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International Business Machines 10-Q 2008

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10 - Q

 

QUARTERLY REPORT

PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED MARCH 31, 2008

 

1-2360

(Commission file number)

 

INTERNATIONAL BUSINESS MACHINES CORPORATION

(Exact name of registrant as specified in its charter)

 

New York

 

13-0871985

(State of incorporation)

 

(IRS employer identification number)

 

 

 

Armonk, New York

 

10504

(Address of principal executive offices)

 

(Zip Code)

 

 

 

914-499-1900

 

 

 

 

(Registrant’s telephone number)

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.         Yes x        No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

Smaller reporting company o

 

 

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

 

The registrant has 1,373,478,587 shares of common stock outstanding at March 31, 2008.

 

 



 

Index

 

 

Page

 

 

PART I - Financial Information:

1

 

 

ITEM 1. Consolidated Financial Statements

1

 

 

Consolidated Statement of Earnings for the three months ended March 31, 2008 and 2007

1

 

 

Consolidated Statement of Financial Position at March 31, 2008 and December 31, 2007

3

 

 

Consolidated Statement of Cash Flows for the three months ended March 31, 2008 and 2007

5

 

 

Notes to Consolidated Financial Statements

6

 

 

ITEM 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

19

 

 

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

43

 

 

ITEM 4. Controls and Procedures

43

 

 

PART II - Other Information:

43

 

 

ITEM 1. Legal Proceedings

43

 

 

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities

44

 

 

ITEM 5. Other Information

44

 

 

ITEM 6. Exhibits

45

 



 

PART I - Financial Information

 

ITEM 1. Consolidated Financial Statements:

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS
(UNAUDITED)

 

(Dollars in millions except

 

Three Months Ended
March 31,

 

per share amounts)

 

2008

 

2007

 

Revenue:

 

 

 

 

 

Services

 

$

14,574

 

$

12,423

 

Sales

 

9,288

 

8,985

 

Financing

 

640

 

621

 

Total revenue

 

24,502

 

22,029

 

 

 

 

 

 

 

Cost:

 

 

 

 

 

Services

 

10,348

 

9,050

 

Sales

 

3,674

 

3,809

 

Financing

 

314

 

304

 

Total cost

 

14,336

 

13,163

 

 

 

 

 

 

 

Gross profit

 

10,166

 

8,866

 

 

 

 

 

 

 

Expense and other income:

 

 

 

 

 

Selling, general and administrative

 

5,620

 

5,089

 

Research, development and engineering

 

1,569

 

1,509

 

Intellectual property and custom development income

 

(274

)

(205

)

Other (income) and expense

 

(125

)

(180

)

Interest expense

 

178

 

73

 

Total expense and other income

 

6,968

 

6,287

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

3,198

 

2,579

 

Provision for income taxes

 

879

 

735

 

 

 

 

 

 

 

Income from continuing operations

 

2,319

 

1,844

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

1



 

(Dollars in millions except

 

Three Months Ended
March 31,

 

per share amounts)

 

2008

 

2007

 

Discontinued operations:

 

 

 

 

 

Income from discontinued operations, net of tax

 

 

00

 

Net income

 

$

2,319

 

$

1,844

 

 

 

 

 

 

 

Earnings per share of common stock:

 

 

 

 

 

Assuming dilution

 

 

 

 

 

Continuing operations

 

$

1.65

 

$

1.21

 

Discontinued operations

 

 

0.00

 

Total

 

$

1.65

 

$

1.21

 

 

 

 

 

 

 

Basic

 

 

 

 

 

Continuing operations

 

$

1.68

 

$

1.23

 

Discontinued operations

 

 

0.00

 

Total

 

$

1.68

 

$

1.23

 

 

 

 

 

 

 

Weighted-average number of common shares outstanding: (millions)

 

 

 

 

 

Assuming dilution

 

1,404.3

 

1,522.8

 

Basic

 

1,383.0

 

1,499.5

 

Cash dividends per common share

 

$

0.40

 

$

0.30

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

2



 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION
(UNAUDITED)

 

ASSETS

 

 

 

At March 31,

 

At December 31,

 

(Dollars in millions)

 

2008

 

2007

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

10,786

 

$

14,991

 

Marketable securities

 

1,241

 

1,155

 

Notes and accounts receivable — trade (net of allowances of $237 in 2008 and $241 in 2007)

 

11,092

 

11,428

 

Short-term financing receivables (net of allowances of $307 in 2008 and $296 in 2007)

 

14,743

 

16,289

 

Other accounts receivable (net of allowances of $13 in 2008 and 2007)

 

1,059

 

1,072

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

752

 

668

 

Work in process and raw materials

 

2,224

 

1,996

 

Total inventories

 

2,977

 

2,664

 

Deferred taxes

 

2,072

 

1,687

 

Prepaid expenses and other current assets

 

4,456

 

3,891

 

Total current assets

 

48,425

 

53,177

 

 

 

 

 

 

 

Plant, rental machines and other property

 

40,009

 

38,584

 

Less: Accumulated depreciation

 

24,539

 

23,503

 

Plant, rental machines and other property — net

 

15,470

 

15,081

 

Long-term financing receivables (net of allowances of $60 in 2008 and $58 in 2007)

 

11,460

 

11,603

 

Prepaid pension assets

 

18,460

 

17,417

 

Intangible assets — net

 

3,122

 

2,107

 

Goodwill

 

18,624

 

14,285

 

Investments and sundry assets

 

6,262

 

6,761

 

Total assets

 

$

121,823

 

$

120,431

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

3



 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

(Dollars in millions)

 

At March 31,
2008

 

At December 31,
2007

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

3,033

 

$

3,673

 

Short-term debt

 

15,235

 

12,235

 

Accounts payable

 

7,329

 

8,054

 

Compensation and benefits

 

3,819

 

4,645

 

Deferred income

 

11,079

 

9,802

 

Other accrued expenses and liabilities

 

6,553

 

5,901

 

Total current liabilities

 

47,048

 

44,310

 

Long-term debt

 

19,951

 

23,039

 

Retirement and nonpension postretirement benefit obligations

 

14,261

 

13,582

 

Deferred income

 

3,235

 

3,060

 

Other liabilities

 

8,600

 

7,970

 

Total liabilities

 

93,095

 

91,962

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

 

 

 

Common stock, par value $0.20 per share, and additional paid-in capital

 

36,252

 

35,188

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:

2008 - 2,069,370,899

 

 

 

 

 

 

2007 - 2,057,607,421

 

 

 

 

 

Retained earnings

 

62,378

 

60,640

 

 

 

 

 

 

 

Treasury stock - at cost

 

(66,619

)

(63,945

)

Shares:

2008 - 695,892,312

 

 

 

 

 

 

2007 - 672,373,283

 

 

 

