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 JUNE 30, 2004

 

1-2360

(Commission file number)

 

INTERNATIONAL BUSINESS MACHINES CORPORATION

(Exact name of registrant as specified in its charter)

 

 

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 l3 or l5(d) of the Securities Exchange Act of 1934 during the preceding l2 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 ý                                                No o

 

Indicate by check mark whether registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý No o

 

The registrant has 1,675,192,134 shares of common stock outstanding at June 30, 2004.

 

 

Index

 

Part I - Financial Information:
	Item 1. Consolidated Financial Statements
	Consolidated Statement of Earnings for the three and six months ended June 30, 2004 and 2003
	Consolidated Statement of Financial Position at June 30, 2004 and December 31, 2003
	Consolidated Statement of Cash Flows for the six months ended June 30, 2004 and 2003
	Notes to Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition
	Item 4. Controls and Procedures
Part II - Other Information
	Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 6. Exhibits and Reports on Form 8-K

 

 

Part I - Financial Information

 

ITEM 1. Consolidated Financial Statements

 

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions except per share amounts)		2004			2003			2004			2003
Revenue:
Global Services		$	11,327		$	10,635		$	22,426		$	20,804
Hardware		7,423			6,613			14,158			12,421
Software		3,458			3,471			6,924			6,600
Global Financing		651			672			1,313			1,377
Enterprise Investments/Other		294			240			582			494
Total revenue		23,153			21,631			45,403			41,696
Cost:
Global Services		8,475			7,879			16,857			15,516
Hardware		5,259			4,831			10,199			9,093
Software		472			479			956			961
Global Financing		264			305			525			595
Enterprise Investments/Other		158			139			332			300
Total cost		14,628			13,633			28,869			26,465
Gross profit		8,525			7,998			16,534			15,231
Expense and other income:
Selling, general and administrative		4,632			4,460			9,116			8,675
Research, development and engineering		1,426			1,226			2,793			2,421
Intellectual property and custom development income		(432		)	(199		)	(612		)	(481		)
Other (income) and expense		23			4			36			88
Interest expense		33			41			68			81
Total expense and other income		5,682			5,532			11,401			10,784
Income from continuing operations before income taxes		2,843			2,466			5,133			4,447
Provision for income taxes		853			741			1,540			1,335
Income from continuing operations		1,990			1,725			3,593			3,112

 

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

 

1

 

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions except per share amounts)		2004			2003			2004			2003
Discontinued Operations
Loss from discontinued operations		2			20			3			23
Net income		$	1,988		$	1,705		$	3,590		$	3,089
Earnings per share of common stock:
Assuming dilution
Continuing operations		$	1.16		$	0.98		$	2.09		$	1.77
Discontinued operations		(0.00		)	(0.01		)	(0.00		)	(0.01		)
Total		$	1.16		$	0.97		$	2.08	*	$	1.75	*
Basic
Continuing operations		$	1.18		$	1.00		$	2.13		$	1.80
Discontinued operations		(0.00		)	(0.01		)	(0.00		)	(0.01		)
Total		$	1.18		$	0.99		$	2.13		$	1.79
Weighted average number of common shares outstanding: (millions)
Assuming dilution		1,713.4			1,763.7			1,721.7			1,761.1
Basic		1,679.6			1,729.8			1,685.6			1,727.6
Cash dividends per common share		$	0.18		$	0.16		$	0.34		$	0.31

 

* Does not total 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

 

ASSETS

 

(Dollars in millions)		At June 30, 2004			At December 31, 2003
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	7,715		$	7,290
Marketable securities — at fair value, which approximates market value		478			357
Notes and accounts receivable — trade, net of allowances		9,564			10,026
Short-term financing receivables		13,854			17,583
Other accounts receivable		1,243			1,314
Inventories, at lower of average cost or net realizable value:
Finished goods		1,093			992
Work in process and raw materials		2,089			1,950
Total inventories		3,182			2,942
Deferred taxes		2,416			2,542
Intangible assets — net		307			336
Prepaid expenses and other current assets		2,650			2,608
Total current assets		41,409			44,998
Plant, rental machines and other property		36,812			37,122
Less: Accumulated depreciation		22,243			22,433
Plant, rental machines and other property — net		14,569			14,689
Long-term financing receivables		10,004			10,741
Prepaid pension assets		18,832			18,426
Intangible assets — net		572			574
Goodwill		7,483			6,921
Investments and sundry assets		6,713			8,108
Total assets		$	99,582		$	104,457

 

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

 

3

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

(Dollars in millions except per share amounts)				At June 30, 2004			At December 31, 2003
				(Unaudited)
Liabilities and Stockholders’ Equity
Current liabilities:
Taxes				$	4,315		$	5,475
Short-term debt				7,505			6,646
Accounts payable and accruals				22,537			25,779
Total current liabilities				34,357			37,900
Long-term debt				14,421			16,986
Retirement and nonpension postretirement benefit obligations				13,957			14,251
Other liabilities				8,017			7,456
Total liabilities				70,752			76,593
Stockholders’ equity:
Common stock - par value $0.20 per share				17,406			16,269
Shares authorized: 4,687,500,000
Shares issued:		2004 - 1,949,801,382
		2003 - 1,937,393,604
Retained earnings				40,309			37,525
Treasury stock - at cost				(26,989		)	(24,034		)
Shares:	2004 - 274,609,248
	2003 - 242,884,969
Accumulated gains and (losses) not affecting retained earnings				(1,896		)	(1,896		)
Total stockholders’ equity				28,830			27,864
Total liabilities and stockholders’ equity				$	99,582		$	104,457

 

(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 SIX MONTHS ENDED JUNE 30, (UNAUDITED)

 

