions experienced a deceleration and it was most pronounced in the growth markets that have a higher transactional content. Comparing year-to-year performance to the previous quarter, major markets decelerated 3.1 points (2 points adjusted for currency) and growth markets improved 1.2 points, but decelerated 1 point adjusted for currency, in the third quarter. In the growth markets, there was growth in both Latin America and the Middle East and Africa region. On a constant currency basis, revenue grew at a double-digit rate in Latin America, however, the Asia Pacific countries declined at a double-digit rate. Within the BRIC countries of Brazil, Russia, India and China, combined revenue decreased 6.9 percent (7 percent adjusted for currency) in the third quarter. While Brazil grew 13.3 percent (13 percent adjusted for currency), China decreased 19.0 percent (19 percent adjusted for currency), India decreased 4.8 percent (7 percent adjusted for currency), and Russia declined 9.1 percent (6 percent adjusted for currency) on a year-to-year basis. Americas revenue decreased 2.2 percent (1 percent adjusted for currency) compared to the third quarter of 2013. Within the major markets, the U.S. was down 3.4 percent year to year and Canada was down 6.3 percent (2 percent adjusted for currency). The Latin America growth markets increased 9.7 percent as reported (13 percent adjusted for currency) driven by the strong performance in Brazil. 64 -------------------------------------------------------------------------------- Management Discussion - (continued) EMEA revenue decreased 2.2 percent (3 percent adjusted for currency) year to year in the third quarter of 2014. Within the major markets, Germany decreased 0.8 percent (1 percent adjusted for currency), the UK decreased 3.2 percent (10 percent adjusted for currency) and France decreased 10.4 percent (10 percent adjusted for currency) compared to the third quarter of 2013. These decreases were partially offset by year-to-year growth in several of the smaller major market countries with Spain increasing 10.1 percent (10 percent adjusted for currency), Switzerland increasing 4.5 percent (3 percent adjusted for currency), and the Netherlands increasing 4.7 percent (5 percent adjusted for currency). The EMEA growth markets decreased 3.6 percent (2 percent adjusted for currency) driven by declines in Russia and other Eastern European countries, partially offset by growth in the Middle East and Africa region which increased 2.1 percent (4 percent adjusted for currency). Asia Pacific third quarter revenue decreased 9.5 percent (8 percent adjusted for currency) year over year. Japan decreased 5.9 percent (1 percent adjusted for currency). Asia Pacific growth market countries decreased 11.8 percent (13 percent adjusted for currency) compared to the third quarter of 2013. Total geographic revenue of $68,336 million for the first nine months of 2014 decreased 3.1 percent (3 percent adjusted for currency) compared to the prior year. Major markets decreased 1.7 percent (2 percent adjusted for currency) and the growth market countries decreased 7.7 percent (5 percent adjusted for currency) for the first nine months of the year. Within the BRIC countries, combined revenue was down year to year 6.6 percent (4 percent adjusted for currency) driven by China which decreased 16.3 percent (16 percent adjusted for currency). While the company had strength in Latin America during the first nine months 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 nine months of 2014 decreased 2.4 percent (1 percent adjusted for currency) compared to the prior year. The major market countries were down 3.4 percent (3 percent adjusted for currency), partially offset by an increase in the Latin America growth markets of 5.0 percent (12 percent adjusted for currency). Within the major market countries, the U.S. was down 2.6 percent and Canada was down 8.5 percent (2 percent adjusted for currency). Within the Latin America growth market countries, Brazil increased 10.1 percent (16 percent adjusted for currency) and Mexico decreased 3.2 percent (1 percent adjusted for currency). EMEA revenue increased 1.1 percent (decreased 2 percent adjusted for currency) for the first nine months of 2014 compared to the prior year. The major market countries increased 1.7 percent (decreased 2 percent adjusted for currency), while the growth market countries decreased 3.5 percent (2 percent adjusted for currency). In the major market countries, Germany increased 7.5 percent (4 percent adjusted for currency), Italy increased 4.8 percent (2 percent adjusted for currency), the UK decreased 3.1 percent (10 percent adjusted for currency) and France decreased 6.0 percent (9 percent adjusted for currency). Asia Pacific revenue decreased 10.1 percent (7 percent adjusted for currency) year to year for the first nine months of 2014. Japan decreased 5.2 percent as reported, but increased 1 percent on a constant currency basis. The Asia Pacific growth markets decreased 13.4 percent (12 percent adjusted for currency). Geographic revenue results in future quarters will reflect the industry standard server divestiture which is expected to impact major markets by approximately 3 points and growth markets by approximately 9 points. Reporting of the Microelectronics business as a discontinued operation will adjust the OEM revenue, but have no impact on geographic results. 