 

 

 

 

 

 

 

 

Accumulated gains and (losses) not affecting retained earnings

 

(3,282

)

(3,414

)

Total stockholders’ equity

 

28,728

 

28,470

 

Total liabilities and stockholders’ equity

 

$

121,823

 

$

120,431

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

4



 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED)

 

(Dollars in millions)

 

2008

 

2007

 

 

 

 

 

 

 

Cash flow from operating activities from continuing operations:

 

 

 

 

 

Net income

 

$

2,319

 

$

1,844

 

Loss from discontinued operations

 

 

00

 

Adjustments to reconcile income from continuing operations to cash provided from operating activities:

 

 

 

 

 

Depreciation

 

1,030

 

949

 

Amortization of intangibles

 

317

 

291

 

Stock-based compensation

 

171

 

178

 

Net gain on asset sales and other

 

115

 

(88

)

Changes in operating assets and liabilities, net of acquisitions/divestitures

 

251

 

(157

)

Net cash provided by operating activities from continuing operations

 

4,202

 

3,016

 

 

 

 

 

 

 

Cash flow from investing activities from continuing operations:

 

 

 

 

 

Payments for plant, rental machines and other property, net of proceeds from dispositions

 

(1,018

)

(917

)

Investment in software

 

(194

)

(215

)

Acquisition of businesses, net of cash acquired

 

(4,962

)

(205

)

Divestiture of businesses, net of cash transferred

 

29

 

 

Purchases of marketable securities and other investments

 

(3,710

)

(8,443

)

Proceeds from sale of marketable securities and other investments

 

4,076

 

7,362

 

Net cash used in investing activities from continuing operations

 

(5,778

)

(2,418

)

 

 

 

 

 

 

Cash flow from financing activities from continuing operations:

 

 

 

 

 

Proceeds from new debt

 

3,742

 

900

 

Payments to settle debt

 

(4,894

)

(104

)

Short-term borrowings/(repayments) less than 90 days — net

 

372

 

436

 

Common stock repurchases

 

(2,427

)

(3,398

)*

Common stock transactions — other

 

965

 

900

*

Cash dividends paid

 

(554

)

(452

)

Net cash used in financing activities from continuing operations

 

(2,796

)

(1,717

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

168

 

52

 

Net cash used in discontinued operations - operating activities

 

 

(3

)

Net change in cash and cash equivalents

 

(4,205

)

(1,070

)

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

14,991

 

8,022

 

Cash and cash equivalents at March 31

 

$

10,786

 

$

6,953

 

 


* First quarter 2007 amounts reclassified to conform with the presentation of Common stock repurchases and Common stock transactions – other which were previously combined in Common stock transactions-net in the Form 10-Q for the quarter ended March 31, 2007.

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

5



 

Notes to Consolidated Financial Statements:

 

1. Basis of Presentation:  The accompanying consolidated financial statements and footnotes thereto are unaudited.  In the opinion of the management of International Business Machines Corporation (the company), these statements include all adjustments, which are of a normal recurring nature, necessary to present a fair statement of the company’s results of operations, financial position and cash flows.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, costs, expenses and gains and losses not affecting retained earnings that are reported in the Consolidated Financial Statements and accompanying disclosures.  Actual results may be different.  See the company’s 2007 Annual Report for a discussion of the company’s critical accounting estimates.

 

Interim results are not necessarily indicative of results for a full year.  The information included in this Form 10-Q should be read in conjunction with the company’s 2007 Annual Report.

 

Within the financial tables in this Form 10-Q, certain columns and rows may not add due to the use of rounded numbers for disclosure purposes. Percentages presented are calculated from the underlying whole-dollar amounts.

 

2. Accounting Changes:  In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS No. 161 expands the current disclosure requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” such that entities must now provide enhanced disclosures on a quarterly basis regarding how and why the entity uses derivatives; how derivatives and related hedged items are accounted for under SFAS No. 133 and how derivatives and related hedged items affect the entity’s financial position, performance and cash flow. Pursuant to the transition provisions of the Statement, the company will adopt SFAS No. 161 in fiscal year 2009 and will present the required disclosures in the prescribed format on a prospective basis. This Statement will not impact the Consolidated Financial Statements as it is disclosure-only in nature.

 

In February 2008, the FASB issued FASB Staff Position (FSP) Financial Accounting Standard (FAS) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive Accounting Pronouncements That Address Leasing Transactions,” and FSP FAS 157-2, “Effective Date of FASB Statement No. 157.” FSP FAS 157-1 removes leasing from the scope of SFAS No. 157, “Fair Value Measurements.” FSP FAS 157-2 delays the effective date of SFAS No. 157 from 2008 to 2009 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). See SFAS No. 157 discussion on page 7.

 

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations,” which will become effective in 2009 via prospective application to new business combinations. This Statement requires that the acquisition method of accounting be applied to a broader set of business combinations, amends the definition of a business combination, provides a definition of a business, requires an acquirer to recognize an acquired business at its fair value at the acquisition date and requires the assets and liabilities assumed in a business combination to be measured and recognized at their fair values as of the acquisition date (with limited exceptions). The company will adopt this Statement in fiscal year 2009 and its effects on future periods will depend on the nature and significance of any acquisitions subject to this statement.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51.” This Statement requires that the noncontrolling interest in the equity of a subsidiary be accounted for and reported as equity, provides revised guidance on the treatment of net income and losses attributable to the noncontrolling interest and changes in ownership interests in a subsidiary and requires additional disclosures that identify and distinguish between the interests of the controlling and noncontrolling owners. Pursuant to the transition provisions of SFAS No. 160, the company will adopt the Statement in fiscal year 2009 via retrospective application of the presentation and disclosure requirements. The company does not expect the adoption of this Statement to have a material effect on the Consolidated Financial Statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair  Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115,” which became effective January 1, 2008. SFAS No. 159 permits entities to measure eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other generally accepted accounting principles. The fair value measurement election is irrevocable and subsequent changes in fair value must be

 

6



 

Notes to Consolidated Financial Statements – (continued)

 

recorded in earnings. The company adopted this Statement as of January 1, 2008 and the adoption of this Statement did not have a material effect on the Consolidated Financial Statements.

 

In September 2006, the FASB finalized SFAS No. 157 which became effective January 1, 2008 except as amended by FSP FAS 157-1 and FSP FAS 157-2 as previously described. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements; however, it does not require any new fair value measurements. The provisions of SFAS No. 157 were applied prospectively to fair value measurements and disclosures for financial assets and financial liabilities and nonfinancial assets and nonfinancial liabilities recognized or disclosed at fair value in the financial statements on at least an annual basis beginning in the first quarter of 2008. The adoption of this Statement did not have a material effect on the Consolidated Financial Statements for fair value measurements made during the first quarter of 2008. While the company does not expect the adoption of this Statement to have a material impact on its Consolidated Financial Statements in subsequent reporting periods, the company continues to monitor any additional implementation guidance that is issued that addresses the fair value measurements for certain financial assets, such as private market pension plan assets, and nonfinancial assets and nonfinancial liabilities not disclosed at fair value in the financial statements on at least an annual basis. See Note 6 on pages 9 and 10 for additional information regarding the adoption of this Statement.