(Dollars in millions)		2004			2003
Cash flow from operating activities from continuing operations:
Income from continuing operations		$	3,593		$	3,112
Adjustments to reconcile income from continuing operations to cash provided from operating activities:
Depreciation		1,940			1,927
Amortization of software		369			365
Gain on disposition of fixed and other assets		(136		)	(59		)
Changes in operating assets and liabilities		1,714			628
Net cash provided from operating activities from continuing operations		7,480			5,973
Cash flow from investing activities from continuing operations:
Payments for plant, rental machines and other property, net of proceeds from dispositions		(1,406		)	(1,673		)
Investment in software		(331		)	(297		)
Acquisition of businesses		(821		)	(1,188		)
Purchases of marketable securities and other investments		(4,185		)	(3,321		)
Proceeds from marketable securities and other investments		4,104			3,171
Net cash used in investing activities from continuing operations		(2,639		)	(3,308		)
Cash flow from financing activities from continuing operations:
Proceeds from new debt		1,093			469
Payments to settle debt		(2,159		)	(2,882		)
Short-term repayments less than 90 days — net		(357		)	(462		)
Common stock transactions — net		(2,223		)	280
Cash dividends paid		(574		)	(536		)
Net cash used in financing activities from continuing operations		(4,220		)	(3,131		)
Effect of exchange rate changes on cash and cash equivalents		(121		)	90
Net cash used in discontinued operations		(75		)	(164		)
Net change in cash and cash equivalents		425			(540		)
Cash and cash equivalents at January 1		7,290			5,382
Cash and cash equivalents at June 30		$	7,715		$	4,842

 

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

 

5

 

Notes to Consolidated Financial Statements

 

1.              In the opinion of the management of International Business Machines Corporation (the company), all adjustments, which are of a normal recurring nature, necessary to a fair statement of the results for the unaudited three- and six-month periods have been made.

 

2.              The company applies Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations in accounting for its stock-based compensation plans. Accordingly, the company records expense for grants of employee stock- based compensation awards equal to the excess of the market price of the underlying IBM shares at the date of grant over the exercise price of the stock-related award, if any (known as the intrinsic value). Generally, all employee stock options are issued with the exercise price equal to or greater than the market price of the underlying shares at grant date and therefore, no compensation expense is recorded. In addition, no compensation expense is recorded for purchases under the Employee Stock Purchase Program (ESPP) in accordance with APB No. 25. The intrinsic value of restricted stock units and certain other stock-based compensation issued to employees as of the date of grant is amortized to compensation expense over the vesting period. To the extent there are performance criteria that could result in an employee receiving more or less (including zero) shares than the number of units granted, the unamortized compensation is marked to market during the performance period based upon the intrinsic value at the end of each quarter.

 

The following table summarizes the pro forma operating results of the company had compensation cost for stock options granted and for employee stock purchases under the ESPP been determined in accordance with the fair value-based method prescribed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation”.

 

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions except per share amounts)		2004			2003			2004			2003
Net income		$	1,988		$	1,705		$	3,590		$	3,089
Add: Stock-based compensation expense included in reported net income, net of related tax effects		25			24			62			45
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects		278			247			554			511
Pro forma net income		$	1,735		$	1,482		$	3,098		$	2,623
Earnings per share of common stock:
Basic - as reported		$	1.18		$	0.99		$	2.13		$	1.79
Basic - pro forma		$	1.03		$	0.86		$	1.84		$	1.52
Assuming dilution - as reported		$	1.16		$	0.97		$	2.08		$	1.75
Assuming dilution - pro forma		$	1.01		$	0.85		$	1.80		$	1.51

 

6

 

3.               The following table summarizes Net income plus gains and losses not affecting retained earnings.

 

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions)		2004			2003			2004			2003
Net income		$	1,988		$	1,705		$	3,590		$	3,089
Gains and losses not affecting retained earnings (net of tax):
Foreign currency translation adjustments		(250		)	521			(423		)	842
Minimum pension liability adjustments		(3		)	(24		)	52			(43		)
Net unrealized (losses)/gains on marketable securities		(22		)	6			6			4
Net unrealized gains/(losses) on cash flow hedge derivatives		172			(23		)	365			16
Total (losses) and gains not affecting retained earnings		(103		)	480			—			819
Net income plus gains and losses not affecting retained earnings		$	1,885		$	2,185		$	3,590		$	3,908

 

4.               In January 2003, the Financial Accounting Standard s Board (FASB) issued FASB Interpretation Number 46 (FIN 46), “Consolidation of Variable Interest Entities,” and amended it by issuing FIN 46-R in December 2003. FIN 46-R addresses consolidation by business enterprises of variable interest entities (VIEs) that either: (1) do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) have equity investors that lack an essential characteristic of a controlling financial interest.

 

As of December 31, 2003 and in accordance with the transition requirements of FIN 46-R, the company chose to apply the guidance of FIN 46 to all of its interests in special-purpose entities (SPEs) as defined within FIN 46-R and all non-SPE VIEs that were created after January 31, 2003. Also in accordance with the transition provisions of FIN 46-R, the company adopted FIN 46-R for all VIEs and SPEs as of March 31, 2004. These new accounting pronouncements did not have a material impact on the company’s Consolidated Financial Statements.

 

5.               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 tables provide the total retirement-related benefit plans’ impact on income before income taxes for the three- and six-months ended June 30, 2004.

 

7

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the three months ended June 30:
Retirement-related plans - cost/(income):
Defined benefit and contribution pension plans - cost/(income)		$	173		$	(12	)	nm	%	#
Nonpension postretirement benefits-cost		82			83			(1.2	)	$
Total		$	255		$	71		259.2	%	#

 

nm - not meaningful

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the six months ended June 30:
Retirement-related plans - cost:
Defined benefit and contribution pension plans - cost		$	372		$	24		nm	%	#
Nonpension postretirement benefits-cost		185			162			14.2		#
Total		$	557		$	186		199.5	%	#

 

nm - not meaningful

 

The following tables provides the components of the cost/(income) for the company’s pension plans for the three- and six-months ended June 30.

 

Cost/(Income) of Pension Plans

 

		U.S. Plans						Non-U.S. Plans
(Dollars in millions)		2004			2003			2004			2003
For the three months ended June 30:
Service cost		$	167		$	142		$	148		$	135
Interest cost		614			629			395			368
Expected return on plan assets		(900		)	(933		)	(578		)	(550		)
Amortization of transition assets		(18		)	(36		)	(3		)	(3		)
Amortization of prior service cost		16			16			3			3
Recognized actuarial losses		58			—			53			25
Net periodic pension (income)/cost—U.S. Plan and material non-U.S. Plans		(63		)*	(182		)*	18		**	(22		)**
Cost of other defined benefit plans		31			34			31			24
Total net periodic pension (income)/cost for all defined benefit plans		(32		)	(148		)	49			2
Cost of defined contribution plans		82			77			74			57
Total retirement plan cost/(income) recognized in the Consolidated Statement of Earnings		$	50		$	(71	)	$	123		$	59

 

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

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

 

8

 

 