65 -------------------------------------------------------------------------------- Management Discussion - (continued) Expense Total Expense and Other (Income) Yr. to Yr. (Dollars in millions) Percent For the three months ended September 30: 2014 2013* Change Total consolidated expense and other (income) $ 6,513 $ 6,458 0.9 % Non-operating adjustments: Amortization of acquired intangible assets (96) (100) (4.0) Acquisition-related charges 0 (12) (97.3) Non-operating retirement-related (costs)/income (29) (103) (72.4) Operating (non-GAAP) expense and other (income) $ 6,389 $ 6,243 2.3 % Total consolidated expense-to-revenue ratio 29.1 % 27.7 % 1.4 pts. Operating (non-GAAP) expense-to-revenue ratio 28.5 % 26.8 % (1.8) pts. * Reclassified to reflect discontinued operations presentation. Yr. to Yr. (Dollars in millions) Percent For the nine months ended September 30: 2014 2013* Change Total consolidated expense and other (income) $ 20,654 $ 21,205 (2.6) % Non-operating adjustments: Amortization of acquired intangible assets (281) (277) 1.6 Acquisition-related charges (10) (25) (58.7) Non-operating retirement-related (costs)/income (106) (329) (67.9) Operating (non-GAAP) expense and other (income) $ 20,257 $ 20,574 (1.5) % Total consolidated expense-to-revenue ratio 30.1 % 29.9 % (0.2) pts. Operating (non-GAAP) expense-to-revenue ratio 29.5 % 29.0 % (0.5) pts. * Reclassified to reflect discontinued operations presentation. Total expense and other (income) increased 0.9 percent in the third quarter and decreased 2.6 percent in the first nine months of 2014 compared to the prior year periods. Total operating (non-GAAP) expense and other (income) increased 2.3 percent in the third quarter and decreased 1.5 percent in the first nine months of 2014 compared to the third quarter and first nine 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 nine months ended September 30, 2014: Three Months Nine Months Three Months Nine Months Currency* 1 pt. 1 pt. 1 pt. 1 pt. Acquisitions** 2 pts. 2 pts. 2 pts. 2 pts. Base expense (1) pt. (5) pts. 0 pts. (4) 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. 66-------------------------------------------------------------------------------- Management Discussion - (continued) Selling, general and administrative expense Yr. to Yr. (Dollars in millions) Percent For the three months ended September 30: 2014 2013* Change Selling, general and administrative expense: Selling, general and administrative - other $ 4,472 $ 4,463 0.2 % Advertising and promotional expense 306 300 2.1 Workforce rebalancing charges 15 18 (15.9) Retirement-related costs 186 239 (22.0) Amortization of acquired intangible assets 96 100 (4.0) Stock-based compensation 105 110 (5.2) Bad debt expense 102 30 241.4 Total consolidated selling, general and administrative expense $ 5,281 $ 5,260 0.4 % Non-operating adjustments: Amortization of acquired intangibles assets (96) (100) (4.0) Acquisition-related charges 0 (11) (97.0) Non-operating retirement-related (costs)/income (48) (89) (46.6) Operating (non-GAAP) selling, general and administrative expense $ 5,137 $ 5,060 1.5 % * Reclassified to reflect discontinued operations presentation. Yr. to Yr. (Dollars in millions) Percent For the nine months ended September 30: 2014 2013* Change Selling, general and administrative expense: Selling, general and administrative - other $ 13,879 $ 14,057 (1.3) % Advertising and promotional expense 991 971 2.1 Workforce rebalancing charges 894 1,015 (11.9) Retirement-related costs 584 742 (21.3) Amortization of acquired intangible assets 281 277 1.6 Stock-based compensation 293 324 (9.7) Bad debt expense 224 77 192.4 Total consolidated selling, general and administrative expense $ 17,146 $ 17,463 (1.8) % Non-operating adjustments: Amortization of acquired intangibles assets (281) (277) 1.6 Acquisition-related charges (10) (17) (40.1) Non-operating retirement-related (costs)/income (162) (286) (43.4) Operating (non-GAAP) selling, general and administrative expense $ 16,693 $ 16,884 (1.1) % * Reclassified to reflect discontinued operations presentation. Total Selling, general and administrative (SG&A) expense increased 0.4 percent (1 percent adjusted for currency) in the third quarter of 2014 versus the third quarter of 2013. The increase was primarily driven by acquisition-related spending (1 point), offset by lower base expense (1 point). Operating (non-GAAP) SG&A expense increased 1.5 percent (2 percent adjusted for currency) primarily driven by acquisition-related spending (1 point) and higher base expense (1 point). Bad debt expense increased $72 million year to year driven by specific provision additions. SG&A expense decreased 1.8 percent (1 percent adjusted for currency) in the first nine months of 2014 versus the first nine months of 2013. The decrease was primarily driven by lower base expense (3 points) and the effects of currency (1 point), partially offset by acquisition-related spending (2 points). Operating (non-GAAP) SG&A expense decreased 1.1 percent (1 percent adjusted for currency) primarily driven by lower base expense (2 points) and the effects of currency (1 point), partially offset by acquisition-related spending (2 points). Workforce rebalancing charges in the first nine months of 2014 were $894 million, a decrease of $121 million year to year, which resulted in a 1 point year-to-year improvement in the operating (non-GAAP) SG&A base performance. Bad debt expense increased $148 million year to year driven by specific provision additions. The receivables provision coverage was 2.2 percent at September 30, 2014, an increase of 60 basis points from year-end 2013 and 60 basis points from September 30, 2013. 67-------------------------------------------------------------------------------- |