 

3. Stockholders’ Equity:  The following table summarizes Net income plus gains and (losses) not affecting retained earnings (net of tax), a component of Stockholders’ equity in the Consolidated Statement of Financial Position:

 

 

 

Three Months Ended
March 31,

 

(Dollars in millions)

 

2008

 

2007

 

Net income

 

$

2,319

 

$

1,844

 

Gains and (losses) not affecting retained earnings: (net of tax)

 

 

 

 

 

Foreign currency translation adjustments

 

459

 

90

 

Prior service costs, net gains/(losses) and transition assets/ (obligations)

 

126

 

208

 

Net unrealized losses on marketable securities (1)

 

(157

)

(19

)

Net unrealized (losses)/gains on cash flow hedge derivatives

 

(296

)

14

 

Total net gains/(losses) not affecting retained earnings

 

132

 

294

 

Net income plus gains and (losses) not affecting retained earnings

 

$

2,451

 

$

2,138

 

 


(1) Sale of Lenovo stock and mark-to-mark adjustment of remaining Lenovo stock accounted for ($151 million) and ($37 million) of the period change in the first-quarter 2008 and first-quarter 2007 periods, respectively.

 

4.  Stock-Based Compensation:  Stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized over the employee requisite service period. The following table presents total stock-based compensation cost included in the Consolidated Statement of Earnings:

 

 

 

Three Months Ended
March 31,

 

(Dollars in millions)

 

2008

 

2007

 

Cost

 

$

29

 

$

46

 

Selling, general and administrative expense

 

127

 

112

 

Research, development and engineering expense

 

15

 

20

 

Pre-tax stock-based compensation cost

 

171

 

178

 

Income tax benefits

 

(47

)

(66

)

Total stock-based compensation cost

 

$

124

 

$

111

 

 

The reduction in pre-tax stock-based compensation cost for the three-month period ended March 31, 2008, as compared to the corresponding period in the prior year, was principally the result of a reduction in the level of stock option grants ($65 million) offset by an increase related to restricted and performance-based stock units ($57 million).

 

7



 

Notes to Consolidated Financial Statements – (continued)

 

As of March 31, 2008, the total unrecognized compensation cost of $1,029 million related to non-vested awards is expected to be recognized over a weighted-average period of approximately three years.

 

There was no significant capitalized stock-based compensation cost at March 31, 2008 and 2007.

 

For Restricted Stock Units (RSUs) awarded after December 31, 2007, dividend equivalents will not be paid. The fair value of such RSUs is determined and fixed on the grant date based on the company’s stock price adjusted for the exclusion of dividend equivalents.

 

5. Retirement-Related Benefits:  The company offers defined benefit pension plans, defined contribution pension plans, as well as nonpension postretirement plans primarily consisting of retiree medical benefits. The following table provides the total retirement-related benefit plans’ impact on income from continuing operations before income taxes.

 

 

 

 

 

 

 

Yr. to Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the three months ended March 31:

 

2008

 

2007

 

Change

 

Retirement-related plans – cost:

 

 

 

 

 

 

 

Defined benefit and contribution pension plans – cost

 

$

361

 

$

540

 

(33.1

)%

Nonpension postretirement plans – cost

 

95

 

103

 

(7.8

)

Total

 

$

456

 

$

643

 

(29.1

)%

 

The following table provides the components of the cost/(income) for the company’s pension plans.

 

Cost/(Income) of Pension Plans

 

(Dollars in millions)

 

U.S. Plans

 

Non-U.S. Plans

 

For the three months ended March 31:

 

2008

 

2007

 

2008

 

2007+

 

Service cost

 

$

 

$

188

 

$

138

 

$

146

 

Interest cost

 

671

 

646

 

506

 

424

 

Expected return on plan assets

 

(995

)

(926

)

(690

)

(604

)

Amortization of transition assets

 

 

 

 

(1

)

Amortization of prior service cost

 

 

15

 

(34

)

(31

)

Recognized actuarial losses

 

70

 

169

 

154

 

220

 

Net periodic pension cost—U.S. Plan and material non-U.S. Plans

 

(254

)*

92

*

74

**

154

**

Cost of other defined benefit plans

 

23

 

30

 

57

 

37

 

Total net periodic pension cost for all defined benefit plans

 

(231

)

122

 

131

 

191

 

Cost of defined contribution plans

 

321

 

116

 

140

 

111

 

Total pension plan cost recognized in the Consolidated Statement of Earnings

 

$

90

 

$

238

 

$

271

 

$

302

 

 


+   Reclassified to conform with 2008 presentation.

*   Represents the qualified portion of the IBM Personal Pension Plan.

** Represents the qualified and non-qualified portion of material non-U.S. plans.

 

In 2008, the company expects to contribute to its non-U.S. defined benefit plans approximately $660 million, which is the legally mandated minimum contribution for the company’s non-U.S. plans. In the first quarter of 2008, the company contributed approximately $147 million to its non-U.S. plans.

 

8



 

Notes to Consolidated Financial Statements – (continued)

 

The following table provides the components of the cost for the company’s nonpension postretirement plans.

 

Cost of Nonpension Postretirement Plans

 

 

 

Three Months Ended
March 31,

 

(Dollars in millions)

 

2008

 

2007

 

Service cost

 

$

14

 

$

17

 

Interest cost

 

79

 

79

 

Amortization of prior service cost

 

(16

)

(15

)

Expected return on plan assets

 

(3

)

 

Recognized actuarial losses

 

3

 

8

 

Net periodic postretirement plan cost - U.S. Plan

 

77

 

89

 

Cost of non-U.S. Plans

 

18

 

14

 

Total nonpension postretirement plan cost recognized in the Consolidated Statement of Earnings

 

$

95

 

$

103

 

 

The company received a $3.1 million subsidy in the first quarter of 2008 in connection with the Medicare Prescription Drug Improvement and Modernization Act of 2003. A portion of this amount is used by the company to reduce its obligation and expense related to the plan, and the remainder is contributed to the plan to reduce contributions required by the participants.  For further information related to the Medicare Prescription Drug Act, see page 115 in the company’s 2007 Annual Report.