		U.S. Plans						Non-U.S. Plans
(Dollars in millions)		2004			2003			2004			2003
For the six months ended June 30:
Service cost		$	327		$	288		$	301		$	265
Interest cost		1,226			1,259			801			724
Expected return on plan assets		(1,804		)	(1,852		)	(1,173		)	(1,086		)
Amortization of transition assets		(36		)	(72		)	(5		)	(7		)
Amortization of prior service cost		31			31			12			9
Recognized actuarial losses		111			—			102			48
Net periodic pension (income)/cost—U.S. Plan and material non-U.S. Plans		(145		)*	(346		)*	38		**	(47		)**
Cost of other defined benefit plans		65			67			65			46
Total net periodic pension (income)/cost for all defined benefit plans		(80		)	(279		)	103			(1		)
Cost of defined contribution plans		183			184			166			120
Total retirement plan cost/(income) recognized in the Consolidated Statement of Earnings		$	103		$	(95	)	$	269		$	119

 

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

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

 

In 2004, the company expects to contribute to its material non-U.S. Defined Benefit Plans an amount of between $700 million and $850 million. The legally mandated minimum contribution included in the amount above for the company’s non-U.S. Plans is expected to be approximately $280 million. In the first six months of 2004, the company contributed approximately $500 million to its non-U.S. Plans.

 

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

 

Cost/(Income) of Nonpension Post-retirement Benefits

 

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions)		2004			2003			2004			2003
Service cost		$	10		$	8		$	20		$	18
Interest cost		81			96			169			191
Amortization of prior service cost		(15		)	(31		)	(31		)	(65		)
Recognized actuarial (gains)/losses		(3		)	2			6			3
Net periodic post-retirement benefit cost - U.S. Plan		73			75			164			147
Cost of non-U.S. Plans		9			8			21			15
Total nonpension postretirement plan cost recognized in the Consolidated Statement of Earnings		$	82		$	83		$	185		$	162

 

9

 

Recently Enacted Legislation

 

The Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act) was signed into law on December 8, 2003. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a prescription drug benefit that is at least actuarially equivalent to Medicare Part D.

 

The method of determining whether a sponsor’s plan will qualify for actuarial equivalency is pending until the U.S. Department of Health and Human Services (HHS) completes its interpretative work on the Act. Based on the current interpretation of the guidance provided in the Act and in relation to the company’s current plan design, any savings to the company are expected to be immaterial.

 

FASB Staff Position No. Financial Accounting Standard 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”, issued in the second quarter of 2004, provides guidance on the accounting for the effects of the Act, including the accounting for and disclosure of any federal subsidy provided by the Act.

 

The enactment of the Act was not a “significant event” as defined by paragraph 73 of SFAS No. 106 “Employers’ Accounting for Postretirement Benefits Other than Pensions” for the company’s nonpension postretirement benefit plans (the Plans) and therefore, the company did not remeasure plan assets and obligations. As discussed above, any federal subsidy related to prescription drug benefits provided under the Plans is expected to be immaterial, based on the current interpretation of the Act. As a result, the company’s accumulated pension benefit obligations as of June 30, 2004 and the net periodic post-retirement benefit costs for the six months ended June 30, 2004 were not impacted by the Act. The company will be required to reflect any changes to participation rates and other healthcare cost assumptions, as a result of the Act, at the company’s next measurement date. The impact of any such change is not expected to have a material impact on the company’ s Consolidated Financial Statements.

 

6.               The changes in the carrying amount of goodwill, by external reporting segment, for the six months ended June 30, 2004, are as follows:

 

(Dollars in millions)		Balance 12/31/03			Goodwill Additions			Purchase Price Adjustments			Divestitures			Foreign Currency Translation Adjustments			Balance 6/30/04
Segment
Global Services		$	4,184		$	349		$	(14	)	$	(2	)	$	(74	)	$	4,443
Systems and Technology Group		161			—			—			—			—			161
Personal Systems Group		71			—			(1		)	—			—			70
Software		2,505			417			(110		)	—			(3		)	2,809
Global Financing		—			—			—			—			—			—
Enterprise Investments		—			—			—			—			—			—
Total		$	6,921		$	766		$	(125	)	$	(2	)	$	(77	)	$	7,483

 

10

 

There were no goodwill impairment losses recorded during the quarter.

 

The following schedule details the company’s intangible asset balances by major asset class:

 

		At June 30, 2004
(Dollars in millions)		Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount
Intangible asset class
Client-related		$	809		$	(323	)	$	4 86
Completed technology		469			(291		)	178
Strategic alliances		118			(50		)	68
Patents/Trademarks		104			(76		)	28
Other(a)		176			(57		)	119
Total		$	1,676		$	(797	)	$	879	(b)

 

		At December 31, 2003
(Dollars in millions)		Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount
Intangible asset class
Client-related		$	704		$	(254	)	$	450
Completed technology		448			(228		)	220
Strategic alliances		118			(38		)	80
Patents/Trademarks		98			(66		)	32
Other(a)		165			(37		)	128
Total		$	1,533		$	(623	)	$	910	(b)

 

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

 

(b) The $879 million at June 30, 2004, comprises $307 million recorded as current assets and $572 million recorded as non-current assets. The $910 million at December 31, 2003, comprises $336 million as current assets and $574 million as non-current assets.

 

The net carrying amount of intangible assets decreased $31 million during the first six months of 2004 due to amortization of existing intangible asset balances, partially offset by acquisitions. The aggregate intangible asset amortization expense was $96 million and $19 0 million for the second quarter and first six months of 2004, respectively, versus $78 million and $152 million for the second quarter and first six months of 2003, respectively.

 

The future 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 June 30, 2004:

 

2004 (for Q3-Q4)		$	167 million
2005		$	293 million
2006		$	173 million
2007		$	106 million
2008		$	70 million

 

11

 

7.               On June 7, 2004, the company purchased Candle Corporation (Candle) for $435 million. Candle helps customers develop, deploy and manage their enterprise infrastructure. The acquisition will provide the company’s clients with an enhanced set of software solutions for managing an on demand environment and complements the company’s middleware solutions. Candle was integrated into the Software segment upon acquisition.

 

The allocation of the purchase price for this acquisition as of June 30, 2004 is presented in the following table:

 

(Dollars in millions)		Amortization Life (yrs.)		Amount
Current assets				$	202
Fixed assets/non-current				82
Intangible assets:
Goodwill		N/A		256
Completed technology		3		23
Client relationships		5-7		65
Other identifiable intangible assets		5		6
Total assets acquired				634
Current liabilities				(119		)
Non-current liabilities				(80		)
Total liabilities assumed				(199		)
Total purchase price				$	435

 

The acquisition was accounted for as a purchase transaction, and accordingly, the assets and liabilities of the acquired entity were recorded at their estimated fair values at the date of the acquisition. The primary items that generated the goodwill are the value of the synergies between Candle and IBM and the acquired assembled workforce, neither of which qualify as an amortizable intangible asset. None of the goodwill is deductible for tax purposes. The overall weighted-average life of the identified amortizable intangible assets acquired in the purchase of Candle is 5.8 years. With the exception of goodwill, these identified intangible assets will be amortized on a straight-line basis over their useful lives. Goodwill of $256 million has been assigned to the Software segment.

 

8.               The tables on pages 65 to 68 of this Form 10-Q reflect the results of the company’s segments consistent with its management system used by the company’s chief operating decision maker. These results are not necessarily a depiction that is in conformity with generally accepted accounting principles (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. A different result could occur for any segment if actuarial assumptions unique to each segment 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.

 

Over recent years, the company has been developing and enhancing a “one team” approach to the collaboration between the Systems Group and Technology Group. This relationship is

 

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crucial given that the core technology of the Systems Group products is a key competitive differentiator for the company. The degree of this collaboration has increased whereby in 2004, the company is managing these groups as one. Accordingly, in the first quarter of 2004, the company combined the two segments into one reporting segment. The new Systems and Technology Group segment will generate one consolidated set of financial results, which senior management will use for joint strategy, budgets, and resource allocation decisions, as well as performance and compensation scoring. The tables on pages 65 to 68 have been reclassified to reflect this change. The company filed a Form 8-K, with the Securities and Exchange Commission (SEC), on April 16, 2004, disclosing the 2003 and 2002 quarterly and full year Technology Group and Systems Group segments results reclassified to conform with the one reporting segment in Attachment V of the Form 8-K. In addition, the company filed a Form 8-K with the SEC on June 18, 2004 that discloses the company’s financial results from 2003, 2002 and 2001 reclassified to conform with the one reporting segment for the Systems and Technology Group.

 

9.               The following table provides the liability balances for actions taken in the second-quarter of 2002 associated with Microelectronics Division and the rebalancing of both the company’s workforce and leased space resources, fourth-quarter 2002 actions associated with the acquisition of PricewaterhouseCoopers consulting business, 2002 actions associated with the hard disk drive (HDD) business for reductions in workforce, manufacturing capacity and space, actions in 1999, and actions that took place through 1993.

 

(Dollars in millions)		Liability as of 12/31/2003			Payments			Other Adj.*			Liability as of 6/30/2004
Current:
Workforce		$	222		$	150		$	47		$	119
Space		129			58			37			108
Other		39			26			—			13
Total		$	390		$	234		$	84		$	240
Non-current:
Workforce		$	587		$	—		$	(54	)	$	533
Space		282			—			(28		)	254
Other		2			—			(2		)	—
Total		$	871		$	—		$	(84	)	$	787

 

* The other adjustments column in the table above includes the reclassification of non-current to current as well as foreign currency translation adjustments. In addition, net adjustments to increase previously recorded liabilities for changes in the estimated cost of vacant space for the 2002 actions ($30 million), offset by reductions in previously recorded liabilities for the HDD-related restructuring in 2002 ($4 million) and actions through 1993 ($19 million) were recorded during the six month period ended June 30, 2004. Of the $7 million of net adjustments, a $4 million credit was included in Discontinued Operations (for the HDD-related restructuring actions) and $11 million of charges were included in Other (income) and expense in the Consolidated Statement of Earnings. Additionally, adjustments for $7 million were made to Goodwill during the six months ended June 30, 2004, to decrease previously recorded liabilities for changes to estimated vacant space and workforce reserves.

 

10.         The company is involved in a variety of claims, 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, securities, and environmental

 

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

 

On July 31, 2003, the U.S. District Court for the Southern District of Illinois, in Cooper et al. vs. The IBM Personal Pension Plan and IBM Corporation, held that IBM’s pension plan violated the age discrimination provisions of the Employee Retirement Income Security Act of 1974 (ERISA). The plaintiffs filed a claim for remedial relief. IBM filed its own brief on remedies, arguing that the remedies requested by the plaintiffs were unsupportable factually and as a matter of law and estimating that remedies under the plaintiff’s theories, which increase over time, could amount to at least $6.5 billion, as of the date of the trial District Court’s decision on liability. The company intends to appeal the District Court’s rulings when the remedies phase concludes. The company believes it is likely to be successful on appeal with respect to the claims that have been decided by the District Court. Given IBM’s belief in the merit of its defenses and the wide range of possible remedies, no provision has been recorded under SFAS No. 5, “Accounting for Contingencies” at this time. The company will review whether a provision is appropriate under SFAS No. 5 upon conclusion of the remedies phase.

 

The company is a defendant and/or third-party defendant in a number of cases in which claims have been brought by current and former employees, independent contractors, estate representatives, offspring and relatives of employees seeking damages for wrongful death and personal injuries allegedly caused by exposure to chemicals in various of the company’s facilities from 1964 to the present.

 

The company is the defendant in an action brought by Compuware in the District Court for the Eastern District of Michigan in 2002, asserting causes of action for copyright infringement, trade secret misappropriation, Sherman Act and Lanham Act violations, breach of contract, tortious interference and unfair competition under various state statutes. IBM asserted counterclaims for copyright infringement, patent infringement and Lanham Act violations in the Michigan action. In December 2003, the court denied Compuware’s attempt to obtain a preliminary injunction. IBM has also asserted patent infringement claims against Compuware in a separate action that IBM brought in the District Court for the Southern District of New York in January 2004. The Court will hear motions in the Michigan case in September 2004. Trial in the Michigan action on all claims other than IBM’s patent infringement counterclaims is scheduled to begin in November 2004.

 

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. The company removed the case to Federal Court in Utah. Plaintiff is successor in interest to some of AT&T’s Unix IP rights, and alleges misappropriation of trade secrets, unfair competition, interference with contract and breach of contract with regard to the company’s contribution of unspecified 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, patent infringement, promissory estoppel and copyright infringement. Trial is scheduled for April, 2005.