 

6. Fair Value:  As highlighted in Note 2 on  page 6, the company adopted the provisions of SFAS No. 157 as amended by FSP FAS 157-1 and FSP FAS 157-2 on January 1, 2008. Pursuant to the provisions of FSP FAS 157-2, the company will not apply the provisions of SFAS No. 157 until January 1, 2009 for the following major categories of nonfinancial assets and liabilities from the Consolidated Statement of Financial Position: Plant, rental machines and other property-net; Goodwill; Intangible assets-net and the Asset retirement obligation liabilities within Other accrued expenses and liabilities and Other liabilities.  The company recorded no change to its opening balance of Retained earnings as of January 1, 2008 as it did not have any financial instruments requiring retrospective application per the provisions of SFAS No. 157.

 

Fair Value Hierarchy

 

SFAS No. 157 specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the company’s own assumptions of market participant valuation (unobservable inputs). In accordance with SFAS No. 157, these two types of inputs have created the following fair value hierarchy:

 

· Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities;

 

· Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly;

 

· Level 3 –  Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

 

SFAS No. 157 requires the use of observable market data if such data is available without undue cost and effort.

 

Measurement of Fair Value

 

The company measures fair value as an exit price using the procedures described below for all assets and liabilities measured at fair value. When available, the company uses unadjusted quoted market prices to measure fair value and classifies such items within Level 1. If quoted market prices are not available, fair value is based upon internally developed models that use, where possible, current market-based or independently-sourced market parameters such as interest rates and   currency rates. Items valued using internally generated models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be inputs that are readily observable. If quoted market prices are not available, the valuation model used generally depends on the specific

 

9



 

Notes to Consolidated Financial Statements – (continued)

 

asset or liability being valued. The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments. For derivatives and marketable debt securities, the company uses a discounted cash flow analysis using discount rates commensurate with the duration of the instrument. In the event of an other-than-temporary impairment of a nonpublic equity method investment, the company uses the net asset value of its investment in the investee adjusted using discounted cash flows for the company’s estimate of the price that it would receive to sell the investment to a market participant that would consider all factors that would impact the investment’s fair value. In determining the fair value of financial instruments, the company considers ‘base valuations’ calculated using the methodologies described  below for several parameters that market participants would consider in determining fair value.

 

· Counterparty credit risk adjustments are applied to financial instruments, where the base valuation uses market parameters based on an AA (or equivalent) credit rating. Due to the fact that not all counterparties have a AA (or equivalent) credit rating, it is necessary to take into account the actual credit rating of a counterparty to determine the true fair value of such an instrument.

 

· Credit risk adjustments are applied to reflect the company’s own credit risk when valuing all liabilities measured at fair value. The methodology is consistent with that applied in developing counterparty credit risk adjustments, but incorporates the company’s own credit risk as observed in the credit default swap market.

 

Items Measured at Fair Value on a Recurring Basis

 

The following table presents the company’s assets and liabilities that are measured at fair value on a recurring basis at March 31, 2008 consistent with the fair value hierarchy provisions of SFAS No. 157.

 

(Dollars in millions)

 

Level 1

 

Level 2

 

Level 3

 

Netting (1)

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

3,963

 

$

3,787

 

$

 

$

 

$

7,750

 

Marketable securities

 

 

1,140

 

 

 

1,140

 

Derivative assets (2)

 

37

 

1,475

 

 

(962

)

550

 

Investments and sundry assets

 

469

 

2

 

 

 

470

 

Total Assets

 

$

4,469

 

$

6,403

 

$

 

$

(962

)

$

9,910

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

Derivative liabilities (3)

 

$

 

$

2,104

 

$

 

$

(962

)

$

1,142

 

Total Liabilities

 

$

 

$

2,104

 

$

 

$

(962

)

$

1,142

 

 


(1)          Represents netting of derivative exposures covered by a qualifying master netting agreement in accordance with FASB Interpretation No. 39, “Offsetting of Amounts Relating to Certain Contracts.”

(2)          The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at March 31, 2008 are $982 million and $529 million, respectively.

(3)          The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at March 31, 2008 are $1,459 million and $645 million, respectively.

 

At March 31, 2008, the company did not have any assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3).

 

Items Measured at Fair Value on a Nonrecurring Basis

 

Certain assets are measured at fair value on a nonrecurring basis and therefore are not included in the table above. These assets include equity method investments that are recognized at fair value at the end of the period to the extent that they are deemed to be other-than-temporarily impaired. Certain assets that are measured at fair value on a recurring basis and are included in the table above can also be subject to nonrecurring fair value measurements. These assets include public cost method investments that are deemed to be other-than-temporarily impaired. The company did not record any other-than-temporary impairment charges for these assets during the first quarter of 2008.

 

10



 

Notes to Consolidated Financial Statements – (continued)

 

7. Accelerated Share Repurchase:  In May 2007, IBM International Group (IIG), a wholly-owned foreign subsidiary of the company repurchased 118.8 million shares of common stock for $12.5 billion under accelerated share repurchase (ASR) agreements with three banks.

 

Pursuant to the ASR agreements, executed on May 25, 2007, IIG paid an initial purchase price of $105.18 per share for the repurchase. The initial purchase price was subject to adjustment based on the volume weighted average price of IBM common stock over a settlement period of three months for each of the banks. The adjustment also reflected certain other amounts including the banks’ carrying costs, compensation for ordinary dividends declared by the company during the settlement period and interest benefits for receiving the $12.5 billion payment in advance of the anticipated purchases by each bank of shares in the open market during its settlement period.  The adjustment amount could be settled in cash, registered shares or unregistered shares at IIG’s option. Under the ASR, IIG had a separate settlement with each of the three banks. The first settlement occurred on September 6, 2007, resulting in a settlement payment to the bank of $151.8 million. The second settlement occurred on December 5, 2007, resulting in a settlement payment to the bank of $253.1 million. The third settlement occurred on March 4, 2008, resulting in a settlement payment to the company of $54.2 million. The settlement amounts were paid in cash at the election of IIG in accordance with the provisions of the ASR and were recorded as adjustments to Stockholders’ equity in the Consolidated Statement of Financial Position on the settlement dates. The adjusted average price paid per share during the ASR period was $108.13, resulting in a total purchase price of $12,851 million versus the original $12,500 million. The $351 million difference was settled in cash.

 

8. Acquisitions:  During the three months ended March 31, 2008, the company completed seven acquisitions at an aggregate cost of $5,198 million. The Cognos, Inc. acquisition is shown separately given the significant purchase price.

 

Cognos, Inc. – On January 31, 2008 the company acquired 100 percent of the outstanding common shares of Cognos, Inc. for consideration of  $5,021 million consisting of $4,998 million of cash and $24 million of equity instruments. Through this acquisition, IBM and Cognos will become a leading provider of technology and services for business intelligence and performance management, delivering the industry’s most complete, open standards-based platform with the broadest range of expertise to help companies expand the value of their information, optimize their business processes and maximize performance across their enterprises. The company acquired Cognos to accelerate its Information on Demand strategy, a cross-company initiative that combines the company’s strength in information integration, content and data management and business consulting services to unlock the business value of information. Cognos was integrated into the Software segment upon acquisition and goodwill, as reflected in the table on page 12 has been entirely assigned to the Software segment. It is expected that 40-50 percent of the goodwill will be deductible for tax purposes. The overall weighted average useful life of the intangible assets purchased, excluding goodwill, is 6.5 years.