 

On June 2, 2003 the company announced that it received notice of a formal, nonpublic investigation by the Securities and Exchange Commission (SEC). The SEC is seeking

 

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information relating to revenue recognition in 2000 and 2001 primarily concerning certain types of client transactions. IBM believes that the investigation arises from a separate investigation by the SEC of Dollar General Corporation, a client of IBM’s Retail Stores Solutions unit, which markets and sells point of sale products.

 

On January 8, 2004, IBM announced that it received a “Wells Notice” from the staff of the SEC in connection with the staff’s investigation of Dollar General Corporation, which as noted above, is a client of IBM’s Retail Stores Solutions unit. It is IBM’s understanding that an employee in IBM’s Sales & Distribution unit also received a Wells Notice from the SEC in connection with this matter. The Wells Notice notifies IBM that the SEC staff is considering recommending that the SEC bring a civil action against IBM for possible violations of the U.S. securities laws relating to Dollar General’s accounting for a specific transaction, by participating in and aiding and abetting Dollar General’s misstatement of its 2000 results. In that transaction, IBM paid Dollar General $11 million for certain used equipment as part of a sale of IBM replacement equipment in Dollar General’s 2000 fourth fiscal quarter. Under the SEC’s procedures, IBM responded to the SEC staff regarding whether any action should be brought against IBM by the SEC. The separate SEC investigation noted above, relating to the recognition of revenue by IBM in 2000 and 2001 primarily concerning certain types of client transactions, is not the subject of this Wells Notice.

 

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) 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. 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. In addition, the U.S. Department of Justice and the SEC have both contacted the company in connection with this matter.

 

In accordance with 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 reasonably be estimated. Any provisions are reviewed at least quarterly and are adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information pertinent to a particular matter. Any recorded liabilities for the above items, including any changes to such liabilities during each of the three years in the period ended December 31, 2003 and for the three months and six months ended June 30, 2004, were not material to the Consolidated Financial Statements. Based on its experience, the company believes that the damage amounts claimed in the matters referred to above are not a meaningful indicator of the company’s potential liability.

 

Litigation is inherently uncertain and it is not possible to predict the ultimate outcome of the matters discussed above. 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 flow will depend on a number of variables,

 

15

 

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 IBM’s Consolidated Financial Statements, and the unique facts and circumstances of the particular matter which may give rise to additional factors, such as, among other things, in the Cooper case referred to on page 14, the amount of any additional obligations that may be imposed on the pension plan by the remedies finally determined, whether such additional obligations would require additional contributions by the company and the size of any such additional contributions.

 

11.         The company’s extended lines of credit include unused amounts of $2,688 million and $2,208 million at June 30, 2004 and December 31, 2003, respectively. A portion of these amounts was available to the company’s business partners to support their working capital needs. In addition, the company committed to provide future financing to its customers in connection with customer purchase agreements for approximately $780 million and $458 million at June 30, 2004 and December 31, 2003, 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, “Accounting for Contingencies”, 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 IP rights, specified environmental matters, and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making an adverse 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 did not have a material effect on the company’s business, financial condition or results of operations. The company believes that if it were to incur a loss in any of these matters, such loss should not have 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 $72 million and $74 million at June 30, 2004 and December 31, 2003, respectively. These amounts include a limited

 

16

 

guarantee of $9 million and $14 million associated with the company’s loans receivable securitization program at June 30, 2004 and December 31, 2003, respectively.

 

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

 

(Dollars in millions)		2004			2003
Balance at January 1		$	780		$	614
Current period accruals		406			381
Accrual adjustments to reflect actual experience		55			40
Charges incurred		(400		)	(396		)
Balance at June 30		$	841		$	639

 

12.         On May 27, 2004, IBM completed the renegotiation of a new $10 billion 5-year Credit Agreement with JPMorgan Chase Bank, as Administrative Agent, and Citibank, N.A., as Syndication Agent, replacing credit agreements of $8 billion (5-year) and $2 billion (364 day). The text of the Credit Agreement is set forth in its entirety as Exhibit 10 hereto.

 

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004*

 

Snapshot

 

(Dollars in millions except per share amounts)		2004			2003			Yr. To Yr. Percent/ Margin Change
Three months ended June 30:
Revenue		$	23,153		$	21,631		7.0	%**	#
Gross profit margin		36.8		%	37.0		%	(0.2	)pts.	$
Total expense and other income		$	5,682		$	5,532		2.7	%	#
Total expense and other income to revenue ratio		24.5		%	25.6		%	(1.1	)pts.	$
Provision for income taxes		$	853		$	741		15.3	%	#
Income from continuing operations		$	1,990		$	1,725		15.3	%	#
Earnings per share from continuing operations:
Assuming dilution		$	1.16		$	0.98		18.4	%	#
Basic		$	1.18		$	1.00		18.0	%	#
Weighted average shares outstanding:
Assuming dilution		1,713.4			1,763.7			(2.9	)%	$
Basic		1,679.6			1,729.8			(2.9	)%	$

 

*The following Results of Continuing Operations discussion does not include the HDD business that the company sold to Hitachi, Ltd. on December 31, 2002. The HDD business was accounted for as a discontinued operation under generally accepted accounting principles. Loss from Discontinued Operations for the three-months ended June 30, 2004 and 2003 were $2 million and $20 million, respectively. Loss from Discontinued Operations for the six-months ended June 30, 2004 and 2003 were $3 million and 23 million, respectively.

 

The selected reference to “adjusting for currency” in the Management Discussion is made so that the financial results can be viewed without the impacts of changing foreign currency exchange rates and therefore facilitates a comparative view of business growth. In the second quarter of 2004 the U.S. dollar was generally weaker against other currencies compared to the second quarter of 2003, so growth rates that are adjusted for currency exchange rates were lower than growth at actual currency exchange rates.

 

** 3.5 percent adjusting for currency

 

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(Dollars in millions except per share amounts)		2004			2003			Yr. To Yr. Percent/ Margin Change
Six months ended June 30:
Revenue		$	45,403		$	41,696		8.9	%**	#
Gross profit margin		36.4		%	36.5		%	(0.1	)pts.	$
Total expense and other income		$	11,401		$	10,784		5.7	%	#
Total expense and other income to revenue ratio		25.1		%	25.9		%	(0.8	)pts.	$
Provision for income taxes		$	1,540		$	1,335		15.4	%	#
Income from continuing operations		$	3,593		$	3,112		15.4	%	#
Earnings per share from continuing operations:
Assuming dilution		$	2.09		$	1.77		18.1	%	#
Basic		$	2.13		$	1.80		18.3	%	#
Weighted average shares outstanding:
Assuming dilution		1,721.7			1,761.1			(2.2	)%	$
Basic		1,685.6			1,727.6			(2.4	)%	$

 

		6/30/04			12/31/03
Assets		$	99,582		$	104,457		(4.7	)%	$
Liabilities		$	70,752		$	76,593		(7.6	)%	$
Equity		$	28,830		$	27,864		3.5	%	#

 

** 3.4 percent adjusting for currency

 

The increase in IBM’s second quarter and first half of 2004 Income from continuing operations and diluted earnings per share from continuing operations compared to the second quarter and first half of 2003, respectively, was due to:

 

•                  Stronger demand associated with the improving economy and continued market share gains for server products

•                  The sale of several PowerPC designs to Applied Micro Circuits Corporation (AMCC)

•                  Favorable impact of currency translation

 

The increase in IBM’s second quarter and first half of 2004 revenue compared to the second quarter and first half of 2003 was due to:

 

•                  Stronger demand associated with the improving economy and continued market share gains for server products

•                  Favorable impact from currency translation

 

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The second quarter of 2004 and, in part, the first six months of 2004, business environment enabled the company’s on demand business model to deliver solid results. The market presented the company with many strong opportunities, most notably in zSeries, the Financial Services and Industrial sectors, new and emerging areas, the Asia Pacific geography, and services. There were also a few challenges such as software, and iSeries and pSeries product transitions. The company’s ability to capitalize on these opportunities and respond to these challenges with flexible resources, variable cost structures, and forward-looking insight are reflected in the solid overall revenue results.

 

The gross profit margin was 36.8 percent in the second quarter of 2004 versus 37.0 percent in the second quarter of 2003. Global Services margin declined but improved sequentially from the first quarter. This improvement is reflected in all services lines of business due to the company’s targeted actions in this area. Increases in hardware margins were primarily due to improved yield and volume performance in the Microelectronics business and the impact of certain hedging transactions (see Anticipated Royalties and Cost Transactions on page 97 of the 2003 Annual Report) partially offset by the impact of higher component costs for personal computers. The company’s total gross profit margin was 36.4 percent for the first six months of 2004 versus 36.5 percent for the first six months of 2003.

 

In the second quarter and first half of 2004, total expense and other income increased over the year-earlier period, primarily due to increased expense for research, development and engineering, retirement-related plans and unfavorable currency translation. These increases were partially offset by higher IP income and gains from the sale of various assets. Overall, the Total expense and other income-to-revenue ratio declined.

 

The effective tax rate for the second quarter of 2004 and 2003, and the first six months of 2004 and 2003 was 30.0 percent.

 

With regard to total Assets, the decline of approximately $4.9 billion from December 31, 2003 to June 30, 2004 was primarily due to the decrease in short-term and long-term financing receivables.

 

Global Services signings were $10.1 billion in the second quarter of 2004 as compared to $10.7 billion for the three months ended June 30, 2003. The estimated Global Services backlog including SO, Business Consulting Services (BCS), Integrated Technology Services (ITS) and Maintenance was estimated at $118 billion at June 30, 2004.

 

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Quarter and First-Half in Review

 

Results of Continuing Operations

 

Revenue

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change				Yr. to Yr. Percent Change Adjusting for Currency
For the three months ended June 30:
Statement of Earnings Revenue Presentation:
Global Services		$	11,327		$	10,635		6.5	%	#		2.4	%	#
Hardware		7,423			6,613			12.3		#		9.6		#
Software		3,458			3,471			(0.4	)	$		(4.0	)	$
Global Financing		651			672			(3.2	)	$		(6.0	)	$
Enterprise Investments/Other		294			240			22.6		#		19.1		#
Total		$	23,153		$	21,631		7.0	%	#		3.5	%	#

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change				Yr. to Yr. Percent Change Adjusting for Currency
For the six months ended June 30:
Statement of Earnings Revenue Presentation:
Global Services		$	22,426		$	20,804		7.8	%	#		1.7	%	#
Hardware		14,158			12,421			14.0		#		9.7		#
Software		6,924			6,600			4.9		#		(0.9	)	$
Global Financing		1,313			1,377			(4.6	)	$		(9.2	)	$
Enterprise Investments/Other		582			494			17.7		#		12.3		#
Total		$	45,403		$	41,696		8.9	%	#		3.4	%	#

 

21

 

(Dollars in millions)		2004			2003*			Yr. to Yr. Percent Change				Yr. to Yr. Percent Change Adjusting for Currency
For the three months ended June 30:
Industry Sector**:
Financial Services		$	5,964		$	5,317		12.2	%	#		8.0	%	#
Public		3,448			3,453			(0.2	)	$		(2.8	)	$
Industrial		3,039			2,807			8.3		#		4.2		#
Distribution		2,060			1,967			4.8		#		1.7		#
Communications		2,113			2,025			4.3		#		1.2		#
Small & Medium		5,124			4,801			6.7		#		2.8		#
OEM		701			588			19.3		#		19.1		#
Other		704			673			4.6		#		4.6		#
Total		$	23,153		$	21,631		7.0	%	#		3.5	%	#

 

(Dollars in millions)		2004			2003*			Yr. To Yr Percent Change				Yr. to Yr. Percent Change Adjusting for Currency
For the six months ended June 30:
Industry Sector**:
Financial Services		$	11,468		$	10,180		12.7	%	#		6.4	%	#
Public		6,684			6,515			2.6		#		(1.9	)	$
Industrial		6,076			5,493			10.6		#		4.5		#
Distribution		4,151			3,887			6.8		#		1.9		#
Communications		4,181			3,862			8.3		#		3.2		#
Small & Medium		10,016			9,061			10.5		#		4.5		#
OEM		1,372			1,278			7.4		#		7.2		#
Other		1,455			1,420			2.5		#		2.5		#
Total		$	45,403		$	41,696		8.9	%	#		3.4	%	#

 

* Reclassified to conform with 2004 presentation.

 

** The majority of the company’s enterprise business, which excludes the company’s original equipment manufacturer (OEM) technology business, occurs in industries that are broadly grouped into six sectors around which the company’s sales and distribution activities, as well as an increasing number of its services and products businesses are organized. The majority of the businesses in the Small & Medium category have fewer than 1,000 employees.