 

Other Acquisitions -  The company acquired six additional companies at an aggregate cost of $178 million that are presented in the table on page 12 as “Other Acquisitions.”

 

The Software segment completed four other acquisitions: AptSoft Corporation, Solid Information Technology,  Net Integration Technologies Inc. and Encentuate, Inc., all  privately held companies. Each acquisition further complemented and enhanced the software product portfolio.

 

Global Technology Services (GTS) completed one acquisition: Arsenal Digital Solutions, a privately held company. Arsenal provides global clients with security rich information protection services designed to handle increasing data retention requirements.

 

Global Business Services (GBS) completed one acquisition: u9consult, a privately held company. u9consult complements the company’s existing capabilities in value chain consulting.

 

Purchase price consideration for the “Other Acquisitions” was paid all in cash. All acquisitions are reported in the Consolidated Statement of Cash Flows net of acquired cash and cash equivalents.

 

11



 

Notes to Consolidated Financial Statements – (continued)

 

The table below reflects the purchase price related to these acquisitions and the resulting purchase price allocations as of March 31, 2008.

 

 

 

Amortization

 

 

 

Other

 

(Dollars in millions)

 

Life (yrs.)

 

Cognos

 

Acquisitions

 

Current assets

 

 

 

$

529

 

$

20

 

Fixed assets/noncurrent

 

 

 

125

 

12

 

Intangible assets:

 

 

 

 

 

 

 

Goodwill

 

N/A

 

4,152

 

143

 

Completed technology

 

3 – 7

 

534

 

12

 

Client relationships

 

3 – 7

 

47

 

8

 

Other

 

3 – 7

 

543

 

12

 

Total assets acquired

 

 

 

5,931

 

207

 

Current liabilities

 

 

 

(782

)

(22

)

Noncurrent liabilities

 

 

 

(128

)

(8

)

Total liabilities assumed

 

 

 

(910

)

(29

)

Total purchase price

 

 

 

$

5,021

 

$

178

 

 

The acquisitions were accounted for as purchase transactions, and accordingly, the assets and liabilities of the acquired entities were recorded at their estimated fair values at the date of acquisition. The primary items that generated the goodwill are the value of the synergies between the acquired companies and IBM and the acquired assembled workforce, neither of which qualify as an amortizable intangible asset. For the “Other Acquisitions,” the overall weighted-average life of the identified amortizable intangible assets acquired is 3.4 years. With the exception of goodwill, these identified intangible assets will be amortized on a straight-line basis over their useful lives. Goodwill of $143 million has been assigned to the Software ($60 million) and Global Technology Services ($83 million) segments. None of the goodwill related to “Other Acquisitions” is deductible for tax purposes.

 

9. Printing Systems Divestiture:  In January 2007, the company announced an agreement with Ricoh Company Limited (Ricoh), a publicly traded company, to form a joint venture company based on IBM’s Printing System Division (a division of the Systems and Technology segment). The company initially created a wholly-owned subsidiary, InfoPrint Solutions Company, LLC (InfoPrint), by contributing specific assets and liabilities from its printer business. The company’s Printing System Division generated approximately $1 billion of revenue in 2006. The InfoPrint portfolio includes solutions for production printing for enterprises and commercial printers as well as solutions for office workgroup environments and industrial segments. On June 1, 2007 (closing date), the company divested 51 percent of its interest in InfoPrint to Ricoh.  The company will divest its remaining 49 percent ownership to Ricoh quarterly over the next three years from the closing date. At March 31, 2008, the company’s ownership in InfoPrint was 36.7 percent. See IBM’s 2007 Annual Report, Note C, “Acquisitions/Divestitures”, for additional information.

 

10. Financing Receivables: The following table presents financing receivables, net of allowances for doubtful accounts, including residual values.

 

 

 

At March 31,

 

At December 31,

 

(Dollars in millions)

 

2008

 

2007

 

 

 

 

 

 

 

Current:

 

 

 

 

 

Net investment in sales-type leases

 

$

4,762

 

$

4,746

 

Commercial financing receivables

 

4,579

 

6,263

 

Client loans receivables

 

4,819

 

4,652

 

Installment payment receivables

 

583

 

629

 

Total

 

$

14,743

 

$

16,289

 

Noncurrent:

 

 

 

 

 

Net investment in sales-type leases

 

$

6,104

 

$

6,085

 

Commercial financing receivables

 

120

 

113

 

Client loans receivables

 

4,808

 

4,931

 

Installment payment receivables

 

427

 

474

 

Total

 

$

11,460

 

$

11,603

 

 

12



 

Notes to Consolidated Financial Statements – (continued)

 

Net investment in sales-type leases is for leases that relate principally to the company’s equipment and are for terms ranging from two to seven years. Net investment in sales-type leases includes unguaranteed residual values of $931 million and $915 million at March 31, 2008 and December 31, 2007, respectively, and is reflected net of unearned income of $1,072 million and $1,016 million and of allowance for uncollectible accounts of $135 million and $127 million at those dates, respectively.

 

Commercial financing receivables relate primarily to inventory and accounts receivable financing for dealers and remarketers of IBM and non-IBM products. Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days.

 

Client loan receivables relate to loans that are provided by Global Financing primarily to the company’s clients to finance the purchase of the company’s software and services. Separate contractual relationships on these financing arrangements are for terms ranging from two to seven years. Each financing contract is priced independently at competitive market rates. The company has a history of enforcing the terms of these separate financing agreements.

 

The company utilizes certain of its financing receivables as collateral for non-recourse borrowings. Financing receivables pledged as collateral for borrowings were $297 million and $258 million at March 31, 2008 and December 31, 2007, respectively.

 

The company did not have any financing receivables held for sale as of March 31, 2008 and December 31, 2007.

 

11. Intangible Assets Including Goodwill:  The following schedule details the company’s intangible asset balances by major asset class:

 

 

 

At March 31, 2008

 

(Dollars in millions)

 

Gross Carrying

 

Accumulated

 

Net Carrying

 

Intangible asset class

 

Amount

 

Amortization

 

Amount

 

Capitalized software

 

$

1,929

 

$

(836

)

$

1,093

 

Client-related

 

1,549

 

(513

)

1,036

 

Completed technology

 

1,045

 

(239

)

807

 

Patents/Trademarks

 

207

 

(71

)

136

 

Other(a)

 

172

 

(122

)

50

 

Total

 

$

4,903

 

$

(1,781

)

$

3,122

 

 

 

 

At December 31, 2007

 

(Dollars in millions)

 

Gross Carrying

 

Accumulated

 

Net Carrying

 

Intangible asset class

 

Amount

 

Amortization

 

Amount

 

Capitalized software

 

$

1,926

 

$

(826

)

$

1,100

 

Client-related

 

1,054

 

(495

)

559

 

Completed technology

 

536

 

(194

)

342

 

Strategic alliances

 

103

 

(103

)

 

Patents/Trademarks

 

128

 

(61

)

67

 

Other(a)

 

154

 

(115

)

39

 

Total

 

$

3,901

 

$

(1,794

)

$

2,107

 

 


(a)  Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems and impacts  from currency translation.

 

The net carrying amount of intangible assets increased $1,015 million during the first quarter of 2008, primarily due to acquired intangible assets and capitalized software additions, partially offset by amortization. The aggregate intangible amortization expense was $317 million and $291 million for the quarters ended March 31, 2008 and 2007, respectively. In addition, in the first quarter, the company retired $338 million of fully amortized intangible assets, impacting both the gross carrying amount and accumulated amortization by this amount.

 

13



 

Notes to Consolidated Financial Statements – (continued)

 

The amortization expense for each of the five succeeding years relating to intangible assets currently recorded in the Consolidated Statement of Financial Position is estimated to be the following at March 31, 2008:

 

 

 

Capitalized

 

Acquired

 

 

 

(Dollars in millions)

 

Software

 

Intangibles

 

Total

 

2008 (for Q2-Q4)

 

$

533

 

$

381

 

$

913

 

2009

 

420

 

455

 

874

 

2010

 

133

 

361

 

493

 

2011

 

7

 

310

 

318

 

2012

 

 

228

 

228

 

 

The changes in the goodwill balances by reportable segment, for the quarter ended March 31, 2008, are as follows:

 

 

 

 

 

 

 

 

 

 

 

Foreign

 

 

 

 

 

 

 

 

 

 

 

 

 

Currency

 

 

 

 

 

 

 

 

 

Purchase

 

 

 

Translation

 

 

 

(Dollars in millions)

 

Balance

 

Goodwill

 

Price

 

 

 

And Other

 

Balance

 

Segment

 

12/31/07

 

Additions

 

Adjustments

 

Divestitures

 

Adjustments

 

3/31/08

 

Global Business Services

 

$

4,041

 

$

 

$

 

$

 

$

63

 

$

4,103

 

Global Technology Services

 

2,914

 

83

 

(3

)

 

119

 

3,113

 

Systems and Technology

 

484

 

 

7

 

 

 

491

 

Software

 

6,846

 

4,212

 

(22

)

 

(120

)

10,916

 

Global Financing

 

 

 

 

 

 

 

Total

 

$

14,285

 

$

4,295

 

$

(18

)

$

 

$

62

 

$

18,624

 

 

There were no goodwill impairment losses recorded during the quarter.

 

12. Segments:  The table on page 48 of this Form 10-Q reflects the results of the company’s reportable segments consistent with the management system used by the company’s chief operating decision maker. These results are not necessarily a depiction that is in conformity with GAAP. For example, employee retirement plan costs are developed using actuarial assumptions on a country-by-country basis and allocated to the segments based on headcount.  Different results could occur if actuarial assumptions that are unique to the segments were used. Performance measurement is based on income before income taxes (pre-tax income). These results are used, in part, by management, both in evaluating the performance of, and in allocating resources to, each of the segments.

 

13. Restructuring-Related Liabilities:  The following table provides a rollforward of the current and noncurrent liability balances for actions taken in the following periods: (1) the second-quarter of 2005; (2) the fourth-quarter 2002 actions associated with the acquisition of the PricewaterhouseCoopers consulting business; (3) the second-quarter of 2002 associated with the Microelectronics Division and the rebalancing of both the company’s workforce and leased space resources; (4) the 2002 actions associated with the hard disk drive (HDD) business for reductions in workforce, manufacturing capacity and space; (5) actions taken in 1999; and (6) actions that took place prior to 1994. See the company’s 2007 Annual Report, Note Q on pages 99 and 100 for additional information on the actions taken in 2005.

 

 

 

Liability

 

 

 

 

 

Liability

 

 

 

as of

 

 

 

 

 

as of

 

(Dollars in millions)

 

12/31/2007

 

Payments

 

Other Adj.*

 

3/31/2008

 

Current:

 

 

 

 

 

 

 

 

 

Workforce

 

$

130

 

$

(35

)

$

8

 

$

104

 

Space

 

30

 

(10

)

10

 

30

 

Other

 

7

 

 

1

 

8

 

Total Current

 

$

167

 

$

(45

)

$

19

 

$

141

 

Noncurrent:

 

 

 

 

 

 

 

 

 

Workforce

 

$

557

 

$

 

$

52

 

$

609

 

Space

 

74

 

 

(7

)

66

 

Total Noncurrent

 

$

631

 

$

 

$

45

 

$

676

 

 


*  The other adjustments column in the table above principally includes the reclassification of noncurrent to current, foreign currency translation adjustments and interest accretion.

 

14



 

Notes to Consolidated Financial Statements – (continued)

 

14. Contingencies:  The company is involved in a variety of claims, demands, suits, investigations and proceedings that arise from time to time in the ordinary course of its business, including actions with respect to contracts, intellectual property (IP), product liability, employment, benefits, securities, foreign operations and environmental matters. These actions may be commenced by a number of different parties, including competitors, partners, clients, current or former employees, government and regulatory agencies, stockholders and representatives of the locations in which the company does business.

 

The following is a summary of some of the more significant legal matters involving the company.

 

The company is a defendant in an action filed on March 6, 2003 in state court in Salt Lake City, Utah by The SCO Group (SCO v. IBM). The company removed the case to Federal Court in Utah. Plaintiff is an alleged successor in interest to some of AT&T’s Unix IP rights, and alleges copyright infringement, unfair competition, interference with contract and breach of contract with regard to the company’s distribution of AIX and Dynix and contribution of code to Linux. The company has asserted counterclaims, including breach of contract, violation of the Lanham Act, unfair competition, intentional torts, unfair and deceptive trade practices, breach of the General Public License that governs open source distributions, promissory estoppel and copyright infringement. In October 2005, the company withdrew its patent counterclaims in an effort to simplify and focus the issues in the case and to expedite their resolution. Motions for summary judgment were heard in March 2007, and the court has not yet issued its decision. On August 10, 2007, the court in another suit, The SCO Group, Inc. v. Novell, Inc., issued a decision and order determining, among other things, that Novell is the owner of UNIX and UnixWare copyrights, and obligating SCO to recognize Novell’s waiver of SCO’s claims against IBM and Sequent for breach of UNIX license agreements. At the request of the court in SCO v. IBM, on August 31, 2007, each of the parties filed a status report with the court concerning the effect of the August 10th Novell ruling on the SCO v. IBM case, including the pending motions. On September 14, 2007, plaintiff filed for bankruptcy protection, and all proceedings in this case were stayed.