 

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(Dollars in millions)		2004			2003			Yr.to Yr. Percent Change				Yr. To Yr. Percent Change Adjusting for Currency
For the three months ended June 30:
Geographies:
Americas		$	9,728		$	9,525		2.1	%	#		2.1	%	#
Europe/Middle East/Africa		7,523			6,902			9.0		#		2.3		#
Asia Pacific		5,201			4,616			12.7		#		6.2		#
OEM		701			588			19.3		#		19.1		#
Total		$	23,153		$	21,631		7.0	%	#		3.5	%	#

 

(Dollars in millions)		2004			2003			Yr.to Yr. Percent Change				Yr. To Yr. Percent Change Adjusting for Currency
For the six months ended June 30:
Geographies:
Americas		$	18,825		$	18,100		4.0	%	#		3.1	%	#
Europe/Middle East/Africa		14,774			13,208			11.9		#		1.5		#
Asia Pacific		10,432			9,110			14.5		#		6.3		#
OEM		1,372			1,278			7.4		#		7.2		#
Total		$	45,403		$	41,696		8.9	%	#		3.4	%	#

 

Revenue from all industry sectors, except the Public sector in the second quarter of 2004, increased in the second quarter and first six months of 2004 when compared to the same periods of 2003 on an as-reported basis, reflecting the company’s go-to-market strategy of designing industry-specific solutions. The Financial Services sector growth was led by banking customers across all three geographies. The Industrial sector was led by growth in Automotive and Electronics, while spending in the Small & Medium businesses increased in all geographies, led by Asia. The Communications sector growth was driven by Telecom customers in the Americas. The decline in the Public sector revenue was primarily due to lower revenue in the Education area.

 

Revenue for the second quarter and first six months of 2004 increased across all geographies when compared to the second quarter and first six months of 2003. Revenue increases in the Americas were across all three of the major regions, with the strongest growth coming from Latin America, notably Brazil. Asia Pacific had the strongest revenue growth, led by China and India, while Japan, which is about 60 percent of Asia Pacific’s revenue, also achieved growth. Europe had mixed performance with growth in France and Spain. Eastern Europe had strong revenue growth. Collectively and as a result of the company’s targeted investments, the emerging countries of China, Russia, India and Brazil had revenue growth of 35 percent to generate approximately $1.9 billion of first half 2004 revenue.

 

OEM revenue increased in the second quarter and first six months of 2004 versus the same periods in 2003 due to second quarter 2004 growth in the Microelectronics business reflecting

 

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operational improvement. Continued strong growth in the company’s Engineering and Technology Services business also contributed to OEM revenue growth.

 

Global Services revenue increased in the second quarter of 2004 versus the second quarter of 2003 as SO continued its steady growth. BCS, ITS and Maintenance revenue increased due to the favorable impact of currency movements. The amount of contract rescopings declined cumulatively over the last several quarters and progress was made in the company’s relatively new Business Process Transformational Services area (see pages 41 and 42).

 

Revenue was very strong for Hardware in the second quarter and first six months of 2004 compared to the same periods in 2003. Systems and Technology Group continued the strong performance in zSeries servers driven by new workloads to the mainframes as clients build their on-demand infrastructures, as well as xSeries servers across the product line. iSeries and pSeries server revenue declined in 2004 primarily due to product transitions that impacted the sale of predecessor products. Storage Systems revenue increased due to greater demand for external midrange disk and tape products. Microelectronics revenue increased in the second quarter of 2004 versus the second quarter of 2003 due primarily to improved yields and increased output in the 300 millimeter factory. Demand for the company’s Engineering and Technology business continues to be strong. Microelectronics revenue declined for the first half of 2004 versus the first half of 2003 due primarily to lo wer demand (from certain customers) in the first quarter of 2004 as compared to the first quarter of 2003.

 

Personal Systems Group revenue increased in the second quarter and first six months of 2004 versus the same periods last year, driven by strong performance world wide by the company’s ThinkPad laptop computers. Retail Stores Solutions also delivered revenue growth in the second quarter and first six months of 2004 due to continued demand for its products as well as the acquisition of Productivity Solutions Inc. in November 2003.

 

Software revenue was essentially flat in the second quarter of 2004 versus the second quarter of 2003 as clients scrutinized their second quarter software spending and deferred purchasing decisions in the last week of the quarter. This was coupled with fewer large transactions in the quarter. Software revenue increased in the first six months of 2004 versus the first six months of 2003 primarily due to the favorable impacts of currency movements.

 

Global Financing revenue declined in the second quarter and first six months of 2004 versus the same periods in 2003 primarily due to a lower income-generating asset base in 2004 and lower used equipment sales. See pages 46 to 53 for additional information regarding Global Financing results.

 

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The following table presents each segment’s revenue as a percentage of the company’s total:

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2004		2003		2004		2003
Global Services		48.9	%	49.2	%	49.4	%	49.9	%
Hardware		32.1		30.6		31.2		29.8
Software		14.9		16.0		15.3		15.8
Global Financing		2.8		3.1		2.9		3.3
Enterprise Investments/Other		1.3		1.1		1.2		1.2
Total		100.0	%	100.0	%	100.0	%	100.0	%

 

Gross Profit

 

For the three months ended June 30:		2004		2003		Yr. To Yr. Change
Gross Profit Margin:
Global Services		25.2	%	25.9	%	(0.7	)pts.	$
Hardware		29.2		26.9		2.3		#
Software		86.3		86.2		0.1		#
Global Financing		59.4		54.6		4.8		#
Enterprise Investments/Other		46.4		41.9		4.5		#
Total		36.8	%	37.0	%	(0.2	)pts.	$

 

For the six months ended June 30:		2004		2003		Yr. To Yr. Change
Gross Profit Margin:
Global Services		24.8	%	25.4	%	(0.6	)pts.	$
Hardware		28.0		26.8		1.2		#
Software		86.2		85.4		0.8		#
Global Financing		60.0		56.8		3.2		#
Enterprise Investments/Other		43.0		39.2		3.8		#
Total		36.4	%	36.5	%	(0.1	)pts.	$

 

The declinein Global Services gross profit margin was due to continued investment in on demand infrastructure and business transformation capabilities including transition costs during the early stages of an SO contract. Increases in hardware margins were primarily due to yield improvements in the Microelectronics business resulting in increased volumes and the impact of certain hedging transactions (see Anticipated Royalties and Cost Transactions on page 97 of the 2003 Annual Report) partially offset by the impact of higher component costs for personal computers. The increase in Global Financing gross profit margin was driven by higher financing margin due to lower borrowing costs.