 

On November 29, 2006, the company filed a lawsuit against Platform Solutions, Inc. (PSI) in the United States District Court for the Southern District of New York. IBM filed its amended complaint on August 17, 2007 and asserted claims for patent infringement, trade secret misappropriation, copyright infringement, tortious interference and breach of contract in connection with PSI’s development and marketing of a computer system that PSI says is compatible with IBM’s S/390 and System z architectures. IBM also sought a declaratory judgment that its refusal to license its patents to PSI and certain of its software for use on PSI systems does not violate the antitrust laws. IBM seeks damages and injunctive relief. On September 21, 2007, PSI answered the amended complaint and asserted counterclaims against IBM for alleged monopolization and attempted monopolization, tying, violations of New York and California statutes proscribing unfair competition, tortious interference with the acquisition of PSI by a third party and promissory estoppel. PSI also sought declaratory judgments of noninfringement of IBM’s patents and patent invalidity. In October 2007, PSI filed a complaint with the European Commission claiming that the company’s alleged refusal to do business with PSI violated European competition law. The company responded to this complaint in December. On January 11, 2008, the court in the New York lawsuit permitted T3 Technologies, a reseller of PSI computer systems, to intervene as a counterclaim-plaintiff, and the court also permitted the company to file a second amended complaint adding patent infringement claims against T3. Discovery is proceeding and the court has  tentatively set the case for trial on March 16, 2009.

 

In October 2003, a purported collective action lawsuit was filed against IBM in the United States District Court for the Northern District of California by 10 former IBM employees alleging, on behalf of themselves and allegedly similarly situated former employees, that the company engaged in a pattern and practice of discriminating against employees on the basis of age when it terminated employees, both in connection with reductions in force and individualized determinations (Syverson v. IBM). Initially, the District Court dismissed the lawsuit on the basis of release agreements signed by all the plaintiffs. On appeal, the Ninth Circuit reversed the trial court’s finding that the release barred these claims, and in January 2007, after denial of IBM’s petition for rehearing, the matter was returned to the trial court for further proceedings. On October 3, 2007, the court dismissed with prejudice plaintiffs’ claim for relief under the Older Workers Benefit Protection Act, and dismissed with leave to amend plaintiffs’ claim asserting disparate impact age discrimination with respect to individualized terminations. On November 6, 2007, plaintiffs filed a Third Amended Complaint, amending the disparate impact claim. IBM filed its answer on November 26, 2007, and discovery is proceeding.

 

In July 2005, two lawsuits were filed in the United States District Court for the Southern District of New York related to the company’s disclosures concerning first-quarter 2005 earnings and the expensing of equity compensation. Pursuant to an Order from the Court dated March 28, 2006, the two lawsuits were consolidated into a single action captioned “In re International Business Machines Corp. Securities Litigation.” Plaintiffs filed a corrected consolidated amended complaint dated May 19, 2006, in which they named the company and IBM’s Senior Vice President and Chief Financial Officer as

 

15



 

Notes to Consolidated Financial Statements – (continued)

 

defendants and alleged that defendants made certain misrepresentations and omissions in violation of Section 10(b), and Rule 10b-5 thereunder, and Section 20(a) of the Securities Exchange Act of 1934. On September 20, 2006, the Court denied a Motion to Dismiss that was filed by IBM. On March 12, 2007, the plaintiffs’ class was certified; class notifications were mailed on or about May 30, 2007.

 

In January 2004, the Seoul District Prosecutors Office in South Korea announced it had brought criminal bid-rigging charges against several companies, including IBM Korea and LG IBM (a joint venture between IBM Korea and LG Electronics, which has since been dissolved, effective January, 2005) and had also charged employees of some of those entities with, among other things, bribery of certain officials of government-controlled entities in Korea and bid rigging. IBM Korea and LG IBM cooperated fully with authorities in these matters. A number of individuals, including former IBM Korea and LG IBM employees, were subsequently found guilty and sentenced. IBM Korea and LG IBM were also required to pay fines. Debarment orders were imposed at different times, covering a period of no more than a year from the date of issuance, which barred IBM Korea from doing business directly with certain government-controlled entities in Korea. All debarment orders have since expired and when they were in force did not prohibit IBM Korea from selling products and services to business partners who sold to government-controlled entities in Korea. In addition, the U.S. Department of Justice and the SEC have both contacted the company in connection with this matter. In March 2008, the company received a request from the SEC for additional information.

 

On March 27, 2008, the company was temporarily suspended from participating in new business with U.S. Federal government agencies.  The notice of temporary suspension was issued by the Environmental Protection Agency (EPA) and related to an investigation by the EPA of possible violations of the Procurement Integrity provisions of the Office of Federal Procurement Policy Act regarding a specific bid for business with the EPA originally submitted in March 2006. In addition, the U.S. Attorney’s Office for the Eastern District of Virginia served the company and certain employees with grand jury subpoenas related to the bid, requesting testimony and documents regarding interactions between employees of the EPA and certain company employees. On April 4, 2008, the company announced an agreement with the EPA that terminated the temporary suspension order.  The company is cooperating with the EPA and with the U.S. Attorney’s Office for the Eastern District of Virginia.

 

The company is a defendant in a civil lawsuit brought in Tokyo District Court by Tokyo Leasing Co., Ltd., which seeks to recover losses that it allegedly suffered after IXI Co., Ltd. initiated civil rehabilitation (bankruptcy) proceedings in Japan and apparently failed to pay Tokyo Leasing amounts for which Tokyo Leasing now seeks to hold IBM and others liable. The claims in this suit include tort and breach of contract.

 

The company is a defendant in numerous actions filed after January 1, 2008 in Supreme Court for the State of New York, county of Broome, on behalf of hundreds of plaintiffs. The complaints allege causes of action for negligence and recklessness, private nuisance, and trespass. Plaintiffs in these cases seek medical monitoring and claim damages in unspecified amounts for a variety of personal injuries and property damages allegedly arising out of the presence of groundwater contamination and vapor intrusion of groundwater contaminants into certain structures in which plaintiffs reside or resided, or conducted business, allegedly resulting from the release of chemicals into the environment by the company at its former manufacturing and development facility in Endicott. These complaints also seek punitive damages in an unspecified amount.

 

The company is party to, or otherwise involved in, proceedings brought by U.S. federal or state environmental agencies under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), known as “Superfund,” or laws similar to CERCLA. Such statutes require potentially responsible parties to participate in remediation activities regardless of fault or ownership of sites. The company is also conducting environmental investigations, assessments or remediations at or in the vicinity of several current or former operating sites globally pursuant to permits, administrative orders or agreements with country, state or local environmental agencies, and is involved in lawsuits and claims concerning certain current or former operating sites.

 

The company is also subject to ongoing tax examinations and governmental assessments in various jurisdictions. Along with many other U.S. companies doing business in Brazil, the company is involved in various challenges with Brazilian authorities regarding non-income tax assessments and non-income tax litigation matters. These matters principally relate to claims for taxes on the importation of computer software. The total amounts related to these matters are approximately $2.3 billion, including amounts currently in litigation and other amounts. In addition, the company has received an income tax assessment from Mexican authorities relating to the deductibility of certain warranty payments. In response, the company has filed an appeal in the Mexican Federal Fiscal court. The total potential amount related to this matter for all applicable years is

 

16



 

Notes to Consolidated Financial Statements – (continued)

 

approximately $500 million. The company believes it will prevail on these matters and that these amounts are not meaningful indicators of liability.

 

In accordance with SFAS No. 5, “Accounting for Contingencies,” (SFAS No. 5), the company records a provision with respect to a claim, suit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Claims and proceedings are reviewed at least quarterly and provisions are taken or adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information pertinent to a particular matter. Any recorded liabilities including any changes to such liabilities for the quarter ended March 31, 2008, were not material to the Consolidated Financial Statements. Based on its experience, the company believes that the damage amounts claimed in the matters previously referred to are not a meaningful indicator of the potential liability. Claims, suits, investigations and proceedings are inherently uncertain and it is not possible to predict the ultimate outcome of the matters previously discussed. While the company will continue to defend itself vigorously in all such matters, it is possible that the company’s business, financial condition, results of operations or cash flows could be affected in any particular period by the resolution of one or more of these matters.

 

Whether any losses, damages or remedies finally determined in any such claim, suit, investigation or proceeding could reasonably have a material effect on the company’s business, financial condition, results of operations or cash flows will depend on a number of variables, including the timing and amount of such losses or damages; the structure and type of any such remedies; the significance of the impact any such losses, damages or remedies may have on the Consolidated Financial Statements; and the unique facts and circumstances of the particular matter which may give rise to additional factors.

 

15. Commitments:  The company’s extended lines of credit to third-party entities include unused amounts of $4,268 million and $3,702 million at March 31, 2008 and December 31, 2007, respectively. A portion of these amounts was available to the company’s business partners to support their working capital needs. In addition, the company has committed to provide future financing to its clients in connection with client purchase agreements for approximately $3,717 million and $3,654 million at March 31, 2008 and December 31, 2007, respectively.

 

The company has applied the disclosure provisions of FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” to its agreements that contain guarantee or indemnification clauses. These disclosure provisions expand those required by SFAS No. 5, by requiring a guarantor to disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. The following is a description of arrangements in which the company is the guarantor.

 

The company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the company, under which the company customarily agrees to hold the party harmless against losses arising from a breach of representations and covenants related to such matters as title to the assets sold, certain intellectual property (IP) rights, specified environmental matters, third-party performance of non-financial contractual obligations and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the company to challenge the other party’s claims. Further, the company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the company may have recourse against third parties for certain payments made by the company.

 

It is not possible to predict the maximum potential amount of future payments under these or similar agreements, due to the conditional nature of the company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the company under these agreements have not had a material effect on the company’s business, financial condition or results of operations.

 

In addition, the company guarantees certain loans and financial commitments. The maximum potential future payment under these financial guarantees was $24 million and $23 million at March 31, 2008 and December 31, 2007, respectively. The fair value of the guarantees recognized in the Consolidated Statement of Financial Position is not material.

 

17



 

Notes to Consolidated Financial Statements – (continued)

 

Changes in the company’s warranty liability balance are presented in the following table:

 

(Dollars in millions)

 

2008

 

2007

 

Balance at January 1

 

$

412

 

$

582

 

Current period accruals

 

92

 

105

 

Accrual adjustments to reflect actual experience

 

16

 

(16

)

Charges incurred

 

(133

)

(167

)

Balance at March 31

 

$

387

 

$

504

 

 

The decrease in the balance was primarily driven by a reduction in estimated future cost as a result of the divestiture of the company’s Personal Computing business to Lenovo Group Limited (Lenovo) in April 2005.

 

16. Subsequent Events:  On April 29, 2008, the company announced that the Board of Directors approved a quarterly dividend of $0.50 per common share. The dividend is payable June 10, 2008 to shareholders of record on May 9, 2008. The dividend declaration represents an increase of $0.10, or 25 percent more than the prior quarterly dividend of $0.40 per common share.

 

On April 29, 2008, the IBM Board of Directors approved a pension adjustment for certain U.S. retirees and beneficiaries. Effective September 1, 2008, this adjustment provides a pension increase to approximately 42,000 IBM retirees who retired before January 1,1997. The impact of this adjustment will be included in the Personal Pension Plan remeasurement at December 31, 2008, therefore, there will be no impact to 2008 net periodic pension cost.

 

On April 3, 2008, the company announced the completion of the acquisition of Telelogic AB for approximately $845 million in cash.

 

18



 

ITEM 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

FOR THE THREE MONTHS ENDED MARCH 31, 2008*

 

Snapshot

 

 

 

 

 

 

 

Yr. To Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions except per share amounts)

 

 

 

 

 

Margin

 

For the three months ended March 31:

 

2008

 

2007

 

Change

 

Revenue

 

$

24,502

 

$

22,029

 

11.2

%**

Gross profit margin

 

41.5

%

40.2

%

1.2

pts.

Total expense and other income

 

$

6,968

 

$

6,287

 

10.8

%

Total expense and other income to revenue ratio

 

28.4

%

28.5

%

(0.1

)pts.

Provision for income taxes

 

$

879

 

$

735

 

19.6

%

Income from continuing operations

 

$

2,319

 

$

1,844

 

25.7

%

Net income

 

$

2,319

 

$

1,844

 

25.7

%

Net income margin

 

9.5

%

8.4

%

1.1

pts.

Earnings per share from continuing operations:

 

 

 

 

 

 

 

Assuming dilution

 

$

1.65

 

$

1.21

 

36.4

%

Basic

 

$

1.68

 

$

1.23

 

36.6

%

Weighted-average shares outstanding:

 

 

 

 

 

 

 

Assuming dilution

 

1,404.3

 

1,522.8

 

(7.8

)%

Basic

 

1,383.0

 

1,499.5

 

(7.8

)%

 

 

 

3/31/08

 

12/31/07

 

 

 

Assets

 

$

121,823

 

$

120,431

 

1.2

%

Liabilities

 

$

93,095