 

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Expense

 

The Total expense and other income expense-to-revenue ratio declined 1.1 points and 0.8 points to 24.5 percent and 25.1 percent in the second quarter and first half of 2004, respectively, versus the same periods of 2003. The decline in the expense-to-revenue ratio was primarily due to the 7.0 percent and 8.9 percent increase in revenue in 2004 versus 2003, respectively. For additional information regarding Total expense and other income, see the following analyses by category.

 

Selling, general and administrative expense

 

(Dollars in millions)		2004			2003			Yr. To Yr. Percent Change
For the three months ended June 30:
Selling, general and administrative expense:
Selling, general and administrative - base		$	4,196		$	3,881		8.1	%	#
Advertising		319			369			(13.7	)	$
Workforce reductions - ongoing		67			154			(56.5	)	$
Bad debt expense		50			56			(11.0	)	$
Total		$	4,632		$	4,460		3.9	%	#

 

(Dollars in millions)		2004			2003			Yr. To Yr. Percent Change
For the six months ended June 30:
Selling, general and administrative expense:
Selling, general and administrative - base		$	8,219		$	7,628		7.8	%	#
Advertising		614			678			(9.5	)	$
Workforce reductions - ongoing		230			233			(1.3	)	$
Bad debt expense		53			136			(61.0	)	$
Total		$	9,116		$	8,675		5.1	%	#

 

Total Selling, general and administrative (SG&A) expense increased 3.9 percent (1 percent adjusting for currency) and 5.1 percent (1 percent adjusting for currency), respectively, in the second quarter and first six months of 2004 versus the same periods in 2003. The increase in the second quarter and first six months of 2004 was primarily due to increased expense for retirement-related plans and unfavorable currency translation. These increases were partially offset by lower workforce reductions, lower advertising expense and lower bad debt expense. Bad debt expense declined primarily due to lower reserve requirements associated with the improvement in the economic conditions and improved credit quality, as well as the lower asset base of the Global Financing receivable portfolio (see page 50) during the first half of 2004 as compared to the same period in 2003. See pages 29 and 30 for further information on retirement-related plans.

 

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Other (income) and expense

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the three months ended June 30:
Other (income) and expense:
Foreign currency transaction losses		$	96		$	52		85.9	%	#
Interest income		(41		)	(38		)	6.2		#
Net gains from securities and investment assets		(6		)	(1		)	nm		nm
Net realized gains from certain real estate activities		(40		)	(1		)	nm		nm
Other		14			(8		)	nm		nm
Total		$	23		$	4		451.2	%	#

 

nm - - not meaningful

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the six months ended June 30:
Other (income) and expense:
Foreign currency transaction losses		$	208		$	157		32.7	%	#
Interest income		(80		)	(80		)	(1.1	)	$
Net (gains)/losses from securities and investment assets		(10		)	4			nm		nm
Net realized (gains)/losses from certain real estate activities		(44		)	13			nm		nm
Other		(38		)	(6		)	nm		nm
Total		$	36		$	88		(58.5	)%	$

 

nm - - not meaningful

 

Other (income) and expense increased 451.2 percent in the second quarter 2004 versus the second quarter of 2003. Foreign currency transaction losses increased as the dollar weakened against other currencies and increased expense associated with ongoing space and capacity actions. These increases were partially offset by gains from various asset sales including certain real estate activities.

 

Other (income) and expense decreased 58.5 percent in the first six months of 2004 versus the first six months of 2003. The decrease was primarily driven by gains from various asset sales, partially offset by higher foreign currency transaction losses and increased expense associated with ongoing space and capacity actions.

 

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Research, Development and Engineering

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the three months ended June 30:
Research, development and engineering:
Total		$	1,426		$	1,226		16.3	%	#

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the six months ended June 30:
Research, development and engineering:
Total		$	2,793		$	2,421		15.4	%	#

 

Research, development and engineering expense increased in the second quarter and first six months of 2004 versus the same periods in 2003 primarily due to increased spending in Systems and Technology Group for Microelectronics and server products as well as increased spending in Software related to acquisitions.

 

Intellectual Property and Custom Development Income

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the three months ended June 30:
Intellectual Property and Custom Development Income:
Sales and other transfers of intellectual property		$	253		$	68		272.1	%	#
Licensing/royalty-based fees		98			69			42.0		#
Custom development income		81			62			30.6		#
Total		$	432		$	199		117.3	%	#

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the six months ended June 30:
Intellectual Property and Custom Development Income:
Sales and other transfers of intellectual property		$	275		$	214		28.5	%	#
Licensing/royalty-based fees		188			138			36.2		#
Custom development income		149			129			15.5		#
Total		$	612		$	481		27.2	%	#

 

Sales and other transfers of intellectual property increased in the second quarter and first six months of 2004 versus the second quarter and first six months of 2003, primarily due to AMCC’s acquisition of the company’s IP associated with its embedded PowerPC 4xx standard processor products for $208 million in the second quarter of 2004. The timing and amount of Sales and other transfers of IP may vary significantly from period to period depending upon the timing of

 

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divestitures, economic conditions, industry consolidation and the timing of new patents and know-how development.

 

Interest Expense

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the three months ended June 30:
Interest expense:
Total		$	33		$	41		(20.8	)%	$

 

(Dollars in millions)		2004			2003			Yr. to Yr. Percent Change
For the six months ended June 30:
Interest expense:
Total		$	68		$	81		(16.7	)%	$

 

The decline in Interest expense was primarily due to lower average non-Global Financing debt and lower effective interest rates in the second quarter and first six months of 2004, compared with the same periods of 2003.

 

Interest expense is presented as part of Cost of Global Financing in the Consolidated Statement of Earnings only if the related external borrowings are to support the Global Financing external business. See pages 51 and 52 for additional information regarding Global Financing debt and interest expense.

 

Retirement-Related Benefits

 

The following table provides the total pre-tax cost for all retirement-related plans. Cost amounts are included as an addition to the company’s cost and expense amounts in the Consolidated Statement of Earnings within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the individuals participating in the plans.

 

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